[00:00:30] During this episode, I’ll also be covering TSM’s business model and competitive advantages, the critical role semiconductors play in our overall economy, potential risks, investing in TSM. As well as the geopolitical tensions between the US and China with the US restricting China from benefiting from the global semiconductor market. Then later in the episode I talk about the key drivers in the stock’s performance, some highlights from Todd Combs’ speech at the Graham & Dodd Annual Breakfast, and be sure to stick around and tell the end to hear Meta stock’s doomsday analysis, and why the company might be undervalued today.
[00:00:55] With that, let’s dive right into today’s episode.
[00:01:51] Apple tops the lists at 42% of the portfolio, Bank of America’s 10%, then Chevron, 8%, and then going down the line, they have Coca-Cola, still American Express, Occidental, Kraft Heinz, Moody’s, and Activision. The only other noteworthy change in Berkshire’s portfolio for Q3 of 2022 was upping their position in Occidental.
[00:02:13] They added 36 million shares, and that now makes 4% of the overall portfolio with 194 million. Now for TSM, it isn’t really clear who exactly at Berkshire decided to make this purchase for the portfolio. It may have been Buffett himself, or it may have been Todd Combs or Ted Weschler, who are also allowed to make some smaller purchases for Berkshire without running it by Buffett.
[00:02:37] If we see that Berkshire continues to add to this position, then it’s pretty likely that Buffett was pretty involved in this decision. Now, Taiwan Semiconductor is a huge company. They have a 400 billion market cap at the time of this recording, and it’s largely known as one of the behemoth in the semiconductor space.
[00:02:56] This is not the type of purchase one might expect from Buffett, but for those of us who have studied him, we know that he’s always willing to change as the facts and environment change. In Buffett’s 2008 shareholder letter, he stated that if a company has lots of technology involved, then he won’t understand it.
[00:03:13] So one would think that he wouldn’t get into the semiconductor industry. But let’s remember that Buffett made a huge bet on Apple that paid off tremendously for him, and that was also a technology investment, which historically he avoids outside of his purchase of ibm. When Buffett was asked about his Apple purchase, he said, I didn’t go into Apple because it was a tech stock in the East.
[00:03:36] I went into Apple because I came to certain conclusions about the value of its ecosystem and how permanent that ecosystem could be. Buffett almost always puts a tremendous amount of emphasis on the competitive advantage of a business as well, and how durable he foresees that advantage being in the future as he.
[00:03:55] The key to investing is not assessing how much an industry is going to affect society or how much it will grow, but rather determining the competitive advantage of any given company and above all, the durability of that advantage. Now, the chip manufacturer industry saw a surge in demand after covid. T S M, for example, was $53 in February of 2020, and then it ranged in the $110 range for most of 2020.
[00:04:25] and then it pulled back to over $60 in October of this year, and the stock got a boost from the announcement that Buffett purchased, and it now sits around $80 per share. The company reported revenue in the most recent quarter at 20.2 billion, which is a really impressive view. Over year increase of 35%, they’re operating margin was around 50% that quarter, which is also really profitable for.
[00:04:50] Plus the company is trading at a Ford PE of only 13, and the General Bear case for why this may be pretty low is that the semiconductor industry is somewhat cyclical, meaning that if we see a pullback in the demand, then these earnings could really pull back as well. They’re projected to do roughly 76 billion in revenue for 2020.
[00:05:13] Just in 2019, they did 34 billion in revenue. So from 34 billion in 2019, all the way up to 76 billion in 2022. Revenue growth so far seems to be pretty resilient despite the macro headwinds as of late. Zooming out a little bit, they grew their revenue by 9 billion total from 2014 to 2019, and they increased their revenue by over 41 billion from 2019 through 2020.
[00:05:43] I always like to check and see the return on invested capital or return on equity as well to see how effectively the management team is able to redeploy those profits back into the business Incredibly. The R O I C and r o e for T S M has been in the 25 to 30% range for the past 10 years. Meanwhile, the stock is up 16.6% annualized over the past 10 years.
[00:06:08] I think one of the biggest concerns for investors in TSM is the possibility of China invading Taiwan. This would likely really hurt TSMs business, but maybe this is a risk that gave Buffett a chance to really purchase a good business at a fair price. When I was looking at the company’s reports, I found the breakdown of their revenue quite interesting.
[00:06:29] In their most recent quarterly report, they list 10 different types of technologies. They. The largest one comprises of 28% of revenue, which is the five nanometer chip. Their revenue by platform was led by smartphones at 41%. In North America was the largest market for sales, which accounted for 71% of overall sales.
[00:06:52] Now semiconductors are not something I was ultimately too familiar with. Prior to doing research on T S M, I was familiar with companies like Samsung and Intel who are in the semiconductor space, and I know that the semiconductor chips were having supply chain issues after Covid. And these chips are used in just so many items today from our smartphones.
[00:07:13] Our computers, laptops, cars, and so. As far as the industry overall, semiconductors are really the foundation of the digital economy. Taiwan Semiconductor is the sole manufacturer of the chips for Apple’s iPhone. Tesla is another company that creates a lot of demand for semiconductor chips. They get theirs from Samsung and T S M alone produces over 50% of the world’s chips, which is just incredible given how critical they really are to our global economy.
[00:07:45] In learning about the overall industry, I really gained an appreciation for just how complex these chips are. What gives this company a competitive advantage is the amount of capital that’s required to build out these sort of manufacturing facilities, as well as the r and d spend required to continue to innovate and improve on these chips.
[00:08:05] In 2021 alone, TSMs depreciation and amortization expense totaled 15 billion, and their r and d expenses were 4.5 billion on top of the capital expenditures that are required in the industry. The expertise is super, super important as well. Much of the talent in the industry is over in Asia, so it would be really difficult for a company to get going in the US because much of that talent is just overseas.
[00:08:32] So the expertise, I believe, is really a key piece to the moat that T s M has. The semiconductor industry overall has really been a big beneficiary of Moore’s Law, which states that the number of transistors on a microchip doubles every two years. So these improvements in the chips lead to the continued exponential improvement of computers in terms of speed and capability.
[00:08:55] Gordon and Moore, who is the co-founder of Intel in 1965, he hypothesized that every two years, the number of transistors that can be packed into a given space will double. This is the foundation of how Moore’s law came to be. His insight eventually came to be the golden rule of the industry. So with Moore’s Law every two years, we essentially pay the same price for a product that ends up being twice as good.
[00:09:21] This continued exponential improvement, of course, can’t go forever because eventually it hits some sort of physical limitation. Moore himself acknowledged this, and engineers believe that sometime this decade we will hit that limit where it’s just simply impossible to create smaller circuits. Now, why did Buffett choose t S M over all these other chip manufacturers?
[00:09:43] T SM is a major provider to Apple, which we all know Buffett is well aware of. Buffett, of course, is bullish on Apple. He put tens of billions of dollars into the company since 2016 and it’s appreciated and value quite well, and he’s continued to purchase shares in Apple, and we know that Buffett really likes to own these companies with really strong brands for a long time.
[00:10:04] So if Buffett expects Apple to do well over the next 10 to 20 plus years, then it makes sense from that perspective that he would choose the semiconductor company that is the primary supplier of the iPhone, which is the most important piece of technology to Apple. If Apple does well, then it’s likely TSM will do well because their businesses are interconnected to some degree.
[00:10:25] So instead of Apple getting vertically integrated and producing their own chips, Buffett has vertically integrated his portfolio, so to speak, and now owns an extension of the Apple ecosystem. Now, given that Taiwan plays such a critical role in the global economy, I found it interesting to go back and dive into the story of how it came to be this.
[00:10:46] TSM was founded by Morris Chang back in 1987, and up to that point, the companies that would create these technologies would just do it in-house. And Chang had essentially started what would come to me known as the Foundry model, which essentially meant that different companies started developing and innovating in the semiconductor industry, and then they would sell these chips to the companies that use these actual products themselves, whether it be cell phone manufacturers, the automakers, et cetera.
[00:11:15] Chang had attended Harvard in M I T and earned his master’s degree in mechanical engineering, followed by his PhD in electrical engineering from Stanford In 1958, he worked for Texas Instruments, which is currently a player in the semiconductor industry, and he worked at Texas Instruments for 25 years and became the head of the semiconductor business.
[00:11:38] In 1987, Cheng could have retired, but instead the government of Taiwan recruited him to create T S M, and this helps boost the country’s technology sector. At the time, most semiconductor companies were in the US and Japan. Most companies would design and manufacture their own chips, and this model really created problems for the.
[00:12:01] Cheang made a really key breakthrough because he focused solely on the manufacturing, and T S M didn’t do any of the designing. So to use Apple as an example. It’s my understanding that Apple does all the designing of the chips for their iPhone, and then T S M will just handle the manufacturing for them.
[00:12:19] Since T S M would handle the manufacturing of the chips, this led to a surge in startups that would solely focus on the design as companies that designed the chips didn’t have to put up all this capital to build out the facilities to manufacture it, and they could just simply outsource this to a company like T S M.
[00:12:38] From 1999 to 2015, sales from the fabulous chip companies that designed chips quadrupled and went from 7% of total semiconductor sales to 29%. Most of this growth ended up flowing to TSM, as they are by far the world’s largest semiconductor foundry, and they’ve captured 60% of the foundry. Morris Chang actually retired in June of 2018 after leading the company for 31 years, and he passed the torch to CC Way who is now the C e o and Mark Liu, who is the chairman today.
[00:13:14] As a lot of people are probably aware, there has been a really big push overall for manufacturing to move to the US rather than being reliant on countries overseas. The US has recognized the importance of the semiconductor industry for the future. As this summer, they passed the Chips and Sciences Act.
[00:13:33] Which provides 52 billion in subsidies for chip makers based in the US Financial Times are an article here in early December that T s M will be investing 40 billion into production facilities into the state of Arizona. They stated the reasons for this was the rising geopolitical tensions and pressures from customers, which my guess would mainly be Apple.
[00:13:56] Here’s the short clip. I wanted to play of Tim Cook discussing this important.
[00:14:02] Tim Cook: As many of you know, we work with TS M C to manufacture the chips that help power our products all over the world, and we look forward to expanding this work in the years to come. As T S M C forms new and deeper roots that America, when you stop and think about it, it’s extraordinary what chip technology can achieve. And now thanks to the hard work of so many people, These chips can be proudly stamped made in America.
[00:14:36] Clay Finck: So the US is taking these steps towards moving the chip manufacturing within its borders. However, even with this investment in the us, many believe that the US is still largely dependent on foreign manufacturers of chips.
[00:14:49] And if China were to happen to invade Taiwan, then this could just totally wreck havoc for all countries globally, and this would really be more detrimental than the Russian invasion of Ukraine is what many believe. The production of these chips are pretty concentrated in Taiwan as they alone produce roughly one third of the world’s chips and 90% of the most advanced chips available.
[00:15:14] Another issue is that the US manufacturing would be one technology generation behind most advanced production that is in Taiwan, the Financial Times article titled T S M C triples Arizona CHIP Investment to 40 billion. This article states that industry executives and analysts said that trying to build the most advanced capacity outside Taiwan with throw TSM C’S operations model into disarray.
[00:15:43] Economically, it just wouldn’t work for T S M to build out the latest technology manufacturing facilities in the US because their research and development is based in Taiwan and replicating that in the US would be extremely costly for them. So it seems like being based in Taiwan really gives them a solid cost advantage.
[00:16:03] One Morningstar analyst stated that the US plants will allow T S M to provide the chips for legacy model iPads, but certainly not the iPhones from the latest product cycle. Apple’s next generation iPhone will start production in the second half of 2023, but TS M’s. Nano Chipp three chips, which those products need, will become available in the US only in 2026, by which time the chip maker is expected to move to the N two in Taiwan.
[00:16:32] The good news about TSM playing a huge role in the semiconductor industry is that although they’re geographically located close to China, they don’t necessarily favor working with China over the us. The founder of TSM is an American citizen, and they have American ties in working with Apple, who is one of the largest companies in the.
[00:16:53] They seem to have played a more neutral role in the global economy in that most of the production is in Taiwan, and they will sell to really wherever the demand is not necessarily favoring one particular country over another. But I did mention earlier that over 70% of sales go to North America, so they do have a really strong incentive to play fair with the us.
[00:17:15] Tim Colpin, who is a columnist from Bloomberg Opinion, touched on his biggest potential risks he foresees in T S M. He did so in an interview on the Odd Lots podcast, Tim mentioned that the first risk he sees is a potential for the technology to become so good in the industry that the better products they provide don’t really move the needle and they aren’t really able to differentiate themselves from the other players in the industry.
[00:17:40] So they could spend billions of dollars developing this new technology to potentially not have as much demand as they might have hoped in the. Another risk Copeman mentions is there variable costs of their manufacturing facilities as a process of making these chips is very energy intensive. Recently, another company called U M C, which is also in Taiwan, recently had a power outage because of the energy issues the country is having as a whole, as Taiwan is currently in a looming energy crisis.
[00:18:11] Another risk I think is worth mentioning is that many tech companies are reducing spend and doing layoffs, and with the tightening market conditions, this could of course affect T S M as well in the short term. Next, I wanted to discuss the geopolitical tensions that are currently happening. On October 7th, 2022, the Biden administration announced a new export controls policy on artificial intelligence and semiconductor technologies to China.
[00:18:39] These restrictions prevent AI chip designer companies like Nvidia and A M D from selling their high-end chips for AI and supercomputing to China. This is really a huge deal and it’s almost hard to believe the steps the US is taking to try and prevent China from getting ahead. Technology-wise. Jordan Schneider from China Talk wrote a wonderful article explaining this in.
[00:19:03] He explained what he calls the Biden Administration’s four semiconductor policy choke holds. The first choke hold he goes into is cutting off access to US made high-end chips. The highest levels of leadership in both the United States and China believe that leading in AI is critical to the future of global military and economic power.
[00:19:24] Competi. In China is a global leader in AI research, AI commercialization, and AI enabled military. In the past, the US made efforts to prevent the chips from getting to the Chinese military by targeted sanctions and not allowing sales to commercial businesses. But these efforts proved to be ineffective in actually preventing the chips from eventually flowing to the Chinese military, which are extremely reliant on US chips.
[00:19:52] So instead of trying to allow some sales and not allow, High-end AI chips can no longer be sold to any entity operating in China, whether that be the Chinese military, a Chinese tech company, or even a US company operating a data center in China. Of course, if China is cut off from US chip makers, they will want to try and develop these chips for themselves, which brings Jordan to the second and third choke hold, which is to cut off access to the US made chip design software and US built semiconductor manufacturing.
[00:20:24] Equip. To take that another step further, the US is even prohibiting any semiconductor manufacturer worldwide from providing services to any Chinese chip design company that is seeking to make high-end chips for AI or supercomputing. Jordan states that any chip manufacturing operation, whether Chinese or otherwise, that seeks to build Chinese chip designs, will risk losing its own access to US semiconductor manufacturers.
[00:20:53] This puts China at a significant disadvantage because their domestic manufacturing just isn’t near as advanced as their US counterparts. The fourth choke hold the US is putting in place is blocking access to US components that are used to build semiconductor manufacturing equipment. Jordan states that designing and building the equipment for manufacturing semiconductors is among the most technologically complex, expensive, and difficult undertaking that could occur anywhere in the global economy.
[00:21:24] So with all these choke points the US has put in place, it’s going to be extremely difficult for China to get up to speed in manufacturing these chips domestically, due to all the reasons I just went through and just how complex this whole thing. You can just imagine how globalized our overall economy is, and if you just force one country to produce something as complex as these semiconductor chips, it can really complicate things for them because you know, someone like the US really relies on these other countries to produce things for them, and the US itself doesn’t even have much of the capabilities that others have.
[00:21:59] Jordan Snyder’s article goes into incredible detail if you’d like to learn more about this piece specifically, but I thought it was definitely worth touching. CC way, who is TS M’s. President and coce O commented on the US’ actions stating. The new regulation set the control threshold at very high end specification, which is primarily used for AI or supercomputing applications.
[00:22:24] Therefore, our initial assessment is the impact to T S M C is limited and manageable regarding to what’s to come for the semiconductor industry. We stated we expect probably in 2023 the semiconductor industry will likely decline, but T S M C also is not immune, but we believe our technology position, strong portfolio and longer term strategic relationship with customers will enable our business to be more resilient than the overall semiconductor industry.
[00:22:54] And that’s why we say in 2023 will still be a year for growth for T S M C and the overall industry will probably decline. End. Related to tsm. I thought it’d be interesting to touch on Intel as well. Intel is an American semiconductor chip manufacturer, and despite the company having grown at a good clip in recent years, the stock has just been in a free fall.
[00:23:16] As of late. The start of the year, it was around $50 a share, and now it trades at around $28 per share. Intel’s PE ratio is just under nine while t s m is 14, so Intel’s PE multiple is almost 40% cheap. For those listeners who prefer to buy something that’s really cheap, Intel may be worth considering. I follow this Twitter accountant blog named Value Stock Geek, and he writes a blog and does deep dives on companies.
[00:23:44] He did a writeup on Intel that was released at the beginning of 2021. In that report, he highlights that the E p s had grown by nearly 20% annualized over the past decade, fueled by the growth in their business as well as the share repurchases boosting their eps. The company’s return on equity has averaged over 20% for the past 10 years, and one reason that Intel is trading so cheap today is because they have fallen behind technologically.
[00:24:13] As of late, competitors like Samsung and TSM have gotten ahead of them keeping up with the newest chips, and Apple announced they’re going to be ending their reliance on Intel chips and going to use their own chips and some of their product. With them falling behind technologically. It’s interesting to see that Intel’s r and d spend is 17 billion over the trailing 12 months, while T s M only spent 5 billion during that same period.
[00:24:38] So with the company’s high r and d spend for Intel, they are somewhat playing catch up with the market. The market this year seems to be pricing as if they won’t catch up to their competitors and the demand for their products will decline. And with the very low multiple on Intel, you can see that the market much prefers companies that design the chips rather than manufacturing them.
[00:25:00] Intel does both and they have a PE of nine, whereas you look at Nvidia, they just designed the chips and they have a PE of 78. It’s just a complete night and day difference between the two in terms of valuation, multiple. I personally tend to take the Buffett approach of believing that turnaround stories often don’t end up panning out.
[00:25:19] But if Intel is able to turn the ship around and get caught up from a technology perspective, we could see plenty of upside for the stock going forward. Intel’s still a really big company, so coming up with the money to develop this technology shouldn’t be a big issue for them. We’ll see how that one plays out during this episode.
[00:25:38] I also wanted to touch on a stock’s return and where the return actually comes from. I think if you asked your typical person what causes a stock to go up, they would tell you that a stock’s increase in value comes from the underlying growth. Growth is a reason why companies like Tesla, Nvidia, zoom, they all get so much attention and got so much attention over the past couple of.
[00:26:02] They had a growth story attached to them and these stocks were doing so well. Well, if you studied Buffett’s work, you’d know that a company’s increase in long-term shareholder value does not come from the growth of the top line revenue. What really matters is the earnings that the company produces, or what Buffett calls owners earnings.
[00:26:22] What’s also just as important is how those earnings are being deployed, whether that be reinvesting back into the business, share repurchases, or issuing a dividend. Todd Combs, who is the CEO of Geico and a portfolio manager for Berkshire, recently spoke at Graham & Dodd Annual Breakfast, and he stated that at Berkshire, they focus on owner’s earnings.
[00:26:45] Owner’s Earnings can be calculated as the reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges, minus the capital expenditures that the business requires to fully maintain its competitive position and its unit volume. How many times on C N B C do you see the reporters talking about owners earnings of a business?
[00:27:07] I would guess it’s likely very little. Cn. BBC wants a lot of viewers on their show, so they aren’t going to point out that maybe Zoom isn’t allocating capital effectively, or that a hundred percent annualized growth isn’t sustainable over the next decade. They want to attract as much attention as possible so they can collect more revenue off their ads and their business.
[00:27:29] So oftentimes the best companies to own are the companies that aren’t shown on cn. Bbc. Odds are most of the companies that the mainstream media likes to talk about probably won’t be great stocks to hold for the long run. Many companies that retail investors are attracted to because of their high growth potential, end up being much more speculative bets because the price you need to pay for these companies relative to the earnings power is really.
[00:27:55] So they need to continue their high growth for many, many years and then grow into their valuation and then start to pay eventually a reasonable level of their earnings relative to the price. So many of the high growth companies are more like venture bets in my mind, where many of them won’t provide that great of a return while a select few will end up paying off really big.
[00:28:18] A venture portfolio might buy 50 startup companies and hope that two or three of them go up a hundred. Now a much more reliable approach to investing in individual stocks is to do it in a way like Warren Buffett does it. He looks for something that’s stable and predictable. There’s not a lot of hype around it.
[00:28:36] Pushing the multiple up. He sees that management is rational and ethical, and they invest money back into the business at a return that is greater than 10% consist. This way to build wealth is regarded as get rich slow. It’s touted as boring. You won’t get rich overnight, but you can earn a reasonable rate of return over a long period of time, and it’s much more reliable when you’re investing in a bunch of growth companies.
[00:29:01] You’re swinging for that grand slam, and with value investing, you’re hitting the consistent singles over and over again. To help further illustrate this, let’s take a look at a stock like Home Depot. Home Depot from 2011 through 2021, grew their revenue by only 8% per year to your average retail investor or to maybe C N B C or mainstream media.
[00:29:23] This is a really boring stock. You walk into their stores and it’s honestly pretty boring unless you’re a plumber or in-home improvement and enjoy purchasing those types of items. But for the most part, it’s a pretty boring business. Let’s take that a step. Home Depot’s store counts have increased by just 65 stores since 2011.
[00:29:44] 65 stores in 10 years. Their store count at the end of 2021 was just over 2300. So how about Home Depot stock performance? Despite their revenues having only grown by 8% per year, the stock had a 10 year annualized rate of return of 18% versus the s and p 500 S 11. So what does this mean? What it really means is that management has done an effective job at returning capital back to the shareholders through dividends and share purchases, and then they also reinvested back into the company where they can earn a high rate of return.
[00:30:21] Home Depot’s return on invested capital has averaged over 30% over the past five years. So management has done an exceptional job at allocating capital on behalf of shareholders, and that has now been reflected in the sheer outperformance. You look at their operating margins, and those have increased by 50% over the past decade.
[00:30:42] Their revenue free cash flow per share, and dividends just march upward year after year, and the share counts are declining as they do share repurchase. These are the types of things you want to see from the companies you own, and these stocks will give you sustainable, longer term growth when they’re purchased at a reasonable price.
[00:31:00] Now, I’m not saying that all investors should avoid companies with high revenue growth, but just remember that what is really going to drive long-term shareholder value is the growth of the company’s earnings in the moat that the company has to ensure that those earnings are sustainable. Moving along into the future.
[00:31:17] As I mentioned during my episode covering Nick’s sleep, sleep, referred to a study that showed that 80% of high growth companies will have their growth rate slow within five years, and 90% of high growth companies will see their growth slow within 10 years. And when that growth does all of a sudden stabilize, then the stock tends to get crushed because the market then reprises its expectations going forward.
[00:31:42] Zoom is a perfect example of this, as their growth has almost come to a grinding halt and their stock is down 60%. Since I mentioned Todd Combs, I’d like to touch more on the Graham and DOD annual breakfast. He spoke at recently a CK called Investment Management Insights. Wrote about the event, if you’re interested in learning more about this, but I’ll provide some of the highlights here.
[00:32:05] During his talk, combs were called that the very first question Charlie Munger asked him was What percentage of s and p 500 businesses would be better businesses in five years? Comb said it was less than 5% in Munger believed that this number was less than 2%. Noting that you can have a great business, but it doesn’t mean that the business will be great in five years.
[00:32:26] And this statistic is quite surprising to me at least, and it’s a good reminder that capitalism is brutal. The rate of change of businesses is as fast as ever, and there’s always another business out there working hard to steal your market share. Todd Combs and Warren Buffett, as many know, get together and talk about businesses on their Saturday afternoons.
[00:32:47] He said that 98% of what they talk about is the qualitative aspects of a. If a business has a 30 times earnings multiple, then you can run the numbers on what it will have to do to achieve run rate earnings, and how the worst businesses are those that need high levels of capital in order to grow and have declining returns, whereas the best businesses grow exponentially with very little capital investment.
[00:33:13] Combs also touched on incentives and look to see if a company and its management team are more focused on internal or external. Charlie famously says that you get what you incentivize, and if management is incentivized to appeal to Wall Street rather than to shareholders, then they may make longer term sacrifices for shorter term gains.
[00:33:34] For example, for, say, home Depot, when they announced in the mid two thousands that they were going to shift away from building new stores, this stock got severely punished. But management knew that they reached their market potential for store counts in that building. New stores wouldn’t be the best use of shareholder capital.
[00:33:52] They were making decisions based on shareholder interests rather than appealing to Wall Street and investing in growth. Just for the sake of. A big signal Combs looks out for is when management changes the kpi, p i, for which they will be compensated by, presumably, because management won’t get compensated if the original KPIs are left as is.
[00:34:12] Combs estimates that 20% of companies in the Fortune 500 are changing the incentive metrics for management, and that’s no accident. Every time Combs meets with a company, there are two questions he always asks the managers. First is, how much time do you spend talking with investors? The median response he gets is 25%.
[00:34:32] Second is, what would you be doing if you were not publicly traded to this question? Combs typically received a list of things management would do. That makes sense. Combs then follows up and asks them why they aren’t doing those things, to which the managers would state that they feel handcuffed. So you can see that when Combs is assessing the quality of management, he wants to avoid the ones that are focused on the quarterly performance rather than focusing on the long-term growth in shareholder value.
[00:35:01] To add to this, he also mentioned that founder-led businesses tend to outperform because the founders are better fiduciaries and tend to have a longer time horizon. Combs also talked a bit about EBITDA or what he and Charlie calls BS earning. EBITDA is a metric I see many investors mention when assessing the performance of a company.
[00:35:23] For those who aren’t aware, EBITDA stands for earnings before Interest, taxes, depreciation, and Amortization. The big problem with EBITDA is that it can make an unprofitable business look profitable, so in effect, it can make a business appear on the surface to be much better than it actually is. When Warren and Charlie are talking to managers and they want to highlight the EBITDA numbers, then red flags really go off in their head.
[00:35:50] Interest taxes, depreciation, and amortization are real expenses, so they should be considered when calculating the owner’s earnings for a company. Buffett has said that the reason it has become so prominent and widely used on Wall Street is really to try and fool investors into thinking they’re buying profitable business.
[00:36:09] Now, that’s not to say there aren’t some uses of ebitda, such as comparing different types of businesses or industries, but this is just another item to be mindful of when you’re analyzing a company. Now, bill Ackman asked a question I’ve always wondered and I’ve really appreciate him bringing it up. He combs about the moral grounds of investing in a company that makes sugary beverages like Coca-Cola, which, you know, Coca-Cola does a really great job at showing skinny people playing volleyball on the beach while drinking their product.
[00:36:41] While many cities around the world are really having a lot of issues related to diabetes, obesity, fatty liver disease, et cetera. And he noted that the company is effectively the Philip Morris or a tobacco company of this generation, and it’s causing a lot of harm to society while doing a really good job of marketing it.
[00:37:01] So Ackman asked homes about the moral grounds of owning a company that really isn’t that great for society. Unfortunately, we didn’t get much of a response from Combs as he said that Coca-Cola wasn’t a name he had chosen on behalf of Berk. When Munger was asked a similar question of Wells Fargo in the past, he stated something to the effect of, we have to invest in the world we live in and not the world we want to live in.
[00:37:26] This is something I’ve pondered a bit in particular with a company like Meta. The Facebook Blue platform and Instagram are both obviously large parts of their business, and there are studies that show that Instagram is harming teens in terms of mental health and depression in that these platforms hire programmers to get their users literally addicted to it.
[00:37:48] Now, I don’t judge anyone for buying a company like Meta or Coca-Cola. It just somewhat irks me personally and tends to lead me to try and look elsewhere for investment opportunities. If I. While we’re talking about meta, I think this is an important stock to touch on as well, and I think there’s a lot we can learn from it.
[00:38:07] I mentioned earlier that just because a company has spectacular revenue growth doesn’t mean the company will have superior stock performance meta since their I P O in 2012 has increased their revenues by 23 times, yet their stock has essentially matched the performance of the s and p 500 over that same time period.
[00:38:27] This company’s I p O was in 2012 at a market cap of around 104 billion, and it reached a trillion dollar market cap in July of 2021 before pivoting to focus on the metaverse, and then the market cap, you know, just plummeted. Now it’s below 300 billion. For Q3 of 2022, Meta’s quarterly revenues were down 4% year over year.
[00:38:50] And to add fuel to the fire, their operating margin, which was 36% last year, is now 22%. So we’ve seen a really drastic drop in their operating margins. Facebook’s financial statement shows a net income of nearly 29 billion in a PE ratio of only 11, and we’re all aware that they are betting big on the metaverse.
[00:39:12] Essentially, the market is pricing in that the pivot to the metaverse is going to be a total failure until proven otherwise, investors really don’t believe that Zuckerberg is making a wise bet into the metaverse, and as far as I can, Why should investors believe them that it’s going to pan out? They haven’t communicated any sort of business model on how they’re going to capitalize on this bet, or when they expected the bet to actually pay off.
[00:39:38] Is it going to be a subscription model to access their platform? Is it going to be based on transactions that happen in the metaverse or is it based on ads? I mean, nobody really knows, from what I’m aware, at least, but let’s not forget what Facebook has achieved to. They have over 3 billion people who spend their time in the ecosystems they own, plus they own an incredible amount of data on these users, and they get most of their revenue from digital advertising, which is a market that has grown substantially during the rise of this company, since its i P o.
[00:40:09] Digital advertising increased from less than 10% of advertising in 2005 to over 70% now in 2020. There’s a simple reason for that. Advertisers tend to get more for their money or they get a better return on investment when they advertise digitally rather than through the traditional methods of advertising.
[00:40:30] This business model is running into headwinds, though, as users are starting to become more conscious of their privacy, and Facebook’s ad business depends on collecting data from. The more data they collect, the more personalized ads they can deliver, the more money they can make. Invasion of privacy is a feature of this business model and not a bug.
[00:40:50] Additionally, the growth of the digital advertising space is beginning to slow, so it doesn’t take much imagination to believe that Facebook and Google’s advertising revenue growth will slow over the coming years. I’m sure Zuckerberg saw this coming eventually, and rather than just accepting the reality of a mature business and lower growth, he decided he wanted to be the leader in this new industry of the metaverse and essentially reinvent the company.
[00:41:16] Now, since 2019, they’ve lost well over 20 billion in their reality lab segment and still only have 2 billion in revenue in the previous 12 months to show. Over the next decade, they plan to invest close to 100 billion in the Metaverse, and Facebook isn’t the first big tech company to invest in new business segments.
[00:41:38] Microsoft, Google and Amazon have successfully invested in the cloud business. Google has their other best division, but the size of Facebook’s investment that they’re doing and doing it in the light of an anticipated recession. It’s a big difference between Facebook’s bet and these other big tech players bets in the.
[00:41:57] We could also argue that the investment in the cloud business by say Microsoft, made a lot more sense in 2015, and Facebook’s investment now is much more questionable. Aswath De Moran, who has been on William Green’s, Richard Weiser happier podcast put together what he calls a doomsday scenario. For Meta, he was on Williams show back on R W H 0 0 5 back in April of 2020.
[00:42:21] In his doomsday scenario for meta, he made four assumptions about the business to come up with a valuation, and I’ll be linking the video to this in the show notes as well. Now, the first assumption for his doomsday scenario for meta, he took what the company made for its operating income over the past 12 months, and he extended that out for the next 20 years.
[00:42:41] One could argue that this operating income is conservative because of the macro headwinds, the strong dollar and the slowing economy. So he is using a conservative income amount to project forward for the next 20 years, and then after that it goes to zero. The free cash flow figure he came up with for this analysis was 26.6 billion.
[00:43:01] The second assumption is that he took what they did for r and d over the past 12 months, which was $32 billion. And ran that r and d spend for the next 20 years. This is really what makes it, what he calls a doomsday scenario. They’re investing like crazy in this metaverse, making these crazy bets, but these investments really turn into nothing in terms of additional operating income in the future.
[00:43:25] The third assumption is that the 10 billion that Facebook lost on the Metaverse will continue for the next 20 years, so the metaverse will net them nothing in positive earnings. And then the fourth assumption is that the cost of capital is 9%, which puts them in the 75th percentile of all companies in terms of risk.
[00:43:43] Under that scenario, he calculated the intrinsic value of the company at 258 billion. If he were to take out the 10 billion annual loss from Reality Labs, then this would lift the intrinsic value to 330 billion. Interestingly, at the end of October, meadow was trading at a market value of 247 billion, which is well below as Watt’s calculation of what it’s worth in the doomsday scenario.
[00:44:12] So essentially he came to the conclusion that the market is being extremely pessimistic on where the company is heading going forward based on the stock price. The market expects the metaverse to just be an utter failure and will return essentially nothing to shareholders. And the market is pricing in no additional income from their core business.
[00:44:32] They just don’t trust Zuckerberg at all. And just think management is totally blowing it in terms of just based on what the stock is priced at. He closes out the analysis by saying that Facebook has failed to communicate to shareholders how these massive investments in the Metaverse are going to pan out.
[00:44:49] They seem happy to communicate how much they will be investing in the metaverse, but they haven’t done a good job of telling their shareholders what their business plan actually is, where the money’s going, and then how these investments are actually going to pay off in the. I’m not saying that meta is a buy or a sell here, but I think after watching that video by Aswath that you know, the argument is quite compelling to take a long position, especially if we see it pull back again to the 90 range.
[00:45:17] Right now the stock is trading at around $114, so it’s rebounded a bit lately. If you’re interested in learning more about Meta, you can check out as Watt’s work, which will be linked in the show. All right. That wraps up today’s episode. I really hope you enjoyed it and found value in it. I learned a lot about the chip war, specifically from TIP’s Daily Newsletter, We Study Markets every day. They deliver high signal content to your inbox for free. If you’re interested in subscribing, you can go to theinvestorspodcast.com/westudymarkets. That is theinvestorspodcast.com/westudymarkets to get yourself subscribed to the newsletter.
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