The Only Reasons to Buy a Stock – Part 2

If you’re in the market to make money, there are really only 3 reasons to buy a stock. If you missed last week’s post about Reason #1, be sure to check it out here.

Reason #2: Long-Term Growth “This business will grow over the long-term, and the stock will grow with it.”

Several readers are already confused. Growth of the business? Isn’t that obviously included in the calculation of value, e.g. Reason #1? Well, yes and no. Growth is certainly part of the value framework. But Reason #2 differs in one key aspect: it’s focused on something beyond the Horizon of Reasonable Predictability. In other words, it’s a gamble on the trend in value.

I use the word gamble here for a reason. If it was anything less than a gamble, if the belief in long-term growth could be backed with evidence, then it would no longer be beyond the HRP. To the contrary, a belief backed by evidence is a very reasonable prediction, and thus would be included in value – and value investing was already covered by Reason #1. But Reason #2, making an investment based on unpredictable long-term growth, more closely resembles religious faith: belief in that which cannot be proven. And that’s part of what makes investing for growth so compelling. Something which can’t be proven also can’t be disproven.

Another appeal of long-term growth investing is that it levels the playing field. The studious analyst has no advantage over the common man, because the difference between worth of the business and stock price is irrelevant. There’s no need to calculate value, because current price does not matter. It sounds blasphemous – after all, countless studies have shown expensive, so-called growth stocks underperform over the long-term. I won’t dispute the findings. But I counter that the problem for those so-called growth stocks was not that their price-to-earnings multiple was too big. No, the problem was that they failed to keep growing.

Let’s talk about a company named Amazon.com and the internet bubble of the late-1990s. If you didn’t experience the exuberance of the dot-com era first-hand, you’ve most likely heard all about it. Investors were so excited about the possibilities of this new technology that they were willing to pay exorbitant premiums for any stock name with a .com at the end. Like all bubbles, it ended poorly. Stock prices collapsed.

Amazon.com was one of the highest flyers, rising 7100% less than two years after its May 1997 initial public offering. By December 1999, they had a market capitalization of $36 billion. Meanwhile, their income statement for the year showed only $1.6B in revenue, and a whopping $700M in losses. The following year, they proceeded to lose twice that much.

Now any level-headed analyst could see the stock was overvalued at a price of more than 20 times their annual revenues. It became even more clear when the bubble popped, and the stock fell by a heart-stopping 95%. But in the years since, Amazon.com has become a household staple. Since the turn of the century, they’ve grown revenues to more than a quarter trillion dollars – an annual rate of 28%. No one, and I mean no one, could have reasonably predicted that kind of growth. In fact, if you’d told someone in 1999 that a seller of used books would one day play such an all-important role in the U.S. economy, I suspect they’d have checked you in to the nearest mental hospital.

But what if you believed it? What if you had ultimate faith in the unknown growth possibilities, and you bought Amazon at the top of one the largest stock market bubbles in U.S. history, right before the bubble popped? You’d have outperformed every major asset class on earth over the next 20 years – even after an initial collapse of 95%. In fact, with the benefit of hindsight, you should have been willing to pay much more! Ready for some stats? You could have paid double the peak 1999 price and still earned an annual 13.8% through September 2020. If your goal was to achieve historical U.S. equity returns of 10%, you could have paid four times more than Amazon’s peak 1999 price. And if instead you simply wanted to match the S&P 500 Total Return Index over that 20+ year period, you could have paid a 900% premium for AMZN on the day of the peak – or $301 billion dollars for a business with $1.6 billion in annual revenues. If a business grows fast enough for long enough, price doesn’t matter.

This investment rationale is a bet on the trend in value rather than the level of value, and the current price of the stock plays no role in the investing decision. To illustrate, let’s look at our value vs. price chart again, this time with value on the rise.

To be clear, expensive multiples don’t equate to great growth. The returns for other high-priced technology companies of the late 1990s, like Intel and Cisco, are far less compelling than those for Amazon. Some investors certainly believed those businesses would generate long-term growth at the time, but history has shown otherwise. Contrarily, General Electric could have been bought at low valuations at points during the late-1890s and early-1900s, but, still in existence 120 years later, clearly grew for longer than anyone could have reasonably expected. It’s not hard to place faith in the wrong deity.

Thus, the biggest problem with choosing a stock based on Reason #2 is that it’s a gamble on the unknown. The only thing separating one stock from another is our confidence level in something we can’t prove. We can’t know in advance whether we’ve chosen Amazon.com or Pets.com, and more often than not, we won’t know for many years, or even decades, if we guessed right.

Check in next week for Part 3!

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

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