How to spot the invisible
There are many ways to create value without showing after-tax profits.
This is obvious to anyone with a biotech background (analysis of historic financials is no way to value a pharmaceutical company), but seems to confuse broad swathes of the investment community. This simple insight opens a world of opportunity that's explicitly excluded from most investment strategies and mandates.
It is a common refrain that ‘value’ is under-performing ‘growth’ (see Asness). Few bother to articulate why a low PE stock should outperform a high PE stock, or indeed, why the opposite happens so often.
This 'value' under-performance has happened for very good reason. Perhaps now more than ever, many of the best companies in the world look terrible on traditional value metrics.
In short, they can invest significant amounts of revenue through their income statement that comes back multiplied over subsequent years. This means they don’t show any earnings for a value investor to value, or indeed, a profit for a government to tax.
Meanwhile, many ‘value’ stocks, with low PEs and low price-to-book values, are terrible stock market performers, typically owning large fixed asset bases that require constant capital replenishment just to stand still or in a good year, generate low single digit revenue growth.
Most of their investment is done through the balance sheet, which allows companies to show substantial after-tax profits in the short term, at the cost of easily ignored depreciation in following years. That always catches up, which is why after a number of years, many of these stocks have gone nowhere.
To see the difference in these two models, and why value has under-performed so much, think of the leading software-as-a-service (SAAS) businesses. These have been some of the best stock market performers, going up >10x in value and creating hundreds of billions of aggregate dollars, while looking outrageous to any value investor the entire time.
The best of these can invest a dollar of revenue in say, marketing, to win a customer. This customer might then return that dollar five, ten or twenty times over. If you look at historic financials, all you see is the dollar cost of marketing. The future value of that customer is not there, it is literally invisible.
Companies with this kind of dynamic quickly discover that the optimal strategy is to spend every dollar of revenue on adding customers. When those dollars come back multiplied, they then spend those on new customers, resulting in the phenomenal compounding growth of the companies above.
Furthermore, as these companies invest in customer value, not physical assets, the value recorded on their balance sheets is negligible, and absurdly low relative to their market capitalization, which provides further fodder for value investors to gripe when the stocks go up five, ten or twenty times.
This is a systematic factor that ensures that anyone unwilling to understand these companies misses the entire sector of the market with the highest return on capital.
Quantitative funds like AQR have it the worst, as they miss this kind of value creation by design.
The thinking behind these strategies is roughly: if value stocks outperform, why not just analyse the whole market with computers and buy a basket of them? That a low PE or PB stock should intrinsically outperform a high one is taken as an article of faith, and can vouch first-hand that the performance of a 'value' factor is taught at places like the London School of Economics.
And it’s easy to systematically rank the 'value' of stocks on earnings, by screening low PE, EV/EBITDA, or EV/(EBITDA-sustaining capex), or asset value, by screening for low price-to-book.
But these screens miss every single company capital-lite company that can expense growth and see it return multiplied.
This is why value is under-performing all around the world, in systematic computer funds, as well as fundamental discretionary funds, according to both anecdote and statistics.
The firms these traditional approaches miss include the highest quality companies that are revolutionising the way we do business like Shopify, Atlassian, Twilio, Afterpay and Xero, all of whom have created billions of dollars of value while never once looking like a ‘value’ stock.
(Note: All the best investments are growth stocks, but not all growth stocks are good investments.)
These errors are compounded by the fact that portfolio managers trim positions, so when they do invest in these firms, they invariably realize a fraction of the long-term return. If you take the full initial risk, you need to capture the full economics.
Our most consequential mistakes have been of this sort: selling companies after they doubled or tripled. When you look at the impact this has had on our numbers, everything else is noise.
These have been hard-learned lessons that we’ve now internalized into our process, of which fact alone makes us very different to the vast majority of managers.
There seems to be some hope in traditional value communities – which may well include most professional investors – that value will have its time in the sun once more. And there have indeed been periods where value investors have outperformed, most notably in 2000-2001.
We would certainly agree that growth and momentum investors who don’t discriminate and focus on value will suffer in the next crisis. By no account am I advocating this genre of ‘growth’ investing, or worse, ‘momentum’ (though momentum no doubt helped quantitative computer-driven funds survive this period, as this factor would have captured stocks like Amazon and Shopify).
The steepness of the 2000/2001 crash was due to a very high starting point.
‘Value’ stocks with large capital bases can actually be more vulnerable in recessions, as low gross margins can be wiped out with a small fall in demand. Autos look cheap, for example, but a 20% fall in global sales (the fall in 2009 was about twice this) would probably shift the whole industry into a loss.
Most industrial companies have high fixed asset bases, require significant capital investment just to keep up with the competition, and are now trading on low PEs: in other words, they look like value stocks, but make poor investments.
Meanwhile, whether GDP is plus 2% or minus 2% is largely irrelevant to a software-as-a-service companies with gross margins of 90%, growing organically at over 50%.
In fact, you could even imagine a world where there are more startups using Shopify, Twilio and Xero in a recession. That’s not to say the stocks won’t fall with the market, or even more so, just that a year or two later, the businesses will be so much larger and stronger that they can be expected to rally twice as hard on the other side.
Compare that to a capital-intensive traditional business, where small falls in top line revenue are compounded further down the income statement and can quickly turn those cheap-looking profits into losses.
One of the key aspects of many of these quality growth businesses is that a dollar of incremental revenue flows largely down to profits… or would, if it wasn’t invested pretax in multiplying the business.
It’s worth adding a few notes on Afterpay, which has become one of the most successful start-ups to come out of Australia in recent years.
Afterpay quickly weeds out those who don’t pay with a simple algorithm: if you default, you’re out. Each cohort of new customers transacts multiple times per year, so as the duds and crooks are cut, the cohort becomes more and more valuable, borrowing at rates far in excess of credit cards, with far lower defaults.
The interesting part is that because Afterpay is constantly growing, the user-base is always quite ‘new’, so this value creation is invisible. Only an understanding of the business dynamics could have predicted that loss rates would fall, which is exactly what was seen in their impressive results last week.
What’s more, as Afterpay’s customer base has been dramatically increasing, there is a constant draw on cash flow to fund the lending. This will only stop when Afterpay reaches steady state, but means Afterpay’s cash flow statement is perhaps the ugliest I have ever seen.
So it’s a good thing the value creation is happening elsewhere!
No amount of historical financial analysis will show what’s going on in companies like this, though many managers base their entire process on analysis of past financial statements.*
In fact, our entire out-performance can be ascribed to the times we’ve been able to spot (and indeed, articulate) these kinds of situations, and our portfolio now consists almost entirely of companies like this.
So how do you value these firms?
First, you have to do the work. We only invest in businesses that are of the highest quality, which can mean many things, but often that they have leading products that people love to use, and use more and more very year.
And you don’t need to be some kind of product wizz, you can literally screen for fast growing companies, then use common sense to figure out which are actually on to something.
True quality, particularly the invisible sort, can only really be assessed firm by firm.
To offer another example, think of Xero, which is effectively a cloud accounting database, and has some excellent characteristics:
1. Accounting is a small expense for most businesses
2. Changing accountant is a nightmare, so customers, which means:
3. No one is going to bother changing accounting platform for a small discount.
Xero can raise prices with minimal customer churn. This is another source of value that is invisible in historic financials, but is kind of obvious once you give it a little thought.
You can generalise these conclusions.
Accounting fits well, but so do databases – no one wants to change those. Other good fits include tools embedded deep into enterprises, like Shopify, which is rapidly becoming Amazon’s top competitor, and Twilio, which handles messaging for a range of start-ups, from Whatsapp and Airbnb down to the newest university spin-out.
Another differentiator between the highest quality growth firms we would invest in, and those we would not, is whether they have been able to create ecosystems of developers building additions to the product.
Xero, Shopify and Twilio all host developer conferences for growing communities of people who invest their own money to improve the product.
Effectively, they’ve outsourced a significant chunk of capex. Without wanting to overdo the point - but it's important - this is also invisible in financial statements and typical value investor metrics, but represents a major competitive advantage.
The companies we invest in mostly have negative churn, ie customers spend more each year than those that quit. Twilio’s net retention rate is running comfortably at over 140%, and they are adding customers on top of this.
Similarly, Shopify is rolling out payments and merchant lending, for which they have direct access to data, and are able to generate more and more from every business that willingly binds themselves into their ecosystem. You won’t find Shopify’s hidden future lending business in their PE ratio.
The funny part of all this is that you can actually value these companies conventionally, you just have to do it over long time horizons, and be creative about analyzing these hidden sources of value, which can be checked against every quarterly update.
The factors above can indeed be quantified if you do the work and model them over a number of years.
The wait is not even that long: 5 years is generally enough, and the firms we like are creating so much value that it’s usually reflected quite quickly in the price. Meanwhile, investors in some low PE value stocks may have to wait a lot longer than that, but I digress!
In other words, instead of valuing a company as it is, we value the company where it will be.
Capital structure matters: these kinds of businesses have no business borrowing. They should hold net cash, invest revenue, and fund themselves with equity (though excessive share compensation is one of the things that can ruin these stocks, and part of our initial checklist that allows us to quickly filter through promising companies).
There’s a certain kind of justice in our approach: weak hands and short-term traders lose out, while long term investors can compound wealth.
To summarize, many of the opportunities that look overvalued are exactly what Munger and Buffett were always advocating:
They have high barriers to entry, extraordinary returns on investment, though done in a way that looks like losses at first glance, and if you’re willing to invest long-term, are trading for less than net cash, on low single digit PEs.
In other words:
Value is dead. Long live value.