We’ve written often on this site and in our monthly strategy report about the speculative nature of the stock market rally in recent years and most especially in recent months. The leading lights of the stock market year-to-date are companies trading at levels that leave no margin of safety for the serious long-term investor. Here, I am talking about the Netflix, Amazon, Facebook, and Googles of the world.
These four companies plus Apple are responsible for over 75% of the return on the S&P 500 year-to-date. Fund managers who eschew these stocks are taking serious career risk, but it is hard to argue that those who hold them are following the prudent man rule.
The Prudent Man rule directs trustees “to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”
I doubt many portfolio managers believe that Netflix, trading at over 385X net year’s earnings is anything but a speculation. It’s owned widely because many feel they have to own it if they want to remain gainfully employed. That’s not to say Netflix isn’t a useful service, or that Apple doesn’t make great products. I’m a Netflix subscriber and I own many Apple products as I am sure many of you do. But great products don’t always make prudent investments.
If you’ve followed our work long, you know that we are one of those advisors who eschews the Netflixes of the world even if it means temporarily trailing the broader market averages. We invest only in dividend payers, and focus only on those with a strong record of regular dividend increases.
Our work doesn’t stop there though. We also strongly favor companies and industries with high barriers-to-entry. It’s easy to forget that, after a couple of years of spectacular gains, many of the market leaders operate some of the lowest barriers-to-entry businesses.
Yesterday’s Wall Street Journal included two notable articles that can serve as a useful reminder of the risk of investing in low barrier-to-entry businesses.
The first article was titled Flipboard, Once-Hot News Reader App, Flounders Amid Competition. For those of you unfamiliar, Flipboard is an iPad app that allows users to read articles on the web in a magazine format on tablets and phones. Flipboard was a great app when it came out and one of my favorites. It became one of the top 100 apps in Apple’s App store. Then competition emerged. Zite, Pulse, Feedly (my new favorite) and Apple are all now competing with Flipboard. As are Facebook and Twitter.
Flipboard’s popularity has plunged. The app now ranks 1,030th among all iPad apps in the U.S. Its advertising revenue has fallen in half and the co-founder and chief technology officer have left the company. Flipboard is a private company so we can’t track the value of its shares, but it is probably safe to say Flipboard is worth a lot less today than it was a few years ago.
The same is true of GoPro. GoPro makes wearable-cameras. The company was founded by a gentleman in 2002 who started the company following a trip to Australia in which he wanted to capture action photos of his surfing, but couldn’t find quality equipment at a reasonable price. GoPro filled a need that the established players in the market hadn’t. But can you guess what happened as soon as GoPro proved there was a market for wearable cameras? Competition emerged. In its latest quarterly report, GoPro reported disappointing third-quarter results and gave weak guidance for the holiday season. The Wall Street Journal reports that there are concerns that the wearable-camera market is drying up, and GoPro is facing new competition from traditional camera makers like Sony and new entrants such as Chinese smartphone maker Xiaomi Corp.
Over the last year, GoPro shares are down over 70% and the multiple that investors are willing to pay for a dollar of GoPro earnings has fallen from about 99X down to 14X.
High valuations and low barriers-to-entry can be a toxic mix.
We advise a strategy that favors companies with a record of making regular dividend increases and operating in businesses with high barriers-to-entry. It is a prudent and proven strategy for building long-term wealth.