Tesla’s stock is flying high, doubling in 2020 alone. The electric vehicle company enjoys many tailwinds, but is the stock price getting ahead of itself?
Tesla has been the talk of the town so far in 2020. The tech-driven company’s stock price has more than doubled since the start of the year thanks to a strong end to 2019 for its business.
With the recent hype around Tesla, here’s a look at some of the reasons why Tesla’s stock may have surged and whether it is still worth investing in.
Free cash flow generation
Previously, one of the concerns investors had with Tesla was its cash burn rate. The company’s high cash burn (see chart below) had resulted in Tesla raising money through secondary offerings that diluted existing shareholders.
However, 2019 could be a turning point for Elon Musk’s brainchild. The electric vehicle company was GAAP-profitable in the second half of 2019 and had generated US$1.4 billion in free cash flow for the same period. Its 2020 outlook was also extremely positive. Tesla said:
“We expect positive quarterly free cash flow going forward, with possible temporary exceptions, particularly around the launch and ramp of new products. We continue to believe our business has grown to the point of being self-funding.”
And although Tesla announced another secondary offering last week, I think this time it was not because of cash flow issues but rather to take advantage of the run-up in its share price.
The chart below illustrates improvements in its trailing twelve months (TTM) of free cash flow over the last 12 quarters.
Another major plus for the company was the announcement that it was going to ramp up production capacity. In its outlook statement, Tesla said:
“For full-year 2020, vehicle deliveries should comfortably exceed 500,000 units. Due to ramp of Model 3 in Shanghai and Model Y in Fremont, production will likely outpace deliveries this year.”
Tesla’s 2020 projection translates to at least a 36% jump in deliveries from 2019.
Perhaps the most impressive part of its 2019 fourth-quarter earnings announcement was that it was able to start Model 3 production in its Gigafactory in Shanghai in less than 10 months from breaking ground- a sign that the company is becoming more efficient in ramping up production.
The China factory will boost production capacity by around 150,000. Besides the factory in China, Tesla has moved forward with its preparations to build a factory near Berlin, which is expected to be open by 2021.
Irresistible demand for products to meet its production ramp-up
The production ramp-up is only possible due to the strong demand for Tesla’s products. In his earnings call with analysts, Musk gushed:
“Our deliveries reached over 112,000 vehicles in a single quarter. It’s hard to think of a similar product with such strong demand that it can generate more than US$20 billion in revenue with zero advertising spend.”
Musk was even more optimistic about Tesla’s new Cybertruck vehicle. He said:
“I have never seen actually such a level of demand at this — we’ve never seen anything like it basically. I think we will make as about as many as we can sell for many years. So — as many — we’ll sell as many as we can make, it’s going to be pretty nuts.”
As Tesla plans to start production of its Cybertruck only in 2021, investors will need to wait at least a year before the initial sales figures are released but the early signs are certainly encouraging.
Better gross margins
In addition, gross margins for Tesla should improve.
Improved efficiency in product cost and higher gross margins for its newest car (Model Y) will be the driving force behind Tesla’s better gross margins.
The company will deliver its first Model Y in this quarter and expects to ramp up sales of its latest model over the year. As the product-mix shifts towards Model Y, I think investors can expect a slight improvement in gross Tesla’s margin.
On top of improvements in gross margin, Tesla also said that it is likely going to be more efficient in terms of capital expenditure per production capacity. The improvements to capital efficiency should enable the company to scale its capacity faster and produce its vehicles at a cheaper rate on a per unit basis.
Other factors
Besides selling electric vehicles, there are a few other potential drivers of growth:
Tesla is at the forefront of the fully autonomous vehicles trend. The technology-driven company logged 500 million autonomous miles in 2018. Tesla is, literally, miles ahead of its rivals, Waymo and GM’s Cruise, which logged 1.3 million and 447,000 miles respectively. Currently, Tesla sells cars that are fitted with the hardware needed for full self-driving (FSD), with an optional upgrade for FSD software features. As FSD technology matures, we can expect Tesla to roll out updates to the software. In addition, Tesla can also retain a fleet of FSD vehicles for rental and driverless transportation- in a way becoming the Uber of driverless vehicles. Ark Invest estimates that autonomous ride-hailing platforms in aggregate could have a value of a whopping US$9 trillion by 2029.
Tesla also sells vehicle software such as its Premium Vehicle Connectivity feature which enables users to stream music on their cars. Owners of Tesla vehicles can also buy other software updates such as acceleration boost, basic Autopilot, and additional premium features. As Tesla grows its suite of software products, this revenue stream is expected to become another important driver of growth for the company.
The company’s energy storage and solar roof installations businesses have also increased year-on-year. Tesla expects both storage and solar roofing to grow by 50% in 2020.
But is Tesla’s stock too expensive?
2019 is a year which Tesla proved many of its doubters wrong. But has the market gotten ahead of itself?
After the surge in its share price, Tesla’s valuation currently tops US$160 billion. That translates to nearly seven times trailing sales. For a company that has a gross profit margin for its automotive business of 22% (which is high for vehicle sales but low compared to other industries), its current share price certainly seems rich- even for a company growing as fast as Tesla is.
Even if Tesla can quadruple its sales figures to a US$80 billion run rate and earn a 10% net profit margin, today’s share price still represents 20 times that possible earnings. And Tesla will need to keep its foot to the floor of the accelerator to generate that kind of numbers.
In addition, the automotive industry has traditionally been in a tough operating environment. Even though demand for Tesla’s vehicle models seem irresistible at the moment, things could change in the future and a drop in popularity could hurt sales.
The Good Investors’ conclusion
Tesla’s products are in hot demand now and the company has plans to ramp-up its production capacity. And if Tesla can deliver on all fronts (including full-self-driving), I could still stand to make a very decent profit if I buy shares today.
However, its stock does seem a little bit expensive. Any misstep in Tesla’s growth could send the stock price tumbling. As such, despite the tailwinds and huge market opportunity, I prefer to take a wait-and-see approach for now.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Many investors think that it’s easy to figure out when stocks will hit a peak. But it’s actually really tough to tell when a bear market would happen.
Here’s a common misconception I’ve noticed that investors have about the stock market: They think that it’s easy to figure out when stocks will hit a peak. Unfortunately, that’s not an easy task at all.
In a 2017 Bloomberg article, investor Ben Carlson showed the level of various financial data that were found at the start of each of the 15 bear markets that US stocks have experienced since World War II:
The financial data that Carlson presented include valuations for US stocks (the trailing P/E ratio, the cyclically adjusted P/E ratio, and the dividend yield), interest rates (the 10 year treasury yield), and the inflation rate. These are major things that the financial media and many investors pay attention to. (The cyclically-adjusted P/E ratio is calculated by dividing a stock’s price with the 10-year average of its inflation-adjusted earnings.)
But these numbers are not useful in helping us determine when stocks will peak. Bear markets have started when valuations, interest rates, and inflation were high as well as low. This is why it’s so tough to tell when stocks will fall.
None of the above is meant to say that we should ignore valuations or other important financial data. For instance, the starting valuation for stocks does have a heavy say on their eventual long-term return. This is shown in the chart below. It uses data from economist Robert Shiller on the S&P 500 from 1871 to 2019 and shows the returns of the index against its starting valuation for 10-year holding periods. It’s clear that the S&P 500 has historically produced higher returns when it was cheap compared to when it was expensive.
But even then, the dispersion in 10-year returns for the S&P 500 can be huge for a given valuation level. Right now, the S&P 500 has a cyclically-adjusted P/E ratio of around 31. The table below shows the 10-year annual returns that the index has historically produced whenever it had a CAPE ratio of more than 25.
If it’s so hard for us to tell when bear markets will occur, what can we do as investors? It’s simple: We can stay invested. Despite the occurrence of numerous bear markets since World War II, the US stock market has still increased by 228,417% (after dividends) from 1945 to 2019. That’s a solid return of 11.0% per year. Yes, bear markets will hurt psychologically. But we can lessen the pain significantly if we think of them as an admission fee for worthwhile long-term returns instead of a fine by the market-gods.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Liquid biopsies look likely to change the world of cancer-treatment, and Guardant Health is at the forefront of this exciting evolution.
Cancer is a devastating disease and a growing cause of death in the developed world. Worldwide, the disease struck more than 17 million people in 2018 and that figure is expected to mushroom in the future. The numbers are scary but the silver lining is that the world is making great strides in combating the disease.
One company that is doing its part to help is Guardant Health (NASDAQ: GH).
The medical diagnostics company sells liquid biopsies to help identify tumours that can be treated with targeted therapy.
Liquid biopsies are a much less invasive method of obtaining information about cancer cells in a person’s body than traditional tissue biopsies. Put another way, liquid biopsies are a fancy term for a simple blood test that can replace painful tissue biopsies.
On top of that, Guardant Health’s first commercialised liquid biopsy, called Guardant360, produces faster results that are as effective as traditional biopsies.
But Guardant Health is not just creating a positive impact on humanity. Its stock price has already nearly tripled since its IPO in 2018, but I think it still has legs to run and could even potentially be a 10-bagger in the making.
Here’s why.
FDA approval
The leader in liquid biopsy has applied for Food and Drug Administration (FDA) approval for Guardant 360. So far, Guardant 360 is being sold without FDA approval and falls into the category of a laboratory-developed test. An approval by the FDA will give the test more credibility and should help it achieve greater commercial adoption.
Gaining FDA approval will also support improvements in coverage by commercial payers and reimbursements. Higher coverage by commercial payers will likely increase the take rate among patients and also enable Guardant Health to increase the selling price of Guardant 360.
Helmy Eltoukhy, Guardant’s co-founder and CEO, said the following in the company’s 2019 third-quarter earnings conference call:
“We believe FDA approval will be an important catalyst for helping to establish a blood-first paradigm that will lead to continued clinical adoption of Guardant360.”
Pipeline products
Besides Guardant360, Guardant has three other products that are either in the pipeline or marked for research use. They are GuardantOMNI, LUNAR-1, and LUNAR-2.
GuardantOMNI is similar to Guardant360 but can identify a broader panel of genes (500 vs 73) from circulating tumour DNA. It was designed for biopharmaceutical companies to accelerate clinical development programs for both immuno-oncology and targeted therapy treatments. GuardantOMNI is being sold for research-use only.
LUNAR-1 is a test that is aimed at detecting cancer recurrence in patients that are in remission. LUNAR-2 is a test to detect cancer in asymptomatic but high-risk populations. Essentially, LUNAR-2 can become a more accessible screening tool to detect cancer early. LUNAR-1 and LUNAR-2 have yet to be commercialised but are in late-stage clinical trials.
Together, these four tests provide immense potential for the company. The chart below provides a nice summary of Guardant Health’s pipeline.
Liquid biopsies have a huge addressable market since it could replace traditional tissue biopsy and cancer screening tests such as colonoscopies.
According to Guardant Health’s IPO prospectus, Guardant360 and GuardantOMNI have a potential addressable market of US$6 billion.
But the biggest potential lies with LUNAR-1 and LUNAR-2, which have addressable markets of US$15 billion and US$18 billion, respectively.
Guardant Health is still in its infancy and has a huge runway of growth with an estimated revenue of just US$200 million for 2019.
International opportunity
Moreover, the addressable markets stated above are only for the US. Guardant Health has a joint venture with Softbank to take its products internationally. The strategic partnership with the Japanese firm should give Guardant Health a first look into the Japanese market and open doors for international expansion.
FDA approval will also enable greater adoption internationally and should be a catalyst for international commercialisation in the future.
Guardant Health is making good progress
The biotech firm has shown signs of progress on multiple fronts. On top of the submission for FDA-approval for Guardant360, Guardant Health’s management also mentioned in the earnings conference call for the third quarter of 2019 that it was likely that Guardant360 could gain Medicare Pan-Cancer local coverage determination, giving more patients access to Guardant360 through the medicare plan.
Guardant Health is also advancing its LUNAR tests and in its earnings announcement for 2019’s third quarter, said that it had enrolled its first patient in its ECLIPSE study, a “prospective multi-site registrational study designed to support the introduction of our LUNAR-2 assay for using guidelines-recommend colorectal cancer screening in average-risk adults.”
These initiatives are encouraging signs for the commercialisation and adoption of the two LUNAR tests.
Financially, the numbers look great
Although Guardant Health’s business is still very much in its infancy, the numbers look promising.
In the third quarter of 2019, revenue was up 181% to US$60.8 million from just US$21.7 million. The number of clinical precision oncology tests increased by 89% to 13,259, while tests for research purposes increased by 111% to 5,280. These figures suggest that oncologists and biopharmaceutical firms are warming up to the idea of Guardant Health’s less invasive cancer testing products.
The gross margin for Guardant Health is also high at 70% and could widen if Guardant 360 earns FDA approval.
Guardant Health is still experiencing losses but this is expected for a company that is spending heavily on marketing, research, and applications for regulatory approvals. The company’s management expects 2019 revenue in the range of US$202 million to US$207 million, representing growth of 123% to 128% from 2018.
Its balance sheet is also healthy with no debt and slightly over US$500 million in cash and short-term marketable securities. Its solid financial footing gives the company the flexibility to continue investing in research and to push for the commercialisation of its two LUNAR tests.
The stock is cheap compared to its addressable market
Guardant Health’s stock trades at around 40 times the projected revenue for 2019. On the surface, that looks expensive but investors should consider the company’s total addressable market and the milestones that the company has achieved towards greater market penetration.
The liquid biopsy firm has a market cap of around US$8 billion, which is tiny when compared to its total addressable market of US$40 billion in just the US alone.
The Good Investors’ conclusion
Having said all that, I acknowledge the possibility that Guardant Health will not live up to its potential. Competition, regulatory restrictions, and missteps in clinical trials are just some of the risks that could derail its growth.
But despite the risks, the signs look promising. The take-up rate for Guardant360 and GuardantOMNI are increasing year-on-year and the possibility of FDA-approval could be a near-term catalyst. Moreover, progress has been made with the two LUNAR tests which can provide the next avenue of growth.
If Guardant Health lives up to even a fraction of its potential, I think the stock will rise much higher.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
There are six investing mindsets that have helped me in my activities in the stock market, both on a personal as well as professional basis.
Having a good framework to find investment opportunities in the stock market is important. But it’s equally important – perhaps even more important – to have the right mindsets. Without them, it’s hard to be a successful investor even if you have the best analytical mind in the world of finance.
There are six key mindsets that have served me well in my investing activities in the stock market, both on a personal as well as professional basis. I want to share them in this article.
The first mindset
Here’s a chart showing the maximum peak-to-trough decline for Amazon’s share price in each year from 1997 to 2018:
Source: S&P Global Market Intelligence
It turns out that Amazon’s share price had experienced a double-digit top-to-bottom fall (ranging from 13% to 83%) in every single year from 1997 to 2018. Looks horrible, doesn’t it?
Now here’s a chart showing Amazon’s share price from 1997 to 2018:
Source: S&P Global Market Intelligence
The second chart makes it clear that Amazon has been a massive long-term winner, with its share price rising by more than 76,000% from US$1.96 in 1997 to US$1,501.97 in 2018. Amazon does not look so horrible now, does it?
The experience of the e-commerce giant is why Peter Lynch, the legendary fund manager of Fidelity Magellan Fund, once said:
“In the stock market, the most important organ is the stomach. It’s not the brain.”
We need the stomach to withstand volatility, the violent ups-and-downs of share prices. As Amazon has shown, even the best long-term winners in the stock market have suffered from sharp short-term declines.
This is why accepting that volatility in share prices is a feature of the stock market and not a bug isa very important mindset for me. When stocks go up and down, it’s not a sign that something is broken. In fact, there’s actually great data to prove that volatility in share prices do not tell us much about how the underlying businesses are doing.
Robert Shiller is an economist who won the Nobel Prize in 2013. In the 1980s, Shiller looked at how the US stock market performed from 1871 to 1979. He compared the market’s actual performance to how it should have rationally performed if investors had hindsight knowledge of how the dividends of US stocks would change. Here’s the chart Shiller plotted from his research:
The solid black line is the stock market’s actual performance while the black dashed line is the rational performance. The fundamentals of American businesses – using dividends as a proxy – was much less volatile than American share prices.
The second mindset
We cannot run from the fact that we humans are emotional creatures. When share prices fall – even with the knowledge that volatility is merely a feature in the stock market – it hurts. And when it hurts, that’s when we make stupid mistakes.
From 1977 to 1990, Peter Lynch earned an annual return of 29% for Fidelity Magellan Fund, turning every thousand dollars invested with him into $27,000. It is this performance that made Lynch a legend in the investing business. But shockingly, the average investor in his fund made only 7% per year – $1,000 invested with an annual return of 7% for 13 years would become just $2,400.
In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why this big performance-gap happened:
“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.
He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”
In essence, investors in Fidelity Magellan Fund had bought high and sold low. That’s a recipe for poor returns, born out of our emotional reactions to the stock market’s volatility.
I think there’s a great way for us to frame how we think about volatility so that we can minimise its damage. This was articulated brilliantly by Morgan Housel in a recent blog post of his (emphasis his):
“But a reason declines hurt and scare so many investors off is because they think of them as fines. You’re not supposed to get fined. You’re supposed to make decisions that preempt and avoid fines. Traffic fines and IRS fines mean you did something wrong and deserve to be punished. The natural response for anyone who watches their wealth decline and views that drop as a fine is to avoid future fines.
But if you view volatility as a fee, things look different.
Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 paid was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.
Same with investing, where volatility is almost always a fee, not a fine.
Returns are never free. They demand you pay a price, like any other product. And since market returns can be not just great but sensational over time, the fee is high. Declines, crashes, panics, manias, recessions, depressions.”
This is why my second mindset is this: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile – great long-term returns.
You might be thinking: Is the fee really worth paying? We saw the case of Amazon earlier, where the fee was definitely worth it. Thing is, the point I made about Amazon can actually be applied to the broader US market too.
A few years ago, Housel wrote an article for The Motley Fool that showed how often the US stock market – represented by the S&P 500 – had fallen by a certain percentage from 1928 to 2013. Here’re the results:
It’s clear that US stocks have declined frequently. But data from Robert Shiller also showed that the S&P 500 was up by around 21,000% from 1928 to 2013 after factoring in dividends and inflation. That means every $1,000 invested in the S&P 500 in 1928 would become $210,000 in 2013 after inflation. The S&P 500 has charged investors an expensive entry fee (in the form of volatility) for a magical show.
Source: Robert Shiller data
The third mindset
A common misconception I encounter about the stock market is that what goes up must come down. Yes it’s true that there’s cyclicality with stocks. But an important point is missed: Stocks go up a lot more than they go down. We’ve seen that with Amazon and with the S&P 500. Now let’s see it with stocks all over the world.
Source: Credit Suisse Global Investment Returns Yearbook 2014
The chart above plots the returns of the stock markets from both developed and developing economies over more than 110 years from 1900 to 2013. In that timeframe, stocks in developed economies (the blue line) produced an annual return of 8.3% while stocks in developing economies (the red line) generated a return of 7.4% per year. There are clearly bumps along the way, but the long run trend is crystal clear.
So the third key mindset I have when investing in the stock market is that what goes up, does not always come down permanently. But there is an important caveat to note: Diversification is crucial.
The fourth mindset
Devastation from war or natural disasters. Corrupt or useless leaders. Incredible overvaluation at the starting point. These are factors that can cause a single stock or a single country’s stock market to do poorly even after decades.
We can study a company’s or country’s traits to understand things like valuations and the quality of the leaders. But there’s pretty much nothing we can do when it comes to catastrophes caused by mankind or Mother Nature.
This is why my fourth mindset is the importance of diversifying our investments across both geographies and companies.
The fifth mindset
We’re living in uncertain times. Toward the end of 2019, China alerted the World Health Organisation (WHO) about cases of pneumonia amongst its citizens that were caused by an unknown virus. That was the start of what we know today as COVID-19. Many countries in the world – including our home in Singapore – are currently battling to keep their citizens safe from the disease. When faced with uncertainty, should we still invest?
How do you think the US stock market will fare over the next five years and the next 30 years if I tell you that in this year, the price of oil will spike, and the US will simultaneously go to war in the Middle East and experience a recession? We don’t need to guess, because history has shown us.
The events I mentioned all happened in 1990. The price of oil spiked in August 1990, the same month that the US went into an actual war in the Middle East. In July 1990, the US entered a recession. Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.
What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table below – constructed partially from Morgan Housel’s data – illustrates. Yet, the S&P 500 has steadily marched higher.
Earlier, I talked about COVID-19. I think it would be appropriate to also show how global stocks have done after the occurence of deadly epidemics.
My blogging partner, Jeremy, included the chart just above in a recent article. It illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics that have happened since. He commented:
“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”
So I carry this important mindset with me (the fifth one): Uncertainty is always around, but that does not mean we should not invest.
The sixth mindset
We’ve seen in the data that market crashes and recessions are bound to happen periodically. But crucially we don’t know when they will occur. Even the best investors have tried to outguess the market, only to fail.
So if we’re investing for many years, we should count on things to get ugly a few times, at least. This is completely different from saying “the US will have a recession in the third quarter of 2020” and then positioning our investment portfolios to fit this view.
The difference between expecting and predicting lies in our behaviour. If we merely expect downturns to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we’re engaged in the dark arts of prediction, then we think we know when something will happen and we try to act on it. Our investment portfolios will thus be suited to thrive only in a narrow range of situations – if things take a different path, our portfolios will be on the road to ruin.
Here’s an interesting thought: If we can just somehow time our stock market entries and exits to coincide with the end/start of recessions, surely we can do better than just staying invested, right?
The chart below is from investor Michael Batnick. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly.
This is why my sixth mindset is that we should expect bad things to happen from time to time, but we should not try to predict them.
In conclusion
To recap, here are the six mindsets that have been very useful for me:
First, volatility in stocks is a feature, not a sign that something is broken
Second, think of short-term volatility in the stock market as a fee, not a fine
Third, what goes up does not always come down permanently
Fourth, it is important to diversify across geographies and companies
Fifth, uncertainty is always around, but we should still invest
Sixth, we should expect bad things to happen from time to time in the financial markets, but we shouldn’t try to predict them
They have helped me to be psychologically comfortable when investing. Without them, I may become flustered when things do not go my way temporarily or when uncertainties are rife. This could in turn result in bad investing behaviour on my part. I hope these mindsets can benefit you too.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
My family’s portfolio has held Booking Holdings shares for a few years and it has done well for us. Here is why we continue to own Booking Holdings shares.
Booking Holdings (NASDAQ: BKNG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Booking shares for the portfolio in May 2013 at a price of US$765 and subsequently made three more purchases (in December 2014 at US$1,141, in February 2016 at US$1,277, and March 2017 at US$1,771). I’ve not sold any of the shares I’ve bought.
The first three purchases have worked out pretty well for my family’s portfolio, with Booking’s share price being around US$1,990 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Booking shares.
Company description
Booking, formerly known as Priceline, was listed in March 1999, right in the middle of the dotcom bubble. When the bubble met its sudsy end, Booking’s share price collapsed by over 99% from peak-to-trough. But like a phoenix rising from the ashes, Booking’s share price then embarked on an incredible climb of more than 30,000% from the bottom (reached in October 2002) to where it is today.
At the beginning of its life as a public listed company, Booking was in the online travel business. Today it is still in the online travel business. The difference between now and then is that Booking was an unproven business with significant losses in the days of yore. Now, it is the world’s largest online travel company, and very profitable. Some of you may have booked hotels online with Agoda or Booking.com – that’s Booking, the company, in action!
In the first nine months of 2019, Booking pulled in US$11.7 billion in revenue. These came primarily from the following brands the company has:
Booking.com – one of the world’s largest, if not the largest, online service for booking accommodation reservations
KAYAK – an online service for users to search and compare prices for air tickets, accommodations, and car rentals from hundreds of travel websites
priceline – an online travel agent in North America for reservations of hotels, rental cars, air tickets, and vacation packages
Agoda – a website for accommodation reservations, with a focus on consumers in the Asia-Pacific region
Rentalcars.com – an online worldwide rental car reservation service
OpenTable – allows consumers to make restaurant reservations online, and provides restaurant reservation management and customer acquisition services to restaurant operators.
Booking.com, which is based in the Netherlands, is Booking’s largest brand – it accounted for 77% of the company’s total revenue in the first nine month of 2019. Because of the location of Booking.com’s headquarters, Booking counts the Netherlands as its largest geographical market (a 77% share of the pie). The US is Booking’s next largest country, with a 10% share of total revenue.
Each time you make a hotel reservation, Booking earns either the entire room rate as revenue, or earns a referral fee. This is because the company runs two different business models:
There is the merchant model, where Booking earns the entire room rate when rooms are booked through its platforms. It is a more complex model as the company has to negotiate room prices and allocations with the operator of the property. Ensuring parity between the company’s room-rate and the operator’s room-rate is likely also a tricky problem.
Then there is the agency model, which is a lot simpler. It allows hoteliers to set their own price and room allocations. Under this model, Booking is the agent that passes customer reservations to hotels and it collects a commission fee for each reservation made. Guests also pay only on checkout, compared to the merchant model where guests have to pay when the reservation is made (so now you know why certain travel websites require you to pay upfront, while some don’t!).
In the first nine months of 2019, 68% of Booking’s total revenue of US$11.7 billion came from its agency business, while 25% was from the merchant model. Advertising and other types of services accounted for the rest. Nearly all of Booking’s agency revenue came from Booking.com.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Booking.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
I’m confident that online travel is a huge and growing market because of a few data points.
First, according to statistics from travel research firm PhocusWright that were cited by travel review site TripAdvisor, the global travel market was estimated to be US$1.3 trillion in 2016, with online travel spend accounting for US$492 billion (38%). The latest data from PhocusWright that was cited by TripAdvisor in the latter’s November 2019 investor presentation showed that the global travel market had expanded to around US$1.7 trillion for 2019.
Second, Allied Market Research released a report in mid-2019 that contained a forecast for the online travel market to grow by 11.1% annually from 2016 to 2022 to reach US$1.1 trillion.
Third, aircraft manufacturer Airbus expects air travel traffic to grow by 4.3% annually from 8.7 trillion RPK in 2018 to 20.3 trillion RPK in 2038, driven by a rising middle class population across the globe (from 3.95 billion individuals in 2018 to 5.94 billion in 2038). Air travel traffic has been remarkably resilient in the past, and had grown by around 5.5% annually in the 30 years from 1988 to 2018. The chart just below shows the growth of global air travel traffic, in terms of RPK (RPK stands for revenue passenger-kilometres, which is the number of fare-paying passengers multiplied by the distance travelled), since 1978.
Source: Airbus Global Market Forecast 2019-2038
The following chart shows the sources for the expected global air travel traffic growth of 4.3% per year from 2019 to 2038:
Source: Airbus Global Market Forecast 2019-2038
For context, Booking’s revenue is only US$14.9 billion over the last 12 months, suggesting a long runway for growth for the company.
2. A strong balance sheet with minimal or a reasonable amount of debt
Booking has a strong balance sheet right now, with slightly more cash and investments than debt as of 30 September 2019 (US$8.8 billion in cash and investments against US$8.5 billion in debt).
Note: Booking’s cash and investments of US$8.8 billion excludes US$2.9 billion in strategic investments that the company has in Trip.com (a China-focused travel agent), Meituan Dianping (a China-based e-commerce platform for services), Didi Chuxing (China’s leading ride hailing platform), and other private companies, such as Grab, the Singapore-based version of Didi Chuxing.
The company also has an excellent track record in generating free cash flow. I’ll discuss this later.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Glenn Fogel, 57, is currently Booking’s CEO. He joined the company in February 2000 and was promoted to his current role in January 2017. Prior to being CEO, Fogel was already a key leader in Booking since 2009. I appreciate his long tenure with the company. Seeing Booking promote from within is also a positive sign on its culture.
Fogel’s total compensation was US$20.5 million for 2018, which is a tidy sum of money. But it is a reasonable amount when we consider that Booking’s profit and free cash flow in 2018 were US$4.0 billion and US$4.6 billion, respectively.
68% of Fogel’s total compensation for 2018 came from long-term stock awards that depend on the performance of Booking’s stock price and adjusted EBITDA (earnings before interest, taxes, depreciation, and amortisation) over a three year period. I’m not the biggest fan of EBITDA and would much prefer the use of earnings per share or free cash flow per share. I also typically frown upon compensation plans that are linked to a company’s stock price. But there are strong redeeming factors in Booking’s overall compensation structure:
The adjusted EBITDA excludes any positive impacts from acquisitions as well as the sale of loss-making subsidiaries; so, the performance of the adjusted EBITDA will have to depend on the growth of Booking’s core businesses.
The changes to adjusted EBITDA and the stock price are measured over three years, which is a sufficiently long time period (although I wouldn’t mind an even longer time frame!).
Fogel’s base salary and cash bonus is designed to be below the market rate, to incentivise him to lead Booking towards strong long-term business performance in order to earn his attractive stock awards.
In all, I think that Booking’s compensation structure for Fogel aligns his interests with mine as a shareholder of the company. I want to point out too that Booking’s other key leaders, including CFO David Goulden (59 years old) and General Counsel Peter Millones Jr. (49 years old), also have similar compensation structures as Fogel’s. In addition, Booking’s compensation plan for its leaders has been substantially similar for many years – that’s another plus-point for me on the integrity of the company’s management team.
I also want to mention Jeffrey Boyd, 62. He has been the Chairman of Booking’s board of directors since January 2013, and was CEO of the company from November 2002 to December 2013. He also became interim CEO from April 2016 to December 2016 (more on this in the Risk section of this article). As Chairman of the board, Boyd’s compensation was just US$491,399 in 2018. It is an extremely low sum compared to the scale of Booking’s business, and I think it’s another testament to the integrity that Booking’s leaders have.
On capability and innovation
Earlier, I mentioned that Booking’s key brand is Booking.com. In 2005, Booking acquired the Netherlands-based Booking.com for merely US$133 million. In just the first nine months of 2019, Booking.com produced around US$9 billion in revenue, representing 77% or so of Booking’s overall top-line. These stunning figures make the acquisition price-tag of US$133 million look like one of the greatest business deals of all time. Jeffrey Boyd, the company’s current Chairman of the Board, was Booking’s CEO at the time of the acquisition.
As a platform for online travel reservations, I believe Booking’s business exhibits a classic network effect, where having more accomodation properties on its platform leads to more visitors, which in turn leads to more accommodation properties. Booking’s management has done a fantastic job in growing its accommodations network over the years. The table below shows this, along with the growth in the number of room nights booked by travellers, demonstrating the power of Booking’s network effect.
Source: Booking annual reports and earnings updates
The company’s growth in unique accommodations is noteworthy. Online travel is a massive and growing market, so I think there is room for multiple winners. But I still see AirBnB, with more than 6 million listings in early 2019, as one of the main threats to Booking’s business. (Note: The definition of listings by AirBnB is different from Booking’s property-count in the table above, but the key point is that AirBnB also has a wide network.) I’m sure most of you reading this have used, or at least heard of, AirBnB’s online platform that provides travellers with alternative accommodation options to hotels. Booking has amassed a sizable inventory of unique accommodations of its own, to management’s credit – and this part of the business is growing faster than Booking’s main hotel business.
There’s an aspect of Booking’s accommodations network that I think is underappreciated by investors: The supplier- and customer-support that is provided by the company. Booking is able to provide 24/7 support in nearly 50 languages – small, independent hotels and owners of alternative accommodations are unable to provide that for travellers. This is why Booking believes its services enable this group of accommodation-providers to reach a wider audience than they otherwise could by themselves. To be clear, Booking believes that its services are valuable to large hotel chains too. It is worth noting that independent hotels make up around 40% to 50% of the total hotel supply in Asia Pacific, Middle East, Africa, Europe, and Latin America; in the US, it is 72%.
Bookiing’s leaders have also proven to be quick to adapt, in my view. I want to bring up two points on the matter.
First, the company had produced significant growth in agency revenue from 2007 to 2017, with merchant revenue being relatively flat (especially from 2011 to 2017). But when the agency business started facing growth headwinds in 2018 and the first nine months of 2019, the merchant business helped to pick up the slack with significant growth. These are shown in the table just below.
Source: Booking annual reports and earnings updates
Second, the company had traditionally been big spenders on performance marketing, which are marketing expenses on online search engines (primarily Google) and other travel-related websites to drive traffic to Booking’s own websites. But after experiencing a decline in the return on investment in performance marketing, Booking started to place heavier emphasis on brand marketing in the past few years.
I believe that brand advertising will be a net benefit to the long-term health of Booking’s business – if the brand advertising efforts are a success, travellers will flock to Booking’s websites without the need for the company to advertise online. The changes in the growth of Booking’s performance marketing spend and brand marketing spend over the past few years is shown in the table below. The early signs are mixed. On one hand, Booking’s direct channel (where customers head to the company’s websites directly) is growing faster than its paid channel (where customers visit the company’s websites because of performance-marketing adverts). On the other hand, management had expected its brand advertising results to be better. I have confidence that Booking’s management will work things out in the end.
Source: Booking annual reports and earnings updates
Booking’s culture can be described as decentralized, empowered, and innovative. According to a 2014 interview of Booking’s former CEO, Darren Huston, the company operates in small teams that are no larger than eight people, and runs more than 1,000 concurrent experiments on its products every day. Booking’s current CEO, Glen Fogel, was interviewed in 2018 by Skift and revealed that constant testing is still very much in the company’s DNA.
Perhaps the greatest feather in the cap of Booking’s management is the fact that the company has handily outpaced its rival Expedia over the long run. In 2007, Expedia’s revenue was almost twice of Booking’s. But Booking’s revenue over the last 12 months was significantly higher than Expedia’s.
Source: Expedia and Booking earnings updates
Being a travel-related technology company, it’s no surprise to learn that Booking also has an innovative streak. The company is working with machine learning and artificial intelligence to improve people’s overall travel experience. In particular, Booking’s highly interested in the connected trip, where a traveller’s entire travel experience (from flights to hotels to ground-transport to attraction-reservations, and more) can be integrated on one platform. Another nascent growth area for Booking is payments, which the company started investing in only in recent years. Here’s CFO David Goulden describing the purpose of the company’s payments platform during Booking’s 2018 third-quarter earnings conference call:
“[The payments platform] does a number of great things for us, for our customers and our partners. For our customers, it gives them many more choices to how they may want to pay for their transactions in advance or closer to the stay, it gives them more opportunities to pay with the payments product of their choice, it may not necessarily be a credit card, it could be something like an Ally pay for example.
For us, it lets us basically provide our customers with a more consistent service, because we’re in charge of exactly how that payment flow works.
And then for our partners, again, we offer them more ability to access different payment forms from different customers in different parts of the world, because we can basically pay them the partner in the form of whatever they like to take even though we may have taken the payment in on the front end, there are different payment mechanisms.”
I also think management’s investments in a number of Asia-focused tech start-ups are smart moves. As I mentioned earlier, Booking has stakes in Meituan Dianping, Didi Chuxing, and Grab. These investments aren’t just passive. Booking is actively collaborating with some of them. Here’s Booking’s CEO Glenn Fogel in the aforementioned interview with Skift describing how the company is working with Didi Chuxing to improve the experience of travellers in China:
“Now until recently by the way, DiDi only had a Chinese app. Kind of hard for most of the people who go to China to use it. Recently now, they have an English language one. But still, we have a lot of customers, English isn’t their language, right? So what we’ve done is this deal is so wonderful.
One, our customers, they go onto the Booking.com or they go to the app and you’ll be able to get that ground transportation from Didi app in the language that they were doing the work with Booking or Agoda. Really good. Nice, seamless, frictionless thing. Second thing is, we’re going to work with them so we can help make sure all those Didi customers know about Booking.com and Agoda. You need a place to stay, that’s where you can go and get a great deal, a great service in Chinese.”
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
I believe that Booking’s revenue streams are highly recurrent because of customer-behaviour. Each time you travel, you’ll need to reserve accommodations and arrange for transport options. Moreover, I think it’s highly likely that Booking does not have any customer-concentration – I showed earlier that 654 million room-nights were reserved through Booking’s platforms in the first nine months of 2019.
5. A proven ability to grow
The table below shows Booking’s important financials from 2007 to 2018:
Source: Booking annual reports
A few key points about Booking’s financials:
Revenue has compounded impressively at 23.6% per year from 2007 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower but still strong at 16.4%.
The company also managed to produce strong revenue growth of 33.8% in 2008 and 24.0% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
Net profit has surged by 35.7% per year from 2007 to 2018. Like revenue-growth, Booking’s net profit growth from 2013 to 2018 is slower, but still healthy at 16.1%.
Operating cash flow has not only grown in each year from 2007 to 2018. It has also increased markedly with annual growth of 37.9%, and been consistently positive. The growth rate from 2013 to 2018 was considerably slower at 18.3% per year, but that is still a good performance.
Free cash flow, net of acquisitions, has consistently been positive too and has also stepped up from 2007 to 2018 at a rapid clip of 38.9% per year. The annual growth in free cash flow from 2013 to 2018 was 19.7% – not too shabby. Booking’s free cash flow fell dramatically in 2014 because it acquired OpenTable for US$2.4 billion during the year.
The net-cash position on Booking’s balance sheet was mostly positive. I include Booking’s investments in bonds and debt as part of its cash, but I exclude the company’s strategic investments.
Dilution has also been negligible for Booking’s shareholders from 2007 to 2018 with the diluted share count barely rising in that period.
2019 has so far been a relatively tough year for Booking. Revenue was up by just 3.7% to US$11.7 billion in the first nine months of the year. Adverse currency movements and a decline in the average room-rate had dented Booking’s top-line growth. Profit inched up by just 0.9% year-on-year to US$3.28 billion after stripping away non-core profits. Booking has strategic investments in other companies and some of them are listed; accounting rules state that Booking has to recognise changes in the stock prices of these companies in its income statement. A 9.4% reduction in the company’s diluted share count to 43.9 million resulted in adjusted earnings per share for the first nine months of 2019 climbing by 11.4% to US$74.52 from a year ago. Operating cash flow declined by 11.0%, but was still healthy at US$3.8 billion. Free cash flow was down 6.9% to US$3.5 billion. The balance sheet, as mentioned earlier, remains robust with cash and investments (excluding the strategic investments), slightly outweighing debt.
Booking has an impressive long-term track record of growth, so I’m not concerned with the slowdown in 2019 thus far. The market opportunity is still immense, and Booking has a very strong competitive position with its huge network of accommodations spanning large hotel chains to unique places to stay.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
There are two reasons why I think Booking excels in this criterion.
Firstly, the company has done very well in producing free cash flow from its business for a long time. In the past five years from 2013 to 2018, its average free cash flow margin (free cash flow as a percentage of revenue) was strong at 26.5%. Booking’s free cash flow margin was 29.8% in the first nine months of 2019.
Secondly, there’s still tremendous room to grow for Booking. This should lead to higher revenue for the company over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Booking in the future.
Valuation
I like to keep things simple in the valuation process. In Booking’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value for two reasons: (1) The online travel company has a strong history of producing positive and growing free cash flow; and (2) the company’s net profit is muddied by the inclusion of changes in the stock prices of its strategic investments.
Booking carries a trailing P/FCF ratio of around 20 at a share price of US$1,990. This ratio strikes me as highly reasonable when we look at the company’s excellent track record of growth, strong network of accommodation options across its websites, and opportunities for future expansion in its business. Moreover, this P/FCF ratio is low when compared to history. The chart below shows Booking’s P/FCF ratio over the past five years.
The risks involved
Every company has risks, and Booking is no exception. There are a few key ones that I see.
The first is management turmoil. I have confidence in the quality of Booking’s current leaders. But the company has seen some management shake-ups in recent years.
Earlier, I mentioned that current Chairman Jeffrey Boyd had to become interim CEO in April 2016 (till December 2016). That’s because the then-CEO of both Booking and Booking.com (Booking.com is the main brand of Booking the company), Darren Huston, stepped down from his roles in the same month after he was caught in a relationship with an employee. He was promoted to CEO of Booking only in January 2014. Gillian Tans, a long-time Booking employee, assumed the position of CEO for Booking.com right after Huston’s departure. But she was replaced by Glenn Fogel after just over three years (Fogel is now the CEO of both Booking.com and Booking the company). Booking’s current CFO, David Goulden, stepped into his current role only in January 2018 after long-time CFO Daniel Finnegan announced his retirement in 2017. The good thing is that Booking can still benefit from Boyd’s experience, and Fogel has a long tenure with the company. I will be keeping an eye on leadership transitions at Booking.
The second risk involves downturns in travel spending. Travellers could tighten their purse strings in the face of a global recession or slowdown in economic growth, for instance, since travel can be considered a discretionary activity. The good thing here is that Booking managed to post significant growth during the Great Financial Crisis. But the company’s much larger today, so it may not be able to outrun a future recession as it has in the past.
Another potential important reason for consumers to travel less will be outbreaks of contagious diseases. The world – particularly China – is currently battling COVID-19. If the situation worsens, Booking’s business could be hurt. The good thing with such cases is that the idea of “This too, shall pass” applies. Natural disasters could also dent travel spending. In 2010, the Icelandic volcano Eyjafjallajökull erupted. Many flights that involved Europe were disrupted for a period of time, and the episode was a speed bump for Booking. The clouds eventually cleared for the company, but there could be similar instances in the future.
The last important risk I see with Booking relates to competition. In 2018, Google launched Google Hotels, its search product that focuses on – you guessed it – hotels. As a result, travel websites such as Expedia and TripAdvisor started feeling the heat from Google. This is what Skift reported in a November 2019 article:
“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact…
… Both Okerstrom [Expedia CEO] and Kaufer [TripAdvisor CEO] complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”
This is where Booking’s huge spending on performance marketing and pivot toward brand marketing comes into play. Booking has been spending billions of dollars on performance marketing, most of it likely on Google Search – this stands in contrast to Expedia and TripAdvisor, which have relied more heavily on free search results from Google. So I believe that Google and Booking currently have a frenemy type of relationship – both rely on each other for business but are also somewhat competitors. But if Booking is successful in building its brand and mindshare among travellers through its brand marketing initiatives, there will be a lot less reliance on Google, thereby lessening the threat of the online search giant.
AirBnB, with its focus on alternatives to hotels, could also be a formidable threat for Booking. Moreover, AirBnB has been making inroads into the hotel-reservations business, such as its acquisition of HotelTonight in March 2019. But like I mentioned earlier, Booking has its own huge and growing supply of hotel-alternatives for travellers to choose from. Ultimately though, I believe that online travel is such a huge pie that multiple winners can exist – and Booking is likely to be one of those.
Meanwhile, in Booking’s latest quarterly earnings report, it also listed other internet giants besides Google – the list includes Apple, AliBaba, Tencent, Amazon, and Facebook – as potential competitors with significant resources to mount a serious assault on the company’s business. So far, Booking has held its own. But it is always possible that another company might build a better mousetrap in the future.
A smaller risk that I perceive relates to Booking’s multi-billion stakes in the Chinese companies, Meituan Dianping, Trip.com, and Didi Chuxing. Booking’s investments in them are based on a variable interest entity (VIE) structure, which is considered to be common with Chinese internet companies. But there’s a risk that China’s government may someday view the VIE structure as a violation of China’s laws.
The Good Investors’ conclusion
I think the online travel market holds immense opportunities for companies, especially for an organisation with a wide network of hotels and alternative accommodations, such as Booking, for instance.
Furthermore, Booking has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. Booking’s P/FCF ratio is also low in relation to its own history.
Every company has risks, and I’m aware of the important ones with Booking. They include recent management turmoil, competition from Google and other tech players, and a few factors that could dampen travel spending. But after weighing the risks and rewards, I’m more than happy for my family’s investment portfolio to continue flying high with Booking.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Shopify’s stock has skyrocketed 18-fold in just under 5 years. While the growth stock looks poised to continue growing, is the stock too expensive now?
Shopify is one of the hottest stocks in the market right now. The e-commerce platform has seen its stock rise 18-fold since it went public in 2015, with much of that gain coming in the past 13 months.
But the past is the past. What investors need to know is whether the stock has the legs to keep up its market-beating performance. With that said, here’s an analysis of Shopify, using my blogging partner Ser Jing’s six-point investment framework.
1. Is Shopify’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Canada-based Shopify is a cloud software company that empowers entrepreneurs and even large enterprises to develop online storefronts to sell their goods.
It earns a recurring monthly subscription from retailers that use its platform. In addition, Shopify collects other fees for merchant solutions such as payment processing fees, Shopify Shipping, Shopify Capital, referral fees, and points-of-sale hardware.
All of Shopify’s services essentially make the entire e-commerce experience more seamless for the retailer. From the building of a website site to the collection of payments and the shipping of the product to the user, everything can be settled with a few clicks of a button.
Based on the way Shopify charges its customers, there are two factors that are needed to drive growth: (1) Increasing the number of users for the company’s platform and (2) higher gross merchandise value (GMV) being sold by Shopify’s retailers.
In 2019, Shopify generated US$1.578 billion in revenue. Of which, US$642 million was from its subscription service and US$935.9 million was from merchant solutions. Shopify also breached the 1 million user milestone in 2019.
On the surface, these figures may seem big but it’s still small compared to Shopify’s total addressable market size.
The global online retail market is expected to grow from around US$3.5 trillion in 2019 to US$6.5 trillion in 2023. Comparatively, Shopify’s gross merchandise value for 2019 was only US$61.1 billion, which translates to just 1.7% of the total e-commerce market.
Shopify is well-positioned to grow along with the wider industry and also has the potential to gain market share.
This growth is likely to be fueled through the company’s international expansion. Shopify only increased the number of native languages on its platform in 2018 as it begun to target the international market.
The number of merchants outside its core geographies of the US and Canada are also growing much faster and will soon become a much more important part of Shopify’s business.
2. Does Shopify have a strong balance sheet with minimal or a reasonable amount of debt?
Shopify is part of a rare breed of high growth companies that have no cash problems. As of December 2019, the software company had US$2.5 billion in cash and marketable securities and no debt.
It is also generating a decent amount of cash from operations. Net cash from operations was US$70 million in 2019, despite it reporting a GAAP loss. Shopify also turned free cash flow positive in the year.
A large part of the diversion between cash flow and the GAAP-loss is that a large portion of Shopify’s expenses are in the form of stock-based compensation, which is a non-cash expense.
In September 2019, Shopify also raised around US$600 million in cash in a secondary offering of shares at US$317.50 apiece. The cash was immediately put to use to pay 60% of its acquisition of 6 River Systems, which makes robotic carts for order fulfillment centres. The acquisition will automate part of Shopify’s nascent but growing fulfillment network, enabling it to compete with the one-day shipping that Amazon is offering.
3. Does Shopify’s management team have integrity, capability, and an innovative mindset?
Tobi Lutke, Shopify’s CEO and founder, has proven to be a capable leader.
Shopify was born after Lutke himself tried to start an online shop selling snowboards. He realised that there were many challenges involved with selling a product online and that a solution to make the whole process easier was needed.
So far, Lutke’s focus on the customer experience has increased Shopify’s market share even though it operates in a highly competitive environment, which includes Amazon and Adobe’s Magento.
I think Lutke has taken the right steps to make Shopify a force to be reckoned with. His decision to focus on the core English-speaking geographies at the start proved sensible as Shopify increased its presence in those markets first before pursuing international growth.
Shopify has also made sensible capital allocation decisions in the past. I think 6 River Systems looks to be an astute acquisition – it should improve Shopify’s competitiveness in terms of the speed and cost of fulfilling orders.
In addition, Shopify’s compensation structure for executives is tilted towards long-term objectives. Lutke received US$586,000 in base salary in 2018 and US$8 million in shares and options-based awards that vest over a three-year period.
It is also worth noting that Shopify has consistently beaten its own forecasts. As an investor, I appreciate a management team that is able to over-deliver on its promises.
4. Are Shopify’s revenue streams recurring in nature?
If you’ve read our blog before, you know that Ser Jing and I love companies that have recurring revenue. Recurring revenue provides a consistent platform for businesses to build on. A company that does not have to worry about retaining existing revenue can focus more of its efforts on growing its business.
Shopify ticks this box.
Its subscription service is a monthly auto-renewal contract that is recurring in nature. As of December 2019, monthly recurring revenue for its subscription service was US$53.9 million. That translates to a run rate of around US$650 million, which is around 35% of its projected 2020 revenue.
Shopify’s merchant solutions are less consistent and more dependent on the gross merchant value (GMV) sold by merchants using its platform.
That said, the GMV sold by merchants on the company’s platform has risen considerably in the past and looks poised to continue doing so.
In 2019, merchants selling on the Shopify platform for 12 months or more grew their GMV year-on-year by an average rate of 21%. The more successful its partner-merchants are, the more Shopify can earn from its merchant solutions.
5. Does Shopify have a proven ability to grow?
Shopify certainly does well here too. The chart below illustrates the company’s immense track record of revenue-growth since 2012.
In 2019 (not pictured in the graph), Shopify’s revenue increased by 47% to US$1.578 billion, and revenue is expected to top US$2 billion in 2020.
Although growth has decelerated of late, Shopify is still expected to grow by double digits for the foreseeable future.
Not only are the number of merchants using the platform increasing, but existing clients are also seeing more sales. The chart below illustrates the revenue earned by annual cohort:
Source: Shopify Year in Review 2018
Shopify’s existing clients have increasingly paid more fees to Shopify. Shopify describes the trend saying:
“The consistent revenue growth coming from each cohort illustrates the strength of our business model: the increase in revenue from remaining merchants growing within a cohort offsets the decline in revenue from merchants leaving the platform.”
6. Does Shopify have a high likelihood of generating a strong and growing stream of free cash flow in the future?
Shopify already turned free cash flow positive in 2019. That’s a good achievement for a company growing as fast as Shopify is.
It’s also important that there seems to be a clear path toward profitability. Shopify’s subscription revenue and merchant solutions have a gross margin of 80% and 38%, respectively.
The high gross margins will enable the company to profit when it reins in its marketing expenses. In 2019, sales and marketing made up about 30% of revenue. However, that has been trending down in recent years. For instance, in 2018, sales and marketing expenses were 35% of revenue.
Although Shopify is still spending heavily on international expansion, based on its 2019 results, I think that it will start to see more consistent profit and free cash flow generation in the future.
It is also heartening to note that management seems sensible in its approach to growth. In a recent interview with the Motley Fool, CEO Lutke said:
“Shopify had an ambition to be a profitable company for its first four years, and then it accomplished this in years five and six. Only afterwards (when) the venture capital and then into an investment mode which we’re still in.
So I know what it feels like to run a profitable company. I loved it. I really want to get back there at some point. Not a lot of things are much better in life than the company you’re running happens to be profitable. But I think it would have been also a grave mistake to not change gears back then, because clearly the opportunity was the right one. We needed this investment money. We needed to invest.”
Risks
Competition
One of the biggest risks I see with Shopify is competition. The e-commerce enabler is fighting with some of the biggest tech companies on the planet. Amazon has its own market place that enables third-party merchants to sell products. Amazon’s fulfilment network also provides merchants with the ability to ship its products within a day.
But unlike Amazon, Shopify enables entrepreneurs to build their very own virtual storefront. Amazon sellers, on the other hand, have to sell their products on a common market place and are also competing with Amazon’s own products. This is why Shopify has been able to attract a growing number of retailers to its platform each year.
Other players such as Magento (owned by Adobe), Woo Commerce, and Wix also provide startups with the necessary tools to build their very own online store.
I believe Shopify currently has an edge over its competitors due to its integration with numerous apps and other services it provides such as payment, fulfillment, and referrals etc. But the competitive landscape could change and Shopify needs to continue innovating to stay ahead.
Key-man risk
Another big risk is key-man risk. Tobi Lutke has led the company from a young start-up to one that is generating more than a billion in revenue each year in a relatively short amount of time. That’s an amazing feat and his leadership has been key to Shopify’s success.
Although I don’t see him stepping down anytime soon, a change in leadership – if it happens – may be detrimental to Shopify’s vision and progress.
Stock-based compensation
Anothing thing I am keeping my eye on with Shopify is its stock-based compensation. Although stock-based compensation could align the interests of the company’s employees and leaders with shareholders’, Shopify’s stock-based compensation has been very high relative to its revenue.
In 2019, stock-based compensation was US$158 million compared to revenue of US$1.57 billion. That means that almost 10% of all revenue generated is being paid back to management in the form of stocks, diluting existing shareholders in the process. Ideally, I want to see revenue grow much faster than stock-based compensation in the future. Stock-based compensation was up by 65.5% in 2019.
Valuation
This is where I think Shopify fails. The e-commerce enabler has a market cap of US$60 billion. That’s a whopping 30 times next years’ sales-estimate. Even for a company that is growing as fast as Shopify is, that number is hard to justify.
Shopify’s valuation today looks pricey even if we assume that (1) it doubles its market share, (2) total GMV grows to US$6.5 trillion, (3) merchants on Shopify’s platform doubles by 2022, and (4) the company generates a 10% profit margin.
If all the above assumptions come into fruition, Shopify’s current shares still trade at a lofty 12 times projected revenue and 120 times earnings.
The Good Investors’ conclusion
There are so many things I admire about Shopify. It is led by a visionary leader who has grown Shopify into a dominant e-commerce player. Besides Shopify’s impressive top-line growth, it is also one of the rare fast-growing SaaS (software-as-a-service) companies that are already free cash flow positive. Moreover, its untapped addressable market is immense.
However, while I would love to participate in Shopify’s growth, the company’s stock seems too expensive at the moment.
I think the market has gotten ahead of itself and the long-term returns on the stock do not look enticing due to its frothy valuations. As such, I prefer waiting for a slightly lower entry point before dipping my toes in this fast-growing SaaS firm.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The life and investing principles of Warren Buffett are laid bare in the book “Tap dancing to Work”. Here are some of the best bits from the book.
I recently read the book Tap Dancing to Work. Compiled by Carol Loomis, Tap Dancing to Work is a collection of articles published on Fortune magazine between 1966 and 2012 that are on Warren Buffett or authored by himself.
Even though some of these articles were penned more than 50 years ago, they hold insights that are still relevant today. With that, here’s a collection of some of my favourite quotes from the book.
On why buying mediocre companies at a cheap price is not ideal
“Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces- never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded by the low returns that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realise a high return. But the investment will disappoint if the business is sold for $10 million in 10 years and in the interim has annually earned and distributed only a few percents on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”
In his 1989 annual letter to Berkshire Hathaway shareholders, Buffett outlined some of the mistakes he made over his first 25 years at the helm of the company. One of those mistakes was buying control of Berkshire itself. At that time, and being trained by Ben Graham, Buffett thought that buying a company for a cheap price would end up being a good investment.
However, such bargain-priced stocks may take years to eventually trade at their liquidation value. This can result in very mediocre returns, even after paying a seemingly low price for the company and its assets.
Buffett later reasoned that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
On why Berkshire does not leverage more
“In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually average. Even in 1965, we could have judge there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.
We wouldn’t have liked those 99:1 odds- and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster.”
It is often tempting to invest on margin (in other words, borrowing to invest) as it can accelerate your gains. However, using leverage to invest can also result in distress and bankruptcy, both for the individual investor and companies alike.
Take the 2008 crisis for instance. The S&P 500 – the US’s stock market benchmark – lost approximately 50% of its value. An investor who invested on a 50% margin would have faced a margin call and his entire portfolio would be wiped out.
Although cases like this are infrequent, as Buffett believes, it is always better to err on the side caution.
On the simple economics of valuing a financial asset
“A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset was valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until judgement day, discounted back to the present at the same interest rate.”
In 1998, Buffett and Bill Gates spoke at the University of Washington, answering any questions that students threw at them. One of the students questioned whether the traditional way of valuing companies was still relevant at that time.
Buffett’s simple method of valuation can be applied to any financial asset. For a stock, it involves coming up with a prediction of the company’s future free cash flows and discounting them back to the present. This simple method of valuation is the ideal method of valuing a stock and is still used by numerous investors today.
On risk
“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the popularity- the reasoned probability- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see (he goes on to describe gold), a nonfluctuating asset can be laden by risk.”
In his 2011 Berkshire letter to shareholders, Buffett addressed the topic of risk. Investors are often concerned about the possibility of making a paper loss in their investments.
However, volatility should not be misconstrued as risk. Buffett instead defines risk as the chance of suffering a permanent loss or the inability of the investment to produce meaningful growth in purchasing power.
On being thankful and giving back…
Buffett is not just a brilliant investor but also a terrific human being. His humility and generosity are clearly demonstrated by his philanthropic pledge to donate 99% of his wealth to charity.
“My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricings of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.
The reaction of my family and me to our extraordinary good fortune is not guilt, but rather gratitude. Were we to use more than 1% of my claim checks on ourselves, neither our happiness nor our well-being would be enhanced. In contrast, the remaining 99% can have a huge effect on the health and welfare of others. That reality sets an obvious course for me and my family. Keep all we can conceivably need and distribute the rest to society, for its needs. My pledge starts us down that course.”
The Good Investors’ Conclusion
Tap Dancing to Work is a priceless collection of articles describing Warren Buffett as a person, a business owner, and an investor. The articles that Warren Buffett penned himself, many of them excerpts from his own annual Berkshire shareholders’ letters, hold immense insights into the global economy and investing. There are many more insights in the book and I encourage all Buffett fans to find the time to read it.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Good capital allocation is the key to compounding shareholder wealth. Here are some ways a company can use capital and how investors should assess them.
Capital allocation is one of the most important decisions a company’s leaders have to make. Good capital allocation will enable the company to grow profits and maximise shareholder returns.
In this article, I will share what are some common uses of capital and how I assess whether management has made good capital allocation decisions.
The different uses of capital
I will start of by describing some of the ways that companies can make use of their financial resources.
1. Reinvesting for organic growth
First, companies can invest their capital to expand the business. This can take multiple forms. For instance, a restaurant chain can spend money opening new stores, while a glove manufacturer may spend cash increasing its annual production capacity. Companies can also spend on research and development for new products or improving an existing product.
A company should, however, only spend on organic growth when there are opportunities to expand its business at good rates of return.
2. Acquisitions and mergers
Big companies with substantial financial strength might decide to acquire a smaller company. An acquisition can help a company by (1) removing a competitor, (2) gaining intellectual property and technology, (3) achieving vertical integration, or (4) increasing its market share and presence.
Ultimately, acquisitions should lead to long-term financial gain for the company and shareholders.
3. Pay off debt
Another way that a company can use its financial resources is to pay down existing debt. This is most effective when interest rates on its debt are high and paying off the debt provides a decent rate of savings.
This is true for a company that has taken on a lot of debt to grow and needs to reduce its debt burden to keep its cost of capital low. Reducing overly high leverage may also be necessary for a company to survive an economic crisis.
4. Share buybacks
A company can also choose to buy back its own shares in the open market. This reduces the number of outstanding shares. What this does is that it increases the size of the pie that each shareholder owns. Share buybacks can create shareholder value if the stocks are bought back below the true value of the company.
5. Pay dividends
Lastly, a company may choose to reward shareholders by returning the excess cash it has to shareholders as dividends. A company may also pay a dividend if there’s no other effective way to use its cash; in such an instance, returning cash may be more beneficial for a company’s shareholders than it hoarding cash.
What’s the best way to use its financial resources?
With so many different ways for a company to use cash, how do investors tell if management is making the best use of a company’s resources to maximise shareholder returns?
Unfortunately, there is no one-size-fits-all solution. Shareholders need to assess manager-decisions individually to see if each makes sense.
That being said, there is one useful metric that investors can use to gauge roughly how well capital has been allocated. That is the return on equity (ROE).
A firm that has been making good capital allocation decisions will be able to maintain a high ROE over the long term. It is also important to see that the company’s shareholder equity is growing, rather than being stagnant (a stagnant shareholder equity implies that a company is simply returning capital to shareholders).
Facebook is an example of a company that has been using its capital effectively to grow its business. The social network’s ROE has grown from 9% in 2015 to 28% in 2018. Furthermore, even after accounting for a US$5 billion fine, Facebook still managed to post a 20% ROE in 2019, demonstrating how efficiently the company is at maximising its resources. Facebook’s high ROE is made even more impressive given that the company has no debt and has not paid a dividend yet.
The best capital allocator
While we are on the subject, I think it is an appropriate time to pay tribute to one of the best capital allocators of all time- Warren Buffett. He has compounded the book value per share of his company, Berkshire Hathaway, at 18.7% per year from 1965 to 2018.
That translates to a 1,099,899% increase in book value per share over a 53-year time frame.
If you invest in Berkshire, you are not merely investing in a business. You are also banking on one of the best money managers of the past half-century.
Buffett’s success in picking great investments to grow Berkshire’s book value per share has, in turn, led to the company becoming one of the best-performing stocks of the last half-century in the US.
The Good Investors’ conclusion
Too often, investors overlook the importance of companies having good capital allocators at the helm. Unfortunately, Singapore is home to numerous listed companies that seem to consistently make poor capital allocation decisions.
These decisions have led to poor returns on equity and in turn, stagnant stock prices. It is one of the reasons why some stocks in Singapore trade at seemingly low valuation multiples.
Knowing this, instead of merely focusing on the business, investors should put more emphasis on the manager’s ability and how capital is being allocated in a company.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The human tragedies of the novel coronavirus (2019 n-CoV) are painful. But as investors, there’s no need to panic if we’re investing for the long run.
As I write this, the novel coronavirus (2019-nCoV) has infected 43,103 people globally and caused the deaths of 1,018 people. China has been the hardest-hit country, accounting for the lion’s share of the infected cases (42,708) and deaths (1,017).
This disease outbreak has already caused plenty of human suffering, especially in China. No one knows how widespread the 2019-nCoV will become around the world. The eventual impact of the virus on the global economy is also impossible to determine. If you’re an investor in stocks in Singapore and/or other parts of the world, it’s understandable to be worried.
A look at the past
But in times like these, we can look at history to soothe our fraying nerves. This is not the first time the world has fought against epidemics and pandemics. If you’re curious about the difference, this is the definition given by the CDC (Centres for Disease Control and Prevention) in the US:
“Epidemic refers to an increase, often sudden, in the number of cases of a disease above what is normally expected in that population in that area… Pandemic refers to an epidemic that has spread over several countries or continents, usually affecting a large number of people.”
My blogging partner, Jeremy, included the chart below in a recent article. The chart illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics. He commented:
“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”
The chart does not show what happened to stocks in the 1910s and 1920s. In 2009, the H1N1 pandemic arose (this is covered in the chart), but it was not the first time the virus had reared its ugly head. The first H1N1 pandemic lasted from 1918 to 1920. The first outbreak infected 500 million people worldwide, of whom 50 million to 100 million died. It was a dark age for mankind.
A tragedy for us, a normal time for investing
But from an investing perspective, it was a normal time. Data from Robert Shiller, a Nobel Prize-winning economist, show that the S&P 500 rose 10% (after dividends and inflation) from the start of 1918 to the end of 1919. From the start of 1918 to the end of 1923 – a six-year period – the S&P 500 rose 48% in total (again after dividends and inflation), for a decent annual gain of 6.8%. There was significant volatility between 1918 and 1923 – the maximum peak-to-trough decline in that period was 30% – but investors still made a respectable return.
I wish I had more countries’ stock market data from the 1910s and 1920s to work with. But the US experience is instructive, since some historical accounts state the country to be the source of the 1918-1920 H1N1 pandemic.
I’m not trying to say that stocks will go up this time. Every point in history is different and there’s plenty of context in the 1910s and 1920s that’s missing from today. For example, in December 1917, the CAPE ratio for the S&P 500 was 6.4; today, it’s 32. (The CAPE ratio – or cyclically-adjusted price-to-earnings ratio – is calculated by dividing a stock’s price with its average inflation-adjusted earnings over the past 10 years.) The interest rate environment was also drastically different then compared to now.
There are limits to the usefulness of studying history. But by looking at the past, we can get a general sense for what to expect for the future. And history’s verdict is that horrific pandemics/epidemics have not stopped the upward march of stocks around the world.
The Good Investors’ take
The human tragedies of a virus outbreak like what we’re experiencing now with the 2019 n-CoV are painful. But as investors, there’s no need to panic if we’re investing for the long run – which is what investing is about, in the first place – and assuming our portfolios are made up of great companies.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
A paradigm shift may be happening soon in the financial markets, according to Ray Dalio. But there’s one thing that won’t change.
Ray Dalio published an article in July 2019 that captured plenty of attention from the investment industry. When Dalio speaks, people listen. He is the Founder, Chairman, and Co-Chief Investment Officer of Bridgewater Associates, an investment firm that is currently managing around US$160 billion.
The times they are a-changin’
In his article, Dalio shared his view that a paradigm shift will soon occur in financial markets. He defines a paradigm as a long period of time “(about 10 years) in which the markets and market relationships operate in a certain way.”
The current paradigm we’re in started in late 2008/early 2009, according to Dalio. Back then, the global economy and stock market reached their troughs during the Great Financial Crisis. The paradigm was driven by central banks around the world lowering interest rates and conducting quantitative easing. The result is we’re now in a debt-glut, and a state of “relatively high” asset prices, “low” inflation, and “moderately strong” growth.
Dalio expects the current paradigm to end soon and a new one to emerge. The new paradigm will be driven by central banks’ actions to deal with the debt-glut. Dalio thinks that central banks will be doing two key things: First, they will monetise debt, which is the act of printing money to purchase debt; and second, they will depreciate currencies. These create inflation, thus depressing the value of money and the inflation-adjusted returns of debt-investors. For Dalio, holding gold is the way for investors to navigate the coming paradigm.
Plus ça change (the more things change)…
I don’t invest based on paradigm shifts, and I’m definitely not abandoning stocks. In fact, I prefer stocks to gold. Stocks are productive assets, pieces of companies that are generating cash flows. Meanwhile, gold is an unproductive asset which just sits there. Warren Buffett explained this view better than I ever can in his 2011 Berkshire Hathaway shareholders’ letter:
“Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while…
… Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At [US]$1,750 per ounce – gold’s price as I write this – its value would be [US]$9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about [US]$200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than [US]$40 billion annually). After these purchases, we would have about [US]$1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with [US]$9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about [US]$160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the [US]$9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
…plus c’est la même chose (the more they remain the same)
But Dalio’s opinion on a coming paradigm shift led me to an inverted thought: Are there things that don’t change in the financial markets? Inverting is a powerful concept in both business and investing. Here’s Jeff Bezos, founder and CEO of US e-commerce giant Amazon, on the topic (emphases are mine):
“I very frequently get the question: “What’s going to change in the next 10 years?” And that is a very interesting question; it’s a very common one. I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time…
…[I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff, I love Amazon; I just wish the prices were a little higher.” “I love Amazon; I just wish you’d deliver a little more slowly.” Impossible.
And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.”
My inverted-thought led me to one thing that I’m certain will never change in the financial markets: A company will become more valuable over time if its revenues, profits, and cash flows increase faster than inflation. There’s just no way that this statement becomes false.
But there’s a problem: Great companies can be very expensive, which makes them lousy investments. How can we reconcile this conflict? This is one of the hard parts about investing.
The tough things
Investing has many hard parts. Charlie Munger is the long-time sidekick of Warren Buffett. In a 2015 meeting, someone asked him:
“What is the least talked about or most misunderstood moat? [A moat refers to a company’s competitive advantage.]”
Munger responded:
“You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied: “You are too young to write a symphony.” The man said: “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said: “Yes, but I didn’t run around asking people how to do it.””
I struggle often with determining the appropriate price to pay for a great company. There’s no easy formula. “A P/E ratio of X is just right” is fantasy. Fortunately, I’m nothelpless when tackling this conundrum.
“Surprise me”
David Gardner is the co-founder of The Motley Fool and he is one of the best investors I know. In September 1997, he recommended and bought Amazon shares at US$3.21 apiece, and has held onto them since. Amazon’s current share price is US$2,079, which translates into a mind-boggling gain of nearly 64,700%, or 33% per year.
When David first recommended Amazon, did it ever cross his mind that the company would generate such an incredible return? Nope. Here’s David on the matter:
“I assure you, in 1997, when we bought Amazon.com at $3.21, we did not imagine any of that could happen. And yet, all of that has happened and more, and the stock has so far exceeded any expectations any of us could have had that all I can say is, no one was a genius to call it, but you and I could be geniuses just to buy it and to add to it and to hold it, and out-hold Wall Street trading in and out of these kinds of companies.
You and I can hold them over the course of our lives and do wonderfully. So, positive surprises, too. Surprise.”
There can be many cases of great companies being poor investments because they are pricey. But great companies can also surprise us in good ways, since they are often led by management teams that possess high levels of integrity, capability, and innovativeness. So, for many years, I’ve been giving my family’s investment portfolio the chance to be positively surprised. I achieve this by investing in great companies with patience and perseverance (stocks are volatile over the short run!), and in a diversified manner.
It doesn’t matter whether a paradigm change is happening. I know there’s one thing that will not change in the stock market, and that is, great companies will become more valuable over time. So my investing plan is clear: I’m going to continue to find and invest in great companies, and believe that some of them will surprise me.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
