Facebook has faced growing scrutiny among regulators. Here are my thoughts on what will happen if it is further regulated or forced to break up.
Most of us don’t go a day without using Facebook or Instagram. But despite its prominence, social media is still a relatively new concept.
The rise of Facebook and social media as an industry has been so swift that regulatory bodies have not been able to properly regulate it.
However, things are starting to change.
Last year, Facebook (NASDAQ: FB) incurred a US$5 billion fine from the Federal Trade Commission (FTC) due to a privacy breach. The company also recently agreed to pay a US$550 million settlement for collecting users’ facial recognition data.
There have also been a few threats from European regulatory bodies and Facebook may even face retrospective fines in the future.
That brings me to my next question: Should Facebook shareholders be worried about regulations?
What are the possible regulatory measures that Facebook faces?
Although fines are painful, they are one-off expenses. The biggest risk is therefore not fines, but regulators forcing Facebook to change the way it operates.
Regulations that could hurt Facebook include prohibiting the kind of advertisements it can offer, or controlling Facebook’s content. Regulators could also force Facebook to spin-off or sell some of its assets. Currently, Facebook owns Instagram, Messenger, and Whatsapp.
Facebook reported in its 2019 fourth-quarter earnings conference call that there are now 2.9 billion people who use Facebook (the social media site), Instagram, Messenger, or Whastapp each month. A recent article from Verge showed that Whatsapp currently has 2 billion users while Instagram has 1 billion (as of June 2018).
The likelihood of extreme regulation
Although regulation is likely to hit Facebook, I think the odds of such extreme regulation are low.
After facing criticism in 2019, Facebook started taking privacy and regulation very seriously.
Facebook’s co-founder and CEO, Mark Zuckerberg, is outspoken about the need for regulation on social media companies. In a 30 March 2019 blog post, Zuckerberg wrote:
“I believe we need a more active role for governments and regulators. By updating the rules for the internet, we can preserve what’s best about it — the freedom for people to express themselves and for entrepreneurs to build new things — while also protecting society from broader harms.”
His willingness to cooperate with regulators should put Facebook in a better position to negotiate.
Moreover, despite all the negativity surrounding Facebook, it’s my opinion that Facebook has done more good than harm to society. Facebook not only provides humans with the ability to connect – it’s also a platform to express ourselves to a wide audience at relatively low cost.
Completely controlling the way Facebook is run will, therefore, have a net negative impact.
As such, I think the risk of extreme regulation is very low.
But what will happen if Facebook is forced to break up
Perhaps the biggest risk is competition law. Facebook is by far the biggest social media company in the world. To promote greater competition in the social media space, regulators could force Facebook to spin-off Whatsapp, Messenger, and Instagram into separate entities.
Such a move will likely erode margins as the separate entities compete for advertising dollars. However, I think the impact of this will not be that bad for shareholders due to the huge and growing addressable market for social media advertising. Zenith estimated in late 2019 that global social media ad spending was US$84 billion for the year, and is expected to increase by 17% in 2020 and 13% in 2021.
A break-up could even be a good thing. It will force Whatsapp and Messenger to find ways to monetise their huge user bases. Currently, Whatsapp is a free platform and does not have any advertisements. If Whatsapp is spun off, investors will want to see it generate some form of revenue either through payments or advertising.
In addition, the separate entities could even command a higher valuation multiple and might even be a net gain for Facebook shareholders prior to the spin-off.
The Good Investors’ conclusion
As social media grows, scrutiny and regulation will inevitably follow. It happens in all industries.
But as a Facebook shareholder, I am not that concerned over regulations. For one, given Facebook’s own stance on regulation, its net positive impact as a platform and its willingness to cooperate with regulators, the odds of extremely unfavourable regulation is very low.
Facebook has also spent big on privacy protection and removing harmful content from its platform. These initiatives should put it in a much better position to negotiate with regulators.
On top of that, anti-competition laws that may force Facebook to break up could even be a good thing for shareholders.
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.
DKAM Capital Ideas Fund may not be that well-known in this part of the world. However its 17.2% annual return since 2008 is definitely worthy of attention.
Actively-managed funds have had a bad reputation in recent years. High fees and poor performance have resulted in the outflow of money from active funds to passive funds. But that’s not to say that there are no active funds that can outperform the market.
DKAM Capital Ideas Fund, run by Donville Kent Asset Management, is one such fund. From its inception in 2008 to 31 January 2020, the North American-focused fund has delivered a compound annul return of 17.2%, compared to the S&P 500’s 11.7%.
For a fund, even outpacing its relevant index by a few percentage points can be hugely rewarding for its investors. This can be seen in the huge difference between DKAM Capital Ideas Fund’s total return and the S&P 500’s. Cumulatively, the fund’s total return since inception is 503.7%, compared to the S&P 500’s 251.9% over the same 12-year period.
With such an impressive track record of growing shareholder wealth, I decided to take a look at some of DKAM Capital Ideas Fund’s materials to see what is the secret behind its success.
It looks for compounders
Some funds invest in “value stocks” and wait for these stocks to rise to their true value before selling. While this is a decent strategy, it requires active management of capital once these “value stocks” hit what the fund managers believe is their true value.
DKAM Capital Ideas Fund, on the other hand, invests in true compounders. Compounders are companies that can grow their value multiple-fold over the long term. True compounders have much higher upside potential and investors need not move in and out of positions to reap the gains.
A broad approach to screening
To look for these compounders, DKAM Capital Ideas Fund uses a broad approach to screening and idea generation.
The first step the fund manager takes is to screen for companies that have a high return on equity, typically more than 15%. A high return on equity suggests that a company is making good use of its shareholders’ equity to generate returns.
On top of that, the fund manager also sources for potential new ideas through the use of other basic screens, communication with industry contacts, the media, and publications.
This broad approach to idea generation has enabled the fund to unearth lesser-known companies.
For instance, as of 31 January 2020, 25 of DKAM Capital Ideas Fund’s positions are not in any major indices.
Long-short but with with a bias towards long
As a long-short fund, DKAM Capital Ideas Fund goes both “long” and “short” equities. (To go long means to invest in stocks with the view that they will appreciate in price; to go short means to invest in stocks with the view that they will decline in price.) The table below shows the fund’s exposure as of January 2020.
The short position covers some of the market’s downside risk while the long position is able to leverage up due to hedges from the shorts.
But overall, the net exposure of the fund is still 100.5% long.
DKAM Capital Ideas Fund short strategy is based on factor analysis and consists of companies that are essentially an inverse of its investment framework.
Bias toward small caps
Donville Kent Asset Management also believes that the small caps universe provide a unique opportunity.
Companies with small market capitalisations are less well-known and hence may have a good risk-reward profile. In a recent article, the fund noted that the top-performing stocks in Canada over the past decade started with an average market cap of C$796 million in 2009. The article explained:
“This is definitely on the small side and many of these stocks would not have met the minimum size requirements for most investors in 2009. We think this is where a lot of the opportunities are, hence why it is important to be open to investing in small companies. Every big company was at one point a small company. Looking back over the trajectories of these companies over the last 10 years shows that strong growth is definitely possible.”
The Good Investors’ view
DKAM Capital Ideas Fund is a fund that stands out in an industry that is gaining a bad reputation in recent years. Its long-term performance is driven by an approach that has enabled them to find gems that other investors have yet to uncover.
If you wish to read more of their investing insights, you can head to the ROE Reporter (the name of its newsletter) segment of the fund’s website.
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.
Although most companies will likely see COVID-19 impact their sales, Teladoc could benefit from the epidemic as more clients warm up to its services.
I try not to let short-term factors affect my long-term investing decisions. The COVID-19 outbreak is one such short-term factor. It is most definitely going to impact economic growth and corporate earnings this year for many countries. But it will likely have no economic impact five years from now.
So despite the huge drop in the S&P 500 and Dow Jones Industrial Average in the US stock market last week, I am still resolutely holding on to all my stocks. I believe that the economic impact will be short-lived and companies with strong balance sheets, recurring income, and steady free cash flow will be able to weather this storm.
At the same time, I am not hopping on the bandwagon of overly-hyped companies that could benefit from the coronavirus situation over the short-term, such as mask and glove producers. These manufacturers may see a sharp spike in revenue over the next few quarters, but the jump in sales will likely only be a one-off event.
All that being said, I think this latest global virus outbreak could still potentially throw up some unique long-term opportunities. One company I see benefiting long term from the outbreak is Teladoc Health Inc (NYSE: TDOC).
Why COVID-19 could benefit Teladoc
Teladoc is the leading telemedicine company in the US. It provides video consultations for primary care, dermatology, and behavioural health. The company’s app makes getting professional healthcare advice so much easier. Patients simply need to open the app and start a video consulting session with a doctor. Best of all, this can be done in the comfort of your own home, which is all the more important when you are suffering from an illness and don’t want the hassle of travelling to your local clinic.
The COVID-19 outbreak in the US could be the catalyst that Teladoc needs for faster adoption of its technology. Video consultations will reduce the spread of infections, enable patients to get real-time advice, and increase the consultation-efficiency for doctors. All of these advantages are important at a time when the virus is rampant and patients need access to quick and effective advice.
CEO Jason Gorevic also said in the company’s latest earnings conference call, “We also see that once members use our services for the first time, they are much more likely to use us again.” As such, if COVID-19 does increase adoption of Teladoc during this time, the likely impact will be that patients who use the technology for the first time will continue using it in the future.
Strong growth even before the outbreak
Although the COVID-19 epidemic will likely increase the rate of adoption of video consultations around the world, Teladoc has already seen rapid growth even without this catalyst.
Teladoc reported a 32% increase in revenue in 2019. The total number of visits increased by 57% to 4.1 million, exceeding the company’s own projections.
And the leading telehealth company is expecting more growth in 2020. Even before factoring the spread of COVID-19 in the US, Teladoc reported in its latest earnings update that 2020 revenue will increase by 25% at the low-end. Over the longer term, Teladoc expects to grow between 20% to 30% a year.
Huge addressable market
Back in 2015, Teladoc said in its IPO prospectus that the Centers for Disease Control and Prevention in the US estimated that there were 1.25 billion ambulatory care visits in the United States per year. Of which, 417 million could be treated by telehealth. And that figure should be much larger today.
Teladoc, therefore, has plenty of room to grow into. In 2019, despite the 57% spike in the number of visits, total visits were still only 4.1 million. That is less than 1% of its addressable market in the US alone.
The international market provides another avenue of growth. Online consultations could be an even greater value-add in countries with lower doctor-to-patient ratios and where access to doctors is even more prohibitive. Right now, international markets only contribute less than 20% of Teladoc’s revenue.
Recurring revenue model
Another thing I like about Teladoc is its revenue model. The telemedicine company has recurring subscription revenue that it derives from employers, health plans, health systems, and other entities. These clients purchase access to Teladoc services for their members or employees.
The revenue from these clients is on a contractually recurring, per-member-per-month, subscription access fee basis, hence providing Teladoc with visible recurring revenue streams.
Importantly, the subscription revenue is not based on the number of visits and hence should have a huge gross profit margin for the company.
Teladoc ended 2019 with 36.7 million US paid members, a 61% increase from 2018. In 2019, this subscription access revenue increased 32% from a year ago and represented 84% of Teladoc’s total revenue.
Other significant catalysts
Besides the COVID-19 outbreak, there are possible catalysts that could drive greater adoption of Teladoc services in the near future.
Mental health services driving B2B adoption: As mental health continues to become an increasingly important health issue, Teladoc’s mental health product has been a significant contributor to its B2B adoption.
Expanding its product offering: Teladoc launched Teladoc Nutrition in the fourth quarter of 2019, offering personalised nutrition counselling. Nutrition is becoming an increasingly important aspect of preventive medicine and the new service could add significant value to existing and new clients.
Regulatory shifts in the US: In April 2019, the Centers for Medicare & Medicaid Services finalised policies that could potentially benefit Teladoc. Its new policies increase plan choices and benefits and allow Medicare Advantage plans to include additional telehealth benefits. Jason Gorevic, Teladoc’s CEO, commented on this: “We view this as further evidence of CMS encouraging the adoption of virtual care in the Medicare population, and we continue to see a significant avenue for growth within the Medicare program.”
Acquisition of InTouch Health: Besides organic growth drivers, Teladoc is expected to complete the acquisition of InTouch Health in the near futue. InTouch Health is a leading provider of enterprise telehealth solutions for hospitals and health systems.
The Good Investors’ Take
The COVID-19 situation is likely going to hinder the growth of many companies in the near term at least. However, Teladoc looks like one that will buck the trend and will instead benefit in both the short and long run from the epidemic.
Besides the COVID-19 catalyst, the long-term tailwinds surrounding the truly disruptive service and Teladoc’s first-mover advantage in this space gives it an enormous opportunity to grow into.
There are, however, risks to note. Competition, execution risk, and the company’s inability to generate consistent free cash flow are all potential risks. Moreover, the telehealth provider’s stock trades at more than 16 times trailing revenue, a large premium to pay. Any hiccups in its growth could cause significant volatility to its share price.
Nevertheless, I think the reasons to believe it can grow in the long-term are compelling. Its addressable market is also big enough for multiple players to split the pie. If Teladoc can even service just 20% of its total addressable market, it will likely be worth many times more by then.
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.
Bill.com’s stock has more than doubled since it went public late in 2019. Is the financial back-office solutions SaaS company worth investing in?
2019 was a mixed year for IPOs. While big names such as Uber and Lyft failed to live up to the hype, others such as BeyondMeat and Zoom were roaring successes.
One company that was hot straight off the bat was Bill.com (NYSE: BILL), whose share price surged 65% on its first trading day. The cloud-based software provider helps small and medium-sized businesses manage customer payments and cash flow.
After releasing a good set of results for its first quarter as a listed company, Bill.com’s share price jumped again and are now trading an eye-popping 143% above its IPO price.
With the surge in price, I decided to take a deeper look into the company and whether its shares at today’s price is a good investment opportunity. I will analyse Bill.com using my blogging partner Ser Jing’s six-point investment framework.
1. Is Bill.com’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Bill.com’s main clientele are small and medium businesses (SMB). According to the US Census Bureau, there were 6 million SMBs in the US in 2018. Data from SME Finance Forum pointed to 20 million SMEs globally in 2019. These numbers translate to a market opportunity of US$30 billion globally and US$9 billion domestically for Bill.com, based on an average revenue of US$1,500 per customer.
Comparatively, Bill.com, as of the end of 2019, served just 86,000 customers and had a US$156 million revenue run rate. That means it is serving just 2.6% of its total US addressable market, giving it a huge opportunity to grow into.
We’ve not even touched the international market opportunity yet. Bill.com currently operates only in the US and if and when it opens its doors internationally, we could see another big wave of growth.
The 61% year-on-year jump in core revenue in the quarter ended 31 December 2019 also demonstrates that the company is on the right track to fulfilling its vast potential.
CEO and founder, Rene Lacerte, outlined five key drivers of growth during the latest earnings conference call that will help Bill.com capitalise on its market opportunity:
Invest in sales and marketing activities to acquire new customers
Seek increased adoption by existing customers by increasing the number of its customers’ employees who become regular users (Bill.com charges each company a fixed amount per user)
Grow the number of network members (network members are suppliers and clients that customers can interact with through the platform)
Enhance platform capabilities through R&D
Expand internationally
2. Does Bill.com have a strong balance sheet with minimal or a reasonable amount of debt?
As is the case for most fast-growing start-ups, Bill.com is still loss-making and burning cash. The company had negative free cash flow of around US$10 million and US$8 million in fiscal 2018 and 2019 (the company’s fiscal year ends on 30 June).
Thankfully, Bill.com is flushed with cash after its IPO. At end-2019, the company had no debt, and US$382 million in cash and short term investments. This puts Bill.com in a commanding position financially and it also means that the company should have the financial power to continue investing for growth.
It is also positive to note that the company’s sharp rise in share price could also open the door for it to raise more money through issuing shares (in a reasonable manner!) to boost its balance sheet in the future.
3. Does Bill.com’s management team have integrity, capability, and an innovative mindset?
Rene Lacerte has an impressive resume. He is a serial entrepreneur who sold his last startup, PayCycle, to Intuit for US$170 million. It was at PayCycle when he realised how difficult it was to run the back-office operations of a company. Hence, he started Bill.com to streamline the back-office processes of SMBs.
His track record as an entrepreneur is a testament to his ability to innovate and lead a team. Bill.com has a 13-year track record of growth and has consistently improved its service and grown its network of partners.
These initiatives have helped build Bill.com into a platform that customers trust and stick with.
I think Lacerte has a clear vision for the company and he has put in place a good framework to achieve that. In addition, his decision to take the company public last year is also smart, given the high valuation that he managed to raise new capital at.
When looking at a company’s management team, I also like to assess whether the compensation structure is incentivised to boost long-term shareholder value.
I think Bill.com has a fair incentive structure. Rene Lacerte is paid a base salary of US$350,000 and also given option awards. As the option awards vest over a multi-year period, it incentivises him to grow long-term shareholder value.
4. Are Bill.com’s revenue streams recurring in nature?
Bill.com has a predictable and recurring stream of revenue. The cash management software company derives its revenue through (1) monthly subscriptions, (2) transaction fees, and (3) interest income from funds held on behalf of customers while payment transactions are clearing.
Monthly subscriptions are recurring as Bill.com’s customers tend to auto-renew their subscriptions. Transaction fees are not strictly recurring in nature, but approximately 80% of total payment volume and the number of transactions on Bill.com’s platform in every month of fiscal 2019 represented payments to suppliers or from clients that had also been paid or received from those same customers in the preceding quarter.
In other words, Bill.com’s customers tend to make recurring payments or collect recurring fees over the platform. This, in turn, generates recurring transaction fees for Bill.com.
In the quarter ended December 2019, subscription and transaction revenue made up US$33 million of the total revenue of US$39.1 million.
Bill.com also has a decent customer retention rate of 82% as of June 2019. The net dollar-based retention rate is an indicator of how much more customers are spending on the platform, net of upsells, contraction, and attrition. Ideally, the number should be more than 100%. Bill.com’s net dollar-based retention rate was 110% for fiscal 2019 and 106% for 2018. Put another way, Bill.com’s customers as a group, paid 10% and 6% more in 2019 and 2018, respectively.
The increase in net spend by existing customers is a good indicator that Bill.com has a business model that promotes recurring and growing revenue from its existing clients.
5. Does Bill.com have a proven ability to grow?
Bill.com has barely gotten its feet wet as a listed company so it has yet to prove itself to the investing public. However, as a private company, Bill.com has grown by leaps and bounds.
The chart below shows the annual payment growth and milestones that it has achieved since 2007.
Bill.com grew to 1,000 customers in three years after launching its demo in 2007. In 2014, it hit 10,000 customers and today serves more than 86,000 customers.
As the company’s revenue is closely linked to the number of customers it serves and the payment volume handled through its platform, Bill.com’s revenue has also likely compounded at an equally rapid pace over the years.
Most recently, Bill.com reported a strong set of results in its first quarter as a listed company with core revenue up 61% in the quarter ended December 2019.
6. Does Bill.com have a high likelihood of generating a strong and growing stream of free cash flow in the future?
As mentioned earlier, Bill.com is still not free cash flow positive. However, I believe the company has a clear path to profitability and free cash flow generation.
For one, its existing customers provide a long and steady stream of cash over a multi-year time period. As such, the company can afford to spend a higher amount to acquire customers.
In its S-3 filing, Bill.com showed a chart that illustrated the value of its existing customer base.
Source: Bill.com S-3
The chart is a little blur so let me quickly break it down for you. The orange bars illustrate the revenue earned from the customers who started using Bill.com’s software in the fiscal year 2017. The revenue earned from the cohort increased from US$6.7 million in FY17 to US$14.2 million and US$17.3 million in FY18 and FY19, respectively.
The dark blue chart shows customer acquisition costs related to getting the 2017 cohort onto its platform. Once the customers are using the platform, they tend to stay on and there is no need to spend more on marketing. Hence, there is no dark blue bar in FY18 and FY19.
The dotted black line is the contribution margin from the cohort. Contribution margin rose from -108% (due to the high customer acquisition cost that year) in FY17 to 73% and 76% in FY18 and FY19, respectively.
In short, the chart demonstrates the multi-year value of Bill.com’s customers and the high potential margins once the customers are on its platform. These two factors will likely drive profitability in the future for the company.
Risks
Execution-risk is an important risk to take note of for Bill.com. The relatively young SaaS firm is just finding its feet as a public company and will need to execute on its growth plans to fulfill its potential and deliver shareholder returns.
With barely three months of a public track record to go on, investors will need to take a leap of faith on management to see if they can actually deliver.
There is also key-man risk. Lacerte is the main reason for the company’s success so far. His departure, for whatever reason, could be a big blow to the company.
In addition, the market for financial back-office solutions is fragmented and competitive. Some of Bill.com’s competitors may eat into its market share or develop better products.
That said, Bill.com has built up an important network of partners and businesses that are already supported on its platform. This network effect creates value for its current customers and I think it is difficult for competitors to replicate.
Valuation
Now we come to the tricky part- valuation. Valuation is always difficult, especially so for a company that has yet to generate free cash flow and with an uncertain future. I will, therefore, have to make an educated guess on where I see the company in the future.
According to its own estimate, Bill.com has a market opportunity of US$39 billion worldwide. To be a bit more conservative, let’s cut this opportunity by half and then assume it can achieve a 20% market share at maturity in five to 10 years’ time.
If that comes to fruition, Bill.com can have annual revenue of US$3.9 billion. Given its high 75% gross profit margin, I will also assume that it can achieve a net profit margin of 25%. Mathematically, that translates to an annual profit of US$975 million.
If the market is willing to value the company at 25 times earnings by then, Bill.com could be worth close to US$24.4 billion.
Today, even after the spike in Bill.com’s share price, it has a market cap of just around US$3.8 billion. In other words, the stock could potentially rise by more than 600% over the next five to 10 years if it lives up to the above projections.
The Good Investors’ conclusion
Bill.com has had a good start to life as a listed company, with shares soaring above its IPO price.
It also ticks many of the boxes that Ser Jing and I look for in our investments. It has a huge addressable market, a proven track record of growth, and a clear path to profitability. The injection of cash from the IPO also gives it a war chest to invest in international expansion.
On top of that, its market cap is still a fraction of its total addressable market and potential future market value. There are risks but if Bill.com can live up to even a fraction of its potential, I believe its stock could 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.
ARK Innovation ETF has an annualised return of 21.7% since its inception in 2015, far outpacing the S&P 500. Here are some things we can learn from it.
ARK Innovation ETF is an actively managed exchange-traded fund run by ARK that focuses on US stocks. As of December 2019, the tech-focused fund boasts a 21.7% annualised return since its inception in late 2014, making it one of the top-performing funds globally. Its performance is also well ahead of its comparative benchmark, the S&P 500, which returned just 11.7% annualised over the same time frame.
So how did ARK Innovation ETF do it?
I took a look at some of the blog posts from ARK’s investing team and its investing principals to find out what is driving the ARK Innovation ETF’s market-beating performance.
It invests for the long-term
Benjamin Graham was one of the pioneers of long-term investing. He once said that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
What this means is that stocks can get mispriced in the stock market simply because of the whims of investors. Over the long run, though, a stock will tend to gravitate towards its true value.
ARK invests with this principle in mind. It explains:
“The market easily can be distracted by short-term price movements, losing focus on the long-term effect of disruptive technologies. We believe there is a time arbitrage ARK can take advantage of. We seek opportunities that offer growth over 3-5 years that the market ignores or underestimates.”
It doesn’t mind going against the grain
ARK is not your typical Wall Street fund manager. In fact, many of its views go against the traditional beliefs of Wall Street.
For example, Wall Street often likes to categorise different types of innovation. But ARK believes that innovation “cannot be boxed into sectors, geographies or market caps.”
It also doesn’t mind having vastly different opinions from the rest. For instance, ARK is famous for being one of the most bullish funds about Tesla, which is also one of the most heavily shorted stocks in the market today.
It goes big on high-conviction stocks
A truly exceptional opportunity does not come around often. And Charlie Munger is famous for saying that the important thing when you find one is to “use a shovel, not a teaspoon.”
I think ARK abides by the principle, betting big on stocks that it believes in.
For instance, 10% of ARK Innovation ETF’s portfolio is in Tesla. ARK is one of the vocal supporters of Elon Musk’s brainchild. So far, the concentrated position has worked well for ARK with Tesla’s stock price up four-fold over the past five years and nearly doubling so far this year.
Open-source approach to research
Instead of relying solely on its own in-house research, ARK is open to new ideas from the public. It frequently publishes its research and encourages readers to provide more insight and comments. ARK believes that its “open research ecosystem allows for an organised exchange of insights between portfolio managers, director of research, analysts and external sources”.
The Good Investors’ conclusion
ARK’s unique approach has certainly worked well for it. The ARK Innovation ETF is now one of the top-performing and most respected funds in the market.
I also have a feeling that year ARK Innovation ETF will extend its winning streak in 2020 due to the recent surge in Tesla’s share price.
Investors who want to learn more about ARK’s research can head here.
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.
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.
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.
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.
