Priced-to-Perfection vs. Priced-to-Fail
Steven is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
What’s better: A single, or triple-digit PE? Both have inherent dangers and follow a different set of expectations. One entrusts management to deliver at a future date, where the other is discounting management’s ability to turn things around. Neither of them is a sound investment strategy to follow over the long-term. But sometimes we end up owning companies that fall into these scenarios. When this happens, would it be wiser to stick around, or pack your bags running? That’s what we’re here to debate today.
It’s a Five Letter Word
Faith. That’s what it takes to own a company with a triple-digit PE and lack of earnings history. Uncertainty also comes to mind. These are the companies that are priced with higher expectations than the stratosphere. Should they fail to deliver, shareholders are at risk for catastrophe. Amazon (NASDAQ: AMZN) is an interesting example here. They have delivered on many aspects of their business, except for one – sustainable earnings growth. Shares have traded with a triple-digit multiple for almost a year. By triple-digit, I mean 286. But fear not, because investors have faith in Jeff Bezos and his vision that sustained profitability will come.
In the last 10 years, Amazon’s PE hit the mid-20s twice and only stayed there for a short period. One of the instances was during the Great Recession, making it probably not the best metric to measure Amazon with. I wonder if there is a puts-businesses-out-of-business metric? On that basis, business is booming. All kidding aside, they have doubled their revenues in two years time. This is the type of growth that has been supporting shares, and fueling investor conviction.
Look Out Below!
Investors either don’t understand Netflix’s (NASDAQ: NFLX) business model, or they’ve lost faith in leadership. Either way, shares plummeted 25% after an earnings meet. Perhaps it was because CEO Reed Hastings raised the roof with his Facebook (NASDAQ: FB) post when he announced to the world how great the streaming business performed. When the numbers came out more or less in-line with previous expectations, reality set in quickly. Getting investor hopes up is surefire way to increase shareholder risk.
Facebook’s recent performance shows how little it takes for investors to lose faith. A poor IPO performance and a bad quarterly earnings report have brought shares tumbling. Investors are unsure what lies ahead for the company and have discounted its earnings potential. Mr. Zuckerberg isn’t being viewed as trustworthy and competent as Jeff Bezos, probably because Facebook was never meant to be a business in the first place. It became one after the fact. I’m not saying that makes a business designed for failure, but it makes finding a clear direction more challenging. Google (NASDAQ: GOOG) is living proof that evolving into a sustainable business is possible. Zuckerberg and his inner genius are still finding their entrepreneurial direction. Depending on that outcome will weigh heavily on investor perception.
Rhymes with The Pope
Hope (capital H). The value trapped investor plan. Hewlett-Packard’s (NYSE: HPQ) shares are cheap if you force yourself to forget about their lack of management and strategic direction. If you factor in all the management shake-ups, bad investments, and current market position, you don’t find good reason to bid up shares. It’s a buyer’s market for HP shares, just like the fixer-upper housing market. There is potential for an improvement in sentiment, but rebuilding investor trust can take years – if at all. It’s a long shot to think management has the capacity to turn things around, especially when past performance has already left such a bad impression. We only can invest for our futures, and holding on to companies in this situation may not being doing ourselves any favors.
Take It or Leave It
It doesn’t take much to derail faith. But when it happens, shareholders are at great risk. Once it's been lost for an extended period, investors become disillusioned. When companies trade with single-digit PE ratios, there’s usually a good reason why. As investors, it is our primary goal to find excellent businesses at excellent prices. We must invest in businesses that deliver on their promises and in ones that know where they are headed. This is crucial to our survival. If we've done this, half the battle has already been won and we are likely in the right place. Now all it takes is patience and our conviction.
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TopDownTrends has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Facebook, Google, and Netflix. Motley Fool newsletter services recommend Amazon.com, Facebook, Google, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.