A massive amount of stock market capitalization is tied up in companies based on both their potential market share and hypothetical future profits. The popular arguments in their favor come from looking at a company’s total addressable market (TAM). Sky high price-to-earnings ratios and massive capitalizations are common in companies with a large TAM as we finish up 2017.

We thought this would be a good time to delve into the concept. What is a TAM? Why is it so popular in today’s stock market? Are there realistic business arenas where the long duration value manager can invest based on total addressable markets that are in the early stages of being fulfilled?

We will give you an example to help explain TAMs. There are approximately 7.6 billion people in the world. To understand the theory of TAM, you first need to think about what portion of people could possibly be a customer of a business. In a perfect world, these people would all eat three meals a day. In that case, if you are in the business of selling meals, your TAM is 22.8 billion meals per day in a perfect world.

McDonald’s (MCD) is one of the greatest success stories in the history of U.S. business and serves one percent of the meals eaten in the world each day. Big Mac trades at 26 times after-tax profits, a healthy multiple, but reasonable if you think they could reach another 76 million people. Also, McDonald’s covers their existing market very profitably, but growth from their size has been relatively hard to come by in the last five years.

Today’s glamour tech stocks like Amazon (AMZN) also have huge total addressable markets. Amazon looks at total retail sales in the U.S. of $5.8 trillion and drools while they wonder what part of it they can get. Amazon had $80 billion in online commerce in North America last year. Jeff Bezos, the CEO of Amazon, has done a great job leading investors to measure his work based on market share in their online commerce rather than on profits. In this way, he leaves them a lot of room to fantasize about what seems like open ended TAM possibilities.

Amazon’s purchase of Whole Foods and its attack on the grocery business is attached to the $350 billion of grocery sales in the U.S. Even though Amazon had attacked this TAM for years through Amazon Fresh, they’ve stepped up the ante by spending $13.7 billion for the right to address the potential in the grocery business. Investors have rewarded Amazon with explosive new stock price highs.

We can remember when folks were excited about the potential of a personal computer in every home or at every desk for Microsoft (MSFT), Intel (INTC) and Cisco (CSCO) in the 1990s. The TAM was enormous, but the fulfillment of that potential worked for the businesses and failed stock owners. Providing cell phone service for everyone looked amazing for McCaw Cellular in 1990. AT&T (T) owns McCaw Cellular now and the business never proved to be as profitable as the TAM might have indicated, even though a huge percentage of the TAM did become customers.

Why is TAM at the top of many investors’ minds? First, the slow growth of the U.S. economy since 2009 has drawn investors to fast growth companies. Since the bull market has lasted eight-plus years, professional and individual investors have moved from profit growth to sales and market share growth. Hence the focus on TAM.

Second, professional and individual investors have been boxed into passive index and concentrated ETF investments in the large-cap space. Momentum begets momentum and these capitalization-weighted portfolios create a positive feedback loop. TAM is a very helpful way to justify overpaying for a potentially great business.

Third, interest rates are at historic lows. The low discount rates make future profits much more valuable and encourage risk taking. It is very common at historical stock market and growth stock peaks for risk taking to gravitate from useful enthusiasm to “irrational exuberance” and TAM is wonderful for hopeful investors.

Lastly, in our careers, valuations in the U.S. stock market have only been more stretched near the height of the technology bubble in the late 1990s. Like McDonald’s, many companies which aren’t growing well or in any kind of special era for their industry, sell at multiples way above where we would consider them for purchase. We will not give up our discipline, even when we could get penalized in the short term.

Warren Buffett says, “What the wise man does at the beginning, the fool does in the end.” There are some wonderful total addressable markets in front of us that are available in companies which fit our eight criteria for common stock selection and are early in getting addressed.

Statistics provided by Zillow (ZG) are proving that millennials are becoming a big factor in home buying. These 22 to 41-year-old Americans are marrying and having children much later in life than past generations, but they are 86-million people strong and represent a huge TAM domestically. We like Lennar (LEN) for the long haul, even though they’ve had a pretty good run lately.

Baby-boomers range in age from 54 to 72 years of age and make up 80 million Americans and a huge number of people in Europe. They are going to live a long time and swill a massive amount of medicine over the next 30 years. Medicine is the cheapest way to treat people with chronic illnesses, even though the cost of some of the best new treatments seem very high in relation to the past.

Amgen (AMGN) has the lead in the reduction of bad cholesterol via its drug Repatha. High levels of bad cholesterol are closely connected to heart disease/cardiovascular-related deaths, one of America’s leading killers. Walgreens (WBA) is the largest filler of prescriptions in the U.S. and the owner of 30% of one of the largest drug distributors in America, AmerisourceBergen (ABC). The possibility of Amazon adding to the pharmacy business as a TAM has given quite a good entry point in Walgreens shares. The past is no guarantee of future success, but Walgreens is a historically wonderful business.

This is the eighth full year of the bull market which started in 2009 and the stock market has gone a long time without penalizing risks based on company potential and popular TAM concepts. For this reason, momentum investments are having their best year relative to the other stocks since 1999 and tax-loss selling among poor performers is as aggressive among all investors as I have witnessed in my 37 years in this business. After all, Peter Lynch said, “Profits are the mother’s milk of stocks.” He didn’t say a company’s potential or its total addressable markets are the mother’s milk, so buyers should operate today with caution.

Warm regards,
William Smead

The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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