Direction Alerts Sunday Edition

  Read This Before Investing In The Next “Cool” Company Sven Carlin, weekday contributor to our [Investiv Daily]( newsletter, wrote a fantastic article this week that I wanted to share with you today. The article discusses how while a “cool” company can be an attractive investment, they are also often incredibly risky. While reading his article, one particular recent IPO came to mind, and I’ll bet you can guess which one. That’s right, Snapchat (NYSE: [SNAP](. I’ve hesitated to write about SNAP mostly because there is already so much that has been written about it, but also because I admittedly don’t completely understand the appeal of it. They say that you should invest in what you know, or in other words, don’t invest in what you don’t understand. From a user perspective, I can’t seem to wrap my mind around why I would want to take the time to record a video or take a picture, slap a bunch of filters on it, and then share it for my friends to enjoy for a few seconds before it evaporates into the ether. It also doesn’t make a lot of sense to me why this social media messaging company considers itself a camera company or why it’s burning through money—to the tune of almost $500 million in the last year alone—focusing on products like its “Spectacles,” sunglasses that take 360-degree video via built-in cameras. The “Spectacles” feel to me like the new GoPro, and we all know what GoPro looks like today. Non-skeptics could say that it’s possible that SNAP could completely change the face of mobile messaging, and that the company could invent a new form of advertising that could compete with Google’s search-related ads, but is it likely? No. And while it is true that Snapchat has engaged a young audience with novel content, it’s also true that when Instagram launched its Stories, which essentially function the same as Snapchat’s Stories, Snapchat was crippled. I think it’s far more likely that SNAP will look a lot more like Twitter in a few years than it will like Facebook, especially considering that their user base is already stagnating. I also think that SNAP is a great example of one of the cool businesses that Sven discussed in his article that come with a hefty side of risk, especially considering that its price is now -16% below its IPO price and $10 below its highest high and we’re only a few weeks in. But enough of me waxing on about SNAP, here’s Sven:  - The investment thesis behind investing in cool businesses is based on stellar growth. As no business can grow forever, sentiment often changes and stock prices plunge. - We’ll discuss, Tesla, Nike, Lululemon, Whole Foods, Under Armour, GoPro, Fitbit, and Microsoft to find the best way to invest in such businesses, because many of them are great businesses. - In the end, it all boils down to earnings. If you’re a long-term investor, focus on the business and its long-term health. Introduction I’m a value investor and as one, I always try to invest with a margin of safety. However, sometimes I get carried away and invest in companies that don’t really meet my investing criteria. The last investing mistake I made—where I invested in something because it was a cool brand, my wife loved shopping there, and it was growing fast—that perfectly relates to the topic of this article, was Whole Foods Market (NASDAQ: [WFM](. I invested in WFM in the summer of 2015. I thought that the price drop was exaggerated as the stock dropped from $56 in February of 2015 to a level of around $40 after accusations of overcharging in [New York City stores](. The overcharging issue quickly faded as I correctly estimated it would, but what I incorrectly estimated was the growth the company would achieve. I replicated past growth rates into the future and estimated a nice 13% return on investment for the next 10 years. Unfortunately, due to strong competition from direct competitors in the organic retail sector and from old-fashioned retailers introducing more and more organic products, WFM stopped growing, both in revenue and earnings. As I bought WFM at a valuation of 25 which is a good ratio for a growth company growing 10% per year, but extremely high for a stable company, the price soon dropped from the $40 I paid to the current $30. I closed my position as soon as it was obvious to me that the company wouldn’t grow that easily, acknowledged my mistake, and kept one share of WFM to remind me of the error. My error was that I invested on hope instead of facts. I looked at the chart above and hoped that the stock price would return to above $50, or even $60 where the stock had been trading at the beginning of 2015 and in 2013. I was hoping for an acquisition or a miraculous return to growth. Unfortunately, investing on hope in something cool is, and was in my case, extremely risky. I lost 3.5% of my portfolio on this trade. However, even though this investment cost me 3.5% of my portfolio, it fortunately is the biggest investment mistake I have made since 2008, so I’m still well off and it will prevent me from making similar investment mistakes in the future. The one stock of WFM that I keep in my portfolio constantly reminds me of how cool companies can be very attractive investments, but are very risky at the same time. What’s important to focus on is the business and the price we are paying for that business as looking at past stock performance can be extremely deceiving. In the current market environment, there are plenty of companies that have been or are still extremely cool. Let’s start with Nike Inc. (NYSE: [NKE]( Lululemon Athletica Inc. (NASDAQ: [LULU]( Under Armour Inc. (NYSE: [UA]( [UAA]( and Tesla Motors (NASDAQ: [TSLA](. All of these companies have or have had a strong cool factor, stellar growth, and stellar stock price performance. What’s significant is that cool companies like UA, LULU, NKE, and WFM haven’t given positive returns to those who have invested in them in the last year or two. The only cool company still going is TSLA. Let’s see what we can learn from these cases in order to not make a mistake like the one I did with WFM. Overestimating Growth The easiest way to rationalize an investment is to plot extremely positive growth rates on current financial numbers. Such positivity can easily make a company like TSLA more valuable than the Ford Motor Company (NYSE: [F](. The current market capitalization of TSLA is $48.6 billion, while Ford’s is $45.4 billion. The market thinks TSLA will continue to grow at its ludicrous pace and increase its sales from the current 76,230 (2016) to above 500,000 vehicles per year as the Model 3 is introduced with additional benefits from energy storage modules and solar roofs. Just for comparison, Ford sold 2,614,697 vehicles in 2016 in the U.S. alone and with a net income of $4.5 billion, while TSLA lost $675 million. Now, even if TSLA manages to sell 7 times more vehicles and its revenue increases 7 times (not likely as the Model 3 will be priced at a lower price than the models S and X), its revenue would come close to $50 billion, or just a third of Ford’s sales. However, a net profit margin of 10% would give equal earnings, and this is what rational investors are betting on, if there are any rational investors investing in TSLA. I don’t know whether TSLA will hit those numbers or not, but what I can discuss is what happens if the estimated growth and profit rates don’t materialize by taking a look at what has happened to WFM, LULU, and UA in the last two years. A look at revenue shows that all stocks except WFM have seen constant revenue growth in the last 5 years. So, if revenue continues to grow, why did the stock prices of UA and LULU plunge while NKE’s stopped growing? A look at earnings will perhaps provide a better explanation. In 2016, UA’s earnings dropped 15%, while WFM’s dropped 11% from 2015. The market reaction was furious as WFM dropped almost 50%, while UA dropped 63% from its 2015 peak. Such drops are huge and show how risky it can be to invest in companies that are cool but are open to competition. Market sentiment and revenue growth can keep hopes up, but many cool companies can’t justify the extreme expectations and eventually falter. Two examples of cool companies that have faltered are GoPro (NASDAQ: [GPRO]( and Fitbit (NYSE: [FIT](. Loses of 90% are extremely damaging for any investor and almost impossible to repair as a 1000% return is required to amend for the damage. In The End, It All Boils Down To Earnings & How Sustainable They Are Cool companies are attractive because they make us dream. However, these dreams are more often than not shattered by earnings and revenue misses. We live in a free world which means the competition can offer the same or similar products which makes the story turn from the product’s coolness to the management’s capability of running a business, thinking about costs, and focusing on profitable growth. Unfortunately, it’s extremely difficult to analyze such characteristics while the companies grow at double digit rates. Now, when surrounded by market euphoria, a cool investment will rarely make sense as earnings aren’t there to back it up. However, when market euphoria fades, and stock prices drop significantly, like they did in the cases of WFM, LULU, UA, GPRO, and FIT, it might be time to look at the businesses behind the stocks as they might have a margin of safety. Price is what determines the quality of an investment. Therefore, cool companies for long term investments should be bought when nobody looks at them anymore from the ‘cool’ perspective, or before the market has acknowledged their greatness. Buying at peak euphoria is the worst investment you can make. A Cool Investment Can Eventually Become A Value & Perhaps A Great Investment Those companies who manage to keep a small, stable, positively operating business with a loyal customer base eventually become interesting investment plays when the euphoria cools off. My favorite example is Microsoft (NASDAQ: [MSFT]( which was supposed to conquer the world back in 1999, which is a pretty similar story to what was expected from GPRO or FIT or is expected from TSLA now. MSFT had a healthy business model that eventually took over the world, however, investors in 1999 had to wait a long time to breakeven on their initial investment. What turned out to be a good investment was investing in MSFT after the crash, especially after the 2009 crash. Conclusion There are a few things to think about when investing in cool companies: - Ask yourself how many things have to align themselves to justify the valuation. Compared to its peers, TSLA should have had earnings of $5 billion in 2016 to justify the $50 billion market cap. As TSLA will, hopefully, reach profitability somewhere in the future, these earnings will have to be much higher than $5 billion. For that to happen, the electric vehicle market has to grow immensely and the competition has to stay put, which is very unlikely. TSLA is entering a market not much different from those that WFM, GPRO, and FIT are dealing with. The nice thing about investing is that nobody is forcing you to invest in anything and you can always wait for all of your investment criteria to align. - Look at how healthy the business model is and whether it is overstretched. Managements love to assume that past growth rates extend into eternity, and invest accordingly. What’s often forgotten is that it’s much easier to grow from $100 million in revenue to $1 billion than from $1 billion to $10 billion. High investment levels put pressure on margins and lower earnings. - If the business model is healthy, profitable, and stable, it’s a good idea to be patient and wait for a good buying opportunity as everything depends on the price paid. I’ll look again at WFM if it drops below $20 as then it becomes a ‘cool’ company with a margin of safety. - If you still want to gamble, wait for market overreactions. Overreactions to guidance, especially negative guidance, is usually extreme when valuations are overblown, but overreactions offer better entry points than when the company is priced to perfection. I’ll conclude with LULU’s stock chart which looks like a rollercoaster, but buying into fear and selling into euphoria would have given excellent returns even as the stock hasn’t gone anywhere in the last 5 years. Disclosure: I own one share of WFM, but have no positions in any of the other stocks mentioned, and no plans to initiate any positions within the next 72 hours.  Sven provides a great primer for thinking about “cool” companies before investing in them at the end of this article. What it really boils down to is that you shouldn’t be swayed by how cool a company is, but should instead take a critical eye to them, just as you do with any other investment, before pulling the trigger. If you haven’t already signed up to receive Investiv Daily, [click here]( to add your email address to the list to get the kind of outstanding content you’ve read above delivered direct to your inbox every day. As for SNAP, if I’m wrong and it becomes a fantastic investment in the next few years, then I’ll open an account and got nuts with all of the filters. 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