Think Like a Bear

We’re investors. The idea is to invest money in companies that are growing revenue and earnings, so that what we buy today is more valuable tomorrow. It’s a pretty basic formula.

Inflation and demographics are on your side. Inflation means that, in the future, it takes more dollars to buy something. And growing demographics means that more people are likely to buying a product in the future, which means more revenue. Any management team worth its salt should be able to turn more revenue into more earnings.

Warren Buffett understands this, perhaps better than any investor ever has. His fortune is built on the idea that the U.S. population will continue to grow, and whatever we are buying today, we will buy more of in the future. That’s why he can make so much money buying things like carpet makers and mobile-home makers…

Investments like these are the most mind-numbingly boring investments you can possibly find. “Oooo, carpet! What a fantastic idea!” said no investor, ever. 

Individual investors tend to like the flashy investments. They want to buy revolutionary companies with game-changing products. Who doesn’t want to be able to tell their neighbor that they saw the future coming? That’s why investors get so enamored with companies like Tesla. Or Facebook. Or SolarCity. 

You can spin a great story about any of these companies…

Facebook’s got a little over one billion members that access the site every day. If Facebook can make just $2 a week off each of them, that’s $100 billion in annual revenue, roughly five times what the company is taking in now.

SolarCity has a business model that could help put solar panels on every house in America.

A total of 16 million cars are sold per month in the U.S. If Tesla captured just 1% market share, that would mean it would sell 1.9 million cars a year. That’s more than 10 times what the company sells now.

Will the Growth Ever End?

I like to call these types of investments “open-ended growth stories.” Because in the early stages, the growth ahead of such companies is truly open-ended. It’s hard to imagine any scenario where they don’t put up phenomenal growth. Companies like these simply can’t be stopped.

It’s a great move to try to recognize these open-ended growth stories. You can make a lot of money. But you’d better understand that it is extremely rare that any “open-ended growth story” truly manages to achieve open-ended growth. Reality pretty much always creeps in and puts the lie to the growth story. In the investing world, we say, “Trees don’t grow to the sky.” And that means there is always an end to growth, and it usually stops long before the lofty projections are met. 

And the really weird thing is, even when the growth story remains largely intact, there will come a time when there’s no more money to be made. Apple is a great example of this. For years it was an open-ended growth story. First it was based on when every American gets an iPhone, then it was when everyone in Europe or China gets one. The stock ran and ran…

It hit its highs almost two years ago. Investors figured out that not everyone would get an iPhone. And eventually, some new technology would change the game. Except that the iPhone has only become more and more dominant. It’s virtually a staple now in America, and it will likely become one in Europe and China. And the competition is falling away. Its biggest rival, Samsung, stopped making Galaxy phones because they were exploding.

And yet Apple gets no credit for its position at all. Apple stock is cheaper than Exxon, which is struggling with low oil prices. It’s cheaper than Johnson & Johnson, which is growing just 6% a year. Apple is 30% cheaper than McDonald’s, which, until a couple quarters ago, was actually shrinking.

Quite simply, Apple should be getting more credit for its growth potential than any of these companies. But it’s not. And it probably won’t, either.

Why You Should Think Like a Short Seller

Yeah, the stock market is a funny place. There really aren’t any single, all-important rules that always work (except the rule of compounding over the long term). So investors have to equip themselves with a handful of rules, so there’s something to turn to when a rule you’ve been using stops working.

Like the “don’t fight the Fed” rule. This one basically means that when the Fed is easing or cutting interest rates, you buy stocks. You stop buying and take some profits when the Fed is hiking. We’ve had the easing part. But you’ll notice that stocks don’t rally so much when economic data shows that the Fed isn’t ready to turn to a tightening cycle. This rule isn’t working right now…

Another one is that when the economy is emerging from a recession, you buy the stocks that have been the worst performers. Coming out of the financial crisis, it was banks and probably casino stocks. Between late 2007 and early 2009, Las Vegas Sands (NYSE: LVS) traded from $135 a share to under $2. Today it’s around $57. 

Today, I want to suggest that you add “think like a short seller” to your rules. Now, for an explanation. A short seller is sort of the opposite of a regular investor. Instead of owning a stock with the expectation that it will be worth more in the future, a short seller is looking for stocks that will be worth less in the future. And not because the market is going down or the economy is headed into recession… the short seller is looking for companies that cannot fulfill the promise of their growth story. 

Earlier, when I was talking about “open-ended growth” stories, I mentioned Tesla and SolarCity. I mentioned them both because they are both Elon Musk companies. And Elon Musk tells a good story. Is he a genius? Yeah, I suppose he is. Clearly, he is a great innovator. But we’ve already seen SolarCity collapse as the reality behind the story was revealed. And then Musk’s other public company, Tesla, bought SolarCity to save it. I don’t know, but this seems like a lot of wrangling to try and keep the story alive…

Would You Short These Stocks? 

Now, I’m not telling you to sell short shares of Tesla. What I am saying is you probably don’t want to be long Tesla stock right now. Because it is very likely that interest rate hikes are coming sometime in the next few months. And when money gets more expensive, the stock stories get a little harder to tell. And believe. 

Let me put it this way: What’s the story for Starbucks? Analysts say that spending at restaurants has peaked. They say coffee prices are going up, competition is building from Dunkin Donuts and others, and Starbucks’ main market for growth, China, is on the verge of collapse. Sounds like Starbucks is headed lower. But would you make a wager that Starbucks is going lower and short that stock? Yeah, me neither. 

What about Disney? Cord-cutters mean that Disney’s flagship ESPN network has lost around 10% of its subscriber base. And there’s no end to the declines in sight. Are you ready to risk real money that Disney is going lower? Again, me neither. 

Sometimes learning to think in new ways can really help your investing. So, spend a little time and learn how the short sellers think. See if you can find some companies with stories that seem more like fairy tales. This exercise will absolutely make you a better investor.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.