Story Stocks And When To Buy Them

Well, it’s time.  The holiday season is upon us!  It’s time of parties, good food, and plenty of socializing and celebrating.  Inevitably, I find myself invited to a few of these holiday parties every year.

My modus operandi at holiday parties tends to consist of standing around with a party-plate filled with snacks, being chatted-up by people I’ve never met.  Some of these party-goers have had a few drinks.  I’m not a drinker, but it’s clear that alcohol provides plenty of social lubrication for these events.

A few of the more talkative party-goers consider themselves investors.  Once they find out I’m a pretty serious investor, they almost always ask my opinion of their favorite “story-stock”.

“Oh!  You’re an investor are you?  What do you think about investing in Uber?  Normally I invest my money in index funds, but the company has really changed the world.  I’ve decided to invest.  Nobody is going to drive (or own) cars anymore! …it’s all going to be Uber in just a few years!  It’s going to be huge!  You should buy shares while you still can!”

Clearly they are mostly interested in sharing their opinion about a investing story they’ve completely bought into, and getting someone (anyone?) to validate their investment.

But are “story-stocks” actually good places to invest?  That sounds like a great topic for a blog post! 🙂

What Is A Story-Stock?

A story-stock is one of those stocks you already know about because it’s always in the news. If you asked 10 people if they’ve heard of any particular story-stock, you’d get 10 positive responses.

These stocks are new, innovative, always in the public eye, and news reporters love to promote them — think of companies like Uber, Lyft, Blue Apron, and Beyond Meat.

Those are all story-stocks.

It is of course the expectation of out-performance that drives the interest in story-stocks.  Investors buy into story-stocks because they believe these world changing companies will also produce incredible investment performance for them.

In other words, people see a new business model they love, have some personal experience with, and they somehow believe it will create a great investment.

Rarely does this turn out to be the case.

What investors tend to miss is that when story-stocks finally become available to the general public (such as in the case of an IPO), that is exactly when the original founders of the business are selling.

An IPO means they’re cashing-out and selling shares to the little guy who buys into the hype.

Typically story-stock IPO’s happen very late in the economic cycle, and tend to be bad investments.  Almost all story-stocks I mentioned earlier are either flat for the year or down for the year 2019.

This is in a year when the the S&P is up over 20%.

A Word About Profitability

In my opinion one of the biggest problems with story-stocks is that they’re usually unprofitable.  Story-stocks might have a great product or service, but as long as they aren’t earning a profit, these stocks are simply handing out shareholder cash to the customers.

Let take a look at some of the more popular story-stocks to see just how profitable these world changing stocks are:

Uber – A net loss of $1.162 billion last quarter.  Expected net loss for the year will probably be around $8 billion.  Yikes!

Lyft – A net loss of $463.5 million in the third quarter.  A little better than Uber I guess.

Blue Apron – A net loss of $26.2 million last quarter.

Beyond Meat – Net income of $4.1 million in the third quarter!  This is the only story-stock to show a recent profit!

Oh sure, story-stocks definitely tell a good “story” where growth eventually causes the company become profitable.  Yeah, nice story.  But we all know stories aren’t always true.

Here’s the thing — If you look at all the really great companies of the world, none of them had early problems with profitability.  If you go back to their early days, their business models typically generated profits from nearly day-1.  Think CocaCola, Microsoft, Disney, or Google.  They printed money almost immediately.

With story stocks it takes a HUGE leap of faith to believe they’ll one day become profitable.  A million things have to go right for them to see profitability.

While it is certainly possible for story stocks to become profitable, it’s actually quite rare.  I’ve never seen one turn over a new leaf, start spending less, and suddenly become a incredible success.

Why is profitability important?  As an investor, you need to ask yourself where does your money come from?  Do you profit from capturing market movements OR by sharing in the profitability of a business?

IMHO, it should be the profitability of the business that generates returns.  Investors should avoid speculating on the wild gyrations of Mr. Market.  Instead, businesses should generate cash above and beyond the replacement cost of their assets, and return that excess cash to investors.

Anything else I consider simply gambling.

A Word About Stock Dilution

Another major problem with story-stocks is stock dilution.   If the company founders are selling their shares as part of the IPO, then it’s usually stock options and stock awards that keep the current executives coming to work every day.  This means the number of shares outstanding continues to grow year after year… which is typically bad for long term shareholders because your owner ship stake gets “watered down” each and every year.

While it is correct story-stocks are usually high growth stocks, this continual watering-down of shares saps a lot of the benefits of growth away from shareholders.

For example:  Uber went public on May 10th 2019 with 1.1 billion shares outstanding.  By September 2019 company filings show this number had grown to 1.7 billion shares.  That’s 54% dilution in less than one year.  Meanwhile revenues are growing at a slower clip of 30% yoy.

If shareholders and potential shareholders believe they’re getting a square deal from a story-stock like Uber, they’ll be sorely disappointed.

Like a broken record, this same pattern of dilution is repeated over and over at most story-stocks.  I’ll leave it as an exercise for the reader to look up the dilution numbers for Lyft, Beyond Meat, and other story-stocks.

I’ll tell you right now, it’s not a pretty sight.

When To Buy Story-Stocks

So, when should you buy story-stocks?

If you happen to chat-me-up at a holiday party, don’t be surprised if 95% of the time I tell you “Never!!  I wouldn’t touch it with a ten-foot pole!”  I simply can’t predict the future, and gambling is no strategy for success.

Although I should never say never … there might be a circumstance where I would consider buying a story-stock:

• In instances where the founder still holds significant (>25%) share in the company after IPO.
• The business is profitable and has significant public data that proves the business model works.
• When stock dilution isn’t a problem.
• When the business has existed through a full market cycle, and shows good stability (or even growth) during a recession.
• Returns on newly invested capital generate growth in cash from operations.

Most story-stocks simply don’t tick all these boxes, and that’s OK.  A good investment *should* be rare!

When all of these boxes get ticked, a couple of things tend to become true – First, the stock is almost always expensive.  Meaning every hedge fund on the planet has already purchased shares and bid the price up.  Even though the business is likely stable and profitable, the “stock” side of the investing coin then becomes the gamble, not the business.

Second, new, fast growing and profitable companies tend to attract a lot of attention … and eventually competition.  For example, you didn’t see Disney entering into the video streaming business until Netflix became profitable.  (Netflix is a rare example of a money losing story-stock that eventually started turning “accounting” profits).

Competition is a fact of life, and most story-stocks exist in rapidly changing industries.  They will likely NOT remain a dominant player for long.

Bah Humbug!

I never want to sound like a Grinch at a holiday party, but the money nerd in me wants to tell the honest truth about investing in so-called “story-stocks”.  I try to tell people how it is.

Frankly, most people will be far better off sticking with index funds instead of gambling on story-stocks.

Unless you’re willing to sit down and read every 10-Q or 10-K that’s been published, I would recommend staying very far away from story-stocks.

Telling people the truth doesn’t make me a particularly popular party guest during the holidays, but I haven’t steered anyone wrong yet.  Maybe that’s why I get invited to these holiday parties every year… people like having a sounding board!

While many story-stock investors have visions of incredible investment returns amongst the sugar-plum faeries, perhaps a little dose of reality comes in handy once in awhile.

Happy Holidays Everyone!

[Image Credit: Flickr1, Flickr2, Flickr3, Charts from Yahoo Finance and Guru Focus]