When is Comes to Investing, Bigger Isn't Always Better – Rivard Report

Updated 1 hour ago

With the stock market at all-time highs and the bull market now in its ninth year, the financial press and investment community at-large have become enthralled with the prospects of a small number of mega cap companies.

These companies are the beneficiaries of investor infatuation. In 2015, Facebook, Amazon, Netflix, and Google were designated by the financial press as the FANG stocks. Their stock prices have risen sharply and have represented a large percentage of the broad stock market’s performance. Recently, Wall Street has donned a new and improved acronym to represent big companies: FAAMG. This collection adds Apple and replaces Netflix with Microsoft.

Over the past six months, these five stocks alone have increased in value by $600 billion, equal to the combined GDP of both Hong Kong and South Africa, according to Barron’s.

Yet, while each of these FAAMG companies were initially built from a single business, their growth strategies suggest aspirations to be identified as much more than just their core business.

Amazon began as an online retailer of books, aimed at disrupting the brick and mortar book industry. More than 20 years later, Amazon’s business aspirations have ballooned. A company with a clear competitive advantage in internet retail is now also in the business of cloud-based web hosting, Academy Award-nominated television dramas, voice controlled virtual assistants (Alexa), and other consumer electronics.

Amazon has now gone full circle, from clicks to bricks, with its recent decision to acquire Whole Foods Market for $13.7 billion. The grocery store industry is fiercely competitive, with a measly profit margin of 4-5% actually being worth writing home about, even more so these days with the competitive set as wide as ever with the emergence of efficient German grocery store formats Aldi and Lidl making their way into the United States.

Google started with the genius idea to simplify internet search. Yet today, Google is hardly an internet search business with disparate divisions that include YouTube; Android; Google’s mobile phone operating system; Nest, which creates smart thermostats and other home devices like security cameras; Google Fiber, a high-speed alternative to traditional broadband offerings; Waymo, Google’s self-driving car enterprise; and even a drug development business, Calico, which is tasked with creating drugs to “cure death.”

It is hard to see these strategies for growth as anything other than a wayward land grab. No company can succeed in all businesses, but each of these companies is trying very hard.

In many respects, we have seen this before. In the 1960s, the investment world became enchanted with the idea of the conglomerate. In a 2015 presentation at the James Grant Interest Rate Observer Conference, James Litinsky of JHL Capital Group detailed the investor infatuation with “bigger being better.” Fueled by accommodative low interest rates, already large companies such as Leasco, Gulf & Western, Teledyne, and International Telephone and Telegraph Corp (ITT) went on a spending spree, gorging themselves with every acquisition they could gobble up – “The bigger, the better.”

The initial results were positive: Investors rewarded these companies with higher valuations given the higher revenues, regardless of them being bought and not built. Their valuations were also the result of investor infatuation. Yet as this dynamic continued, these large “blue chip” companies became a victim of their own success as they eventually capitulated under the increasing pressure to continue to generate sales and earnings growth – A classic boom and bust.

Technology stocks are often about the future – comparable to looking through a telescope rather than a microscope – and the stock market prices in estimates of future sales and profitability. But the investment story can’t just be about future expectations. Valuations do matter.

Amazon’s tremendous growth, for example, has come at a cost. Despite generating annual revenues of more than $136 billion, net profit totaled less than $3 billion, a profit margin of less than 2%.

Is it in the best interest of shareholders for these companies to seemingly seek out competition in other industries at the expense of profits, which belong to shareholders?

The stock market appears to be valuing these companies under the premise that they can succeed at everything.

My advice: Tread lightly.

While many of these companies have wildly successful core businesses, their business model of using the cash flows from their core business to expand in so many different areas brings risk – risk that I believe is being underappreciated.

Bigger is not always better. Regulators keep watchful eyes on monopolies, and hubris can set in with management teams. Don’t get me wrong, I love the FANGS and am an avid user of their products and services, as many of us are.

However, a great product or service is only one component of an investment decision.