Regular readers know how I feel about Snapchat (SNAP) as an investment. I find it amazing that Wall Street has the ability to float such an over-hyped commoditized text messaging service pile of money-losing garbage to market participants. Snapchat came public at about $24 per share which valued the company at $28.8 billion. And it only lost about $500 million in GAAP earnings in 2016. Yet, Wall Street is able to sell shares to you and tell you it’s an investment. That’s like punching you in the face and telling you it’s a medical procedure.
Red is the New Black
Apparently, losing money is now valued more than making it. It’s true. Investors value companies more if they lose money than if they make money. This phenomenon is usually found in tech companies that woo investors with stratospheric growth rates. The theory goes that if you focus on growing the top line through massive scale, then the bottom line will eventually catch up. Companies can operate in the red for years if they’re well-capitalized. While I do agree that this works in theory, I have to draw the valuation line somewhere.
It worked for Facebook (FB). They went public in May 2012 at $38 per share valuing the company at $104 billion. Unlike Snapchat, Facebook actually made money during the year it went public. It was a small profit: $50 million on $5 billion in revenue. Shortly after Facebook went public, their stock dropped to $18 a share, a loss of more than half from the IPO price. Many retail investors bought the stock above $38 a share on opening day.
Facebook got it’s act together and has since returned close to 300% from their IPO price five years ago. That’s a compounded annual return of 31.60%. They killed it. How? Through stratospheric top line growth and a net profit that followed suit, that’s how. Facebook has managed to grow its annual revenue to $28 billion with profits of $10 billion. Now that is how you scale. Facebook mints money for its shareholders. I think Snapchat is a different story.
Wall Street got its hands on Snapchat and extracted as much value as they could. Wall Street doesn’t value companies at fair value. They get the price as high as possible because the equity stakeholders make more money this way. It’s not that I think that Snapchat is a bad company. They may do quite well but their valuation is holding them back. The price of the company is so high, they’d have to outperform for the next 10 years to justify it. I don’t know any company, let alone a tech company, that can outperform over a 10 year period.
How Do You Know What Something’s Worth?
I value companies based on discounting their future cash flows back to the present. Call me old school, I know. To do this, you forecast the expected cash flow that a company will generate and discount back to present value using an interest rate. This interest rate is called the discount rate and is equal to the companies’ weighted average cost of capital (WACC). Companies will generally have a couple different growth rates during the forecasted time period. They might grow their cash flows at 10% for a couple years, then 5% for a few more years, then 3% in perpetuity.
It’s really not that hard but it’s definitely harder than just swallowing the hype that Wall Street is shoving down your throat. Here’s a illustration for those visual learners:
The formula for discount cash flow by year to present value is: Cash Flow / (1 + Discount Rate)^n where n = the number of years.
The company in the above example will make $100 million this year. We expect their cash flow to grow at 10% in years 2 and 3, 5% in years 4 and 5, with a terminal rate of 3%. What the hell’s a terminal rate? That’s just the rate we expect the company to grow its cash flow until the end of time. The $1,963 in the above example is calculated by taking the cash flow times the terminal rate divided by the WACC minus terminal rate.
(terminal year cash flow * terminal rate) / (WACC – terminal rate)
Have I sufficiently lost everyone? Ok, hope not. In normal speak what we’re trying to do here is simply see how much cash the company will generate in the future. Then we need to see how much that cash will be worth as of today to value the company. In the example above, the company is worth $1.662 billion based on the discounted cash flow method. This is fair value. Ideally you’d want to pick up the company at a price less than that.
Investment or Gambling
You can’t value Snapchat like this because – shocker – they don’t have positive cash flow. You could value Snapchat on revenue. The company that had revenues of $400 million in 2016. Facebook is valued at 14.7x its annual revenue. Twitter trades at 4.2x its annual revenue. Even if you’re generous and value Snapchat at 20x revenue, it would be worth $8 billion. At this price and given its growth rates, $8 billion seems high but in-line with what you’d expect from a tech firm like this. Snapchat is instead priced at 72x its 2016 revenue, or $28.8 billion.
I think you’re better off buying lottery tickets than “investing” in Snapchat stock. Let’s say you invest in 100 shares of SNAP stock at $24 per share for a total outlay of $2,400. You could easily lose half your investment or $1,200. You’d be better off “investing” in $100 worth of lottery tickets. This way you’d only lose $100 instead and you’d actually have a chance of winning something. You’d definitely have more fun with the lottery tickets. You can take out your favorite quarter and scratch away. Now I’m not saying to buy lottery tickets instead of overvalued stock.
What I’m saying is if you want to gamble, which is what you’re doing if you buy certain stocks, then you should actually gamble (with small amounts). You’ll lose less money, have less emotional stress, and you won’t be kidding yourself. If you think that you’re going to get rich investing in Snapchat, you are kidding yourself. The people who got rich off this puppy filter have already made their money. You’re just being sold to.
It’s interesting to me to compare gambling and investing. They’re both math-based and statistical. There’s a certain mindset that some people have that investing is similar to gambling. “I don’t want to lose money,” is what you’ll hear people say when they’re talking about possibly investing. That’s a legitimate concern. Who wants to lose money?
Value Is What You Get
I’m a value investor at heart. Sure, I love having a few high-flying growth stocks in my portfolio purchased at what I think is a good price. But the majority of my stock purchases are based on being a good value (using discounted cash flow analysis). I like to buy 50 cent dollars. In some markets it’s more realistic to buy 75 cent dollars. Wall Street likes to sell you IPO’s as expensive dollar bills. They take $3 from you in return for one dollar in value they provide.
“Price is what you pay. Value is what you get.” ~ The Oracle of Omaha
In theory, once the value of the stock approaches fair value (a one dollar dollar), I should sell and sit on a pile of gold like Scrooge McDuck. It’s much more difficult to know when to sell stocks in practice. All kinds of different variables are changing constantly. It takes some work to cut through the noise and figure out long-term trends for the stock.
I’ll use selling my utilities and REITs as a real life example. I held NextEra Energy (NEE), Realty Income (O), and Southern Co (SO) in my portfolio for years. I then decided to sell every utility and REIT in the summer of 2016. I could no longer justify such crazy high valuations for companies with just ok growth prospects. I sold after years of unsustainable gains, slowing dividend growth, and the lowest interest rates we’ve seen in years.
Reasons why I sold utilities and REITs and why I won’t reinvest until the next recession.
1) High Valuations – I couldn’t justify owning utilities and REITs at such sky-high valuations. Companies in this space are generally low growth and regulated: utilities are regulated and the only way REITs grow is by issuing more debt to buy property. I’m not excited about the prospects of either. I’d rather put my money to work in companies that aren’t regulated and have greater scale. It also helps if the company has a brand and can charge a premium. When’s the last time you thought of your electric company as a brand? Would you be willing to pay more for electric if it came from one company over another? Of course not! It’s a commodity. The unsustainable gains I mentioned above can be tied into high valuations. I company can only expand their valuation so much. It will hit a wall eventually and will revert to the mean.
2) Slowing Dividend Growth – I love a good dividend growth company. But when the growth becomes lackluster, you have to consider other options. You want to at least keep up with inflation plus a small margin. I’ve developed the Dividend Performance Indicator to use as a guideline on buying dividend growth stocks. Knowing when to sell them is a little more difficult.
3) Rising Interest Rates – Rising interest rates act as a drag on returns, especially with companies like utilities and REITs who rely on cheap money to prop up their value. As rates increase, projects become much less profitable because the WACC increases. Some projects that don’t have as good a return on investment and will be nixed entirely. I’m not sure if interest rates will stay low for the next decade or rise in the near future. It seems to be that we’re in a global liquidity trap that is not sustainable. Rising interest rates may be difficult to do unless we see real growth in GDP.
I won’t reinvest in utilities or REITs until the next recession hits and we get a major discount in the price of the shares. There are many other places to invest your capital where you can earn a better rate of return with a lower risk. It’s a no-brainer but some people are conditioned to stick with certain types of investments even if the investment has the chance to crush their returns.
Margin of Safety
When considering valuations of companies you also have to consider the degree of your margin of safety. Chapter 20 of the Intelligent Investor is titled “Margin of Safety” as the Central Concept of Investment and lays out everything you’ll need to know about investing with a margin of safety. Graham boils it down to this: “In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earnings power considerably above the going rate for bonds.” He then goes on to give an example of a company earning 9% and the bond rate is 4%, resulting in an average annual margin of 5%. This ensures that the company will be to continue to pay its debt obligation and have excess to reinvest in the business or pay out as dividends.
What do you think the margin of safety is on a company that loses hundreds of millions annually and has a WACC in excess of 10%? You guessed it: ZERO. Investing in companies that don’t have a margin of safety is speculating or gambling. Call it what you will. It’s why I think lottery tickets are a better use of your money. At least in the case of lottery tickets, you know you’ll lose all your money. In the former, it’s not as clear, giving you fake hope that you’ll become rich from your investment. It’s one huge scam on people who don’t understand the way stocks are valued.
“In making decisions under conditions of uncertainty, the consequences must dominate the probabilities.” – Peter Bernstein
It’s also important in a discussion of margin of safety to understand the risk inherent in your portfolio. Leading up to the Great Recession, Bill Miller a Legg Mason fund manager, held Countrywide Financial, Bear Stearns, and other financial firms that almost went bankrupt. He held a concentrated portfolio that outperformed until the Great Recession hit, causing his fund to go down about 75%.
ClearBridge Value Trust (LMVRX) performance June 1, 2007 – March 6, 2009
Source: Google Finance
“The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?” –Bill Miller, 2008
It’s the portfolio concentration that helped Bill Miller outperform the market for fifteen years but it’s also what led to his severe underperformance in 2008. Did Bill Miller make the wrong investment decisions for his fund? It seems like an easy answer in hindsight: no, he should’ve been more diversified. But it’s not that easy when you consider probability. The probability of the occurrence of different possible outcomes. The outcome could’ve been different and thus Bill Miller would have continued his market beating streak.
Consider probability in this theoretical example. I decide not to make an investment in company X. That company then proceeds to beat the market by a factor of 5 over the following year. Did I make the incorrect investment decision? Again, it may seem like the answer is yes. But when you consider probability, the answer is not so clear. What was the probability that the stock would outperform? What are the distributions of outcome for the stock? How does the stock fit into my overall portfolio? Since we don’t know something prior to it happening, we have to consider the distribution of potential outcomes. This is where risk management comes in – understanding the probability of occurrences is essential to risk management.
I recommend investors follow a Triad Portfolio when setting up their investments. The Triad Portfolio plan prescribes investing in three different asset categories: risk-free, core, and alternatives. The amount you should invest in each category depends on your risk profile, age, and investment objectives. After you figure out your allocation to each asset category, you then need to figure out your asset class segments (the investments that are within each asset category).
I mainly write about retirement planning, which includes:
- How to maximize your Social Security
- Investment strategy and tactics
- Economics and how it effects your portfolio
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