Fads Attract Cads

NBR Articles, published 20 December 2022

This article, by Te Ahumairangi Chief Investment Officer Nicholas Bagnall,

originally appeared in the NBR on 20 December 2022.

Investing in a business is generally a long-term commitment. If you buy shares in a business and hold onto them indefinitely, it will typically be well over a decade before the cumulative value of the dividends you receive will exceed the value of your initial investment. For this reason, it is reassuring if you can be confident that the people behind the business are also committed for the long term and will be making decisions with a view to growing the value of the business over time by consistently (and profitably) adding value for customers.

A common hazard with investing is the risk of inadvertently backing people who aren’t so focussed on long-term value, but instead are hoping to make a quick buck at the expense of customers and/or investors. For example:

  • If a firm is winning customers with hype and then losing them through excessively priced products/services or poor service delivery, it will not be able to grow for very long.
  • An even worse scenario for investors can be if the team behind a company see their road to riches as being the opportunity to sell expensively-priced stock to gullible investors, rather than by growing the value of their business over time.

How can investors weed out the short-term opportunists and invest with the management teams who are truly focussed on adding value over the longer term?

An obvious starting point is to look at track record. If a firm has been owned and managed by the same people for a long period of time and their track record has shown a commitment to long term value-accretive non-dilutive growth (Mainfreight is a good example of this) then it seems unlikely that that their modus operandi is to stitch investors up with over-priced stock. But if a management team without much of a track record (or even worse, a “serial entrepreneur”) is seeking to raise large sums from outside investors, it pays to be a little wary.

Where the Confidence Men Congregate

When you’re seeking to avoid quick-buck opportunists, it also pays to be aware of where they tend to congregate.

Quick-buck artistes are invariably attracted to whatever is currently hot and trendy. Why is this? Essentially they want to be able to sell stock in a company for significantly more than it costs to build the company, and this is easiest if the people buying the stock aren’t too concerned about the price they’re paying.

The universe of potential buyers for a companies’ stock includes several different types of investors including: passive (index-following) investors; people who latch onto themes and “buy the story” regardless of price; growth-orientated investors who chase growth (but pay at least some attention to price); and fundamental-based investors who pay more attention to a company’s financial statements (and try to evaluate whether they’re getting good value relative to what they’re paying).

The greatest opportunity for making a quick buck will be where the quick-buck opportunist can rely almost entirely on demand from unsophisticated investors who simply “buy the story” regardless of price, such that they don’t have to sell stock to more sophisticated investors who look more closely at the fundamentals. If they get enough theme-based investors to buy the story, then the passive investors will ultimately follow, and they won’t have to concern themselves with those troublesome investors who actually want to see some fundamental backing for a stock’s valuation.

“Selling the story” without fundamentals has clearly been the game for promotors of new crypto currencies (for the simple reason that there are no fundamentals behind a crypto currency), but it also seems to have been a large part of the modus operandi for promotors of shares in other hot areas of investment such as manufacturing electric vehicles. Over the past 3 year, companies like Nikola, Lordstown, Fisker, Workhorse, Lucid, and Rivian have managed to raise billions of dollars because the success of Tesla has encouraged theme-based investors to chase the next hot electric vehicle company without worrying too much about the price they are paying, or how far away these companies may be from profitably selling meaningful numbers of electric vehicles. Already, three of these companies are facing investigations or charges from the US Securities Exchange Commission, with the most amusing example being when Nikola released a video of one of its trucks seemingly driving across the desert, only for it to later be revealed that the truck didn’t have a working motor and was simply rolling down a gentle hill!

Another hot area for investors has been solar power, with numerous companies involved in various parts of the solar power industry coming to market over the last few years (generally through SPAC mergers rather than outright IPOs).

It is easy to understand why investors are excited about solar: The reduced cost per kWh of solar panels and the need to reduce carbon emissions mean that is inevitable that there will be a massive increase in solar generation over the next decade. However, seemingly indiscriminate investor demand for any solar-related company (in the US market at least) makes this a fertile area for opportunists. If you want to invest in this area (which is understandable given the size of the opportunity), you should take care to ensure that the reported revenues of the companies that you invest in are not artificially inflated and try to find companies that truly have some intellectual property that gives them a unique edge. It seems inevitable that time will reveal that at least some of these companies are run by charlatans who preferred the easier road to riches of creating the illusion of an innovative solar technology company to the far more difficult roads of actually improving solar technology or making a profit through low-cost provision of generic products or services in this very competitive space.

The perils of valuing companies based on revenues

One approach that investors often take to valuing rapidly growing companies is to pay more attention to the revenue line than the profit line. The logical basis for focussing on revenues for rapidly growing companies is easy to understand: While many of a company’s expenses are variable (meaning that they should be expected to grow roughly in line with revenues), some costs will be “fixed” – the company may not have to significantly increase its spending on these items as revenue grow. Hence, rapid revenue growth can give an initially loss-making company the operating leverage to grow its way into profitability. If the revenue opportunity in an emerging sector is particularly exciting, it will therefore often make more sense to focus on the relative size and trajectory of each company’s revenue line rather than to get fixated about current levels of profitability.

However, investors should be aware that they are stepping into dangerous territory when they start paying high multiples for currently unprofitable revenue lines and show a willingness to pay even higher multiples if revenue growth accelerates. Such behaviours scream opportunity to opportunists, who will not be blind to the “arbitrage” opportunity created if an extra dollar of unprofitable revenues causes investors to pay an extra five or six dollars for their company. During the TMT boom of the late 1990s, some early-stage companies blatantly took advantage of this through “strategic alliances” and other not-so-well-disclosed arrangements whereby company A agreed to buys services from company B in exchange for company B agreeing to buy services from company A. Voila! Both companies became more valuable using a simplistic revenue-multiple valuation approach.

One sub-sector that has attracted extraordinary valuations recently has been companies offering cloud-based subscription services, such as DataDog, Cloudflare, Crowdstrike, and MongoDB. All of these companies are unprofitable, all of them have raised at least some cash from new equity over the past 3 years, and yet the market values each of them on more than 10 times trailing revenues. Although I have no specific reason to disbelieve any of these companies’ reported revenues, I would argue that scepticism is warranted if you’re investing in such companies on the basis of the momentum in their revenues, as the incentive for such companies to find some artificial way of inflating their revenues is too high to ignore.

Outsource your fad-chasing?

Clearly, investing in faddish sectors requires a higher level of due diligence than many individual investors can do on their own. Should they maintain their enthusiasm for hot sectors, but do this through funds rather than picking stocks by themselves?

Unfortunately, it is not just the promoters of listed companies that seek to make a quick buck from investment fads. My own industry (funds management) also has a poor track record in this area, with a history of selling investors what they want rather than what they need. The funds management industry launched several TMT (tech, media, telecommunications) funds during the TMT boom of the late 1990s, switched to promoting infrastructure funds in the early 2000s, and pushed property funds before the global financial crisis. More recently, the trend has been to launch growth and ethical funds. For an extra buck, some operators appear to have few scruples about what they are willing to package up for retail investors, as demonstrated by a number of crypto funds that were launched shortly before the crypto bubble burst a year ago.

In itself, there is nothing wrong with fund managers providing specialist offerings, but timing has tended to be bad for investors, and the emphasis on the investment theme is often used to obscure the fact that these funds often carry higher than average fees and the managers of these specialist funds often lack a track record.

On paper, “momentum” investing (a.k.a. following trends) looks like it should have been a profitable strategy in equity markets, but the reality is that the greatest number of people jump into trends during their final stages. As it takes time for quick buck opportunists to put together an “offering” that exploits the latest fad, it is during the final stages of a trend that this risk is the greatest.  


Nicholas Bagnall is Chief Investment Officer of Te Ahumairangi Investment Management

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that invest in global equity markets.