In “Big Data Baseball,” the author, Travis Sawchik, tells the story of a highly anticipated prospect making his way to the major leagues. As he blazed his way through the lower ranks, the prospect received significant notoriety in the baseball community and even landed on the cover of Sports Illustrated magazine. But before too long, the bright future once imagined started to fade. A few years after the cover shoot, the dream had died; the highly anticipated prospect, still in his prime baseball years, wasn’t even playing in the majors anymore.
In the book, the author makes an interesting point about the prospect:
“The ‘Sports Illustrated’ cover jinx is perhaps not a jinx at all but a mathematical phenomenon: ‘Sports Illustrated’ tends to capture athletes at their extremes, at their highs or lows. From that cover, there was only regression for [the prospect].”
We see a similar phenomenon in the business world. Consider a quick example.
In 2015, Under Armour (UA, UAA) was widely perceived as a force to be reckoned with. The company had strung together years of more than 20% revenue growth, with no signs of slowing down. In addition, Under Armour had secured long-term endorsement deals with rising stars, including Jordan Spieth and Steph Curry. At that time, the opportunities for the company appeared endless.
The financial media took notice. Under Armour made the top 10 on Forbes' list of the world's most innovative companies. Footwear News gave the company its “Brand of the Year” award. Finally, founder and CEO Kevin Plank was added to a select list from Barron’s of the 30 best CEOs in the world (and was regularly compared to Nike (NKE) founder Phil Knight).
The optimism showed up in analyst estimates as well, as noted in this Business Insider article:
“The company is on pace to reach a staggering $20 billion in revenue by 2025, up from nearly $4 billion this year, according to Morgan Stanley analysts … By that point, Under Armour's market share in North America is expected to jump to 12% from 4% last year ...”
The stock reflected this optimism, trading at a high of approximately $50 per share (split-adjusted). At that price, the company traded at roughly 4.5x forward (2016) revenues. Using 8% net margins (rough estimate based on historic results), the stock was trading at roughly 55x forward earnings.
But things didn’t quite go as planned. Under Armour missed near-term (fiscal year 2018) financial targets by a mile, and a resurging Adidas (ADDYY) regained its spot behind Nike in the U.S. In the eyes of the media, Plank fell a long way as well. In addition to being removed from the Barron’s CEO list (after a repeat showing in 2016), he found himself on a few “Worst CEO” lists at the end of 2017. The stock, at a recent price of $16 per share, is off about 70% from its highs.
This might be an extreme example, but the pattern is fairly common. Glowing headlines and favorable mentions for the CEO usually follow a period of impressive stock price performance (and probably a good run for the business as well). That’s not surprising: The stock price is an easy way to assess management success, even if it’s not the best way. You’re unlikely to find your way on to Barron’s top 30 list for the first time if your stock was down 10% last year.
The issue is that you’re susceptible to catching a company (or its CEO) at a near-term peak. Things have been going well for the past few years (otherwise they wouldn’t be on the list). In that situation, if the stock is at a level where it is pricing in a future that will match or exceed the results delivered in the recent past, the risk/reward for investors may no longer make sense.
Painting with a broad brush, that leaves us with two takeaways. First, external praise should be taken with a grain of salt. Past performance, particularly when measured by short-term stock returns, may not be indicative of future results. Second, markets reflect consensus opinions. The optimism or pessimism of the crowd is reflected in prices. When the CEO is smiling on the cover of Barron’s and everyone agrees future success is assured, it’s time to be cautious.
The goal is to stay levelheaded at the extremes. Next time you see a glowing headline from the financial press, think back to the numerous examples you've seen in the past that didn't work so well.
When a company or a CEO is broadly perceived as the next great thing, it’s probably reflected in the stock price. As a result, the odds of surprising to the upside may be small. As always, remember that a great company or a great CEO can be a bad bet at the wrong price.
The answer, as usual, is to do your own research. Does the story mesh with reality? And are you being appropriately compensated for the risk you’re assuming? It looks like the answer to that second question was a resounding “no” for UA in late 2015. Now that investor perception of the company and the management team has clearly changed, the answer may be different.
Disclosure: Long UA.
