Profitability Doesn’t Matter?
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.
A 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.
No Growth
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.
[Image Credit: Flickr]
I LOVE Amazon Prime. If I had known that ” a mere $5,000 investment in Amazon is now worth $2.4 million” years ago, I would have bought some Amazon stocks (as anyone else would, I guess).
Whenever we hear someone gaining a big return to their investment in some startups or fast growing companies, we tend to feel like we have been missing out on a big profit. I feel like that all the time. But then I have to remind myself that investors must have the expertise, the money, and the appetite for risk to make that happen. We talk about the big wins, but we don’t know how much money they’ve lost invested in someone else.
Absolutely. Most startups fail, and a lot of ‘growth’ only exists because of a ridiculous amount of shareholder dollars being thrown at it. The risks are very real.
Take stock in the fact that the surviving companies will eventually make their way into an index. 😉
Mind you, I did NOT invest in Amazon.com, nor would I invest in another startup based on what i know now. However, contrasting Amazon.com with Pets.com we see in the case of the former an update of the old-fashioned Sears & Roebuck mail-order catalog. People been making money with that business model for at least a century and a half. Probably going to make some money doing that going forward, too. In the case of the latter, we had a mail-order business with some promise (lots of folks have pets to feed), but the high profile sock-puppet seems to have lacked the business gravitas to weather a recession. The modern-day Benjamin Graham has to novel out the difference between geeks spouting flashy, impenetrable technobabble, then distinguish the flash in the pan as pyrite versus gold. Good luck with that.
I enjoyed your post. It took me back to the mid-1990’s when I started investing. I have always been a boring index fund investor. For me, I don’t know what stocks will turn into the next Amazon. I remember Toys.com and other dot.com flops all too well from that period. The closest that I ever came to chasing growth was to buy the Janus Worldwide Fund in 1999. It has since merged with the Janus Global (JAWWX). Without looking at me notes, I remember that the fund went from being a 5-star darling to loosing money for 6 or 7 years straight years following the dot.com bubble.
I owned some Janus funds back in the day too… I forget the names, but I remember the terrible performance after the dot-com bubble! 🙁
I consider it a lesson well learned, one that I’m attempting to share today.
You never know what the future holds. 20 years from now even some very large seemingly irreplaceable profitable companies could be gone (looking at you Eastman Kodak). If large profitable companies can disappear then growth companies with no profits are even more susceptible.
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I agree growth is a giant guess! I firmly believe that index investing is the way to go and you’re right, companies that get it right end up in the index and even if you’re passive you invest in them.
During the latest Berkshire annual conference Buffett even said that Geico was paying $11 a click way back in the day for google ads and he didn’t invest. But if you think about it if you’re paying $11 for a click that costs nothing to serve – that’s a pretty good business. If one of the best investors didn’t pick up on it… Better off to buy the market and instead focus on your savings rate.
Amazon is amazing, but I remember thinking about investing in the 90’s and being fraidy scared about some of the risks. In particular, I thought that a lot of their early success was due to sales tax arbitrage – people were buying there because they didn’t owe local sales taxes and that more than justified any shipping costs. They did a great job fighting that longer than I would have thought possible – until they were part of the fabric of almost every consumer’s life, and then it didn’t matter. Your point about other companies failing is valid – Amazon out-executed everyone, and their brilliance in that regard wasn’t obvious until after some of the serious money had been made.
I do wish Amazon would slow down in all of the new areas and make some serious profit to justify the valuation. Given their enormous success in some areas of their business, I think they’re in a race against time to profit before the FTC starts to get curious from a monopoly angle.
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Once upon a time we decided to hire an analyst for our team and the best job description we came up for this position was – “In this position you will have to predict something really great and explain later why your prediction didn’t come true”. I like risk (sometimes) and I always realize that things might not become as predicted. I invest 25% of my retirement money in Growth and Income index funds, these funds are wild horses but…
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Amazon currently has a P/E ratio of 186!! So I’m thinking it’s slightly overvalued. 🙂 Thanks for the always-important reminder that investing is a marathon. I love the Munger quote. Turns out, it’s a lot harder to be not stupid than it seems. It’s so easy to get sucked into the mass hysteria.
Yup, much better to go slow and steady rather than trying to get lucky and knock it out of the park. That goes for other things in life too, not just investing. I think this is why I read so many “side income” and “online business” and tried them out but never got anywhere. FIRE was the only sure thing that lead me to freedom.
Over the long term, indexing always wins over trying to predict the next hot shot stock. Invest, don’t gamble.
Trying to be consistently not stupid with investment dollars is definitely a marathon by itself. Chasing growth feels dangerous, because a company can only get so big before anti-trust lawyers sniff around. A good company is better than a big company.
Mr. Tako, you are very wise. this post really hit a chord. I remember when I used to work for company IPOs, all these wild numbers I had to help come up with in excel modeling for the financial projection seemed entirely baseless to me; yet, investors still asked these questions and you come up with rational sounding answers. We are all educated enough to come up with good bullsh*t. But mind you, these are PEs and institutional investors who obviously played with other people’s money, so they really just needed to have a good justification ready in case it fails(if it wins, they get a big pay check, if they lose, then they don’t lose anything, seems quite unfair to me) But not too many people wants to hear it since, I think it might have been Buffett who said it, good investing is really boring(like farming). Hunting is much more exciting. You can probably hunt occasionally for the thrill and possible quickloot but if you do it consistently, sooner or later you get hurt(as I have learnt big time in my early investing days). But I digress. Your post hit a chord also because I was analyzing the numbers on the Dividend Champions, and was trying to come up with a semi-rational way to sort out the most relevant metrics. Looking at the estimates/next x year items, I feel those are probably the least relevant(as you said analysts often are wrong). History can’t predict future but at least attest to the company’s competence. The Dividend Champions is really great, I just wish it added one more data: last 5-10 years dividend payout ratio, so we can see a trend of whether the company has consistently paid out more, I guess the DEG ratio sort of captures it, but would be nice to have it laid out year by year.