Investors Should Look Out for This

It would be silly to think you will always find winners.

It takes time to find them. And often what you thought was a winner turns out to be the opposite.

Investing is a game of predictions. You’re working with known unknowns and unknown unknowns.

That’s why the market likes certainty.

If prospects are certain, then a stock’s market price is more likely to reflect its true value. If we throw uncertainty into the mix then there’s potential to pick up opportunities that can rise five- to 10-times.

Professor of valuation at Columbia Business School, Brue Greenwald likes to say that investors never really know what’s going to happen.

When investors like a stock, ‘nobody thinks it’s a 60% chance. If they think it’s a good stock, they think it’s 100% chance that it’s a good stock. If they think it’s a bad stock, they think it’s 100% chance it’s a bad stock,’ Greenwald told Forbes.

Even when investors stumble across a good idea, they often do very poorly by taking that idea to extremes.

Let me explain why…

If you’re on the hunt for some profitable ASX plays, check out this free report.

A good business idea doesn’t always benefit the investor

It’s very hard coming up with great ideas at will.

Finding and understanding a good business is one thing. Then you have to find out whether the stock is worth the price it trades for.

When investors do find a good idea, they get infatuated with that idea.

The subscription business model is one example.

When a business is on the subscription model, they receive sales upfront. This is an incredible position to be in.

Not only does the business not have worry about collecting payments from customers, they can use upfront cash for marketing to gain even more clients with what is essentially free money.

Of course, a good or service has to be transferred at some point down the road. But production of these goods or costs of these services can essentially be funded with client’s money.

The subscription model eliminates the need to take on much, if any, debt.

Customers on the subscription model also tend to be a lot ‘stickier’, less likely to leave, so they yield more recurring revenue. Each customer acquisition adds a whole lot more to revenue growth.

The model is so attractive even Alphabet, Inc. [NASDAQ:GOOG] is thinking about moving some of their free products to a subscription basis. The Australian Financial Review writes:

‘…companies that have been at the vanguard of offering services for free, such as Google, are seriously investigating the use of subscriptions for products that have always been made available for free.

It seems hard to believe that the world’s most successful advertising company, which has built an empire valued at $765 billion, should be looking at subscriptions, but Chanticleer understands this is the case.

It is understandable, given the success other large technology companies have had in diversifying their earnings through subscription services.

Apple has shown how important it is for technology hardware companies to diversify earnings by offering subscription services. These services promote deeper engagement with customers and provide reasons for users to stick with Apple products.

In the three months to September, Apple earned a record $10 billion in revenue from services which include a range of digital content services paid for with subscriptions.

Services comprised about 16 per cent of Apple’s total revenue of $62.9 billion in the three months to September. The revenue was up 17 per cent on 2017.

A world leader in subscription services is Amazon, which has perfected this through Amazon Prime. It is bizarre but studies show that subscribers to Amazon Prime in the US have bought more through the service simply because of the offer of free delivery within short time frames.

There is a belief among Amazon Prime customers that in order to capture the value on offer in free delivery they have to buy more things.

Of course, the pin-up company in the world of subscriptions is Netflix. It benefits from three things: great content, a low price of subscription per month and the apathy of consumers having their credit cards charged each month.

Google’s move to investigate subscription services would involve turning its current business model on its head.

While it could be a good idea for Google to increase their subscription-based services, it might not be the best idea for investors to load up on subscription businesses…

Is the stock over-valued?

Even with good ideas, investors can do poorly. And it’s because humans often take good ideas — or what sound like good ideas — to extremes.

Warren Buffett’s mentor, Ben Graham would often say ‘you can get in way more trouble with a good idea than a bad idea, because you forget that the good idea has limits’.

Just take a look at, Inc. [NASDAQ:AMZN]. Investors love the Amazon Prime service. Not only does it mean faster delivery for customers, it creates stickiness.

If you pay for a Prime subscription and you need something, you’re more likely to jump onto Amazon. Why? Because you want to use that Prime subscription you’re paying for.

So as more people buy into Prime, you’d assume Amazon’s e-commerce revenue growth will continue. What investors seem to forget however is that the growth Amazon is experiencing is not unlimited.

Amazon’s stock price trades for 64-times expected 2018 earnings.

Netflix is the same type of deal. Investors focus on their subscription numbers and bid the stock up ever higher when those numbers exceed estimates. Netflix trades at more than 100-times expected 2018 earnings.

Now you might do OK in the short-term if you buy either of these stocks. But wonderful long-term returns from such high prices would require both companies to move mountains. They both need to achieve extraordinary growth, and sustain it over a long period of time.

Whether either stock can pull it off remains to be seen. Surely it’s better to look for one foot bars to step over instead of two metre bars to jump over?

Your thrifty friend,

Harje Ronngard,
Editor, Money Morning

PS: If you want to lay down a little money on the hottest corner of the ASX right now…but you don’t know your way around the small-cap sector…this report is for you. Get access now (free).

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

Money Morning Australia