Investing is a form of time travel. Investors know the past and the present but need to imagine the future. This isn’t a wishy-washy meta concept. It’s tangible. The value of any asset – what it’s worth – is the sum-total of the usability of the asset over its lifetime. In the case of investing, the usability is measured by cash flow. The value of an investable asset, therefore, is the sum-total of all the cash flows that asset will generate in the future, discounted of course. This applies to both stocks and bonds. It also applies to other assets like Real Estate. If you think about it applies to almost everything we buy. We don’t do math, explicitly, when we buy most things. But we usually have a “feeling” of the value of any object. When we pay a price for it, we usually pay no more than what we think is fair.
I apologize in advance – I’ll get into a bit of a Financy discussion here. But it's important to set the stage.
In the investing world, things get a bit more mathematical (although there are many investors who invest just with their “gut feeling”). In bonds, the math is straightforward. Bonds pay coupons, usually every 6 months, over the life of the bond. The coupons are known in advance – they’re contractual. The final payoff is known and contractual – it’s usually the principal amount. So, bond investors expect to get paid interest every 6 months, and then also get their money back at the end of the term. The final yield on the bond is the rate used to discount back all these known quantities. Easy math, except that there is the issue of Risk. In bonds, the main risk is this: not getting your money back, either partially or entirely. To compensate for that risk, the company or government entity issuing the bond pays a regular coupon (interest rate) and, based on the term of the bond, offers an implied yield. For example, in 2017 Netflix issued a $1.6 billion tranche of 4.875% Senior Notes that pays a coupon of, well, 4.875% split over two payments every year until 2028. This is a known fact. If Netflix doesn’t go belly up, it will repay the principal on that bond in 2028, or sooner if it refinances that tranche.
Stocks are a different beast. They’re riskier because other than current price, nothing else is known. Sometimes a dividend is sort of known. But even that’s not guaranteed – case in point: GE. Everything else – future revenue, earnings, cash flow etc. – are impossible to know. They can be estimated, or guesstimated based on historical numbers, expectations of the future of the industry in which the company operates, and hints we get from the company’s management in quarterly earnings calls. There is always a risk that the company can go kaput AND there is the issue of unpredictability if it doesn’t go belly up. Academics and the Wall Street crowd call this earnings volatility. So, to keep it simple, stocks have more layers of risk than bonds.
This same group of people – Academics and Wall-Street – uses math to adjust for these extra layers of risk in stocks. They normally do it in the discount rate. They guesstimate future cash flows (or in some cases earnings, which is an accounting number not firmly grounded in reality) over the next few years and into eternity and then discount that cash flow back to the “present value”. Discount rates have 3 main components:
- Inflation: The value of money decreases over time.
- Cost of Debt: Most companies borrow money, and so interest must be paid.
- Cost of Equity: A mathematical calculation of a proxy for stock-specific risk. This is supposed to take care of those things like unpredictability of cash flows.
So, back to the numerator: guesstimates of cash flows. You can visualize that the way the math works out is that higher the numerator, the higher the value of the firm. We know the cash flows over the last 12 months or the last few years. Those are facts. To guesstimate, analysts assume some growth rates which they attach to the historical numbers. These growth rate assumptions are a major (mathematical) driver of stock price calculations. These assumptions are a big deal. How big, you ask? One of my former professors – Jeffrey Williams – had quantified it many years ago:
“Seventy percent of a company’s value is determined by efforts in place to refresh ageing products. The company’s price/earnings ratio is a measure of this: the degree to which current earnings are multiplied by the expectations that earnings can be sustained and improved.” – Jeffrey Williams, Renewable Advantage.
When he says “…expectations that earnings can be sustained or improved”, he’s talking about growth assumptions. 70% of a firm’s calculated value is based on that. This is, of course, an average number over many companies, and the study is outdated. But the way this discounted cash flow models work, mathematically 70% is probably pretty close to the real number even today.
The P/E Ratio
Professor Williams mentioned the P/E Ratio. I’m sure you’ve heard of it, or have even used it as a criterion for selecting investments. The numerator is Price (of the stock) and the denominator is Earnings-per-Share (EPS). I’m not going to get into why EPS is a bogus number, but I’ll just let Mr. Buffett clear the air for now:
“Buffett considers earnings per share a smoke screen…To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.” – from The Warren Buffett Way by Robert Hagstrom.
But many people, including professional investors, still use P/E ratios. A low number is good, which implies that you’re getting a good deal, theoretically. But there are “growth investors”, who don’t care about how high P/E ratios can go. Why is that? What separates a high P/E ratio from a low P/E ratio? Why is Google trading at approximately 40X EPS while Apple is at 13X? That’s what Williams is talking about. Most of that difference represents Mr. Market’s differing views of growth expectations. It’s safe to say the Mr. Market expects Google to grow a lot faster than Apple.
A P/E ratio of 15X means that you’re paying 15X the company’s last-12-months-profit, mathematically speaking. Does that mean that you expect the company to keep churning out profits after 15 years? Well, yes, I hope so. But that’s not the calculation. As an investor, you’d expect earnings to fluctuate from the current level (over the last 12 months). They will either grow or decline. They are almost certain to fluctuate.
When pegging a P/E ratio to a company – determining that “XYZ stock trading at, say, 15X is a good deal”, investors are thinking about 2 variables above all:
- How much will a company’s earnings grow and how fast?
- How volatile will be this earnings stream be?
4 Flavors of Growth
There are 4 main varieties of growth stories that we see amongst the menu of investable companies:
- Massive Profit, No expectations of Growth:The company has reached “peak earnings”, and earnings will barely keep up with inflation in the future.
- Massive Profit, expectations of Moderate Growth:As an investor you may expect the next few years to be especially good for a company in, say, the Renewable Energy industry. You may factor in a higher growth rate than is historically evident.
- Massive Profit, expectations of Massive Growth:This is the Holy Grail of equity investments. These types of companies are rare – companies that have demonstrated that they can actually turn in a decent profit but are also on a path towards greater profits. The best example I can think of is probably Google. That’s because they’ve demonstrated that they can turn a massive profit from their Advertising business, but their expertise in AI in several tangential industries can justify rosy projections of growth from this point onwards.
- No Profit, expectations of Massive Growth: These are the growth stories that everyone loves to talk about. These are what I call the “trader-bro” stocks, like Amazon 10 years ago, or Netflix 5 years ago. A lot of people take credit for “calling it” because these stocks shot up, but don’t be fooled. They may have been right that Amazon will dominate e-commerce but that’s not their main cash cow - AWS is. Netflix has yet to generate cash. This variety is almost purely speculative.
I’ve left out this particular variety: No Profit, No Growth. Needless to say, if that’s what you expect, then it’s best to stay away.
Growth of Growth
Remember high-school calculus? Remember the Second Derivative. Lately, you may have read several reports about the “slowdown of growth” in Cloud Computing. Here’s one. This is second-layer thinking. People try to guess whether growth will accelerate or decelerate. Investors and traders look for signs of an inflection point, so they can get in or get out before most of the market. If growth is decelerating, a math student may say that the second-derivative of the profit function is negative.
This factors into the issue of unpredictability I had brought up earlier. Earnings go up and down. And that makes investors nervous. The more it swings, the lower the P/E ratio of the stock is likely to be, ceteris paribus. This is best explained using an example.
Micron generated almost $10 billion in free cash flow in 2018. Even if we use the flawed measure of profitability – earnings – it generated $14 billion. In contrast, Amazon generated about $10 billon. Micron trades at 3X earnings; Amazon trades about 80X earnings. That’s the effect of growth expectations. Why such a stark contrast?
Micron makes memory chips, which has traditionally been a very cyclical industry. Earnings have been volatile. And in such industries, profit can vanish quickly. Investors remember the last downturn in 2016. In cases like Micron, investor watch for inflection points with bated breath. They look for signs of growth in growth or slowdown in growth. And if they see one, either greed or fear takes over. Investors expect another 2016-type event to occur. And therefore, most of them will refuse to attach a higher multiple to Micron’s earnings, which are even more than one of the most storied American companies, Amazon! Just a few weeks ago, Micron released its quarterly earnings. They generated record profits. But the market punished the stock for it. Why? Because Management said that the company will not grow as fast in the first half of 2019 as it did in 2018. I can imagine a “trader-bro” panicking while pounding on the “Sell” button.
If you’ve been a frequent reader of The Buylyst, you’ll know that I strongly disagree with the market’s assessment of Micron. My main disagreement is with earnings volatility. I think Micron’s earnings (I prefer Free Cash Flow) will be much more stable going forward.
Does The Buylyst invest in Growth Stories?
Let me go back to the 4 flavors of Growth:
- Massive Profit, No expectations of Growth.
- Massive Profit, expectations of Moderate Growth.
- Massive Profit, expectations of Massive Growth.
- No Profit, expectations of Massive Growth.
At this point I should introduce a major point of difference: There is a gap between OUR expectations of growth and the MARKET’S expectation of growth. If there is a big gap between these two opinions, and my thesis proves out to be correct, that’s where I make the most money.
Let me get #4 out of the way. #4 is almost always a no-no for The Buylyst, whether categorized based on OUR expectations or MARKET expectations. If a company can’t generate cash flow and keeps promising that one day it will, I usually pass. That’s pure speculation. In some cases, I may make an exception. Those exceptions will be made for truly exceptional companies – ones that dominate what they do, with no signs of any credible competition in the near future. You’re probably thinking about Netflix but I’m a little reticent to dig into them because competition will almost certainly heat up. Usually, with these types of companies I take Charlie Munger’s advice: “Invert, always invert”. I ask myself the question: “how much growth do I need to assume to justify paying the current price for this no-profit company?”. In most cases, the answer I’m left with is: too much. In the case of Netflix and most others of the #4 variety, MARKET expectations of growth outstrip OUR expectations of growth. However, one example of an exceptional story that fits profile #4 is Twilio. They facilitate the back-end code and infrastructure for sending event-based text messages and emails sent by retailers across the US and the world. They recently acquired Sendgrid, which used to dominate such event-triggered emails. Together they make a formidable force with minimal competition. But they hardly generate any profit or cash. I’d have to factor in a massive growth rate to justify the price. I am very curious to find out.
That leaves #1, #2 and #3. The Buylyst invests mostly in companies that fit profile #2 or #3 according to OUR expectations. We expect these companies to grow – either modestly or massively – but we try to find them at cheap prices. Said another way: we invest in companies that generate a ton of cash and are expected to generate much more, but we’d rather not pay for that growth. That’s our way of incorporating Margin of Safety. These companies are hard to find. Based on MARKET expectations, these companies usually fit #1 or #2. It’s not too hard to back out the market’s assumptions from the current price of the stock. It just needs some accounting and valuation know-how. If you don’t have the inclination to learn them (I don’t blame you), no worries – it’s part of the service at The Buylyst. We do the work, so you don’t have to.
Examples of OUR #2 but MARKET #1 are IBM and Micron. In fact, in those cases the market expects their cash flow and profits to decline. I don’t. I expect them to be able to at least maintain the profitability they’ve shown over the last 12 months. An example of OUR #3 but MARKET #2 is Xilinx. When I first rated the company as a “buy”, I factored in some growth from the last-12-months numbers at that point. That story worked out the way I had expected. But that growth rate to a “sustainable level” of free cash flow wasn’t a blind assumption. It was based on The Buylyst worldviews on AI and Big Data. And this brings me to my last point.
The Growth vs. Value Investing debate
Investors often get boxed (or box themselves) into a particular “style” of investing. Two popular ones are “Growth Investing” and “Value Investing”. Most Investment Consultants and Advisors will have you believe that those 2 styles are mutually exclusive. Apparently, you can’t be a Value investor that invests in Growth stories. I take great issue with this rigid categorization.
The Buylyst looks for value, as any investor does. But we don’t look for speculative bets like profile #4. We look for calculated bets. We like companies that we think will grow but we don’t want to overpay for them. That’s our main risk management tool – don’t pay too much. If that puts us in the “Value” bucket, then so be it. But traditionally, the “value” style has been reserved for investors who buy very low P/E companies, maybe ones that even pay a dividend. In fact, if you dig through the factsheets of these “Value” ETFs, you’ll notice that two of the main defining characteristics are stocks with Low P/E ratios and/or High Dividend stocks. These are just accounting numbers that don’t get into the heart of the matter: is this company going to remain steady, grow modestly or grow massively?
By the Fund Management industry’s standards, The Buylyst would not fit the bill of a “value investor”. We don’t care about P/E ratios and dividends. But we don’t fit into their criteria of Growth Investors either. We don’t invest in #4 companies. We don’t look for numbers like Forward Year One EPS growth. We care deeply about the price we’re paying. And because we’re adherents of Intelligent Investing, advisors and consultants might get confused: Are they Growth or are they Value? To alleviate that, here’s what The Buylyst looks for:
A. Companies that are playing the right sport. We don’t want to invest in companies that are champions in structurally declining industries.
B. Companies that generate a lot of cash.
C. Companies that have low debt.
D. Companies that have high ROE.
E. Companies that are expected to keep generating a ton of cash, and maintain low debt and high ROE. This involves evaluating whether a company has:
- A distinct competitive advantage that is…
- Durable and...
- Run by a competent Management Team.
Criterion A is a result of our Worldview. Think of it as tailwind. If a company passes Test A, we go onto the others. Criteria B, C and D are facts – either a company has generated a lot of cash over the last few years or it hasn’t. Criterion E is where growth expectations enter the scene. The Buylyst factors in growth in many cases to arrive at a Sustainable Free Cash Flow number. This growth expectation is based, in large part, on the findings of Criterion A. If we believe the company is playing the right sport, we think it’s less risky. Risk, in fact, is the primary consideration for going through the exercise of putting down on paper our Worldview.
We try to buy assets that are cheap GIVEN our expectations of growth. Does that make us Value Investors or Growth Investors? We don’t care much for those labels. We definitely don’t intend to pick up “cigar butt” stocks. These are companies that are suffering but are trading at prices so cheap that an asset liquidation would cover the value of the equity. Benjamin Graham, who was Buffett’s mentor, believed there was a time and place to make these types of investments. He may have been right – maybe in the first half of the 20thcentury this was possible. Fortunately for Buffett, his partner Charlie Munger talked him out of it.
“…having started out as Grahamites - which, by the way, worked fine - we gradually got what I would call better insights. And we realized that some company that was selling at two or three times book value could still be hell of a bargain because of the momentums implicit in its position, sometimes combined with an unusual management skill plainly present in some individual or other, or some system or other.”
…I imagine that Buffett improved his mentor Benjamin Graham’s approach after he read from another giant of investing, Phil Fisher…
“The true investment objective of growth is not just to make gains but to avoid loss.”
…which led Buffett to believe…
“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.”
…and he doesn’t like being boxed into investment “styles” either…
"Fund consultants like to require style boxes such as 'long-short', 'macro', 'international equities'. At Berkshire our only style box is 'smart'."
At The Buylyst, we like to think our “style” is also “Smart”. Finding companies that are growing, in industries that are growing, is a big part of that. That’s where most “comfortable companies” are found. If we find that they’re trading at comfortable prices, we pounce.