Avoiding investment traps and being Amazoned
Last week, for a short moment, Jeff Bezos was the world’s richest man. The basic talk track percolating on the street is that whatever product Amazon gets involved in and whatever industry it chooses to enter will lead to disaster for the incumbents.
The almost unstated belief is that Amazon will essentially take over the world. Although it is true that Amazon is an incredible company with an enormous business moat and scale, it is still unlikely that all incumbents will succumb so easily. It is also true, however, that a large number of them will. So this leaves an investment manager with a bit of a quandary — where will Amazon annihilation happen and where will it not.
The macro story
Change and innovation is happening at an ever-increasing rate in our society. For example, it took the telephone 75 years, the internet 10 years and Angry Birds only 35 days to reach 50 million users.
The scope of disruption is also extensive — where blue collar occupational jobs have been the target for automation in the past, both blue AND white collar jobs are now within scope for technological obsolesce. Entire industries are getting turned on their heads and old business models are becoming extinct.
Therefore it is true to acknowledge and factor in change as part of any investment strategy. Missing sector evolutions will put you at a distinct disadvantage. Buffett’s foray into IBM may be one case in point.
Over the last few years IBM has always “screened” cheaply relative to the technology sector. There has, of course, been a legitimate reason for this. Its older lines of business are being slowly replaced by more modern business models like cloud computing. It tried to hide its troubles by offsetting its declining sales with aggressive share repurchase in order to prop up earnings per share. At the end of the day, however, it was a business in decline fighting some very difficult secular forces and it was, in retrospect, not as cheap as it first appeared.
This being said, it’s also very important that in many cases it’s not necessarily change that adds value but rather growth of a better version of the same. Jeff Bezos recently said it best: “I very frequently get the question: “What’s going to change in the next 10 years?” That’s a very interesting question. I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that second question is actually the more important of the two.”
The investment implication from this suggests it’s not really necessary to find “new” things to garner outsized investment returns but rather companies doing the same things in better form.
Take retail for example. People still value low prices and rapid acquisition. That hasn’t changed but the delivery method has — think online vs. brick and mortar. The value is created here by doing what has always been done in a better way. The key, as mentioned above, is to find the change that can be somewhat consistent and which will allow those leading companies the ability to compound gains over time.
Take Facebook’s network as another example. They don’t need to reinvent the delivery mechanism or format much. They simply enhance and add to their platform by delivering better advertising or content. The product architecture is static but the options for compounding revenues and earnings is massive. The same yet growing. Not understanding or ignoring secular changes and competitive models can walk investors straight into value traps.
How to avoid the traps (and being “Amazoned”)
First, consider being contrarian on contrarians. In investing it does often pay to be contrarian but you will be punished if you think it’s good to be contrarian for contrarian sake. True contrarian success only happens if you’re right. You may disagree with the markets assessment of certain sub-sectors’ value brought down by Amazon’s involvement but your assessment won’t produce returns unless you are right on the ultimate outcome.
Here are a just a few thoughts and investment considerations to ponder when “dumpster diving” companies hit by Amazon announcements:
1. Admit, in many cases, you are just trading. This may be semantics but, in my opinion, buying a company at a depressed multiple and hoping it trades up to a less distressed multiple is trading. “Cigar-butt investing” (buying a company to eke out the last puff of value) made popular by many famous old school value managers is far more difficult today given the proliferation of information. You are not likely to find a company trading at two times earnings that is being “overlooked” by the market given the extensive use of screening and quant funds.
Banking on a return by saying things are not that bad (but still bad) is really buying in the hopes the market slightly changes its mind. I will use Seagate as an example. Over the past year it’s traded from around $30 to over $50 per share. If you were nimble and traded in and out of the stock you could have netted great gains. Ultimately, however, it’s down 33 per cent over three years and produced only half the annual return of the S&P 500 over the past five years. The whole time it has traded in a mouth-watering price to earnings multiple average of less than 10 times earnings. A classic value trap?
A key consideration to help avoid these companies that keep trading perennially cheap is to avoid those that have negative sales growth. If you can’t grow the top line over a series of years it’s pretty obvious your business is in decline and no amount of cutting is likely to save you. I have yet to come across a company that has cut its way to growth and future prosperity. Again, as mentioned, it doesn’t mean that there is not a few more “puffs on the cigar butt” but don’t fool yourself into believing it is anything more than a trade unless it somehow reinvents itself.
2. Numbers need to match the narrative. Sometimes the change is real and the company or sector deserve a lower multiple and subsequently lower valuation. Competition could be fiercer, growth may be slowing, margins could be compressing.
Therefore, to suggest that something traded at 10 times earnings in the past and now only trades at eight times earnings and is therefore cheap is not completely true. It’s important to truly acknowledge what the company does and its value proposition. The qualitative factors and the story of the company should be weighted more heavily than historic multiples when factoring in the future value of the company or industry under pressure.
In many cases, the industries being clobbered right now are in secular decline and Amazon’s influence is only coincidental. Make sure you understand the true story not just the easy story.
I will give you an example: millennials arguably spend a lot more on technology gadgets and “experiences” — they are not as interested in clothes. Therefore, one could argue clothing retailers who are now under pressure are not selling off solely on concerns about Amazon but also may be declining due to longer term secular shifts in consumption.
3. If you do it then be patient. If you simply can’t wait to buy that “cheap” stock maybe consider the following aspects before you dive in. Wait for the insiders to confirm that they believe there is value. Why would you buy something if the CEO isn’t? Wait for the insiders, who have far better information than you, to buy before you commit your own personal capital. This is no guarantee but it has been proven to be a successful strategy.
Also, consider using technical analysis to time your entry. Technical analysis, in my opinion, is a little bit of voodoo when assessing value but it does help on timing purchases. It doesn’t usually pay to buy the first gap down or trying to snag the perfect bottom. Wait for an uptrend to establish itself — you may miss out on the first gain but you may also avoid much larger additional losses.
Contrarian value investing is a very legitimate investment strategy. If done right it offers exceptionally good returns. Snagging good companies with temporary setbacks can be a great investment.
Some companies who are currently being sold on Amazon fears will turn out to be great buys if they get bought out by private equity or even go private. Many, however, will likely be taken out on their shields as the landscape shifts dramatically over the next few decades. If you are investing, just be careful to avoid dumpster diving in areas where there are real legitimate qualitative factors that are depressing the company’s performance. Remember too, wealth has successfully been accumulated by buying higher quality, compounding companies with dominant positions at a decent price and then holding them for the long run.
Jeff Bezos’ brilliant advice for anyone running a business Jillian D’onfro, Business Insider, February 1, 2015. https://tinyurl.com/Bezos-brilliant
TechWorm By Maya Kamath on March 13, 2015. https://tinyurl.com/techworm
Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own.
Disclaimer: The author and clients of Anchor Investment Management own shares of Facebook at the time of publication of this article. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.