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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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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Operating leverage – how it caused Gamestop (GME) to plunge into the red
From the earlier post, we learned that not all growth is value-adding. Today, we are going to discuss an equally important concept – operating leverage. Not all sales growth has the same effect on profitability.
With these 2 articles, I wish to highlight to readers that sales growth, profit growth, and value creation are distinct. Growth in sales creates value only when a company earns a rate of return greater than its cost of capital. Furthermore, the percentage increase in profits may be vastly different than the increase in sales growth and vice versa as a result of operating leverage.
Operating leverage is a measurement of how an additional dollar of sales translates into operating profit. A 10% increase in sales may result in a 30% increase in net profits. Likewise, a 10% decline in sales may send a company’s share price earnings into oblivion. As we will see in Gamestop’s case study later.
How does operating leverage work?
Operating leverage is the most common in businesses which require a large amount of fixed assets investments. Theme parks are an example of a business with high operating leverage. Approximately 75% of their costs are fixed, with labor being the largest component. This means that if visitor numbers decline (i.e. sales), their operating profit will decline at a much larger magnitude.
Fixed costs are costs that a company must bear regardless of the sales level. For example, Starbucks must continue paying its rent, labor, and utilities regardless of the amount of coffee sold per store.
Variable costs are costs that are linked to the sales level. For Starbucks, this would be their coffee beans, whipped cream, etc. The more Frappuccinos they sell, the higher the amount of cost they would incur for the raw materials (i.e. coffee beans, etc).
The chart below from Credit Suisse illustrates nicely the impact on operating profit margin based on revenue changes and cost structure (fixed vs variable).
The concept of operating leverage is best explained with an example. ABC is a company with a higher operating leverage, 75% fixed expenses and 25% variable expenses. XYZ is a company with a lower operating leverage, 25% fixed expenses and 75% variable expenses.
Both of them are having sales of $10,000,000 and $8,000,000 in expenses. Giving them a profit of $2,000,000.
Assuming a 20% increase in sales from $10 million to $12 million would result in a proportional rise in variable expenses.
For ABC, variable cost would increase from $2 million to $2.4 million. And for XYZ, from $6 million to $7.2 million.
The fixed cost for ABC and XYZ would remain fixed at $6 million and $2 million respectively.
Net profits for ABC jumped 80% while XYZ’s increased by only 40%! This is operating leverage at work. For ABC, a larger proportion of their expenses are fixed. When expenses don’t grow as fast as sales, net profit will grow at a much higher rate.
Operating leverage cuts both ways. For a company with high operating leverage, a decline in sales would cause net profits to decline at a much larger magnitude as well.
When revenue declines by 20% to $8 million, variable cost would decline to $1.6 million and $4.8 million for ABC and XYZ respectively.
Net profits for ABC declined a whopping 80% while XYZ suffered a 40% decline. Fixed expenses still must be incurred when sales decline. When expenses do not decline as fast as sales, net profit will tumble at a much larger rate.
Case Study: GameStop Corp (NYSE: GME)
Errors in analyst forecasts tend to be larger in businesses that have high operating leverage. Likewise, investors are often caught by surprise when investing in businesses undergoing a secular decline that have high operating leverage. As the decline in sales inevitably resulted in a much larger decline in earnings (and share prices).
Briefly, GameStop (GME) is a video game retailer largely in the USA. With the internet, sales have plummeted as Amazon took up its market share and platforms such as Playstation and Xbox began selling digital games directly. Skipping a third-party retailer like GME altogether.
GME began to attract a lot of attention as ‘Big Short’ legend, Michael Burry, took a sizable stake in the company. The popular thesis was that the company has a ton of cash and a lot of value could be unlocked by GME repurchasing their shares. Creating a short squeeze on the short sellers (the stock was heavily shorted).
Many investors focused on the potential upside as Burry took a position. But many missed the important fact that a company in secular decline coupled with high operating leverage could be disastrous to earnings.
GameStop AR 2019
From their annual report, sales declined by 24%. However, it’s selling, general and administrative (SGA) expenses declined only 5%. This tells us that most of GME’s SGA expenses are fixed as reduced sales did not allow GME to save on SGA expenses. It still has to pay its employees and rent to run the business despite having fewer sales.
Adjusting for impairments, we are able to observe that operating earnings declined by a whopping 103%. From $453m to an operating loss of $14m. Despite only a 24% decline in revenue.
Likewise, investors who bought in 2017 at $25 were caught off guard with the sharp decline in earnings. The stock tumbled 80% as it lingers around $5 today.
GameStop Corp (GME) Stock Price Chart
Key lessons
Here I will summarize the key learning points I hope you can takeaway:
Operating leverage by itself is neither bad nor good.
It works both ways, a company with rising revenue could potentially see a much bigger increase in earnings and vice versa.
Companies with both high operating leverage and financial leverage will see greater swings in earnings.
Companies with high operating leverage and financial leverage are often the biggest gainers off a market bottom.
In the long run, all expenses are variable expenses.
This is a sequel to Getting Hurt Chasing Yields – Part 1. Apart from investing in instruments and companies that are unable to sustainably pay out interest and dividends based on their operating cash flow, investors are committing a mistake by solely focusing on investing for income.
Income investing means building a portfolio of interest or dividend-paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain their desired lifestyle.
Investors should not be fixated on chasing yields. Rather, they should focus on the maximum total return they can derive from their investments. Total return includes both income and capital gains.
“The best way to approach this is to invest for the highest total return you can achieve and sell whatever shares or units you need to provide cash. However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.”
Terry Smith, CEO of Fundsmith
When investors focus on income-producing stocks, most are focused on stocks that have a high dividend yield. Generally, this would be limited to companies that pay out most of its earnings as dividends such as REITs or mature companies such as Singtel and Comfortdelgro.
These companies do not retain most of their earnings for reinvestment. Largely because they are unable to reinvest at high returns. Cash generated by the business will have to be deployed at other places (e.g. acquisitions) or returned to owners (e.g. via dividends or share buybacks).
Investors focusing on dividend yield alone would miss out on the great compounders – companies that are able to reinvest at a high rate of returns. Instead of paying out a dividend, they would retain most of their earnings for reinvestment. Growing the intrinsic value of their businesses.
Let’s look at an example comparing two businesses and understand which yield a higher total return. The first company, Compounding Corporation. It has the ability to reinvest all of its retained earnings at high returns due to its strong reinvestment moat. As a company that grows at a high ROIC, the market assigns it a higher multiple, at 20x earnings.
The second company, Dividend Corporation. It is a mature and steady business that pays out good dividend yield and trades at 10x earnings.
Assume that, over time, both companies will be valued approximately in line with the market, at 15x earnings. In this case, Compounding Corporation will suffer a multiple derating, while Dividend Corporation will enjoy a multiple expansion.
Let’s observe which company would provide shareholders with higher total returns:
By focusing on companies that provide a high dividend yield, investors would miss out on companies like Compounding Corporation. Although income investing would provide a decent result. The opportunity cost of doing so is huge (total returns of ~700% against ~300%).
The desperate search for yield has led to a number of people choosing to invest in income funds, or in mature companies providing a high dividend yield. On the surface, it might sound sensible, but it is erroneous. It may lead to investors underestimating the risk of investing in high yield instruments. Moreover, what is less obvious is the opportunity cost of focusing on yield only, as opposed to the total returns of a company that is able to compound at a high clip.
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Figuring out a company’s intrinsic value with PE ratio
The price-earnings (P/E) multiple is one of the most popular tools which analysts use to value stocks. A company trading at 10x P/E implies that for every $1 in net income generated investors are willing to pay $10 or a 10% earnings yield.
Despite its popularity, it remains one of the most misused misunderstood metric. A share valued at 30x P/E might not be expensive relative to another stock trading at 15x PE. Likewise, a share trading at lower P/E today, when compared to its 10-year median P/E, does not imply that it is a bargain.
To apply this tool, we must first deconstruct the P/E ratio to better understand what goes in. The P/E ratio is a short-cut to arrive at the Discount Cash Flow valuation. The most sensible way to determine the worth of a business is to estimate the cash flows a business will generate for its owners over time, and then discount these cash flows back to their present value.
Hence, to figure out the intrinsic value we need to ask ourselves these questions:
How much free cash flow (FCF) will the business generate over its lifetime for shareholders?
Can the business grow?
What is the discount rate (i.e. required rate of return/cost of capital)?
In this post, we are going to focus on the relationship between – (1) the amount of cash flow the business generates and (2) its ability to grow this future stream of cash flow.
This brings us to the next question, Why is the cash flow available to shareholders different across companies? Two companies with the same amount of revenue and net income may well generate different levels of cash flow for shareholders.
This is because different companies require different amounts of reinvestment in their business for growth. The more a company needs to reinvest to achieve growth, the less the company retains for shareholders. And this variation is largely driven by the differences in the return on invested capital (ROIC) achieved.
ROIC’s impact on FCF & Growth
Consider two companies, Company A and Company B both generate $1 of earnings per share. Both companies aim to grow their earnings by 10% next year. It would require the companies to reinvest their earnings for expansion.
The key is understanding how much capital is required for each company to achieve a growth of 10% in earnings?
Suppose Company A is able to generate 60% ROIC (similar to a business like Mastercard). This means that every $1 invested in the business, results in a 60% growth in earnings. For it to grow its earnings by 10%, Company A would only need to reinvest 16.7% of this year’s profit. Since a 60% return on 16.7% of current earnings will create a 10% increase in profit. This means that Company A is able to distribute 83.3% of current year’s earnings, or 83.3 cents of the $1 in earnings back to shareholders, through dividends, share buybacks, or by reducing its debt.
On the other hand, Company B is only able to generate 12% ROIC (similar to the S&P 500’s average). To grow its earnings by 10%, it would need to reinvest 83.3% of its earnings. Since a 12% return on 83.3% of current earnings will create 10% more profit. This leaves only 16.7 cents of the $1 in earnings for Company B’s shareholders.
Here we can see that Company A’s ROIC is 5 times greater than Company B’s. To achieve the same growth of 10%, Company B needs to reinvest 5 times its earnings compared to Company A.
Essentially, this shows us that not every dollar of earnings is worth the same amount. Although both companies have the same earnings per share of $1 and generate 10% growth, they require different reinvestment rates. Thus, it boils down to the ROIC that a company is able to generate.
All else constant, a company with a higher ROIC should command a higher P/E multiple and vice versa. A company trading at 30x P/E and another company trading at 12x P/E could both be fair value.
We need to dig deeper into its ROIC and evaluate its sustainability.
Why growth may destroy value
Not all growth is good for shareholders. For growth to generate value for shareholders, its ROIC must be greater than its cost of capital.
The S&P 500 index has returned an average of approximately 10% since inception. Hence, we can consider using 10% as the cost of capital. When deciding whether or not to grow, management should evaluate whether the ROIC from reinvesting earnings could exceed 10%.
If ROIC is 8%, reinvesting for growth would reduce value for investors. Companies should choose to distribute out all its earnings to shareholders as the returns from reinvesting earnings fails to exceed the cost of capital of 10%.
The best way to think about this is to imagine a company borrowing at 10% interest rate and investing for 8% returns. Every dollar borrowed to invest for growth would result in a -2% returns for shareholders. While the cost of equity capital isn’t an interest expense, it is anopportunity costfor investors.
It is important to be aware of this. Even if companies have the same earnings per share and the same growth rate does not mean that they are worth the same P/E multiple. Because ROIC makes a huge difference to whether growth adds value, or destroys value.
How to think about the P/E ratio
In assessing the worth of a company using the P/E ratio, we must first consider whether the company is able to generate ROIC in excess of the cost of capital and growth second. Growth only creates value if the investments generate a return in excess of cost of capital.
For example, here is a quick and dirty way to evaluate Apple’s P/E ratio:
Apple’s Stock Price Chart
It has traded at P/E of below 10x two times over the past decade (points A and B). This is way below Apple’s average P/E ratio. Mr Market was essentially saying that Apple is unable to maintain its ROIC and was unlikely to grow further.
When compared with the broad market’s valuation (S&P 500). Apple was also below the market’s valuation P/E ratio of 17x during point A and 21x during point B. Mr Market was telling us that Apple’s ROIC and growth will be lower compared to the average American company.
Investors should then evaluate if the current P/E underestimates Apple’s ROIC and growth going forward.
In hindsight, Apple continued to generate a high ROIC of approximately 30% and grew its EPS at a CAGR of 11.13%. A rate far above the S&P 500’s ROIC of 12% but lower than Apple’s historical average ROIC of 40%. Apple should rightfully have suffered a P/E contraction. But Mr. Market over discounted Apple with its P/E collapsing below the average S&P 500 companies’ P/E multiple.
Mr. Market eventually corrected Apple’s P/E multiple. Investors who have been right on evaluating its ROIC and growth, and bought Apple when it was trading at P/E multiple of ~10x would generate handsome returns of approximately 600% in 7 years and more than 300% in 4 years if they bought in at points A and B respectively.
I also wish to share that I’m currently reading the updated version of the book Joys of Compounding by Gautam Baid. This book is highly recommended, and it is incredibly helpful in improving my thoughts about personal finance, investing, and life in general.
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Earnings season has kicked off this week and this gave us a glimpse into the damage COVID-19 has done on the economy. While it was obvious in Mar 2020 that earnings for companies directly caught in this crisis such as tourism and restaurants would be obliterated, quarterly reports from digital companies have displayed a certain level of earnings resilience on top of their fortress-like balance sheet.
“I’ve always believed that in times of economic downturn the right thing to do is keep investing in building the future.“
Mark Zuckerberg
Earnings update
Revenue for Q1 grew 17% YOY to $17.4 billion. The company experienced a strong start to the quarter but saw a drop in advertisement revenue in Mar. The decline has since stabilized and Facebook has guided that Apr 2020 revenue would be flat compared to the same period a year ago.
During this period, there was a strong growth in the gaming and eCommerce advertisement demand. This offsets the significant declines in travel and auto, as these industries were hit the hardest. The increase in sales was largely due to increased engagement at lower ad prices.
Impact of COVID-19 on Facebook
Increased engagement due to shelter-in-place measures but some of this increased engagement will be lost once measures are relaxed in the future. Engagement increased by ~10% YOY across all measurements, compared to ~7% in the previous period. Demonstrating Facebook’s attractiveness as a platform for users to connect with their friends and family.
COVID-19 has accelerated pre-existing long-term trends, dramatically increasing online private social communication.
Zuckerberg emphasized that ensuring that Facebook’s services are stable and reliable is a top priority. It is important to appreciate the platform’s ability to scale up to the sudden spike in usage because of the company’s significant investments in infrastructure over the past 4 years.
The quality that I look for in managements is the “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.
Tom Russo
Facebook has indeed backed up their claims, by constantly outspending their depreciation charges to invest for growth. Their CAPEX/Depreciation ratio has constantly exceeded 1 and we can observe that from 2016 to 2019, they have ramped up capital expenditures (CAPEX) on building data centers.
Excerpt taken from 2019 Annual Report
To put these numbers into perspective, Twitter, Snapchat, and Pinterest collectively spent $2.2 billion in CAPEX for the past 5 years. While Facebook spent $15.1 billion in 2019 alone.
The company has highlighted that it will continue to spend aggressively on CAPEX as they seek to expand their footprint. Management has guided for CAPEX spending to be between $14 – $16 billion in 2020.
Facebook’s ability to invest for the long run, at the cost of short term results is remarkable. Or in Tom Russo’s words – a company’s capacity to suffer. And this is largely due to two factors:
Founder led company with Zuckerberg as the controlling shareholder.
Strong margins
In Q1’20 earnings call, Zuckerberg puts it across best: “This economic pullback has certainly reinforced for me the importance of maintaining high margins. Our financial position has allowed us to continue investing in building products and making investments.”
Plans for growth
Facebook has taken a pivot into regulating the platform and limiting the spread of misinformation amidst COVID-19. This includes working with health officials and governments in delivering critical information to its users. And rebranding itself as a reliable source to obtain information.
This shutdown also highlighted the importance of allowing users to connect via video. And they have rapidly announced product improvements around video communications presence in 3 categories – video calling, video rooms, and live video.
Facebook is also targeting a share of the eCommerce pie, from competitors like Amazon and Shopify. By allowing businesses to establish a virtual store within their apps and for customers to buy directly from Facebook & Instagram platform.
Setting up a website is expensive and challenging for many SMEs, especially on such short notice due to the shutdown. In Singapore, we have seen many F&B businesses set up a Facebook page to reach out to their customers.
One of Facebook’s biggest investment is their partnership with Jio Platforms in India. Facebook invested $5.7 billion into this deal since India is the largest user base for Facebook and Whatsapp. They seek to bring together its apps with JioMart in targeting SMEs and create a better shopping experience.
In summary, Facebook is seen to be proactive in upgrading itself in their reaction to this crisis as we observed that years of digitalization progress has been compressed into 2 months for most companies. And Facebook is continuously investing to capture market share by making themselves a reliable platform for people to connect, and for business to reach out to their customers.
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At the peak of pessimism between Feb to Mar 2020, many investors were worried about the headlines on how COVID-19 will destroy the economy. During times of great uncertainty, the market tanked at a neck-breaking pace. Dropping more than 33% in about 30 days, freezing many investors on their track.
“The present value of the stream of cash that’s going to be generated by any financial asset between now and doomsday.”
Warren E. Buffett on valuing a business
Impact on intrinsic value
It is important to understand that the intrinsic value of a business is the present value of all the cash generated over its lifetime. And most would agree that COVID-19 would be a temporary event. It would be silly to sell your stocks or to hold on to your investable cash because this year’s earnings would show a drastic decline due to COVID-19 induced shutdown.
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%. However, we have seen many stocks crashed more than 30%.
For those who love numbers, you may check out the DCF illustrationhere.
In this example, we will assume that the market has earnings of $12 per share with a discount rate of 4% and a multiple of 25x (4%) as the residual value.
Based on this illustration, if a company has no earnings for 3 months, its intrinsic value should be impaired by less than 1%. And in the worst-case scenario of 4 years of no earnings, the intrinsic value should suffer by less than 15%. However, by Mar 2020 we have seen most stocks decline between 30% to 60% even for high-quality companies. In other words, Mr. Market went into a manic depressive mode and assumed that most businesses will have no earnings for more than 4 years.
If we believe that COVID-19 is going to cause a temporary dent to companies’ earnings, then Mr. Market definitely has served up some compelling bargains. Beyond my usual requirements, additional questions I focus on during this period would be:
Is the company’s future earning power going to be permanently affected?
As investors, we have to train ourselves to cut through the noise and focus on what is important. The media and headlines are written to capture readership and would more often than not, cloud our judgment. While these are legitimate concerns, here are some of the common reasons that kept investors from investing during the decline:
The Shiller-PE ratio isn’t historically low yet
We have not seen the bottom yet
Unemployment rates are at a historical high
Airlines are going bankrupt
US debt level is exploding
Interest rate is too low
Oil prices are tanking
And many more..
“I don’t think about the macro stuff. You know, I just – the important – what you really want to do in investments is figure out what’s important and knowable. If it’s unimportant or unknowable, you forget about it. What you talk about is important but, in my view, it is not knowable.“
Warren E. Buffett
I think it pays a lot for investors to remember this diagram when it comes to investing. And in this situation, the only things that matter is whether the company can survive and whether they will emerge stronger. What we can control is to invest in high-quality companies and ensure that we have sufficient emergency funds to tie us through this period.
To end off, here is an interview by Yahoo Finance around Feb 2020 with Warren Buffett on how he approach COVID-19, oil prices and politics. Enjoy!
How Ferrari delivered outsized returns for investors with its economic moat
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle,”
Warren E. Buffett
An economic moat is a term popularized by Warren Buffett, as he drew references to how business is like a castle, and having a strong moat is essential to deter invaders. Buffett invests in businesses that have a sustainable competitive advantage to protect themselves against competitors eyeing a slice of the market share.
Why should investors care about a company’s economic moat? The answer can be explained by the economic theory, mean reversion. Most of the time, investors & forecasters have a tendency to extrapolate the current trend. Companies that previously generated high growth are forecasted to continuously generate a high return and vice versa.
In reality, high returns will likely revert to the mean. Mean reversion is like gravity to returns on capital. An industry becomes attractive when incumbents generate high-returns on capital, enticing competitors to enter. New entrants will compete for market share, driving returns down for the incumbents.
Without a strong economic moat, high returns on capital would not be sustainable. Familiar examples that illustrate this trend in Singapore would be bubble tea, yogurt ice cream, poke/acai bowl, fried salted egg chips, etc.. you get the point. Without a moat, the success of these trendy concepts will attract competitors to pop up and reduce the incumbents’ profitability.
The outliers
That being said, there are companies that have defied mean reversion and continued to generate high returns on capital (in excess of 20%) for investors throughout the years. Some examples that spring to mind include Hermès, Costco, Facebook, Coca-Cola, and Illumina.
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Warren E. Buffett
A company’s moat is either expanding or declining, it never stays stagnant. As investors, it is our job to determine if the business has a sustainable moat and evaluate if management continues to invest in growing the moat. Popularized by Pat Dorsey, moats can be classified into the following categories: (1) Strong brands, (2) Patents or licenses, (3) Network effect, (4) Low-cost producer, and (5) High switching cost.
A strong brand name
“It’s not Christmas or New Year until you see Coca-Cola ads.” Or so the saying goes. Occupying a share of consumer minds is no easy feat. Brands such as Coca-Cola, Ferrari, Hermes, and Tiffany & Co brands have been extremely successful in occupying a share of our minds, allowing them to earn a much higher return than their competitors.
At the risk of this article becoming too long, we will discuss 1 of the 5 moats in this writing. Specifically, Ferarri (ticker: RACE) and how its strong branding has allowed investors to generate outsized returns over the years.
The birth of automobiles
Ever since the first introduction of cars in 1886, more than 2,000 carmakers have attempted to penetrate the market and most of them have ceased to exist. The automobile industry is notoriously competitive and capital intensive, companies often have to rely heavily on debt. Furthermore, it is also an extremely cyclical industry, where demand will taper off sharply (especially during times like these) as consumers will defer the decision to purchase a new vehicle when times are tough.
As a result, most carmakers have lumpy earnings and many generate negative Free Cash Flow (FCF). Making survival in this industry very challenging. As an example, General Motors (GM) generated a cumulative negative FCF of -$50.9billionover the last 5 years. And they have made up for this shortfall by aggressively piling on debt to survive.
“What you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million now (the year 2001). So it’s easy to figure out the losers, the loser is the horse. But the winner is the auto overall. 2000 companies (carmakers) just about failed.“
Warren E. Buffett
The bright red car
Amidst the pack of car markers, Ferrari has the ability to charge astronomical prices for their vehicles. The power of the Ferrari brand is clearly evident here in Singapore. Despite our stringent speed limits and countless traffic lights, drivers still own Ferrari because the brand signifies wealth and affluence.
Ferrari’s moat allows it to earn outsized returns against other carmakers. The company has consistently commanded an average of 50% gross margins, while its competitors languish at an average of 15% gross margins.
In other words, the car which costs $50,000 to make can be sold at $100,000 for Ferrari. Its competitors, on the other hand, produce cars at the same cost of $50,000 but are only able to charge $59,000.
The fat margin leaves a lot of room for Ferrari to invest in widening its moat (e.g. invest in R&D and marketing) or to reward its shareholders.
Taking a look at their pricing power, Ferrari is able to command € 381,474 (SGD 588,000) per car on average. Competitors such as Ford and GM are only able to charge a fraction at $25,000 (SGD 35,600) and $16,000 (SGD 22,800) per car on average respectively.
Ferrari’s Cars Sold and Revenue per car
During the 2008-09 global financial crisis, we saw the United States’ new car sales plummeted by 40%, sending GM and Chrysler into bankruptcy while Ford had to take a substantial loan from the government to stay afloat.
Car sales fell across the board for most carmakers, except for the company that made the bright red car. Despite the industry buckling down, Ferrari managed to see a 26% jump in the U.S. with its vehicles sold increasing to 6,587 in 2008, an increase of 122 from the previous year. And during 2019, it only saw a 1% decline in revenue.
The brand of Ferrari is so strong that its revenue growth continues to stay resilient through crises such as the 2008-09 financial crisis, Europe debt crisis, and trade war.
It targets the ultra-rich, and the company produces a limited number of cars each year. The long waiting list of up to 2 years, created a real sense of exclusivity for customers who can get hold of one. Even if customers have the cash to purchase a new vehicle, there is a limited quantity. This discourages those on the waiting list from withdrawing their orders even during bad times. And even if they do drop out, there is a long list of customers to take up their spot!
The moat surrounded Ferrari has proven to benefit investors immensely. Since its spin-off in 2016, it has delivered a CAGR of 37.3%, delivering a 400% return prior to Covid-19 within a short span of 4 years. Comparing this result with Ford, GM, or even the S&P 500, Ferrari has generated astounding returns for its investors.
To sum it up, having a strong brand that occupies a large share of consumer’s minds is a great moat, enabling companies to sustainably generate high returns on capital. As investors of quality compounders, we need to monitor if management is engaging in activities that widen the moat. Such as spending on marketing, increasing customers’ satisfaction, etc.
“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
– Sir John Templeton
For the past two months, since Feb 2020, the S&P has been trading like a penny stock, making extremely volatile movements of more than 5% on many trading days. It took only 6 days for it to reach correction (a decline of 10%) and 16 days to become a bear market (a decline of 20%). It was one of the fastest drawdowns in the market ever since.
The upswing was as intense as the downswing, with the market rebounding 28.5% since its bottom on 23 Mar 2020.
“In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.“
– Charlie T. Munger
A look at previous crises
Historically, we experience a 10% market drop every 2 years. Since the 1950s, stocks have fallen 20% or more only 11 times (about once every 6 years). Including now, a decline of 30% or more has only happened 6 times; an opportunity that happens once every 12 years.
“The time to buy is when there’s blood in the streets.”
Investors should always expect the market to move up, down or sideways. We should not be surprised when the market has a sharp drawdown. However, when something this drastic happens, it will freeze most investors. Some of the most common statements I hear amidst this Covid-19 induced downturn include:
I may be catching a falling knife
Unemployment claims have never been so high before, there is too much uncertainty
Globally, the number of infected cases is still rising exponentially and we don’t see anyone travelling or dining out soon
These are all legitimate concerns, but in investing you either get a cheap valuation or a rosy outlook; you will never have both at the same time. You pay a very high price in the market for a cheery consensus. The important question investors should be concerned about is,
“Which companies will survive and do even better coming out from this crisis?”
Someone once said that the best time to buy is when your stomach starts to churn. And it is important for us to prepare a watchlist of high-quality companies so that we may take advantage of the downturn. As Howard Marks put it best in his recent memo: “The most important thing is to be ready to and take advantage of declines.”
The market has emerged higher from every crisis
Covid-19 is going to leave a mark, but it is going to come and go. If history is a good indicator, the stock market will increase over time as corporate profits rise. Despite ‘unthinkable’ disasters happening, America’s markets have displayed their resilience and it would be unlikely that Covid-19 will destroy their economic engine permanently.
As the saying goes, this too shall pass.
On average, US corporate profits rise 8% annually. But bear in mind that companies do not increase profits on a straight-line. There will be down years and up years, and what’s most important that we understand our companies to have the conviction to hold through downtimes.
Equally important is that we must not invest in cash that we need within the next 5 to 10 years and we must not invest our emergency savings. The market sometimes can stay irrational longer than you can stay solvent.
What do I do during a crisis?
I buy.
More specifically, I buy companies on my watch-list in tranches. There is no rule to this and I deploy my available funds based on probability of these events happening:
20% market decline: Likelihood of occurrence is 15%, I will deploy 50% of my available funds at this stage
30% market decline: Likelihood of occurrence is 8%, I will deploy 30% of my remaining funds at this stage
>40% market decline: It has only happened 3 times since 1950, I will be fully invested by this point.
Apart from deploying my available cash, I would also be selling lower-quality stocks in my portfolio and buying high-quality companies as the market throws them out. High-quality growth companies and cheap/ reasonable valuations seldom come hand-in-hand. And when the market gives the opportunity to be an owner of these companies, pounce on them!
As you sell your companies to buy high-quality companies in a downturn, it will inevitably be painful as you will likely have sold it at a discount. In moments like these, it is helpful to remember Warren Buffett’s saying:
“I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day. The first rule is that nobody goes home after the first race, and the second rule is that you don’t have to make it back the way you lost it.“ – Warren E. Buffett
To sum it up, markets will go up in the long run and during a crash, there will be a lot of commentators predicting what will happen next. The most important thing is to have a watch-list beforehand and follow your game plan as the market provides you with opportunities to own great companies. Never invest in cash you would need in the next 5 to 10 years, you must stay in the game for this to work.
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I started my investing journey around 14 years ago, after reading Rich Dad, Poor Dad. The idea of acquiring income-producing assets resonated and I have since started consuming books after books and resources on the web regarding investing. Today, I focus mainly on growing companies with a wide moat and great management in place.
Looking back on my investing journey, I first started out using a mix of fundamental and technical analysis. I was thrilled when I saw gains of 30% to 50% within a short time frame of 6 to 12 months. It got me to dive deeper into the subject and I subsequently learned about deep value investing, buying companies so cheap, that I could make 30% to 50% if the company was liquidated.
However, those were one-off returns and I was lucky that some of my early investments turned out okay.
Technical analysis paints a nice story as to why the share price moved up, down or consolidate (sideways). It is impossible to be consistently right on the patterns and I find myself questioning “What does historical price movement has got to do with the future and is it reflective of business fundamentals?”
Deep value investing, otherwise also known as cigar-butt style investing is as its name sounds, it gives you one last puff. Once the stock revalues upwards, it will be sold off and we will have to hunt for the next idea. Deep value stocks are often cheap for a very good reason. Usually, they are either facing structural decline or they are in a cyclical industry. Both of which could be adverse to your wallet. And nobody knows when the stock will revalue, waiting for the stock revaluation is like watching the paint dry.
In order for me to build up wealth, I switch my approach to looking for companies with a wide moat and can continuously reinvest its earnings at a high clip. The book 100 Baggers by Chris Mayer illustrate this approach the best, quality companies that have a long runway are able to continuously reinvest for growth.
This brings me to the 2 basic rules of compounding:
The longer you let it work, the bigger its impact – time, not rate of return, is the most important factor in the compounding formula
If you lose big money even a few times in your compounding journey, you will not receive its benefits, even in the long run (Google Long-Term Capital Management for example.)
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
Warren Buffett
With that in mind, the following are the list of filters I learnt and apply over the years to steadily compound my wealth:
1. Do I understand the business?
Value investing require us to be able to reasonably assess the intrinsic value of a company. Companies with complicated business models or accounts would go straight into the “too hard” pile. As Warren Buffett puts it “I don’t look to jump over 7-foot bars: I look around for 1-foot bars I can step over.”
There are plenty of companies with a simple business model which has generated above-market returns over the years. Names like Starbucks, Google and Monster Beverage should be familiar to many and easily understood.
2. Does the company have a wide moat?
Moats are what protects the company’s profits from its competitors and wide moats enable a company to generate a high return on capital. A company’s moat is either widening or narrowing. Here I am looking for companies who are continuously investing to widen the moat and focus on the long term outlook of the company.
Companies such as Amazon and Monster beverage have delivered >100x returns for their shareholders as they were willing to sacrifice short-term results and focus on widening their moat.
3. Is the company able to reinvest at high returns?
I prefer companies that do not issue dividends and is able to sustainably reinvest its earnings at above 15% returns. For compounding to work its magic, the company should have a long runway for growth. I look for companies whose revenue are small relative to the potential market.
For example, Facebook currently captures approximately 20% of the global digital advertising market and the digital market is expected to grow 12% per annum over the next 5 years.
4. Does the company generate high Free Cash Flow?
Not all earnings are created equal. Charlie Munger once joked about his friend John Anderson’s construction equipment business at Berkshire’s AGM. The company makes 12% return on capital yearly, shows a profit every year but there is never any cash. The profits are all the metals sitting in the yard. In order to keep going, the cash is constantly ploughed back into the business and there’s neither growth nor cash for the shareholders.
I look for companies that are able to generate high Return on Tangible Assets (ROTA) of at least 20%. A company that shows high ROTA is able to bring in income with relatively little assets.
In Warren Buffet’s 2019 shareholder letter, he highlighted that the companies Berkshire owns typically earn more than 20% on the net tangible equity required to run their businesses without employing excessive levels of debt.
5. Competent and Shareholder Friendly Management
“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without [integrity], you really want them to be dumb and lazy.”
Warren Buffett
Here I am looking for management who are great capital allocators, open communicators and preferably with significant skin in the game. Judging management is really more of an art than science, here are some key indicators I look out for:
Ownership – Do the executives & directors have a stake? For this I look at the portion of net worth the management has that is tied up to the company’s stock. The classic example is Warren Buffett with more than 90% of his net worth in Berkshire Hathaway!
Insider Trading – As Peter Lynch says, insider buys only if they feel that the stock price is going to increase!
Remuneration – Is there an agency problem? Is management excessively remunerated compared to net income of the company and is it exorbitant compared to competitors? I will also look at their remuneration structure, are they compensated for long-term capital allocation skills or short term results (e.g. next year’s EPS growth)?
Capital Allocation – Based on their past records, have they generated at least a dollar for every dollar retained in the business?
Related Party Transactions – Red flag that warrants further investigation if its a significant percentage.
Shareholder Letters – Are they frank in their annual letter to shareholders, highlighting both success and failures. I regard Warren Buffett from Berkshire and Ronnie Chan from Hang Lung as the gold standard in this area.
As minority shareholders, we are passive in deciding how a company is managed and run. Here, we must select competent management with a demonstrated interest for shareholders to generate positive returns for us as shareholders.
While not perfect, this investment framework has helped me pick up high quality companies over the year that would compound my wealth steadily. As Peter Lynch says “In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”
P.S. Below is an advert on Wall Street Journal posted by Warren Buffett back in 1986 which outlines his filter for investments. Enjoy!
