Death and taxes are two of the few certainties in life. In investment too, there is little certainty. Of course, we can improve our chances of success in investing, for example by focusing on low-cost and broadly diversified funds. Or by buying back the shares of companies with solid competitive advantages.
One thing seems certain, however: investing in stocks with unpredictable cash flows when they are trading at breathtaking valuations is a recipe for failure. These are actions to be avoided.
For today’s screen, we isolate stocks with high or very high fair value uncertainty ratings that are trading at least double our fair value estimates.
Before we share the results, let’s take a step back and take a look at what the uncertainty rating is. The uncertainty rating represents the predictability of the company’s future cash flows and, therefore, the level of certainty we have in our estimate of the fair value of that company. We value a business based on a detailed projection of its future cash flows and re-discount those flows to today’s dollars using a proprietary cash flow model. Uncertainty rating captures a range of likely potential intrinsic values for a business based on the characteristics of the business underlying the stock, including such things as operational and financial leverage, sales sensitivity to l economy, product concentration and other factors. If the range of potential intrinsic values is narrow, the company obtains a low uncertainty rating. If the range is large, the business gets a high uncertainty rating.
Is this therefore bad to buy an overvalued stock with high uncertainty, given that we are not very confident in our estimate of the true value of that company’s stock? Certainly, one could argue that in the case of a stock with high uncertainty, the valuation could be put aside and that we should instead focus on something else – growth prospects, for example. Given the lack of predictability of cash flow, we might underestimate the value of these names.
However, we might also overestimate their value.
That’s why we favor conservatism: we suggest investors avoid high-priced, high-uncertainty stocks. If one is really tempted to assume uncertainty, we recommend doing so with only a significant margin of safety, even if that fair value is, in itself, uncertain.
Twelve overvalued and highly uncertain stocks were scrutinized.
Here’s a closer look at three of the names on the list.
“While Narrow Moat Square maintained its growth momentum in the first quarter and made progress in improving profitability, we remain comfortable with our fair value estimate of $ 89. We highlight the difficulty of estimating a long-term valuation for a fast growing and scalable business. which has yet to demonstrate sustainable profitability, this consideration being the main driver of our very high uncertainty rating. We continue to believe that the current market price reflects a very optimistic view of Square’s long-term outlook.
“We believe Square’s business model, characterized by effective customer integration, innovative point-of-sale devices, fixed costs, and a suite of in-house developed and integrated software solutions, enables the company to achieve and to retain micro-traders who are not viable for other buyers. Essentially, we believe Square’s success stems in large part from expanding the acquisition market, rather than stealing significant shares from existing players.
“To develop sufficient scale, Square needs to move beyond its micro-merchant base, and recent results suggest it is doing just that. At this point, just over half of its payment volume comes from merchants generating more than $ 125,000 in annual gross payment volume. In addition, the absolute growth of customers above this threshold has accelerated significantly over the past two years, while the absolute growth of merchants below this threshold has remained largely stable. upstream and cross-selling will allow Square to significantly improve margins in the coming years and demonstrate the viability of its business model. But we see Square as a narrow-ditch niche operator, not a disruptor, with market share constrained by its relatively high prices and long-term margins constrained by its relative lack of scale. “
–Brett Horn, Senior Analyst
Dr Reddy’s laboratories (RDY)
“We give Dr. Reddy’s Laboratories a very high uncertainty rating due to their focus on commodities in a highly competitive market that includes large-scale peers.
“Dr. Reddy’s increased its market share in the United States primarily through aggressive pricing for small molecule drugs. Low-cost manufacturers are actively competing for less differentiated generics in the United States, where regulatory barriers are lower than in Europe. Dr. Reddy’s has also established a brand in many emerging markets where increasing disposable income, a fragmented customer base and lower generic drug use rates offer attractive growth opportunities. Like many undeveloped global markets of drugs do not have a consolidated and efficient drug distribution infrastructure, generic drug manufacturers typically sell most of their products – often referred to as brand-name generics – to independent pharmacies and physicians in these fields. Brand recognition for these generics generally promotes customer loyalty and more stable prices, but governments can intervene with mandatory prices or tenders.
“Gains in market share for basic generics in the major regions of the United States and Europe have historically driven Dr. Reddy’s sales growth, but this has been tempered recently by intense pressure on prices with the consolidation of procurement entities. launches, but its scale of manufacture, research capabilities, distribution networks, and legal acumen still lag behind its larger competitors, in our view. While we expected his low-cost operating structure to support his current market share gains, Dr. Reddy’s focus on commodified developed markets has started to erode his returns on capital.
“Management hopes to develop more complex manufacturing capabilities in market segments where limited competition promotes higher pricing power and higher profitability, but market pressures have limited the company’s progress. Dr. Reddy’s made relatively significant inroads into over-the-counter generics and launched four biosimilars – near-generic equivalents of biotech drugs – in India and other emerging markets. However, we believe that US and European approval of Dr. Reddy’s biosimilars remains unlikely in the near future, especially in light of the company’s recent regulatory challenges. “
–Damien Conover, strategist
“Farfetch is one of the world’s leading online distribution platforms for personal luxury goods. It connects buyers and sellers of luxury products and offers a wide choice of products to consumers (3.9 million storage units at the end of 2017, 10 times more than the next largest, even if we believe that the model Farfetch business line shows traces of a source of network advantage gap, we are currently hesitant to attribute a gap to it, given the early stages of industry development, small size and reach (3% share of online luxury goods segment, reaching less than 1% of the luxury goods buying population) and lack of monetization of the business model.
“Although the online luxury segment is relatively fragmented (the biggest player YNAP has around 10% stake), we believe it will be dominated by a limited number of powerful global players. Nonetheless, we believe there is a low probability that a single player will dominate online distribution, given the market power of big brands and their reluctance to depend on a single player for online distribution. But the space shouldn’t be too fragmented either, in our opinion, given that brands are wary of overrepresentation in too many channels, with the risk of brand commoditization, excess inventory and discounts. We believe Farfetch has the potential to become a major player in the industry, given its value proposition for brands (better economy than wholesale and retained inventory and price control), retailers (who are engaged in the supply chain rather than in competition) and customers (through a wide selection of unique products and items).
“Considering the early stage of maturity of the industry and the high risks and opportunities for the business, we believe there is a great deal of uncertainty about investing in Farfetch stocks.”
–Jelena Sokolova, analyst