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Summary

  • Most of the articles about stocks are about buy or sell recommendations or about previous investment successes. Seldom investors focus on debugging their mistakes in order to avoid them in.
  • Sometimes market multiples are misleading. Investors look at market multiples trying to identify bargains but end up owning depressed businesses.
  • In this article I will present my experience with Nokia stock. This investment led me to commit some mistakes with market multiples that I would like to share.

Introduction

I have read lots of texts exposing investment principles and exemplifying successful investment strategies. In this article I intend to do exactly the opposite, I will share my experience with one unsuccessful investment.

Value investors and growth investors are not so different as sometimes is suggested. Both groups are looking for the same thing in different places. I started by being a value investor apprentice and this comes with some pitfalls.

Usually, value investors look for financial ratios that indicate value metrics below the industry's average, which, at least in theory, means buying some assets below its true worth. However, most of the times, the investor ends up buying companies in a falling trend, that are not even close to start rebounding.

On the other hand, growth investors, for example in industrial companies, try to assess the production efficiency, the marketing ability and R&D efforts. After this, they also look at the management's ability to keep things going and finally they have in consideration the price to pay for all of this. Like the value investor, the growth investor is looking to buy assets below its true worth.

My experience tells me that valuation multiples should be the last thing to look at. Ratios like PER or PSR, are only going to tell us how much we are going to pay for each dollar of profits and sales. We might have a company trading at 8 times earnings, but what does that actually do for us? Is it worth only paying 8 times the shrinking earnings of a company with old production facilities, weak sales reach, alienated R&D department and negligent management team? I believe the answer is no!

In my early days I committed the mistake of making a choice between two companies based on market multiples. Since I believe that if you pay dearly for your mistakes, you should make those mistakes be worth their price. Here goes my lesson:

Nokia

Nokia (NYSE:NOK) had a huge success in the mobile phone market during the first decade of the century. In 2009, Nokia was the market leader for both mobile phones and smartphones. The company had leading manufacturing and logistics systems, excellent relations with the telecom operators and a huge commitment with R&D. The biggest problem facing Nokia was the introduction of the iPhone in 2007, which was eating the high-end of the phone market, traditionally a Nokia's stronghold. This had some negative impact in the company's margins, resulting in a stock price fall.

Basically, the iPhone brought two main problems for Nokia, the new trend for the touch screen form factor and the lack of software correctly designed to perform well in touch screens.

Graph 1 - Nokia's stock market performance since the introduction of the iPhone to the end of 2009

(click to enlarge)

My view, at the time, was that Nokia would be able to recover part of the high-end segment by just keeping pushing R&D and adapting to the new generalized trend. In my opinion, the company had almost everything in place to do it. The company only lacked a bit of software competences that I believed they could develop on time.

Nokia was developing a new operating system (OS) for smartphones based on Linux, which should be the foundation for future superphones. The first reviews of this OS were good (source: Engadget), and reinforced my conviction that the company was on the right track.

So if the company had everything it needed to be back to glory and the stock price was very attractive, what went wrong?

Basically the company's management was under enormous pressure to present results (source: microscope). Many products were being delayed to market, because of the underdeveloped software, which was worrying the board of directors. Then, in July 2010, the board of directors decided to fire the CEO Olli-Pekka Kallasvuo and bring in Stephen Elop, from Microsoft (NASDAQ:MSFT). At the time I thought that this could be a good move to improve the execution on the software side. I shouldn't have been so upbeat, changing the CEO in these circumstances is always a worrying sign.

Later, in February 2011, Nokia announced that was going to change its proprietary operating system to Microsoft's OS. At that time I came to the conclusion that after that change there was no hope left. With at least 12 months left to develop the first windows' smartphone, I got the feeling that the transition wouldn't be smooth, certainly leading to the decrease of both market share and profits. What never crossed my mind was the extent of market share loss experienced by Nokia.

With the passage from the in-house OS to the Microsoft's Windows Phone 7 (WP7), Nokia was exposing to the risk of deleveraging several competitive advantages. The company had economies of scale in the software development costs, by changing to a fixed fee model, these economies of scale disappeared. Nokia had great relationships with telecom operators, by partnering with Microsoft and by adding Skype to the default apps in Nokia's smartphones, the company compromised those relationships. The brand recognition suffered with the publication of the "Burning platform memo" which created distrust among the stakeholders.

Conclusion

I sold all my Nokia share's right after the Windows Phone announcement. My loss was small, but the cost of opportunity was much higher. I had compared Nokia against Apple (NASDAQ:AAPL), and although I found Apple a good investment, I thought Nokia had a better potential for stock price appreciation. I was so far off the truth back then! Apple was trading around $150 and in the way there were products like the iPad, the iPhone 4 and iPhone 4S. Basically I passed on the opportunity to buy an excellent company during one of the most successful innovating streams ever experienced by a technological company and I did this to invest in a troubled company with better value metrics. We can now say that the value metrics reflected the company's lack of proper management direction, which is never cheap enough!

However, my little cautionary tale should not be interpreted as a manifest against low market multiples in favor of high market multiples. Stock picking is always a matter of correctly assessing and weighting the several dimensions of a stock.

The "Burning platform memo" was sent to Nokia's employees a couple of days before the WP7 announcement. Its main idea was that the current software strategy was like a burning oil platform and the only way to survive was to jump into the water. This leaked memo is credited by having recreated an Osborn effect in Nokia's Sales, by retracting current potential customers from buying Nokia phones.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Lost Bets Chronicles: Nokia