Investing in an idea that will change the world is not a proper thesis.
A proper thesis for investing in a stock, or a sector, or a company involves a deep understanding of the company’s fundamentals: its products, its capital structure, its total addressable market, its revenue growth rate, market expansion capabilities, product pipeline, and management acumen.
These are difficult ideas to grasp, let alone model for a single company. And investors need to model these various moving parts for all of the companies in their portfolios. We all do this with imperfect information, although some have better information than others. It’s no surprise that so many active retail investors underperform passive, long-term investors: they lack the information and time to do the due diligence necessary to understand all of the various factors that impact a stock.
No industry is more prone to this problem than technology, where hopes of a big, paradigm-shifting technology will change the world forever. Ill-informed investors will jump into these trends and buy heavily, causing stocks to jump significantly. Then when reality sets in—change tends to be gradual and evolutionary and market-changing technologies will not benefit all companies equally (think Yahoo and AskJeeves in the 1990s)—those stocks sell off quickly.
This pump and dump tendency of over-excited investors was the backdrop of a legendary investor’s retirement. Julian Robertson, one of the fathers of the hedge fund, retired from finance in 2000 amidst the dot-com bubble, which he correctly said was set to fall (but which he incorrectly timed). Robertson remains a mentor to many old analysts and employees, whose hedge funds he has since funded.
It’s cliche—and probably wrong—to say that we’re in another tech bubble, since many new tech companies like Facebook (FB) are doing fine. Many others are not, though:
The last couple of years, when the Fed has been quietly unwinding quantitative easing and begun hiking rates, has caused investors to look more carefully at their investments as they cannot bet on a growing monetary base lifting all stocks equally. Overhyped industries like 3-D printing (DDD), online streaming (NFLX, P), and electric cars (TSLA) are getting looked at more intensely than before. And many investors do not like what they see.
So the paradigm-shifting thesis underperformed, but why? Each stock and industry has a different story to tell, but the most recent news from the wearables industry, as told by Fitbit (FIT), sheds light on why prudence and patience can often benefit investors.
When FIT first went IPO less than a year ago, wearables were seen as the logical next frontier of technology. First computers were in offices, then in homes, then in pockets; next was the wrist, the eye, the body. While Apple (AAPL) and Google (GOOG) were getting in this world, the paradigm-shift had already happened with profit-producing Fitbit, causing investors to jump in with excitement. The stock soared 70% in 2 months, and has continued to fall since then.
Then last week, the company saw double-digit declines as 50% revenue growth and a 333% EPS beat (10c) weren’t enough to please investors. Guidance was not good on earnings, but revenue guidance was far above expectations, at $2.55b for the full year versus $2.46b expectations. The reason seems to be disappointing EPS estimates for the second quarter, of just 8-11 cents per share below 26 cents expectations.
But as most growth investors know, EPS is rarely a concern for high-growth tech stocks, where companies are expected to grow into strong earnings by having high and fast revenue growth. Fitbit produced that, expects to produce more of that than the market was expecting, and yet the market has punished Fitbit. Why?
At least right now, FIT is being treated as a stock, not a high growth tech stock. The reasons for this are up for debate, but they need to be understood. For whatever reason, the market is not interested in seeing FIT as a paradigm-shifting titan of a new generation of technology. Instead, they are seeing it as a money-producing consumer goods stock, and pricing it accordingly—at a P/E of 18.5, far below the S&P 500’s 23.77.
Does this mean it’s time to take another look at FIT? If anything, it means it’s time to look at it not as a paradigm shifter but a company with strong sales growth, free cash flow growth potential, and sustainable profitability and sales expansion. In other words, it’s time to look at FIT not as an idea that will change the world, but as a company that makes and sells stuff.