The “Trader-Bro” market

I wonder if anyone has quantified the “Robinhood Effect”. Robinhood, as you may know, is a popular trading app that disrupted the online brokerage industry by offering $0 commissions on stock trades. This was huge. It made trading accessible to people with smaller sums of “play-money”. Consider this: Someone with $2,000 in play-money has just about $200 to spend on each stock on average – that is, if we assume he or she wants at least 10 stocks to diversify. Online brokerage firms used to charge $5-7 per trade. That’s 2.5%-3.5% of commission per trade for our friend. That’s a lot of money to the croupier.

Robinhood changed all that. But I wonder if it has a big effect on the market. Stocks of companies that are expected to grow at a fast and furious pace have shot through the roof. Tesla is obviously the posterchild of this phenomenon. I call it the “trader-bro” phenomenon. It’s all about the thesis: “I love the product, therefor I buy the stock; valuation shmaluation be damned!”

It looks and feels like the dot-com bubble of the 90s, when companies that made huge losses were trading at ridiculously high prices. We know how that movie ended. But hang on; there were a few hyped-up names from that era that actually made good on their promise. Amazon is the prime example (pun intended, sorry). It’s possible that there is some merit to this “trader-bro” thesis. Maybe 1 out of every 10 trader-bro stocks will go the Amazon way, and that’s good enough. It’s a Venture Capital approach to Public Equities, albeit with a much simpler “analysis”.

At The Buylyst, we believe in cash flows and valuation. We can’t shake off “old-school” principles such as “thou shall invest in profitable companies”. We spend a lot of time trying to estimate FUTURE cash flows or FUTURE profitability; we are less concerned with current cash flow. This has been an evolution in our process over the last couple of years. Why did we make a slight shift in our approach? Because most of our investment themes are in their nascent stages – like AI or Fintech. We don’t dismiss companies that are unprofitable today but show good promise of profitability in the near future. When I say, “good promise”, I mean a combination of Amount and Probability.

Probability is important. We need to be reasonably sure of future profitability. Obviously, this is a subjective call, so we can never be 100% sure. But if we can break down the company into its elements – like Price and Volume of goods sold – we can make educated assumptions. Now, we tend to do this type of prognostication for companies that dominate their field – what we call Global Dominators. We did it with Spotify. We did it with ASML. We did it with TSMC. For these Global Dominators, we ask ourselves, “what do we need to believe about future revenue growth to buy into this company today?”

Now, in this analysis we won’t break the companies down into price and volume of products. But we will go fairly deep in trying to answer the same question, asked in two parts:

1. What revenue growth is implied in the current stock price?
2. Can we believe in it?

Off the Charts

We’ve put together about 26 stocks, most of which we would classify as “trader-bro”. We’ve also added a few of our holdings – mostly for context but also to do a sanity check on them.

Here’s how some of these trader-bro names have done over the last 3 years:

Wish this was your portfolio over the last few years? Don’t we all? But let me assuage your regret. In hindsight, it’s all rosy. But if you’re investing in a company without a reasonable amount of insight into how they will be profitable, you’re gambling. Gambling is risky. But even gambles pay off occasionally. “I love the product, therefore I love the stock” is a gamble. “I love the product and can clearly see a path to profitability, therefore I love the stock” is investing. In the former case, you’ve got to be honest with yourself: you’re really betting on other people liking the stock as much as you do. That is speculation.

Here’s Uncle Warren on the topic of Investing vs. Speculation:

“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

We’re not saying that all trader-bro stocks are speculative. But many are, and to distinguish a blind gamble from a sensible bet takes some work. That’s why we work so hard.

Let me assuage any feelings of FOMO with one last insight from Uncle Warren (I’m paraphrasing): An error of Omission is better than an error of Commission. With the former, at least you don’t lose money.

Having said that, let’s try and estimate what we need to believe about these trader-bro stocks for us to pull the trigger. Should we commit?

Do you believe?

Let’s jump right into it. Here are our estimates of Revenue Growth that we need to believe about our Trader Bro portfolio:

The chart looks simple but it took a little bit of digging in – we made some assumptions about the future cost structures of these companies. But that’s a boring discussion, so I’ve left it for the last section. Feel free to dig in. Insights are more interesting.

You may use this chart however you wish but we’re using it for:

1. Possible investing ideas
2. Prioritization of our time
3. Doing a sanity check on our portfolio holdings.

Here are our top insights:

1. Let’s address the elephant in the room: Tesla looks ridiculously priced. But more on that below.
2. Gaming stocks still look reasonably priced, including our very own Electronic Arts.
3. Nvidia – which we’ve held since late 2018 – looks surprisingly expensive. We’ll need to revisit our valuation.
4. Netflix looks cheaper than Nvidia based on this measure!
5. Google is the most attractive “FAMANG”.
6. Qorvo (makes 5G and IoT components) looks attractive. We’ve been hesitant about them because of their China exposure. But this analysis prompts us to take another look.

Tesla has been a trader-bro favorite. I think there is some merit to the trader-bro thesis that they can dominate the EV market. Now, the last time I did some work on Tesla, it still looked too expensive. But I don’t regret not buying it – it’s not as if Tesla is selling a lot more cars suddenly. Their trailing 12-month revenue ending June 30^th, 2020, barely increased from the same time last year – from $24.9 billion to $25.7 billion. Granted, there’s a pandemic. But if you look at the stock chart, you wouldn’t think so. As I did last time, I would break Tesla down into Price and Volume in order to estimate future profitability. Our estimate today suggest that we need to factor in a 11X growth in revenue for us to buy in. But to believe that number, we’ll need to assume:

1. All cars will be electric in less than 10 years.
2. Tesla’s head-start in manufacturing EVs will remain intact – meaning VW, Toyota, Daimler or BMW won’t be able to catch up and produce EVs at the same scale. Hint: they already are.

But maybe Tesla doesn’t need 20-30% market share in order to grow revenue by 11X. We should dig in. Funnily enough, while the chart above screams “stay away from Tesla”, our curiosity has outmaneuvered our better senses.

But before Tesla, we’ll dig into the following:

1. A couple of Gaming companies that look attractively priced.
2. A review of our Nvidia valuation.

Digging in

As promised, we’ll delineate how we arrive at our “Believe” chart. You’ll find the raw data below, in case you want some light reading. :)

Here’s what we did:

1. Estimate the “intrinsic value” of the company that would make it attractive to us. We did that by tacking on 30% to the company’s current market value.
2. Back-solve into the Sustainable Free Cash Flow (SFCF) that would justify that valuation. If you’re a long-time reader of the The Buylyst, you know that we slap on a 20X multiple on SFCF to estimate intrinsic value. This time, we went backwards – we divided the market value from #1 by 20 to arrive at our SFCF.
3. Next, we asked ourselves – what level of Revenue would result in this SFCF? To do this, we had to make some cost-structure assumptions. 
   1. Assume that only Cost of Goods Sold are variable costs. In essence, we assume Gross Margin remains constant.
   2. All other operating costs assumed to be fixed costs.
   3. Assume similar amount of working capital tied up in the business as we saw in the last 12 months.
   4. Assume that Capital Expenditure will increase with revenue – in essence, we assumed the Capex as a % of Revenue remains constant. The rationale is that as the business grows, so does the need for upkeep and investments towards widening the economic moat.
   5. Deducted 20% from the cash flow waterfall to account for interest charges and cash taxes. This is a conservative assumption for some companies (like Google) that hardly have any debt. We made this 20% assumption because many companies don’t report cash paid for interest and taxes in a user-friendly way. Sure, interest and taxes show up in the Income Statement, but they’re not cash numbers. Thank you, US GAAP!
   6. The result of all of the above is Free Cash Flow.
4. Using the cost-structure assumption mentioned above, we back-solved in the level of revenue that would result in the desired SFCF. So, just to recap: 
   1. We back-solved into the “desired SFCF” using the estimate of “desired intrinsic value”, which is 30% above current market-cap.
   2. We back-solved into “desired revenue” from the “desired SFCF” using all the assumptions mentioned in point #3.

We believe our assumptions are reasonable. Here is a table with all our data:

We hope this exercise was useful to you while you wrestle with your feelings of FOMO. We all have it. But if history is any guide, FOMO can result in huge losses. Some of the brightest minds have suffered its consequences. In the 1700s, Sir Isaac Newton bought into the South Sea Bubble because of FOMO, and lost a massive amount of money. He concluded:

“I can calculate the movement of stars but not the madness of men!”

Many Happy Returns.