Negative Cash Flow & The Problem with Paying High Prices for Systematic Dilution

Broken Business Models

• Our recent paper on Small Caps, The Low Price of High Quality, identified the market’s highest quality firms trading at reasonable valuations
• That work also documented the dangers of cash burning firms trading at nosebleed valuations that were little more than rank stock speculation
• The first graphic below shows the total issuance of firms that are in the bottom quintile of buyback yields has just hit $65bn, a level last seen at the peak of the internet bubble
• The second chart shows that the valuation of these firms is at 4x sales or a 60% premium to the peak of the internet bubble!
• We believe the risks to owning such firms are substantial and urge caution

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Running Out of Money

Summarily, investors are now paying record prices to own firms that lose money. The history books are full of the disasters that follow periods of such epic folly. For investors seeking to own profitable firms with defensible moats that pay dividends and grow, please reach out to [email protected]

The Internet Bubble

The stocks that make up the brutal charts above are very much like the internet companies and technology stocks that dominated the stock market during the dot.com mania. These firms today, like their predecessors in the dot com bubble, required substantial capital investments as they developed exciting new products and services. In the thrall of Wall Street analysts, venture capitalists, and the seeming ease with which investors were making money, cash flow statements were thrown to the wind.

Share prices today, as in 1999, seemed destined to march forever higher. All of these novel and new firms, like clean technology stocks, brought with them great promises of taking market share from companies that were no longer “with it.” When the profits are rolling in like today, speculating is an enormously rewarding experience.

Having lived and invested through many bubbles the KCR research team understands this phenomenon all too well. We highlight these risks in the hope that we can encourage a few investors to contemplate the risks they are taking.

Everyone knows that on March 10, 2000, the entire charade came crashing down. Investors would be decimated as the Nasdaq plunged a staggering 80% and the broad market fell nearly 50%. Our research provides a potential alternative.

For those seeking quick riches and promissory research, KCR is not for you. Denizens of behavioral finance, we believe in the importance of paying reasonable prices for high-quality firms with healthy balance sheets.

The good news, in our view, is that the frenzy for stocks that are little more than variants of the now-infamous Enron or pets.com, has left many blue-chip companies trading at discounts. In that light, we hope investors interested in compounding capital safely will read some of our work on the remarkable opportunities available today.

In our piece What Does Volume Mean in Stocks, we demonstrate that there are terrific opportunities in stocks that are not part of the speculative fervor underway. That piece also identifies and flags investors about the risks in some of the most popular stocks in the market.

For those looking for the, few truly cheap stocks left and willing to do some research check out Cheap Stocks are the Exception Not the Rule. In that piece, we document the rare firms with big profits that are trading at low prices and, historically, prone to going higher.

In over a decade, KCR has published a large and ever-growing collection of White Papers, Quick Takes, and simple (if often brutal!) Charts for the Curious. All our work is designed to help investors interested in compounding wealth safely. Our work seeks to exploit the behavioral errors of others and help those with patience and discipline.

To see a group of stocks that have positive earnings but many of the fundamental factors like those found in some of the most dangerous dot.com stocks, please visit our post, Enron Hat.

Thank you for your interest!