General investing articles archive : Page 7 of 25

Recession and Stocks

A recession may be coming. Should we wait for the coast to be clear before investing in stocks?

In my August 2022 article, The Truths About Investing In Stocks During Recessions, I discussed why jumping in and out of stocks based on whether a recession is coming or ending is a bad idea. It seems that many people are currently obsessed with whether the US is on the verge of – or already experiencing – a recession, based on the commentary that I have been seeing lately. In light of this, I want to bring up as well as expand on a point I made in my aforementioned article: That stocks tend to bottom before the economy does.

When I wrote about stocks reaching a trough before the economy, I used historical examples. One of them involved the S&P 500’s experience during the US’s most recent recession prior to COVID, which lasted from December 2007 to June 2009. Back then, the S&P 500 reached a low of 676 in March 2009 (on the 9th, to be exact), three months before the recession ended; the S&P 500 then rose 36% from its trough to 919 at the end of June 2009.

After the recession ended, the US economy continued to worsen in at least one important way over the next few months. The figure below shows the unemployment rate in the country from January 2008 to December 2010. In March 2009, the unemployment rate was 8.7%. By June, it rose to 9.5% and crested at 10% in October. But by the time the unemployment rate peaked at 10%, the S&P 500 was 52% higher than its low in March 2009 and it has not looked back since.

Chart — *Source: Federal Reserve Bank of St. Louis, Yahoo Finance*

During an economic downturn, it’s natural to assume that it’s safer to invest when the coast is clear. But history says that’s wrong, and so do the wise. At the height of the 2007-09 Great Financial Crisis, which was the cause of the aforementioned recession, Warren Buffett wrote a now-famous op-ed for the New York Times titled simply, “Buy American. I Am.” In it, Buffett wrote (emphasis is mine):

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

If you wait for the robins, spring will be over. This is a really important lesson from Buffett that we should heed throughout our investing lives. Meanwhile, investing only when the coast is clear is a thought we should banish from our minds.

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. I have no interest in any companies mentioned. Holdings are subject to change at any time.

What Makes Some Serial Acquirers So Successful

What makes serial acquirers such as Berkshire Hathaway so successful?

Serial acquirers are companies that acquire smaller companies to grow and they can make for excellent investments. They use the cash flow produced by each acquisition to buy even more companies, repeating the process and compounding shareholder value.

There are many serial acquirers that have been hugely successful. The best-known of them is Warren Buffett’s Berkshire Hathaway. But there are others who have been tremendous successes in their own right.

Markel Corp, for example, is like a mini Berkshire. It is an insurance company at its core, but has used its profit and insurance float to acquire numerous companies and build a large public stock portfolio. Over the last 18 years, Markel’s share price has risen by 286%, or 7.8% compounded.

In the software space, Constellation Software has made a name for itself by acquiring vertical market software (VMS) companies. Its targets are usually small but have fairly predictable and recurring streams of cash flow. Constellation Software’s stock price has compounded at 33% over the last 16 years. The total return for shareholders is even higher, as Constellation Software started paying a quarterly dividend a decade ago and has given out three bumper special dividends.

Another great example of a niche serial acquirer is Brown & Brown Inc. Founded way back in 1939, Brown & Brown is an insurance brokerage company that packages and sells insurance products. The industry is highly fragmented but Brown & Brown has grown to become a company that generates billions in revenue each year. The company has done it by acquiring smaller insurance brokerage firms across the USA to build a large presence in the country. In the last 18 years, Brown & Brown’s stock price has grown by 439%, or 9.8% per year. In addition, Brown & Brown’s shareholders have also been receiving a growing dividend each year.

After reading through the success stories, here are some things I noticed that many of these successful serial acquirers have in common.

Buying companies at good valuations

Good returns on capital can be achieved if acquisitions are made at a reasonable valuation. Constellation Software is a great example of a company that makes acquisitions at really reasonable valuations.

The companies acquired by Constellation Software are often not fast-growing. This can be seen in Constellation Software’s single-digit organic growth in revenue; the low organic growth shows that Constellation Software does not really buy fast-growing businesses. But Constellation Software has still managed to generate high returns for its shareholders as it has historically been paying very low valuations for its acquisitions, which makes the returns on investment very attractive. It helps too that the companies acquired by Constellation Software tend to have businesses that are predictable and consistent.

Focusing on a niche

Constellation Software and Brown & Brown are two serial acquiries I mentioned above that focus on acquisitions within a particular field.

Judges Scientific is another company with a similarly focused acquisition strategy – it plays in the scientific instrument space. Specifically, Judges Scientific acquires companies that manufacture and sell specialised scientific instruments.

Since its IPO in 2004, Judges Scientific has acquired 20 companies and its share price has compounded at 27.9% per year. Its free cash flow has also grown from £0.3 million in 2005 to £14.7 million in 2021.

Serial acquirers that focus on a special niche have a key advantage over other acquirers as they could become the buyer of choice for sellers. This means they have a higher chance of successfully negotiating for good acquisition terms.

Letting acquired companies run autonomously

Berkshire Hathaway is probably the best known serial acquirer for letting its acquired companies run independently. The trust that Buffett places in the management teams of the companies he buys creates a mutually beneficial relationship.

This reputation as a good acquirer also means Berkshire is one of the companies that sellers want to sell to. Often times sellers will approach Berkshire themselves to see if a deal is possible.

Other than Berkshire, companies such as Constellation Software and Judges Scientific also have a reputation for allowing companies to run independently. Judges Scientific’s top leaders, for instance, may only have two meetings a year with the management teams of its acquired companies and they let them run almost completely autonomously.

Returning excess capital to shareholders

One of the common traits among all successful companies – be it a serial acquirer or not – is that their management teams emphasise shareholder value creation. This means effective use of capital.

When successful serial acquirers are unable to find suitable uses for capital, they are happy to return excess cash to shareholders. They do not let cash sit idly in the company’s bank accounts. Companies like Brown & Brown, Judges Scientific, and Constellation Software all pay dividends and rarely let excess capital build up unnecessarily on their balance sheets.

Final thoughts

Serial acquirers can be great investments. Those that are successful are usually great stalwarts of capital. While no single acquisition is the same, the thought process behind the acquisitions is repeatable. With a structured approach to acquisitions, these serial acquirers are able to repeatedly make good acquisitions to grow shareholder value. And when there are insufficient acquisition targets available, successful companies are not afraid to put their hands up and return excess capital to shareholders.

When you invest in a serial acquirer, you are not merely investing in a great business but in great managers and great processes that can keep compounding capital at extremely high rates of return for years to come.

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. I have a vested interest in Markel Corp. Holdings are subject to change at any time.

3 Best In Class Practices That All Companies Can Learn From Constellation Software

Constellation Software’ stock price has climed by more than 100x since 2006. Here are some of the reasons for its success.

Constellation Software (TSE: CSU) is a Canada-based software company that grows by acquiring vertical market software (VMS) companies. Since its founding in 1996, it has grown to become one of the largest diversified software companies in the world. In 2021 alone, it generated US$5.1 billion in revenue and US$1.2 billion in free cash flow.

Shareholders of Constellation have been healthily rewarded over the years. Since its IPO in 2006, the company’s stock price has skyrocketed by around 114 times in value, which equates to a compounded growth rate of 32% per year. In addition, for the past decade, Constellation shareholders have been collecting a dividend each quarter and have enjoyed three special dividends.

Why has Constellation been such a success? One of the main reasons is that management has been excellent stalwarts of its capital. The company uses most of its cash flow generated from operations to acquire and buy smaller software companies at a relatively low price. These software companies tend to be already free cash flow positive, which means they can generate more cash flow for Constellation once they become part of the family. The process is repeated with the cash flow generated from these new acquisitions.

But other than making excellent acquisitions, Constellation’s management also has best-in-class practices that serve shareholders extremely well. Here are three big ones that all other companies can learn from.

Not giving stock-based compensation to employees

Stock-based compensation (SBC) is a great way to incentivise employees to think like shareholders. But the dilution from SBC can be a real problem.

Constellation’s solution is to not give SBC at all. The idea is that SBC in the form of options or restricted stock units (RSUs) that can be sold immediately upon vesting can sometimes encourage employees to drive up a company’s stock price over the short term. Constellation wants its employees to focus on the long term.

Instead, Constellation buys its own shares in the open market and then pays these shares to employees as a bonus. Employees are restricted from selling these shares for an average of four years. The difference between Constellation’s practice and more common forms of SBC is that no new shares are created – they are bought from the open market – resulting in no dilution. The multi-year restriction on selling shares also ensures that Constellation’s employees are not too focused on the near-term stock price of the company.

Not letting cash sit idle

Constellation first started to generate more than a billion US dollars in free cash flow in 2021. Instead of letting all this cash sit idle on Constellation’s balance sheet, management is consistently looking for ways to redeploy that capital. Management typically looks for companies to acquire. But when suitable candidates are insufficient for Constellation to deploy all its excess cash, the company returns capital to shareholders.

This, to me, is the fiscally responsible thing to do as shareholders are able to put that cash to work through other investments or even subscribe to Constellation’s dividend reinvestment plan. This enables shareholders to own a larger percentage of the company over time.

This practice is unlike many companies – such as many that are found in Singapore – which have hurt shareholders by letting their excess cash sit idle in low-yielding accounts in the bank. This cash could have been put to better use by returning them to shareholders.

Mark Leonard, Constellation’s founder and president, explained his reasons for paying a special dividend in 2019. He said:

“Capital allocation is a perennial topic for our board discussions. This quarter I got the sense that the board hit a tipping point. There were a number of factors. We had excess cash. We are deploying more capital in the vertical market software sector, but don’t see dramatic growth this year unless competition slackens. One of the directors mentioned that they were disappointed with my efforts to find new avenues for investment (outside of vertical market software), and that we should apply more effort. I don’t disagree, but that is unlikely to reduce our cash meaningfully in the short term. Those factors seemed to combine to make this the right time to pay a special dividend. Perhaps dividends are perceived as a failure… but to my mind, they are less of a failure than sitting on excess cash.”

Not buying back shares mindlessly

Share buybacks that are conducted at low prices can be a better use of capital than dividends if the dividends are subjected to tax. But if the buybacks are done at high prices, it could lead to lower returns for shareholders.

Some companies mindlessly buy back their shares even when their share prices are high. This is detrimental to their shareholders who would be better off just getting the cash in dividends. Unlike such companies, Constellation’s management is cognisant of the benefits and drawbacks of share buybacks.

In 2018, Leonard flashed out his thoughts on buybacks:

“History is replete with examples of directors and officers using insider information to abuse shareholders. Regulators eventually twigged to the problem and market-making by insiders is now illegal except in highly prescribed circumstances. Despite these regulatory efforts, the scholarly research is clear that buybacks commonly increase short-term share prices and are more frequently associated with insider selling than insider buying. My sense from the research is that most buybacks help short-term sellers rather than long-term owners. I’d prefer that our employees be aligned with Constellation’s long-term owners. Alignment with long-term owners may not work in PE-backed or venture-backed companies or when the majority of your investors are transient. In those instances, catering to the objectives of short-term sellers is more rational.

There are a minority of cases where a company designs a buyback to benefit long-term owners by acquiring shares at less than intrinsic value. If you consider only long-term owners, the “success” of this kind of buyback is dependent upon the company acquiring as many of its shares as far below intrinsic value as possible. In that case, the directors and officers could maximise “success” by 1) convincing the market not to buy the company’s shares, and 2) convincing some existing company shareholders to sell their shares below intrinsic value. This is one of those instances where the moral compass and the apparently common-sense definition of “success”, point in opposite directions. When there are reasonable alternatives, I try to avoid such dilemmas.

If the problem is determining how to return capital to shareholders when its shares are trading for less than intrinsic value, why expend energy on the inherent conflict of a buyback, when dividends are a good alternative? In those circumstances I can think of only a couple of examples where I might prefer a buyback to a dividend… i.e. if most of our shareholders were taxable entities, or if I’d had a sincere conversation about the company’s prospects with a sophisticated large block shareholder who still wished to sell.

If the problem is that company shares are trading at a value significantly below or above intrinsic value, and the directors and officers have exhausted all other methods of broadly communicating that fact, then a buyback or share sale may be warranted. “

I think the main benefit of buybacks for long-term shareholders is that it is a more tax-efficient than receiving dividends which are, in some circumstances, taxed. However, in Constellation Software’s case, this argument may not hold as Canadian residents are not taxed on dividends received from Canadian companies. As such, Constellation Software has no reason to prefer buybacks over dividends. (Non-residents of Canada who are shareholders of Constellation Software may benefit from buybacks but this group of shareholders is likely the minority.)

Closing thoughts

It is no coincidence that Constellation’s shareholders have been healthily rewarded for many years. Management is prudent with the company’s capital, and is extremely thoughtful when it comes to the major financial decisions that impact shareholders.

I believe that as long as Constellation continues to uphold such high standards, shareholders will continue to be well-rewarded for years to come.

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. I don’t have a vested interest in any companies mentioned. Holdings are subject to change at any time.

When Should Companies Buy Back Their Shares?

The scenarios in which share buybacks make sense.

Stocks have taken a beating this year, to say the least. The S&P 500 is down around 19% year-to-date while the NASDAQ has slumped by around 30%. Many high-growth stocks have fallen even harder than that and it is not uncommon to find stocks that are down more than 80% this year.

While these declines are painful, a downturn in stock prices does provide a potential upside: The opportunity to conduct cheap buybacks. Low stock prices mean that companies can buy back their shares at relatively cheaper levels. When done at the right prices, share buybacks can be highly value-accretive for a company’s shareholders.

Measuring the impact of share buybacks

Buybacks reduce the number of shares outstanding. A company’s future cash flows are, hence, divided between fewer shares, leading to more cash flow per share in the future. But it comes at a cost. The cash that’s used to buy back stock could have been used to pay a dividend to shareholders instead. So how do share buybacks impact the long-term shareholder?

To better appreciate what happens when a company buys back its own stock, let’s examine a simple example. Let’s assume that Company A generates $100 in free cash flow per year for 10 years before it stops operating. The company has 100 shares outstanding, so it essentially generates $1 per share in free cash flow for 10 years. Let’s imagine two different scenarios.

In Scenario 1, Company A decides to pay all its free cash flow to shareholders each year. Hence, shareholders will receive $1 per share in dividends each year for 10 years. In Scenario 2, Company A decides that it wants to buy back its shares after the first year. Let’s say its stock price is $5. Therefore, Company A can use its $100 in free cash flow in year 1 to buy back and retire 20 shares, leaving just 80 shares outstanding. From year 2 onwards, Company A decides that it will start returning its cash flow to shareholders through dividends. The table below shows the dividends received by shareholders in the two different scenarios.

In scenario 1, shareholders were paid $1 per share every year starting from the end of the first year. In scenario 2, shareholders were not paid a dividend at the end of the first year, but were paid more for each subsequent year.

We can measure the present value of the two streams of dividends using a discounted cash flow analysis. Using a 10% discount rate, the dividends in Scenarios 1 and 2 have a net present value of $6.14 and $6.54, per share, respectively. In Scenario 2, shareholders were rewarded with better value over the 10 year period even though they had to wait longer before they could receive dividends.

When buybacks destroy value

In the earlier example, Company A created value for shareholders by buying back shares at $5 a share.

But let’s now imagine a third scenario. In Scenario 3, Company A’s stock price is $7.50 and it decided to conduct a share buyback using all its cash flow generated after the first year. Company A, therefore, spent its first $100 in free cash flow to buy back 13 shares, leaving the company with 87 shares outstanding. The table below shows the dividends received in all three scenarios.

In Scenario 3, because shares were bought back at a higher price, fewer shares were retired than in Scenario 2 (13 versus 20). As such, Company A’s dividend per share in subsequent years only increased to $1.15. The net present value of Scenario 3’s dividends, using the same 10% discount rate, is only $6.04. This is actually lower than in Scenario 1 when no buybacks were done.

This demonstrates that buybacks are only value-enhancing when done at the right price. If the required rate of return is 10%, buybacks in the example above should only be done below the net present value per share of $6.14 if no buybacks were done.

Applying this to a real-world example

We can use this framework to assess if companies are making the right decision to buy back their shares. Let’s use the video conferencing app provider Zoom as a case study. Zoom started buying back its shares this year even as its stock price tanked.

In the first three quarters of its fiscal year ending 31 January 2023 (FY2023), Zoom repurchased 11 million shares for US$991 million. This works out to an average share price of approximately US$90 per share.

The table below presents my estimate of Zoom’s future free cash flow per share. I made the following assumptions:

Revenue grows at 10% for the first few years before growth tapers off slowly to 0% after 15 years.
The free cash flow margin improves from 27% currently to 45% over time.
Dilution from stock-based compensation is 3% a year
Zoom stops operating after 50 years
Its revenue starts to decline in the last seven years of its life

The table above shows the free cash flow per share generated by Zoom in each year under the assumptions I’ve made. Using a 10% discount rate and including current cash on hand (that can be used for buybacks or returned as dividends) of around US$18 per share, Zoom’s net present value per share works out to around US$112.

Recall that Zoom was buying back its shares at an average price of US$90 a piece. Under my assumptions, Zoom’s buybacks are value-accretive to shareholders.

Time to shine

Buybacks can be tricky to analyse. Although buybacks delay the distribution of dividends, they can result in value accretion to shareholders if done at the right price. With the stock prices of many companies falling significantly this year, buybacks have become a potential source of value enhancement for shareholders.

But remember that not all buybacks are good. We need to assess if management is buying back shares because the shares are cheap or if they are doing it for the wrong reasons. With stock prices down and the capital markets tight, I believe that this is a time when good capital allocation is essential. A management team that is able to allocate capital efficiently will not only cause its company to survive the downturn but potentially create tons of value 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. I currently have a vested interest in Zoom. Holdings are subject to change at any time.

A Genius’s View On How The Stock Market Works

A polymathic genius talks about how he invests in the stock market, and what works and what does not.

Claude Shannon was a polymathic genius. Vannevar Bush believed that Shannon was “an almost universal genius, whose talents might be channelled in any direction,” according to the book about Shannon’s life, A Mind at Play. Bush himself was a giant amongst men; among his achievements were the construction of an analog computer (a differential analyser) in 1931, and leading the Manhattan Project (the name of the US government’s project to build the atomic bomb during World War II) to success.

As for Shannon, he is perhaps most well-known for the creation of information theory in the 1940s, a collection of ideas that form the foundation for much of how information is transmitted electronically today. But he was not just an amazing scientific thinker – he was also an incredible investor. David Senra has a podcast series named Founders and in an October 2019 episode, Senra spoke about his learnings from reading A Mind at Play. During the episode, Senra said:

“When I covered Fortune’s Formula, Claude Shannon had one of the best investing records of all time. They compared like 1,025 different investment managers. This is professional managers doing it full-time – hundreds of researchers having all kinds of resources and Shannon’s investment returns were better than all of them. And he did it part time, with his wife on an Apple II computer. This kind of gives you the person we are dealing with here.”

So how did Shannon think about investing and the stock market? Senra said (emphases are mine):

“Shannon’s most attended lecture ever was when he started talking about the stock market. Everybody thought that he is a mathematical genius and he must have all the algorithms and that he can predict everything. No. He realised that he could not do that.

So his approach which I found fascinating. “Complicated formulas mattered a great deal less”, Shannon argued. “It is the company’s people and products.” He went on, “a lot of people look at the stock price when they should be looking at the basic company’s earnings. There are many problems concerned with the prediction of the stochastic processes. For example, the earnings of a company is far too complex. The general feeling is that it is easier to choose a company that is going to succeed than to predict short term variations, things that will last only weeks or months, which they worry about down on Wall Street. There is a lot more randomness there and things happen which you cannot predict which cause people to sell or buy a lot of stock.”

It was his [Shannon’s] view that market timing and tricky mathematics were of no match to a solid company, strong growth prospects, and sound leadership. And this is also something that we heard a lot the last few weeks from Buffett and Munger who would agree with his statement there.”

In a September 2017 article for his blog Abnormal Returns, Tadas Viskanta – the Director of Investor Education at Ritholtz Wealth Management – wrote about Shannon and A Mind at Play. Here are some excerpts from the book Viskanta picked out that further fleshed out how Shannon invested:

“The bulk of his wealth was concentrated in Teledyne, Motorola and HP stocks; after getting in on the ground floor, the smartest thing Shannon did was hold on…

…He and his wife were, in his own words, “fundamentalists, not technicians.” The Shannons had toyed with technical analysis and they found it wanting. As Shannon himself put it, “I think that the technicians who work so much with price charts, with ‘head and shoulders formulations’ and ‘plunging necklines’ are working with what I would call a very noise reproduction of the important data.’”

Put simply, Shannon’s view on investing is that investors should be focusing on the long-term business health of a company, rather than the unpredictable short-term movement of its stock price. If this is good enough for a genius such as Shannon, it is good enough for me.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Apple. Holdings are subject to change at any time.

The Drawbacks of Stock-based Compensation

Stock-based compensation conversation gets pushed to the back when stock prices are rising but problems start to creep up when stock prices tank.

Stock-based compensation (SBC), where a company pays its employees partly with shares, is table stakes when attracting talent for growing companies. And for good reason too.

Employees value SBC as it allows them to profit from a potential rise in a company’s stock price. From a shareholder perspective, SBC is also useful as it aligns employees’ interests with theirs. This is critical for high-level management who make executive decisions in a company; the idea is that executives who earn SBC will make decisions that drive shareholder value.

In addition, using shares instead of cash for compensation also improves a company’s cash flow. For cash-strapped businesses, SBC can be a good way to attract talent without breaking the bank.

But SBC is not without its drawbacks. This is becoming more apparent in recent times as stock prices of many fast-growing companies fall.

How does SBC work?

Before discussing some of the drawbacks of SBC, I’ll first quickly go through how SBC works. There are a few types of SBC. The most common forms of SBC that I’ve seen so far are restricted stock units (RSUs) and options.

RSUs are shares that are given to employees over a period of time. They are typically granted when an employee initially signs for a company or renews an employment contract. These RSUs vests over a few years. For example, an employee may start his employment at a company and be granted 100 RSUs that vest over four years. Essentially, the employee will get 25 shares of the company every year for four years.

The other common form of SBC is options. Options give the employee the right to buy shares of the company at a pre-determined price. Employees are also typically given options that vest over a number of years. For example, an employee may be given 100 options, with an exercise price of $100 per option, that vests over four years. This means that in each year, the employee will collect 25 options and he or she can decide whether to exercise the option and convert it into shares. The employee will need to pay the company $100 in exchange for the shares. If the share price is more than $100 in the open market, the employee can sell the shares and pocket the difference.

What’s the real cost?

Although SBC does not result in any cash expense for a company, it does have a cost – shareholder dilution.

This is because by giving away new shares to employees, the total number of the company’s outstanding shares increases. The higher number of shares outstanding means existing shareholders now own a smaller cut of the pie.

For instance, as of 30 September 2022, Palantir had around 2.08 billion shares outstanding. However, it also had around 331 million unvested or unexercised options and 131 million unvested RSUs. When vested (and if exercised), the outstanding share count will increase by 22%. Ultimately, what this means is that Palantir’s economics will have to be split among 22% more shares and each share will be entitled to lesser economics.

When stock prices fall, employees are unhappy

SBC is designed to reward employees when stock prices rise. It also encourages employees to stay with the company in order to collect the RSUs and options that vest over time. But when stock prices fall, these RSUs are worth less and there is less incentive to stay.

For example, in March of 2021, Okta’s president of field operations, Susan St Ledger, was given 43,130 RSUs that vest over four years. At the time, Okta’s stock price was around $228; today, it’s around $67. St Ledger has around 26,956 RSUs that have yet to vest. At the time of the grant, these unvested RSUs were worth $6.1 million. Today, her remaining unvested RSUs are worth just $1.8 million.

Okta announced recently that St Ledger is retiring. Although there are many possible reasons for her retirement, the decline in value of her unvested RSUs may have played a role in her decision.

Making up for shortfalls

As shown above, falling stock prices can have a big impact on the actual dollar value of unvested RSUs. To retain existing employees, some companies may opt to increase the number of RSUs that employees receive in order to make up for the decline in the dollar value of the unvested RSUs.

Zoom is one company I know of that has done just that. In its latest annual report, Zoom said, “In October 2021, we added a feature to new and existing stock awards that provide employees with additional awards based on certain stock price criteria.” The key word here is “existing“.

In typical employee contracts, the company is not required to increase the number of RSUs if the stock price falls. This is supposed to be the risk to employees for agreeing to SBC, and employees are meant to be impacted by lower SBC, which should drive them to work harder to increase the company’s stock price. But Zoom decided to step in to make up for the loss in RSU value by increasing the number of shares paid to employees over and above what was previously agreed.

Zoom has a reputation for emphasising employee welfare and pay packages are undoubtedly part of that equation. But retroactively increasing RSU grants is at the expense of shareholders who are getting more dilution in the process.

Offering more stock to new hires

Besides increasing the number of RSUs initially agreed upon for existing employees, companies need to offer higher number of shares to attract new talent and as “stock refreshers” to retain employees.

Let’s say a potential new hire wants a pay package that includes $100,000 worth of RSUs per year. If the stock price is $100 per share, the company would need to offer the employee 1000 RSUs per year. But if the stock is only trading at $50, the company will need to offer the employee 2,000 RSUs per year. This will lead to two times more dilution.

Unfortunately for shareholders, this is exactly what is happening to many companies in the stock market today. Take Facebook’s parent company, Meta, for instance. The total value of RSUs granted in the first nine months of 2022 and 2021 were around US$20 billion and US$16 billion, respectively, at each grant date. This only a 22% increase in dollar value.

But the true cost is the number of RSUs granted. In the first 9 months of 2022, Meta granted close to 100 million RSUs, while in the same period in 2021, Meta awarded 53 million RSUs. This is an 86% increase.

The discrepancy between the increase in value versus the increase in the number of RSUs is because the weighted average grant price in the first nine months of 2022 was US$201 compared to US$305 in the first nine months of 2021. The lower stock price meant that Meta needed to promise more RSUs to provide the same dollar-value compensation to employees.

As you are familiar with by now, more RSUs granted means more dilution down the road. And it may get worse. Meta’s stock price has fallen to around US$123 as of the time of writing, which will result in even more RSUs needing to be offered to match the dollar value of compensation.

And it’s not just Meta that is facing this issue. Companies like Zscaler, Snowflake, Netflix, Okta, Docusign, Amazon, Shopify, and many more have all granted multiples more RSUs and/or options so far this year compared to a year ago.

Final thoughts

SBC is a difficult topic to fully understand. Although it’s not a cash expense, it does have a very real impact on shareholders as it ultimately results in shareholders’ split of profits being diluted down.

When stock prices are high, dilution from SBC is low and it’s not too concerning. But when stock prices are low like today, dilution from SBC can become a real problem.

This issue should not be lost on investors. We need to monitor how our companies handle this issue and whether they are doing the fiscally responsible thing for shareholders.

In my view, SBC should be reserved for executive management who make important decisions for the company and its shareholders. Other employees should be paid less in SBC and predominantly or exclusively in cash, especially when the company has sufficient cash. Employees who want stock can use cash compensation to buy stock on the open market. This reduces dilution to shareholders. This is particularly important when stock prices are low and somewhat undervalued. Companies should be trying to buy back shares at these prices rather than issuing new shares.

Although the increase in SBC is leading to more dilution, it is not totally out of control yet. For example, Meta’s dilution (the number of grants awarded against the number of outstanding shares) this year is still only in the low single-digit percentage range.

But companies need to start being more prudent with their SBC before dilution gets out of hand. I believe that businesses that are able to find the right balance in times such as these will likely be the big winners once this downturn is over.

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. Of all the companies mentioned, I currently have a vested interest in Meta, Docusign, Amazon, Okta, Zoom, Shopify and Netflix. Holdings are subject to change at any time.

What Is A Fair PE Ratio To Pay For A Stock?

Valuing a stock can be tricky. A high PE ratio may not mean poor returns and vice versa. Here’s a simple framework of what is the right ratio to pay.

One of the trickiest elements of investing is finding out how much to pay for a stock.

To make things simple, investors often divide the current stock price of a company by its earnings-per-share to gauge how expensive or how cheap the company’s shares are. This is known as the price-to-earnings, or PE, ratio.

For instance, a company that is earning $1 a share and trades at $20 a share has a PE ratio of 20. Another company that is earning $1 a share and trades at $10 a share has a PE ratio of 10.

On the surface, the latter company seems cheaper. But that’s not always the case. Other factors such as growth rates, reliability of earnings, and durability of growth come into play.

With many variables influencing stock valuation, here’s a simple framework that helps me gauge what is the right PE ratio to pay for a stock.

The DCF method

Before going further, we need to understand the discounted cash flow (DCF) valuation method. A DCF is the backbone behind valuing any stock.

The idea behind the DCF is that the value of a stock is the sum of all its future cash flows discounted back to today.

Let’s start with a simple example. Company A earns and pays out $1 a share in one year’s time before it closes down. If you are an investor, you will not want to pay $1 for a share of Company A today. You will want to pay less than $1 so that in one year’s time you will be able to reap a profit. Let’s say your required rate of return is 10% per year. In this case, you will only be willing to pay $0.909 ($1 discounted by 10%) a share. In a year’s time, you would be given back $1, which is 110% of your initial capital.

This is the thinking behind the DCF method of valuation. If a company will survive for more than a year, we can add more cash flows to the equation and solve for the net present value in order to ensure that we earn our required return.

Setting the stage

The DCF is the core concept that drives stock valuation. The PE ratio that we discussed earlier is a shorthand that gives us a quick sense of how much we are paying for a company.

Using the DCF method, and making some assumptions, we can find out what is a fair PE ratio to pay. To make things simple, I will make a few assumptions and parameters for this exercise. They are:

First, in the following examples, I use a 10% required rate of return.
Second, I assume that the companies’ earnings are the same as free cash flow to the shareholder.
Third, I assume that these earnings are distributed to shareholders who can invest the cash at a similar required rate of return (10% in this case).
Fourth, the companies’ earnings grow or shrink at the stated CAGR (compounded annual growth rate) evely.
Fifth, investors hold these stocks forever or until the business closes down.

A no-growth company

Using the assumptions above, let’s start with how much we should pay for a no-growth company.

Let’s say Company B will earn $1 a share a year for eternity. As mentioned above, our required rate of return is 10%. The DCF formula to find the net present value of this company is:

(E*(1+G))/(R-G), where E is next year’s earnings, G is growth and R is the required rate of return.

Plug Company B’s numbers into the equation and you get a value of $10 a share.

In this case, an investor will need to pay $10 a share to earn 10% per year. This makes perfect sense as the earnings yield needs to meet our expected rate of return because the company is not growing. In this scenario, the fair PE ratio is 10 (we need to pay $10 a share for Company B that is earning $1 per share).

A growing company

Let’s take another example.

Company C will earn $1 a share next year but will grow its earnings at 2% a year for eternity. Using the same formula, we find that we can make a 10% return if we pay $12.75 for the company. This means we should be willing to pay a PE ratio of 12.75.

What happens if there’s a company that can grow even faster? Let’s say Company D, with $1 a share of earnings next year, can grow at 8% per year for eternity.

Plug those numbers into the formula and you will find that you can now pay $54 for the company. This translates to a PE ratio of 54.

As you can see, the higher the growth rates, the higher the multiple that you can pay.

A shrinking company

The same formula works for a shrinking company too. For example, Company E will earn $1 a share next year, but from then on, its earnings will shrink by 5% a year.

Plug those numbers into the equation and you will find that in order to earn a 10% return on investment, you will have to pay $6.33 a share. That’s a PE ratio of 6.3. The table below is a compilation of the PE ratios that an investor should be willing to pay for companies with different growth profiles.

Growth plateaus

In practice, however, companies don’t grow to perpetuity. They tend to grow fast during the early stages of their life cycle before growth plateaus or goes to zero.

For example, a company may grow 5% for ten years before its growth zeroes and its earnings will thus remain flat forever. In this scenario, a fair PE ratio would be around 14.8 to achieve a 10% rate of return. The table below shows the fair PE ratios to pay for companies growing for 10 years at different rates before growth reaches zero.

As you can see, even if a company’s growth goes to zero after 10 years, an investor would still be able to pay a PE ratio of 132 for a company that is going to grow its earnings per share by a compounded annual rate of 35% for the first 10 years.

Limited life companies

In all of the above scenarios, I’ve assumed that the companies would last forever. However, in real-world scenarios, companies die out eventually.

As such, I have also modelled a scenario where a company grows for 10 years, before growth is zero for the next 30 years. From year 40 to 50, the company’s earnings then steadily falls to 0.

In this scenario, if the initial growth rate is 5%, a fair PE ratio to pay for the company is 14.8. The table below shows the fair PE ratios to pay for companies in the above scenario but with different initial growth rates.

But what if a company’s initial growth is more durable and lasts for 20 years instead of 10? Here are the reasonable PE ratios to pay for a company that will experience 20 years of growth before its growth is zero for 30 years and its earnings per share then slowly declines to zero from year 50 to year 60.

Using this information…

A company’s CAGR and the duration of that growth rate can have a large impact on what is the right multiple to pay for a company.

Some investors may be more demanding and require a higher rate of return than 10%. Personally, I target a 12% rate of return on my investments which means I will be willing to pay a lower PE ratio than those who demand just a 10% rate of return.

While this exercise gives us a feel of what sort of PE ratios to pay for a stock, there are some limitations to this method. For instance, inaccurate projections and wide variations in outcome-probability can impact valuations. In addition, holding a company’s shares to perpetuity or till the company shutters may not be feasible for most investors.

In the former case, the exit multiple of the stock and the market’s required rate of return at the point of exit is an important consideration. This will be influenced by factors such as the prevailing interest rate environment at the time of exit.

So while this is not a foolproof method, this framework at least gives us a sense of whether a stock is cheap or expensive based on our own required rate of returns.

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. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Singapore Airlines Is Redeeming The First Tranche of MCBs – Is That Good For Shareholders?

SIA shareholders were treated to the news that the company was in a position to redeem the first tranche of MCBs. Here’s what that means for shareholders.

Singapore Airlines (SGX: C6L), or SIA, will be redeeming its first tranche of mandatory convertible bonds (MCBs).

These bonds were issued by the airline merely 2.5 years ago in 2020, near the peak of COVID-19 lockdowns. Back then, SIA had to pause most of its operations as passenger air travel was severely restricted due to the pandemic. Cash was short for SIA and it desperately needed to raise money. But things have improved significantly for the company this year as it reported a record profit in the first half of FY23 and free cash flow was also comfortably positive.

With its finances moving in the right direction, SIA’s management has decided that redeeming the airline’s first tranche of MCBs would benefit its shareholders. In this article, I explore whether the airline is making the right decision.

First, is redeeming the MCBs a good use of capital?

In my view, the short answer is yes. The MCBs are a costly source of capital for SIA and redeeming them early will save the company significant money.

The MCBs are zero-coupon bonds but have a set annual yield that starts at 4% before rising to 5%, and then 6% (head here for more detail on the MCBs). What this means is that the longer the MCBs are left unredeemed, the more expensive it becomes for SIA to redeem them in the future.

Moreover, if left unredeemed for 10 years, these MCBs will automatically convert to shares. The conversion price of the shares is S$4.84 at the end of the 10-year mark, which is lower than SIA’s current share price. (A low conversion price is bad for shareholders as it means more shares are issued leading to more heavy dilution.) Bear in mind, the conversion price is not based on the principle paid. It is based on the principle plus the accumulated yield.

If converted to shares, the MCBs will heavily dilute SIA’s current shareholders, leaving them with a smaller stake in the entire company.

All of these lead me to conclude that redeeming the MCBs now seems like an efficient use of capital by SIA on behalf of its shareholders.

But should SIA conserve cash instead?

SIA has a history of producing irregular free cash flow.

I looked at 15 years’ worth of financial data for SIA (starting from 2007) to calculate the total free cash flow generated by the company. In that period, SIA generated a total free cash flow of a negative S$3 billion. Yes, you read that right – negative free cash flow.

In 15 years of operation, instead of generating positive cash flow that can be returned to shareholders, SIA actually expended cash.

This is mostly due to the high capital expense of maintaining its aircraft fleet. Capital expenditure for the expansion of SIA’s business was only S$5.6 billion, meaning the value of its fleet only increased by S$5.6 billion.

I say “only” because even if I exclude the expansion capital expenditure, SIA only generated S$2.6 billion in total free cash flow over 15 years. This is an average free cash flow of just S$174 million per year. Keep in mind that this free cash flow was generated off of a sizeable net PPE (plant, property, and equipment) base of around S$14 billion in 2007. The free cash flow generated is a pretty meagre return on assets.

What this shows is that SIA is a business that struggles to generate cash even if it is not actively expanding its fleet. This said, SIA does have a significant amount of cash on hand now.

With the cash raised over the past two years and the strong rebound in operations, SIA exited the September quarter this year with S$17.5 billion in cash. Redeeming its first tranche of MCBs will cost SIA around S$3.8 billion, around a fifth of its current cash balance.

The airline also has a relatively young fleet of planes now, which means its net capital expenditure requirement for maintenance is going to be relatively low in the near future, which should lead to higher free cash flows in the next few years.

And with the global recovery in air travel as countries around the world get a better handle on COVID-19, SIA’s operating cash flow is also likely to remain positive this year.

As such, I think it is fair to say that SIA does have the resources to retire the first tranche of its MCBs pretty comfortably despite its business’s poor historical ability to generate cash.

Can it retire the 2021 tranche of MCBs?

This brings us to the next question: Can SIA retire the second tranche of its MCBs which were issued in 2021? To recap, besides the S$3.5 billion raised in 2020 via the issuance of MCBs, SIA raised a further S$6.5 billion through this second tranche of MCBs in 2021.

Including interest, the total outlay to redeem the second tranche of MCBs will be slightly more than $6.5 billion (depending on when exactly SIA redeems the MCBs).

After redeeming the first tranche of its MCBs, SIA will be left with S$13.7 billion in cash. But the airline also has S$15.8 billion in debt (including long-term liabilities), which means it will have net debt (more debt than cash) of around $2.1 billion.

Bear in mind that the MCBs are not considered debt according to SIA’s books. Instead, they are considered equity as they have a feature where they are “mandatorily converted” in 10 years. So the debt on SIA’s balance sheet are additional borrowings which will eventually need to be repaid or refinanced. Given the small net cash position, I don’t think SIA should stretch its balance sheet to pay back the second tranche of MCBs yet.

SIA executives should also have wisened up to the fact that the company should keep some cash in its coffers to avoid another situation where they have to raise capital through the issuance of stock at heavily discounted prices (which happened during COVID-19) or through borrowing at usurious terms. A secondary offering or expensive debt in troubled times will be much more costly to shareholders than the MCBs.

The bottom line

All things considered, I think it is a good move by SIA’s management to redeem the first trance of the airline’s MCBs. The MCBs are an expensive source of capital and retiring them early will benefit SIA’s shareholders. The airline is also in a comfortable financial position to do so.

But the second tranche of MCBs is a different story altogether. After redeeming the first trance, and given SIA’s history of lumpy and meagre cash flow generation, I don’t think management will be willing to stretch its balance sheet to redeem the second tranche of MCBs just yet.

It is worth mentioning that SIA also decided to start paying a dividend again. I would have thought that management would prefer to retire the airline’s second tranche of MCBs before dishing out excess cash to shareholders.

One needs to remember that despite its poor cash flow generation in the past 15 years, SIA still paid dividends nearly every year. In hindsight, this was a mistake by management as the distributed cash would have been better off accumulated on the airline’s balance sheet to tide it through tough times such as during the COVID pandemic.

Ultimately, SIA paid dividends in the past 15 years, only to claw back all of the money (and more) from shareholders by issuing shares in 2020. This was certainly a case of one step forward, two steps back, for shareholders. Let’s hope for the sake of shareholders that history doesn’t repeat itself.

Pocket Aces, Stocks, and Variance

Variance plays a big part in poker. Investing is just like poker in that sense. We may deviate from our long term expected rate of return.

Pocket Aces is the best starting hand in Texas Holdem Poker. Against any other starting-hand combination, Pocket Aces will win approximately 80% of the time.

When facing just one other player, that gives Pocket Aces an expected return of 60%. This expected rate of return includes the times when Pocket Aces loses.

In poker, a profitable bet arises in any situation where your expected return is above 0%. Stock-picking is similar to poker. As stock pickers, we make calculated bets based on the expected rate of return. If the expected rate of return meets our target or exceeds other opportunities, then investing in the stock makes good investment sense.

Expected return for stocks

Like poker, when calculating the expected rate of return for stocks, we should consider all the potential paths a stock can take. In poker there are only two possibilities – you either win or lose. But stock picking is a little more complicated than that. There are numerous potential outcomes that we need to consider when estimating a stock’s expected rate of return.

Stock returns can range widely from -100% (a total loss) to +X,000% (thousands of percent) or more. The expected return for stocks should include an aggregation of all these possible outcomes.

Difference between expected and potential return

The expected rate of return should not be confused with the potential rate of return. The potential rate of return is the upside of investing and does not take into account the other possibilities.

For instance, in poker, when playing Pocket Aces, the potential return is 100% over a single hand played. But the expected return over many hands is 60%.

On the flip side, if you are holding a random starting hand against Pocket Aces, your potential return is still 100% as you still have a 20% chance to win the hand. But the expected rate of return is negative 60%.

Investing in stocks is just like poker. Many stocks may have high potential returns if the company’s management executes perfectly but the actual expected returns may be much lower or even negative as the probability that management executes so perfectly is low.

When investing we are looking for stocks that are just like “Pocket Aces”. These are companies that have high expected returns and not just high potential returns.

Variance and diversification

Another element of poker that transfers well to stock picking is the concept of variance.

If we play just one hand of poker, we are expected to lose with Pocket Aces 20% of the time. In the unfortunate case that Pocket Aces loses over a single hand, our actual returns for that game would be substantially lower than our expected rate of return.

Over two hands, we will break even 32% of the time, lose twice 4% of the time and win twice 64% of the time. In this case, we would now be below our expected return 36% of the time. Poker professionals call this phenomenon variance, which is why small-sample results usually mean nothing for poker players.

However, if we make numerous such bets on Pocket Aces, our rate of return will eventually converge toward 60%.

This is the same when investing in stocks. While we may have put our money in a stock that has a high expected return, the actual outcome may deviate substantially from the expected return.

Final Thoughts

I’ve been fascinated by the game of poker for many years. It is a game of calculation, game theory and exploitation of opponents’ mistakes.

Many elements of poker can also be transferred to investing such as position sizing, return calculations and even portfolio management.

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. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Lessons From The Ongoing Bear Market

Surviving long-term, the importance of cash, and good management teams are some of the key lessons from this bear market.

This year demonstrated the cruel realities of investing in stocks.

Year-to-date, the widely followed US stock market benchmark, the S&P 500, is down 14%. Meanwhile, the NASDAQ Composite, a tech-heavier benchmark for US stocks, has lost 22% of its value.

But that’s just the tip of the iceberg. Many fast-growing companies have had it worse. For instance, the ARK Innovation ETF, an exchange-traded fund that invests in high-growth tech companies, is down by more than 50%.

Multiple stocks that were big winners during the COVID-induced lockdowns have also since returned all their gains; some are even trading well below their pre-COVID prices.

In my nine years as an investor, I’ve never seen such sharp and steep drawdowns across such a wide array of companies. But this likely won’t be the last time either.

With this in mind, I’ve penned down a list of investing thoughts to prepare myself for future downturns.

Don’t celebrate when prices go up

Stock prices gyrate wildly. During the booming market of 2020, there were many investors who celebrated when prices went up. Today, many of the stocks that rose in 2020 have returned all those gains – and then some.

2022 has so far reinforced the fact that stock prices really don’t matter in the short run. If prices run up without fundamentals, they will come back down eventually. Similarly, if stock prices fall below intrinsic values, don’t panic. Prices will eventually return to their underlying values.

As a long-term investor, I have learned to ignore near-term price movements and focus on business fundamentals and valuations.

Cash matters!

When stock prices were rising, companies could raise capital easily by issuing new shares at inflated prices. This increased their cash balances with minimal dilution to existing shareholders.

But now that stock prices have fallen, this source of capital has evaporated. Debt has also become more expensive due to rising interest rates.

It is in times of crisis that companies with strong balance sheets survive, while those with weak financials struggle. Companies that are burning cash and have insufficient cash may end up in a liquidity crisis or end up having to raise more capital at depressed valuations, which could severely impact existing shareholders. If these companies are unable to raise money, their debt holders may end up taking over them, leaving equity holders with scraps.

Invest in strong managers!

With asset prices low, this is a time for companies with the financial muscle to double down on investing for their future. This is a time when prudent managers shine through.

If a company has a great capital allocator at the helm, the company can come out of this bear market stronger than before.

Berkshire, for instance, has started to become more aggressive with its investments in terms of both buybacks and acquiring stakes in other businesses. I believe Warren Buffett’s recent decisions will pay off handsomely for Berkshire shareholders in the future.

Diversify

When stock prices were going up, there was a lot of discussion about concentrating one’s portfolio into just a few stocks.

But this is a risky strategy. Every company has its own set of risks that could result in long-term underperformance of its stock. Companies that are still growing fast and burning cash bear even more risk.

When investing for the long run, we are placing a bet on a company performing well for many years. This doesn’t always pan out. In fact, most companies don’t do well over time and the strong performances of market indexes are driven by just a small handful of companies. When investing, we never deal with absolutes. We are always playing the probability game.

As a long-term investor, survival and long-term steady returns are more important to me than simply maximising earnings. While having a diversified portfolio might reduce my expected returns, it increases my odds of long-term survival and stable returns.

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. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.