This is not investment advice. Do your research before taking a position in any of the securities mentioned in the post below.
It’s a rare thing to have great questions, let alone great answers. But when we can ask ourselves the right questions, they can lead us to insightful answers.
Which metrics are repressed/overinflated today?
When assessing valuation - we often look at the multiple or (P/E, P/NTA, P/CF). However, the better question is... is the company over or under-earning and where does it show itself?
P&L: Do the current year's Rev/GM%/NPAT look remarkable compared to prior years. Alternatively - would it still 'almost' make sense if you bought the business on an earnings miss of 10-20%? Example of Timber company below
Timber Company's cash flow
NTA: Did the company recently face a change in accounting practices (e.g. AASB16) that materially impacts the NTA of the business. Alternatively, are there any creative ways in which intangibles or market securities are held on the balance sheet which make you nervous about their net asset position?
Starbucks Balance sheet shows negative equity (due to Nestle unearned rev & leases)
Cash flow: What is the real run rate for capex? Did they spend big this year but they may require smaller capex in the future? How is it being funded; through stock issues or debt?
Signature Banks's cash holdings due to Crypto deposits
Five obvious examples of unders/over-earning
In considering the concept of over/under-earning, I think of it in 5 tiers:
Aggressively over-earning (e.g. furniture stocks in COVID-19 or oil stocks in 2022)
Subtle over-earning (e.g. FAANG stocks and auto insurers/lenders in COVID-19)
Subtle under-earning (e.g. Aussie Big-4 lenders or Annuities businesses)
Aggressive under-earning: (e.g. all travel/hospitality stocks in COVID-19)
Difficult to tell (e.g Chinese Tech, Active Fund Managers)
Generic ways in which you can assess unders/overs
What distinguishes the 'aggressive over-earning' vs 'mild over-earning' depends on whether something is a transitory change or something more permanent
Transitory examples:
Less movement = fewer insurance claims, less travel, less FX
Supply chain issues = record shipping profits, commodities make super profits
High consumer staples/medical = low consumer discretionary
Low-interest rates = Record Highs for all asset classes, particularly "risk-on" areas of the market (e.g.VC)
Structural examples:
Change in economics: Is the company facing a "Kraft Heinz" moment, where they are losing the economics to a counterparty (e.g. generic retail brands)
Change in innovation: Is there a tech trend that has been gathering speed (e.g. cloud computing growth). This is hard to assess because NOT ALL tech ruins old-world businesses (e.g. Visa/Amex still boom despite rise in crypto) but eventually the innovator wins
Shift to ESG-friendly assets: in 20yrs, carbon assets will likely become stranded, however, fundamentals are still important for green-investing. Some, not all, 'green assets' will likely perform better than carbon assets eventually
Increase in passive funds: passive funds are winning the battle against the typical 2/20 model. To decry all active equity would not be reasonable - but if you are to invest in an active fund manager - expect an uphill battle
Although these are VERY generic statements, the point remains that you should try to have a basic framework in assessing themes and over-earning
Simplified examples where it is important to look at under/over-earning
Below are some simplified examples of where I am applying the under/over-earning
D.R. Horton:
Historical "under-building" of houses means that demand for houses should be strong from a top-line perspective
D.R. Horton are trying to leverage their market position to reduce the working capital cycle and hold less inventory (e.g. buying land on option)
Today they >70% of land options in the US; meaning they do not have to pay full price for land today
In valuing - assume a large inventory level (i.e. cash consumption) as they move from buying land options to land upfront
ALLY CORPORATION:
Ally Financial is one of the largest full-service automotive-finance operations in the U.S. trading on 1x NTA
The 2nd hand car market is at an all-time high and residual values for non-EV cars is likely to fall as EVs become more commonplace
Although there are other considerations (e.g. interest rates) it is likely that Ally will face losses on residual value
In valuing - assume higher than historical auto impairment on the existing book and contracted NIM on future loans
FACEBOOK:
There has been a well-document reduction in advertising revenue from IDFA and increased capex from Metaverse investment
Unfortunately, I find it difficult to forecast future drivers for any of these investments
In valuing - ask someone else how to deal with these changes. Sorry!
BLACKROCK:
As noted above; there has been a general shift toward passive investing and whilst Blackrock is famous for the iShares platform they generate a material amount of their return from active equities
For the full year, BLK generated $49b inflows into active equities and $104b sustainable inflows (a higher margin product)
I would also evaluate the level of sustainable inflows vs. the returns of these funds
In valuing - assume average FUM flows & lower active equity flows given the weight of capital chasing low margin, passive investment
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