If you could go back in time to the start of this year, which of the following groups of real-life companies would you be interested to invest in?
Table 1 below shows the historical revenue and free cash flow for the two companies in Group 1, namely, Company A and Company B. It’s clear that Company A has not grown its revenue much over the past four years and its free cash flow has also not been steady. Meanwhile, Company B’s revenue has barely budged and although its free cash flow has improved in every year, there’s only so much juice that can be squeezed from improving the free cash flow margin*.
Next we have Table 2 below, which shows the historical revenue and free cash flow for Group 2 consisting of Company C and Company D. Both companies have displayed excellent revenue growth for 2017 to 2021, with Company C quadrupling its revenue and Company D increasing its topline by nearly five times. Both companies have also experienced consistent and impressive growth in free cash flow over the period.
So would you prefer to invest in Group 1 or Group 2 when you take your time-machine back to the start of this year? It’s clear that Group 2 contains the superior businesses – not only do they have fat free cash flow margins, their revenues have also been growing rapidly. If you’re a business-focused investor – like me – you likely would have picked Group 2. But if you did, you would now be nursing a big loss of around 50% for both companies in the group. On the other hand, the stock prices for the companies in Group 1 have been about flat. Table 3 shows the identities of the companies in the two groups, and their year-to-date stock price performances.
But interestingly, over the past five years, Trade Desk’s (NASDAQ: TTD) stock price is up by 823% whereas Kellogg’s (NYSE: K) and Coca-Cola’s (NYSE: KO) stock prices have delivered much poorer returns of -7% and 31%. Adyen (AMS: ADYEN) was listed only on 13 June 2018 and from then to today, its stock price is up by 175%; in this time period, Trade Desk, Kellogg and Coca-Cola’s returns are 404%, 4%, and 34%, respectively.
What this fun exercise shows are a few important traits of the stock market:
- In the short run, business fundamentals and stock prices can move in completely opposite directions in unpredictable ways.
- But in the long run, business fundamentals are what dominates stock prices
The stock market has been really rough in the past few months, especially for higher-growth companies. Keeping the aforementioned traits of the stock market in mind should help you make better decisions in, and react better to, the volatile stock market we’re all experiencing right now.
*The free cash flow margin refers to a company’s free cash flow as a percentage of revenue
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Ser Jing owns shares of Adyen and The Trade Desk.
