People are naturally drawn to stocks that tell an exciting story.
Helmed by CEO Elon Musk, cofounder of PayPal and SpaceX, Tesla runs on idealistic visions and lots of risk.
Since its founding in 2003, Tesla has traveled a rocky road, once coming within a month of bankruptcy, constantly being jolted by Musk’s unpredictable behavior.
This history describes a revolutionary company whose chief executive routinely challenges the conventions of “normal” CEOs.
A great story … on the surface.
If you dig a little deeper into the statement of cash flow, you learn about potential hazzards for the long-term success of the company.
While Tesla posted its first year of net income in 2020, much of that income came from regulatory credits, rather than from selling cars.
While Tesla is undergoing rapid growth, the company consumes mountains of cash to build factories, produce cars and manufacture batteries. Experts are split over how to evaluate its future.
For now, that makes Tesla a “Question Mark,” one of four categories in the Growth Share Matrix (GSM). First developed by Boston Consulting Group in 1968, the GSM originally evaluated companies according to market share.
Investors subsequently adopted the model to evaluate companies in terms of earnings growth and cash-flow generation.
The four categories of the GSM:
1. Question Mark
Cash flow: Low/Negative
Recent examples: Tesla, WeWork
Question Marks are companies with high growth, but low or negative cash flow.
Question Marks are generally exciting because they promise to change our world in some fundamental, necessary way.
Per its website, Tesla wants to “accelerate the world’s transition to sustainable energy.”
Another recent example was WeWork.
Cofounder and ex-CEO Adam Neumann conceived WeWork to inject feelings of togetherness and belonging into the modern workplace, going so far as to trademark the word “We.”
For a few years, WeWork grew at an outrageous pace, but never posted positive earnings.
WeWork’s story was exciting and its vision inspiring, but at the original IPO offering a few years ago, investors refused to participate.
Question Marks don’t stay Question Marks forever. They can go one of two ways.
Either their cash flow turns positive and they become “Rising Stars,” or their growth slows and they become “Dogs.” Let’s look at the positive scenario first.
2. Rising Star
Cash flow: Positive/High
Recent examples: Apple, Amazon
Rising Stars sit at the extremely favorable intersection of high growth (25%+) and high cash flow.
Of course, a company doesn’t become a Rising Star overnight.
Companies like Apple and Amazon endured years (decades, in Apple’s case) of dubious cash flow before blossoming into the titans they are today.
But if Question Marks’ key offerings catch on, they become excellent wealth-creation vehicles.
Investors like Rising Stars and often feature them prominently in their portfolios.
But Rising Stars don’t stay that way forever. Rapid growth is impossible to sustain in perpetuity.
Rising Stars can take two possible paths. Either their growth slows, but their cash flow remains positive, making them “Cash Cows,” or both their growth and cash flow dry up and they become “Dogs.” We’ll save Dogs for last.
3. Cash Cows
Cash flow: High/Positive
Recent examples: Johnson & Johnson, Exxon Mobil
Another favorite of investors, Cash Cows have low growth (~10%) but high cash flow.
They’ve reached a point where it’s difficult to grow at a rapid clip, but where their key offerings have become an instrumental piece of life and/or business.
Unlike Question Marks and Rising Stars, companies like Exxon Mobil don’t make headlines very much, but they make for extremely solid portfolio foundations.
Like Question Marks and Rising Stars, Cash Cows can go the way of the Dog if their cash flow goes negative.
Cash flow: Low/Negative
Recent example: GE
For more than 100 years, GE was the gold standard in blue-chip stocks.
GE’s share price peaked around $400 in June 2000, but over the next couple of decades things would change.
They sold off their slow-growth businesses, prompting a precipitous decline starting in late 2007.
Down to $75 by early 2009, the share price floundered, dropping as low as $48.56 in July 2020. It currently sits around $108.
Investors don’t like negative-75% returns, and don’t like Dogs.
But if Question Marks, Rising Stars and Cash Cows can all turn into Dogs, how do investors know which ones to pick?
How can you avoid the doomed and fill your portfolio with the best?
P/E ratio and meaningful transitions
Investors like me watch out for transitions: the moments companies go from one category to another.
We rarely invest in Question Marks because there are too many variables — and because most Question Marks run out of money before their fifth anniversary.
But when Question Marks look poised to become Rising Stars, we grow interested.
My firm only bought into companies like Ebay, Amazon and Priceline in 2002/2003.
Because by that time, the dotcom bubble had come and gone. Most of these companies’ competitors had failed, but they had survived. They had begun to gobble up market share and make the transition to Rising Stars.
This transition is signaled by a compression in the companies’ price-to-earnings (P/E) ratio.
The P/E ratio measures a company’s current share price against its earnings per share.
Investors use this to gauge a stock’s value.
A particularly high P/E ratio either means a stock is overvalued or will produce high earnings in the future. A particularly low P/E ratio either means a stock is undervalued or future earnings will be low.
There’s not one absolutely “good” or “bad” P/E ratio, and it’s not the only factor investors use in analysis.
A growth company might have a P/E of 25 or higher. A value company might have a P/E between 12 and 20.
By tracking a company’s P/E ratio over time, you can get a good picture of its overall trajectory, where along the GSM it falls and what role, if any, it should play in your portfolio.
The most important lesson is to dig deeper than news headlines when you make investing decisions. An exciting mission and a dynamic CEO only go so far. Hard-nosed accounting metrics tell investors how safe or how risky an investment can actually be.
Watch the transitions, either toward greater reliability — Question Marks to Rising Stars — or toward greater uncertainty — Cash Cows to Dogs.
Numbers tell a much more meaningful story than crusading executives or internet chat rooms.
David Edwards is president and wealth advisor with Heron Wealth based in New York City and advises clients across the U.S. and around the world. Dustin Lowman contributed additional research for this column.