A few days ago, I published an article covering 10 Reasons Not To Buy A Stock. These reasons are mostly related to the quality of the underlying business and what should prompt you to approach an investment with caution.
I couldn’t help but notice that many investors in the comment section were pointing out to additional reasons that would keep them away from buying a stock. Reasons that, in my view, should not educate an investment decision and could potentially keep you away from a great investment opportunity for all the wrong reasons.
As explained recently in my article covering The Art Of Not Selling, in a study covering more than two decades of stock performance, 25% of all stocks were responsible for all of the gains.
And if you are looking for stocks that can truly create life-changing returns for your portfolio, it gets even more complicated. Only 6% of stocks significantly outperformed the index (by 500% or more).
That begs the question. What are the characteristics of these companies that end up on the extreme right of the chart?
There is a wide range of books covering the superior features of the best-performing stocks in history. For example, in his book 100 Baggers, Christopher Mayer studied companies that returned $100 for every $1 invested between 1962 and 2014. He pointed out to some of the common positive traits of these outstanding winners:
- They have long periods of high growth.
- They have a high gross margin.
- They are often led by an owner-operator that founded the company.
Today I want to cover some of the less positive features of the very best-performing stocks that could be considered more controversial. You may not realize this, but during most of their lives, these best performers have many traits that would be generally considered as negative for a stock or the underlying business. These so-called unflattering traits will keep many investors at bay, scared of starting a position despite the obvious superiority of the business.
This issue is referred to as analysis paralysis, a situation in which “an individual or group is unable to move forward with a decision as a result of overanalyzing data or overthinking a problem.” This usually leads to missed opportunities for gains because it impacts your buying decision.
Let’s review 10 semi-controversial features of some of the best stocks.
1) They are “overvalued”
The greatest businesses – the ones with the most promising long-term potential – will be rewarded by Wall Street with a higher valuation. In essence, if you are avoiding businesses that are considered overvalued at any given time, you might be ignoring the best-of-breed businesses without realizing it.
I’ll admit it. I’ve always found any analysis declaring that a company is “overvalued” based on XYZ not very insightful.
And for good reasons.
They often use a specific metric such as P/E (price/earnings) or PEG (price/earnings to growth) without realizing it makes little sense based on the stage the company is in.
I came across this fantastic chart shared by Brian Feroldi on Twitter showing the different stages of the life of a company and its corresponding P/E ratio (price to earnings).
|Stage of the business||PE ratio||Use-case||Duration|
|1) Introduction||Negative||Useless||0-20 years|
|2) Hyper-growth||Very High||Semi-Useless||1-10 years|
|3) Maturity||Normalized||Useful||1-50+ years|
|4) Decline||Very Low||Useless||1-10+ years|
|5) Death Spiral||Negative||Useless||1-10+ years|
For companies that are still in stage 1 (introduction) or stage 2 (hyper-growth), trying to use a P/E ratio becomes useless. If you are screening for stocks solely based on their P/E ratio, you will exclusively invest in companies that are already in stage 3 (maturity), and you will often feel tempted to invest in companies that are in stage 4 (decline) just because they appear “cheap,” without even realizing it.
You may fall in love with a company that is “out of favor” just because it has a very low PE. It can give the illusion of a margin of safety. But if the company is on a secular decline, it could soon turn its slowing profits into losses, and the value play will turn into a value trap when they enter stage 5 (death spiral).
I’ve recently illustrated how some companies may appear ridiculously overvalued or seem doomed to fail if you don’t look at the underlying business close enough.
Let’s use first an example of so-called overvaluation based on cash flows.
How many analysts have called Netflix (NFLX) overvalued based on its negative cash flow over the years?
The streaming platform is spending heavily on building its own catalog of exclusive original content. This creates a front-loaded cash expense and makes their cash flow margins look terrible in the short term. But in the process, the company is fueling its back catalog with more original content.
The company is poised to see tremendous returns over time because the cost of new content is a one-off expense while the subscriber-base continues to go up and to the right.
Naysayers have been focused on the negative cash flows of the company without understanding the long-term premise of the business model. Because of that, in their view, Netflix never traded at a valuation that would be cheap enough to justify an investment. And yet, it’s one of the best-performing stocks of the past decade, growing +3,693% from 2010 to 2020.
Let’s use a second example of so-called overvaluation based on earnings.
The Trade Desk (TTD), long-time favorite of the App Economy Portfolio, has seen its business grow like a weed since going public in 2016. The company has always been profitable and cash-flow positive since its IPO.
If we look at TTD’s P/E ratio, it has oscillated between 40 and 160 over time.
Let’s assume for a second that your timing is absolutely awful and that you bought the stock exclusively when the company was trading at a P/E ratio of 120 or more.
- Back in June 2017, TTD had a P/E of 120. The stock is up 7x since then.
- Back in September 2018, TTD also had a P/E of 120. It’s up +165% since then (vs. a meager +7% for the S&P 500 (SPY)).
I could go on to illustrate this based on EV to EBITDA, price-to-sales or any other valuation metric.
The long-term potential of a business matters immensely more than its valuation at any given time. While valuation gives you a sense of your margin of safety on the way down, the quality of the underlying business gives you a sense of the scope of the opportunity on the way up.
Overvaluation is like beauty. It is in the eye of the beholder.
2) They are already up a lot
I previously wrote about the idea that your temperament is the single greatest factor in your portfolio’s returns.
One of the most common behavioral biases we all suffer from as investors is anchoring. We tend to attach our thoughts to a reference point. We rely too much on the very first information we have found. The first price you see is likely to influence your opinion of a stock, potentially forever.
The more relevant the anchor seems, the more people tend to cling to it. The more difficult it is to value something, the more we tend to rely on anchors that give us an artificial sense of control and knowledge.
When I bought shares of Shopify (SHOP) at $100 in 2017, it was very daunting. At the time, shares had already been on a tear, almost 300% up from their 2015 IPO price. Here is how the stock chart looked like back then:
It was very tempting to just say that shares were already up a lot, and that it was probably preferable to avoid the stock. I had “missed the boat.”
Fast forward almost three years, and the shares are more than 800% from where they were at the time. Companies that beat the market by an extreme margin will keep on looking this way, giving you the impression that they are running away from you if you haven’t invested in them.
For example, SaaS valuations have been all the rage in recent years and have prompted many investors who have remained on the sidelines to call it a “bubble.” What they may not realize is that analysts have claimed we are in a so-called SaaS bubble for almost an entire decade.
Look at a company like salesforce.com (CRM). It was trading at an EV/Sales multiple of 9 ten years ago, and it still does today. The price multiple hasn’t changed for a decade. Meanwhile, the share price grew +700% during that time.
Investors anchor EV/sales multiples today to where they were in 2005 to evaluate where they are in 2020. Many refuse to invest in a stock because it’s 20% above where it was when they added it to their watch list. They potentially miss a huge investment opportunity simply because they anchor their opinion to the first information they have seen.
All these decisions need to be recognized for what they are: emotional biases.
3) They are not profitable
Going back to point 1) about the various stages of the life of a company, not all companies that are losing money should be avoided.
Au contraire my friends, many of the very best investment opportunities of the past two decades have been companies that were scaling aggressively, re-investing in themselves, and showing an income statement in the red for the vast majority of their hyper-growth stage.
Look at a company like ServiceNow (NOW). The business has been losing money from its 2021 IPO up until very recently. Yet, the company has been a 16-bagger (returning more than 1,500%) since it became public.
Companies that have a very good visibility and understanding of their customer behavior over time have the luxury to re-invest in themselves aggressively. They are spending today knowing with a high degree of certainty that the revenue they will make tomorrow will more than make up for their short-term losses.
Cloud-based SaaS companies are able to do this through cohort analysis and estimating their customer lifetime value. They use KPIs like “net dollar-based retention rate” that show how much revenue they make out of a given cohort over time, net of churn. If that number is above 100%, the implication is that a company can grow its top line even without signing new customers.
Slack (WORK) is notorious for having an extremely high net dollar-based retention rate, at 132% in the most recent quarter. The only public company with a higher metric is Twilio (TWLO) with 143%. Using Slack’s annual recurring revenue from their S-1 filing, if you have a business that is highly predictable and improving over time for every single cohort of customers, it will look like this:
Slack has yet to turn a profit. But a company that can grow its revenue above 30% without signing new customers has the luxury to reinvest in itself without the need to worry about short-term profitability.
I could be cherry-picking all-day companies that have been unprofitable and turned into a great investment. I recognize that there is a certain dose of hindsight bias in the process. The point here is merely to say that a company that is losing money can still be a good investment. Filtering a company out of your watch list simply because it’s not profitable will make you miss some of the most disruptive and innovative businesses of our time.
As explained in my 10 Reasons Not To Buy A Stock, if a company has 1) strong unit economics and 2) a high gross margin illustrating a strong product-market fit, its losses are likely to be temporary and only a reflection of its growing pains.
4) They don’t pay a dividend
Many long-term investors require their companies to have a growing and sustainable dividend. They may be looking for an investment vehicle that is generating income for a wide range of personal reasons. And that’s completely okay.
But we need to address the fact that there is no rule that says that only dividend-paying stocks are good investments. There is a plethora of amazing opportunities out there where you won’t find any dividend. And usually, what is not offered in dividends is offset by a strong potential in stock appreciation.
Let’s look at the 10 best-performing stocks of the S&P 500 in the past 10 years according to Barron’s:
|Ticker||Returns 1/2010 to 12/2019||Dividend|
|MarketAxess Holdings (MKTX)||+3,015%||0.48%|
|TransDigm Group (TDG)||+2,015%||No|
|United Rentals (URI)||+1,559%||No|
|Regeneron Pharmaceuticals (REGN)||+1,457%||No|
|Align Technology (ALGN)||+1,393%||No|
|Ulta Beauty (ULTA)||+1,312%||No|
|Old Dominion Freight Line (ODFL)||+1,283%||0.37%|
As you can see, 7 out of the 10 best-performing stocks of the past decade did not offer a dividend. This chart is merely here to illustrate that when it comes to selecting individual companies to generate alpha, ignoring companies that don’t pay a dividend can be a colossal mistake.
Unless you are specifically in need of generating income on a regular basis, a dividend should not be a criterion to select a stock. It offers no insight into the quality of an investment and its capacity to generate alpha.
5) They are already too big
Just because a company is already big doesn’t mean it has no more room to run. Just four years ago, Amazon was already a $400 billion market cap and one of the biggest companies on the planet.
Fast forward to 2020, and Amazon is now a $1.3-trillion company.
The entirety of FAANG stocks (Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix, Google (GOOG) (NASDAQ:GOOGL)) are mega caps that have beaten the market time and time again.
We live in a world where the biggest get bigger over time. They tend to become anti-fragile and reinforce their dominating position over time as their smaller competitors suffer under pressure.
Sure, they have to face a different set of risks such as government regulations, public scrutiny and more. But every time they survive these challenges, they turn into even stronger platforms. The largest ecosystems benefit from sustainable and wide economic moats such as:
- Network effect (Facebook).
- Intangible assets (Apple, Netflix).
- High switching costs (Amazon Web Services).
- Scalability (Google).
Ignoring an entire group of companies solely because of their large size can make you miss on the very best businesses of this century.
6) Short interest is very high
Short interest is defined as “the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out.” This is usually expressed as a percentage of the float of shares outstanding.
Stocks with a high short interest are usually approached with extreme caution by investors. The implication is that market sentiment is negative and everyone is selling, indeed.
The contrarian view here is that a high short interest is, in fact, a bullish indicator. Short sellers have to cover their position, eventually, which can create a significant upward pressure on the stock’s price – also known as a “short squeeze.”
Short sellers can be dead wrong, just like any other type of investor. How many of them have lost their shirts short selling companies like Tesla, Amazon or Netflix over the past decade?
A short interest as percentage of float is usually considered high above 10%, and extremely high above 20%.
As illustrated below, a company like Tesla has seen a short interest between 15% and 25% for the vast majority of the past 10 years. Yet, the stock is up +3,920% over that time.
This situation usually occurs when a company is deeply misunderstood by investors and might keep on beating expectations over time due to a clear misconception from analysts.
Firm conviction can be the enemy of truth. Investors can be convinced that a business has no future, without considering future outcomes that have yet to be reflected in the financials or depend on micro-trends that have yet to be fully grasped by society at large.
Look at Match Group (MTCH), the world leader in online dating. The short interest in percentage of float has been above 40% for the majority of the past two years and is now at an astounding 96%.
Online dating remains a micro-trend that is deeply misunderstood by older generations who didn’t grow up and didn’t experience being single in the age of the internet. For some people, there is a profound stigma around dating online, and many believe the entire thing is a scam. I honestly don’t blame them for not understanding what people who are 20, 30 or 50 years younger than them care about.
Match Group offers a freemium model, with a multitude of apps serving a wide range of demographics and psychographics. It serves a wide range of needs and preferences. This is another aspect that is misunderstood by most investors who are solely thinking of online dating as a hook-up service.
Match Group is almost a 7-bagger since going public in 2015 and currently sitting at an all-time-high. So if you are wondering who is right, you have the beginning of an answer here. And if you let the short interest ratio scare you away today, you might be missing an opportunity to invest in a company that has some of the most impressive tailwinds you can find on Wall Street today.
7) The share price is too high
I was recently discussing an investment opportunity with one of my smartest friends, a Ph.D. in oncology. We were talking about a small precision oncology company, and she suggested that the opportunity had probably passed, now that the shares were trading close to $100.
“The share price rarely goes much above $100 in the stock market, doesn’t it?” she asked. “I noticed most oncology companies don’t trade above $100,” she added. Only then did I realize that many smart individuals who are simply dabbling around with investing lack the most basic understanding of how a stock price works.
This bears repeating for the less experienced investors reading this. The price per share has no impact whatsoever on the future returns of an investment. A stock trading at $1,000 is not less likely to generate high returns than a stock trading at $20.
The current market price of each share depends on the market capitalization of a company divided by the total number of shares allotted by the company. You can’t analyze a share price in a vacuum. Only the market cap (or enterprise value if you strip out the net cash/debt position) can educate how big a company is. Its share price ultimately depends on the number of shares issued, which is completely irrelevant to whether or not an investment is promising.
8) The competition is fierce
Aaaah competition! A term often bandied around to justify selling a great investment or staying away from it altogether.
Here’s the catch. Virtually every public company on earth has competition. Businesses that don’t have competition are either too narrow or don’t have a product that people want, which would not serve your long-term returns. If tough competition is a reason to stay away from an investment, you might want to give a second look at any position you already own.
Competition is at the top of the list of factors that can create analysis paralysis. The problem with this is that the better a business is, the more it will attract competition. As a result, the best-of-breed business will often have the most fierce competitive landscape.
Businesses that can grow their revenue at a fast pace all while maintaining a high gross profit margin are showing you all you need to know about their capacity to survive in a highly competitive environment.
If you decide to ignore entire segments of the market, such as e-commerce, cloud-based SaaS or digital payment simply because there is a lot of competition, you might be missing the best opportunities of our time.
9) Insiders are selling
Insider selling can be easily misinterpreted and isn’t necessarily a bad sign. In fact, all insiders are selling, at one point or another.
When I see insider selling making the news, I often roll my eyes wondering who it may serve. Short sellers often use any data about executives selling some of their shares as a tactic to scare investors. It’s a misleading indicator that makes the less experienced investors among us potentially panic-sell or stay away from a stock for the wrong reasons.
Insiders are not just executives living at the top of an ivory tower. Just like any other investor, if they have a lot of their net worth attached to an individual stock, it’s natural for them to sell over time and diversify into other assets, no matter how high their confidence in their own business really is. They have life events, such as getting married or putting a down payment on a house, that may prompt them to sell a lot of stocks at a given time.
Insider selling should always be put in context:
- Is it part of a trading plan created in advance following the 10b5-1 ruling?
- How large is the existing position of the officer selling shares?
Overall, insider selling is an indicator that may scare away investors, when most of the time it should just be ignored.
An indicator I like to watch instead is insider buying. If you see an insider buying shares on the open market, despite having already a substantial position, that’s a very bullish indicator. That insider could still be wrong. But it means that someone having full access to the inner circles of the company is confident that the future is bright, and is willing to put money behind it.
10) They are dilutive
It’s always fascinating to see armchair experts commenting on the fact that a company is using too much stock-based compensation. My guess is that those making such comments have never run a young, fast-growing company.
Retaining talent is one of the most challenging tasks of a company’s leadership. As a shareholder, you should feel good about seeing the people running the company having their future aligned with yours.
Just like insider selling, dilution must also be put in context.
Let’s look at Twilio, a perfect example of a Silicon-Valley based software company with high stock-based compensation. Since going public, Twilio has issued almost 60 million shares, an increase of 70% in total shares outstanding.
Now, let’s put the increase in number of shares outstanding in perspective with the rise in the stock price. While a 70% raise in shares outstanding is not something to overlook, the stock price has risen by 670% since the 2016 IPO.
If you focus too much on dilution, you might miss out on opportunities to invest in some of the most promising and vibrant companies available on the market.
I could have used many of the companies in hyper-growth mode in the cloud software category such as CrowdStrike (CRWD), MongoDB (MDB), Alteryx (AYX), DocuSign (DOCU), Datadog (DDOG) or Zoom Video (ZM). They are all highly dilutive compared to the rest of the market. But their performance and potential over the long term far outweigh the concern for dilution.
Don’t let some of the traits that are universally considered as negative attributes for a stock prevent you from buying and holding some of the best-of-breed businesses available on the market.
All businesses come with strengths and weaknesses, opportunities and threats. If you can look past the obvious negative features, you might find a secular grower that is likely to outperform even the wildest expectations from Wall Street.
The same way turning off the noise can help you stay the course, looking past shortsighted negativity may help you find, buy and hold some of the best companies trading publicly.
To do so will require a leap of faith. In investing – as in most things in life – being an optimist will serve you more than it will hurt you.
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The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software and more.
While keeping in mind some of the best recommendations from experienced gurus of Wall Street such as Warren Buffett, Peter Lynch, Burton Malkiel or Philip Fisher, I am trying to beat the S&P 500 index by a significant margin.
Here are some of the trends reflected in the portfolio:
Disclosure: I am/we are long AAPL ABMD ALGN AMZN AYX CRM CRWD FB GOOG MDB MTCH NFLX SHOP TTD TWLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.