Great companies can make terrible investments

Published in the Sunday Times on 21st November 2021.

Here’s a stock market statistic that may surprise you; in the last twelve months the share price of Zoom has nearly halved, whilst Exxon Mobil has more than doubled (as at October 22nd 2021). 

This jars with the prevailing narrative over the last year; fossil fuels bad, remote working good. 

What’s going on here? Lots, but I think there are two conclusions to draw from this.

Great companies can make terrible investments - depending upon the price at which you buy them. Secondly, a superficial, but appealing narrative is often enough for investors to buy into a story. We would do well to consider the second order effects of decision making.

Cisco is a great company

As regards the “great companies - terrible investments” thesis, Zoom is probably a bad example as it hasn’t really been around long enough to make the ‘great’ claim. But it has certainly been a terrible investment over the past twelve months.

I think the best historical example of this has to be Cisco, briefly the world’s largest company in 2000. A couple of months ago, Cisco hit its first high since March 2000. Having dropped back since, that’s an astonishing 21 year hiatus, where anyone who bought at the top is still in the red.

As John Authers from Bloomberg notes in a recent article, Cisco, by most measures, is a successful company. Its revenues today are 2.5 times their 2000 level. This didn’t justify paying a multiple of 46 times revenue at the turn of the century. The stock now trades at 4.6 times. As one acerbic market commentator noted around the time, its price was not only discounting the future, but the hereafter. Great company. Terrible investment.  

Paying a high price doesn’t always mean poor returns

It doesn’t have to be so. Paying a high multiple of revenues does not preordain catastrophe. Amazon traded at around 45 times revenue at its first peak in 1999. Granted, you had to wait over a decade to break even, but 22 years on, those that persevered have been extremely well rewarded. Which brings us to the current stock du jour, Tesla, which topped the $1 trillion market capitalisation in recent weeks. The parallels are unmissable. But is it Amazon or is it Cisco? I’m afraid the conclusion to that one is above my pay grade. 

A cynic might observe that Tesla ‘only’ trades on about 20 times revenue. When Amazon was sporting its nosebleed valuation, its revenues were less than $2bn. Tesla’s revenue is already north of $50bn. Amazon had a far longer runway ahead. Maybe Tesla can use its dominant position in EVs to take advantage of opportunities that don’t exist now but will in the future. I simply don’t know, but this seems to be reaching.

Which brings us to the second lesson – the superficial, but seductive narrative that draws us in where we fail to ask the “and then what” question before making an investment decision.

First order effects are easy to think about

Investing for many of us often operates on a short term gratification basis, despite claims to the contrary. All we generally think of are first-order effects, and fail to consider other possible outcomes.

In America the law introducing compulsory wearing of seat belts was introduced in the 1960’s. Contrary to what was expected, the introduction of the law did not reduce the total number of deaths. There was a decline in driver deaths, but this was almost entirely offset by an increase in pedestrian deaths. Once you tell people that cars are safer, they will drive faster and more recklessly. This is a second order effect. 

Thinking about first order effects is easy. Buying Zoom a year ago was an easy decision.  Thinking about second or higher order effects is hard. But just because it’s harder, doesn’t mean one shouldn’t do it. 

The seeds of investment failure are sown when we invest with first-level thinking; the Internet will change the world, house prices never decline, China will grow forever, the future of the office is remote. The simple crutch of first level thinking, translates into a simple action, often with expensive consequences. 

Discounting the hereafter

I’ve often lamented that public markets are too focused on the short term, caring only about the next quarter’s earnings. But I do think that we are in a different world now. One in which investors seem a bit less interested in capital discipline and a bit more interested in the distant future. Tesla is but one of many examples of this.

As John Authers notes, there is a version of the future in which buying Tesla at 153 times earnings (as at 03/11/21 on a forward earnings basis) might prove a bargain. But there are far more futures in which paying this sort of price for Tesla looks terrible. Consider the possibilities.

One possibility is you’re paying to come along for the ride. A more likely possibility is you are being taken for one!