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Is there a Lionel Messi in your portfolio?

There are risks to holding on to star performers in your portfolio beyond their sell-by date, says former hedge fund analyst Steve Clapham
Is there a Lionel Messi in your portfolio?

The ignominious departure of Lionel Messi, one of the greatest footballers in the world, from Barcelona, one of the greatest football clubs in the world, was a disappointment. No question on Messi’s ability, but a serious question on his pay.

I am not a football fan and this article is about investing rather than football, but there are some interesting aspects to football club finances, so bear with me.

About 10 years ago, when the Financial Fair Play rules were introduced, my training company Behind the Balance Sheet conducted an analysis of the Premier League clubs’ finances over the previous 10 or so years. We knew that there was a group of superclubs and the rest. Most clubs simply passed on increases in broadcast revenues to the players in the form of wages; hence, the differential between the clubs’ financial performance came down essentially to whether they invested in players wisely. Most clubs and managers paid too much for players and sold them at a loss.

In a sense, this is not too surprising – a football player is a classic example of a depreciating asset. As a player ages, his value declines with his playing life. Two clubs stood out in that analysis. Arsenal was the most successful in making a real profit on transfers, partly because it was more parsimonious than the other large clubs, spending little more than the average Premier League club.

Sir Alex Ferguson similarly made a cumulative profit on the transfer fees, mainly because he sold David Beckham, a home-grown player, to Real Madrid for €35m in 2003 (that was real money, then), but more importantly he sold Ronaldo for €90m to Real Madrid in 2009 (Man U spent £100m more buying players than Arsenal, but Chelsea spent nearly twice as much, and Man City and Liverpool were also big spenders). We only published the analysis once, because it was a huge amount of work and not that profitable – perhaps we should resurrect it.

But what has this got to do with investing, I hear you ask?

Two things, actually. First, when researching a company, you need to pay attention to the fixed assets. This is true even for tech stocks – many commentators think it’s all about intangible assets these days, but even tech stocks make often substantial investments in fixed assets too, as shown in the table.

 

 20192020 20192020
$bnFixed Assets Capex
      
Alphabet84.697 -23.5-22.3
Amazon97.8150.7 -16.9-40.1
Apple37.445.3 -10.5-7.3
Facebook44.855 -15.1-15.1
Microsoft52.970.8 -15.4-20.6
Total317.5418.7 -81.4-105.5

 

This is an important subject, which I plan to return to, as I think it’s often overlooked or paid insufficient attention by analysts and investors. Football clubs, interestingly, are a classic example – as I mentioned, revenue increases tend to end up in the players’ pockets (University of Michigan sports professor Stefan Szymanski has done detailed studies showing the correlation between wages and league success). Clubs’ financial performance therefore effectively is the outcome of the manager’s skill in the purchase and sale of players. Close attention to capital expenditure and the quality of the asset base are similarly significant elements of my share research process.

The table above showed the sheer scale of the asset base for the big tech stocks in the US. Absolutely huge for companies which are supposedly based on intangible assets, although these stocks of course have huge market capitalisations. Such high levels of capex have a significant impact on free cash flow, the primary input to most serious valuation processes. The chart below shows the impact of a 10 per cent flex in capex on the group’s free cash flows (FCF).

 

 

Most sensitive is Amazon (US:AMZN), whose FCF is depressed by significant growth investment; least sensitive is Apple (US:AAPL) which outsources all its manufacturing and is, perhaps surprisingly, the most asset-light of this group. Of course, this sensitivity would not flow through directly into valuation, as the stock market rewards companies for successful investment. But the total asset base grew by over $100bn last year, raising a question whether this group (and notably Amazon) may be increasing its asset intensity and possibly putting pressure on future returns.

 

 

Second, when considering your portfolio, you need to think about whether it contains any Lionel Messi stocks. These are companies that were incredibly successful, were really highly valued and performed well, boosting the value of your portfolio; recently, however, either:

  • they are still very highly rated but some of the gloss has come off their performance, or
  • their valuation has become so rich that future share price performance is at risk.

Such stocks can fall from grace quickly if the market falls out of love with them or they become unfashionable. Often, however, there is a period (which can be quite extended), when the operational delivery is deteriorating, growth is slowing but the gloss has not quite come off the stock; or the growth slows on the larger base but the valuation continues to increase.

The reason, I believe, is that investors may have owned this stock for years and they fall in love with their successes; they get close to management and form an emotional attachment to the company, to its products and most injurious to their performance, to the stock. It’s hard to remain rational when something you are fond of has delivered such success.

If it’s hard to sell a stock that has done well for you, it must be much harder to dispose of a player, especially one as gifted as Messi. But Barcelona hung on to Messi for too long. They continued to pay him beyond his value – Simon Kuper in the Financial Times suggested that he was paid over €555m in the past five years. And of course there is a knock-on effect in the pay for the remainder of the team: “Hey, I am half as good as Messi, I want half his pay.”

I shall look at some of the signals to watch for when a company is “rolling over” in this way and how to assess them in a future article. I believe that selling is one of the skills that separate the professional investor from the amateur. A primary reason is emotion or behavioural biases and this is one area many private investors should focus on to improve investment performance.

The lesson is clear; whether you are managing a football team or a portfolio, once a stock or team member can no longer live up to its valuation, it’s time for a change.

 

Stephen Clapham is founder of Behind the Balance Sheet and author of The Smart Money Method.