If there is one rule of long-term investing that any growth investor needs to understand, it is that the size of the prize is proportional to the audacity of the business idea. But there is an important corollary: The bigger the prize you are going after, the more volatility you should expect with every quarterly report.
High levels of volatility arise from ebbs and flows in business momentum, which investors extrapolate far out into the future. When these forward projections are positive, stocks spike. But when near-term results aren’t as strong, investors tend to panic about long-term value, and stock prices tumble.
Two stocks in my Strategy Lab model portfolio, Tesla Motors Inc. and Redknee Solutions Inc., recently reported quarterly earnings that nicely demonstrate what I’m talking about. Redknee disappointed investors while Tesla excited them, and it’s worth diving into some of the details to understand what it means to a long-term investor. Keep in mind that, in my view, long-term investors should focus on long-term results, not surprises on a quarterly statement that might dramatically affect earnings in the near term but pose no real change to the long-term business opportunity.
Redknee Solutions sells software that helps wireless network operators manage customer billing. After buying a large business unit from Nokia, they’re transitioning several new customers to newer software with a different payment model. Sales seem to be going quite well, but gross margin was reported at only 44 per cent compared with 55 per cent in the year-ago period. This led to lower-than-expected earnings, which prompted analysts to cut their near-term forecasts and target prices for the stock. Redknee shares fell 20 per cent in the two days following the earnings release.
I don’t think the weak financial results have much bearing on the company’s future. The order backlog is at record highs, and the comparatively weak gross margin was the result of heavier spending to get the software up and running at customers’ offices. Redknee seems to have a transient spending problem, which is being addressed, rather than a demand problem. Management still needs to prove it can cut costs, but if it does, I believe this will prove to have been a great buying opportunity.
Shares of Tesla Motors, on the other hand, are trading 11 per cent higher following its July 31 release of quarterly earnings. Did they sell far more of the Model S electric car than expected? No. Did they post incredible gross margin improvement? No they didn’t. Tesla’s results were pretty much in line with expectations. The stock price was instead reacting to some of the statements management made about the company’s future. These are things that have yet to be proven.
What things? How about being able to manufacture an electric drivetrain for a vehicle at a lower cost than a comparable gasoline drivetrain? They expect to achieve this in less than 10 years and they’ve explained in detail how it will happen. This would give Tesla a compelling advantage in building electric cars. None of the big automotive companies have said anything similar, to the best of my knowledge. Tesla also expects to be shipping about 2,000 cars per week by the end of next year, which would put the firm’s annualized revenue at about $10-billion, or roughly half the size of Porsche, with much faster growth.
With Tesla trading higher on shareholder optimism, we are dealing with the exact opposite situation as Redknee. Tesla may still be a compelling stock to own, with market-beating results ahead. But we’re paying up for results far in advance of the company actually achieving them. Given their track record and the size of the potential prize, it’s something I’m willing to do. Just keep in mind that at some point, Tesla will post a result that represents a short-term disappointment. The stock will come tumbling down. As long as it isn’t a threat to the long-term objective I’ll just get up, dust myself off, and keep my eyes on the bigger picture.
Remember: Most investors are not willing to take a long-term perspective. If you can evaluate quarterly results from this perspective, without having to worry about what Wall Street thinks, I think you’ll make more money.
The author owns shares of Tesla and Redknee in both his personal and Strategy Lab portfolios.
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