You can’t predict the future of the stock market, but you can try to find businesses that have many possible futures. David Gardner shares four traits for finding companies with possible optionality.
Rule Breaker Investing
Netflix, Amazon, and the Future
It's the Rule Breaker Investing Podcast with Motley Fool co-founder, David Gardner. And welcome back to this week's Rule Breaker Investing Podcast. I'm David Gardner. Thank you so much for tuning in and telling your friends and family about this podcast because let's face it, Rule Breaker Investing should be shared with everyone. And I mean absolutely everyone, but especially anybody that you love. Okay. Talking of love, we won't be talking about that this week. We'll be talking about the future, the future. The future is that which is yet to be. I love the etymology of words. I went in to see if there was some really interesting history of where the word future came from. It turns out not really. It's just from futurus, the Latin, basically the future participle of the word for to be essay. So the future of what will be goes right back to the Romans, futurus, future that which is yet to be really important for investing. In fact, that's where all your returns are going to come from, we hope, the future. That's what you need with my help to piece together as we figure out which stocks to pick and which ones not to pick. The future is all that really matters to me at any given moment, especially as an investor. And I want to talk about one future versus many futures this week. Before I do that though, I want to start with a story. It's just a story of Amazon.com back in the early days of Amazon because it was a recommendation from ours from 1997 and by 1998 and 1999 the stock was doing very well. But there was a lot of skepticism. It appeared to be dramatically overvalued to many people. And in particular, people, market commentators were focused on a certain number. We're going to go over that term this week. It's gross margins, gross margins. So get ready for a little bit of financial statements 101. So gross margin, every company has sales. We know that at least almost every company except for development stage companies or biotechs might not have any sales yet, but every company has sales. And right underneath that line that you're accounting for it in the financial statement, the income statement is the word, the phrase cost of goods sold. So when you net out the cost of goods sold from your sales, you hope you have a positive number. Otherwise, you're going to go bankrupt really fast. But really how much is left over after goods are sold is what was at issue back then in 1998 as people looked at Amazon.com. So let's take two quick examples of where this is really relevant. Let's look at cars and software very briefly. So you can imagine that these two businesses have very different cost of goods sold. Let's take Ford, Ford Motor Company, last year sales of about $144 billion, cost of sales, $119 billion that leaves $25 billion left over. And if you do that $25 billion known as gross profit as a percentage of sales, you're left with 17%, so 17% of your top line is all you have left as you start to try to pay some other expenses. So that's a heavy business, right? That's cars. What are cost of goods sold? Cost of the products, cost of raw materials. The direct labor cost for whoever produces those products, you can picture that, it's big and heavy for Ford. Now let's take Microsoft by contrast. Microsoft last year in the year closed June of this year had sales of $94 billion and the cost of sales for Microsoft, $27 billion, leaving $67 billion left over after cost of goods sold, 71% of the top line drops through as potential profit for that business. So I just gave you two big numbers there, Ford 17% left, Microsoft flipped those numbers, 71% left. Now you can see the difference between what we call very heavy and expensive businesses to run like cars and very light. Light businesses to run often highly profitable businesses like software, so to close the loop on Amazon's gross margin today in the most recent fiscal year finished, Amazon had gross margins of about 31%. So somewhere midway between a car company and a software company. So the real question returning then to Amazon was what is this company going to look like because back in those days, Amazon was an online bookseller and its gross margins were pretty low and especially in comparison to an offline company like Borders, which at the time was a juggernaut. Amazon was smaller than Borders at this time. The big question was Amazon doesn't have particularly good gross margins compared to the booksellers and just wait till all these booksellers, Borders, etc., come online and compete with Amazon, they're going to drive all the profit out of the business and as it is, Amazon's gross margins are not impressive. And so that was the bear case for Amazon in the late 1990s. Here's what was missing though, consideration of the future, our theme this week. And across the Motley Fool's chief investment officer came up to me one day years ago and said, you know, Dave, there's one thing that I can see clearly that's different between how you invest and how Warren Buffett teaches people to invest and how he invests. He said, Buffett is looking for companies with one future and you're looking for companies with many futures and I've held on to that bit of wisdom ever since and I've used it in talks and speeches or articles just to kind of try to capture the difference in thinking here. There's a lot of overlap, tremendous amount, all of us, all of us have learned so much from Warren Buffett and his brilliance and his billions of profits as an investor. But sometimes we do contrast on some points and at least for me this is a key one. So think about what Buffett loves, right? Buffett loves says candies. Buffett loves insurance, Buffett for years loved the Washington Post. These are all businesses that pretty much are going to be the same from one year to the next. There's no surprises that are going to hit says candies probably and insurance. Well, that just seems like it's going to be insurance a decade from now just as it is insurance today. But by contrast, think about what amazon.com in the future became Amazon turned from just being a bookseller to starting to sell music and movies and Amazon went on from there to sell ladders and in time cloud services in addition to developing the Kindle and creating its own hardware. The fire tablet, the list goes on of all the things that Amazon has done since. Any possible futures. So that's my real focus as an investor where we often use for that synonymous with this is optionality does a business have the opportunity or possibility of morphing into something completely different from how it started. Ever heard of Cardinal Health? Well, that was a company I was looking at recently. The company was founded in 1971 in Dublin, Ohio. That's where its headquarters are today. Cardinal Health is a fortune 500 healthcare services company. But Cardinal Health 44 years ago was founded as Cardinal Foods. Completely different business, although both were kind of into wholesale and retail in a lot of ways. But that's an incredible example of a company morphing from what it started as to what it has become since today and a much, much larger company than it was probably than it would have been as a food company. So that's an easy example. But whether we're talking about Cardinal Health or Amazon, let me just toss out a few other examples of companies with great optionality that have captured that optionality that have capitalized on that. Think about Netflix. Netflix began really as a DVD mailing company. But then Netflix had the possibility, had a possible future in internet streaming and indeed through great visionary leadership sees that position and that wasn't all though. When Netflix started to realize it could actually produce its own content, not just show others. And so now today, Netflix is a leading content production company in addition to being the leading internet streaming service. Netflix looked overvalued early on. If you didn't see the possibility, the optionality for what that business could become. Think about Tesla. Tesla, still formerly called Tesla Motors today, but increasingly looking like an energy company as it starts making home batteries. And really, with the Gigafactory out west in the United States of America, is going to become a massive producer of batteries. These are all businesses that don't just have great optionality, but they've actually capitalized on it. And that's why they're some of our best stocks. So I think there are to close a short list here of four traits that I think you can find in these kinds of companies. And the better you develop your own pattern recognition around this, the better off you'll be as an investor. So businesses with lots of possibilities. You know, I guess I should say lots of real possibilities because I always think back to that Saturday Night Live fake commercial where it was a dessert topping. It was a floor wax. And sure enough, not every product can serve very well as a dessert topping and a floor wax. So you need to make sure we're thinking about real possibilities. So four things that typically indicate the possibilities of optionality, the possibility of many possible futures for companies. I think the first is maybe just the technology that the company has itself. If you think about something like 3D printing, which at different points the last five years has been a great place to be invested or a bad area to be invested, still very early on in that technology, but think about the optionality that 3D printing represents. Think about all the many things that can be 3D printed, think about all the many reasons people might want to 3D print in different companies, or whole new businesses will come out of that technology in the next few decades. That's one of the reasons we continue really to like it as disappointing as some of those stocks have been over the last 18 months. So the technology, when you can see that technology being used in new and different ways, biotech that happens a lot. Biotech companies will have an initial FDA clearance for one sort of indication, but then they'll find out that they're able to give that same drug or a modification of that drug to a different group of people for a different reason, and it works there too, and all of a sudden new possibilities, profits, and higher multiples and higher stock prices result. So it's often number one in the tech. Number two, it's in a name. The name Amazon.com was a great name, Amazon. It wasn't onlinebooks.com. Onlinebooks.com is a company name would very much indicate to me a one future company, not a many possible futures company. So often you can look at the brand names of companies and see the possibilities, or sometimes the lack of them. On a small side note, I'm really glad we called our company the Motley Fool, and not the online investor. I don't know. We'll go with org. Third, third, it's in the visionary. What actually has made it possible for Netflix and Tesla and many other of the rule-breaking companies that we've celebrated and invested in over the years, what's made it possible for them to succeed wasn't just that they had a great technology positioning and/or name. It was that they had great people at the helm that recognized the possibilities and with ambition, but control went after them and delivered. So Reed Hastings, Elon Musk, the list goes on, of course, Jeff Bezos, many of these people. Many people lesser known than these celebrated CEOs who recognize that potential, and when you can see some vision in your CEO, regardless of the size of his or her businesses or the industries that they're playing in, when you can see that vision, it's very valuable and you should respect it. Fourth and finally, if you can look at a company and just see how it could extend itself into more or different things, quick example, Chipotle. Part of Chipotle's future and its present-day multiple, that is the valuation of its stock day, part of it is predicated on the idea that Chipotle won't just be Chipotle, but will also include its new Southeast Asian kitchen concept and its new pizza concept. Both of which, either of which really, if they take off, will add tremendous amounts of value, but you can see how Chipotle could do it. You could see how, through their understanding of how to do fast casual well, everything from the food to the operations to the marketing, you could see how Chipotle might be able to succeed with a second and/or a third concept. So there we have it, one future versus many possible futures. Now, either can work out really well, and certainly Warren Buffett will always, in his life, have made way more money than you or I will with our investing. So those who seek that one future approach, done really well, can earn brilliant returns. But I want you to know with my cards on the table, I'm the many possible futures guy. In fact, the license plate of my Washington DC car is the word "future." It's a word that matters a lot to me. I even got it without having to monkey around with Leet speak. It's just the word "future." No one else, apparently, in Washington DC was thinking enough about the future so that I could get the future license plate. The word means a lot to me, but again, many possible futures, and I will say, I think with the ever-increasing technology that surrounds us every day in our world, the wind is at our backs as investors looking for optionality in our companies, because there's going to be more morphing in the future than we've ever seen in the past. So it's good to have your eyes and your mind awake to these possibilities. So thus much for the future. We went over a quick list of four traits that are often present in companies that have real optionality to some. It's in the tech, it's in the name, it's in the visionary, it's in the extensibility, the extensibility of the concept. Thanks a lot for listening this week. Next week, I'm going to preview my title right now and just leave it right there of killers and kings. Thank you for listening to this Rule Breaker Investing Podcast, I'm David Gardner. Fool on. As always, people on this program may have interest in the stocks they talk about, and the Miley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Learn more about Rule Breaker Investing at rbi.fool.com . [BLANK_AUDIO]