There’s method to the madness

Embrace the (apparent) chaos! It can make you rich in the long term.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Hand flipping wooden cubes for change wording" Panic " to " Calm".

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Trying to explain moves in the stock market can be a thankless task.

Not ‘17th-century astronomer Galileo proving the Earth goes around the sun and being branded a heretic for his troubles’ level thanklessness.

More “it’s all a casino, isn’t it mate?” style head-shaking.

And I can understand why.

The regular booms, busts, and moments of madness we see in markets are not what most people would imagine an efficient mechanism for determining the value of companies should look like – no more than a dozen drunks going at it on the dodgems recall the Highway Code.

For what it’s worth, even I don’t believe the market is perfectly efficient.

I wouldn’t waste my time trying to pick stocks to beat an index fund if I did.

But I do think it’s mostly efficient.

Partly that’s because of the academic theory. But it’s also because those same index funds outperform most fund managers over the long term – at least after fees.

There’s not much evidence, in other words, of obvious mispricing strewn all over the place that any old skilful investor can scoop up in their day job.

Bargain or basket case?

Nevertheless, faith that the market makes sense can be severely tested at times.

A recent case in point: Ocado (LSE:OCDO), the online grocer and warehouse automation and logistics facilitator.

A company whose share price chart would put Pinocchio’s output from a polygraph to shame.

Ocado’s shares recently jumped 30% overnight on a deal to build robotic warehouses for the South Korean grocer Lotte Shopping.

No financial terms were given to underwrite that price appreciation, mind you.

In as much as it did comment on earnings, Ocado only said there would be a negligible impact in the current financial year.

But the shares soared anyway – from £4.71 to as much as £6.70 on the day – for a 40% gain.

That near-instant uplift alone is pretty remarkable.

But consider too that at the start of 2022, Ocado’s shares cost over £15. And they were priced above £28 in late 2020.

Yet you could buy them for a paltry £4 just three weeks ago.

A price that falls 85% in two years only to scream 40% higher in a day on back-of-a-napkin maths based on finger-in-the-air guesswork doesn’t seem to reflect a market rationally valuing a stock.

But I’m here to – thanklessly – argue that it does.

Bargain or basement?

First things first, Ocado is a loss-making company.

And not on the basis of rigid accounting that obscures some wonderful money-making machine at the core, either.

Ocado is still posting negative cashflows, 22 years after it was founded. So far, the only machine that’s been created from an investor’s perspective is one that eats money.

How, then, is it still in business?

Because it keeps raising it money to carry on.

Ocado has raised just over £4bn in its lifetime, if you count the £750m it got from selling half its UK online grocery business to M&S.

And before the South Korean deal-inspired price spurt, Ocado was valued by the stock market at less than… £4bn.

So, in two decades it had generated no value on all that capital invested.

But was the Lotte Shopping deal a jackpot capable of turning around this sorry tale?

Not on the face of it.

Ocado will work with Lotte to develop half a dozen fulfilment centres by 2028. The first will go live in 2024. As boots hit the ground in 2024 and beyond, capital expenditures will in fact ramp up.

Management says the deal will create “significant long-term value” but any jam here is very much a tomorrow story. I wouldn’t rule out more capital raises to come.

So, we have a business that makes no money seeing its shares up 40% on the basis of a deal that – in the short term – will just add to the cash burn.

Senseless, surely? The market can’t do the simplest of sums!

Discount value

Of course, it’s not that simple and fund managers are all highly educated and smart.

Yes, on the basis of its profits right now, the business is superficially worthless.

Share price £0.

But what could profits be in, say, 20 years?

A full discounted cash flow analysis is beyond the scope of this article. But in a recent investor presentation – held before the new deal – Ocado noted it had announced the equivalent of 58 similar fulfilment centres, which it expected to bring in £900m in revenues in the medium term.

At the time Ocado also reiterated it would roll out its smart platform for online groceries to 11 major retailers around the world – boasting £210bn in total sales that might be transitioned to its platform.

Finally, consider that the Lotte news is the first such major announcement since 2019 and we begin to see why a 40% jump in the share price could be justified.

Of course, only a small part of that move should be attributed to any future value created from the new partnership in South Korea.

The bulk of the share price gain is better chalked up to a reaffirmation that Ocado’s technology platform remains a competitive market-leader – which in turn gives credence to those forecasts of £900m in annual revenues from these operations within a few years’ time.

Buy in time for Christmas

At the presentation day, Ocado forecast approximately 50% margins for its technology business, eventually, by way of the EBITDA measure so beloved of analysts

Bump up annual revenues to £1bn on the back of the Lotte deal and that could equate to £500m in EBITDA earnings annually. And that’s ignoring any profit from UK grocery and logistics operations.

Put a 10x multiple on £500m and you get a £5bn market cap.

Which is roughly where the shares sit today!

Of course, those profits are not guaranteed. And they lie in the future, so should be discounted back accordingly.

But equally, if Ocado does get to making those sorts of revenues with that kind of margin, we can be sure the growth story isn’t over.

That potential must be factored into the price too.

So, what’s it all worth? More than nothing that’s for sure, and potentially tens of billions.

And this is the problem the market is grappling with – which is what leads to huge and apparently senseless swings in Ocado’s share price.

On the one hand, it’s a profitless money-burner. On the other, it’s a future globe-striding tech play in a massive sector with vast potential.

In-between is a blank sea of uncertainty and doubt.

No wonder anything that appears to guide the way will send the shares flying – or sinking.

The way to win

We can’t expect a (mostly) efficient market to be synonymous with a sedate one, where there are no surprises and no sudden share price moves.

Nor – to the disquiet of Galileo fans – should we imagine prices and earnings ought to move in a predictable and orderly way, like the motion of the planets around the sun.

With a company like Ocado, there are just too many variables and unknowns for that.

It’s a chaotic system.

But though it sounds like heresy to say during a bear market, I’m actually grateful for the maelstrom.

If investing in shares was as predictable as putting money into a savings account, then everyone would do it with every penny they had.

Share prices would soar – and then plateau at some permanently high level.

And never again would we see 8-10% annualised returns from the tumult of owning equities, which is at the core of any good plan to grow your wealth.

The uncertainty surrounding Ocado might be too much for you. But the same uncertainty about the market writ large is the source of our gains as equity investors.

Embrace the (apparent) chaos! It can make you rich in the long term.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

The Motley Fool UK has recommended Ocado Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

5 steps to start buying shares with under £500

Learn how this writer would start buying shares with a few hundred pounds in a handful of steps, if he…

Read more »

Young happy white woman loading groceries into the back of her car
Investing Articles

The FTSE 100 offers some great bargains. Is this one?

Our writer digs into one FTSE 100 share that has had a rough 2024 to date, ahead of its interim…

Read more »

Smiling white woman holding iPhone with Airpods in ear
Investing Articles

£9,000 of savings? Here’s my 3-step approach to aim for £1,794 in passive income

Christopher Ruane walks through the practical steps he would take to try and turn £9,000 into a sizeable passive income…

Read more »

Group of young friends toasting each other with beers in a pub
Investing Articles

I’d buy 29,412 shares of this UK dividend stock for £150 a month in passive income

Insiders have been buying this dividend stock, which offers an 8.5% yield. Roland Head explains why he’d choose the shares…

Read more »

Red briefcase with the words Budget HM Treasury embossed in gold
Investing Articles

Could the new UK budget spell growth for these 6 FTSE stocks? I think so!

Mark David Hartley considers six UK stocks that could enjoy growth off the back of new measures announced in the…

Read more »

Investing Articles

With a 6.6% yield, is now the right time to add this income stock to my ISA?

Our writer’s looking to boost his Stocks and Shares ISA. With this in mind, he’s debating whether to buy a…

Read more »

Dividend Shares

This blue-chip FTSE stock just fell 12.5% in a day. Is it time to consider buying?

Smith & Nephew is a well-known, blue-chip FTSE stock with a decent dividend yield. And its share price just dropped…

Read more »

Investing Articles

At 72p, the Vodafone share price looks to be at least 33% undervalued to me

Our writer looks at a number of valuation measures to determine whether the Vodafone share price reflects the fair value…

Read more »