The Cream Will Rise to the Top

Posted on May 19, 2021 in Investment Strategy

The Cream Will Rise to the Top

Around 20 years ago, when Farr, Miller & Washington was just about five years old, the capital markets were rocked by two of the largest corporate frauds in history. Of course I’m speaking about Enron and WorldCom. The collapse of these two companies, which resulted from a combination of willful misconduct and a failure of corporate governance, came shortly after the bursting of the dot com bubble. Both stocks obviously fell to almost zero, triggering more selling across the stock-market complex. Investors, understandably, became disillusioned by stocks as an investment class. Perhaps more importantly, there was somewhat of a crisis in confidence in corporate America. If two public companies this large could pull the wool over investors’ eyes, how can we trust the rest of the companies out there?

I can still clearly remember a conversation I had with one of my analysts a few months prior to the collapse of Enron. Impressed by the stock’s unrelenting ascent, I had asked him to look at Enron for its possible inclusion in client portfolios. My analyst took a week or so to run the numbers, and was now getting back to me. He said, “Michael, I just cannot figure out how they are making their money.” I pressed him hard, trying to poke holes in his thesis. How could he be missing the obvious investment attributes which had caused Enron’s stock to go up exponentially? So then I decided to take a few hours and look into it myself. Sure enough, my analyst was onto something. It appeared as though the analysts that followed the stock for the big brokerages were largely acting as sycophants and placing blind faith in Enron’s management. Nobody on the sell side seemed willing to put a big source of investment banking fees at risk by questioning the business model. It slowly began to occur to me that analysts who normally cover the Utilities sector were charged with understanding an incomprehensible business model. In sum, I was hard pressed to find any analyst reports with independent insight into how Enron made its money.

I’m reminded of this story because of the large downward swings we are seeing in many segments of the market right now. Even as the major market indices are still pretty close to their all-time highs, we are seeing some massive pain in such areas as SPACs, electronic vehicles, fuel-cells, and cryptocurrencies. Some stocks and ETF’s in these sectors are down by a third or more from their highs earlier this year. What do they all have in common? They almost all lack the fundamental support that comes from highly dependable revenue and earnings streams. Their valuations are based more on a wing and a prayer than reality.

I’m not saying that the various cryptocurrencies or SPACs or green energy companies are frauds. I’m not drawing that parallel at all. In fact, it’s conceivable that some form of digital currency could ultimately displace the dollar as the world’s reserve currency. Individual SPACs may end up finding great companies to take public. And green energy almost certainly will take the place of fossil fuels over the next 30 years. I’m simply saying that, as things now stand, I can’t figure out how the earnings and cash flows generated by many of these companies can justify their valuations. In other words, I can’t see a clear line of sight as to how I, as a long-term investor, will make money on these investments.

Sure, you can play the “greater fool” game and hope that someone else buys me out at a higher price. You can get on the chat boards and see what’s being hyped that day and try to jump on the bandwagon. You can trade based on Elon Musk’s Twitter feed. But that’s not investing; that’s gambling. Yes, it’s great that a new generation of investors has been born. It’s also a positive development that young investors have been empowered with more resources and online venues for dialogue. And it’s great that they now pay zero commissions. But these developments also bring peril. Not that there is anything nefarious going on, but banding together to drive up a stock several hundred percent based almost solely on a celebrity endorsement or chat-board hype does not strike me as a sound investment strategy. I can think of one example of a company that had a market capitalization of over $4 billion despite reporting first-quarter revenue of just $500,000. Think about that.

Warren Buffett famously said that when the tide goes out you see who is swimming naked. The tide may or may not be receding right now, but some day it will. Those investors with a sound process that focuses on fundamentals will be the ones with the swim suits.

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