Jeremy Chia, Author at The Good Investors : Page 17 of 21

Shopify’s Shares are Flying High: Is it too Late To Buy Now?

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 gene r ated 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:

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.

Timeless Warren Buffett Insights

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.

The Importance of Investing in Companies That Make Good Capital Allocation Decisions

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.

What Investors Don’t Get About Netflix

Netflix may be one of the most divisive stock in the market today. However, I think there may be some aspects of the company the bears are overlooking.

As one of the best performing stock of the 2010s, it is no surprise that Netflix is also one of the most talked-about stocks on the internet. But despite the seemingly endless discussions online, I still think there are some aspects of the company that some investors may be overlooking.

I want to discuss these aspects in this article.

#1 There is a clear path to positive free cash flow generation

Netflix had a negative free cash flow of US$3.5 billion in 2019, extending a streak of eight years of increasing cash burn. This burn rate certainly cannot go on forever and it is what’s putting many investors off. The negative free cash flow is even more alarming when you add the fact that the company is in a net debt position of around US$9 .7billion.

However, Netflix’s high cash burn rate may soon be a thing of the past. Netflix’s CEO, Reed Hastings, believes a turnaround is on the cards. In its most recent 2019 fourth-quarter shareholder letter, Netflix said:

“For the full year, FCF was -$3.3 billion which we believe is the peak in our annual FCF deficit. Our plan is to continually improve FCF each year and to move slowly toward FCF positive. For 2020, we currently forecast FCF of approximately -$2.5 billion… With our FCF profile improving, this means that over time we’ll be less reliant on public markets and will be able to fund more of our investment needs organically through our growing operating profits.”

I think management’s confidence is entirely warranted. Let’s break it down. The majority of the cash Netflix is spending is for the licensing and production of content. In 2019, Netflix spent US$14.6 billion on streaming content, meaning around 75% of its US$20 billion in revenue was spent on content alone.

To improve its free cash flow metric, Netflix needs to spend much less as a percentage of its revenue. And I think its entirely possible that this scenario will play out sooner rather than later.

The math is simple.

There is a fixed cost to producing content but the value of the content scales as the user count grows.

For instance, the content that Netflix is producing today can reach its 167 million global subscribers. But as the number of subscribers grows, the content it is producing will reach a larger subscriber base. Put another way, the fixed amount spent on each movie or series will be spread out across a much larger revenue base as user count grows.

Over time, the amount of cash spent on content will take up a much lower percentage of revenue and, in turn, free cash flow should eventually be positive.

#2 Content retains value over a long time frame

Another point to note is that the company is actually already profitable and has been for a few quarters. Then why is the company free cash flow negative?

For one, the company is spending money upfront for content that it is only releasing in the future. As such, it does not recognise this into its income statements. Think of it as capital expenditure for the future.

The second reason is that the content is amortised over a multi-year time frame. I think investors underappreciate the fact that much of the original content that Netflix is producing will be in its content library forever. Good content, while most valuable when it’s first released, retains some of its value to viewers for years. Case in point include hits such as Friends and Seinfield, which fans love to rewatch.

I think investors often overlook these two facts: (1) that Netflix’s current cash burn includes its spending for the future, and (2) good content retains its value over a multi-year period.

#3 Competition is not hurting Netflix as much as feared

When Disney and Apple announced that they would be entering the online streaming market, I’m sure many Netflix watchers (shareholders included) must have feared the worse. Disney has a vast library of intellectual property and Apple is flush with cash. Surely, Netflix would be in trouble.

However, competition has not hurt Netflix as much as some may have feared. In the fourth quarter of 2019, Netflix’s paid memberships in the United States increased by 400,000. While this fell short of analyst estimates, the growth in paid subscribers at a time when Disney Plus was released shows how sticky Netflix’s user base is. More impressively, the gain in member-count in the US in 2019 coincided with an increase in the membership price by US$2.

Internationally, growth continues at a breakneck pace. Paid memberships outside of the US increased from 80.8 million in 2018 to 106 million in 2019, a 25% increase.

There are a few things to glean from these trends.

First, Netflix’s subscriber base is sticky. The lure of original content that customers love and the fact that Netflix’s price point is still considerably lower than cable TV means customers are willing to stick around despite price hikes.

Second, Disney Plus, Apple TV, Amazon Prime, and Netflix can co-exist.

A recent survey of Netflix subscribers showed that they are willing to subscribe to multiple streaming video subscriptions. The trend is fueled by consumers reducing their spending on traditional TV offerings by turning to streaming services.

On top of that, subscribers who want to watch Netflix Originals have no alternative besides subscribing to Netflix.

In its most recent shareholder letter, Netflix explained:

“We have a big headstart in streaming and will work to build on that by focusing on the same thing we have focused on for the past 22 years – pleasing members.”

With Netflix’s content budget dwarfing all its competitors (US$15 billion in 2019 vs US$6 billion for Amazon Prime, the second-largest spender of content), the chances that subscribers switch to another online streaming platform looks much slimmer than what investors may have initially feared.

The Good Investors’ conclusion

Netflix is one of the more divisive stocks in the market today. There seems to be an endless discussion between bears and bulls online.

In my view, I think there are a few crucial aspects of Netflix that some investors may be overlooking:

Netflix has a clear path towards free cash flow generation
It is spending wisely on well-loved content that retains value over a multi-year period
The threat of competition is not as bad as it looks

Moreover, management has a knack of spotting trends well before they develop. As such, shareholders should be confident that management will be able to adapt and thrive even as operating environments change.

Given all this, I think Netflix looks poised to prove its doubters wrong.

Share Buybacks: Good or Bad?

When should a company conduct a share buyback? Here are my thoughts on share buybacks and what investors should know about it.

Share buybacks is one of the more divisive topics in investing.

If you’re not familiar with the topic, share buybacks refer to a company repurchasing its own shares. Put another way, buybacks occur when the company uses its cash to purchase its own shares in the open market.

Simple economics suggests that share buybacks boost share prices by reducing the number of outstanding shares in the market. Fewer outstanding shares means remaining shareholders now own a larger piece of the pie.

However, share buybacks also reduce the company’s cash position. As such, the size of the pie is also smaller after share buybacks.

So when are share buybacks good for shareholders and when are they detrimental?

When do share buybacks make sense?

Share buybacks can benefit shareholders if they tick certain boxes. The great Warren Buffett is a big fan of buybacks at the right price. He once said,

“The best use of cash, if there is not another good use for it in business, if the stock is underpriced is a repurchase.”

One advantage share buybacks have over dividends is that share buybacks reward shareholders in a more tax-effective manner in certain countries. In the US, local shareholders are taxed on dividends, while foreign shareholders from certain jurisdictions incur a 30% withholding tax. These taxes invariably reduce shareholder’s returns. But with share buybacks, companies can reduce their shares outstanding without incurring any tax expenses.

Share buybacks should also be most beneficial when shares are bought back below their true value. Apple, for instance, has a share buyback plan that reduced the total shares outstanding of the company. The share buybacks were made at strategic periods when shares of Apple traded at unfairly low valuations.

Competing for capital…

But share buybacks should only be undertaken when it is the best use of capital. On top of buybacks, a company has so many ways to deploy its cash, such as paying dividends, reinvesting the cash into the company, and acquiring other firms. Management, hence, needs to examine each possibility before deciding which is the best way to allocate capital. Jamie Dimon, CEO of JP Morgan Chase, reiterated:

“Buybacks should not be done at the expense of properly investing in our company.”

Again, Apple is a great example of buybacks done right. The iPhone maker generated more than US$50 billion in free cash flow each year for the past few years. Its shares were trading well below what the management believed to be its intrinsic value. As a result of its share repurchase plan, despite a fall in net income in the fourth quarter of fiscal 2019, Apple still managed to post a slight increase in earnings per share.

With more than US$100 billion in net cash, finding ways to put the capital to use can be a tough ask for Apple. That’s why I believe Apple’s decision to use the cash for buybacks when its share price was depressed is a prudent use of its excess cash.

When are share buybacks bad?

As mentioned at the start, share buybacks can be bad for shareholders too. This can happen when companies decide to pursue buybacks for the wrong reasons.

Below are some commonly cited but bad reasons I’ve come across that companies use to validate their buyback plan:

To prop up their share price
As a means to negate the impact of dilution due to share-based compensation
To fend off an acquirer
To boost earnings per share
Because they have run out of ideas for the cash

Such companies do not take into account whether the shares are cheap or not. Simply buying back shares to boost earnings per share or prop up the share price is not good to shareholders if the stock is overpriced.

Worse still, companies that buy back shares so that they can negate the impact of dilution without thinking about the stock price will invariably hurt shareholders.

I also believe that companies that use debt to make buybacks are asking for trouble. Buybacks should only be made when the company has excess cash and as a way to reward shareholders.

In addition, in Singapore, paying dividends is just as beneficial to shareholders as buybacks. Dividends in Singapore are not taxed and by paying out dividends, shareholders can decide for themselves if they wish to reinvest the dividends back into the company by buying more shares.

The Good Investors’ conclusion

Buffett is a big fan of share buybacks and with good reason too. It is a tax-efficient way (in certain countries) of rewarding shareholders and are a great way to allocate capital if the company’s shares are trading below its true value.

However, buybacks can also harm investors if the company buys back shares that are overpriced or do not provide a good return on capital.

As investors, we should not assume that buybacks are always the most efficient use of capital. We need to look deeper into the decision-making process to assess if management is really making the best possible capital allocation decision for growing shareholder value over the long-term.

My Thoughts on Elite Commercial REIT

Elite Commercial REIT will start trading on 6 Feburary 2020. Here are some factors to know If you are considering buying into the UK-focused REIT.

Elite Commercial REIT is set to be the first REIT listing in Singapore in 2020. I know this article is a little late as the public offer closed yesterday. However, if you are still considering buying units in the open market, here are some factors to consider.

Things I like about the REIT

Let’s start with a quick rundown of some of the positive characteristics of the UK-based REIT. There are many points to go through here so I will be as brief as possible for each point.

Multi-property portfolio

Based on the prospectus, Elite Commercial REIT has an initial portfolio of 97 commercial properties in the UK. While the properties are all located in the United Kingdom, the large number of properties means that the REIT is not overly-reliant on any single property. The properties are also well-spread across the entire UK, with properties situated in Northern Ireland, Wales, Scotland and England.

Another thing to like is that all except for one property is free-hold. Even the sole property that is not free-hold has a very long land lease of 235 years.

Reliable tenant

Perhaps the most appealing aspect of the REIT is that all of its properties are leased to the UK government, specifically the Department for Work and Pensions.

As it is virtually impossible that the UK government will default on its rent, there is very little tenancy risk.

Long leases

The weighted average lease expiry for the properties stands at a fairly long 8.6 years. Given the long leases, investors can rest easy knowing that the distribution will be fairly consistent for the next few years.

However, investors should note that some properties have a break option in 3.6 years. Assuming these options are exercised, the portfolio’s weighted average lease expiry will drop to 4.89 years.

The properties are important to the UK government

80 of the 97 properties in the portfolio are used for front-end services such as JobCentre Plus. Furthermore, 86.3% of these JobCentre Pluses do not have an alternative JobCentre Plus within a 3-mile radius. This is important as investors need to know that there is a high likelihood that the Departement for Work and Pensions will renew its leases when the current contracts expire in 2028.

Triple net leases

The UK government has signed triple net leases for the properties. What this means is that it will cover all operational costs, property taxes and building insurance. The triple net leases provide the REIT with more visibility on cost for the period of the remaining lease.

Low gearing

Another thing to like about the REIT is its low gearing of 33.6%. That is well below the 45% regulatory ceiling, giving it room to make acquisitions in the future.

Decent Yield

The REIT’s IPO price of £0.68 represents a price-to-book ratio of 1.03 based on Collyer’s valuation report. In addition, the indicated distribution yield of 7.1% is higher than the average distribution yield of Singapore-listed REITs.

What I dislike

There are certainly a lot of things I like about Elite Commercial REIT. On the surface, it looks like a very stable REIT with a reliable tenant and the potential for acquisition growth. However, looking under the hood, I found unsavoury characteristics that might put off some investors.

Leases all expire at the same time

The previous owners of the property negotiated to lease the properties back to the UK government with all leases expiring on the same day- 31 March 2028. I much prefer a staggered lease expiry profile as it gives the REIT time to find new tenant should existing tenants fail to renew their leases.

Another concern is whether the UK government will indeed renew all contracts with the REIT when their leases expire. While the REIT is quick to point out that the UK government is likely to renew its leases, things could easily change in the future. If the UK government decides not to renew a few of its leases, the REIT will need to find a quick solution to prevent a rental gap.

Inflated market value

Another thing that I got alerted to by a fellow blogger’s article was that Collyer’s valuation of the portfolio was based on current rental leases. The existing leases are slightly above market rates and could suggest that the market value is somewhat inflated.

Likewise, as market rent is below the current rent, we could see rental rates reduce come 2028 when new contracts are signed.

IPO NAV Price Represents a 13.1% jump from purchase price just a year ago

Another thing to note is that the private trust of Elite Partners Holdings is selling the portfolio to the REIT just a year after buying the property. The sale price represents a 13.1% gain for the initial investors of the property portfolio.

Floating rate debt

The REIT has taken a floating rate loan. While floating-rate loans tend to have lower rates when it is first negotiated, it can also rise in the future. Even though rates have been dropping the last year, things could change in the future. Higher interest rate payments will result in lower distribution yield for investors.

Brexit concerns

The United Kingdom has just finalised its exit from the European Union. There are so many uncertainties regarding its exit. How will this impact its economy, property prices and even the value of the pound?

All of which could potentially impact distribution and rental rates in the UK.

The Good Investor’s Take

Elite Commercial REIT has both positive and negative characteristics. The indicative 7.1% yield and backing by the UK government are the main draws. However, the fact that all leases expire on the same day, the uncertainty surrounding Brexit and the potentially inflated market rate of the properties are things that investors should be concerned about.

Given these concerns, I will likely be staying on the sidelines for now.

*Editors note: In an earlier version of the article I stated that one of my concerns was that the private trust of Elite Partner Holdings was not participating in the IPO. However, upon clarification with the managers of Elite Commercial REIT, I realised that the four individual investors and Sunway Re Capital, who were the investors in the private trust that initially owned the portfolio were individually participating in the IPO. They each rolled over their principal investment amount from the private trust to the REIT. Elite Partner Holdings also has an interest in the REIT via Ho Lee Group and Tan Dah Ching. I have since edited the article to reflect the new information gleaned from management.

Why Facebook Shareholders Shouldn’t Panic

Facebook saw its shares slip 6% after releasing its 2019 fourth-quarter results. Despite this, I’m more bullish than ever on its prospects.

I woke up last Thursday to a rude surprise. My shares of Facebook had fallen 6% in a single trading session, following the company’s 2019 fourth-quarter earnings results. A big jump in expenses during the quarter was the culprit.

However, after reassessing Facebook’s position, I think the decline was unwarranted. In fact, I feel more optimistic than ever for the social network’s long term prospects and am more than happy to hold onto my shares.

Why investors have been put off

Before discussing the reasons why I am bullish about Facebook, let me first say that I acknowledge that there are very real reasons why the broader market is sceptical of Facebook.

The first possible reason is that Facebook carries a degree of regulatory risk. We can’t sugarcoat that.

In recent months, Facebook incurred a US$5 billion fine from the Federal Trade Commission due to a privacy breach and had to pay a US$550 million settlement for collecting users’ facial recognition data. In addition, there have also been a few threats from European regulatory bodies.

These regulatory concerns are, in turn, the reason why Facebook’s expenses have skyrocketed. The company has spent big hiring thousands of employees to update its platform and make it safer for users.

The second reason is Facebook’s decelerating growth. Facebook enjoyed 36% annualised top-line growth over the last 3 years. However, that growth has since decelerated. Shareholders who have been accustomed to the 30%-plus growth rate may have been disappointed by the latest figures.

Despite these two factors, I think Zuckerberg’s brainchild is still a great investment. Here’s why.

The numbers are still really good

Despite a slight deceleration in growth in recent times, Facebook is still posting solid numbers.

In the fourth quarter of 2019, Facebook saw revenue jump 25% and income from operations grow 13%. Looking ahead, management said that it expects revenue-growth in 2020’s first quarter to decelerate by a low to a mid-single-digit percentage point compared to 2019’s fourth quarter.

Although a deceleration looks bad, that still translates to a healthy 20% increase in revenue.

The social media giant is also now sitting on US$55 billion in cash and marketable securities, and zero debt. On top of that, its cash flow from operations in 2019 was 24% higher than in 2018.

Other metrics are healthy too

Besides its financials, the company’s all-important user engagement metrics are also very healthy. Daily active users, monthly active users, and family daily active people were up 9%, 8% and 11% respectively at end-2019 compared to a year ago.

The worldwide average revenue per user also ticked up 15.6% from 2018’s fourth quarter, demonstrating that Facebook is doing an excellent job improving the monetisation of its gargantuan user base.

Facebook is addressing the regulatory concerns

Zuckerberg and his team have also taken privacy concerns very seriously. Zuckerberg emphasised in his recent conference call with analysts:

“This is also going to be a big year for our greater focus on privacy as well. As part of our FTC settlement, we committed to building privacy controls and auditing that will set a new standard for our industry going beyond anything that’s required by law today. We currently have more than 1,000 engineers working on privacy-related projects and helping to build out this program.”

Facebook is also rolling out a privacy checkup tool to close to 2 billion of its users to remind them to set their user privacy control to the level they wish for.

I think with Facebook’s size, the task of managing privacy is going to be a multi-year process but Facebook’s commitment to addressing the issue is certainly heartening for investors.

Becoming a Super App

While advertising is Facebook’s bread and butter, the social media giant has the potential for so much more.

It now has online dating features, e-commerce, gaming, Watch and other features. Although not all of these features will cater to everyone, they each appeal to a certain segment of people. This will grow user engagement and increase ad impressions per user.

This is similar to WeChat in China. The Super app of the East has built-in functions such as payments, e-commerce, bookings, and much more. Facebook, with its billions of users, has the potential to become the Super app of the world.

New functions also give Facebook a different source of revenue. One example is through implementing a take rate for payments made on its platform. This could be a new revenue growth driver as Facebook plans to roll out WhatsApp payment and payment services to facilitate Facebook Marketplace.

History of great capital allocation decisions

Although there is a lot to like about Facebook’s business going forward, I think the most exciting thing is how Facebook will use its massive cash pile, which is growing by the day.

As mentioned earlier, Facebook is sitting on US$55 billion in cash (US$50 billion after it pays off the aforementioned US$5 billion fine). That’s an incredible amount of financial resources and the possibilities are endless.

Most importantly, Facebook has a brilliant track record of spending its cash wisely. In the past, it bought Instagram for just a billion dollars in 2012, solidifying its position as the leading social media player in the world. On top of that, the outlay for the Instagram investment should have already been more than covered by the ad revenue that Facebook has generated from it.

More recently, Facebook has been aggressively buying back shares. In its latest announcement, it said it has earmarked another US$10 billion for share repurchases, which I think is a great use of capital given its stock’s ridiculously cheap valuation (more on that later). This again shows that the decision-makers in Facebook are doing the right things with its ever-growing cash hoard.

Valuation too cheap to ignore

It is no secret that Facebook is not the most loved stock on Wall Street. Despite growing its top line by 26% in 2019 and the numerous tailwinds at its back, the stock still trades at just 23.5 times normalised earnings (after removing the one-off fines and settlement charges).

That’s the lowest multiple among the FAAMG stocks. For perspective, Alphabet, Apple, Microsoft and Amazon trade at price-to-earnings multiple of 31, 25, 29, and 87 respectively.

I simply don’t see how Facebook can suffer a further earnings multiple compression unless there’s a market-wide collapse.

Even after factoring the deceleration in growth, Facebook is still expected to grow revenue and profits by close to 20% in 2020 and beyond. Moreover, Facebook has so much cash on hand, its growth could even be boosted if Facebook decides to make an acquisition down the road.

The Good Investors’ Take

With so many opportunities for growth and the heavy fines behind it, Facebook is likely to see double-digit growth to its bottom line for years to come. Its enduring competitive moat looks unlikely to be eroded any time soon and the capital allocation decisions have been extremely sound.

Just as importantly, the stock trades at unreasonably beaten down valuations. Given everything, I’ve seen, I like my position in Facebook.

Does Twilio Fit Our Investing Framework?

Twilio’s stock has risen more than eight-fold since its IPO in 2016. Is the Communication software as a service company still worth investing?

Twilio (NYSE: TWLO) isn’t a household name, but many of us unknowingly use it every day. The software company provides developers with an in-app communication solution. By integrating phone numbers and messaging communications, Twilio offers communication channels including voice, SMS, Messenger, WhatsApp, and even video.

When your Uber arrives and you receive a text, that’s Twilio. Airbnb uses Twilio to automate messages to hosts to alert them of a booking. eBay, Twitter, Netflix, Wix, Mecardo Libre each use Twilio in some form or other.

With in-app communications set to boom and Twilio the top dog in this space, is Twilio worth investing in? To answer this, I will use my blogging partner’s six-point investment framework to dissect Twilio’s growth potential.

1. Is Twilio’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?

Twilio recently surpassed US$1 billion in annualised revenue run rate in the third quarter of 2019. That’s tiny compared to its market opportunity. The CPaas (communications platform as a service) segment is forecast to grow from US$3.3 billion in 2018 to US$17.2 billion in 2023- a 39% annualised growth rate.

International Data Corporation said in a report that CPaaS companies are driving this growth by “integrating new segments, churning out new use cases, and piquing the interest of enterprise developers with innovative digital solutions for customer engagement.”

With the acquisition of SendGrid last year, through an all-shares purchase, Twilio added email communication into its array of products. SendGrid also brought with it 84,000 customers, giving Twilio a new base of developers to cross-sell existing products to.

2. Does Twilio have a strong balance sheet with minimal or a reasonable amount of debt?

Twilio is financially sound. As of 30 September 2019, it had US$1.9 billion in cash and marketable securities and around US$450 million in debt (in the form of convertible senior notes). That translates to a net cash position of around US$1.5 billion.

That said, Twilio’s cash flow from operations has been lumpy over the past few years as it chased growth over profitability or cash flow.

While its relatively large cash position should provide it with a buffer to last a few years, investors should continue to monitor how Twilio is using its capital.

Twilio already ended up having to issue new shares in a secondary offering in 2019 to raise money. This diluted existing shareholders, and current shareholders of Twilio should not rule out further dilution in the future.

The table below shows Twilio’s cash flow over the past four years.

3. Does Twilio’s management team have integrity, capability, and an innovative mindset?

Twilio’s founder Jeff Lawson has overseen the company from the start (the company was founded in 2008). As mentioned earlier, Twilio has a US$1 billion revenue run rate. That’s an impressive achievement, and a testament to Lawson and the rest of the management team’s ability to scale the company.

I also believe Twilio’s executive compensation structure promotes long-term growth in the company.

Lawson’s base salary in 2018 was only 2% of his target pay mix. 51% was in restricted stock units and the other 47% was in stock options. As the stock options vest over a few years, it encourages planning towards increasing shareholder value over the long term.

Lawson’s base salary of just US$133,700 in 2018 is also low in comparison to what other CEOs are getting.

So far, Twilio’s management has also been able to strategically acquire companies to expand its product offering and customer base. Its purchase of SendGrid brought with it email communication capabilities and more than doubled Twilio’s existing active users.

Twilio’s management has also taken the opportunity to raise more capital as its shares trade at relatively high multiples. This, to me, seems like a prudent move, considering that Twilio needs some cash buffer as it looks to grow its business.

Twilio is also proving to be led by innovative leaders as the company has consistently introduced new products. In 2018, Twilio introduced Twilio Flex, a programmable contact centre that integrates multiple tasks into a single user interface. Twilio Flex opened a new door of opportunity to tap into.

4. Are Twilio’s revenue streams recurring in nature?

Twilio’s enjoys a sticky customer base. Its existing customers have a history of becoming increasingly dependent on Twilio’s services over the years.

The communication software company’s net dollar base expansion rate, a metric measuring net spend by existing customers, was 132% in the quarter ended 30 September 2019. What that means is that existing customers spent 32% more on Twilio’s services in the last 12 months compared to a year prior.

More importantly, Twilio’s net dollar expansion rate has been consistently north of 100% for years. Its net dollar expansion rate was 140%, 128%, 161%, and 155% for 2018, 2017, 2016 and 2015.

The beauty of Twilio’s business model is that there are no built-in contracts. Customers simply pay as they use the company’s software. The more messages they send using Twilio’s API, the more Twilio charges them.

As customers such as Uber, Lyft, Airbnb grow their own customer base, the need for in-app messaging increases, and Twilio grows along with its clients. The model also allows small enterprises to start using Twilio at the get-go due to the pay-as-you-go model.

It is also heartening to see that there is little concentration risk as the top 10 accounts contributed around 13% of Twilio’s total revenue in the most recent quarter.

5. Does Twilio have a proven ability to grow?

With a steady base or recurring revenue, Twilio has been able to focus its efforts on expanding its services and winning over new customers. Its customer account has risen more than six-fold from 2013 to 2018.

The growth in customer accounts is also reflected in its financial statements. Revenue increased from below US$100 million in 2013 to more than US$600 million in 2018.

That growth still has legs to run with base revenue (excluding the impact of its acquisition of SendGrid) in the first three quarters of 2019 increasing by 47% year-on-year.

6. Does Twilio have a high likelihood of generating a strong and growing stream of free cash flow in the future?

While Twilio’s topline has shown impressive growth, it has neither been able to generate consistent profit nor free cash flow.

Twilio has been spending heavily on research and development and marketing. In fact, the company has consistently spent around a quarter of its revenue of research and development.

However, I believe that there is a clear path towards profitability and free cash flow generation, as Twilio can eventually cut back its R&D and marketing expenses.

That being said, the company is still laser-focused on top-line growth at the moment and consistent profitability and free cash flow generation may take years.

Risks

One of the big risks I see in Twilio is succession risk. Lawson is the biggest reason for Twilio’s success so far. He is the founder and has led Twilio every step of the way.

That said, Lawson is only 42 this year and is likely to continue at the helm for the foreseeable future.

I also believe that the high cash burn rate is still a concern. Investors should keep a close watch on Twilio’s free cash flow levels and hopefully, we can see it turn positive in the coming years.

Twilio also faces competition that could eat into its market share. Its competitors such as Nexmo, MessageBird, and PLivo are also growing quickly. Twilio will need to consistently upgrade its APIs to ensure that it defends its competitive edge. For now, Twilio’s competitive moat includes the high switching cost to a competitor.

Twilio also enjoys a network effect. In its 2018 annual report, Twilio said:

“With every new message and call, our Super Network becomes more robust, intelligent and efficient…Our Super Network’s sophistication becomes increasingly difficult for others to replicate over time as it is continually learning, improving and scaling.”

Valuation

Valuing a company is always tricky- especially so for a company that has no profits or consistent free cash flow.

As such, we will need to estimate what is the company’s long term growth potential and mature-state profit margins.

While some best-in-class SaaS companies enjoy profit and free cash flow margins of around 30%, that does not seem feasible for Twilio.

Twilio’s gross profit margin is only around 54%, much lower than other software companies such as Adobe which has a gross margin north of 80%. As such, I think that Twilio’s steady-state profit margin could potentially be closer to 10%.

Given the total addressable market of US$17 billion, and assuming Twilio can achieve a market share of around 50%, revenue can increase to around US$8 billion. Using my 10% net profit assumption, net profit will be around US$800 million. If growth can sustain at current rates of around 35%, Twilio will take around seven years to hit this size.

We also have to estimate a reasonable multiple to attach to its earnings. Adobe has a price-to-earnings (P/E) ratio of 58 but it is still growing. Let’s assume a discount to that multiple and assume Twilio can command a P/E ratio of 40. That translates to a US$32 billion market. Given all these assumptions, Twilio will have a market cap that is twice its current market cap in seven years, which translates to a decent 10% annualised return for existing shareholders.

The Good Investors’ conclusion

There are certainly compelling reasons to like Twilio as a company. Its 40%-plus top-line growth, huge market opportunity, dominant position in the CPaaS industry, and capable management team, are just some of the reasons why I think Twilio has a bright future ahead.

However, its stock is richly priced, trading at more than 16 times revenue. It has yet to record a profit and has been burning cash. There is a lot of optimism baked into the stock already and the company needs to live up to the high expectations if investors are to make a decent annualised profit from the stock.

While my valuation assumptions predict a decent return, there are certainly risks involved. Any stumble in those growth projections or an earnings multiple compression will result in mediocre returns to investors. I suggest that investors who want to take a nibble off of Twilio’s growth should size their position to reflect the risk involved.

Investing Advice From Robert Vinall, A Little-known Investing Expert

Robert Vinall’s fund, Business Owner TGV has compounded at more than 19% per annum. How did Vinall achieve such mouth-watering returns?

Robert Vinall may not be a name that rings a bell with many investors. Yet, his investing performance certainly warrants some attention. His fund, Business Owner TGV, has produced a mouth-watering 649.6% total gain since its inception in late 2008. That translates to a 19.6% annualised return, easily outpacing the MSCI World Index’s 9.47% annualised return over the same period.

I recently spent a few hours reading some of his writings on investing and his investment philosophy to gain some insight on how he managed to achieve these amazing returns.

He invests like a business owner

As the name of his fund suggests, Vinall invests as though he owns the businesses that he invests in. He says:

“My philosophy can be summed up as: Investing like an owner in businesses run by an engaged and rational owner with the capital of investors who think like an owner.”

But what does thinking and acting like a business owner really entail? In essence, it means ignoring short-term movements of share prices, and putting greater emphasis on buying great companies that can compound value over time.

Vinall is, therefore, comfortable with buying shares that (1) have a troubled short-term outlook but have solid long-term prospects, (2) have no near-term price catalysts or (3) is shunned by Wall Street analysts.

Because of the above, he is able to buy shares that Wall Street has ignored, giving him a great entry point on what he believes are long-term compounders.

In addition, he also looks for business managers who act like business owners. Shareholder-friendly managers focus on long-term steady results, rather than near-term share price movements.

He looks for four key things in a company

To determine if a stock is worth investing in, Vinall looks for four key characteristics in a company:

It is a business he understands
The business is building or has a long-term competitive advantage
The managers act with shareholders’ interests at heart
The share price is attractive

Using this framework, Vinnal has found investments that have compounded meaningfully over time.

Although the framework is simple it is by no means easy. Vinall points out:

“An investment process which consists of four steps, each of which has a “yes” or “no” answer may sound simple and indeed it is. This is because the best capital allocation decisions are typically made at moments of extreme market distress. To operate effectively in such an environment requires a process which is robust and simple to administer.
However, each capital allocation decision is preceded by months of research and often years of waiting for the right price to come along.”

He has a concentrated portfolio

Some of the best investors such as Warren Buffett, Chuck Akre, and Terry Smith prescribe having a concentrated portfolio and Vinall is no different.

As of January 2020, Business Owner TGV only had 10 stocks in its portfolio. That’s a heavily concentrated portfolio when compared to most other funds.

A concentrated portfolio of high-conviction stocks gives investors a better chance of market-beating returns. In his 2019 letter to shareholders, Vinall noted that he had dinner with legendary investor Charlie Munger at his home. Over the course of dinner, one of the topics that came up was how concentrated an investment portfolio should be.

Vinall wrote:

“His (Munger’s) bigger point was that the truly exceptional opportunity only comes along a few times in a lifetime. When it does, the important thing, according to Charlie, is to: ‘use a shovel, not a teaspoon’.”

He believes it’s always better to be invested than on the sidelines

With recession fears looming, investors today are asking whether it is a good time to invest.

Vinall believes there are two faulty assumptions underlying this question. The first faulty assumption is that the stock market gyrates around the same level. On the contrary, developed markets should increase at around 6% per year which translates to around an 8-fold increase over 48 years.

Vinall wrote:

“If you have a 40 year plus time horizon and an investment opportunity that will go up 8-fold, how much is there to think about? The smart money is invested, not on the side-lines fretting about what to do.”

The other flawed assumption is that investing is easy. Investing is never easy, as most successful investors will tell you. As such it is not as simple as asking whether now is a good time to invest.

Vinall explains:

“In my experience, good investment opportunities are always plentiful. The limiting factors are the ability to identify them and, having identified them, the courage to act.”

The Good investors’ conclusion

Vinall has been one of the top-performing investors of the last decade. His fund’s return speaks for itself. Vinall is also an exceptionally generous investor who is willing to share his investing insights, philosophies, and success stories. I strongly encourage you to read more of his writings which can be found here.

Should Investors Be Worried About The Wuhan Virus?

The Wuhan virus is sadly proving more destructive than earlier anticipated. What should investors do in these uncertain times?

Sadly, the Wuhan Virus is proving more devastating than earlier expected. The latest figures yesterday afternoon showed that the death toll had already risen to 102, with more than 4,500 cases confirmed. These numbers are almost certain to mushroom.

The coronavirus has also impacted global stock markets as investors fret about the financial impact of the disease.

The S&P 500 in the US fell 1.6% on Monday, while the Straits Times Index at home in Singapore was down by as much as 3% yesterday. So what should investors do now?

Think long term

Unfortunately, the Wuhan Virus is certain to impact the world economy. Tourism to and from China is expected to fall. Shopping malls in China are closed. Schools and universities there have extended their Chinese New Year holiday and will only be reopened on a case by case basis.

China has even shut public transport in certain cities to discourage people from going out. It is likely that we will see consumers in China adjusting to the fear of the virus by going out less and spending less for a few months after the virus is controlled.

All of which will have a very real impact on not just companies in China, but around the world. The impact is exacerbated due to the Wuhan virus epidemic coinciding with the Chinese New year period- a period that usually sees higher travel and consumer expenditure.

That being said, investors should not let the near-term impact of the virus affect their investment decision making.

The SARs, H1N1, and Ebola epidemics have each been devastating. However, financial markets continued ticking on like clockwork.

As you can see from the chart above, 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.

Where do you see the world in five years?

With society more prepared today to deal with a global epidemic, the spread and impact of the Wuhan virus will also hopefully not be as devastating as prior outbreaks.

Perhaps the best way to keep a clear head in these uncertain times is to do a simple mental exercise.

Consider the questions below:

In 5 years time, will Chinese consumers still fear going out?
Will shopping malls in China still be closed?
Are public transports likely to be still shut down in five years time?
Will we still even be talking about the Wuhan virus?

I think the most likely answer to all of the questions is “No”.

The Good Investors’ conclusion

Sadly, the Wuhan virus is having a devastating impact. Lives have been lost and the number of deaths is likely to balloon. My heart goes out to everyone affected by this destructive disease.

But from a financial point of view, we as investors should not let the near-term earnings-impact cloud our judgement. Yes, the Wuhan virus will likely affect the economy and bottom-line of some companies. However, I believe the world today is better equipped to curb the spread of an outbreak than ever before. As such, I believe investors who continue to focus on fundamentals, ignore the noise, and think long will likely be rewarded eventually.