“There are decades where nothing happens; and there are weeks where decades happen.”
- Vladimir Lenin
These are exciting times in the markets
I am more excited about today’s markets than I was earlier this year. Falling stock prices provide better opportunities to buy a great company at more attractive prices. In other words, with the same amount of money, you can afford a bigger share in the business you like. Today’s markets are especially interesting because of wide divergence in the performance of different sectors: the broad-market index S&P500 is down 16% YTD, while Tech-heavy NASDAQ - 25% and oil & gas is up +33%.
Market performance: winners and losers (YTD)
Source: Google Finance
I think there are two strategies to consider. Firstly, if you have a regular income (e.g. employment) and some free cash, increasing your exposure to equities makes sense. Even if the macro outlook is highly unclear, it is generally better to buy during a crisis than when things are great (recent examples of sharp market declines during 2008/09, Q4 2018 and 2020 are good examples). It is also important not to be too smart about buying companies that have fallen the most, hoping to benefit from the biggest rebounds. Buying a broad market index (S&P500 or MSCI World) may be a more straightforward strategy that should generate adequate returns over the long term. Alternatively, buying companies with a long track record of positive earnings, established market positions, and solid balance sheets (low leverage) is also a good option.
The second strategy is to try to improve your existing portfolio if you are close to being fully invested and do not have spare cash. In my case, I have Altria, a more defensive business that has done relatively well. It could be a source of funds to buy faster-growing companies that are now selling at more attractive prices. I also have two small-cap Japanese stocks that could be candidates for a replacement. In theory, Berkshire Hathaway is another candidate since its future returns are close to 10% (15% in an optimistic scenario). Arguably, smaller businesses with a great product led by talented management operating in a growing industry have better chances of generating 20-30% returns over the medium term. Later, I may consider trimming my exposure to Berkshire (currently the largest position). Berkshire provides much stability to my portfolio, reduces downside risks, and makes me a better investor (forcing me to think about long-term business fundamentals and steering me away from market speculation). So even after a strong performance, I am not too interested in reducing my position in Berkshire.
I want to share one important lesson that I have learned over the past few years, which has helped a lot during the last market drop in 2020. I wish I had known and followed this idea earlier in my career. Most finance books discuss specific ratios and market indicators (equity risk premium, beta, smart beta, delta, factor investing). This adds little (if any) value to ordinary investors and may even be counterproductive.
Two strategies to generate returns from stock market investing
The first way is to capture a valuation discount. You establish a fair level of value for a business and compare it to a quoted price on the market. You try to pick stocks with the most significant discounts. Of course, you pay attention to downside risks (leverage, profit margins, management and capital allocation). Avoiding value traps is an essential part of this strategy (see my previous post on How to avoid value traps).
The second way to generate returns is by owning a growing business. You may pay a fair price initially (e.g. $150 for a stock with $10 EPS or 15x PE), but as long as the company keeps increasing its earnings by 15% p.a., you can expect it to earn already $20 EPS in just 5 years. If the stock multiple remains the same (15x) PE, its price will reach $300. You would earn 100% in 5 years or 15% per year, the same return as the growth of the company’s earnings.
The quality of the business, its sector, and its management are the key areas of focus if you apply the second approach. The best companies can expand their operations by creating new businesses within their operations (e.g. AWS Cloud service by Amazon).
The key metrics that matter the most when analysing the second type of opportunities are the Return on Capital and especially the Return on Incremental Invested Capital. The second measure allows you to estimate how efficient the new investments are and provides a good understanding of the company’s reinvestment opportunity and growth potential. Some quality companies operating in mature sectors (like Altria) have exceptional Return on Capital (c. 50% for Altria) but face a shrinking consumer base and minimal re-investment opportunities. Hence, they distribute 80% of earnings as dividends and reinvest only 20% back in the business.
The two strategies I described can be viewed as two types of pies. The first one is fixed; it does not change over time. The idea is to buy it as cheap as possible (below what it is worth). The second is a pie that keeps growing. So even if you pay a fair price for that pie, the value of your investment goes up as the pie gets bigger.
Why I prefer growing businesses to cheap ones
I started investing as many others focusing on the first strategy. I think it is appealing because it is logical (pay less, sell at a higher price) and is rules-based. It looks scientific (e.g. it relies heavily on numbers, mathematical ratios, formulae). Because of this, it seems more objective.
Making a judgement about which management team is more talented makes you feel like you choose between the two contestants in The X Factor.
However, eventually, I got to appreciate the benefits of focusing on business fundamentals, quality of the product, management, and long-term prospect instead of how low the price I am paying.
Here is why I don’t particularly like buying just cheap stocks.
1. It is more speculative than it appears. While in theory, the method looks quite analytical and objective, in practice, your return depends on the stock’s re-rating (e.g. from 10x PE to 15x PE). This re-rating requires a change in market sentiment; most investors should start looking at the company more positively and be willing to pay a higher multiple for it. Sometimes such change happens due to management’s efforts (cutting costs, raising dividends, launching new products). In this case, you have to bet that the company can change for the better. After buying a low-priced stock, I often found that my future returns depended on other investors’ sentiment and, occasionally, the company’s efforts (I am still waiting with the two Japanese stocks I bought in 2020). Low PE stocks can be easily found in more competitive sectors (e.g. apparel retail) with low barriers to entry, so management’s efforts rarely could change things for the better.
2. Low-quality companies generate sub-par returns on capital. Unless the stock re-rates, its share price tracks earnings, which in turn are driven by return on capital. Often, companies valued at a low multiple are struggling in some ways (non-competitive product, high costs, poor capital allocation, unfavourable regulation). These problems eventually lead to lower returns and often lower profits. So even if you bought a company for 10x PE and sold it for 10x 3 years later, but earnings have declined 30% in the meantime, you would lose 30% on your investment.
3. After re-rating takes place, you have to pay capital gain tax and look for a new opportunity. Unless you hold the stock in a special account, you would have to pay a tax on your gains. Moreover, you would need to re-invest cash which creates 3 problems. Firstly, you generate close to zero returns while your money is not deployed. Secondly, your new investment may be much less successful, which would erode your one-time gains. Finally, by trading more often, you spend some of your capital on brokers’ commissions, although it has become less of an issue these days.
4. Low PE stocks depend much more on macro. Perhaps counterintuitive at first, but to be successful at picking low priced stocks, you often need to make the right macro calls. Usually, such companies have lower margins and may have some structural disadvantages. This makes them much more sensitive to the external environment. It may benefit them, but it can also create significant problems. Many value investors started looking at the oil sector as early as 2015, but it turned out to be too early. There were many companies in the sector that did not survive the prolonged oil market weakness.
The second strategy that focuses on high-quality businesses in growing sectors has none of these problems. You do not pay tax until you sell the stock. You do not have to sell it as long as business fundamentals remain solid and long-term prospects strong. Moreover, if the company accelerates investments in marketing or R&D, they would be added to its costs, reducing taxable profits. It is also less speculative because a quality business has solid financials (easy to check), a great product you can learn about, and talented management with a public track record.
The two critical risks of the second strategy are overpaying and a shorter actual growth phase than you may have first estimated. To avoid the first risk requires discipline. Regardless of how much you love the business, there is a price at which even the best business becomes a mediocre investment. The second risk could be partially mitigated by more active channel checks, interviews with industry participants, suppliers, and customers. Companies can enjoy longer growth phases with what Buffett calls a ‘moat’ - a durable competitive advantage. This could include barriers to entry for new players (e.g. scale), high switching costs (e.g. MS Office product), positive network effects, stronger R&D, unique corporate culture.
The best opportunities lie in growing businesses disguised as slow-growth companies. These could be businesses with loss-making divisions or temporary setbacks (e.g. loss of a large customer, as was the case with Amex in 2015 when Costco decided to stop accepting its cards).
It also helps to have more experience with a real business to apply the second strategy successfully. As Buffett says, “I am a better investor because I am a businessman, and a better businessman because I am an investor.”
What I am doing today
The recent market correction provides excellent opportunities to pick up some quality businesses at much more attractive prices. I have about 10% of my assets in cash, and I plan to use it to increase my exposure to equities. Besides, I plan to improve the quality of my portfolio and add more growth potential by potentially replacing mature businesses with smaller and faster-growing ones.
I suggest spending as much time learning about great businesses and products as you can and spending as little time as possible on the macro. It does not look pretty. It makes me worried. A combination of higher energy prices, higher interest rates, supply-chain disruptions on top of growing geopolitical tension, and a war in Europe create major risks. Consumers will likely reduce their spending, causing global demand in the economy to decline, forcing businesses to reduce investments and cut some personnel.
However, I do not believe I can get any edge in macro. Too many variables can impact the outcome. I also think that all the issues I described are well-known and partially in the price already. Stocks are down a lot this year on the back of those concerns. Finally, the economy is cyclical: economic booms follow periods of weakness. It is better to buy stocks when there is pessimism in the markets and sell on optimism, not the other way round.
I have been intensively reading annual reports, earnings presentations and call transcripts of the companies on my Watchlist (see my previous post here).
Out of all the names that I have been focusing on recently, I think SWK and NFLX are closest in terms of the best Price / Quality combination. Other names are either not cheap enough for me, or I am not comfortable with their business models (I may simply lack knowledge of the industry). I have taken off ANF as I decided I do not want to own a business that has to get the fashion trend right every season. It is operating in a highly competitive sector with structural pressure from e-commerce. If anything, TJX is more interesting as it does not have to ‘guess’ what the new hit will be. Its army of loyal customers visits its shops every time to look for unique bargains. TJX, however, is still expensive in my view (around 20x PE).
I am also less inclined to look at stalwarts (e.g. BAC, 3M) since I partially have exposure to those names through Berkshire Hathaway. Besides, they are usually worth holding at the peak of the market due to their defensive qualities. Today, they represent some re-rating opportunity, but beyond that, their shareholder returns would match their relatively low-return business model.
SWK closed at $121.6 on 13 May 2022. Management has guided for $10 EPS in 2022, which includes a negative impact from commodity & transport inflation and the closing down of the Russian business. The combined negative effect is $3.65. The stock traded at 12.2x PE based on the 2022 outlook and 8.9x if the negative $3.65 impact is added back to earnings. Moreover, SWK targets long-term growth of 10-12% per year, although only 4-6% organic. Historically, the company has been quite successful with M&A deals, although I would not rely on them delivering a successful deal every year.
In the case of Netflix, I have been thinking quite simply that if they can convert half of the 100mn households that share passwords into paid subscribers (generating c. $150 of annual subscription revenue per account), this could generate $7.5bn of additional revenue with close to 100% incremental margins (c. $7bn of FCF). With an $84bn market cap, Netflix could be generating close to a 10% FCF yield. The company has unique culture and management; it is led by its founder Reed Hastings who bought $20mn of stock in January this year (at an average price of $388). I plan to analyse how content spending per customer has changed over time and how it compares to major competitors, especially Disney. Changing strategies in the sector (from market share grab to value creation) could be an inflection point for shareholder returns (similar to US Shale companies who have started to prioritise value over growth after the COVID pandemic).
I have added 2 more companies to my Watchlist: Eurofins Scientific and Kering.
Eurofins Scientific is a company that provides various tests to pharma companies (drug tests), patients (clinical), and other sectors (food safety, environment, genomics). Founded by Gilles Martin in 1987, the company has grown its revenue by over 20% a year, generating positive earnings and cash flow most of the time. Mr Martin remains the company’s CEO and its largest shareholder with a 33% interest. Eurofins is trading at c. 16x PE, targeting 6.5% mid-term revenue growth. It is below historical growth rates as 2020-2021 results were boosted by COVID-related testing revenue (c. 20% of total 2021 revenue).
Kering is a group of famous luxury goods brands (including Gucci, Yves Saint Laurent, Bottega Veneta, Brioni, Boucheron and others). It was created as an investment company by the French businessman Francois Pinault in the 1960s. The company is now headed by the founder’s son, Francois-Henri Pinault. The Pinault family owns a 41.7% interest in Kering. At a €57.7bn market cap (and almost debt-free), the company is trading at a 7% FCF yield. It distributes about 50% of earnings as dividends and has recently launched a small buyback programme. As a typical luxury goods company, it has outstanding financial metrics (EBIT margin of 28-30%, almost 20% net income margin, ROE of 26% and closer to 30% if amortisation of goodwill is excluded). I want to learn more about the CEO Francois-Henri Pinault and how the company has been allocating capital far (what multiples the company paid for new brands, how these brands performed under the new umbrella).
I plan to finish my work on these names in the coming days and will likely add one or two of them to my portfolio.
Thank you for reading this post. As usual, I would like to stress that these are my personal thoughts and they do not represent investment advice.
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