Investing expert Robert Johnson explains why it’s important for investors to realize that a great product isn’t necessarily going to translate into a great investment.
The iconic fund manager Peter Lynch, who led the behemoth Fidelity Magellan fund, popularized the notion of investing in companies that you know. In his bestselling book, One Up on Wall Street, Lynch emphasized that individuals are often able to spot trends in their local community before that information gets the attention of investment analysts. For instance, one might identify that a new restaurant chain is becoming popular or that a new product is being praised by friends and family.
Unfortunately, many people stop there, believing that all they have to do to succeed in investing is to identify great products and services. They forget that Lynch also emphasized that those companies must have a sustainable business model and be attractively priced.
Great Products Aren’t Always Great Investments
Many people who own a Tesla car and are also investors in the stock. They reason that the maker of such a wonderful product simply has to represent a terrific investment opportunity. I am a Tesla bear, and it has nothing to do with the quality of the automobiles that Elon Musk is producing.
Renowned baseball philosopher Yogi Berra once said “It’s tough to make predictions, especially about the future.” This has indeed been the case regarding the automobile industry. Speaking before a gathering of business titans at Sun Valley in 1999, Berkshire Hathaway CEO Warren Buffett described the experience of the auto industry in the early part of the last century as follows:
“There were two thousand auto companies: the most important invention, probably, of the first half of the twentieth century. It had an enormous impact on people’s lives. If you had seen at the time of the first cars how this country would develop in conjunction with autos, you would have said, ‘This is the place I must be.’ But of the two thousand companies, as of a few years ago, only three car companies survived. And, at one time or another, all three were selling for less than book value, which is the amount of money that had been put into the companies and left there. So autos had an enormous impact on America, but in the opposite direction of investors.”
The lesson is that in areas of significant transformation, one not only has to identify the technology that is going to prove to be enduring, but one also has to identify the firms that will be the ultimate winners and losers. The second half of that equation has proven to be particularly illusive. I am unconvinced that when the smoke clears, Tesla will be the winner in the electric car sweepstakes.
I would much rather invest in Ford or GM at a forward price-to-earnings ratios of 7 and 6, respectively than market darling Telsa trading at a stratospheric forward PE of 136. Ford and GM offer an attractive margin of safety that value investors are drawn to like moths to a flame.
Even more troubling than the apparent exorbitant valuation of Tesla involves the comportment of its CEO. I have trouble committing capital to a company with a leader who seemingly has to prove that he is the smartest guy in the room. Recently, Mr. Musk exhibited an alarming lack of emotional intelligence while participating in an earnings call with analysts, engaging in trolling Berkshire Hathaway leadership, and tweeting on April Fool’s Day that “Elon was found passed out against a Tesla Model 3, surrounded by “Teslaquilla” bottles.” Musk comes off as an intellectual bully, essentially inferring that people simply don’t have the capacity to recognize his brilliance.
One need look no further than the music world to find a case in which a company that makes an iconic product is a poor investment. Gibson Brands, the maker of the Les Paul guitar played by countless music giants including Carlos Santana, Bob Marley and Jimmy Page, filed for bankruptcy in late April.
Investors should heed Albert Einstein’s words that “Everything should be made as simple as possible, but not simpler.” Identifying a superior product or service is a good start to an investment idea, but it is only a start. The numbers must make sense. You may wish to drive a Tesla automobile, but don’t let Tesla drive the value of your portfolio.
Robert R. Johnson, PhD, CFA, CAIA, CLF is Principal, Fed Policy Investment Research Group, LLC in Charlottesville, VA. He is co-author of the books Strategic Value Investing, Invest With the Fed, Investment Banking for Dummies and The Tools and Techniques of Financial Planning.