Own Companies That Feel Inevitable
I saw a tweet the other day that said “invest in companies that feel inevitable.” The author is slipping my mind, but whoever it was, thank you, but I have an addendum to improve it:
“Invest in companies that feel inevitable but are misunderstood by the market”
“Inevitable” companies (or, maybe, Thano’s companies?) have historically treated investors kindly if bought at the right price. But what do I mean by an inevitable company that is misunderstood? That’s a tough question, but one that I’ll try and answer over the next few paragraphs.
What Does Inevitable Mean?
There are a few paths investors could go down here, so don’t think my definition is exact. Inevitable is a general term.
From a broad perspective, I think an inevitable company is a quality business (high margin/reliable/good management) that has a strong chance of still being a quality business at a substantially larger size a decade from now. It should be able to weather market downturns, attacks from the competition, and changes in consumer behavior. Why? Because all these headwinds and more will likely happen if you own the company long enough.
It’s easy to identify these companies in hindsight. The past is already written, but the future (especially in 2020) is hard to predict. So to give an example, I’ll use a stock that has a business line that was “inevitable” 5 years ago and another one I think will seem “inevitable” in 2025.
That business is Square. Square’s seller business was something prescient investors identified as a quality business (again, high margin/reliable) that had a large runway for growth. I think the same thing about the Cash App, Square’s consumer offering, and its potential over the next few years.
However, with Square’s stock more than doubling this summer, I think the market is starting to understand the inevitability of the Cash App. This leads me to believe at least some of the growth is priced in. Does it mean I won’t invest in the company? No, not by a long shot. But I’m hesitant to make it a large percentage of my portfolio at this moment. What I strive for is to make my largest holdings companies that I think are inevitable but that the market misunderstands.
What Does Misunderstood Mean?
It is difficult to find companies that are inevitable. It is equally so trying to identify if they are misunderstood. An example from a few years ago is Roku. It was trading at a sales ratio below 5 because the majority of investors thought it was a low margin hardware play. That couldn’t have been further from the truth, and investors have been rewarded greatly from not only the business succeeding but multiple expansion.
5 years ago Roku was a hardware story. About 85% of revenue was from players. Today, that's under 30% and will likely drift lower. It's tempting to look at a business once and then never reconsider because you already know the situation. Resist. Things can change. — Ryan Reeves (@investing_city) September 26, 2020
Would investors have done well if Mr. Market understood the potential of advertising on the Roku platform, giving it a sales ratio closer to 15 than 5? Definitely. Roku’s business has grown substantially over the last few years, and unless you bought when it was trading at a sales multiple in the ’20s, the stock has likely done well for you. But if you got in when the market misunderstood it (i.e. you got to enjoy a valuation rerating and business growth) the returns would have been even better.
One stock I currently think is inevitable (or, in reality, has a high chance of being inevitable) that the market misunderstands is Nintendo. Read/listen to our Deep Dive on them here.
The Four Potential Quadrants
To visualize the inevitability/misunderstanding rule of thumb, here is a table with the four scenarios you could have:Inevitable/Misunderstood (Huge Returns)Inevitable/Understood (Average Returns)Uncertain/Misunderstood (Detrimental Returns)Uncertain/Understood (Average Returns)
You want to put your money into companies that fit the top left quadrant. Since no investor is perfect, you’ll sometimes be wrong, which is fine if the money is put into the far right column. But what must be avoided is the bottom left quadrant. If you invest in a bad business that the market doesn’t understand is a bad business, you not only get hurt by poor financial performance but a market rerating to the downside.
After finding mispriced companies, the next step is having the discipline to hold them over the long-term, while also having an open mind to selling if/when the time comes. But that is a topic for another day.
Disclosure: The authors are not financial advisors, and may have an interest in the companies discussed in this article.