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Bruce W. Kaser, CFA
October 11, 2019

Mark Twain and The Value of History

  • History can teach investors how to interpret media commentary on stocks

    Here at New Generation Research, home of The Turnaround Letter, we are big fans of history. Not only do we find history fascinating in its own right, we have also learned that by understanding what has happened in the past we can better understand our current environment. And, perhaps more importantly, we can improve our ability to recognize and evaluate what might happen in the future. The famous quote, attributed to Mark Twain, that “history doesn’t repeat itself but it often rhymes,” captures this idea well.

    The merits of studying history definitely applies to investing. However, successful investors will want to learn how to recognize when history will probably rhyme, and when it may start to play a different tune. This is particularly true when stocks are discussed in the media.



    News stories about companies will often feature language like “… XYZ shares are among the strongest performers this year”. The article will then describe the impressive results that the company has produced in the past. Perhaps it has participated in a rapidly-growing new product or service category, it has expanded its profit margins, or it has increased its dividends for however-many consecutive years. The article is saying, in effect, “buy this stock because its past has been so good”.



    The implied assumption: buy this stock because the future will look just like the past.



    Netflix (NFLX) illustrates this well. The company essentially created the streaming movie market, which is increasingly dominating consumers’ viewing habits. Netflix’ revenues grew 23x over the past 13 years to nearly $12 billion in 2017 and its shares surged at a 34% annualized rate. Investors buying Netflix shares at $400 in mid-2018 clearly were impressed by the company’s historical growth.

    Ignore history when it is too good to continue…



    The problem: this analysis says nothing about whether the company can continue its impressive growth. Economist Herb Stein, who chaired the federal government’s Council of Economic Advisors many decades ago, offered another quote: “If something cannot go on forever, it will stop.”



    With Netflix, its rapid revenue growth rate could not go on forever. Not only had it reached U.S. market saturation (international is still a decent source of growth), but inevitable competition from other streaming services was poised to pressure its membership growth and pricing power. By October 2019, with Netflix’ revenue growth rate decaying, these backward-looking investors have seen the company’s stock price tumble by over 30%.



    This type of rearview mirror analysis also ignores valuation. In many cases, a stock may become so expensive that merely maintaining its otherwise impressive fundamental trajectory would be insufficient to push the shares ever-higher. And, any hint of fundamental weakness could send the stock sharply downward. Netflix (which still has yet to show a profit) could hardly be expected to show results that justified its 82x EV/EBITDA multiple in mid-2018.


    … or too bad to continue



    Similarly, for weak stocks and companies, investment stories will frequently describe how “WXY shares have fallen 50% this year…”. Here, Herb Stein’s quote can inspire a source of attractive contrarian ideas. If a company’s fortunes become bad enough, investors may no longer tolerate the decay and demand aggressive change. Hindsight-focused articles may completely miss how the future might be different from the past.


    How contrarian investors can benefit from others’ backward-looking analysis



    What kinds of change produces turnarounds? A new chief executive, an outside investor pressing for change, or perhaps industry conditions have started to improve. Maybe a legal overhang is being favorably resolved. Companies that emerge from bankruptcy may now be in great shape, but commentators linger over its past problems.



    Contrarian analysis focuses on separating the companies that will reverse their misfortune from those that won’t. Understanding history remains vital: why did the company get into trouble? How much control did it have over its prior fate? Chipotle Mexican Grill (CMG)’s remarkable recovery since early 2018 is instructive. Its debilitating problems were almost entirely of its own making – weak food quality control and sloppy operations. With new leadership, Chipotle reversed its downward spiral, then restored its impressive revenue growth. Its shares have surged 150% since.



    So, when you read or hear commentary from the media or even Wall Street analysts describing how a company’s past tells you everything you need to know, ask yourself which history lesson applies: Mark Twain or Herb Stein.

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