Investors have gotten manic many times in the past, frequently for profitless companies.
It always turns out badly.
By Dan Ferris
Investors today are making one of the quintessential and most often repeated mistakes of all time…
They have fallen too deeply in love with risky situations. They’ve forgotten basic concepts like risk and profitability.
Earlier this year, marketing entrepreneur and NYU business-school professor Scott Galloway gave a 24-minute presentation at a conference titled, “How Amazon Is Dismantling Retail.”
Galloway argued that, “Amazon has essentially changed the relationship between companies and shareholders… It has replaced profits with vision and growth.”
Galloway’s remarks about Amazon perfectly encapsulate the big mistake equity investors are making right now: believing there’s ever a substitute in business for profitability.
Yes, vision and growth saw Amazon through to profitability. Anybody who has read Amazon’s incredible 1997 shareholder letter – to which CEO Jeff Bezos still refers today – knows of its grand vision (which mentions profitability as a key goal, by the way). But that doesn’t mean vision and growth are a substitute for profitability. There is no substitute for profitability.
Investors have pushed that reality aside and fallen in love with companies that have a great story and a soaring share price… regardless of profitability. What they don’t realize is that equity only has value if a company earns a profit. That means there’s a much higher probability than investors currently acknowledge that unprofitable highfliers might be worth… zero.
Amazon was founded in 1994 and became profitable in 2003. Since then, it has earned a total of about $14.2 billion in pretax income. It trades at a market cap of more than $450 billion – about 32 times all the profits it has ever produced since its founding.
The company has revolutionized the e-commerce marketplace. Amazon dominates online retail. It started with books. But today, Amazon’s marketplace for third-party sellers, video streaming, “one-click shopping,” and two-day shipping services attract buyers of everything from consumable media to clothes to auto parts and more. And Amazon Web Services dominates cloud computing.
Over the past 10 years, Amazon’s sales grew more than 800% from $14.8 billion to $136 billion. Its stock price has appreciated from a split-adjusted $1.50 at its 1997 IPO to more than $1,000, a more than 600-fold gain.
Amazon’s ranking in the S&P 500 based on various measures gives you a good idea of how deeply in love investors have fallen with it…
The massive company is ranked fourth out of 500 companies by market cap. Just three S&P 500 companies are valued higher today: Apple, Alphabet (“Google”), and Microsoft. And yet it’s ranked just 93rd for net income over the last 12 months.
Amazon is the World Dominator of online retail, the World Dominator of cloud computing, and probably the World Dominator of other stuff I can’t recall right now. It’s one of the greatest businesses in history.
I doubt its potential is anywhere near fully tapped. I bet one day, it will completely take over all the non-fun parts of its Amazon Prime customers’ shopping – everything from socks and underwear to groceries, pet supplies, lawn and garden… you name it. Then instead of getting $1,300 in annual revenue per Prime customer, perhaps it will hit $5,000 or even $10,000 per year. (Non-Prime shoppers spend about $700 each year.)
I expect at some point in the near future, Amazon will send Prime shoppers a box once or twice a month, and they’ll decide what to keep and what to send back. It will become the operating system for shopping in your life. As long as you have Amazon Prime, you’ll never worry about running out of essential items again.
Perhaps by valuing Amazon at 32 times all the profit it has ever earned, investors are discounting these future possibilities… in addition to the high improbability any competitor ever unseats it or even dents it.
Though there’s only one Amazon, investors seem to think there can be more than one…
Investors have fallen too deeply in love with companies trying to imitate Amazon’s formula for market dominance by growing fast while incurring huge net losses. It worked once, it can work again, right? The answer is effectively, no. The odds are way, way against you finding another Amazon. As usual, everybody’s looking in the rearview mirror.
Galloway noted the huge losses being incurred by similarly visionary, fast-growing companies…
Snap Inc. – the maker of image-messaging and multimedia mobile app Snapchat – grew revenues nearly 600% in a year, from $59 million in 2015 to $415 million in 2016. Investors love it, but it’s not profitable. Snap lost $373 million in 2015 and $515 million last year. Shortly after its IPO earlier this year, it reported a $2.2 billion loss in the first quarter of 2017. The share price fell 20% the next day.
Information on ride-hailing service Uber is limited since it’s not a public company. But various sources say it produced $3.8 billion in revenue in the first nine months of 2016 – nearly triple the $1.4 billion it did in the same period of 2015. And yet, it reportedly lost $2.8 billion in 2016.
Galloway stared out at his audience and dryly concluded, “Loss is the new black.” In other words… vision, growth, and losses have replaced profitability as the business attributes that investors most reliably reward in the marketplace.
Again, that Amazon is finally profitable doesn’t matter. It’s not Amazon’s profitability that the new loss makers believe they’re imitating. They’re imitating the quest for rapid growth and dominance without a priority on profitability – a goal achieved very, very rarely.
This might not end well. This might be the wrong strategy long term. It might have some underpinnings of something scary brewing in the economy… But the reality is that retail investors love this model of vision and growth, and they ignore profits or a lack thereof.
I must credit Galloway for not saying, “Profits don’t matter anymore.” He said they don’t matter to retail investors anymore. And he’s right. That’s the real problem here. (Galloway is more in tune with the financial markets than I’d previously thought. He recently pointed out some fin-de-siècle warning signs in retail and technology and noted that it’s been several years since the last market crash.)
Mom and Pop have fallen in love with stories about companies that don’t make any money because they think they’re buying the next Amazon. They’re buying equities with the mentality of a lottery-ticket buyer.
The world as it exists: Equity only has value over the long term if a company earns a profit.
The world as investors see it: Fast-growing, visionary businesses will succeed at becoming the next Amazon despite massive losses and extremely low odds of success.
When Things Get Manic, Smart Investors Keep Their Distance
Investors have gotten manic many times in the past, frequently for profitless companies. But profits or not, it always turns out badly.
Three of the six manias in my lifetime featured profitless companies roaring to great heights. Each time, investors forgot there’s no such thing as an investment that’s good at any price.
The first one happened around the time I was born in the early 1960s. Technology companies with “-tron” or “-onics” in their name (like Powertron Ultrasonics) doubled and tripled the day of their IPOs and traded as high as 100 times earnings.
The mania pushed the broader market higher for a little while, as it often does. The Dow Jones Industrial Average peaked at 734.9 in late 1961… and bottomed at 535.8 in early 1962 – a 27% nosedive. Manias always end badly, even when they’re about profitable companies.
It happened again in the late ‘60s and early ‘70s, when the so-called “Nifty Fifty” companies (50 popular large-cap stocks on the NYSE) were presumed to be such wonderful businesses that they could be bought at any price, even 80-100 times earnings. Stocks like Polaroid and Avon Products soared, and they ended up losing 80%-90% of their value as they hit bottom in 1973.
It happened in the late 1970s when gold and gold stocks (many with no revenues or profits) roared, ruining many investors in the early 1980s when then-Federal Reserve Chairman Paul Volcker ratcheted interest rates sharply higher. Gold peaked at $850 an ounce in January 1980 and fell about 65% to right around $300 per ounce by mid-1982. It finally bottomed around $250 per ounce in 1999.
It happened during the biotech boom of the 1980s, when biotech stocks soared, most with no profits, some with no revenues. It happened in the late 1990s when anything with “.com” at the end of its name (many with no profits) was presumed a great investment. It happened with mortgage providers and homebuilders in the early 2000s.
And now in 2017, it’s happening with fast-growing visionary businesses that think they’re imitating Amazon, like Snap and Uber. With zero profits to invest back into their businesses, these companies will eventually fail… And investors who piled in will suffer.
It’s always a bad idea to participate in a mania. Investors forget every single time that everything is cyclical and manias always crash after a few years.
It’s easy to see why it’s wrong to emphasize growth and vision over profits: Without profits, you’ll go out of business and your vision will die. But looking into the future is hard. Let’s instead look backward at a historical “loss is the new black” moment from the dot-com era.
This story was published in the Wall Street Journal on May 16, 2000 in an interview with then-CEO of MotherNature.com, Michael Barach.
MotherNature.com was an online health-products retailer. It offered “30,000 vitamins, herbs, and supplements. And expert advice. On everything from breast tenderness to gout. In complete and total privacy.”
It went public at $13 per share on December 10, 1999. It raised $195 million in that IPO, and its share price peaked at $14.56. By Barach’s May 2000 interview, MotherNature.com had $35 million left with no profits in sight. And its share price had collapsed to $2 (-86%).
When asked if public-equity markets were crazy to emphasize growth and brand building to the exclusion of everything else, Barach told the Wall Street Journal, “Only history will tell, but it makes a lot of sense. The capital markets and the public chose to finance the Internet.”
Asked about his company’s initial strategy, Barach said, “We had a GBF strategy. GBF stands for Get Big Fast… Growing revenue does not blend well with becoming profitable. But it’s OK as long as the market rewards that.”
Like Galloway seems to do, Barach accepts the stock market’s verdict without question. Also like Galloway, Barach focused on the short term, specifically the recent past. He wasn’t thinking about getting a long-term return while recognizing and controlling risk.
At the time of the interview, MotherNature.com had abandoned “Get Big Fast.” According to Barach, the company was already operating under “a totally different mindset,” spending “as little money as possible,” and it was “not as focused on 40% growth.”
“It’s relatively easy to buy revenue,” Barach concluded. “What’s hard is to get profits.”
MotherNature.com shut down in early 2001.
Barach learned all too late that GBF is no substitute for profits – the singular financial hallmark of a real business.
Another quick example is Global Crossing, the dot-com era telecommunications provider that wanted to connect the whole world with fiber-optic cables. There was plenty of growth there, and lots of vision too. Investors loved it. Revenues grew nearly tenfold in just three years, from $420 million in 1998 to $3.8 billion in 2000.
But it was unprofitable and overleveraged. Global Crossing racked up $2.3 billion in net losses and more than $12 billion in debt. The company started up in 1997, went public in 1998, and went bankrupt in 2001.
Paying up for losses because you think you’re buying the next Amazon is crazy (or at least super risky). But overpaying for a profitable company can destroy your long-term returns, too…
IT and networking World Dominator Cisco Systems’ revenue grew roughly tenfold from $2.2 billion in 1995 to $22.3 billion in 2001. It earned a big profit every year (and still does). But anybody who bought the stock between November 1999 and January 2001 is still underwater almost 18 years later. If you paid the all-time high price of around $80 a share in 2000, forget about breaking even in this lifetime. Shares are around $33 right now.
It’s the same with Microsoft. The software giant grew revenues nearly threefold, from $8.7 billion in 1996 to $25.3 billion in 2001. It made huge profits every year. But if you bought it at the 2000 top, you had to wait 17 years to break even.
If a firm – even a highly profitable one – grows really fast, it’s likely investors will overpay for it and lose money on their investment. If the company never gets profitable, or becomes only marginally profitable, it’s still unlikely that investors will realize an adequate return.
A business has to generate enough profit relative to what an investor pays for it before it’s reasonable to expect an adequate return. None of the companies Galloway mentioned are doing anything close to that.
Investors seduced by growth and vision are making these same mistakes again, right now…
Losses may be the new black, but you’ll freeze to death if that’s all you’re wearing when the weather changes. When things get manic, smart investors keep their distance.
It’s Not ‘Different This Time’
How likely is it for a company to become the next Amazon? Highly unlikely.
Amazon is currently valued at nearly $500 billion, even though it only earned $2.4 billion in profits last year.
Uber is valued at $70 billion, but it lost $2.8 billion in 2016. Snap is valued at a little less than $20 billion, but it lost $515 million.
A lot of investors will lose a lot of the money they’ve put into stocks like Snap if those companies never turn a profit. Even if they do become profitable, they’ll never earn enough profit fast enough to grow into their current valuations. If Uber and other overvalued private companies go public at their current reported private valuations, I’m willing to bet big investor losses will result.
Amazon is the model for these other companies and its bottom line is nowhere near caught up to its enormous market cap. But the would-be Amazon imitators are either barely profitable or taking huge losses (like Snap and Uber). Their value has yet to be established, yet private- and public-market investors confidently value them in the tens of billions.
None of these companies are investments. They’re pure speculations.
Those retail investors Galloway mentions seem to believe what no one should ever believe: It’s different this time. This time, the laws of economics have been suspended or permanently changed, and investing is no longer about cash return on invested capital or even earning any profit at all.
I promise you, it’s never different this time. Profits always matter. They matter most when everyone believes they don’t, because that’s the moment of greatest vulnerability to naïve investors.
Benjamin Graham – the father of value investing – once said the market is a voting machine in the short run and a weighing machine in the long run.
The voting machine has elected Amazon and Snap, among others. We can’t predict how long it will take… But I expect the weighing machine to declare Amazon’s share price in need of dramatic weight loss and to encourage Snap to get its affairs in order and spend time with loved ones.
Amazon will remain a fantastic business, but its share price could correct sharply (at which time it could be a great buy). If Snap doesn’t stop losing money within a couple years, it could go bankrupt.
Equity gets its value from whatever is left over after a company pays everybody else. Equity investors are the least senior and riskiest claim on a corporation’s assets and earnings. When a company liquidates, equity holders are the last to get paid, after (in order of seniority) secured creditors, unpaid wage earners, taxes, trade creditors, unsecured debt holders, subordinated unsecured debt holders, and preferred stockholders (if any).
Even if the company never liquidates, all those people must be paid before equity holders can get dividends.
Equity only has value if there’s something left over for investors after all those other commitments are met. That excess is cash profit. Equity only has value if a company earns a profit.
If you think “this time is different” and we’re in a “new era” where profitability doesn’t matter to equity investors, you’re wrong.
It’s never “different this time” when it comes to human nature.
Solomon knew this. In Ecclesiastes 1:9, (according to tradition) he wrote, “The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun.”
Shakespeare knew it. He wrote in Sonnet 59…
If there be nothing new, but that which is
Hath been before, how are our brains beguil’d,
Which, labouring for invention, bear amiss
The second burthen of a former child!
Philosopher George Santayana knew it. He wrote, “When experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it.”
If baseball legend Yogi Berra were alive, surely he’d say the mania in equities is “like déjà vu all over again.”
Fast-growing, visionary companies are alluring, no doubt about it. They seem like easy money. And most people just don’t have the kind of memory you’d need to resist the apparent allure of easy money in public-securities markets. But to not get killed in stocks – and to make money in the aftermath of a market mania – you must look beyond the current emotionally charged moment to a time when it will seem stupid to have done what everyone is doing today.
Fear is the dominant emotion in the market at all times. It’s fear of losing more at the bottom and fear of missing out at the top.
Besides the hit-me-in-the-face moment I think any experienced investor would feel when watching Scott Galloway’s presentation, there are quantitative measures that tell me to be careful right now too.
The Second-Worst Time in History to Buy U.S. Stocks
The dot-com bubble was the most overpriced moment in U.S. stock market history, as measured by Harvard business professor Robert Shiller’s cyclically adjusted 10-year average price-to-earnings (P/E) ratios.
The dot-com bubble peaked at a Shiller P/E ratio of 44. The 1929 crash was preceded by the second-highest Shiller P/E of 30. That’s about where the Shiller P/E is today… it surpassed 30 this summer.
According to daily closing price data compiled by Bloomberg back to 1990, the dot-com bubble was also the most overpriced moment by price-to-sales ratio (2.35 times sales). By this measure, today is the second most expensive moment in U.S. stock market history.
Investors who buy stocks at hyper-expensive moments tend to do poorly for years afterward. March 23, 2000 was the only other time besides right now that the S&P 500 rose above two times sales. From the day’s close (1,527.35), the index fell 49% to 776.76 on October 9, 2002. The S&P 500 didn’t get back to its 2000 peak price level until mid-2007. The S&P 500 didn’t eclipse its October 2007 peak until the first quarter of 2013.
The moral of the story is this: Buying when the S&P 500 trades above two times sales can be very bad for your financial health.
If history is any guide, we are now entering one of the worst times to buy U.S. stocks. Again, that’s not because this is the top. We have no idea when or if the top will arrive. But I’m certain that U.S. stocks are now priced for very poor returns over the next few years, maybe longer.
I’m not telling you to sell everything and head for the hills. I’m not telling you to sell stocks short and forget about them for two years. For all we know, the big stock indexes could still shoot up in a speculative frenzy. That generally happens when investors get really manic. My colleague and fellow American Consequences contributor Steve Sjuggerud calls it a “Melt Up.”
I’m only recognizing that current data indicate U.S. stocks are very expensive and come with plenty of risk right now. “Prepare, don’t predict,” and you’ll be much better off.
Calling market tops and bottoms in the big indexes is totally unnecessary and you’re highly likely to be wrong. All you need to do is recognize that U.S. stocks are priced for lousy returns for several years to come.
Dan Ferris is the editor of Extreme Value, a monthly investment advisory that focuses on some of the safest and yet most profitable stocks in the market: great businesses trading at steep discounts…
His strategy of finding safe, cheap, and profitable stocks has earned him a loyal following – as well as one of the most impressive track records in the industry. And his work has been covered extensively in Barron’s and other respected news outlets.