The Second Worst Mistake Investors Make

The second worst mistake investors make is to invest into garbage companies.

I’m always amazed at the crap that people buy these days. In a world where Angie’s list is seriously valued at half a billion and where Etsy somehow managed to pull an IPO at a value of $4 billions (LOL), what else can we expect from people? I mean, just look at this mess:

Both these companies are worth $0. They’re worthless. Well technically, no, they’re not worthless: they’re worth the probability of getting bought out (which is very low), times the expected value in case of a takeover (which is also very low).

There is no reason to buy that garbage - ever. It’s a disaster waiting to happen. “But F.S., it’s easy to talk after it happened!” Fair enough. Here’s more worthless stuff for you:

It took me five seconds to figure out this company is worthless. Here:

• Revenue was $20.3 million, an increase of 56% period-over-period

So APPF trades at 6 times its annual revenues. For a high-risk company offering a software that could be replaced by something better at any time. What a deal! This company can become worthless in a second. A high chance to lose 100% of your money at any time for a company trading at five times its revenues? And that is losing millions every quarter? Where do I sign?

Do you remember Tamagotchi? You won’t remember Fitbit neither. Fitbit’s valuation was $0 as soon as the Apple Watch came out. See: GPRO.

First of all I’m not even sure what this company is, but if you think a $1.4B company can compete with Amazon, Google, Microsoft and Apple, you are wrong.

This company is amazing - as a private company. Great concept, terrible stock. How this company was once valued at $10B - 1/7 of Goldman Sachs - is a mystery I’ll never understand.

It didn’t take me long to find these companies. All those companies have something in common: you definitely shouldn’t invest in them. Why?

Because they’re crap!

Why people insist in investing into that garbage year after year puzzles me. I mean, it’s not like there is a draught of good companies to invest in neither. Why do people insist on buying terribly overvalued companies year after year when you have companies paying a stable 8% dividend just around the corner or another with a 4% dividend growing at 10% per year right there.

There is no reason to invest in these companies, ever.

Now, make no mistakes: there are several reasons to trade them, but there is no reason to ever invest into them. If you want to bet on a rebound, go for it, and all the luck to you, but as an investment, forget it. Even if it does end up making you money, it’s just far too risky.

You know back when MCD was biting the dust and it was all about CMG? Buy CMG, buy CMG, buy CMG! Well yes, Chipotle is great - but not at a market value of $20B. In fact, it’s not even great at a market value of $13B. With annual profits of around $600M, Chiptole is a GREAT buy at $8B, an okay buy at $10B and only passable at $12B. It’s a company that makes burritos, just how much can you expect anyway? And yes, I know McDonald’s trades at higher metrics, but it’s a totally different companies that is far more diversified with a cleaner balance sheet and definitely less risk.

Next, let’s look at TSLA, that infamous stock that will keep losing money for the next 5 years at least. Tesla is another overhyped company trading at five times what it should be trading at. Tesla would be an amazing buy if it was the only electric car on the market; it isn’t, sadly, and Nissan, Ford, GM, Honda and, although I hate to admit it, all the others are about to offer electric cars that will be at least 90% as  good as Tesla. With around $4B in revenues, a 30% gross margin and a ton to be invested in Capex, you are looking at a very pricy company that is very high risk, in a market with several well-established companies (and soon Apple?). Is it crap? No, it’s not crap, and it will probably keep going up for a little while as there are several big players backing the stock, but just realize it’s ultra high-risk company valued at more than half of Ford, with 1/38 of the revenue (and losing $180M instead of making $1.8B)

If you want to overpay for a company, at least buy quality

But to be honest, I wouldn’t blame anyone investing in CMG or TSLA. At least these companies have proven they were quality companies. I just wonder why someone would pick them over well-established companies like PG, ENB, KRFT, AAPL, KO and all the others. What’s the point? CMG might or might not become a leader in fast-food; it might as well fizzle out and be replaced by CMG 2.0 in a few years. TSLA might end up with the biggest slice of the electric car market once things are settled; it might as well get beaten by GM and end up totally unable to make any profit. Why would you prefer these companies over well-capitalized ones?

Even if you would rather invest in junior companies, at least buy companies that are not grossly overvalued by almost any metric. Generally speaking, when I buy a small company, I use the “Will this company double within 5 years or not?” If the answer is no, I don’t buy it. I fail to see anyone today coming to me and saying “Tesla will trade at $400 within 5 years.” It may, and five years ago it was trading at $22 (a near 900% rise, nothing less!), but we are no longer five years ago. Will TSLA be worth $52B in five years? Possibly, but that’s a big, big stretch.

How to determine whether a company is crap or not

There is no absolute, ultimate way to determine whether a company is good or not. Arguably, I was wrong several times evaluating whether a company was crap or not (in both ways). These days, I tend to be very conservative; it’s better to miss a good buy than buy a crappy stock, in my humble opinion. Here’s one such mistake I made:

Back in November, I was looking at a severely beaten-down company that owned some high-quality hotels. The company was still earning $200M in revenues per year and has a 29% operating margin. It was valued - at the time - at $100M. The dividend is not really sustainable, but one might expect it to come back when things improve in Alberta. The oil crisis wasn’t affecting them nearly as bad as some people thought (revenue down only 8%) and I saw a genuine opportunity to make money here. These guys knew how to run these business and after the downturn, I expected a swift recovery to the $3-4 level.

Yet I recently sold it all, using the latest bounce as an exit point and losing 25%. Why? Because the company is crap. A little more digging and investigating would have shown me that the hotel business, which is not a business I know at all, is one of the most risky, especially when a company is concentrated around one region (and especially when the region does poorly). For all I know, this company will go bankrupt if things don’t improve in Alberta in 2016 and in order for things to improve in Alberta, oil needs to kick at $60 a barrel. And with $568M in debt, it just takes a little tick to make your stock worthless!)

When I look at TSE:TPH, everything tells me it’s undervalued (with nearly $742M in assets!), yet I forgot the second most essential rule:

Never buy crap companies!

TSE:TPH, or Temple Hotels, is a crap company. You don’t want to touch it, period. Even at $0.01 per share I would not buy it. Even for free, I wouldn’t accept the shares. Okay, I might take them for free, but you get my idea.

TPH may or it may not go back up. Hell, if all stars are aligned, it may go to $5 within a year. Either way, it’s not worth it: too risky and remember the second most important rule in finance: don’t buy crap companies.

The first thing to realize when you want to determine whether a company is crap or not is that you shouldn’t even look at the stock price. Yes, the stock price can be seen as a proxy of the quality of a company, but the proxy is often wrong. In fact, the stock price should be the last thing you look at, right whenever you took the decision to buy or not. I’ve seen plenty of crap companies with overinflated values and plenty of amazing companies with terrible stocks. If you look at the stock price, it might make you believe that a crap company is actually good (see: TWTR). Now, how do you determine whether you are looking at a garbage company or now? While I do not pretend to have the answer and while I make mistakes often, I have a simple model to help me determine that. Let me share my secret with you, right now

How to determine if a company is crap

I ask myself five simple question. Question 1 is a sina qua non, meaning that if it’s not a resounding “Yes,” I don’t invest in the companyno matter what. For the other 4 questions, I expect at least 3 Yes out of 4. If I get 4 yes, that’s even better, but this is pretty rare. Now, the questions are:

1. Does their business model make sense?
2. Are they immune to a competitor squeezing them out?
3. Do they have a competitive edge?
4. Is there a reasonable chance they will keep their competitive edge for the next 10 years or develop one?
5. Is the company currently significantly undervalued based on my financial models (P/E, PEG, margins, etc.)

Here are all the companies in this article, along with UBER and BABA as a comparison (using UBER’s whisper IPO value), along with the answers to the questions (yes or no), so you can get a better idea.

Starting to get it? I can justify any “yes” or “no” on that list. For instance, TPH business model doesn’t make sense because they have $568M in debt - at 5.37% interest per year, nothing less. That’s $30M that is wiped out every year JUST in interest and given that they generate $13M in cash flow per quarter, it’s just terrible.

As you can see, the only company I would invest in in that list is BABA. I get a few close calls and if LC was cheaper (much cheaper), I would consider investing in it. A few more for you, some companies I already covered on this website:

Arguably, I only post research reports on companies I believe are solid, which explains the higher scorecard. Lastly, I have to say the answer is often not as clear as yes or no, but rather somewhere in the middle. HABT for instance is probably correctly priced where it is at the moment.

Still, you have a better idea of how I differentiate the crap from the non-crap. Once I make the decision to invest in a company, I rarely, if everm sell my position. Something would have to majorly change for me to consider selling. For instance, say I had invested in a newspaper company and the internet came along; I would definitely consider selling my newspaper companies. Other than that, I hold as long as the answers to the question above remain what they are.

There is much more to my buying process and this is nothing but the first step, but this simple test will differentiate between a crap company and a company you can actually invest in. Try to fill this grid by yourself! Can you differentiate the crap from the non-crap?

I’ll post the answers in a bit! See it as a homework. Good luck!