IFB54: Company and Industry Maturation in the Stock Market

industry maturation

Welcome to Investing for Beginners podcast this is episode 54. Andrew and I are going to talk about the maturation of different industries. We’re going to discuss how when you’re looking at companies to invest one of the things you want to look at is
how the industry that it’s in is maturing and what stage of growth they might be in along that path.  Without any further ado, I’m going to turn over to Andrew and he’s going to get us started.

Andrew: thanks Dave, this is something that actually really haven’t read anything about when it comes to investing and everything it’s just one of those things I kind of noticed as I was looking through financial statements, kind of trying to observe like how different stocks kind of move throughout the years.

I’ve done a ton of research and a post on my blog about companies that have failed also companies that have really succeeded and looking at the financials and trying to piece together what happened in the very beginning and then how did it play out as the years went on and I’m sure this is probably like common sense stuff for I don’t know business majors econ majors whatever.

But we’re DIY investors and we’re just trying to soak in as much information as we can and  it’s good to keep our eyes open try to be observant in a similar fashion to one of the previous episodes where I talked about unconventional investing rule to have for your portfolio I figured this would be kind of another cool thing to discuss and talk about.

I mean it’s obvious when you look at a single stock standpoint that stocks will mature and they will reach a point where I don’t want to say it’s like too big to fail but they do get to a point where they’re kind of too big to grow in a sense. I talked about this in one of the daily emails several weeks back where if you look at a company like Amazon as they trade today it’s somewhere around 700 almost 800 billion dollars in market cap you have the high valuations and I love the company I absolutely use them I think they’re revolutionizing the world they are changing the world they are making everything convenient I have an Amazon package at my front door probably once a week.

I love the company however as an investment and looking at the valuation metrics it’s just not something that I want to take a bite out of and you’ll see  you’ll continue to see much rationalization when it comes to people who are following the stock and just the average Joe investor who wants to spout his opinion online, and and you can tell a lot of it’s just strictly uneducated they have no concept of valuation no concept of any sort of fundamentals and they’ll just kind of quote random facts that fits their narrative and has a confirmation bias where it it just looks bullish and  they are bullish on the stock.

And I don’t want to say that the stock won’t continue the client from here I mean it could easily climb in our 10 20 percent and I don’t see that as not being out of the realm of possibility. However when I look at stocks I’m looking at the very long term we discussed last week about me selling strategies and I discussed how ideally I would like to hold a stock and hold it for forever that means collecting dividends all along the way that means the stock is growing its dividend I’m reinvesting that dividend. And that also means that the stock is at least growing close to obviously ideally better than the average but close to the average stock market appreciation point which historically has been 10%, and you can see just so many studies out there that have shown that and the US stock market 10 percents been the average for over a hundred years.

The problem with that is when you look at a company like Amazon for them to grow  if my holding periods forever but let’s look at like a basic 20-year holding period for the stock to grow 10% a year for 20 years I don’t know what the exact numbers will be but let’s just say  what are the odds of Amazon 10x ing from here again I don’t have a calculator  after a certain point in years 10% a year compound that over and over and over again will eventually double your money triple your money and then 10x your money.

For Amazon to 10x, it’s going to have to go from its current market cap of 700 billion dollars which is crazy we talk about billions of dollars all the time you hear people talk about trillions of dollars when you turn on CNBC, and they’re talking about the government. It’s at a certain point it just kind of gets lost in our foggy mind right where it’s just they’re talking about billions like it’s all just big numbers and there’s no concept on the actual scale of this but when you talk about 700 billion dollars and to 10x that that becomes 7 trillion dollars.

That’s higher than the GDP of I wrote this in the email it’s higher than the GDP of the UK India and Canada combined as they sit today and in 10 20 years it the GDP will probably be much higher for those companies I mean those countries. But again we’re talking about GDPs that grow if you talk about the US or the UK one of the more developed economies it’s maybe two three four five percent a year. India’s seen maybe 10 percent because they’re more like a growth economy.

But like come on you think a company like Amazon is going to get so big that it’s going to eclipse all these other countries out there it’s a fantastic company it’s wonderful it’s it’s bringing in a lot of revenue it’s spending a lot of money to get that revenue. But to think that it’s not going to have these issues down the line we just saw it this week with Facebook right where they had a huge data breach the valuations have been pretty high for it for me time and  they lost I think it was a news article saying that they lost the value of Tesla and market cap in like two days.

And that bow was very dramatic eyes like they already had much market cap that it was maybe like a ten percent drop or something that wasn’t like the whole company is going to go bankrupt or anything.

But that’s just one example of a company that got large that now it’s having a hiccup and there are just these big problems with companies, and then we’re going to talk about industries in the second. But these companies just getting  large and there’s just only the world is only so big, and I’m optimistic, and I love to talk about compound interest explosive growth and how trillions of dollars of wealth can be created in the future, but at the same token we have to be realistic, and we have to put me realistic boundaries on what to expect when it comes to these investments when it comes to the economy when it comes to how much can business really create more wealth for everybody involved.

When I’m looking at stocks, and I look at whether me of the other options besides Amazon I think there’s plenty of stocks out there that have the potential to let 10x over’s say a 10 or 20 year period, and it’s very reasonable to see that a company like that can 10x.

Let’s take like your average small-cap stock right they will trade somewhere around the two billion dollar range for it to go from two billion dollars to 20 billion dollars is it going to reach a point where it’s like breaking new records or taking over countries. No I mean there’s plenty of companies out there that are twenty billion dollars and a lot of them are developed industries have several a couple big players that have several hundred billion dollars.

It’s not unreasonable to think that the smaller you go, the more opportunity you have for your investment to 10x or-or grow at a high compounded rate per year. And what you’ll tend to see when you look at industries is kind of the the more the more they mature the more that there’s going to be acquisitions the more than the big fish swallow the little fish  and  it basically comes down to once you’re  big if you’re at four hundred billion dollars to grow 10% a year that means for the billion dollars.

It’s once you start looking at those numbers and Warren Buffett’s starting to see those kinds of issues with Berkshire Hathaway when he’s looking at his investments, but it’s much harder to create let’s say 40 billion dollars of revenue that it is to create four billion dollars of revenue. Yes, they have more resources they have more assets all these things. But as you get bigger and bigger and you as a business you kind of start to really busy and you get that stereotype with corporations where the bigger ones tend to have more office politics and all these sorts of things, and there’s just a lot of blow and excess right whereas maybe a startups very lean and their and their expenses are really small, and they’re just focused so much on growth.

There’s just a big difference there, and it’s important to realize that the bigger and bigger these companies get the harder it is for them to maintain double-digit growth and you need to factor that into your investments, and that’s kind of why I’m a big proponent of small-cap stocks. It is part of it is too that a lot of them have seen lower valuations over the past four or five years, so I have been just naturally gravitating towards those.

I think this is something that is an idea that I think will be fleshed out more in the future and I hope discussed by people way smarter than me. But I think that there’s a lot of opportunities when you’re looking at small companies, and again I go back to that research that I did where I looked at me of the most successful dividend stocks of the last 25 years.

It was based on an article that Ben Reynolds did, and I took that what he wrote about and took it a step further to look at what were the different qualities of these businesses when they first started out and a lot of them were in that small five hundred million dollar – let’s say – the three billion dollar range and part of that’s just inflation, but a big part of that is also these companies growing in and promoting themselves from small growers to more medium established businesses.

I think if you can find that sweet spot in market cap you can help your investment performance because you have these forces these natural forces of business that are more working for you rather than against you.

Dave: that was interesting, let me go to the next step then you mentioned earlier the different types of industries. I’d be interested in learning a little bit more about what your thoughts were on that?

Andrew: yeah I’m glad you asked  I talked about before how there’s like there’s something weird about like things falling into place into threes, and I don’t want to get too far into our world like a blog post about it they didn’t get hardly any traffic.

But what I wrote is that like for example if if you pull up Google and you type in a search like let’s say you search Investing for Beginners oh there’s Andrew site right but there will be whatever you search on Google will show up three different web site  ten different web sites but what the data has shown that google has talked about is that you’ll have like forty percent of people who search will click on the first link twenty percent will click on the second and ten percent will click on the third link. And then the rest will kind of sprinkle into the fourth through ten.

Basically the idea behind that is that there’s like three major big players that that take up all the attention then kind of get all the results while the rest don’t really do much and  what was interesting to me is that I saw this a lot in industries in the stock market, and you actually tended to see it in industries that were more mature than others and again this is kind of speculation I don’t know I don’t have any like hard data behind it.

But it seems to me that a lot of these industries you’ll see like mergers acquisitions you’ll see bigger companies swallow smaller companies and you have to think like is this something with the US government and regulation where  obviously they want to keep monopolies out of that the stock market and the business world as much as they can.

industry maturation

And does that does that enforcement naturally creates two or three big players and is that by design maybe that’s the answer maybe that’s kind of what I’m trying to figure out and haven’t yet. I’m sure I’ve read various things throughout my investing journey that probably lived it to this here and there, and it’s not like all my ideas are completely original, but I think it’s again I think it can be useful.

Because let’s say for example you have an industry where maybe instead of having those three players they have two big ones and two small ones well it’s likely that one of the smaller ones will swallow up the other smaller one to make that kind of third final piece of the industry and if you can maybe pick out the better investment out of the two you might get higher returns than if you maybe bought one of the bigger ones.

Or even like okay let me let me look at the beverage industry because this is kind of easy to talk about and then I’ll talk about how we can use that an actionable sense if we look at beverage industry you got Coca-Cola, Pepsi Co, Monster Beverage, and Dr. Pepper.

Right now they’re not the big three they’re big four, and I’m just looking at well all these industries I’m going to talk about today I’m just looking at those in the United States if you want to do this at home you can go to the finviz.com use a screener and they-they sort it by industry. You can pick out a specific industry if you type in any stock in the search bar it will show you what industry they’re in and you can click in that industry and it will it will filter you for just that industry.

And I’m sorting by market cap, and there are other competitors out there that are  billion dollars there’s one here for billion dollars, but  those aren’t really big players we’re talking about the big ones here  Coca-Cola is at like 183, PepsiCo’s 153, and then Monster Beverage, and Dr. Pepper are both at 31 and 21.

Let’s say all the valuations all the numbers aside let’s take the whole industry theory and try to do an investment thesis based off of that. You could say that Coca-Cola is number one, they’re going to continue to grow, and that might be the smart thing to do. But let’s say you really want something that can give you 15% returns a year  is Coca-Cola going to get a 10x in 10 or 20 years well right now they’re at 183 billion dollars to 10x from here that would be one trillion dollars in market cap which I’m sure we could find a bunch of small countries that have don’t have that much of a GDP.

That might und pretty unreasonable but can like a Dr. Pepper
Go from 21 billion to two hundred or twenty-one hundred billion sorry 21 billion to two to ten billion I mean I think that sounds more reasonable now we’re talking about a stock that went from mid-cap status to blue-chip status.

And not only that but I think when you buy these smaller companies those are probably more likely to get bought out if this industry continues to mature let’s say that thesis I was talking about comes true where these four players turn into three that means let’s say either monster and Dr. Pepper could merge and become that final third piece they’d be at around fifty-two billion dollars that could happen or Pepsi could swallow up Dr. Pepper to better compete with coca-cola or coca-cola could swallow up either a Monster or Dr. Pepper to cement their number-one status over Pepsi.

All those things can happen, and what we generally see with the merger or an acquisition and I say generally, and this is probably I don’t know 75 to 90% true, but you tend to see businesses overpay for a company that they’re acquiring and this happens on a more grander and extreme scale the further into a bull market you get. The more euphoria you get.

Robert Shiller referred to it as irrational exuberance, and it often gets paired with things like a bunch of IPOs that get popped up out of nowhere you get just a lot of aggressive accounting and like mortgage backed securities stuff like that you just see everywhere it’s it’s all over the finance world and the higher that all the all the bullish and greedy behavior becomes the more and more this happens  you’ll see more and more companies that get acquired at higher multiples, and that’s great for shareholders who are holding it.

Because yeah in one sense whatever you don’t get to hold the company forever but you get paid out a very large amount that’s going to be a great gain, and I gave a great realized portion of your capital that you can either keep in the parent
company and that can now continue the compound. or you can you can pull it completely out and find a brand new opportunity and start the compounding process all over now with a much larger
base and that can compile into even greater things.

You can see like kind of an accelerated compounding you can do a mix of the two you can you can see your compounding continued in the parent company and now you have way more shares of the parent company than you would have if you just bought it outright.

In my mind, there’s a lot of benefits to buying these smaller cap companies that could get acquired and not strictly because of they
could 10x but al because they can be bought up and you could get paid out in that way.

I think that’s another benefit, and depending on the market conditions they tend to be undervalued as well, and that’s what we’ve seen at least lately. If we look at another industry like let’s look at tech right now you have Google which is, they’re called Alphabet now Facebook and Twitter and those look like the big three were Google and Facebook are really the big two and Twitter’s is kind of a small player and they’re actually kind of in the range with one two three four or five like six other companies that are around ten billion dollars.

In this case, you might argue well maybe this industry isn’t that matured yet and we’re talking about tech and yeah that makes a lot of sense. There’s still a lot of competition going around there’s a lot of different market share the fight over and this industry is anything but matured  it would make sense that so it doesn’t make sense to invest in a company like Google that has seven hundred and forty 1 billion dollars in market cap or one of these other smaller tech ones that could grow 5 X 10x easily from here yeah again that that’s the kind of call you have to make.

One of the things that I can look back to is how Exxon Mobile
back in the day was the number one stock and market cap and just because the valuations were good at that time it was one of those things where it’s like how much higher can it grow and ended up having that industry had its kind of hiccup and it still really hasn’t recovered from those highs.

Microsoft hit like a 500 billion dollar market cap back in 1999 it’s it was just sometimes these stocks kind of fly too close to the Sun and they just literally can’t physically grow anymore and  it might make more sense to buy a smaller market cap stock and again the higher market cap you go in by definition that means that your
Valuation is higher. We are talking buy low sell high, and that has a big factor in that as well.

If we look at industry like retail Walmart’s the number-one by pretty significant margin, and then you got Costco and target and then Dollar Trees the number four a Dollar General and Dollar Tree that one’s kind of still in the process of maturing and  that’s kind of like the discount store space, and you can argue whether Amazon has a place in that or not.

And then the last one I wanted to look at was like if you go to Finviz and you put in oil and gas, you have Exxon and Chevron and then in the US, those are pretty much the last two. That you can say that that one’s a lot more matured and I remember looking at a similar industry list for oil and gas back in the day, and there were a lot more companies on there.

I think that one of those things where the industry had a lot of problems and a lot of the companies I don’t know if they got swallowed up or if they want bankrupt. But you saw the list of companies shrink over time and I think oil and gas is probably a lot more mature than some of these younger industries and it’s probably businesses like Exxon and Chevron I mean they’re the one in the number two they’ve had staying power.

But if you’re in that kind of 4 through 10 range, there’s a lot of risks if your business is not placed on a firm foundation when it comes to the balance sheet.

I don’t know just my kind of random thoughts I had my things to consider and my things to when you’re looking at a stock that you want to buy. Is this stock have room to grow what’s the industry look like are they in fierce competition in the industry more matured where they’re just playing against one or two big players and how do you think that can play out in the future? Depending on how the industry looks maybe your business doesn’t have as much of a margin of safety as you would think just because either the competition is big or a business that’s in the same industry is doing so well that there’s no way that you can compete.

Or is them either the industry is really competitive and you have a chance to really scoop it up or is one of the top three players showing me weaknesses that a business that’s in there can kind of exploit and take advantage of some things to keep in mind, and I think definitely if you want to take one thing away from today.

I would say look at the biggest market cap businesses and realize that they may continue to grow during a bull market but what are they going to do for a 10 and 20 year period if you’re buying them near these super high peaks. Is there room for them to grow are they even at reasonable valuations anymore? I would say the majority of the time they’re not, it, in general, it’s probably safer to err on the smaller side of the market cap as long as you’re not getting too small like below 1 billion dollars we’re really anything could happen to your business.

But trying to get in that sweet spot I think for most investors will pay off nicely because it gives a nice balance of financial strength and al having kind of room to grow and I think that’s something that’s not discussed enough in the investment world.

Dave: I agree with it. I think the study of the maturation of businesses and industries is something that is often overlooked and I don’t think people discuss it near enough.

So I have one burning question for you Coke or Pepsi?

Andrew: well I’m very very going to drink.

Dave: I’m not talking about investment.

Andrew: I know I’m very biased towards Diet Coke, okay that’s been a thing that like I never liked as a kid and then for whatever reason like I got hooked and now I like I can’t drink soda unless it’s Diet Coke.

Dave: yep I’m kind of right there with it that and Diet Dr. Pepper those are two of my favorites.

I like I like all the things that you were saying, and I guess a question I had that was popping into my head while you were talking was thinking about how companies will go through the circle of life if you will. Of being a start-up and growing to a small cap and and growing into  a big player and then as you were saying  eloquently flying too close to the Sun as Microsoft did and thinking about  even in my lifetime  when I was in high school near closer to andrew’s age Microsoft was king and  their computers were it and now they’re they’re still kind of are and it’s come back but if I think of a computer company I think of Apple and you think about the  explosion of Apple from  10 years ago just with the iPhone and all the derivatives of that with the watch and the iPads and on that companies just exploded, but I guess you come back to that question of can they grow 10x at this point?

I don’t know if they can are they mature you it’s one of those things yes they’re a tech company, but they’re also really a phone company I guess along the lines with Apple can they grow more can they grow 10x?

It kind of falls into that same category that Amazon’s going to fall into it can they grow that much, and I also think about the maturation of companies. Andrew mentioned to the oil industry and I read this great article recently by one of my favorite authors is named Vitaliy Kantsenelsen I’m probably butchered his last name but a very interesting guy his website is the contrarian edge, and he’s a value investor, and he’s very interesting.

But he wrote this great article about Exxon recently, and he was talking about the kind of along with similar lines of Andrew and I were talking about but a different tact. And he was mentioning that the company is kind of in his death throes and the reason why he was mentioning that was that they are doing things to try to keep the appearance of a productive company.

And they really are not growing and as Andrew said they’re one of the largest in the US and can they really keep growing and that’s kind of where he was coming from when can they really keep growing and they were he was talking about that the company has had to leverage itself quite extensively to continue paying its dividend because it has not been generating the cash flows to continue to pay this very high dividend that they’ve had and they don’t want to cut it because that, of course, sends out all kinds of bad signals to the market and they’ve been doing everything they can to try to maintain the illusion if you will that there’s still a very high profit growing company.

But if you look at the last ten years of their cash flows, they’ve been steadily dwindling and it all kind of correlates with the price of oil falling precipitously was over $100 a barrel, and now I think it’s in the
The mid-50s if that. And who knows if it’s going ever to recover and the company has been around since Standard Oil back in the early 1900s, and it may be at the end of its lifecycle and who somebody may step into that but.

That I think that goes along with what we’re talking about with the maturation of companies  not only are you looking at the potential continued growth of a company like that you could argue as coca-cola really going to grow 10 10 X I mean with beverage consumption especially with sodas of continuing to drop year after year after Year they’re going to have to reinvent themselves, or something’s going to have to change for that to continue  I’m not saying coca-cola is going out of business, far from it.

But I want to point out that there are tops to everything nothing can grow forever and I think that’s a little bit what Andrew was trying to talk about Amazon can’t grow forever Walmart can’t grow forever at some point.

I mean we think of our lifetimes we’ve seen companies Sears Kmart Borders  just to name a few that have peaked at a certain point and they went out of business because they either couldn’t keep up or they couldn’t change, or somebody came in to disrupt their business, and that’s something that you have to keep in mind as well when you’re looking at these companies.

I think Andrew made me great points about if you’re at a top can you really continue to grow the way it’s growing and looking at small caps gives you that opportunity to potentially get a ten bagger a 20 bagger a 30 bagger and especially if you’re younger like Andrew is  that could just be monstrously huge for your retirement as you get older like me.

You get the grumpy old state grumpy old men stage like I am then that’s those are that’s where you can make me serious money in the stock market.

Andrew: yeah I’ve run like numbers real quick on compound interest  it would take 25 years at 10% a year to 10x. are the businesses that we’re all talking about can they continue what kind of growth
they have for 25 years, and I think it depends on the situation, and you need to evaluate that, and like you said they could make a huge difference in your final returns.

Dave: yeah excellent point excellent point all right folks well that is going to wrap up our discussion about industry maturation and companies that may or may not be at the top and how those can help your investments in looking for other opportunities covering more rocks small caps ie that can help you grow your wealth ten twenty thirty times over a lifetime  these are important things to think about when you’re investing and Andrew and I both agree that they are not discussed, and we hope that we’ve opened a few eyes with our discussion tonight and we hope you learned a nugget or two.

Without any further ado I’m going to go ahead and sign us off Diet Coke is the fan favorite here on the show love to hear what you guys think.

without any further ado you guys have a great week go out find some intrinsic value invest with a margin of safety emphasis on the safety.

You have a great week and we’ll talk to you guys next week!

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