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Ken McGaha
Ken McGaha
Articles (67)  | Author's Website |

To Avoid Big Losses, Remember That Cool Products Don’t Always Mean Hot Profits

July 15, 2014 | About:

It is really quite easy to allow oneself to get caught up in the hype and excitement that often surrounds a hot, new product that is just plain cool. Quite often, these hot products can be priced well beyond the reach of the average consumer and the average investor. Sometimes, we begin to think that, even if we can’t afford to own the product we can at least achieve some level of status by owning the stock so we can talk about it with our friends at social gatherings and such.

There can be times when the company with the cool products is also an excellent investment opportunity. This happened just recently when the world inexplicably decided that Apple (NASDAQ:AAPL) had lost its value virtually overnight and the share price plunged by almost 50% to under $400/share. The company was still selling some of the most wanted electronic devices in the world and was gushing cash but once the carnage started, the stock price was decimated and it fell to bargain basement levels. I had always chosen to keep my mouth shut on previous occasions when Apple was being discussed because I thought it to be over priced as an investment and I was just too cheap to buy the expensive products. When the time finally came where I wanted to talk about it, everyone else hated it. All I got were the profits I made from buying the stock under $400/share (pre-spilt) and holding on.

As most will know, if not readily admit, it can be quite uncomfortable, when the topic of the new company with the latest cool product is being discussed to openly state that the products might be cool but the business is a bust. If being in that role makes you uncomfortable, then one always maintains the option of remaining silent. However, as an investor, we should never allow our desire to be involved in the “cool companies” influence our investment decisions. If it is a great business, the day will come, as it did for me with Apple, when the price is right and a value oriented investor will be able to act. Unfortunately, at those times, most of us still never be the cool one in the conversation because the value investments tend to be value priced because they are not popular. That is the way to make big profits with cool products, we wait until the business is temporarily uncool.

Don’t Buy Stocks Of Bad Businesses With Cool Products

While Apple was a high priced stock with cool products, it also was, and still is, a great business. It enjoys thick profit margins and produces rivers of free cash. Even while its share price plummeted, Apple’s giant cash hoard continued to grow and became an ever-increasing percentage of Apple’s market capitalization reaching over 30% of the total value at one point. Apple stock was trading at the ridiculous level of 6 times cash flow after discounting for the cash on hand! World class businesses just don’t get that cheap and it simply screamed to be bought.

However, as previously suggested, cool products don’t necessarily mean great business models. An excellent example of that situation today is Tesla Motors (NASDAQ:TSLA). Tesla, just in case anyone doesn’t already know is the manufacturer of the coolest electric car on the planet. It is a sports car in the truest sense of the word. It is sleek, it is fast and it is on everyone’s A-list of cool things to own. It also costs between $70,000 and $100,000 depending on the model and options. So we have a company that produces a really, I mean REALLY, cool product that most of us can’t afford to buy as a toy. So, should we just buy the stock and profit as Tesla sells their really cool electric cars and the price goes up along with the profits? If only it were that easy. You see, Tesla’s product might be very cool, and their stock has certainly been very hot, but the business fundamentals send me fleeing in fear.

How Bad Can The Business Be With Such A Cool Product?

Despite what many people might automatically think by first instinct, the actual products produced have very little connection to the fundamentals of a business. In the case of Tesla, about the only thing more expensive than their cars, is their stock.

To begin with, this business does not currently earn enough cash from selling cars to even cover the interest payments on their existing debt. Of course, part of the reason for that is that the businesses doesn’t have positive earnings yet. While they are expected to generate a slight profit this year, it is projected to provide them with a P/E multiple in against 2014 earnings of 2,726:1. And just think, when you were reading the previous installment in this series, you probably thought Amazon’s 290:1 P/E multiple was high! I guess all things really do depend upon to what they are compared. Amazon almost looks cheap now, doesn’t it? Well, it is not and neither is Tesla. But both are darlings of Wall Street because they are “cool”. Even compared to the projected 2015 earnings, Tesla sports an astronomical P/E of 92. The analysts projected earnings growth rate of 28.8%/year for the next five years doesn’t even come close to justifying the current valuation the market is placing on this business.

As with most value investors, I like to give serious consideration to cash flow as a valuation metric and in this regard, the company changes hands today at a multiple of 104 times free cash flow. Simply put, this means it would take the company 104 years to recoup its market capitalization in unencumbered earnings. I am as much of a long-term investor as anybody I know, but 104 years? Man, I am 60 years old already, I don’t think I have quite that long to wait!

One other little thing that could cause this business some difficulty is their system for accounting for the value and profit from their leasing program. The company is selling three-year lease agreements on their cars but claiming that the value of the used vehicles at the end of the leases will still be $50,000. Most observers who have seriously looked at the general depreciation of any vehicle and the high cost of replacement for the battery pack in these vehicles are having trouble believing the value estimate being assigned by Tesla to these used vehicles. If the company is wrong, the result will be a massive write-down for the company.

When a business is priced as richly as Tesla is based on fundamentals and also carries a valuation equal to 12.8 times sales, it just really can’t afford to have any additional risk like questionable leasing calculations surrounding it. Yet, as I type, the company is now being exposed to allegations that its battery packs might tend to catch on fire.

Final Thoughts And Conclusions

As a value driven investor, my normal approach is to research stocks looking for reasons not to buy them. This approach helps me to assure myself that I am buying real value for my money. In the case of Tesla, it would be hard for me to find any reason that I would ever consider buying the stock, the cars…………maybe. The stock………….no way just based on the fundamentals.

Given the bleak existing picture and the ultra-high valuation, even under a best case scenario, I just want to run away from this one. However, the professionals who would like you to pay them for advice on where you should invest your money disagree with me. Of the 12 analysts covering this stock, 3 rate it a strong buy, 2 consider it a moderate buy, 6 think you should hold it and only one rates it as a moderate sell. And these are the same people who tell you individual investors can’t do better than the “professionals” when it comes to investing.

Peter Lynch said we could. I believed Peter Lynch before I wrote this series on over-priced stocks and now I REALLY see what he was talking about. With one article left to go in this series, I hope you are beginning to understand why fundamental analysis on your own is important and how detached stock prices can become from reality. I also hope you are beginning to see the kind of over-priced stocks you can get involved with by taking the advice of Wall Street analysts rather than relying on your own hard work and due diligence. It is our money and we are foolish if the think anyone else is going to deploy it with more care than we will.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 25 years.

He is a full-time copywriter as well as a freelance contributor to several investment related websites.

Ken also prepares analysis pieces of individual stocks on a contract basis for other individual investors.

Visit Ken McGaha's Website

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