When stocks become collectibles

Cash was king

Traditionally, equity research evaluated the ability of a company to generate cash. Published three years after Joy of Cooking and equally influential in its field, Benjamin Graham’s Security Analysis recommended buying companies that were valued by the stock market at less than the amount of money on their books. That was the ideal situation. Failing such opportunities, prudent investors could purchase firms that had high expected future cash flows relative to their stocks’ current price.

For Graham, what mattered was corporate operations, rather than the actions of rival investors. Wrote Graham, “The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” Similarly, “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

From Graham derived both Warren Buffett and the Chartered Financial Analysis program. Buffett followed in Graham’s footsteps to become the modern investment master, accumulating a self-made $100 billion. (As when my college roommate’s father won a Nobel Prize, Buffett’s accomplishment required not only smarts but also longevity.) Meanwhile, since the CFA program began in 1963, it has trained tens of thousands of investment professionals. Its curriculum, too, evaluates companies primarily for their ability to produce cash.

Branching out

However, not every publicly traded company lends itself to traditional analysis. Some businesses burn cash rather than create it, as they are unprofitable. Such losses may occur because the company is emerging and has yet to post earnings, or they may happen because a once-successful entity has suffered hard times. Either way, unless future profitability can reliably be predicted, traditional security analysis struggles. Implicitly, it advises to avoid such situations.

That can be poor counsel. The IPO investor who dismissed Amazon.com (AMZN) when it went public in 1997 because the company was years away from profitability forfeited the chance to pay $1.50 per share (when split-adjusted) for a stock that is now worth $3,000 per share. Similarly, Apple (AAPL) struggled mightily from 1996 through 2000, losing a collective $1.7 billion. It has since gained over 40,000 per cent.

Thus, dollars-and-cents calculations cannot be applied to all stocks. Some money-losing companies are very much worth buying. Their merits cannot be determined only through computations that rely on the assumption that the future will largely resemble the past. The investment math must be supplemented by an understanding of how things might change.

All fine and good. Venture capitalists are often asked to envision what might become, not what currently is. So, at times, are public-market investors. There’s nothing wrong or unusual about using narratives to evaluate stocks. Although such trades are sometimes criticised by conservative shareholders, they are mainstream activities. No less than investing by the numbers, investing on the prediction of how a company will fare is based on economic fundamentals.

Becoming collectibles

What crosses the line is when the trade becomes detached from corporate fortunes, so that the purchase comes not from considering how the company will fare but instead, to use Graham’s words, from wanting to beat other investors at their game. A stock is to be prized because it is expected to rise and to be avoided because it will fall. These outcomes depend not upon the company’s results but instead upon the investor’s view of how the marketplace will react.

Consider Tesla (TSLA). Most of the company’s terrific stock market performance owes to its business results. In 2010, Tesla’s annual revenues were a modest $117 million. Early believers were undeterred, believing that the firm’s sales would skyrocket. They were correct. Last year, Tesla recorded $31.5 billion in revenues, making for a 75 per cent annualised 10-year growth rate. Tesla would not have appealed to Ben Graham, but he would have appreciated the reason for the stock’s success.

Recently, though, Tesla’s stock price has sometimes appeared to diverge from its corporate affairs. In 2020, for example, Tesla gained 780 per cent, although the firm’s revenues and profits finished slightly below analysts’ estimates. True, those results were achieved during an unanticipated global recession, so there was good reason for the stock to rise. But the amount seems excessive. So, too, does the stock’s 19 per cent increase on March 9, a day without significant company news.

It’s hard to avoid the conclusion that, to some extent, Tesla’s stock has become a collectible--a security that is prized not solely for its company’s virtues but also for the belief that it will appreciate because others desire it.

A clearer case is GameStop (GME). Over the past two months, its price has soared from $20 to a peak of $480, retreated to $40, and then advanced once again, now registering $260. None of these movements have had anything to do with the company’s operations. As was the case entering this year--again, nothing has changed--GameStop is currently unprofitable, with rapidly declining sales. Its stock’s price has become divorced from its business.

Broader ramifications

To date, few stocks qualify as collectibles. It is, however, a development that bears watching because of two economic implications.

The first being that the public might become disenchanted with stocks. The happier that investors are with equities, the more they will participate in the stock market, thereby making their monies available to entrepreneurs. That is a social good. So far, the market’s recent gyrations have not harmed investor enthusiasm. However, should enough stocks behave as if they were collectibles, the perception that the stock market resembles a casino could damp interest.

The other potential problem is that the financial markets are the mechanism by which capital is allocated. Historically, that mechanism has been driven by the ability of businesses to generate cash. Companies that earn ongoing profits, or at the least hold the promise of doing so, raise more capital than those that do not. If stock prices no longer operate by those rules, then capital will be allocated differently--and almost surely less efficiently. That would damage the economy.

Early days yet, to be sure. However, it’s worth noting that beneath the amusing stories about how some stocks have run amok lie serious concerns.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.