Is a good company always a good investment?

• South Africa
• Black Swan, Multiples, Price, Risk, Sharpe Ratio, Standard deviation, Tech, Value, Volatility
• July 12, 2020

This question was posed to me last week by a reader and makes perfect sense. Simply put, is it always true that a strong company with a great brand and solid products is also an attractive investment?

Immediate logic dictates that the answer must be yes – after all, the world’s most famous companies are almost indestructible, aren’t they? Isn’t life in the spotlight exactly where investors should be playing?

Without delving into high profile corporate failures, which unfortunately do occur from time to time, there are two other topics that are worth touching on in answering this question:

1. Adequate return for risk
2. The concept of price vs. value

[the_ad id=”3223″]

Return vs. risk

The absolute foundation of investment theory is that a riskier investment must offer a higher return.

Risk is usually measured by volatility, standard deviation and related measures which try to capture the likelihood of the value of the investment changing. There’s another important concept called kurtosis or “fat tails” – all you need to understand here is that extreme events are often more likely to occur than traditional statistical models would predict.

The Global Financial Crisis or lockdown are perfect examples of these. They are also known as “Black Swan” events when they are extreme events to the negative. Positive extremes are of course also possible, but long-term investors don’t mind those. Traders and hedge funds certainly do, as they sometimes bet on a negative or flat outcome vs. an extreme positive.

Because of this, it is possible that a money market account paying 5% is as attractive an investment as a listed company returning 15%. It all comes down to units of return per additional risk taken on, measured neatly by a method called the Sharpe Ratio.

We won’t delve into the Sharpe Ratio here as it’s a topic deserving of its own article, but the critical thing to understand is that two investments can be equally attractive despite offering different returns, purely because their risk profiles could be very different.

If you have the option of taking R5 right now on a risk-free basis, or the option of trying for a larger number (but also the risk of zero), what would the larger number have to be before you are willing to take the gamble? That’s the way risk-adjusted decisions work.

Before I explain how this relates to market-leading companies as investments, we need to touch on another concept.

Price vs. value

Warren Buffett is over-quoted in financial writing to the point of nausea, but it’s for a good reason. In some contexts, he explains it best.

“Price is what you pay. Value is what you get.” – Warren Buffett

The point is that the price of something isn’t always equal to its value. The art of “beating the market” over time depends entirely on an ability to consistently identify undervalued companies i.e. value < price.

If you invest in companies where price > value, then at some point your return will likely be below that of the market. That isn’t to say that you’ll lose money, but you won’t have maximised your return for the risk you are taking on.

What does this have to do with famous companies?

Famous companies sometimes trade at such high multiples (calculated as share price divided by profit for example, or sales) that they simply aren’t attractive investments anymore. No matter how great a company is, there’s always an element of risk. Shareholders need to be compensated for this risk and that won’t happen if the entry price is too high.

If investors have pumped up the share price to lofty heights, it might not be a good idea to climb in at that stage.

We are seeing this right now in the US market, as tech companies keep reaching new highs. Tesla in particular has shot the lights out, becoming the most valuable automotive company in the world despite being loss-making every year.

Tech investors are completely focused on the future, with little regard for the current financial positions of these companies. It works in some cases and fails horribly in others (like WeWork which failed to list successfully because it is little more than a property company pretending to be a tech company).

I’ve written before about how I’m worried that Netflix is a media company pretending to be a tech company. Is Tesla just a car and renewable energy company pretending to be a tech company? Only time will tell as the world’s established car manufacturers start to fight for electric vehicle market share.

I’m personally loathe to bet against Porsche in that fight…

Answering these questions isn’t easy, but the key point is that these famous companies aren’t automatically great investments. If they are overvalued, they might not provide an adequate return for the risk you are taking on as a shareholder.

Is the rulebook being thrown out?

Having said all this, we are witnessing historic times in the market. It feels like tech could be the new gold, as capital flocks to the world’s largest tech companies in times of need. Gold is only a safe haven asset because people believe it is a safe haven. It’s a self-fulfilling prophecy. That belief can change.

If tech goes the same route, traditional valuation techniques may not be appropriate anymore for tech companies. In that case, you aren’t betting on the specific tech brand anymore (e.g. Amazon), you’re betting on a sustained structural shift in investment theory.

I’m not saying it isn’t possible. I’m just saying it’s riskier than most people will warn you about.