Riding The Wealth Elevator

Imagine for a moment — You are riding an elevator.  This elevator goes up and down like all other elevators, but there’s no display telling you which direction the elevator will go next.  No blinking numbers indicating direction either.  Similarly, you don’t know how many floors are in the building, or even what floor you are on.  It’s a blind ride.

What makes this elevator so unusual, is that it moves in response to how many riders get on or off.  When more riders get on-board, the elevator tends to rise  When riders get off, the elevator begins to fall.

This is what I like to call: Riding the Wealth Elevator.

Riding The Elevator

As you might have guessed by now, this little story about the elevator is actually about investing in publicly traded stocks.  Most people want to ride that elevator (stocks) as high as they can, gaining wealth.  They will happily jump on the elevator when it appears to be rising.

The only problem is, as soon as the elevator starts to show even the slightest sign of falling, riders begin jumping off in droves!  Due to the unique properties of this elevator, these “exiting riders” actually exacerbate the decline (of the stock) when they sell and jump off.  These declines can spook other investors, causing them to sell in-turn.

This is why some profitable companies like GE can see their stock drop like a rock after a few bad years, and others (which haven’t a cent in earnings) can rise 300% in a single year!

What’s not clear is if the riders who jumped-off were premature.  Will the elevator will begin rising again?  Or, will it continue falling to the basement?

This wealth elevator ride is analogous to “momentum investing”, which has been very popular lately.  Stocks like Tesla and GameStop have attracted a ton of new investors looking for quick returns from stock market momentum.  As long as other investors (riders) reman confident, rising prices can become something of a self-fulfilling prophecy for a stock.  Due to the growing demand for shares, prices can skyrocket very quickly.

The higher a stock price becomes however, the more likely it is investors will start “cashing-in” their gains, hastening the decline.

Investor perceptions around the movement of a stock (or even the entire stock market) can have even greater effects on the stock’s performance, than even it’s business fundamentals!

Even if you don’t buy into all this “momentum investing” stuff, it’s at least worth understanding how a stock’s performance can be affected by the Wealth Elevator.

The Lifecycle Of A Business

To understand how to succeed in a world where investor perception matters, I think it’s important to first understand the lifecycle of a business.  Yes, stocks do have lifecycles, just like living organisms!

That lifecycle typically follows a pattern, with the following stages:

Startup — In this phase there is rapid organic growth (30%+ yoy growth), but little profitability.  The business is typically not self funding, and usually looks to venture investors (or an IPO) to provide cash for expanding.

Expansion — In the profitable expansion phase, the business becomes self-funding and cash flow positive.  Fast organic growth continues albeit at a slower pace (15-25% yoy).

Maturity — When a business reaches maturity it has difficulty finding profitable places to invest excess cash.  Often times it begins buying back shares, or paying a dividend in order to return capital to shareholders.  Organic growth is minimal at this stage (5-10% yoy).  The prospects for future growth in the original business are small.  The best hope for the future is typically an acquisition of another business.

Decline  — The decline phase is typically marked by declining revenues of the original business.  Revenue declines can be slow (taking many years) or can be quite fast.  If there were failed acquisitions made during the maturity stage, the business will begin writing them off, reporting large losses.  Despite accounting losses, the business may remain cash flow positive and continue to pay dividends and buy back shares.

Dissolution — At some point, the revenue declines begin to increase, and profitability dries up.  When this happens the business is usually dissolved — Inventories, buildings, and equipment are sold, employees are laid off, and any remaining capital is returned to shareholders.

Displayed graphically over time, the business lifecycle looks something like this:

Revenue, growth rates, and profitability are the key indicators to look for in determining where a stock sits in the business lifecycle.   These attributes will attract or repel investors like no other!  They also determine how much of a premium investors are willing to pay to own that stock.

For example:  Growth investors are almost always willing to pay a large premium if a stock is growing quickly.  This is premium typically happens in the Startup or Expansion stage of a stock’s lifecycle.  Think Tesla or Netflix here.  These are fast growers in exciting new industries.  Investors are often willing to pay *incredible* premiums to own these stocks.

Once a stock reaches the Maturity phase however, growth investors begin jumping-off and a few (albiet smaller group) of investors called “value investors” tend to jump on.  Value investors are also much more careful about the price they’re willing to pay for a stock, so typically there is little-to-no premium on the stock price.

Generally speaking, any stock in the Declining phase I recommend you avoid.  These are difficult waters to succeed in, and the stocks are treated like garbage.  Yes, they’re extremely cheap, but nobody really wants to own them.  How will you get your money out if you decide to invest?  If you invest in stocks like these, be willing to ride them all the way down to zero (until dissolution).

A Case Study: The Multiples Of Microsoft

The lesson I’m trying to impart in this post, is that investing is more than just a game of calculating the sum of discounted cashflows.  It’s also about understanding how other investors perceive a stock, and what kind of premium they’ll pay to be an owner of it.

Microsoft offers a great example of how this idea works in the real world.  It makes for a great case study in understanding how the wealth elevator works.

First, let’s go back to the 1980’s and 1990’s.  At the time, Microsoft was a high flying technology stock and PC’s were the king of the tech world.  Investors were paying PE multiples in the 50’s and 60’s in the late 90’s to own a part of Bill Gate’s software business.

Microsoft was growing rapidly, and it was good times for investors jumping on-board MSFT stock because it just kept going up.

Those good times came to an end in late 2000 when the “Dot Com bubble” finally popped.  Sales of PC’s began to slow in the resulting recession, and the invention of tablets and smartphone caused PC sales to further stagnate.

Consequently, Microsoft’s PE multiple compressed significantly in the following years… eventually falling to an all-time low PE of 9.06 in March of 2009.  This was a tough time to be a MSFT investor, despite the dividend it began paying in 2003 (further signaling its maturity).

Even though earnings, and dividends continuously rose from 2001-2013, investors had little confidence in Microsoft.  It was considered a “mature” business, and possibly one that was starting to decline.  As a result, Microsoft’s stock stagnated for 12 long years.

The stock price remained flat from 2001 to 20013.

As you can see from the more recent years on the chart, Wall Street’s crystal ball turned-out to be totally wrong about Microsoft.  Those who got off the elevator during the stagnation period managed to miss out on some of MSFT’s biggest stock moves ever.

Why did this happen?  What changed investor perceptions?  A new Cloud business, a change of CEO’s, and a world-wide pandemic completely altered investor perceptions around Microsoft stock.

These days, Microsoft is a back in the Expansion business phase.  Revenues are growing rapidly, and investors are willing to pay a PE multiple of 36 to own Microsoft again.  That’s not quite the highs we saw back during the dot-com bubble, but it’s clearly enough of a premium to show that Wall Street got it wrong.

Turnarounds of this magnitude are rare, but they do happen.

The Lessons Of The Wealth Elevator

If there’s one important lesson to be learned from the story of the Wealth Elevator it’s this — Investor sentiment can change dramatically over the course of a stocks life.  Investors should know that buying stocks is more than a simple calculation of “buying low” and “selling high”.

Investing can be as much about understanding what’s “in fashion” with other investors (and what they’re willing to pay a premium for), as it is about metrics and fundamental indicators.

In recent years, investors seem willing to pay premiums for any ‘technology’ stock that’s growing rapidly.  They’re dumping the mature slow-growth stocks (the so called “value stocks”).  Value has underperformed rather badly during this time period.

Maybe it has something to do with growing expectations of faster inflation?  Perhaps these high flying tech stocks are thought to perform better in an inflationary environment?

Your guess is as good as mine!  Just remember this — It’s just as easy to get caught on the wealth elevator when it’s falling.

Be on the lookout for riders getting off!  Good luck out there! 🙂

[Image Credit: Flickr]