The stock market loves growth. The faster a company grows, the larger its market valuation. The investing world is literally in love with growth stocks.
When Forbes writes articles about how a mere $5,000 investment in Amazon is now worth $2.4 million, it makes even the most rational value investor wonder if they’re missing out on the wonderful returns that growth stocks provide. In Amazon’s case, a ridiculous 49,000% return.
Fast growth doesn’t always mean profitability however. Fast growing companies are frequently very unprofitable, burning through shareholder capital like it’s water.
So does profitability actually matter anymore? In this era of no-profit high-growth companies is the secret to achieving great equity gains all about capturing growth?
Rewind To The Year 2000
Remember the Dot-com bubble in the late 90’s to the early 2000’s?
The investing world was playing a similar tune at the time. Investors no longer cared about profitability, it was all about fast growth. Profitability would come later. Investors put billions of dollars into the ‘high growth’ internet sector with nary a dollar of profit in sight.
Rising valuations were all the “proof” would-be investors needed to validate this high-growth investment approach, so they continued to invest even more…
Inevitably, the bubble popped. Stock prices dropped, and shareholders were no longer willing to put up capital to fund money losing businesses. Once these “fast growers” no longer had access to cheap shareholder dollars, business quickly dried-up.
Anyone who’s ever worked at a startup knows, this is the game — drive customer behavior with a deeply discounted widget (or service) and hope that you’ll eventually grow large enough that economies of scale will take-over. Profitability will happen… some day.
Of course, a few of the 90’s era internet startups actually survived and prospered. They were big winners. Could you have picked Amazon as the eventual King of online retailing? Probably not.
Back in the 90’s, Amazon mostly sold books online. Was there any hint of what Amazon might become back in the 90’s? Any inkling of Amazon Prime, AWS, Alexa, Amazon Video, or even Amazon Echo?
Hell no! Amazon mostly sold books! During the dot-com bust, many investors thought Amazon might actually go bankrupt.
And this leads me to my first point — Growth is often a giant guess.
Yes, a big fat guess.
Fast growing companies are like a game of musical chairs — While the music plays, times are good. Customers are attracted to the good deals and ‘easy money’. Growth rates are incredible.
When does the music stop? Nobody knows. When it does, and the money finally dries up, frequently so do the customers. Growth slows considerably, or it turns negative.
Take for example another growth company of our current era — Tesla. What if Tesla suddenly doubled the price of their cars to achieve profitability? Growth would grind to a halt.
All those growth predictions that fuel sky-high valuations and irrational exuberance? No longer relevant!
Wall Street doesn’t like to admit this of course. They hire analysts whose entire job is to try to figure out the answer to this growth question — Very, very smart people who study the problem, and are frequently very WRONG.
Analysts attempt to predict these growth rates using industry data, proforma projections, fancy powerpoints, ivy-league business degrees, and pixie-dust…. yet they still frequently fail.
Yes, Profitability Still Matters
Any business school student could tell you — profitability still matters. Profitability is what sustains a company when the investment winds change, and all the easy money dries up. Profitability is what keeps a company solvent when the next recession comes.
Profitability means a company can go from burning cash to actually compounding cash. Without profitability there is no compounding, and every investor loves compounding!
So where is all of Amazon’s profitability? It’s actually there, just hidden. Amazon is choosing not to be profitable at this time. Instead, they’re investing like mad into new businesses, promotions, and R&D… items that greatly inflate SG&A (Selling General and Administrative) costs, and mask profitability.
I firmly believe Amazon could become very profitable if they wanted to. The only problem is, they’d have to take a foot off the growth gas pedal to do it. Prices might rise slightly, free shipping might disappear, and we’d see fewer innovative products come out of Amazon.
So where does this leave all of us “regular” investors who want to capture some of those incredible growth rates?
Actually, in a very good position.
Let’s go back to Amazon to illustrate — Amazon went public in 1997, and was later added to the S&P 500 in 2005. You would have missed out on some decent gains during that time period.
But, by being a humble index investor you didn’t miss the boat. The vast majority of Amazon’s share price growth actually happened in the past 12 years… after it joined the S&P 500.
While Amazon’s proportion of the S&P 500 may have been small in the beginning, you probably saved yourself from losing a ton of money. It’s just as likely you could have picked a failures like Webvan or Kozmo, as you would a winner like Amazon.
Remember, $5 trillion of market value was lost when the Dot-com bubble popped. Winning in investing, is often the same as not losing.
In most cases it’s probably safest for investors to avoid high-growth companies, they’re just too speculative.
At some point, investing in that fast growing company is no longer really investing, it’s actually just gambling — Essentially no different than going down to the nearest track and putting money on the horses.
I’m reminded of the wise words of Charlie Munger — “It is remarkable how much long-term advantage [we] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
While the press may trumpet the incredible gains of investing in growth stocks like Amazon, please don’t change your strategy. Fast growth investing is just gambling on wild-assed guesses. Investing for financial independence isn’t about picking the fastest horse, it’s about who lasts the longest.
Want to survive the investing game for a very long time? Stick with the steady investment returns of index funds (and predictable slow growth stocks).
You’re far more likely to avoid mistakes over the long term by sticking to a slow and steady strategy, than you will by gambling on your favorite
horse fast growth stock. Investing is a marathon, not a sprint.
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