Category: Investment Philosophy

Can’t wait for Fed Speak to be over… long-live Fed Speak?

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Do you feel like all anyone is talking about is what the Fed will do next? I feel like conversations have shifted from fundamental work to “will the Fed cause a recession?”… and we’ve been doing that in earnest for a year now and I’m over it.

Well, we’ve been doing it for 14 years at least, but it feels really heightened right now.

Some people may say, “yeah, they can cause a recession and impact earnings!” and I get that. But it feels like digesting “Fed speak” is the only conversation right now.

Some people may say, “that’s how it has always been. The Fed moves markets. Don’t fight the Fed.” Was it really always this way? As a result, I guess do limited fundamental work and just monitor the Fed? A lot of people do that I guess. It sure does take the fun out of fundamentals. It doesn’t feel like companies like Autozone or Monster Beverage did well simply based on what the Fed did.

I remember when it was “jobs Friday” and everyone waited on bated breath for a weaker jobs number so that it meant the QE spigot stayed on. And a weak number sent stocks higher. But did a lot of that anxiety really matter? I don’t know. Maybe. But we’re doing it again, on steroids.

I think after each crisis we say to ourselves, “the Fed is been so dominant because of extraordinary measures taken to support the economy [or stifle inflation].” But even so, it stays part of the conversation…

Truth is, something will always dominate the conversation. Probably just to distract. Especially when there’s limited new earnings releases.

Anyway, more of a “musings” post, but I wonder if it’s an opportunity if we were to zoom out with a longer-term perspective. I’m not saying people aren’t doing any fundamental work, and I am not saying you can tune out the Fed completely.

But I am asking myself if I would be a better investor for tuning out 80%+ of the Fed stuff and poured myself into at least medium-term analysis of where I think a company will be. I think its tough to argue with that.

Veteran Tip: ALWAYS open Friday 8-k’s $BIG

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Alright, I’m no veteran. But in my career I have learned one important tip… ALWAYS open Friday 8-k’s.

Why would a company file a “current report” that represents something “material” at Friday at 5pm? Hmmm. Seems obvious in hindsight, right? They don’t want people to focus on the said material item.

I’ve seen this a few times in my career. 9/10 times it’s benign. But one time it was a company disclosing a large loss on a hedge contract. Another it was an executive departure that gave a hint results would be bad. There’s more I can’t remember.

This time it’s Big Lots with an ominous signal! For future reference. I’m writing this at 5:30pm on a Friday after getting this notification in my inbox. While they are increasing the size of their credit facility by $300mm, to $900mm, they also are suspending the fixed charge covenant for a period of time. Hmmm

Now, Big Lots historically didn’t need a credit facility this large. But they just bought back a bunch of stock and, like other retailers, have bloated inventory now. They actually went from no debt, tons of cash, to $271mm drawn and limited cash.

The working capital is sucking liquidity, which just happened to Bed, Bath and Beyond. And now the latter is questionably solvent.

This could be a nothing burger. Or it could be an obvious sign that BIGs earnings will indeed suck like the rest of the space. That’s why they need to suspend the covenant. Perhaps they’d fail it otherwise.

I still think BIG will make it through this period and the stock will be higher in 5 years. But in the meantime… not a great sign.

What Drives Stock Returns Over the Long Term? $AMZN $MSFT $KO $COST $ROL

Reading Time: 2 minutesWe’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.

 As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.

The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.

A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements.  One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).

In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.

I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).

Why I like to invest in good companies with bad balance sheets $ESI

Reading Time: 5 minutesIf you take a look at my personal investment recommendations, you might notice a lot of the companies I target have “bad balance sheets”  as some would define it. Why do I target these companies?

  1. The Equity market clearly overreacts to companies with bad balance sheets (which provides opportunity to nab good businesses that can support higher leverage)
  2. Patience is rewarded
  3. I think how people measure bad balance sheets is too simplistic
  4. As the company pays down debt, every dollar of debt paid down is a dollar gained to the equity

It may be best to walk through a few examples. And to be clear, in most cases, I am discussing names that don’t have near-term maturity issues as it is hard to bank on the capital markets always being open. That is my one important disclaimer.

The company I will be discussing today is Platform Specialty Products (now called Element Solutions), a specialty chemical company that originated as a SPAC formed by Martin Franklin. Franklin is a serial deal maker, known for a strong track record at Jarden where he conducted dozens (maybe even hundreds) of bolt-on acquisitions. According to Fortune, Jarden’s 10 yr annualized return was 17.9%. Not too shabby.

Anyway, Franklin’s strategy with Platform was to buy “Asset light, high touch” business. That is, those with limited capital intensity, but high margins because of the service the businesses provided to its customers. This alone would tell you the businesses he was targeting have high barriers given the margins plus service component that is hard to replicate.  Platform would also carry a “high” leverage amount — around 4.5x EBITDA — but if you assumed the companies were worth 12.0x together, it wasn’t that big on a debt-to-cap basis.

That’s a problem with how people view bad balance sheets – you cannot look at leverage in a vacuum. 4.5x leverage on an auto supplier is much different than 4.5x leverage on a sticky, recurring, non-cyclical business.

Long story short, after a series of frenzied acquisitions (mostly funded via debt), Platform got over its skis. Fundamentals for its Agriculture chemicals business got burned by the Brazil real devaluation, and the company was 7.0x levered. The stock fell from $28 to slightly below $6, valuing the company at ~8.0x EBITDA (when comps were trading at double-digits), plus a high-teens FCF yield to equity, and a portfolio of strong businesses.

pah_chart

The headlines and chatter at the time were ridiculous. The company’s nearest maturity was >5 years out and people were concerned about Platform tripping a covenant (it had no covenants other than on its revolver, which would only spring into play if it was drawn down a significant amount. Even still, revolver lenders roll over on these covenants pretty customarily as they do not want to own the business).

As the company addressed some of its debt problems, the stock moved up to $15/share ~1 year later for ~150% return.


This to me is a clear example of the 2-3 items I noted above (except for number 3, which I’ll show more below). The problem for some investors is that the volatility in share price can pick up because of this, but as Warren Buffet likes to say, if your neighbor shouted a price to buy your home everyday, would you panic and sell if the number he shouted began to go down? Certainly not.

Let’s then look at an example of purchasing an investment home. We all know the math – buy with a mortgage and assume it will be covered by rent. As you can see, putting 20% down on a house and assuming no growth in rent or home price appreciation provides a nice little IRR. This is because we were able to buy an asset we otherwise couldn’t afford and essentially have it paid for by the rent. Notice below each dollar of debt paid down accretes to the the equity.

You are essentially LBO’ing your home — every homeowner in America is in the LBO market!

(Note, I assumed a 5% mortgage rate here)

home 80_20

Now that is pretty good, but what if you were looking at an investment of solid property, same assumptions. This will be an investment for you that you plan to sell in 5 years, but you have to pay a 5.5% mortgage rate to compensate for higher risk (i.e. putting less cash down).

home 90_10

As a result, you get a 70% return on your money (vs. 40% in the first example) and put less down which frees up capital to put elsewhere.

The key here is that I am assuming this is a good, solid property. Maybe the best house on Main street that will keep its value and decline.

Levered bond?

Said another way, if you view a high quality company as a stream of cash flows, then levering those cash flows can help boost returns.

Let’s say you bought a 5% coupon bond trading at 95 with 100% equity. If you held it to five years to maturity and sold it at par (or 100) your IRR or yield to maturity would be ~6.2%.

Bond IRR_Equity.PNG

Now lets say you bought that bond by borrowing half of the purchase price with debt, funded at 3.5% (which Interactive Brokers actually offers, so I’m not being crazy). The IRR then boosts to 8.8%.

Bond IRR_debt.PNG

There’s clearly risk here if the bond does not return par, since leverage cuts both ways. If the bond only paid back 90 cents on the dollar, you’d be down ~10% instead of only 5%.


All in all, this is no different than private equity. They have tremendous returns partially because they don’t have to mark-to-market every day like public equity fund managers do. That’s why I like these scenarios as a long-term investor. In the case that something goes right for these levered assets, that obviously provides even more upside.

As I result, I have invested in past in names that were levered 8x when I thought the business was worth 6x when I thought the fundamentals were moving in the right direction and EBITDA growth would help the leverage scenario. I’ve also bought into companies that were in the middle of negotiating covenant relief with banks, as banks typically will provide relief if it is a result of 1x issues or even a cyclical issue that is expected to pass in the longer term and the company can still make payments.

Catching Falling Knives amid Headline Risk $FB $AAPL $MSFT

Reading Time: 2 minutesHere we go again. Facebook’s stock has hit another pocket weakness and was down to $132/share as I write this piece (-5.5% on the day). New articles have been posted in the media about Facebook having a morale problem and there has been in-fighting and finger-pointing during this time of “chaos” in the company…

All of this sounds EERILY familiar to an article entitled “Apple’s Employee Morale Problem”, published in 2013, another which pointed to its top execs leaving, published in 2012, or the plethora of articles written about how Apple can no longer innovate (published first in 2013 and again in 2015).

If you recall, these articles were being published at a time when it was not fun to be a shareholder of Apple. It was absolutely a falling knife and the headlines everyday were only negative. Although we have hindsight to help us, we now know what those headlines ended up being worthy of…

You can’t blame the media for publishing on large cap names that have been under selling pressure. If you own the stock, you’re definitely going to search around and see what the hell is going on. Is there something I am missing? “If key employees are leaving, how will the business stay on top?” Selling begets selling and articles get clicks.Apple

What I love about the stock market is that we can come back to real data in our analysis to see what is priced in. As of this writing, Facebook trades at 7.7x 2020e EBITDA… by comparison Microsoft trades at 13x. Apple trades at 9.1x. Visa, no question a good business, trades at 17.6x EBITDA… The S&P in aggregate trades at 12.6x LTM.

Facebook looks way too cheap me today, especially when you look at sales growing at 20%+ CAGR at least over the next 3 years (and they haven’t even truly monetized WhatsApp yet). The business also earns extremely high returns on capital, which supports the multiple. In other words, Facebook is worth more than the average S&P500 company…

I cant help but think this is another case of Apple. Can I say when the slide will stop? No. But I can look at the numbers to help realize the market is pricing in much worse case than I think will be the reality.