Warm and Fuzzy Investing

September 2017

We like sports. We like investing. Which is why the recent sale of the NBA’s Houston Rockets caught our attention. The sale price of US$2.2 billion struck us as an awful lot of money to pay for a team based in only the tenth-largest market of the big four professional sports (NBA, NFL, MLB, NHL). So we looked at what kind of valuation this represented. The team’s most recent EBITDA1 is estimated at US$62.7 million. That means the Rockets were purchased at an EV/EBITDA2 multiple of 35x. For comparison, the S&P 500 Index is currently trading at 13x. That’s a heck of a valuation premium.

The Rockets transaction isn’t an outlier, either. In 2014 former Microsoft CEO Steve Ballmer purchased the NBA’s Los Angeles Clippers for US$2 billion. We would calculate the EV/EBITDA multiple of this transaction, but the team is estimated to be unprofitable. An EV/EBITDA multiple analysis would be useless.

Why would anyone pay so much money for an investment that generates so few profits? An argument could be made that the new owners are betting on future appreciation in the value of the franchises. Indeed, the previous owner of the Rockets bought the team for US$85 million in 1993, meaning the price appreciated at 14.5% per year. Not too shabby!

We’re skeptical, however, that the buyers viewed these purchases as a shrewd investment. Instead, we believe that the reason the buyers were so enthusiastic to pay exorbitant prices is similar to the reason eight-year-olds are so enthusiastic for Christmas Day: they got cool new toys.

Hype and the Markets

This type of behaviour isn’t limited to billionaires buying sports teams. Investors in the public markets have regularly shown an appetite to buy shares simply because a company’s business model was personally attractive.

A modern-day example that comes to mind is the electric car manufacturer Tesla Inc. (TSLA-NASDAQ). For environmentally-conscious investors, TSLA may offer an appealing opportunity to put their money where their mouth is. The enthusiasm for TSLA’s environmentally-friendly goals has helped push the company’s market capitalization above each of Ford (F-NYSE), General Motors (GM-NYSE), and Fiat Chrysler (FCAU-NYSE). This is despite the fact that TSLA sold just 22,000 vehicles last quarter compared to 1.7 million at F and 2.3 million at GM.

Although it’s not a company, the digital currency Bitcoin has also been an appealing purchase for those who firmly believe in the technology. Bitcoin’s proponents say that its decentralized nature and ability to transact anonymously mean that it could eventually replace traditional, government-issued currency. Enthusiasm for Bitcoin has grown so strong that buyers have now pushed its price to over US$4,600 from US$13 at the start of 2013.

Good Companies are Attractive, But…

The point we’re trying to raise from this discussion is simple: there is a world of difference between a good company and a good investment. Investors who focus solely on a company’s prospects while ignoring its valuation are apt to be disappointed over the long term. Let’s consider TSLA. We will accept that the company has more attractive growth prospects than the big three Detroit automakers (who are reliant on internal-combustion engines). But there is a price to be paid for that growth. TSLA is currently trading at 82x EV/EBITDA; F is the next-highest at 2.5x. In contrast, F now sells 77x more vehicles. Are TSLA’s growth opportunities that much more certain that a valuation premium of that magnitude is justified?

Or what about Bitcoin? Again, we will accept that it offers some advantages over and above traditional currencies. But does that mean it’s worth 4,600 U.S. dollars? Or is it worth 13 U.S. dollars? Maybe somewhere in between? Below we’ve included a screenshot of our proprietary financial model that attempts to quantify the intrinsic value of one Bitcoin in U.S. dollar terms:

Since we can’t estimate what a Bitcoin is worth, there is no situation where we would dedicate client money to speculate on its value. Thus, you won’t be seeing it appear in your holdings report from Cowan Asset Management.

Pride in Ownership

There’s nothing wrong with buying a company, or a share in a company, in which you believe strongly. But it is important to be honest with yourself about why you’re doing it. Cowan Asset Management’s primary concern is, first, to protect client capital and, second, to grow this capital over the long-term. So we will never be buying companies solely because they make us, or our clients feel good. Instead, valuation will remain of utmost importance in all of the investment opportunities that we analyze. And if we can buy a company we love at an attractive price, that’s an added bonus.

 

1 Earnings before interest, taxes, depreciation, and amortization.
2 Enterprise value (the value of equity plus debt) divided by EBITDA.