Recently, we were asked by a few subscribers to explain why we believe that the markets of today are very similar to what they were in 1999 when the NASDAQ (NASDAQ:QQQ) bubble eventually crashed 75% and took some 15 years to recover from its lows. It is not a memory we want to remember but it is one we really should.
The dot-com bubble grew so large because of "irrational exuberance," according to then chairman Alan Greenspan of the Fed (Federal Reserve Bank). We are finding a growing number of companies that are being priced at astronomical valuations with no earnings again. Hope and emotional attachment are not great investing strategies. We think that consistently high FCF (free cash flow) and return on invested capital is a better gauge of the future prospects of a company.
There are many examples of stock with little or no free cash flow or profits that are rising to huge market capitalizations, but in this article, we will focus on just one of the Wall Street darlings we expect to fall back down to earth in the not-so-distant future. The stock we will be using as a perfect example is Shopify (NYSE:SHOP) (a Canadian company), which has experienced a stock price rise to the mesosphere (the layer above the stratosphere) recently.
Now, when you see such moves, it is something amazing to see (and equally gratifying when you own the stock). Unfortunately, when you dig a little deeper, it makes you not only want to hide under the bed with the cats, but also actually go out and build a bunker outside and bring the cats there with you. Why do we say that?
Are you ready? Drum roll please…
Yes, the company has experienced massive revenue gains; however, those gains were made by losing money. Even though we see "Total Cash from Operations" as a positive number, when you look at the carnage on the next three lines, you should "be afraid, be very afraid" (from the movie, The Fly).
You can't blame investors these days as "ignorance is bliss," and since ignorance is working like it did in 1999, the smart move (in the eyes of blissful investors) is to be ignorant. Just three weeks ago, the Ringling Bros., Barnum & Bailey Circus closed after 146 years of operation, and we are reminded of a famous quote that P.T. Barnum, the founder of the circus, once said:
"There is a Sucker Born Every Minute."
Well, underwriters on Wall Street understand this quote better than anyone. Just look what they did with Shopify.
The latest company information, including net asset values, performance, holding & sectors weighting, changes in voting rights, and directors and dealings.
There is so much demand for these shares that the company issued another $500 million in shares to meet it. This is what was happening in 1999 when stocks like Shopify (no earnings, no problem) were soaring to the moon.
This is all happening because of the Amazon (NASDAQ:AMZN) business model where Jeff Bezos, the modern day P.T. Barnum, has been performing his magic for years and just keeps increasing revenues by selling everything at cost or below cost. We provided this example of how he is doing it earlier this week.
I went to Barnes & Noble (NYSE:BKS) and saw a book that I wanted to buy for $35 and then I went to Amazon and saw it for $25 with free shipping. Now I worked in a bookstore in my youth and know that booksellers get a 40% discount from publishers. So the $35 book cost Barnes & Noble $21. It then has to pay employees and rent, etc. So Barnes at $35 probably ended up making $2 pure profit on the book. Amazon sells it at $25 and then covers the shipping cost which is $3.99. So Amazon made a $4 profit and then used that to pay for the shipping and ended up with a 1 penny profit. That went to employees and distribution centers, etc.… Amazon still booked the revenue, so it looks like it made money but it did not as Mr. Bezos tells investors that he invests everything back into the business to expand operations. Since Amazon keeps expanding into other markets, following the revenue growth model generated at cost or at a loss, there is a lot of room to keep going and companies like Shopify are trying to copy the model along with many internet startups like Uber (UBER).
"Uber's gross bookings for 2016 hit $20 billion, more than doubling from the year prior, according to financial figures the company provided to Bloomberg. Its net revenue, after drivers took their cut, totaled $6.5 billion for the year. But that rapid growth came at a cost. Uber says it lost $2.8 billion in 2016, excluding the China business it sold midway through the year. Uber's CEO had previously said it was losing $1 billion a year in China, prior to selling its China business to rival Didi Chuxing in August."
So, as you can see, UBER's $70 billion or so valuation is based off of massive losses, and as we saw in 2001-2003, after the dot-com boom and bust, that when reality eventually shows up, valuations also adjust and investors eventually lose their shirts. Those who survive for another day are those who invest in elite companies, with elite management at the helm, but that also generate tremendous free cash flow return on invested capital (FROIC), such as Apple (NASDAQ:AAPL), Accenture (NYSE:ACN) and Sherwin-Williams (NYSE:SHW) as examples of holdings in our model portfolios. These companies grow revenue, but only do so if certain profitability standards that each has priced into its business model can be met.
In 1998, Nokia (NYSE:NOK) was the king of the cellphone market and actually came out with the first smartphone way before Steve Jobs did. The mistake that Nokia management made was to get in a price war with Asian knockoffs and in doing so ended up destroying its cell phone business, which was sold to Microsoft (NASDAQ:MSFT), which eventually shut those operations down. So, going for revenue only, without profits, has been shown throughout history to be a terrible business model that eventually ends in doom for those who practice it. Nokia is the poster child example, but you will see many more companies implode eventually because once revenue slows, investors panic and all head for the exits all at the same time. The similarities between this market and the dot-com boom and bust are quite clear and that is why we continue to hold a large position in cash, as only cash will protect you when reality shows up. We cannot give you the exact date as to when it will happen, but when you see the FANG stocks (Facebook (NASDAQ:FB), Amazon, Netflix (NASDAQ:NFLX), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL)) all hitting new highs continuously based on investor panic buying, then it's time to stock up the bunker with supplies and move in there with the cats.
We sleep well because we have elite companies with elite management at the helm and, even though some may have a tough quarter once and a while, in the long run, our holdings will do very well because they are insanely profitable. And the elite, highly profitable companies will be the first to recover after a major correction. In the meantime, we still have a ton of cash on hand to take full advantage of any drop, properly positioning our model portfolios (and subscribers) to take advantage of whatever shows up.
Do not get caught up in the emotional games that Wall Street plays telling us that we will regret not being 100 percent in the market all the time. That is to the industry's advantage because it lives off of transactional incomes and commissions. It needs us all to invest all we have all of the time. That is how Wall Street makes money. It is its best interest for us to invest at the top of the market, not ours. Naturally the message coming out of Wall Street analysts will always be buy until it is too late. Once the market sells off substantially, we will hear the sounds of panic coming from the same folks telling us to sell. Guess who will be on the other end of those transactions at bargain prices? Wall Street will be buying and so will we. Patience eventually leads to long-term profits in these times time of irrational exuberance. Deja Vu?
Disclosure: I am/we are long NFLX. 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.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.