We’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).
If 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?
The Equity market clearly overreacts to companies with bad balance sheets (which provides opportunity to nab good businesses that can support higher leverage)
Patience is rewarded
I think how people measure bad balance sheets is too simplistic
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 tough” 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.
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 a 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)
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).
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.
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%.
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.
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.
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.
Investors are notoriously short sighted. But how often have you capitulated at the wrong time on an investment simply because (a) the headlines get worse and worse and/or (b) your losses are mounting (or your gains are shrinking)?
Any experienced investor has these cases. Equally as bad is not acting when your diligence and work suggests the value of the company is not impaired or that the news is bad, but they will make it through.
I wanted to highlight a few examples I’ve taken note of over the years and are hopefully recent enough to be relevant. My goal is for us to remind ourselves of these cases and to profit from similar cases if they are to occur again in the future, which they always do.
Case Study 1: Facebook IPO
I remember the Facebook IPO well. Mostly because it was one of those where I knew the business would be fine and had large run way ahead of it, but yours truly talked themselves out of buying it.
It was 2012, so not too long ago, and this was going to be one of the largest IPOs in recent history of a large tech company. The IPO was also extremely over-hyped. Yelp had IPO’d just recently and popped 64% on the first day of trading. Everyone I talked to that was outside of the finance realm was going to buy into Facebook (which scared me, since if everyone is a buyer, what value is there to be had) and they knew nothing about how the company made money (which scared me again). The stock IPO’d at $38 (after a technical snafu delayed trading). The stock traded poorly and the underwriters on the deal actually downgraded their growth estimates for the company.
Then, the lock-up period on the stock ended a few months later that released 133MM shares, which was a large increase in float compared to the 180MM that had been sold in the IPO. Fear began to build around this “technical” factor, as 1.2BN shares were going to free up thereafter. With so much supply and tepid demand, who would support the stock??
People were concerned about these short term factors, but completely missed the point. FB filed the IPO with $4BN in LTM Revenue and actually was very profitable – with 24% net income margins. The stock bottomed at $19 / share, which foots 9.5x estimates of EBITDA over the next 12 months. The thing about that multiple is that FB would go on to grow EBITDA from ~$1.2BN to $27.4BN in the LTM period.
Let’s say you bout in the IPO and sat through the pain… you would have experienced a ~50% loss, but would’ve turned into a 325% gain up to now.
Case Study 2: Apple and the death of Steve Jobs
This one will be quick because I think everyone knows the story. Apple had essentially made a comeback of a life time when Steve Jobs came back, after being on the verge of bankruptcy. Now, everyone knows it as the $1 trillion dollar company that has a well entrenched customer base that refuse to change phones, even when the prices exceed $1,000 per phone.
But there were several times in which people thought that the death of Steve Jobs would again impair Apple’s business model. What people forget is that men and women can have lasting impacts on firm culture, even after their deaths or departures.
Steve Jobs dies in late 2011, but it wasn’t until 2013 really that people became concerned about innovation. The company was still launching iPhones and iPods, but it wasn’t launching the NEXT thing (I guess people were expecting microchips in their heads). And that brought about serious fear in the company’s outlook and led people to anchor on quotes like this one from Larry Ellison, the CEO of Oracle.
“Well, we already know. We saw — we conducted the experiment. I mean, it’s been done. We saw Apple with Steve Jobs. We saw Apple without Steve Jobs. We saw Apple with Steve Jobs. Now, we’re gonna see Apple without Steve Jobs.”
As shown in the chart above, the stock fell 40% from its highs. But you already know what happened next. Customers didn’t frantically leave, Apple kept improving and innovating, and is still a dominant player in the space.
What actually came to be was an interesting cycle. Apple had an upgrade cycle that was becoming evident every 2 or so years. In the lulls of those cycles (i.e. the low periods when less people decided to upgrade), the headlines would be overly negative. Again, we would hear about the lack of innovation in the company and actually, despite seeing a rebound in 2014-2015, the headlines came back in 2016 and Apple’s stock got crushed again. Articles like these, appropriately titled, “Apple’s Core Problem Is That It Can No Longer Innovate“, were so proliferate it was hard not to buy in.
Again, that turned out to be a lot of noise and Apple’s stock today sits at ~$230 a share.
The question is, now that we are in the next lull cycle, will the market learn from these last mistakes?
Case Study 3: Intrepid Potash
I wanted to provide another example of overly negative sentiment, but this time related to cyclical downturn + headlines of bankruptcy risk. There were plenty of examples of this with the 2016 oil downturn and there are actually even a few I had the choice from related to just overly concerned bankruptcy risk, but I wanted an example that maybe you haven’t heard about.
Intrepid Potash (ticker:IPI) is a US potash producer, which is used as a fertilizer for crops. IPI’s capacity was relatively high on the cost curve, meaning there were mines in the world out there that could produce the same commodity for cheaper, giving those producers an advantage if prices fell.
Well, prices did indeed fall. By a lot. Back when corn was $8/bushel in 2010/2011 time frame, fertilizer prices also benefited. Farmer incomes were solid allowing them to spend more on fertilizer and other inputs. When corn supply caught up with demand (driven by higher ethanol demands), the price collapsed and potash has fallen with it, as shown in the chart below.
All the potash and other fertilizer producers stocks fell as well. This obviously makes sense because the earnings of these companies looked to be significantly impacted, at least in the near term. To make things worse, in the “good times” several major potash producers announced they would be adding capacity. Well, it takes about 5 years for that capacity to come online and guess what… it came on right at the worst time.
In my opinion, this is a classic example of a cyclical (not secular) downturn in a commodity. Demand for food should move up +/- 2% each year with a rise in population, which will in turn increase demand for corn. Increased demand for corn, in turn, will increase demand for inputs, like potash. In the short term though, the price of commodities can be highly volatile due to mismatches between supply and demand and could be low for awhile before the new supply is absorbed by slowly increasing demand.
Being higher up on the cost curve was a problem for Intrepid. IPI’s realized potash prices went from a peak of $541 / ton to $200 / ton. While the company was able to take some costs out, its COGS / ton moved from ~$225 / ton to $175 / ton. Obviously, that means margins earned on each ton sold were squeezed significantly and that’s before S,G&A and capex are taken into account as well.
That’s when the negative headlines came out. You see, fundamentals were bad and there was no sign of a turn around. Worse still, the company was about 6.5x levered and the company was in breach of its covenants. Headlines at that point came out about the company filing for bankruptcy. However, all you had to do is go to the filings and see that the lenders to IPI were a group of Agricultural focused banks. These banks understand that Ag has cycles, though it may not cycle with the general economy, and they likely wouldn’t want to force bankruptcy on IPI and take the keys. IPI after all was still in an OK liquidity position at the depths of a pretty bad cycle (and it was clear the banks were issuing extensions to help the company). I also liked that the CEO of the company was buying stock en masse during these times. Lastly, the company was public, so it could issue stock if it needed.
And that’s actually what the company did. I found it surprising, but instead of pressuring the stock further, it put liquidity / bankruptcy concerns at rest and stock went from $1 to over $3 on the news. The company issued $58MM of equity and moved on and instead of the stock falling from dilution, it shot up 300%.
The stock still has well to go before it recovers to the levels seen before, but keep in mind we’re still what I would call trough fundamentals, given where potash and corn prices are.
Case Study 4: Lululemon
The last case study is Lululemon, the athletic wear retailer, ran into a few PR snafus during 2014. First, the company’s leggings were found to be shear and even at some points see through. Instead of the CEO saying, “mea culpa… we’re working to fix these quality issues and will provide refunds to those who purchased products not up to our standards,” he blamed it on customers being too “big” to fit in the products.
The CEO and founder then stepped down. Lululemon at the time seemed to be in peril. Retail is littered with companies who have been left behind as consumer tastes changed.
But that is the thing. Customer perception of the product remained favorable. In addition, it was a brand focused mainly on women at the time and has now started to gain entry into men’s fashion as well. That would mean an untapped market for the company to provide extra growth. Lastly, at the end of 2013, the company had 254 locations in the US and Canada. Compare that to a more mature company, like the Gap, which had 3,700 locations at the time and you can see there was a long roadway ahead before the brand matured. Lululemon now has 415 locations and is still growing.
Holding on, or buying in, to the stock would’ve been the right call as the company has continued to have positive momentum and the stock chart below shows that.
My goal of this post was for you to read these case studies and see if they apply to any other companies you can think of now. Hopefully you take note of these situations as well, so you can apply these scenarios to future ones. The goal is to profit from lessons learned, especially regarding mismatches in negative sentiment and actual fundamentals. Some of these sentiment changes occur over and over with the same companies (Apple and Facebook), but I’ve recently seen these examples in other companies as well.
Any companies you follow now that seem to be on this trend?
I’ll admit it. When someone asks me what type of investor I am, I always say value investor. But is that accurate? What really is the difference between growth vs. value stocks?
On one hand, traditional value investors would describe themselves as ones who buy statistically cheap stocks. The companies they buy may be down and out, but there is still a solid business supported by earnings / cash flows that you can nab for cheap. If sentiment improves or results come in better than feared, that’s all gravy.
On the flip side, I think growth investors are often relegated to universe of momentum investors. They are viewed as ones searching quickly growing companies and often ignore what the earnings of the business are.
But is this description correct or warranted? When considering growth vs. value stocks, I think people forget that growth is coming at some value. That is why I view growth and value investors as one in the same.
Value investors are searching for companies that they think can be a low hurdle that investors are ascribing to the business. Growth investors are searching for assets that they think will beat a high hurdle.
In fact, I’ve come to learn over the years that growth can pay for a lot of sins. As Charlie Munger once said,
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.”
Example of Growth & Value
Facebook’s recent decline in which it lost more than any other company in a single day is an example of this. At the end of the day, yes. Facebook has had some privacy issues among other things, but it is still a solid platform. They also own Instagram (which I spend way too much time on) and Whatsapp. Indeed, even after the disappointing earnings call that led to the drop, analysts still expect sales to grow 25% over 2018’s level and 21% in 2020. EBITDA is expected to grow at a 20% CAGR as well (slower than sales due to the company’s margin comments).
Let’s examine what can happen when you buy an asset that is growing at this level. Note, this is not Facebook’s results, but an example of how growth can pay for “high-multiple” transgressions. Facebook currently has ~60% EBITDA margins, so allow me to use something more along the lines of Google and Apple at high 30s range (which is still incredible, though capex will also be high).
Let’s say you buy a business similar to this for 20x EBITDA (for context, FB trades for 14.3x est. EBITDA for this year).
Again, these are all made-up numbers, but lets assume strong growth rates for the next few years that starts to level off over time. The business maintains high incremental margins (but offset by capex reinvested in the business). I assume little debt needed as these businesses such as Google, Apple, and Facebook don’t actually consume much cash (which is why their cash balances balloon).
As you can see, the end result is still extremely attractive. I cut the multiple to 8x EBITDA which is well below where it started at 20x. The important factor still, as I have written before, is that the business has a competitive moat so that it can reach these targets. If they can, tech companies in particular are attractive since a company like Facebook or Google have tremendous platforms and additional customers or users cost next to nothing for them to serve.
On the flip side, if you’re buying a fashion retailer (something that is subject to fads), or a technology that is good today but could be disrupted tomorrow, then this is less attractive because it could be here and grow well in year 1, but destroyed in year 2 (perhaps a Snapchat IPOing vs. Instagram stories…).
Frankly, I’m tired of people saying they are a value investor when in fact they are just buying low P/E stocks and hoping it re-rates higher. I think it takes more than that, such as analyzing how the company will compound (re: grow) earnings.