It is common for investors to be biased towards the stocks that they own. After all, it took Amazon about 15 years to turn a profit and now it serves as an inspiration for many who hold stocks that are losing money.
While its anyone’s guess which stock may be the next Amazon, there are indeed tell-tale signs that investors can look at when it comes to valuing such stocks.
In this article, I’ll be looking at:
- why money-losing companies feel more pain in times of inflation,
- what is one key ratio that investors can include in their analysis when evaluating such stocks,
- 4 factors to consider when re-evaluating your stocks, and
- how you can use what I covered here to decide how to approach your portfolio today.
But first, a little about what’s happening now:
Current State of the Economy
If you’re holding on to any stocks which aren’t generating profit, I’m quite certain that the past 3 weeks would surely have taken a toll on you as such stocks have been punished far more severely than value stocks or large-cap tech stocks.
When interest rates are low, the economy grows, and inflation increases. Conversely, when interest rates are high, the economy slows and inflation decreases.
Inflation & Interest Rates Relationship Explained – Investopedia
Investment Theme 1 – Inflation
When Covid hit in early 2020, the US Federal Reserve adopted an easy-money policy that involved reducing interest rates as well as ramping up the “printing of money”. The concept of printing money doesn’t mean that they switched on the printer and churned out actual paper notes – what they actually did was add credit to banks.
This caused overall demand to increase which then provided temporary relief for the economy. However, over time the supply was unable to keep up, causing the prices of goods/services to increase.
Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country.
International Monetary Fund
Think of it this way, if the price of raw salad greens went up from $1 to $1.10, it may cost you an extra $0.10. But for a global salad franchise group that sells millions of salads everyday, this price increase can really hurt their profitability.
This is exactly what’s happening to companies right now as across the board, the Cost of Goods Sold (COGs) is increasing, therefore causing the profit margins of companies to shrink. This puts companies who do not have a profit margin at an even greater disadvantage as it may take them longer to achieve profitability (if any at all).
Governments can combat inflation with a variety of tools, one of which is the adjustment of interest rates. This leads us to our next point.
Investment Theme 2 – Interest Rates
The interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned.
Interest Rate – Investopedia
Interest rates can be interpreted as the cost of money. In a low-interest rate environment (which is what the Federal reserve did in March of 2020), it is cheaper for companies to borrow money to fund their growth, hence the continuation of the bull rally after the March 2020 crash.
At present, the Federal reserve is looking to raise interest rates. This helps reduce inflation as it causes the “price of money” to increase, hence causing the economy’s overall demand to slow down. This hurts money-losing companies even more as though they are losing money and in most cases, they need to “borrow” it. With higher interest rates, the cost of borrowing also increased.
With inflation and interest rates combined, there is no situation in the near term where money-losing stocks come out as victors. This is exactly why any company without a PE is having its price presently hammered.
1 Ratio for valuing Money-Losing Stocks: Price-to-Sales Ratio
When we seek to value such stocks, what we are trying to do is determine the “worth” of such companies. One of the easiest ways to do so is through the Price-to-Sales Ratio (P/S Ratio).
The price-to-sales ratio shows how much the market values every dollar of the company’s sales. This ratio can be effective in valuing growth stocks that have yet to turn a profit or have suffered a temporary setback.
– investopedia
A low P/S ratio is ideal as it can indicate the possibility of a company trading below its intrinsic value. However, it should never be used in isolation when analysing a stock. Instead, investors should consider comparing it against a benchmark such as the industry average or other companies operating within the same space.
That said, let’s take a look at how the P/S Ratio of these 3 China EV stocks fare against each other (All 3 are money-losing and have no PE).
If we analyse these numbers at face value, it is clear that Xpeng is trading at a higher P/S ratio than the other two. This is not to say that Xpeng is over-valued in any way, however it can be concluded that it is indeed trading at a higher valuation than Nio and Li.
It is actually interesting to me that Xpeng is commanding such high P/S ratio despite the sell-off, which can possibly indicate that investors do actually prefer to park their money in Xpeng. Therefore, it should not always be assumed that a high P/S ratio is a bad thing.
One common factor among all the 3 companies is that their respective P/S ratios are considered to be high, as the general consensus among analysts is that a P/S ratio of 4 and above is generally considered to be unfavourable.
This is because the higher the P/S ratio, the more investors are paying for every $1 of the company’s sales.
4 more Factors to Consider
While the P/S Ratio is relatively easy to calculate and analyse, below are other factors that investors should consider as well:
- Product Life Cycle – Has sales for the company already hit its peak and yet it is still unable to make a profit? (Reference to Peleton)
- Length of Profitability – It took Amazon 15 years to achieve a full-year profit, while Telsa took 18 years and Netflix 5 years. Airbnb has been operating for almost 12 years but has yet to turn a profit, possibly due to the emergence of Covid. In this case, is it worth investing in?
- Risk to Rewards in Comparison to Addressable Market – If the company is unprofitable at present but the addressable market which it is serving lacks competitors etc., then the risk for the investor is somewhat justifiable due to the potential return that the investor may receive in the future.
- Management Team – Can the management team lead the company to profitability? Do they have a proven track record?
To Accumulate or Avoid?
It really boils down to just two schools of thought – to either accumulate or avoid such companies. In my opinion, such companies most often trade on momentum and may not be the best investments to merely buy and hold as they do indeed go down just as fast as they went up.
A general rule of thumb is that such companies should never occupy the majority of your portfolio due to the risks/volatility that they possess to the investor. That said, it is possible for the success of even one of such companies to be the ultimate stock that causes you to achieve an “Alpha” in your portfolio’s NAV.
