Growth demagogues will argue that valuation is irrelevant for high-growth companies because the price you pay for growth doesn’t matter. They call value investors “accountants.”
The price you pay matters. If you bought high-growth companies near the end of the dot-com bubble in the late 1990s, it took more than a decade to break even (after double-digit losses).
Consider Qualcomm The company’s shares returned 2,619% in 1999. That is not a typo. Indeed, Qualcomm truly is an incredible company (My firm owns shares, which we bought for the first time in 2015). Qualcomm owns essential patents on wireless technology. Your mobile phone runs on Qualcomm’s intellectual property. Every time a mobile phone is sold on any part of this large planet, Qualcomm collects a few bucks.
From 1999 the mobile phone market went through an enormous growth spurt — it’s hard to find a market that grew faster globally. Yet Qualcomm stock slid 83% in the early 2000s. It took 15 years for Qualcomm to revisit its 1999 high, while its revenues went up 6x over that time.
If Qualcomm doesn’t remind you of Tesla it should — electric cars are the future. (I wrote a short book about this, which you can read here.) Tesla stock was up eight-fold in 2020 and the company joined the exclusive S&P 500 Index Tesla stock is trading at an astounding 22x revenues, or some (meaningless) price-to-earnings multiple (the company is barely profitable). I have discussed Tesla’s valuation in the past, and I’d wager that the expected return for the stock over the coming decade is quite unattractive. Again, the price you pay (even if you love the product) still matters.
Now that I’ve made a lot of friends in the growth demagogue camp, let’s make some among the value demagogues.
Value demagoguery starts when value investors read Benjamin Graham’s “The Intelligent Investor” and the main point they get out of the book is that they need to buy statistically cheap stocks. Value demagogues often miss the key investing philosophy embedded in Graham’s book. I spelled out that philosophy in an essay, “The 6 Commandments of Value Investing” (you can read it here).
Value demagogues also look at the statistical valuation of high-growth companies and ignore that this number is based on rear-view mirror earnings. They also ignore that there’s tremendous value in growth which is unlocked when a growth company matures. At that time, costs increase at a slower pace than revenues, margins expand, and earnings skyrocket.
This is why in our models my firm looks at companies based on their expected earnings at least four years out. If we have a unique insight into the sustainability of a company’s protective “moat” against competitors, along with an exploding total addressable market, we are looking out farther than four years and then discounting back to today.
What makes the analysis of some of the growth darlings more difficult nowadays is that their income is distorted (depressed) by investments (in customer acquisition, for instance) that are made through their expense line on the income statement.
For example, Walgreens Boots Alliance when it was opening several stores a day during its high-growth stage, was doing so through its balance sheet. It would buy land, build a store and stuff it with inventory — all these activities happened on Walgreen’s balance sheet.
A store is a long-term asset that will help Walgreens generate sales and profit for decades. Walgreens would depreciate the land and building over 30 years; thus, as an investor, you would only see 1/30th of the building’s cost going through the income statement in any given year. Inventory would show in the income statement as cost of goods sold when they were sold. Costs in the income statement matched revenues they helped to generate.
When software-as-a-service (SAAS) companies acquire customers, the costs are expensed through the income statement, depressing earnings (they never touch the balance sheet). Though the customer may stick around for 10 years, the cost of acquiring that customer hits the income statement on day one (e.g., in the salesperson’s commission). The faster you grow, the heavier the customer acquisition burden you carry.
Research and development (R&D) efforts also don’t flow through the balance sheet but are expensed through the income statement. R&D is building an asset that will have a long-term life (just like a Walgreens store), but almost all of R&D cost is expensed in the year it happens.
Modern accounting conventions were created for the industrial economy, which was heavy on physical, easy-to-identify, depreciable assets (stores, factories, etc.). Over the past two decades significant parts of the economy changed, but we are not going to wait for accounting conventions to change, so we need to change.
We don’t want to be either value- or growth demagogues. Our goal is to produce good returns for our clients (and ourselves since we own the same stocks) while sleeping well at night. Over the years we’ve made gradual changes to our analytical process to capture value when it resides in growth. Nowadays traditional value (defined as slower-growth companies) has been underperforming growth for too long. High-growth stocks (even adjusting for nuances in their accounting) appear tremendously, if not insanely, overvalued. There’s real value now in those slower-growth stocks.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which holds long positions in Walgreens Boots Alliance and Qualcomm, and put options on Tesla.