Fundamentals-based investment research can be fun. It involves constant learning. Serious investors can gain insights into many different businesses and evaluate their potential long-term outlook. Investment research can help you understand the latest innovations in fields such as technology and medicine. At the same time, you can also gain greater knowledge about older, more traditional businesses.
There are different ways to invest. At BWFA, we favor value investing, which focuses on identifying companies trading at a discount to their estimated fair market value. For the most part, companies favored by value investors have been in business for a number of years. Oftentimes, value investments have performed well in the past but have experienced a setback that caused their businesses to fall short of expectations and their stock prices to fall. If such companies are financially strong and well managed, then the opportunity for recovery is great.
Value investing is also inherently conservative. Oftentimes, value investments are more mature businesses; they may also pay dividends. This allows investors to be “paid to wait,” as they receive a regular income stream while holding the shares. A growing dividend is even better. Value investors also tend to hold shares longer, lowering their tax bill and their transaction costs.
One thing value investors can miss out on, however, is the opportunity to invest in stocks that grab headlines or those that regularly top the list of the market’s best-performing stocks. Such stocks are more commonly the purview of growth or momentum investors. Such investors seek stocks that are performing well and/or exhibiting strong growth. They buy with the view that such companies will continue to grow. However, as a company’s revenues or earnings increase, the growth rate will typically slow. This is partly because of “the law of large numbers.” For example, if a company has $200 million of annual revenues, 25% growth represents a $50 million revenue increase. On the other hand, if a company has $2 billion of annual revenues, 25% growth represents a $500 million increase. The larger the company gets, the harder it is for it to maintain its growth rate.
In the auto industry, Tesla[i] is a company with great potential. But, today, it is priced too dearly for BWFA and its clients. Currently, Tesla’s market cap is $31.7 billion. Over the last 12 months, it realized $3.5 billion in total revenues. This equates to a price-to-sales (P/S) ratio of about 9:1. The best-known U.S. car company is General Motors[ii]. It has a current market cap of $57.2 billion and generated revenues of $35.7 billion over the last 12 months, which equates to a P/S of 0.6:1. While we recognize that P/S is only one means of valuing a company, based on P/S, Tesla is about 15-times more expensive than GM. Is it possible Tesla could become the market leader in automobiles and generate considerable growth? Yes. But, we do not know for sure. Perhaps, we could have recognized Tesla’s potential earlier and bought the shares at a more attractive valuation. But, there is considerable uncertainty about the outcome. We are more comfortable not participating in the Tesla story – at least for the present.
In the late 1990s, JDS Uniphase was an optical equipment manufacturer with a high-flying stock price. The shares peaked at $1,172.25 in March of 2000. Ultimately, the stock fell out of favor. In 2009’s first quarter the shares bottomed at $3.09. Today, they trade for $12.67. We are not saying that Tesla is going to follow JDSU’s path. However, to us, risk is better defined as the risk of loss of capital and not as volatility. An investment in JDSU at the wrong time could have resulted in the loss of significant capital. When investing, we prefer to take the safer path. It may be less exciting. It should also help preserve capital.
[i] Shares of Tesla are not currently on BWFA’s “Buy/Hold” list of stocks.
[ii] Shares of General Motors are not currently on BWFA’s “Buy/Hold” list of stocks.