Danger Signs: 4 Things to Investigate Before Investing in A Public Tech Company

Accounting is a slippery beast.

Under the guise of boring number crunching and mired in a seemingly endless stream of rules and regulations, the field can seem at times dry and unapproachable. Which, of course, makes it the perfect place to get dirty. Smoke and mirrors and tedium are a brilliant cover for shady activity; after all, hiding things in plain sight is a great way to eke by unnoticed.

I’m telling you this because I want to help you invest smarter.

With opportunity knocking and danger lurking, parsing the warning signs can feel daunting, but never fear: I’m going to share with you some of the red flags we look out for here at Worm Capital, so that you can invest smarter. We’re over that antiquated earnings per share (EPS) methodology, and here’s why.

The old way of doing things is dying.

Forget what you know about EPS, it’s too easily manipulated to be useful these days. I know EPS is front and center when executives are talking, but that’s because most executive incentives are geared around earnings per share. But this is no traditional Wall Street analyst manual, and we are way more interested in gross business earnings, i.e. what companies are actually making versus what they appear to be making.

The old way of doing things is dying.

So: Throw the old way of thinking out the window. I’m going to tell you what to look at if you want to assess how a business is really doing.

SALES

Rule number one when looking at sales: Revenue had better be growing. Period. When you see revenue declining — even if there’s no movement in EPS — it’s a red flag. Once revenue is on the decline, in my experience, the probability of a rebound drops precipitously. Very few companies recover from the downward slide.

Rule number one when looking at sales: Revenue had better be growing.

A major part of the problem is the way expenses tend to get misaligned when revenue falls. Sometimes companies don’t cut expenses fast enough. Other times the cuts are too sharp and too deep, a knee-jerk reaction that guts vital assets like R&D and critical employees, a move that’s akin to firing the doctor when you break your leg because you don’t way to pay the hospital bill.

So yes, unless you have a crystal ball, it’s very, very hard to cut expenses in a helpful way when the company starts to tank.

Compounding this is the fact that management will generally be in denial about the reality of the situation. They will always have a charming excuse, which is all the more reason for you to know what to really look for when deciding to invest.

So yes, unless you have a crystal ball, it’s very, very hard to cut expenses in a helpful way when the company starts to tank.

Gross Profit

Gross profit is the difference between sales numbers and the cost of goods, and you can bet your ass that this number needs to be growing for a company to be considered healthy. You’ll see these figures high up on income statements and you need to watch it: If it’s dropping, that’s a bad sign.

Gross profit also gives important information to the shareholders regarding the future of the company. It says that the company has options, that they can move around and get business done thanks to the flexibility afforded them by gross profit growth. When that number starts shrinking, management becomes limited and must find ways to stay afloat amid the constraints of dwindling resources.

This may seem super obvious—of course we want gross profit and revenue to be going up — but a surprising number of people ignore these metrics in favor of EPS. However, unlike EPS, these numbers are very hard to manipulate.

Which is why we like them.

Net Assets

When it comes to the future of your company, assets define your potential: simply put, they are the gatekeepers of what’s possible and what’s not. And if net assets are in decline, you know that’s the possibilities are shrinking, a huge red flag for any investor.

There are two major ways that shareholder assets can be abused, and you would be wise to keep an eye out for them. First, any excessive interest in buybacks is a neon flashing DANGER sign. When you burn company assets for the sake of an outdated performance metric, taking money from the company and turning it into a falsely inflated EPS, you limit the future capacity of the company to take action and grow.

Stealing from your left hand to pay your right only works if the left hand has a steady stream of income replacing the all the theft and, to be frank, companies that get into buybacks generally aren’t doing it because their revenue stream is good. They’re doing it to keep their holiday bonuses by falsely inflating the EPS to make the company look better.

Another big thing to look out for is frequent acquisitions. Think about it this way: if you wanted to make a great birthday cake, you’d start with research. You’d look up cake recipes and reviews, source the best ingredients and equipment, and meticulously perform the operations of baking your precious delicacy. Or, you could just go to the store and pick one up at a price that’s been inflated to cover the cost of the labor someone else spent to make it and the profit margin that’s keeping the bakery afloat.

Also, with your cake, you know it’s going to be good. You did your research, you can make adjustments, you can craft it to your exact needs and specifications. But store cake? Might be crap.

Obviously this is a fast and dirty metaphor for acquisitions, and there are certainly times when acquisitions are necessary and improve a company’s health. But every time a company buys another one, there’s risk the move will fail, as well as a higher cost for the same product that you could have built yourself.

Just look at IBM and Amazon regarding their cloud performance: Amazon built their cloud computing capacities in-house to their own detailed specifications and did a beautiful job growing enterprise-level service from the ground up. IBM went out and bought SoftLayer, which in our view is a small-biz-sized cloud provider that nobody likes and no one is using.

Oops.

Value Proposition

Value proposition can be thought of as an exchange of cash for a promise to provide goods and services. Always watch and be critical of the trends in value proposition. Is it competitive? How is it moving? What’s the future look like? When you’re thinking about the outlook of how the value is going to change over time, then you’re really getting into what we do here at Worm.

Netflix is a great example of a company with a stellar value proposition. Because half of their revenue goes to purchasing and producing content, the more people giving their money to Netflix, the more content they can provide, and the more value each customer gets for their dollar. The more successful the company, the better deal it becomes for its subscribers. That’s a hell of a value proposition.

And it doesn’t take an insider to know which way the value proposition is going. Here’s where you can outshine industry professionals who glued to their inflated EPS numbers and old school ways of thinking. You don’t even have to crunch numbers to start with value proposition. Ask yourself: Who is booming in the industry? Where’s the energy? Who is getting the new customers? What are they selling, and who’s got the best version on offer?

Sure, Wall Street has their tools, but we’ve got ours. From the perspective of many investors, the world begins and ends with EPS but we know it just doesn’t work that way anymore.

The game is changing, EPS is dead, and with a just a few easily found metrics, even the most novice investor can roll in and make some good decisions. Just don’t listen to executives standing hopefully atop sinking ships.

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Got a question? Contact us: info@wormcapital.com.

Disclosures:

The opinions expressed herein are those of Worm Capital, LLC and are subject to change without notice. The company (or companies) identified or referenced herein is an example of a current or potential holding or investment target and is subject to change without notice. This information should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the investments or strategies referenced were or will be profitable, or that investment recommendations or decisions we make in the future will be profitable. Past performance is no guarantee of future results. Worm Capital reserves the right to modify its current investment views, strategies, techniques, and market views based on changing market dynamics. This article contains links to 3rd part websites and is used for informational purposes only. This does not constitute as an endorsement of any kind.

Arne Alsin and Worm Capital clients are currently long Amazon (AMZN), long Netflix (NFLX) and also own options positions in IBM and stand to benefit if the trading price of Amazon increases and/or the trading price of IBM decreases.

Worm Capital, LLC does not accept any responsibility or liability arising from the use of this document. No document or warranty, express or implied, is being given or made that the information presented herein is accurate, current or complete, and such information is always subject to change without notice. Shareholders and other potential investors should conduct their own independent investigations of the relevant issues and companies involved in this article. This document may not be copied, reproduced or distributed without prior written consent of Worm Capital.

Worm Capital, LLC is an independent investment adviser registered in the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Worm Capital including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request. WRC-16- 11