Markets Will Always Present Opportunities For The Patient Investor
There is a theory that markets perfectly process external information such that they always serve up fair valuations for a stock. I beg to differ. I have had serious reservations about the validity of the efficient market hypothesis for a long time. I believe that markets overreact to negative news that is not stock specific. I’ll provide a couple of examples where I think this is the case. Alibaba I have had my eye on Alibaba’s (NYSE: BABA ) stock for a considerable period of time. Ever since the IPO in fact, I had been looking for opportunities to own the stock. However, time and again, the company just proved itself too be too far out of my strike zone, and traded above a valuation at which I would be interested to make a purchase. I didn’t let that disturb me too greatly as I felt the next scare about China related growth or fears of a worldwide recession would bring the company back to a price that I was more comfortable buying. It’s not hard to see why I was so keen on the Alibaba business. The company benefits from strong network effects, courtesy of being the dominant e-commerce play in China. At latest count, BABA had roughly 367M buyers across its marketplaces. Taobao in particular enjoys strong brand loyalty among a younger generation of Chinese consumers. A platform with the greatest number of buyers attracts the greatest number of sellers and provides strong monetization for Alibaba. Having such a dominant platform makes it hard for competitive platforms to find a place. Others either need a clear value proposition to supersede BABA, such as better pricing, or offer services in a small niche that Alibaba doesn’t cater to. What’s interesting to note is that the Alibaba business has been on a constant upswing in recent times. Revenues have grown at a strong pace over the last five years, averaging just under 30% annually. Operating income and EPS have shown similar levels of growth over the last five years. Most recent quarterly growth has been outstanding as well, with revenue and operating income increasing 30% year on year. BABA’s growth potential remains immense. China’s e-commerce sales still only represent about 10% of total retail sales, implying that there is still a long way for digital commerce to go. Yet looking at the movements in the Alibaba stock price suggests a market that is confused by the prospects for this business. Alibaba’s stock was down 20% in 2015. In the year to date, the stock is down another 7%. However, it was a lot worse just several weeks ago when the stock was down almost 26% year to date. Alibaba’s prospects haven’t changed at all in the intervening few months. There have been no new competitive threats, no profit warnings and no stock specific bad news. Yet the stock plunged almost 25% in the year thus far on concerns over poor Chinese data, even though the underlying business is in glowing health. Even if poor economic data from China did indicate a slowing down of the economy, does that justify marking down a high quality business growing at 30% annually by almost 25%? Baidu Another victim of market irrationality was Baidu (NASDAQ: BIDU ). Baidu is the “Google of China” and controls close to 80% of the overall share of internet search in the country. This provides a natural monopoly for the business. Users are likely to continue to leverage the dominant search engine if it continues to provide them with the most relevant search results. Having the most users in turn tends to attract the largest share of advertisers willing to pay the most to advertise. The company has a great track record of long-term growth. Average annual revenue growth over the last 10 years has come in at close to 82%. Revenue growth over the last couple of years has still averaged over 40%. Yet, the stock has been hammered. It was down 17% in 2015, and down almost another 26% at various points during 2016. While the stock has significantly bounced back in the last few weeks, Baidu was another name that sold off in the absence of specific information impacting the underlying business. With the Chinese online advertising market set for steady growth over the coming decade, market hand wringing over Baidu’s prospects arguably set up an attractive share valuation for patient, long-term oriented investors. I have given examples of 2 companies that I think have compelling growth stories that should be well placed for the long term, which the market chose to mark down on no real company specific news. I’ll offer one further example of a company that I believe has been overly marked down on a company specific event. Chipotle Chipotle (NYSE: CMG ) is a relatively rare success story in the retail space, as it is one of the few businesses that has managed consistent revenue growth at close to 20% annually over the last decade. This also isn’t a case of a business with growth that has started strong and been progressively declining. The business has seen 3-year average revenue growth top 20% for each of the last few years. Chipotle’s gross margins and operating margins have been responsible for juicing earnings growth. It’s amazing that gross margins have increased from 18.5% to almost 27% in the last decade. Even more impressive is that operating margins have grown from 4% to 18.5% in that same time. However, a spate of E. coli and noro virus scares have decimated the company and the company’s stock. Chipotle’s stock plunged from close to $750 in 2015 to a low point of $400 which was reached early in 2016. That’s a fall which is just shy of 50%. This is another example of a business that I have really liked, which was trading at a valuation that I wasn’t comfortable with. However, that large share price drop was tough to ignore. Now these sorts of E. coli scares and virus epidemics are actually relatively common place in the fast food industry. A lack of hygiene amongst employees and problems in the supply chain make these incidents unavoidable. In fact, Jack In The Box (NASDAQ: JACK ) had a particularly nasty virus outbreak a number of years ago that caused the deaths of close to 10 people. Comparatively speaking, Chipotle’s problems are thankfully relatively less severe, but nonetheless, its stores are currently sparsely populated and the company’s earnings have suffered. Thankfully, consumers have relatively short memories, and they typically return back to these stores after a period of time. Lost consumer traffic takes about a year to recover, but consumers eventually return. The market seems to be pricing Chipotle on the basis that it will see severe and sustained consumer losses that will hurt long-term growth. I think a 50% reduction in business value is an overly pessimistic assessment of the business’s prospects and overstates how long a consumer’s memory is. Markets always offer up opportunities for the patient investor. The key is to be willing to wait for them.