Category: Investing

Business models, timeless investment concepts, and behavioral science in markets.

How growth, return on capital, and the discount rate affects valuation

How growth, return on capital, and the discount rate affects valuation

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Michael Mauboussin has written countless white papers on this topic. His paper published on 9 Jun 2020 introduced the concept of how stock duration and interest rates caused multiples of high-quality companies to justifiably shoot up.

High-quality companies have the following characteristics: Return on capital is significantly higher than the cost of capital, able to grow, and has a competitive advantage (i.e. moat).

How is value created?

Before we jump into new concepts such as stock duration, it is important to quickly recap on how value is generated.

A company creates value only when its investments generate a return higher than the opportunity cost of capital (COC).

This means that having a large total addressable market (TAM) with huge growth prospects does not make a good investment. Revenue and earnings may show growth but it offers little with aspect to value creation.

If a company generates a return on capital equaling COC, then it does not matter whether they grow. They are both worth the same multiple.

Mauboussin refers to this group of companies as commodity businesses that deserves a commodity P/E multiple.

The commodity P/E multiple

The commodity P/E multiple is the multiple you would pay for $1 of earnings into infinity assuming no value creation (return on capital = cost of capital).

You can find out the multiple by taking the inverse of the cost of equity capital. If the COC is 8%, the commodity P/E multiple is 12.5 (1/0.08 = 12.5).

This multiple is not constant. The multiple a commodity business commands is derived from the cost of equity capital for each period.

The concept of duration

Duration is a concept that bond investors would be familiar with. It measures how a change in interest rates would affect the price of a bond.

The faster an investor is paid back, the lower the duration. The longer it takes to be paid back, the higher the duration.

Let’s take a look at a simplified example.

Assuming a five-year $100,000 bond at 5%. This means the bond will pay you $5,000 at the end of every year.

This would all be fine and the price would remain the same (at $100,000) if interest rates doesn’t change.

If interest rates shot up to 10%, investors would expect to be paid 10% for their investments.

To achieve this interest rate, the $100,000 bond paying $5,000 (5%) annually would have to drop its price to $50,000. Only then it will be able to match the 10% interest rates given by the current market ($5,000 interest on $50,000 bond).

Generally, the longer it takes for an investor to be repaid, the higher the duration will be. And the bigger the magnitude the change in price of the bond when interest rates shift.

How duration affects stock valuation

Similar to bonds, stocks of businesses that reinvest heavily in the short run to generate higher cash flows in the long run have longer durations than companies that lack the opportunities to reinvest.

Duration sheds important insight into understanding the magnitude of an asset price change when interest rates change. Mauboussin highlights, “Long-duration assets are more sensitive to changes in interest rates than are short-duration assets…companies that can invest a lot today at high returns on capital will not only grow faster than the average company, their stocks will have valuations that are more sensitive to changes in the discount rate.

Low interest rates

Low-interest rates are frequently associated with poor economic outlook and slow real earnings growth. This creates a conundrum where low-interest rates raises asset values (i.e. higher value for a stream of cash flows due to lower discount rates), but the prospects are reduced by slower expected cash flow growth.

Data from Robert Shiller suggests that the impact of slow growth will outweigh the former. The P/E multiple for the market has followed an inverted “U”.

Low median P/E multiples are associated with very low and very high interest rates while high median P/E multiples are associated with real interest rates in the middle of the range.

Mauboussin continues to explain, “Research shows that low Treasury yields allow industry leaders to generate excess returns and that the magnitude of those returns increases as yields approach zero. While the median P/E may come under pressure as a result of slower growth prospects, a handful of companies may continue to generate strong growth and return on incremental investment.

How the math works out

Impact of growth rates on valuation

Mauboussin demonstrated how low-interest rates leads to bigger shifts in valuation multiple with the following:

Assuming the base year’s earnings are $100, slowing earnings growth from 10% to 7% reduces next year’s earnings by only 2.7% (from $110 to $107). However, the P/E multiple dropped a steeper 22.9% (from 32.3 to 24.9).

“Investors often calculate the P/E multiple using the current price and next year’s earnings. As a result, they sometimes believe that the market overreacts to what appears to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified.

Here, next year’s earnings are revised down by 2.6% (from $115 to $112) but the P/E multiple decline is 25.3% lower. When return on incremental invested capital (ROIIC) is well above the COC, the value of the business is very sensitive to changes in the growth rate of NOPAT.

As we can observe in the following graph, growth and the P/E multiple have a convex relationship. In other words, small changes in growth expectations can lead to big changes in the P/E multiple.

This effect is amplified when the company growth rates are high.

“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous.”

Warren Buffett

The key takeaway here is that growth doesn’t matter for businesses that generate returns close to the COC. However, for companies that are able to generate high returns on capital, it is a huge amplifier of value.

Impact of ROIIC on valuation

ROIIC indicates how much a company is required to invest to attain an assumed growth rate. A high ROIIC means that the company don’t need to invest heavily to grow, leaving a lot of cash on the table for shareholders and vice versa.

Take for example company A and company B, both of them aim to generate a 10% growth in earnings for the next year. From current year earnings of $100 to $110, an additional $10 in earnings.

All else constant, A generates 50% ROIIC while B generates only 25%.

A is only required to invest $20 of the current year’s earnings to achieve an additional $10 ($20 x 50%) in earnings the following year. This leaves $80 of the remaining earnings for its shareholders.

While B is required to invest $40 of the current year’s earnings to achieve an additional $10 (25% x $40) in earnings the following year. Leaving only $60 of the remaining earnings for shareholders.

Thus, a company generating higher returns on capital would rightfully command a higher multiple, assuming growth rates are constant.

Impact of discount rate on valuation

The cost of equity is comprised largely of 2 components – the risk-free rate (i.e. common referred at the yield on the 10-year Treasury note) and the equity risk premium (i.e. how much investors expect in return for assuming risk).

As of 1 Jun 2020, Aswath Damodaran’s estimate of the cost of equity dropped to 6%. The 10-year Treasury note offering historically low yields at 0.7%, while the equity risk premium accounts for 5.3%.

Mauboussin observes “Nearly 90% of the expected return from equities now comes from the risk premium, up from about 75% at the beginning of the year.”

Importantly, long-duration assets are highly sensitive to changes in the discount rate. In today’s environment of low expected returns, the valuation of these companies are substantially higher than before.

Conclusion

Nobody will know where interest rates are headed, but it is important to appreciate the relationship between the discount rate and long-duration assets. In other words, we should be mindful that an increase in interest rates will bring down the valuation of companies that are investing heavily today for higher future cash flows tomorrow.

It is also important to bear in mind that for most companies, return on capital will eventually drift lower with competition, maturation, obsolescence, and disruption. Without a moat protecting its returns, the company will suffer a multiple contraction as observed above.

You may find all of Michael Mauboussin’s work here.


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If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful. As an extension to the regular posts, I send out weekly newsletters sharing timeless ideas on life and finance.

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Why pay up for quality businesses?

Why pay up for quality businesses?

Fundsmith performed an exercise looking at 25 quality compounders, and what an investor could have paid for a compound annual growth rate (CAGR) of 7% between 1973 and 2019. Over this period, the MSCI World Index produced a CAGR of 6.2%.

“An investor could have paid 281 times earnings for L’Oreal, 156 times for Colgate, and 147 times for Brown-Forman and still beat the market.”

Terry Smith, Fundsmith

What this means is that the market continuously underpriced these great businesses over time. Giving investors the opportunity to achieve market-beating returns by sticking to these compounders.

For Fundsmith, quality companies have the following characteristics: high returns on invested capital, strong margins, good cash conversion, defensive business models and long growth runway.

“Provided you have the patience, these quality stocks do tend to produce the sort of performance over long periods of time that makes their valuation fade into insignificance.”

Terry Smith, Fundsmith

The origin of the above statement comes from Charlie Munger “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

Take some time to let the quote above sink in.

Let’s look at what Munger said with an example. We have company A earning 6% and company B making 18%, both with an intrinsic value (IV) of $100 today.

The market price of company A is half of IV, at $50. While company B is commanding a premium and the market is demanding twice of IV at $200.

Now let’s see what happens when Company A compounds its intrinsic value at 6% while Company B compounds its intrinsic value at 18% over 40 years.

Over a long period, the power of compounding will drive Company B’s IV through the roof!

Let’s be conservative and assume that Company A is trading at double of IV at year 40. While Company B is trading at half of IV at year 40.

Even if Company A’s valuation jump by 4 times (from half of IV at year 1 to double of IV at year 40), it’s returns did not deviate far from its ability to generate 6% return on its business.

For company B, even if you paid an expensive looking price (double of IV), and subsequently valuation gets cut (half of IV), it still generated satisfactory returns of 16% for its investors. Close to its 18% return on business.

Key takeaway

The key takeaway is to understand value. Undervalued companies might not come in the form of low P/E or P/B. If these companies are generating returns on capital below their cost of capital, they would rightfully deserve the low multiples.

For companies that are able to sustainably generate returns above cost of capital, they would rightfully deserve a higher multiple.

Especially in today’s environment, its important to shift our mindset away from solely buying companies that are trading at low multiples. Focus on companies that are able to generate market beating returns instead.

Here is an excellent video of Terry Smith explaining the importance of investing in companies that are able to continuously reinvest their earnings at a high return on capital:


Thank you for taking the time to read my blog.

If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful. As an extension to the regular posts, I send out weekly newsletters sharing timeless ideas on life and finance.

I do not share these content elsewhere.

Join others and subscribe to our newsletter today to receive a free investment checklist!

Why you should keep an investment journal

Why you should keep an investment journal

When it investing, it helps immensely to have these 3 tools in your arsenal — an investing journal, a watch list, and investing checklist.

As I was reviewing my investing journal this week, let me share with you the reasons for this practice.

Peak-End Theory

The peak-end theory was shared by the Nobel Prize-winning Israeli psychologist Daniel Kahneman. His definition is as follows:

“The peak-end rule is a psychological heuristic in which people judge an experience largely based on how they felt at its peak (i.e. its most intense point) and at its end, rather than based on the total sum or average of every moment of the experience.”

Cognitive biases alter our memories as our brain cannot remember every minute detail of our experiences. It finds ways to efficiently process the many data points encountered at any given time.

As a way to prioritize our memories, our brain tends to create highlights. By applying a cognitive shortcut to focus on memories on the most intense aspects of an experience and what the ending is like. Omitting the full range of experiences (i.e. you forget most stuff other than the peak and ending).

The implication of this is that we forget most of the full suite of experiences and thoughts when investing. Much of what makes an investor successful is the ability to develop a framework for making decisions, especially during times of maximum pessimism and the ability to keep emotions at bay.

Here is what Warren Buffett has to say:

“If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius,” Warren Buffett is often quoted as saying. In fact, Warren Buffett places more emphasis on rationality and emotional stability.  “Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential,” says the Oracle of Omaha.

Warren Buffett notes, “To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework.

Having an investment journal allows you to revisit your thoughts and evaluate your past decisions. This helps with forming your decision-making framework overtme.

This is essential to continuously improve as an investor and allow us to learn about ourselves, and how we could better manage our emotions.

As Adam Smith famously said “If you don’t know who you are, the stock market is an expensive place to find out.”

It’s important to quickly learn about oneself, and not continuously repeat the same mistakes. A journal provides a reference point in the future to look back on where my thinking went awry.

Peter Lynch 2-minute drill

I approach my investment journal similar to Peter Lynch’s 2-minute drill. The rationale is to find out if I really understood the business. A good litmus test is the ability to explain my thesis clearly and concisely.

Writing it down forces me to slow down and really think things through.

Generally, I will briefly write about the business model, why the business will become bigger and more profitable in 5 years, how does it compare to other opportunities out there, and the risks involved.

Keeping my emotions in check

Other times, I write about my emotions in investing. As you can see my entry on 23 March 2020, as the stock market went on a roller coaster ride.

I used the journal to jot down my immediate thoughts and emotions. This helps to clear my mind and capture my emotions on paper for evaluation.

This helps me make better judgement amidst all the noise and flurry of emotions.

My investing journal on 23 Mar 2020

Final thoughts

As with anything, sustainability is key. You don’t have to write an elaborated essay or in perfect sentences. This journal is for you and you only, to help you become a better investor by providing you the opportunity to revisit and study your thoughts/ decisions.

Initiated a position in Fastly

Initiated a position in Fastly

Initiated a stake in Fastly recently to make myself follow through on deep diving into this company.

So what piqued my interest with Fastly?

They reported a strong set of Q2 results, with revenue rising 61.7% y-o-y. It was also the first time their EPS became positive, at $0.02 per share. Yet its share price took a hit and declined 33%. Largely due to Donald Trump threatening to ban Tik Tok, which accounts for 12% of Fastly’s revenue.

Even if Tik Tok were to be banned, I see this as a temporary blip to Fastly’s prospect. Fastly mainly serve enterprise clients. Many of the leading digital companies chose Fastly’s edge computing capabilities due to its capabilities, speed and reliability.

Source: Fastly’s presentation

It is worth noting that they have recently bagged Amazon and Shopify as their clients. With both of them enjoying the tailwind of e-commerce acceleration due to COVID-19, Fastly would stand to benefit as well.

Without further ado, and without being overly technical, let’s jump into what Fastly does!

What problems does Fastly address?

Traditionally, when we listen to music on Spotify or stream videos on Netflix, our request would first travel all the way back to the data center (or the cloud). It would be processed at the cloud before the content (along with recommendations for our next song or show) is delivered back to our devices.

This would usually not be a problem. But with increasing devices and applications moving to the cloud, shared bandwidth becomes a problem.

And this is what happens:

Netflix Loading GIF - Netflix Loading Buffering - Discover & Share ...

I hope you did not stare at the above gif for too long. I’m just trying to illustrate that high data usage (i.e. increased load) would increase the latency (i.e. response time).

And we know how detrimental this would be for user’s digital experience.

To give an idea of how much data is running on our networks:

Given how much data is running through our networks, the huge load and distance between user and cloud data centers are bound to increase latency.

Any lag would be detrimental to time-sensitive operations such as self-driving cars, smart hospitals, etc (and of course also to us streaming on Spotify and Netflix).

This is where Fastly’s edge computing capabilities comes in — to solve the latency issue. By bringing data processing closer to the edge of the network where the raw data is generated.

Edge computing sits closer to the users. For a Netflix user in New York, rather than having the request traveling to a remote data center (e.g. AWS data center), getting processed together with millions of other users’ requests. It gets processed at an edge computing server locally, referred to as Points of Presence (PoPs), which is closer to the user.

Apart from ensuring a fast and smooth streaming, edge computing is smart and is able to ensure that the right type of content is served each time by allowing for more on-device computing and analytics. The cloud is able to do these as well. But with millions of requests going to the cloud at the same time will drastically increase latency.

By being strategically distributed in city hubs, edge computing reduces latency by reducing the distance traveled and by distributing the load each server has to process.

Edge computing also helps reduces cost as cloud (e.g. AWS and Azure) is on a pay as you use model. By using edge computing, it helps reduces cloud usage and thus bring down costs.

An example would be the use of security cameras that automatically uploads the videos onto the cloud. Edge computing is smart, users can program it to upload only videos with moving motions onto the cloud for further processing. As opposed to uploading the entire 4k video onto the cloud.

Hence, Fastly essentially solves 2 problems — reducing latency and bringing down costs for its customers.

Developers focused

For enterprise software providers, winning over developers’ hearts is critical.

With a developer-focused usage-based sales model, companies like Datadog, Twilio, and Fastly empower the developers, who are the closest to the products being built to make the purchasing decision.

Fastly is developer-centric with a strong appeal to the developer community because of their advantages in performance, security and programmability.

This is opposed to the traditional model where a single buyer sign a huge contract on behalf of the entire company. An individual developer can proceed to Fastly’s website, register and starting building on their new idea in less than 30 minutes.

Large and growing TAM

Source: Fastly presentation

According to research firms, MarketsandMarkets and IDC, content delivery network (CDN) & Streaming and App Services & Security at the Edge are estimated to be a $35.4 billion by 2022 and is expected to continue growing at a high clip.

Fastly’s trailing-twelve-month (TTM) revenue is currently $845 million. They are in a good position to continue eating up market share as they continue to innovate and rapidly roll out new product offerings in edge computing.

Metrics to keep an eye on

Revenue: As with any growth companies trading at high valuations, it is important that they are able to sustain a high growth rate. Due to their strong Q2 revenue growth of 61.7% y-o-y, management has guided for Q3 revenue growth of 49.6% y-o-y.

Dollar-Based Net Expansion Rate (DBNER): This represents how much existing customers spent today compared to previous years. With a focus on large companies as opposed to their competitors (e.g. Cloudflare who focuses on SMBs), customer curation allowed Fastly to achieve the best-in-class DBNER.

DBNER was up 133% in Q1 and 132% in Q2, meaning their customers increased their spending by by 33% and 32% respectively y-o-y. As a rule-of-thumb, anything above 120% is excellent.

Number of customers & average spend per customer: We want to see that Fastly is able to keep grabbing market share. Total customers count increased to 1,951 in Q2, representing a 20% annualized growth.

Enterprise customers increased to 304 in Q2, from 262 the previous year. Enterprise customers are defined as accounts which spend in excess of $100,000 over the year.

Average enterprise customer spend grew 29%, from $556,000 in Q2 2019 to $716,000 in Q2 2020.

Gross margin: Gross margin was 56.7% in Q1 2020 and jumped to 61.7%. Management attributed this to improved efficiency in the operating model. As they continue to introduce high-margin products and scale, management expects gross margins to improve to 70%.

Why companies are investing heavily in Cloud

Ultimately, it boils down to its value proposition — creating a win-win situation for all parties. The opportunities here are huge due to the cost savings and increased capabilities it can provide.

Final words

Fastly is still a young company at its early innings with its moat still being developed. Compared to my other investments which form the core of my portfolio, Fastly is expected to experience higher volatility (which is not necessarily a bad thing).

Traditional metrics such as P/E ratio would not work for reasons covered in my previous posts. You may check them out below:

In my future posts, I will be covering Fastly’s risk, management, competitors, and valuation. Subscribe to the newsletter to follow along!

So far I have been able to publish at least 1 article per week and hopefully that has been value-adding to you!

I aim to publish 2 articles over the next month to spend more time catching up my backlog of reading and to do a deep-dive into other companies that have piqued my interests.

Disclaimer: This is not a recommendation to buy or to sell securities. Please conduct your own due diligence or consult your advisor. I merely write to improve my investment and thought process.

What fund managers are saying about the current environment

What fund managers are saying about the current environment

No one knew the market would decline more than 30% in March.

No one knew it would recover all its losses by August.

No one knows what it will do the rest of the year.

— The Motley Fool

The year 2020 has been interesting, to say the least. With the market crashing down at an astonishing speed, and then shooting back up within a short period of time.

New winners and market leaders will emerge from every crisis. For the COVID-19 crisis, tech companies have emerged as the clear winner. Early into the crisis, as CEO of Microsoft, Satya Nadella put it, “We’ve seen two years’ worth of digital transformation in two months.”

While Mr. Market is being lazy and pricing all SaaS companies to the moon, not all of them will be worth the rich valuation. Companies are likely to cut costs and non-essential cloud services are likely to be terminated.

Furthermore, if the pricing model is based on per employee subscription, a surge in unemployment would cause some serious pain for some of the SaaS companies.

Drew Dickson of Albert Bridge Capital describes the current environment best in his latest letter:

People shouted about the “new era” in 1972 and again in 1999; and they are shouting about a new era in 2020.  

There is no new era.  Stocks are still worth the present value of their future cash flows

Alright, enough of my ramblings. Let’s hear what fund managers have to say about the current environment!

P.S. You can access all fund managers letters and learn how to track their buys and sells under Resource.

Nick Train, Lindsell Train

The letter for his UK’s fund can be found here and global fund here.

When Mr. Market is mood swings sharply in both directions and its tough to reasonably estimate business value:

In a market marked by big swings in sentiment and with, understandably, little clarity about the prospects for many businesses we stick to a favoured adage – “when in doubt do nothing.”

While there’s a huge uptick for “virtual” experiences such as e-sports, humans are fundamentally social creatures. Innately, we yearn for “real” experiences:

I have no doubt that human beings both crave & will return to “real” activities & experiences. Clubbing, Disney theme parks, luxury shopping and, yes, attending live football matches will all come again. Because it is human nature.

Fred Liu, Hayden Capital

One of my favorite letters to read, can be found here.

During the second quarter, they generated 93.2% returns for the fund. Compared to S&P 500 returning 20% and the MSCI World returning 18.8%.

They attribute their competitive advantage to their ability to stomach volatility. It is an important trait that differentiates the greats. For investing, legend Peter Lynch says the key organ in your body is your stomach, it’s not your brain.

Stock prices moving up and down is not risk. Buffett explains “Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you’re in, and it comes from not knowing what you’re doing.”

The benefit for our partners though, is that there’s very few investors who are set up to tolerate such volatility – which means that we have sparse competition for our strategy & return profile.

Although the fund has generated outsize returns this quarter, the big money lies in the long-run. The ability to stay invested is just as important as identifying the new winners and future market leaders.

Even though our investments have performed well since that capital call a few weeks ago, I firmly believe the real money is going to be made in the next several years, as consumers take their new habits and the increased online reliance developed during this period, into well after this virus subsides.

There’s going to be multi-bagger returns for the winners, far beyond the mid-teens percentage rebound we’ve seen in the indices these last few weeks

On how they achieved two 10-baggers within 2 years (SEA) and 6 years (Amazon) respectively:

The takeaway is, we need to find companies that 1) are growing quickly, 2) are capturing more value as they grow (as opposed to leaking that value away into their ecosystem), and 3) buy them at an underappreciate multiple which will (hopefully) expand over time as the company proves itself, and thus providing a tailwind to our stock performance.

Not all sales growth are good:

However, the nuance is that the sales growth must come from value-adding activities, either in the form of direct profits, or by strengthening the business’ network effect with each new customer added.

VIG Partners

The letter may be found here.

They discussed their error of selling Spotify based on their concern that churn would increase due to lower usage from less traveling. Lesson here — Never buy or sell based on short-term issues.

Selling a long-term investment holding based on short-term issues is an error that we rarely make, and we will learn from this bitter experience.

Sell only when growth prospects have diminished, not when the share prices have had a run-up.

There have also been occasions when we have forgone substantial gains by selling high-quality companies which are continuing to growth rather than stay the course. We need to avoid the error of “cutting the flowers and watering the weeds.”

If we have extracted substantially all the value from a situation, particularly in a company that has a relatively modest growth outlook, we need to be disciplined about selling.

Characteristics they look for in a business:

An attractive industry structure, pricing power, a resilient revenue stream, high cash-flow generation, a strong balance sheet and the potential to steadily grow earnings.

Jake Rosser, COHO Capital

A copy of his letter may be found here.

The fund delivered a return of 46.6% for the first half of 2020. The most important takeaway on investing from this pandemic:

While the pandemic pulled forward digital demand, the more important takeaway for us is the notion that a good business model provides the ultimate margin of safety.

On evaluating consumer facing technology companies:

One of the most important considerations in consumer facing technology investing is asking whether the product alleviates pain points, reduces friction or enhances convenience. Whether it is Amazon, Netflix or Peloton, all winning consumer platforms exhibit these attributes.

On investing in platform leaders:

Value investors talk a lot about patience, but typically it is about waiting for the market to rerate a company’s multiple after digesting an excisable problem. Better yet is the patience required for a company achieving global scale in a winner take most market – Facebook, Netflix, Google. The economics of these businesses are rarely apparent when in reinvestment mode, but the dominant strains of their business model often are.

Daniel Loeb, Third Point

You may find the letter here.

Third Point was traditionally an “event-driven, value-oriented” fund. Focusing on special situations such as spin-offs, demutulizations, and post-reorg equities.

Side note: To learn more about this strategy, check out Joel Greenblatt’s book: You Can be a Stock Market Genius : Uncover the Secret Hiding Places of Stock Market Profits.

As markets have evolved, selecting high-quality companies on top of the traditional value plays have become essential.

As markets have changed, I have realized that while event‐driven is still an essential investment lens, today, quality is also an essential screen.

This investment environment is characterized by breakneck technological innovation and sluggish growth which has only been amplified by COVID‐19. Considering this, it is essential to find companies with great leadership and unique products in growing end‐markets in which they are gaining share and achieving high topline growth and strong margins.

It is also important not to make the mistake of overpaying for these “compounder” company.

However, when investing in a quality or “compounder” company, it is critical to find an entry point at which an investment is attractive since most of these businesses trade at relatively high multiples.

Peter Rabover, Artko Capital

The letter can be found here.

On the recent market’s dislodge between prices and value. From speculative surge of unprofitable firms such as Hertz and Kodak. To sharp increases in prices due to share splits such as Apple and Tesla, which has no bearings on value.

It is the problem of the definition of “the stock market.” At the heart of it, the stock market is a market where participants exchange fractional ownership of 1000s of companies which are called stocks.

While this may seem like an obvious statement, it is not called “fractional ownership of companies market” and for a lot of market participants the term “stock” becomes something of a cognitive dissonance from what it truly represents and takes on a meaning of its own.

To put another way, the market has participants that are interested in investing in companies underlying the stocks and for them the stock market is a medium through which they can invest in those companies.

The market also has a speculative arm of those that invest in stocks and for whom the underlying company economics matter less, if not at all and the trading behavior of the instruments matter more. These parties are more interested in the patterns of the stock prices and pay close attention to actions of buyers and sellers.

What we are witnessing today is almost a complete domination of the speculative arm of the market, impervious to the deep recession we have found ourselves in, chasing momentum in stocks.

On their strategy with operating leverage (read more about operating leverage here):

While “old school” value investing involves buying companies at cheap price to book values and hope they revert to the mean, our strategy involves buying companies at balance sheet prices and with the expectation that their fundamental results missed by the market will make them valued as growth companies in the long term.

The market has consistently underestimated the operating leverage of companies on the way up and on the way down, which is where we generally like to find most of our ideas, a lesson we learned early on in our career from Michael Moubisan (formerly of Legg Mason) and have reliably witnessed work a substantial number of times over the last two decades.

David Einhorn, Greenlight Capital

As always, Einhorn disses Tesla again in this quarter’s letter. You may read more about it here.

One thing I learn from his continuous spat with Elon Musk is to never short a company with a cult-like following. It can get really expensive even though your points about their accounting and valuation are spot on.

Einhorn shares the same sentiment as Rabover from Artko Capital on the current market euphoria:

We believe the market groupthink that profitless growth stocks that trade at astronomical valuations, in part on the basis that interest rates are low, will be disrupted by rising inflation expectations even in the absence of a corresponding increase in Treasury yields. Other markets like Japan and Europe have long recognized that artificially-controlled long-term interest rates are no justification for stratospheric equity valuations

Ensemble Capital

I have always enjoyed reading Ensemble Capital letters. They are of the view that the recession has ended as economic activities have started to pick up. You may read more about their thesis here.

As investors, we should focus on what matters and what we can control. Anything else is noise that should be ignored.

While we believe that we have a superior ability to do company analysis and select stocks that will outperform the market over the long term, we also know that we do not have any special ability to guess where the market will go in the near term.

This is one of the most frustrating realizations that we think all investors need to come to terms with. If in fact there was a way to systematically predict short-term movements in the market, we would be happy to adopt this approach. But in the absence of this ability, we know that attempts to guess where the market will go next, is one of the surest ways to ruin your long-term investment returns.

They also highlighted why stocks are not highly correlated with the US economy in the short-term.

I wrote about this back in April as well “In performing a discounted cash flow (DCF) analysis, the loss of 12 to 24 months of cash flow due to a complete shutdown would generally reduce a company’s intrinsic value by no more than 5% to 10%.” You may read more about it here.

One mistake we think some investors have made during this unprecedented period, is substituting a forecast of the virus for a forecast about the economy or financial market performance. While clearly the pandemic is a huge negative impact on the economy, they are not the same thing. Stocks are not a direct reflection of the US economy.

The market does not care about the economy today, it cares about corporate cash flows over time.

Today, it seems that the stock market and the economy are totally disconnected. In reality, stock prices are reflecting a view that while the economy is very bad now, it will recover in the years ahead. And in fact, you do not even need to believe the entire US economy will recover to understand the rebound in the market.

Pollen Capital

You may read more about it here.

On focusing on things that matter and capturing the companies that are benefiting from the value migration:

While we do not make macro-economic predictions or claim to know how markets will perform in the coming quarters, we continue to have conviction in the strength and durability of the businesses we own and believe that most, if not all of them, will emerge from this period stronger.

The secular tailwinds that many of our companies enjoy also appear to be strengthening as a result of spread mitigation policies globally… The companies benefitting from these shifts have the largest weightings within our Portfolio.

Robert Vinall, RV Capital

This whole letter is worth a read as he covers on his new investments such as Tencent and offers good insights to analyzing businesses at its early stage. You may read more here.

Robert gave a honest review of his feelings during the crash, which is something most of us have to battle with during a sharp drawdown:

I would rate my own performance during the panic as, at best, average. I was tentative when I should have been bold. I preferred to add to existing holdings rather than make new investments. I held back some cash when I should have been all-in (whereby in my defence, I wanted to have cash available to be able to support our companies though ultimately it was not needed).

He also argues why investors shouldn’t only look at digital-first companies due to tail-end risk. Just as nobody expected a pandemic to take down the economy, it is hard to imagine a computer virus that would take down these companies.

In fact, in January I wrote that the greatest longtail risk to the economy was from a virus… of the computer variety (so near to glory, and yet so far). I still believe a computer virus is a major risk and strongly recommend reading “Sandworm” by Andy Greenberg to get up-to-speed on how fragile the Internet is.

The big lesson from this crisis, or any crisis, is that the unexpected sometimes happens. The correct investment strategy is not to try to predict the unpredictable (which is futile), nor is it to just own Internet companies (which is simplistic). It is to own companies that have sufficient reserves of strength to weather any crisis.

Bill Miller, Miller Value Partners

You may read the letter here.

On the disconnect between economic reality and stock prices:

The biggest problem with those who believe the market is disconnected with economic reality because the economic numbers still to come will be dreadful (and they will be) is that those numbers report the past and the market looks forward. The market predicts the economy; the economy does not predict the market.

My final thoughts

A few of my friends have talked to me about stock splits. Given Apple’s and Tesla’s recent stock splits and its impact to intrinsic value.

TL;DR — There’s no impact on intrinsic value. Don’t invest because of the hype surrounding it.

Image

The best way to explain stock splits is using pizzas. Cutting a 12 inch pizza into 8 slices or 40 slices doesn’t change the size of the pizza.

It is still a 12 inch pizza.


Thank you for taking the time to read my blog.

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How to analyze SaaS companies?

How to analyze SaaS companies?

Software as a Service (SaaS) companies share prices skyrocketed since March 2020 as the market recognized that COVID-19 has caused rapid digitalization. SaaS companies also have a fantastic characteristic – recurring revenue.

Understanding its moat

Despite most of the SaaS companies commanding lofty valuations, not all of them will meet the high expectations set out by investors. We have to first ask ourselves if this company has a moat – e.g. high switching costs.

Is it easy for competitors to woo their customers over?

Consider Adobe and Zoom, both offering their software services for a subscription fee.

Most designers will find it impossible to switch Adobe due to the amount of time spent learning the software. They’re taught this in school and would be very resistant to master another designing software. Doing this would be akin to having to pick up another language for work.

Zoom’s success has been dependent on its user interface — its ease of use. You don’t have to set up an account and it is not cluttered with buttons. However, ease of use is a double edge sword. Users can easily switch away when Zoom stops innovating and delivering added-value to fend off competition.

Comparing Adobe and Zoom, Adobe has a much stronger moat (i.e. switching cost). Its users are locked in and thus Adobe is able to extract value for a longer period (higher lifetime value).

This is important as SaaS companies spend huge capital outlay (i.e. sales and marketing expenses) in acquiring customers. With distribution costs near zero, the optimal strategy is to acquire as many customers as possible.

Read our earlier articles on marketing and R&D expenses to understand why SaaS companies appear unprofitable at first!

Its returns are very dependent on its ability to retain customers. Bringing us to our first metric – churn rate.

Churn Rate

Churn rate measures the percentage of customers who canceled their subscription over the period. The best way to think about this is how much gross profits were lost as a result of customers canceling their subscription?

The churn rate provides us insights into how sticky the software is and it is a key determinant of profitability for the company.

Lower churn rates equate to longer customer lifespan. This directly translates to higher lifetime value (LTV) of each customer.

The longer a customer stays subscribed, the more value may be extracted from the initial capital outlay – customer acquisition cost (CAC).

Churn rate may be expressed in the formula below:

For example, you have 100 users each paying $100 per month for your software. Taking the typical gross profit margin of 80% for most SaaS companies (GPM ranges between 75% – 80% for mature SaaS companies).

This gives us a gross profit of $8,000 per year (100 x $100 x 80%).

Say 20 users dropped out that year. Resulting in a loss of $2,000 in gross profits ($100 x 20). The churn rate would come up to 25% ($200/$800).

Customer Lifespan is simply the inverse of churn rate. With a 25% churn rate, the projected customer lifetime is 4 years (inverse of 25%).

Understanding the churn rate will allow us to know the Lifetime Value (LTV) of a customer.

Lifetime Value

LTV is how much I can expect to receive from each customer on average over the lifespan of their subscription.

LTV may be expressed in the formula below:

Knowing the LTV gives me an idea of whether the customer acquisition cost (CAC) provided good returns.

It helps answer the question – Did acquiring these customers bring in more profits than what it cost?

Customer Acquisition Cost

CAC is the total sales and marketing cost to acquire each customer. This includes items such as salaries of sales staff, advertisement expenses, and everything else it took to successfully onboard the customer.

CAC may be expressed in the formula below:

Let’s say it costs $1,000 in a year to acquire 100 new paying customers. Our CAC will be $10.

In other words, it costs, on average $10 to bring in one new customer!

By knowing the LTV and CAC, we can understand if the company can make more profit from a customer than the total cost of acquiring them.

Unit economics

Unit economics is simply an evaluation of profitability on a per-customer basis. Copying Buffett’s euphemism, CAC is what you pay and LTV is what you get. SaaS companies are ‘profitable’ if LTV exceeds CAC.

A useful way to evaluate this is to look at the LTV to CAC ratio:

Ideally, this ratio should be between 3 and 5. The company’s customers are providing profits three to five times the cost to acquire them.

If it is below 1, that would mean that the cost spent to acquire a customer is higher than their lifetime value. Some companies start off with below 1 to get a network effect going (e.g. Grab and Uber offering massive discounts initially). However, this is ominous if it persists over a prolonged period.

If it is above 5, the company could be missing out on valuable opportunities. Customers are bringing in huge returns and companies may want to spend more on sales and marketing to quickly scale the business.

Update: Insightful discussion on LTV-CAC ratio with the team from Moneywisesmart below:

The timing of the LTV would affect the Internal Rate of Return (IRR) of customers (time value of money). Also, shorter payback times are advantageous as less working capital is required. This in turn provides companies the ability to scale faster.

Conclusion

It is important to understand the LTV vs CAC trade-off when evaluating businesses. Especially for SaaS companies, this metric must be closely studied to understand its profitability.

Bluegrass Capital put it across succinctly, “If I can find a company that invests $1 in acquiring a customer and they can get back $3 to $5 in gross profits, it doesn’t matter to me if the EBITDA margin is negative or positive.”

For many of the SaaS companies today, they are spending heavily today to scale. These companies will not appear profitable today but would be highly profitable in the future, provided they have a strong moat and sound unit economics.

To end off, I will re-share this gem from Marcelo Lima’s 2Q 2018 letter:


In our future article, we will go through a case study on evaluating a SaaS company.

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How to filter for high-quality compounders?

How to filter for high-quality compounders?

A high-quality compounder is a business that is highly profitable, has a strong competitive advantage (i.e. moat) and the ability grow (i.e. huge total addressable market). Companies such as Ferrari, Mastercard, Facebook, Berkshire, Amazon, Monster and Starbucks are great examples.

A key characteristic of a high-quality compounder is a high Return on Invested Capital (ROIC). The problem is that ROIC is a function of operating income and invested capital. For example, many high-growth companies spend heavily on marketing and R&D. Filtering by ROIC may cause you to miss many high-quality compounders.

A great solution to overcome this is to use the gross profitability as a first-level filter instead of ROIC. Professor Novy-Marx defines gross profitability as revenues minus cost of goods sold, measured against the book value of total assets. In other words, it measures the amount of gross profit a company generates for every dollar of assets.

Reasons gross profitability is a great filter

Gross profitability is highly persistent in both the short and long term. This allows investors to make a reasonable estimate of future profitability based on historical records. Research shows that businesses with higher gross profitability generally deliver better total shareholder returns.

Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more ‘polluted’ profitability measures become. Gross profitability doesn’t ‘penalize’ companies for investing heavily in growth.

Many of the investments (largely marketing and R&D) that companies make for their long-term future growth can cause short-term hits to reported operating income.

A good gross profitability benchmark

So what is a good benchmark for gross profitability?

In Novy-Marx paper, gross profitability of 33% or higher is considered attractive. A look at Amazon’s gross profitability shows that it surpassed this level easily.

It is also worth noting that in Novy-Marx back-testing, a dollar invested in the market between 1973 to 2011 grew to over $80. While the same dollar invested in businesses that have high gross profitability (i.e. above 33%) grew to $572 in the same period.

Similar results were shown in a more recent study conducted in 2018 here. By investing in companies with high gross profitability of over 20%, it would produce returns in excess when compared to the overall market.

Conclusion

The gross profitability ratio is a great way to do a first-level filter. With growing revenue and gross profitability of over 20%, it is a great indication that the company could be a high-quality compounder which warrants further investigation.

In our future article, we will discuss in detail the issues with ROIC and how we may adjust the reported earnings figure to use this metric.

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Amazon and the problem with reported earnings

Amazon and the problem with reported earnings

Amazon share price has recently broke $3,000 per share and is currently trading at a lofty P/E of 147x. In fact, the company often trades above 80x P/E. Merely looking at the earnings would deter most value investors from owning Amazon.

Building on our income statement series on gross profit margins and marketing expenses, Amazon is the poster boy for not giving a hoot about reported earnings. Here is what Bezos have to say:

Bezos has an incessant focus on the Amazon’s long term prospect. He emphasized a high return on invested capital (ROIC) by reinvesting relentlessly to become the market leader. He understands that for growth to deliver long-term value, the ROIC must be sustainably high.

Amazon build up its moat by spending aggressively on research and development (R&D). R&D expenses include developing new products and infrastructure to enhance customer experience and improve process efficiency:

Looking beyond reported earnings

When we look at Amazon’s operating income, it looks rather mediocre. In 2014, the company made a meager $178 million in operating income on the back of $88 billion in sales. Giving it a razor-thin operating margin of 0.2%.

Adding R&D expenses into operating income would paint a drastically different story. In 2014, Amazon spent $9.2 billion on R&D. Adjusting for R&D expenses would give the company an operating margin of 10.6%.

This is a consistent trend for Amazon over the years. On the surface, the operating margin continued to linger below 6% even in recent years. Adjusting for R&D expenses, we can observe that the margin has actually exploded upwards to 18%.

This is largely due to higher margins segment third-party seller services (3P) and Amazon Web Services (AWS) operating segment rapid growth. This is the result of their aggressive investments in R&D earlier.

Capacity to suffer

The “capacity to suffer” is key because often the initial spending to build on these great brands in new markets has no initial return. Many companies will try to invest smoothly over time with no burden on currently reported net income, but the problem is that when you are trying to invest in a new market, smooth investment spending really doesn’t give you enough power to make an impression. You end up letting in a lot of competition that will drive down future margins. 

Tom Russo, Gardner Russo & Gardner

Capacity to suffer” is a term coined by Tom Russo and its a key trait I look for in companies. Companies that have the capabilities to look beyond short-term Wall Street expectations. Family controlled businesses or founders who have a majority of the voting rights are a commonplace to look for such businesses.

Amazon could have appeared very profitable if it wanted to. By pulling the plug on R&D expenses which drove growth and strengthened the company’s moat. But that’s not how Bezos does things. It always boils down to achieving growth and sustaining a high ROIC.

Here is my favorite statement from Bezos this year:

The problem with GAAP earnings

For digital companies, its economic engine is built on the back of R&D, brands (i.e. marketing efforts), customer relationships, software, and human capital. These intangible investments are akin to the traditional industrial company’s hard asset investments – factories, buildings, and machinery.

For the traditional hard asset investments, expenses are recognized over its useful life. A machinery that cost $10,000 would reduce the current year’s earnings by $1,000. This expense recognized over its useful life of 10 years. Recognizing that wear and tear reduces the value of these assets over time.

However, for the digital company, investment in its economic engine is not capitalized as assets. Instead, they are treated as expenses and charged in entirety towards the current year’s earnings. Despite intangible investments generally having multi-year benefits, or in certain cases, enhance in value over time.

When a firm engages in R&D, marketing, software development, or training employees, it must charge these long-term value-creating expenditures the same way it recognizes general expenses such as office space rents in the current year period.

In short, there is a mismatch between the value delivered and the timing of recognizing the expenses. Also, these intangible benefits are not recognized as assets on the balance sheet.

Take Amazon for example, its value increases as it onboard more sellers, which in turn attracts more customers as it offers a great range of products and vice versa. Its value growth is driven by the network in place, not by increments of operating costs.

Hence, the most important thing for digital companies is to invest aggressively in its early years to achieve market dominance and command a “winner-take-all” profit structure.

Here is a short excerpt from Marcelo Lima’s 2Q 2018 letter to Heller House fund clients:

“Winner-take-all” structure

Since 1996, Amazon has grown revenue at a 50% compounded annual growth rate (CAGR). Even at its current size, adjusted operating income (excluding R&D expenses) grew at 28% CAGR for the past 5 years.

The eventual profitability is a result of continuous investment into the company’s economic engine to achieve market dominance in e-commerce and cloud (i.e. AWS).

For SaaS companies, many have spent years and tons of capital growing despite producing meager accounting profits or are running losses. They are profitable though, when evaluated in terms of unit economics, and when they stop investing every dollar generated into further growth (i.e. once market dominance is achieved). A good example would be Adobe.

In our next article, we will discuss how to analyze SaaS companies unit economics by looking at two important metrics – Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC).

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Conclusion

Where the key value driver of a company is in intangible investments, investors need to look beyond reported earnings. Especially for innovative companies in their early stage as they invest heavily in growth. Compressing their earnings and balance sheet assets.

Finding the next multi-bagger by understanding operating expenses

Finding the next multi-bagger by understanding operating expenses

Earlier, we have covered the first 3 lines of the income statement – revenue, cost of goods, and gross profits. This allows us to calculate the gross profit margin (GPM), which measures pricing power and production efficiency. We also went through some of the common misconceptions about GPM.

Today, we are going to move further down the income statement – operating expenses. I pay special attention to this segment because this is where you can identify the characteristics of the next 100 baggers. Operating expenses include:

  • Selling, general, and administrative costs (SG&A) – Salaries of headquarters staff, marketing expenses, and utilities bills.
  • Research & development (R&D) – Salaries of staff doing R&D and its consumables used in developing new products.
  • Depreciation – Fixed assets expenses recognized over time. E.g. A laptop costing $3,000 will be charged as $1,000 in depreciation expense over 3 years. Think about it as expensing it over its useful life.
  • Amortization – Recognizing the impairment of intangible assets.

    Update: Our friends from MoneyWiseSmart shared that the impairment of goodwill over 40 years has changed. It is not compulsory for companies to amortize goodwill over 40 years. Companies may opt for it to be evaluated for impairment on a periodic basis. If it is not impaired, the value will be carried on the company’s books indefinitely.

We are able to derive operating profits by subtracting the above expenses from the gross profits.

Operating profits = Gross profits – SG&A – R&D – Depreciation & Amortization

Dividing operating profits by revenue, we will obtain the operating profit margin (OPM). The OPM gives us clues as to how the management is managing operating costs compared to past years and compared to its competitors.

Reported earnings vs true earning power

As usual, we are going to use case studies to understand these concepts. Reported earnings of high growth companies are often misunderstood by investors. Current earnings do not equate to real earning power.

Companies that are growing rapidly often reinvest heavily and their earnings are distorted as a result.

Earnings are the reported numbers. But real earnings power reflects the ability of the company to earn high rates of return on capital and grow at a high clip.

Companies that are able to generate high returns on capital and grow rapidly often will enjoy a big share price increase from multiple expansion and earnings growth.

Monster Beverage

Adapting from Chris Mayer’s 100 baggers, investing $10,000 in Monster Beverage would return $1,000,000 in 10 years. This is the essence of 100 baggers, the stock returning 100 fold your original investment. If held for 18 years it would have returned more than $7,000,000 (700 bagger!).

Monster copied Coca Cola’s playbook. By adopting a capital-light business model – focusing only on marketing and branding. They have no in-house manufacturing and outsourced their bottling business.

At the start, Monster spent a disproportionately large percentage of its revenue on marketing (i.e. SG&A). The company understood that they needed to develop their competitive advantage by building up Monster’s brand and rapidly eat up market share.

Scaling and building its moat

There are several reasons why Monster focused relentlessly on expanding market share and building up its brand:

  • Economies of scale in marketing – Less advertising dollars are required to sell additional Monster drinks as it becomes increasingly popular.
  • Lower distribution costs – Offer less discounts and distribution partners may offer concessions to retain Monster Beverage.
  • Operating leverage – A dollar increase in sales will result in a multiple fold increase in earnings due to fixed cost.

Monster aggressively ramp up its marketing efforts. We are able to see that the marketing team grew by almost 7 times within 5 years. The net sales per marketing employee stayed stable, suggesting that the company did not over-hire.

Monster’s investment in marketing paid off. As net sales increased more than 6 fold, from $96.5 million to $605.8 million within 5 years! We get net sales by subtracting promotions (e.g. discounts we see at the supermarket) from gross sales.

Lollapalooza effect

As the Monster brand gains awareness and experience rapid growth, the benefits of rising bargaining power, and operating leverage kicks in:

  • Increasing net sales/gross sales – Less promotions (discounts) were required to be given to retailers.
  • Rising gross profit margins – Copackers and distribution partners offered concessions to retain Monster as their client.
  • Rising operating margins – Due to operating leverage, operating income rose 32 fold! From $5.3 million to $171.3 million over 5 years. We can also observe this from the jump in operating margins.

This combination of positive factors stated above created a Lollapalooza effect. Investors watching the Monster story play out had until 2004 to jump on this ride before it begins its ascent.

Warren Buffett on marketing expenses

Buffett covered this topic extensively in his 1999 letter to shareholders. GEICO, the low cost car insurer owned by Berkshire Hathaway increased its spending on marketing from $33 million in 1995 to $242 million in 1999.

Buffett explained that he does not care if marketing expenses depress current year earnings. As long as the value of the brand outweighs the cost in the long-run. This is vastly different from most companies that are concern about Wall Street’s estimates. And would cut back on expenditure which increases the size of the moat.

He further illustrated that it probably wouldn’t cost this much to maintain GEICO’s brand position. However, with a large Total Addressable Market (TAM), the benefits from gaining scale was huge. GEICO had approximately 4.1% market share of the auto-insurance market back then.

Limitation of accounting

Accounting rules require companies to recognize marketing expenses, R&D, etc as they are incurred. For example, GEICO spending $242 million in marketing would reduce its pre-tax profits by the same magnitude.

This is despite such expenditure providing benefits that goes beyond one year. Brand names such as Coca-Cola, Nike, etc spent huge dollars on marketing. As a result, they dominate consumers’ minds and we favor these products over others when making our purchasing decisions.

As investors, we have to analyze the company’s operating expenses together with management’s strategy explained in conference calls and annual reports. It helps to ask ourselves these questions:

  • Are the earnings depressed because they are aggressively spending to build up the company’s moat?
  • Is the TAM huge compared to its current market share?
  • Are the benefits of the company’s expenditures reflected in operating metrics such as higher sales, rising gross margins or operating margins (over time)?
  • These must be evaluated in conjunction with the strategies laid out by management in the annual report and conference calls.

Our next article will discuss R&D expenses with Amazon as the case study. At first glance, Amazon looks like it has razor-thin operating margins. Diving deeper, it was actually a result of Jeff Bezos reinvesting a large portion of earnings back into the business to increase the size of the company’s moat.

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P.S. I strongly recommend Chris Mayer’s book 100 baggers to understand the essence of investing in high-quality compounders.

Analyzing the gross profit margin

Analyzing the gross profit margin

Reading the financial statements is important to understanding businesses. For beginners, it may be daunting at first. I will try my best to make it come alive with case studies!

For this post, we will focus on the top 3 lines – Revenue, Cost of goods, and Gross profit. Now, imagine you are running a lemonade stall:

  • Revenue is the total sales made from selling those lemonades.

    Revenue = Price per glass x Number of glasses sold

  • Cost of goods is the cost of the ingredients and labor costs for making that lemonade. It would include the cost of lemons, water, ice, and syrup. If you hired someone, their wages would be included here too!

  • Gross profit is simply the difference between revenue and cost of goods. If you made $100 from selling lemonades and it cost you $40 for the ingredients, your gross profit is $60!

    Gross profit = Revenue – Cost of goods

Gross profit margin

You’ll frequently see the term Gross Profit Margin (GPM). Which is simply gross profit/revenue x 100%.

It signifies pricing power. The higher it is, the more pricing power you have. In our lemonade example, our GPM is 60%. Which means we make our lemonade for $0.40 and sell them for $1.

It could also reflect cost structure and production efficiency. As companies scale, they may have more bargaining power over their suppliers and demand lower prices (e.g. Walmart & Costco).

Low margins doesn’t mean its bad

Costco is one of America’s largest retail chains and its mission statement is “To continually provide our members with quality goods and services at the lowest possible prices.”

And we can see this being echoed in their annual report as well. They outline their strategy as follow:

Does Costco walk the talk? Let’s take a look at their income statement. Their gross profit margin is only 11%. This means that when you bulk purchase toilet rolls at $15, it cost the company $13.35.

How do they fare when compared to Walmart? Did they fulfill their mission – to provide the lowest possible price? As we can see, Walmart’s gross profit margin is at 24%. The same toilet roll that cost you $15 at Costco, would cost you $17.57 at Walmart!

What about Target? Their gross profit margins are at a staggering 28%. Meaning the toilet roll would cost $18.54!

By studying the gross profit margin, we can see that Costco is truly the “pricing authority” in retailing. Which explains their success, in winning over customers and delivering returns for shareholders (20% CAGR) over the past 10 years. Who wouldn’t want to get the best prices?

Importantly, we can see that low gross profit margins doesn’t mean it is a bad business. For Costco, low prices are their competitive advantage. They pass all the cost savings to consumers. What matters is the consistency of the margins. If it declines, we will need to investigate and understand if its pricing power is being eroded.

This brings us to our next case study on Victoria Secret, also known as L Brands.

Declining margins almost always spells trouble

Victoria Secret used to be regarded as a premium brand. Since the late 1990s, Victoria’s Secret has been one of the best-known and most talked-about brands in the country.

Robert Cialdini aptly points out, a higher price truly can influence us psychologically into perceiving the product as more valuable. For premium brands such as Victoria Secret, Louis Vuitton, and Hermès, prices send a strong signal of value in the products.

For a business whose competitive advantage lies in its brand, the gross profit margin tells us whether its pricing power is intact. And here we can see that Victoria Secret heavily discount its products. In an attempt to clear its inventory. The gross profit margin declined rapidly from 43% to 34.5%.

The company’s competitive advantage (moat) has since been breached. A tarnished brand is difficult to rebuild. Its share price has seen shrunk from $74 to $15, an 80% decline.

Other times, a declining margin may suggest that the company is a price-taker. As the cost of goods increases, the company is unable to raise the prices and pass down the additional costs to consumers.

Making sense of revenue

The revenue is one of the most helpful figures in evaluating management’s growth plans. In the business section, management will inform you of information such as the number of stores and average square feet. As Ulta Beauty did.

Ulta has a total of 12,540,000 (10,000 sq feet x 1,254 stores). And they made $7.4b in revenue as stated in their 2019 annual report. That comes up to $590 per square feet made per year!

Measure this figure against past years. If revenue made per square feet has been rising, great! It means the company has more room for growth. If its declining, it may suggest that the company has over expanded.

I would also do this for premium brands. To measure if they are diluting the brand by lowering prices. For Ferrari, I would take revenue divided by the number of cars sold. If the average revenue per car is going down, that may be a red flag!

Growing gross profit per customer

Companies that are able to keep growing its gross profit per customer often signals a high-quality company. To achieve this, the company must have recurring revenue and the ability to scale (i.e. grow).

SaaS companies such as Adobe and Autodesk have been able to raise prices by delivering additional features to their software without a corresponding rise in the cost of goods. And the revenue is extremely sticky as consumers pay subscription fees to enjoy the functionalities.

For consumer staples, Starbucks has been able to enjoy this with its premium brand. They have been able to raise prices at a faster clip than the cost of goods. The revenue is stickier than other restaurants as coffee is a staple for some and often consumed daily. Starbucks has also been able to improve consumer loyalty with its membership program.

Steady Compounding Updates

Do let me know if this has been helpful or if there are any other topics you are interested in by commenting below!

The next section on understanding income statement would be on operating income. Where we will take into account other expenses such as depreciation, amortization, rental, marketing, and more!

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