Portfolio Strategy: Don’t Go Long on Position Short Conviction
Three investment drivers investors need to know about.
Price anchoring works both ways. What is price pegging and why it’s bad for long-term returns.
Why the return on investment (“KING“) is so important for upside potential. And technology is not always offer the best return on investment.
Investors should be skeptical of the growing number of stocks among tech companies.
Commodities currently have a very high return on investment and a declining share count given the large buybacks at countless companies.
Meanwhile, investing in “new economy”“Companies are now fraught with risk and will struggle to keep the number of shares from skyrocketing.
Conclude with practical investment information.
Remind me, what is price anchoring?
Are you more likely to say A) or B)?
A) The stock is incredibly cheap, its price is only $9 right now, and it can easily be $15. Look, it was $60 during COVID, period!
B) This company is incredibly cheap, its market cap is $1.8 billion and it trades for less than 5x free cash flow?
In example A, the investor examines the price of a stock and argues that it is cheap relative to its previous price. This investor is the price anchor. This does not provide any ultimate value in this strategy.
In example B, you are rightly or wrongly trying to before watch. You think, I’m paying 5 times free cash flow, so assuming the business remains stable, in five years the investment will pay for itself.
Do you see the difference? How in A do we look back? And in B we can’t wait?
With B, we are essentially arguing that we get a 20% free cash flow yield (5 x FCF to market cap).
That said, it is important to be in harmony with yourself.
Many investors largely prefer to pay for a high-quality, sustainable business with an extended track. The problem, however, is that too often we are led by rising stock prices to believe that the company is of higher quality than it really is.
Don’t let the market tell you what a good investment is.
Why Price Pegging Is Killing You
I follow a lot of companies and I interact with a lot of investors. And I hear the same comments over and over again. Tech companies have fallen so much that they must be a bargain. It’s the thought – if not now, then when?
And to that, I argue, that just looking back to when things were more expensive doesn’t immediately mean things are cheap. We are now in a totally different environment. You have significant geopolitical risk, rising interest rates, slowing economies, to name a few risks.
Likewise when I highlight Commodities everyone pushes back and says many Commodities have gone up so much in the last 12 months that they are way overdue for a pullback?
And again, I repeat. It doesn’t matter where the stock price has been. It only matters where it goes. If all there was to invest was to look back, the best investors would be librarians.
You must study financial history, to have a context of what will happen in the future.
Think about return on investment
The primary driver of shareholder return is growth in free cash flow per share.
Why focus on cash flow? Because a stock is a share of a company’s future cash flow and therefore cash flow, more than any other variable, seems to do the best job of explaining a company’s stock price on the long term (Jeff Bezos, 2001).
The problem, however, is that when we consider free cash flow, modern tech companies add a huge amount of stock-based compensation. With that in mind, does this free cash flow Actually free? And shouldn’t we avoid investing in companies that don’t have strong free cash flow, once we factor in stock-based compensation?
In the ideal world, you want to invest in a business that has a very high cash return on invested capital. In plain English, this means that the company does not have to invest a significant amount of capital and incur pesky costs, including stock-based compensation, to increase revenue at a significant rate. It’s the ideal world. You always want to position yourself in companies with a high return on investment.
Free cash flow drives return on investment, which drives the stock price higher over the long term, as Bezos pointed out in 2001.
Share-based compensation, the new Capex?
In an old-economy stock, when you invest in capital-intensive companies, you might buy companies that were priced at 15 times earnings, as the company increased its revenue by 15% and that you would have paid a very reasonable valuation. . The PEG ratio here is 1, and that’s very reasonable.
The problem is that often around 50% or more of those profits had to be reinvested in the business as capital expenditures for equipment, so the investors’ free cash flow was half of those profits. declared. So the PEG ratio was closer to 2 or more and the stock was not as cheap as it looked on the surface.
In new economy stocks, the company does not have to invest in a factory with costly capex requirements, but rather invest in its team. They hire high quality engineers who demand to be paid in stock.
And it worked very well, as all the stocks went up. And now? Now, with tech stocks down more than 50%, at least, from the highs, this “monopoly moneydistributed as remuneration does not seem so attractive. And if you want to motivate executives and boost their morale, you’re going to have to pay them even more.
So now your business capital expenditure “or capitalized expenditure,” will become the worst expense. Cash in advance, to motivate executives to stay.
Are you making it too difficult?
Here is a very simple rule.
If you find that revenue is up 20% YoY, but stock-based compensation is up more than 50% YoY, you need to start thinking: maybe these executives are being overpaid. for what they offer? This is a very poor return for the dilution incurred.
And look at the number of shares outstanding over the past two years. Are you diluted by more than 30% over two years? This means you need the stock price to jump 30% just to get you back into balance on your stock portfolio.
And people don’t pay stupid anymore “multiplefor stocks. Investors today ask the hard questions first, before they consider buying. Rather than buying first and asking questions later.
Practical investment examples
Let me give you a few examples.
Look at the coal companies. Even the most expensive coal companies, once you factor in their hedged books, are valued at around 2x free cash flow. This means that, assuming stable coal prices, the company has paid for itself in two years, and after that everything is up for shareholders. No matter what companies do after two years, over the next 10 years everything is up.
And so many investors are pushing back that coal will soon be heading back lower. And that’s a very strong possibility. And that’s why these management teams have very well defined capital return programs. Everyone knows that the industry tends to blow up capital, so it just pays back capital. Think special dividends with massive redemptions, or a combination of the two.
I can make the same example for natural gas, oil companies, steel, lumber, aluminum, basically anything you really need to drive economies forward. We forgot that there is a real world out there.
These companies generate significant free cash flow in 2022 and 2023 and return huge sums to shareholders. Why?
Because after this prolonged bear market, investors just want the capital back. It is a multi-year trough space KING this led to very few participants getting involved. Warren Buffett calls business with few incoming moats. See how much capital you would need to build a fully integrated steel fabrication plant. Who would provide capital in excess of $10 billion? Clearly, no one.
Or you can invest capital in another “as a service“a company that has just advanced its maturity, where management is arguing that digital transformation is a tailwind, that their company has not exceeded its maximum growth rates, where management is clearly playing with the playbook of yesteryear.
And for that, investors are still paying far more than 40 times the non-GAAP ESP for companies that will never again grow at a 30% CAGR. Mathematically, it just doesn’t make sense. Is there no gap there? This business is solid until the next fully funded venture capital firm comes along.
In essence, everything always comes down to the same thing. Try to invest in companies where management is on the same side of the table as you. You want to position yourself in a win-win scenario rather than a zero-sum investment.
There will be a reset in investor sentiment, where investors get used to the “new normal”.
The days of having to pay over 40 times the EPS for a colorful story are over. As long as countless companies are priced at less than 10x free cash flow, it makes no sense to pay more for a sexy story.
I stole the title of this piece from Goldman Sachs’ Jeff Currie. The phrase embodies the portfolios of most investors.
Everyone recognizes that energy, raw materials, fertilizers, etc. are going to be very strong, but investors are still trying to play the winning strategy of the last decade. Hoping and praying “buy the dip“strategies that have worked so well to have work to move forward.
Therefore, although investors are convinced that we are entering a new investment environment, people are not adopting these positions in their portfolios. Hence, short of position.
Thanks for the reading.