Quote of the Week: Why are Consistent Earnings so Important?

Buffett Quote of the Week - Earnings consistency

 

All of a sudden it is pretty apparent that the stock market has moved a long ways from the recession of 5 years ago.

Today, OpenTable, with a net income of $33 million is being purchased by Priceline for $2.6 billion. Facebook, is now worth nearly $200 billion, twice the value of McDonalds despite having just one fourth of McDonald’s profits. And Tesla Motors is worth $33 billion – exactly half the value of Ford, despite selling just 22,400 cars in 2013. (To put that in perspective, that is how many F-150 pick up trucks ford sells in about 2 weeks, and is less than 1% of the total number of vehicles that ford sold in 2013).

 

Investors have one thing in mind when paying these exceedingly high prices – The prospects of future growth.

 

Neither of the companies mentioned above have the fundamentals to back up their sky high valuations, but that doesn’t seem to be stopping investors from dreaming.

 

The potential money to be made “finding the next google” will always blur an investor’s vision.  Dreams of money to be made are like the beer goggles of the investment world – Investors immediately begin to make assumptions and ignore obvious risks for a chance to get lucky.

 

 

But, one day these investors will wake up and ask themselves “What the hell did I invest in?”

 

Facebook has no long term history of profits (and I am convinced not even a long term plan on how to generate that profit) and Tesla is finding out the capital requirements to produce quality cars from scratch is staggering.

 

For Facebook to be worth its lofty valuation, it needs to find a way to earn tens of billions of dollars every year, from a service that makes its money selling sub $1 ads on a user’s sidebar. Tesla needs to produce cars that are cheap enough for people to afford, yet dependable and priced high enough to bring in enough money to start paying down their $2+ billion loan used to build a battery factory.

 

Both of these companies have had tremendous runs in their stock price over the last couple of years:

fb_vs_tsla_chart

 

But what this chart really represents is rising optimism of investors. Tesla’s stock is up 800% in 2 years. And they haven’t made a penny. Investors are not weighing the risk of Tesla going to $0, but instead just drunk on the prospects of another doubling of their shares.

 

There is a huge risk today buying Tesla at a market cap of over $33 billion. And all too often, over-hyped company stocks like this get bid up to the moon, only to soon see the picture not as pretty as originally dreamt, and investors quickly see a decade of stock gains turn to nothing.

 

This is where Buffett comes in to this week’s Quote of the Week. How often do you see the worlds most famous investor bidding up today’s hot new stock? Or paying a 100 multiple (P/E of 100) for a company?

 

The answer is never, because Buffett understands the risks that exist when buying into this hysteria. He understands a good deal from a poor one, and he knows that he doesn’t have to take wild risks, because he understands what a decade of responsible investing can yield.

 

Buffett Quote Image

“Over the years, a number of very smart people have learned the hard way that a long stream of impressive numbers multiplied by 0 equals 0” – Warren Buffett

 

 

This is a core philosophy in Buffett’s investment style, and a reason he only buys companies that meet certain criteria.

 

Buffett frequently speaks about investing in companies in which you “know what they will be doing in 10 years”, and with companies in which have a consistent history of solid earnings.

 

Why is this so important?

 

 

Buffett’s quote recently rang true for long term investors in General Motors. In 2009, GM declared bankruptcy, wiping out 100% of value for common shareholders. Why did GM struggle to produce consistent profit and gain a competitive advantage?

–          High costs of research and development

–          Constantly changing style / technology

–          Highly competitive

–          High debt

 

Despite years in which General Motors had net incomes in the billions of dollars, they were always forced to spend billions just to keep up with the likes of Ford, Honda, etc… When the economy took a turn for the worse, General Motors could not afford to pay its employees, pay its massive debt and build cars.

 

Despite years of impressive earnings, General Motors became a ticking time bomb. When it finally went off, it wiped out every shareholder. All of a sudden Buffett’s 15% year after year looks pretty good.

 

GM_profit_chart

 

The result? What may have been DECADES of savings for an investor, tens or hundreds of thousands of dollars is now $0.

 

All because of ONE year. One big 0.

 

 

I’m not making a forecast that Tesla will go bankrupt tomorrow. What I am trying to make clear is exactly what Buffett points out in his quote, that despite what may be decades of strong stock returns, if a company is not built on a solid foundation, investors have a chance to lose everything. As Tesla takes on debt to venture on in it’s quest to build electric cars, all it takes is for Tesla to not quite grow fast enough to repay its growing debt payments and your investment is worth $0. How likely is it? I’m not sure. You can buy a company today with a competitive advantage and decades of 15% Return on Equity, or you can flip a coin and gamble on Tesla.

 

So when the opportunity presents itself for you to put some money to work in the stock market, consider how sure you are that a big 0 does not lurk down the road.

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