Debunking An Investment Myth

Instead of fretting over stock prices, it is better to focus on how much cash the company can generate and return to shareholders.

There are some investing beliefs that are widely accepted but may not be entirely true. One such belief is the idea that a company has a “common” intrinsic value.

When investors think of investing in stocks, the thought is often that a stock has the same intrinsic value for everyone, and eventually the stock price will gravitate toward that intrinsic value. But this may not be the case.

Intrinsic value is dependent on the circumstances of an investor.

Imagine a stock that consistently and predictably pays out $1 per share in dividends every year for eternity. An investor who seeks to find investments that will give a return of 10% a year will be willing to pay $10 per share. In other words, $10 is the “intrinsic value”. On the other hand, another investor may be highly connected and can find high-return investments that gives him 20% a year. This investor will only pay $5 for the above company. His intrinsic value is thus $5 per share.

As you can see, the intrinsic value for the same share is very different.

Intrinsic value changes with rates

Besides the circumstances of each investor, the intrinsic value of a stock can also change when the risk-free rate changes. If the risk free rate goes up, theoretically, investors will gravitate towards the now higher-yielding bonds. As such, stocks will require a higher rate of return and hence their intrinsic value falls.

As the last couple of years have shown, interest rates can have a very big impact on stock prices.

While all this is happening, the company in question is still the same company.

So despite being the same company, it can have different intrinsic values to different people and may also have different intrinsic values on a day-to-day basis based on the risk-free rate at the time.

So what?

This naturally leads to the question, what price will a stock trade at if its intrinsic value differs from person to person and from day to day?

I believe that it’s impossible to know what price a stock should or would trade at. There are too many factors in play. It depends on the market as a whole and with so many market participants, it is almost impossible to know how the stock will be priced.

Given this, instead of focusing on price, we can focus on the dividends that will be distributed to the investor in the future. This means we do not need to predict price movements and our returns are based on the returns that the company will pay to shareholders. Doing this will ensure we are not beholden to fluctuations in stock prices which are difficult to predict.

What’s more predictable is how a company will perform and whether it can generate cash flows and dividends to the shareholders. As such, I prefer focusing my efforts on looking for types of companies with predictable earnings and paying a price that fits my personal investing returns requirement.

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 no vested interest in any company mentioned. Holdings are subject to change at any time.

A Radical Idea To Improve Stock-Based Compensation

Here’s a radical idea to improve stock-based compensation so that employees are inclined to drive long term shareholder value.

The idea of giving stock-based compensation is to turn employees into partners. In theory, giving employees stock will make them part-owners of a business and drive them to think and act like a business owner.

However, the reality is that the way SBC programmes of many companies are designed today actually does not motivate employees to think or act like business owners.

In today’s world, SBC is predominantly given in the form of RSUs or options that vest over three to four years. This means that employees are given a fixed number of shares/options every month over a three to four year period. Although this turns employees into shareholders, it may not adequately motivate them to think like owners of a business.

The reason is that employees can sell the stock as soon as they receive them. Many employees are also not inclined to hold the stock for a long period of time, instead opting to sell the stock when the prices go up. Employees may also consider their contribution to the company as too small to make any difference to the stock price.

As such, this form of SBC does not make employees think like shareholders at all. In fact, I would argue that cash-based compensation would be a better motivator for employees.

Complete lock up

One way that companies try to get around this is to have a lock-up period. In this way, employees are not allowed to sell the shares they receive for a number of years. The lock up period can range from months to years.

But, I think that this is still not enough. Employees need to think like perpetual shareholders where returns are driven by cash flows and ultimately dividends paid to shareholders.

As such, my radical proposal is for SBC to have perpetual lock ups. This means that employees who receive SBC are never allowed to sell unless they are forced to sell via a buyout.

By having perpetual lock ups, employees become true long-term shareholders whose returns are tied to how much cash flow a company is able to return to shareholders.

In this way, employees really think hard about how to maximise cash flow to the company so that the company can pay them a growing stream of dividends in the future instead of just fretting over stock prices. Stock prices are also not entirely in the control of a company as stock prices can also fluctuate based on sentiment and interest rates. Cash flow on the other hand is entirely influenced by management decisions and employee actions.

Although perpetual lock ups may not seem enticing to employees at first, if the company is able to grow and pay dividends in the future, the employee is entitled to a new stream of regular and growing cash income.

Possible push backs

I know there are many possible push backs to this proposal.

For one, some employees may not want to wait so long to receive dividends as an early stage company may take years, if not decades, to start paying dividends. Such a long lock up will not be attractive to employees who want to get rich quick. But that’s the reality of being a long-term shareholder of a business. True business owners are not here to flip the business to someone else but to reap the growing cash flows that the business builds over time. These are patient business builders and that is exactly what we want from employees.

Another pushback would be that it would encourage management to pay dividends instead of investing in other higher return investments. Although this is possible, management who have received shares and are long-term thinkers should be willing to forego some cash dividends today to earn a much larger stream of future cash dividends. Ultimately, a perpetual lock up should drive management to maximise dividend cash flow to themselves over the entire life cycle of the business and not just maximise dividend payment for the near term.

Final words

A perpetual lock-up sounds like a radical idea but it may make employees really think like long-term business partners.

The current model for stock-based compensation via vesting periods and short lock-ups just do not have the same effect in my view. Employees end up focusing on how to drive short term price movements or they just aren’t motivated at all to think like a business owner. In this case, cash incentives and the current form of SBC is not much different.

The only true way to make employees act and think like long-term shareholders is to make them one. And perpetual lock ups probably are the best way to do this.

Beware of This Valuation Misconception

Don’t value your shares based on cash flow to the firm, value it based on cash flow to the shareholder.

How should we value a stock? That’s one of the basic questions when investing. Warren Buffett answers this question extremely well. He says:

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

While seemingly straightforward, a lot of investors (myself included) have gotten mixed up between cash flow that a company generates and cash that is actually taken out of a business.

While the two may sound similar, they are in fact very different.

Key difference

Extra cash flow that a firm generates is termed free cash flow. This is cash flow that the company generates from operations minus any capital expenditure paid.

But not all free cash flow to the firm is distributed to shareholders. Some of the cash flow may be used for acquisitions, some may be left in the bank, and some may be used for other investments such as buybacks or investing in other assets. Therefore, this is not cash that a shareholder will receive. The cash flow that is taken out of the business and paid to shareholders is only the dividend.

When valuing a stock, it is important that we only take cash that will be returned to the shareholder as the basis of the valuation.

Extra free cash flow that is not returned to shareholders should not be considered when valuing a stock.

Common mistake

It is a pretty big mistake to value a stock based on the cash flow that the company generates as it can severely overstate the value of a business.

When using a discounted cash flow model, we should not take free cash flow to the firm as the basis of valuation but instead use future dividends to value a business.

But what if the company is not paying a dividend?

Well, the same should apply. In the case that there is no dividend yet, we need to account for that in our valuation by only modelling for dividend payments later in the future.

Bottom line

Using discounted cash flow to the firm to value a business can severely overstate its value. This can be extremely dangerous as it can be used to justify extremely unwarranted valuations, leading to buying overvalued stocks.

To be accurate, a company should be valued based only on how much it can return to shareholders.

That said, free cash flow to the firm is not a useless metric in valuation. It is actually the basis of what makes a good company.

A company that can generate strong and growing free cash flows should be able to return an increasing stream of dividends to shareholders in the future. Free cash flow to the firm can be called the “lifeblood” of sustainable dividends.

Of course, all of this also depends on whether management is able to make good investment decisions on the cash it generates.

Therefore, when investing in a company, two key things matter. One, how much free cash flow the firm generates, and two, how good management is in allocating that new capital.

An Attempt To Expand Our Circle of Competence

We tried to expand the limits of our investing knowledge.

Jeremy and I have not invested in an oil & gas company for years. The reason can be traced to the very first stocks I bought when I started investing. Back then, in October 2010, I bought six US-listed stocks at one go, two of which were Atwood Oceanics and National Oilwell Varco (or NOV). Atwood was an owner of oil rigs while NOV supplied parts and equipment that kept oil rigs running.

I invested in them because I wanted to be diversified according to sectors. I thought that oil & gas was a sector that was worth investing in since the demand for oil would likely remain strong for a long time. My view on the demand for oil was right, but the investments still went awry. By the time I sold Atwood and NOV in September 2016 and June 2017, respectively, their stock prices were down by 77% and 31% from my initial investments.

It turned out that while global demand for oil did indeed grow from 2010 to 2016 – the consumption of oil increased from 86.5 million barrels per day to 94.2 million barrels – oil prices still fell significantly over the same period, from around US$80 per barrel to around US$50. I was not able to predict prices for oil and I had completely missed out on the important fact that these prices would have an outsized impact on the business fortunes of both Atwood and NOV.

In its fiscal year ended 30 September 2010 (FY2010), Atwood’s revenue and net income were US$650 million and US$257 million, respectively. By FY2016, Atwood’s revenue had increased to US$1.0 billion, but its net income barely budged, coming in at US$265 million. Importantly, its return on equity fell from 21% to 9% in that period while its balance sheet worsened dramatically. For perspective, Atwood’s net debt (total debt minus cash and equivalents) ballooned from US$49 million in FY2010 to US$1.1 billion in FY2016.

As for NOV, from 2010 to 2016, its revenue fell from US$12.2 billion to US$7.2 billion and its net income collapsed from US$1.7 billion to a loss of US$2.4 billion. This experience taught me to be wary of companies whose business results have strong links to commodity prices, since I had no ability to foretell their movements.

Fast forward to the launch of the investment fund that Jeremy and I run in July 2020, and I was clear that I still had no ability to divine oil prices – and neither did Jeremy. Said another way, we were fully aware that companies related to the oil & gas industry were beyond our circle of competence. Then 2022 rolled around and during the month of August, we came across a US-listed oil & gas company named Unit Corporation.

At the time, Unit had three segments that spanned the oil & gas industry’s value chain: Oil and Natural Gas; Mid-Stream, and Contract Drilling. In the Oil and Natural Gas segment, Unit owned oil and natural gas fields in the USA – most of which were in the Anadarko Basin in the Oklahoma region – and was producing these natural resources. The Mid-Stream segment consisted of Unit’s 50% ownership of Superior Pipeline Company, which gathers, processes, and treats natural gas, and owns more than 3,800 miles of gas pipelines (a private equity firm, Partners Group, controlled the other 50% stake). The last segment, Contract Drilling, is where Unit owned 21 available-for-use rigs for the drilling of oil and gas.

When we first heard of Unit in August 2022, it had a stock price of around US$60, a market capitalisation of just over US$560 million, and an enterprise value (market capitalisation minus net-cash) of around US$470 million (Unit’s net-cash was US$88 million back then). But the company’s intrinsic value could be a lot higher.

In January 2022, Unit launched a sales process for its entire Oil and Natural Gas segment, pegging the segment’s proven, developed, and producing reserves at a value of US$765 million. This US$765 million value came from the estimated future cash flows of the segment – based on oil prices we believe were around US$80 per barrel – discounted back to the present at 10% per year. Unit ended the sales process for the Oil and Natural Gas segment in June 2022 after selling only a small portion of its assets for US$45 million. Nonetheless, when we first knew Unit, the Oil and Natural Gas segment probably still had a value that was in the neighbourhood of the company’s estimation during the sales process, since oil prices were over US$80 per barrel in August 2022. Meanwhile, we also saw some estimates in the same month that it would cost at least US$400 million for someone to build the entire fleet of rigs that were in the Contract Drilling segment. As for the Mid-Stream segment, due to Superior Pipeline’s ownership structure and the cash flows it was producing, the value that accrued to Unit was not significant*.

So here’s what we saw in Unit in August 2022 after putting everything together: The value of the company’s Oil and Natural Gas and Contract-Drilling segments (around US$765 million and US$400 million, respectively) dwarfed its enterprise value of US$470 million.

But there was a catch. The estimated intrinsic values of Unit’s two important segments – Oil and Natural Gas, and Contract Drilling – were based on oil prices in the months leading up to August 2022. This led Jeremy and I to attempt to expand our circle of competence: We wanted to better understand the drivers for oil prices. There were other motivations. First, Warren Buffett was investing tens of billions of dollars in the shares of oil & gas companies such as Occidental Petroleum and Chevron in the first half of 2022. Second, we also came across articles and podcasts from oil & gas investors discussing the supply-and-demand dynamics in the oil market that could lead to sustained high prices for the energy commodity. So, we started digging into the history of oil prices and what influences it.

Here’s a brief history on major declines in the price of WTI Crude over the past four decades:

1980 – 1986: From around US$30 to US$10
1990 – 1994: From around US$40 to less than US$14
2008 – 2009: From around US$140 to around US$40
2014 – 2016: From around US$110 to less than US$33
2020: From around US$60 to -US$37

Since oil is a commodity, it would be logical to think that differences in the level of oil’s supply-and-demand would heavily affect its price movement – when demand is lower than supply, prices would crash, and vice versa. The UK-headquartered BP, one of the largest oil-producing companies in the world, has a dataset on historical oil production and consumption going back to 1965. BP’s data is plotted in Figure 1 below and it shows that from 1981 onwards, the demand for oil (consumption) was higher than the supply of oil (production) in every year. What this means is the price of oil has surprisingly experienced at least five major crashes over the past four decades despite its demand being higher than supply over the entire period.

Figure 1; Source: BP

We shared our unexpected findings with our network of investor friends, which included Vision Capital’s Eugene Ng. He was intrigued and noticed that the U.S. Energy Information Administration (EIA) maintained its own database for long-term global oil consumption and production. After obtaining similar results from EIA’s data compared to what we got from BP, Eugene asked the EIA how it was possible for oil consumption to outweigh production for decades. The EIA responded and Eugene kindly shared the answers with us. It turns out that there could be errors within EIA’s data. The possible sources of errors come from incomplete accounting of Transfers and Backflows in oil balances:

Transfers include the direct and indirect conversion of coal and natural gas to petroleum.
Backflows refer to double-counting of oil-streams in consumption. Backflows can happen if the data collection process does not properly account for recycled streams.

The EIA also gave an example of how a backflow could happen with the fuel additive, MTBE, or methyl tert-butyl ether (quote is lightly edited for clarity):

“The fuel additive MTBE is an useful example of both, as its most common feedstocks are methanol (usually from a non-petroleum fossil source) and Iso-Butylene whose feedstock likely comes from feed that has already been accounted for as butane (or iso-butane) consumption. MTBE adds a further complexity in that it is often exported as a chemical and thus not tracked in the petroleum trade balance.”

Thanks to the EIA, we realised that BP’s historical data on the demand and supply of oil might contain errors and how they could have happened. But despite knowing this, Jeremy and I still could not tell what the actual demand-and-supply dynamics of oil were during the five major price crashes that happened from the 1980s to today**. We tried expanding our circle of competence to creep into the oil & gas industry, but were stopped in our tracks. As a result, we decided to pass on investing in Unit.

I hope that my sharing of how Jeremy and I attempted to enlarge our circle of competence would provide any of you reading this ideas on how you can improve your own investing process.

*In April 2018, Unit sold a 50% stake in Superior Pipeline to entities controlled by Partners Group – that’s how Partners Group’s aforementioned 50% control came about. When we first studied Unit in August 2022, either Unit or Partners Group could initiate a process after April 2023 to liquidate Superior Pipeline or sell it to a third-party. If a liquidation or sale of Superior Pipeline were to happen, Partners Group would be entitled to an annualised return of 7% on its initial investment of US$300 million before Unit could receive any proceeds; as of 30 June 2022, a sum of US$354 million was required for Partners Group to achieve its return-goal. In the first half of 2022, the cash flow generated by Superior Pipeline was US$24 million, which meant that Unit’s Mid-stream segment was on track to generate around US$50 million in cash flow for the whole of 2022. We figured that a sale of Superior Pipeline in April 2023, with around US$50 million in 2022 cash flow, would probably fetch a total amount that was in the neighbourhood of the US$354 million mentioned earlier that Partners Group was entitled to. So if Superior Pipeline was sold, there would not be much proceeds left for Unit after Partners Group has its piece.

**If you’re reading this and happen to have insight on the actual historical levels of production and consumption of oil during the past crashes, we would deeply appreciate it if you could get in touch with us. Thanks in advance!

What The USA’s Largest Bank Thinks About The State Of The Country’s Economy In Q4 2023

Insights from JPMorgan Chase’s management on the health of American consumers and businesses in the fourth quarter of 2023.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the fourth quarter of 2023 – was held two weeks ago and contained useful insights on the state of American consumers and businesses. The bottom-line is this: The US economy remains resilient, but there are significant risks that are causing JPMorgan’s management team to be cautious.

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

1. The US economy and consumer remains resilient, and management’s base case is that consumer credit remains strong, although loan losses (a.k.a net charge-off rate) for credit cards is expected to be “<3.5%” in 2024 compared to around 2.5% for 2023

The U.S. economy continues to be resilient, with consumers still spending, and markets currently expect a soft landing…

…We continue to expect the 2024 card net charge-off rate to be below 3.5%, consistent with Investor Day guidance…

…In terms of consumer resilience, I made some comments about this on the press call. The way we see it, the consumers find all of the relevant metrics are now effectively normalized. And the question really in light of the fact that cash buffers are now also normal, but that, that means that consumers have been spending more than they’re taking in is how that spending behavior adjusts as we go into the new year, in a world where cash buffers are less comfortable than they were. So one can speculate about different trajectories that, that could take, but I do think it’s important to take a step back and remind ourselves that consistent with that soft landing view, just in the central case modeling, obviously, we always worry about the tail scenarios is a very strong labor market. And a very strong labor market means, all else equal, strong consumer credit. So that’s how we see the world.

2. Management thinks that inflation and interest rates may be higher than markets expect…

It is important to note that the economy is being fueled by large amounts of government deficit spending and past stimulus. There is also an ongoing need for increased spending due to the green economy, the restructuring of global supply chains, higher military spending and rising healthcare costs. This may lead inflation to be stickier and rates to be higher than markets expect.

3. …and they’re also cautious given the multitude of risks they see on the horizon

On top of this, there are a number of downside risks to watch. Quantitative tightening is draining over $900 billion of liquidity from the system annually, and we have never seen a full cycle of tightening. And the ongoing wars in Ukraine and the Middle East have the potential to disrupt energy and food markets, migration, and military and economic relationships, in addition to their dreadful human cost. These significant and somewhat unprecedented forces cause us to remain cautious.

4. Management is seeing a deterioration in the value of commercial real estate

The net reserve build was primarily driven by loan growth in card and the deterioration in the outlook related to commercial real estate valuations in the commercial bank.

5. Auto loan growth was strong

And in auto, originations were $9.9 billion, up 32% as we gained market share, while retaining strong margins.

6. Overall capital markets activity is picking up, but merger & acquisition (M&A) activity still remains weak…

We are starting the year with a healthy pipeline, and we are encouraged by the level of capital markets activity, but announced M&A remains a headwind and the extent as well as the timing of capital markets normalization remains uncertain…

…Gross Investment Banking and Markets revenue of $924 million was up 32% year-on-year primarily reflecting increased capital markets and M&A activity…

…So as you know, all else equal, this more dovish rate environment is, of course, supportive for capital markets. So if you go into the details a little bit, if you start with ECM [Equity Capital Markets], that helps higher — and the recent rally in the equity markets helps. I think there have been some modest challenges with the 2023 IPO vintage in terms of post-launch performance or whatever. So that’s a little bit of a headwind at the margin in terms of converting the pipeline, but I’m not too concerned about that in general. So I would expect to see rebound there. In DCM [Debt Capital Markets], again all else equal, lower rates are clearly supportive. One of the nuances there is the distinction between the absolute level of rates and the rate of change. So sometimes you see corporates seeing and expecting lower rates and, therefore, waiting to refinance in the hope of even lower rates. So that can go both ways. And then M&A, it’s a slightly different dynamic. I think there’s a couple of nuances there. One, as you obviously know, announced volume was lower this year. So that will be a headwind in reported revenues in 2024, all else equal. And of course, we are in an environment of M&A regulatory headwinds, as has been heavily discussed. But having said that, I think we’re seeing a bit of pickup in deal flow, and I would expect the environment to be a bit more supportive.

7. …and appetite for loans among businesses is muted

C&I loans were down 2%, reflecting lower revolver utilization and muted demand for new loans as clients remain cautious…

…We expect strong loan growth in card to continue but not at the same pace as 2023. Still, this should help offset some of the impact of lower rates. Outside of card, loan growth will likely remain muted.

8. Management is not seeing any changes to their macro outlook for the US economy

So the weighted average unemployment rate and the number is still 5.5%. We didn’t have any really big revisions in the macro outlook driving the numbers, and our skew remains as it has been, a little bit skewed to the downside.

9. Management’s outlook for 2024 includes six rate-cuts by the Fed, but that outlook comes from financial market data, and not from management’s insights

[Question] Coming back to your outlook and forecast for net interest income for the upcoming year with the 6 Fed fund rate cuts that you guys are assuming. Can you give us a little insight why you’re assuming 6 cuts?

[Answer] I wish the answer were more interesting, but it’s just our practice. We just always use the forward curve for our outlook, and that’s what’s in there.

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.

Companies Need to Stop Doing These Stupid Things

Stock-based compensation, EBITDA, and buybacks are often conducted poorly by companies.

We see companies do stupid things all the time that erodes shareholder value. Here are three of them that really irk me.

Targeting stock-based compensation as a percent of revenue

Many companies don’t seem to understand stock-based compensation.

Twilio is one such example. In an investor presentation last year, Twilio mentioned that it was targeting to reduce stock-based compensation as a percent of revenue.

Stock-based compensation on the income statement is recorded based on the share price at the time of grant. Using a percent of revenue as a stock-based compensation measure just shows how little management understands it.

Stock-based compensation on the income statement can drop simply because share prices have fallen. So lower stock-based compensation on the income statement does not necessarily correlate with a lower number of shares issued.

In fact, if share prices drop drastically – as was seen with tech stocks in 2022 – stock-based compensation recorded on the income statement may end up being lower, but the absolute number of shares vested could be even more than before. This can lead to even larger dilution for shareholders.

Twilio is not the only company that does not understand stock-based compensation. More recently, DocuSign also suggested that it is targeting stock-based compensation based on a percent of revenue, which shows a lack of understanding of the potential dilutive effects of this form of expense.

Instead of focusing on the accounting “dollars” of stock-based compensation, companies should focus on the actual number of shares that they issue.

Focusing on EBITDA

Too many companies make financial targets based on EBITDA.

EBITDA stands for earnings before interest, taxes, depreciation and amortisation. Although I appreciate the use of EBITDA in certain cases, it is usually not the right metric for companies to focus on.

In particular, EBITDA ignores depreciation expenses, which often need to be accounted for, especially when a business requires maintenance capital expenditures. Capital expenditure is cash spent this year that is not recorded as an expense on the income statement yet. Instead it is recorded as an asset which will depreciate over time in the future. Ignoring this depreciation is akin to completely ignoring the cash outlay used in prior years.

Management teams are either being dishonest by focusing on EBITDA or truly do not appreciate the pitfalls of focusing on maximising EBITDA instead of actual cash flow per share. In other words, they’re either incompetent or dishonest. Either way, it’s bad.

Framing stock buybacks as returning cash to shareholders

Too many companies frame buybacks as a way to return cash to shareholders. However, if we are long-term shareholders who do not plan to sell our shares, we don’t get any cash when a company buys back stock.

Don’t get me wrong.

I think buying back stock when shares are relatively cheap is a great use of capital. However, saying that buybacks is returning cash to shareholders is not entirely correct. Only a small group of shareholders – the shareholders who are selling – receive that cash.

Instead, companies should call buybacks what they really are: A form of investment. Buybacks reduce a company’s shares outstanding. This results in future profits and dividend payouts being split between fewer shares which hopefully leads to a higher dividend per share in the future for long term shareholders.

Naming buybacks as a form of returning cash to shareholders is undermining the truly long-term shareholders who in reality have not seen any cash returned to them.

If a company mistakenly thinks that buybacks are a form of returning cash to shareholders, it may also mislead them to buy back stock periodically without consideration of the share price. Doing this can be harmful to shareholders.

On the other hand, if the company correctly realises that buybacks are instead a form of investment, then the share price will matter to them and they will be more careful about buying back shares at a good price.

Bottom line

Companies do stupid things all the time.

Although I can give them the benefit of the doubt for many stupid things they do, I draw the line when a company cannot grasp simple accounting concepts or make silly statements.

It may seem trivial, but making silly statements shows a lack of understanding of key concepts that mould a company’s capital allocation decisions.

Executives are paid good money to make good decisions and I expect a basic level of understanding from the people who make key decisions on shareholders’ behalf.

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 Docusign. Holdings are subject to change at any time.

How to Get 10% Returns a Year

Investors may be bombarded with so many different methods to value a company. Ultimately it all comes down to how much cash will be returned to the shareholder.

How much should you pay for a stock to get a 10% return? In this article I explore a valuation method that helps me find just that.

The dividend discount model

First, we need to understand that the core concept of investing is that we are investing to earn a stream of future cash flows. Ideally, the amount we receive in the future should exceed the amount we invest today.

In this exercise, I’ll make one assumption: We are long term “buy and never sell investors” who make our money through the cash a company returns to shareholders as dividends.

Using this assumption, we should use the dividend discount model to value a stock. A dividend discount model discounts all future dividend income back to the present. It also assumes that you can reinvest the dividend at a rate similar to the discount rate.

Achieving a 10% return

So how do you get a 10% return? Let’s start with a simple example. Suppose a company will pay $1 per share in dividends for 10 years. At the end of the 10 years, it closes down with no liquidation value.

In total, you will receive $10 per share in dividends.

Using a dividend discount model, and discounting all the dividends to the present day at a 10% discount rate, we can calculate that the price to pay for the stock is $6.14. You can find the calculation in this spreadsheet.

Just looking at the price alone, it may seem strange that the dividend yield that you are getting is more than 10%.

At $6.14 per share, you will be earning a dividend yield of 16.3% but your annual return is still 10%. This is because the company closes down after 10 years and your initial capital will not be returned to you. To make up for that, you need to generate more than 10% in your annual dividend yield just to make a 10% annualised return.

More durable companies

In the above scenario, the company is not durable and is only able to pay you a dividend for 10 years. But for more durable companies, you can afford to pay more to achieve the same return.

For instance, there’s a more durable company that pays $1 per share in dividend for 20 years before closing down. In this scenario, you can pay $8.51 per share to earn a 10% return.

The more durable the company, the more you can pay. If a company can pay you $1 per share in dividend for eternity, you can pay $10 per share to earn a 10% yield and a 10% return.

Vicom – a no-growth company

An example of a steady but no-growth company is Vicom, which provides car inspection services in Singapore. It is a stable business as Singapore’s law requires vehicles to undergo regular inspections for road-worthiness.

Vicom, with its longstanding history, is also trusted by Singapore’s authorities to provide these inspection services, making it difficult for competitors to encroach into the space. But there is limited opportunity for Vicom to grow as the authorities regulates the number of vehicles given entitlement to be owned and driven in Singapore, resulting in zero vehicle-growth in Singapore for many years. In addition, the inspection fees are also likely regulated by the government, ensuring that consumers are protected from price gouging.

As a result, Vicom’s annual net income has hovered around S$25 million for years. The company also pays out around 100% of its net profit to shareholders.

Given all of this, as well as assuming that Vicom’s business can sustain for a long period of time and we want a 10% annualised return from owning Vicom’s shares, Vicom’s value should be S$250 million, representing a dividend yield of around 10%. Vicom’s current market cap is around S$450 million, which means that shareholders will earn less than a 10% rate of return.

Amphenol – a growth stock

Amphenol Corporation, a company based in the USA, designs and manufactures electronic connectors and sensors. Unlike Vicom, Amphenol has a track record of growing revenue and earnings per share while paying a growing dividend.

Since 2011, Amphenol’s revenue and earnings per share has compounded at 10.5% and 13% per year, respectively. In addition, the company’s dividend per share has grown from US$0.02 per share in 2011 to US$0.83 per share in 2022, for an annulised growth rate of 40%. Amphenol’s business can likely continue to grow at a steady rate if the company continues to acquire other companies for growth.

How much will you pay for its stock? Let’s assume Amphenol will pay US$1 per share in dividend in 2023 and grow that dividend at 9% per year for a long period of time.

In this case, using a dividend discount model, we can calculate that to earn a 10% return on investment (assuming no dividend withholding tax), we will need to pay around US$109 per share. My calculation can be found here.

You may notice that the dividend yield based on the price we are willing to pay is only 0.9%. Yet, we can still make 10% a year because the dividend that we will collect in future years grows over time.

Using the model

This model can be applied to all companies as long as you can predict its dividend stream. However this model only works if you are going to be holding the company for the full duration of its lifespan. If you intend to sell the shares to someone else, the share price that you are able to sell the shares at depends on the buyer’s own required rate of return.

This can be influenced by a range of factors, such as the risk-free rate at the time of the sale, or the state of the economy.

The model also assumes that you can predict with strong certainty the timing and amount of dividends. In practice, this may be hard to predict for companies without a history of dividend payments.

Nevertheless, this framework provides me with a clear way of thinking about valuation and gives me a sense of how I should approach valuing companies.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

More Thoughts on Artificial Intelligence

How is artificial intelligence reshaping the world?

I published Thoughts on Artificial Intelligence on 19 July 2023. Since then, developments in AI have continued at a breath-taking speed. In here, I want to share new thoughts on AI that I have, as well as provide updates on some of the initial discussions.

Let’s start with the new thoughts, in no particular order (note that the caution from Thoughts on Artificial Intelligence that my thinking on AI is fragile still apply):

AI could be a long-term tailwind for the development of biotechnology drugs. AlphaFold is an AI-model from Alphabet’s subsidiary, Google Deepmind, that is capable of predicting the structure of nearly every protein discovered by scientists thus far – this amounts to more than 200 million structures. And Alphabet is providing this data for free. Proteins are molecules that direct all cellular function in a living organism, including of course, humans. A protein’s structure matters because it is what allows the protein to perform its job within an organism. In fact, diseases in humans can be caused by mis-structured proteins. Understanding the structure of a protein thus means knowing how it could affect the human body. Biotechnology drugs can be composed of proteins, and they tend to manipulate proteins, or the production of proteins, within the human body. According to an Economist article published in September this year, AlphaFold has been used by over 1.2 million researchers to-date. Elsewhere, researchers from biotechnology giant Amgen noted in a recent paper that with the help of AI, the company has reduced, by 60% compared to five years ago, the time it needs to develop a candidate drug up to the clinical-trial stage. But the researchers also shared that AI could do more to help biotechnology companies make the development process for protein-based drugs faster and cheaper. An issue confronting biotechnology companies today is a lack of sufficient in-house data to build reliable models to predict the effects of protein-based drugs. The researchers proposed methods for biotechnology companies to share data to build more powerful predictive AI models in a way that protects their intellectual properties. As AI technology improves over time, I’m excited to observe the advances in the protein-drug creation process that is likely to occur alongside.
It now looks even more possible to us that generative AI will have a substantial positive impact on the productivity of technology companies. For example, during Oracle’s earnings conference call that was held in September, management shared that the company is using generative AI to produce the code needed to improve all the features in Cerner’s system (Oracle acquired Cerner, a healthcare technology company, in June 2022), instead of its usual way of writing code in the Java programming language. Oracle’s management also said that even if AI code generators make mistakes, “once you fix the mistake, you fix it everywhere.” In another instance, MongoDB announced in late-September this year that it’s introducing generative AI into its MongoDB Relational Migrator service, which helps reduce friction for companies that are migrating from SQL to NoSQL databases. When companies embark on such a migration, software code needs to be written. With generative AI, MongoDB is able to help users automatically generate the necessary code during the migration process.
The use of AI requires massive amounts of data to be transferred within a data centre. There are currently two competing data switching technologies to do so, namely, Ethernet and Infiniband, and they each have their supporters. Arista Networks builds high-speed Ethernet data switches. During the company’s July 2023 earnings conference call, management shared their view that Ethernet is the right long-term technology for data centres where AI models are run. In the other camp, there’s Nvidia, which acquired Mellanox, a company that manufactures Infiniband data switches, in 2020. Nvidia’s leaders commented in the company’s latest earnings conference call (held in late-August this year) that “Infiniband delivers more than double the performance of traditional Ethernet for AI.” It’s also possible that better ways to move data around a data centre for AI workloads could be developed. In Arista Networks’ aforementioned earnings conference call, management also said that “neither technology… were perfectly designed for AI; Infiniband was more focused on HPC [high-performance computing] and Ethernet was more focused on general purpose networking.” We’re watching to see which technology (existing or new) would eventually have the edge here, as the market opportunity for AI-related data switches is likely to be huge. For perspective, Arista Networks estimates the total data centre Ethernet switch market to be over US$30 billion in 2027, up from around US$20 billion in 2022.

Coming to the updates, in Thoughts on Artificial Intelligence, I discussed how AI software, especially generative AI, requires vector databases but that NoSQL databases will remain relevant. During MongoDB’s latest earnings conference call, held in August this year, management shared their view that the ability to perform vector searches (which is what vector databases do) will ultimately be just a feature that’s built into all databases. This is because standalone vector databases are point-products that still need to be used with other types of databases in order for developers to build applications. I am on the same side as MongoDB’s management because of two things they shared during the company’s aforementioned earnings conference call. Firstly, they see developers preferring to work with multi-functional databases compared to bolting on a separate vector solution onto other databases. Secondly, Atlas Vector Search – MongoDB’s vector search feature within its database service – is already being used by customers in production even though it’s currently just a preview-product; to us, this signifies high customer demand for MongoDB’s database services within the AI community.

I also touched upon the phenomenon of emergence in AI in Thoughts on Artificial Intelligence. I am even more confident now that emergence is present in AI systems. Sam Altman, the CEO of OpenAI, the company behind ChatGPT, was recently interviewed by Salesforce co-founder and CEO Marc Benioff. During their conversation, Altman said (emphases are mine):

“I think the current GPT paradigm, we know how to keep improving and we can make some predictions about – we can predict with confidence it’s gonna get more capable. But exactly how is a little bit hard. Like when, you know, why a new capability emerges at this scale and not that one. We don’t yet understand that as scientifically as we do about saying it’s gonna perform like this on this benchmark.”

In other words, even OpenAI cannot predict what new capabilities would spring forth from the AI models it has developed as their number of parameters and the amount of data they are trained on increases. The unpredictable formation of sophisticated outcomes is an important feature of emergence. It is also why I continue to approach the future of AI with incredible excitement as well as some fear. As AI models train on an ever increasing corpus of data, they are highly likely to develop new abilities. But it’s unknown if these abilities will be a boon or bane for society. We’ll see!

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 Alphabet and MongoDB. Holdings are subject to change at any time.

The Worst (Best) Time To Invest Feels The Best (Worst)

Stocks can go on to do deliver great gains even when the economy is in shambles; stocks can also go on to crumble when the economy is booming.

The world of investing is full of paradoxes. In a recent article, I described the example of stability itself being destabilising. Another paradox is that the worst time to invest can feel the best, and vice versa.

This paradox can be aptly illustrated by the State of the Union Address, a speech that the President of the USA delivers near the start of every year. It’s a report on how the country fared in the year that passed and what lies ahead. It’s also a barometer for the sentiment of US citizens on the country’s social, political, and economic future.

This is part of the speech for one particular year:

“We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity — and, therefore, such a profound obligation — to build the more perfect union of our founders’ dreams.

We begin the [year] with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

My fellow Americans, the state of our union is the strongest it has ever been.”

In short, American citizens were feeling fabulous about their country. There was nothing much to worry about and the economy was buzzing. In another particular year, the then-president commented:

“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who’d already known poverty, life has become that much harder. This recession has also compounded the burdens that America’s families have been dealing with for decades — the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.”

This time, Americans were suffering, and there were major problems in the country’s economy.

The first speech was delivered in January 2000 by Bill Clinton. What happened next: The S&P 500 – a widely followed barometer for the US stock market – peaked around the middle of 2000 and eventually declined by nearly 50% at its bottom near the end of 2002. Meanwhile, the second speech was from Barack Obama and took place in January 2010, when the US was just starting to recover from the Great Financial Crisis. In turned out that the next recession took more than 10 years to arrive (in February 2020, after COVID-19 emerged) and the S&P 500 has increased by nearly 450% – or 14% annually – since the speech, as shown in Figure 1.

Figure 1; Source: Yahoo Finance; S&P 500 (including dividends) from January 2010 to September 2023

It’s not always the case where a crumbling economy equates to fantastic future returns in stocks. But what I’ve shown is the important idea that the best time to invest could actually feel like the worst, while the worst time to invest could feel like the best time to do so. Bear this in mind, for it could come in handy the next time a deep recession hits.

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.

One Of The Largest Disconnects Between Fundamentals & Price I’ve Ever Seen

VinFast Auto has a mammoth market capitalisation but the same may not be said for its business fundamentals.

VinFast Auto (NASDAQ: VFS) became a public-listed entity in the US stock market on 15 August this year through a SPAC (Special Purpose Acquisition Company) merger. I think it is also a company with one of the largest disconnects between fundamentals and price that I’ve ever seen. I’ll lay out what I know, and you can judge my thought.

Founded in 2017, VinFast manufactures EVs (electric vehicles), e-scooters, and e-buses. The company started producing e-scooters in 2018, ICE cars in 2019 (the production of internal combustion engine vehicles was phased out in late-2022), and e-buses in 2020. Its first EV product line consists of a range of SUVs (sport utility vehicles) which it began manufacturing in December 2021. VinFast’s manufacturing facility – which has 1,400 robots and is highly automated – is located in Hai Phong, Vietnam and has an annual production capacity of 300,000 EVs. Through June 2023, VinFast has delivered 105,000 vehicles – most of which are ICE vehicles – and 182,000 e-scooters.

Vietnam is VinFast’s headquarters and the company’s primary market at the moment. As of 30 June 2023, VinFast had sold around 18,700 EVs, mostly in Vietnam, since inception; the deliveries of the 182,000 e-scooters since the company’s founding all happened in the same country too. The company has ambitions beyond Vietnam and has set its sights on the USA, Canada, France, Germany, and the Netherlands as its initial international markets. VinFast commenced US deliveries of EVs in March this year while it expects to start delivering EVs into Europe in the second half of 2023. The company has recorded around 26,000 reservations for its EVs globally as of 30 June 2023.

Controlling nearly all of VinFast’s shares currently (99.7%) is Pham Nhat Vuong, the founder and majority shareholder of Vingroup, a Vietnam-based conglomerate. Vingroup has a major economic presence in Vietnam – the company and all of its listed subsidiaries collectively accounted for 1.1% of Vietnam’s GDP in 2022 and they have a combined market capitalisation of US$21.0 billion (note that this does not include the value of VinFast) as of 30 June 2023.

In the two weeks since VinFast’s listing, the company’s stock price closed at a high of US$82, on 28 August 2023. This gave VinFast a staggering US$190 billion market capitalisation based on an outstanding share count of 2.307 billion (as of 14 August 2023). At the market-close on 29 August 2023, VinFast’s share price was US$46. Though a painful 44% fall from the previous day’s closing, the US$46 stock price still gives VinFast a massive market capitalisation of US$107 billion, which easily makes it one of the top five largest auto manufacturers in the world by market capitalisation. But behind VinFast’s market size are the following fundamentals:

2022 numbers (I would have used trailing numbers, but they’re not readily available): Revenue of US$633.8 million, an operating loss of US$1.8 billion, and an operating cash outflow of US$1.5 billion
As I already mentioned, VinFast has (1) 26,000 reservations for its EVs globally as of 30 June 2023, and (2) delivered 105,000 vehicles – most of which are ICE vehicles – and 182,000 e-scooters from its founding through June 2023.

For perspective, here are the equivalent numbers for Tesla, the largest auto manufacturer in the world by market capitalisation (US$816 billion on 29 August 2023), and a company whose valuation ratios are often said by stock market participants to be rich:

Trailing numbers: Revenue of US$94.0 billion, operating income of US$12.7 billion, and operating cash inflow of US$14.0 billion
Trailing deliveries of 1.638 million vehicles worldwide.

So given all the above, what do you think about my statement above, that VinFast is “a company with one of the largest disconnects between fundamentals and price that I’ve ever seen”?

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 Tesla. Holdings are subject to change at any time.