Shopify Stock Price: Will It Also Fail the Royal Bank Test?

Investors looking for sustainable long-term growth could be taking too much risk holding onto Shopify Inc. (TSX:SHOP) (NYSE:SHOP)

Ryan Bushell | January 25, 2021 | SmallCapPower: Although their influence faded in the second half of the year, technology stocks were the clear leaders in 2020. In fact, both the S&P 500 and the TSX Composite indexes would have been down in 2020 if it were not for the Big 6 technology companies in the U.S. (Facebook, Apple, Amazon, Netflix, Google and Microsoft) and Shopify alone in Canada.

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Shopify Inc. (TSX:SHOP) (NYSE:SHOP), an e-commerce services provider, was the best performing stock in Canada last year, adding more than 4% (689 index points) all by itself to the TSX’s performance in 2020. Like many technology stocks, Shopify benefitted both operationally, and especially from an investor sentiment perspective, from the pandemic. Following a year of strong performance, Shopify is now the largest company in Canada by stock market value, exceeding the value of Royal Bank, which has consistently been among Canada’s largest companies. In fact, Shopify becomes the fourth technology/health care company in the last two decades to exceed RBC’s stock market value. The chart below depicts all companies that have grown larger that RBC by market capitalization in recent history:

Nortel (green), Research In Motion (yellow), and Valiant Pharmaceuticals (red) all saw their share prices rise dramatically for a few years as investors chased growth. All three of these companies subsequently witnessed their stock market bubbles burst when underlying business performance failed to live up to the hype. Although mistakes are easy to spot in retrospect, remember that each of the ascents occurred over a period of 5+ years.  During periods of positive momentum, the fear of missing out caused more and more investors to convince themselves to pay higher and higher prices for three different companies without a dividend to protect their capital value to the downside. Remember too that the dividends paid by RBC each year would significantly add to their long-term performance shown above.  If Shopify is anything like Nortel it may have much more room to run to the upside over the next few years. It is an innovative company and a Canadian success story, but so too were RIM, Nortel and Valiant Pharma.  I will not risk a clients’ hard-earned savings chasing growth given the complete destruction of capital that is possible in these types of companies. I would much rather be invested in a steady company like RBC, that has the staying power to preserve and grow capital for the long-term, while providing a consistent dividend.

I created “The Royal Bank Test” in the summer of 2015 when Valiant Pharmaceuticals (red) exceeded the value of RBC (blue) after a meteoric rise over the course of three years. The test compares fundamental criteria of each company with the aim of coming to a rational rather than emotional conclusion.

“The Royal Bank Test” using Shopify is shown below:

The test has only one question: Which company feels more sustainable? This is not to discredit Shopify’s business. Hopefully, they become the Canadian company to break the disappointing trend of popped bubbles shown in the chart on the previous page. For now, though, Shopify has a lot of work to do to satisfy the market’s high growth expectations based on the metrics above and history has shown that investors will not give them the benefit of the doubt if they fail to stay ahead of their competition.

The story of the tortoise and the hare is a fable as old as time and is overused by cautious long-term investors including myself. The reasoning though, is sound. I was very fortunate to have had a wise mentor in my formative years who asked me, “what would you rather have: 50%/year for 7 years? Or 7%/year for 50?” After completing the math and witnessing a great many of the 50% for 7’s come crashing back to earth, the seasoned investor learns to look for a high probability of sustainable, steady returns found in high-quality dividend paying equities. The problem is that most learn this lesson too late.

The preceding was an excerpt from our Q4 commentary.  You can read the full version here

Ryan Bushell is President and Portfolio Manager of Newhaven Asset Management Inc., where he focuses on meeting the needs of his individual clients. He has been a regular guest on several BNN Bloomberg programs, including Market Call, since 2011 and is a frequent contributor to the Globe and Mail, Toronto Star, Reuters and Bloomberg. He can be reached at rbushell@newhavenam.com

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