Lottery Ticket Stocks: A Quick Review of Money Losers

Loss Making Companies in the R2500V vs. the R2500G

• Our recent paper, Russell 2500 Growth Index, explained that the R25G had record exposure to loss-making stocks vs. its own history and compared to the Russell 2500 Value Index
• The analysis in that paper was brutal, the charts simple and the evidence overwhelming
• The chart below shows that the returns of money-losers in the R25V trounce those in the R25G
• Loss-makers in the Value index tend to be a “different animal” than those in the Growth Index
• This quick note offers a simple explanation and compares today to the peak of the dot.com bubble

Get our insights direct to your inbox: SUBSCRIBE

This newsletter has consistently suggested that chasing speculative loss-making companies favored by shills will end badly. To us, this market has felt like a lottery stock market where understandably angry small investors chase stocks of companies that may never turn a profit. The good news, as we have explained, is the opportunities for GARP investing have never looked better, in our view!

The Best Lottery Stocks are Pretty Ugly

For those who take umbrage at our decision to call firms that fail to generate net income, like a lot of cleantech stocks, “lottery tickets,” let us make some prompt amends. We understand that some of these loss-makers are tech startups that go on to become huge companies despite their lack of profitability. The KCR research team believes that the ability to predict which of these stocks will become the winners is dismal. Our piece on fast growing stocks explains why we believe our approach, like Buffett’s, will preserve capital and win-out over a full market cycle.

In our paper on How to Find the Next Amazon, we gave the actual empirical odds of finding an Amazon. In our view, the odds are akin to a lotto ticket. How about for all loss-makers? According to a site we found on Google, the odds of winning on some scratch tickets can be 1:4 or 25%.

As the chart below shows…. maybe calling all firms generating net losses lotto tickets is indeed a tad hyperbolic. Going from left to right here is what the data tells us:

• First navy blue bar: loss-making stocks in the R25 Value Index win in 47% of 12m rolling periods
• First light blue bar: loss-making stocks in the R25 Growth Index win in 37% of 12m rolling periods
• Second navy blue bar: When R25 Value stocks with negative profit margins lose, they lose by -8.5%
• Second light blue bar: When R25 Growth stocks with negative profit margins lose, they lose by -9.9%
• Both groups have poor batting averages and inflict steep losses on investors when they lose

Summarily: Loss-making Growth stocks are 10% less likely to win than their loss-making counterparts in Value. We remind readers that “Las Vegas was built on a 1% edge,” and over time, a 10% deficiency in hit rates is nothing short of a disaster in an already disadvantaged group.

How to Value Unprofitable Companies Made Simple

In our piece on Bear Market Traders, we noted that valuations in this bubble eclipsed those seen during the dot.com era. People have completely walked away from free cash flow statements and even income statements. “Analysis” has often been reduced to examining the rate of total revenue growth, applying some arbitrary price to sales ratio on future expected numbers, and setting a price target.

The table below explains why we think loss-makers in Value tend to do better than loss-makers in Growth. The table also shows why we are pounding the table for investors and allocators to dump Small & Midcap Growth Index Funds and move money to active managers in that space.

The top two rows in the table shows the fundamental characteristics of the companies in the Russell 2500 Growth Index losing money both at the Dot.Com Peak and today. There is literally no difference in our view. If you are counting on some bizarre method of calculating an enterprise value to EBITDA ratio to save you in those names, we wish you the very best. We suspect you will need it.

The bottom two rows show the characteristics of companies that lose money in the Russell 2500 Value Index at the peak of the Dot.Com bubble and today. One could tentatively suggest that these stocks look slightly worse than they did at the peak of the dot.com bubble. But with that said…. they are still MUCH less expensive than the speculative money-losing names in the R2500G.

Article after article from IBD, the Wall Street Journal, and even Cramer have suggested investors dump money losers. AND FOR GOOD REASON.

Is the Company Profitable?

KCR’s equity research team has held fast to the belief that financial statements and rigorous fundamental analysis are essential to compounding wealth safely over time. KCR’s research team recently wrote that Growth at a Reasonable Price had never looked more compelling than it does today. The core tenet of that research was identifying firms with increasing profitability at modest valuations.

The chart below shows the compound returns to merely buying the stocks in the R25G and R25V that are profitable over time. You can see that despite the recent explosive returns in the growth stocks, value is still tied with growth over the long haul. This is consistent with the conclusions from our research on how to find safe investments.

The data provides a powerful and simple message: when you buy a stock, does it make money? A simple “yes” is a surprisingly good starting place for any investment process!

For a list of companies that are not only losing money but are in the bottom 100 of our ranks and failed the screen that identified Enron[1] prior to its implosion, please see our paper from last week.