4Q 2020

15 November 2020

On today’s show we have assembled the TIP mastermind group for the 4th Quarter of 2020 to talk about 4 different stock ideas.

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  • What is the intrinsic value of Diamond Hill Capital Management?
  • What is the intrinsic value of Oracle?
  • What is the intrinsic value of Footlocker?
  • Why Reliance Industries is a bet on the growth of India.
  • Why Preston is doubling down on Bitcoin.
  • Ask The Investors: How do I decide on the right discount rate to use?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Intro  0:00  

You’re listening to TIP.

Preston Pysh  0:03  

Hey, everyone, welcome to The Investor’s Podcast. Today, we bring back our Mastermind Group with Toby Carlisle and Hari Ramachandra, where we go around the room and we make a pick in the stock market. We talk about why we think there’s value. We help troubleshoot each other’s picks. We poke holes through it. We talk about what we do like about it. 

In general, it’s just a fun thing that we do every quarter to show people we’re thinking about what we think is valuable in the market and the thought process and mechanics behind how we do our analysis.

With that, this is the fourth quarter’s Mastermind discussion. Let’s get started.

Intro  0:45  

You are listening to The Investor’s Podcast where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  1:06  

Hey, everyone, welcome to The Investor’s Podcast. I’m your host Preston Pysh. As always, I’m accompanied by my co-host, Stig Brodersen. We have Toby Carlisle and Hari Ramachandra here.

Guys, welcome back. What’s going on?

Tobias Carlisle  1:20  

What’s up, fellas? 

Hari Ramachandra  1:22  

Hey, guys! Good to see you.

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Preston Pysh  1:23  

It just feels like we get crazier and crazier every time we record one of these things. The backdrop gets crazier and crazier. It’s kind of when is this going to let loose? I mean, I don’t know. Do we have anyone who wants to go first?

Tobias Carlisle  1:41  

I’m always happy to go first. I feel bad pushing in front of the line, but I [want to just] get it out of the way. 

A few weeks ago, we launched a new deep value ETF-focused on small and micro stocks. The ticker is DEEP. The pick is one of the holdings in DEEP. It’s called Diamond Hill. The ticker is DHIL for the thing that I’m picking.

Diamond Hill is a value investor, funnily enough. This is a very simple overview. They run about $20 billion and the economics of an investment manager are quite good. They have a very high return on equity and sustained it for a long time. They’re very good investors. They have long only funds and long short funds. They earn fees on the funds. 

Basically, they’ve suffered along with every other value investor out there, both in the AUM and performance, but also in the underlying company that owns all these businesses. It’s listed. 

I think it’s a phenomenally good business and it’s phenomenally well run. It’s the sort of thing that I like to find because it’s a phenomenal business. Very free cash flow generating and very high returns on invested capital, but suffering because it’s going through an industry downswing. That’s just that value has sucked for a long time.  

Value managers have lost some assets. The performance doesn’t look great. The equity in the value manager has been punished along with their performance. 

I think Diamond Hill are very good investors, when value gets a little bit more of a tail they’re going to do very well. They’re in no danger of anything happening to them in the interim because they’re making so much money. They just don’t go free cash flow negative. It’s just that kind of business where it’s a good business all the way through. 

It’s really small to $420 million market cap at the most recent close. PE is tiny at about 12 for something like this which is a phenomenal business. Its return on equity is about 30% pretty much the whole way through.

They’re paying out a special dividend because they’ve had too much cash in the balance sheet. However, they’ve constantly got a little buyback going on. 

I think it’s one of those things that it’s a simple business. It’s well executed. It’s at the bottom of its business cycle. It’s cheap relative to where it is now. It’s likely that the fortunes of this business turn around with value. 

If you believe in value, you’re going to get three ways to win this. Their AUM is going to grow. Their performance is going to get better. The stock is going to follow along with that. Then because it’s undervalued, the stocks are also going to close up. For me, it’s basically a perfect opportunity.

Preston Pysh  4:18  

Toby, you know where I always go, which is to the top line. When I’m looking at the company, and this is something I’ve been doing more recently is when I’m looking at the top line of a company, I’m particularly looking at how they performed in the third quarter and how they performed in the second quarter. I’m looking at that from the previous second and third quarter for these companies to try to maybe use the numbers as a gauge for COVID. 

When I’m looking at where they were, and I think my numbers right here, $31 million here for the third quarter. $28 million for the second quarter. Compared to a year before, they were down 10% and they were down approximately 10-15% for those two quarters when you compare into the previous year. It seems like maybe there’s some type of COVID thing that’s impacting their top line. Do you know what that might be?

Tobias Carlisle  5:12  

Yeah, they’re an asset manager. Their fees are earned on the assets under management they have. When their assets under management go backwards, their fees go down. That’s why they were impacted.

However, as I said, the really telling part for this business is not so much what the top line does. It’s how their gross margins go through the whole way. Their gross margins are fat and they’re able to… It’s a very scalable business. It’s all basically income that they can control their costs. 

They’re not going to flip cash flow negative as a result of having a backwards few quarters. Then if COVID drops as it goes away, their fortunes are going to be tied to their performance and the performance of value.

Stig Brodersen  5:53  

I like this pick in many ways. What an interesting way of making a value peg investing in the value investing company.

Tobias Carlisle  6:01  

It’s better, isn’t it?

Stig Brodersen  6:02  

Yeah, it is. I like a lot of things. When you read about them and what they do, when you read the shareholder letter from their CEO, Heather E. Brilliant, a lot of good things. She’s saying all the right things. To me, that’s good, but it’s also been a concern. 

Let me elaborate a bit on that. In the annual letter to shareholders, she addressed the issue of passive investing head on. She was saying, “It’s good for investors but that’s not our game. We’re alpha seekers, right? We want to outperform the market.”

Let’s talk about that. Can they outperform the market? 

I think one thing that’s really against this business, with all the good things that you guys just mentioned, there are a lot of good things. I love the tailwinds but the main issue is really interest rate, the way I see it right now.

Back in the day, Buffett had this 0625 system of “Hey, just pay me on performance. It’s all about performance.” Those days are just gone and they’re gone for so many reasons. Back when he said, “I can always do more than 6%.” But guess what? With the risk-free interest rate in the 10-Year Treasury is 6%. It’s a lot more easy to be compensated on performance.

You are in the world right now where I look at the products and I look at the global mutual funds. I look at the All-Cap US. I’m looking here at expense ratios of 85 basis points or 87 basis points, respectively. 

This makes me think, “Well, if the US is priced at 3% and the world is priced at less than 5%, I pay a lot of that performance, a lot of that potential alpha. I’m paying a lot of that to just front up in fees and I’m paying that to someone following a strategy that has just been punished yearly and with no sign of any change because that’s not how the world thinks.” 

They’re looking at how better is performance like, “Hmm, okay. They’re not really giving me any kind of yield and I still pay a percentage.” 

I mean, this company is not going anywhere. I think in the latest update, they have $22.4 billion in the management. It’s not going to go away, but it is having that value investing mutual fund high fee structure. 

I don’t think it’s made for the world right now with more than half of all AUM that’s passive investing. I kind of feel those headwinds are a bit concerning but let me try to be a bit more positive. I like the valuation.

Preston Pysh  8:21  

That’s what I was just going to say, Stig. What do you think of the valuation?

Stig Brodersen  8:24  

I think the valuation is good. I guess what I would be concerned about is what’s going to happen next time whenever the market drops 4%. 

What really worked out well this time was that the stock market just bounced back. What if it doesn’t? It’s not only 4% that’s just gone. Think about how many people like… I don’t know if I even want to be in stocks. 

However, if I am going to be in stocks, it is definitely going to be big tech. It’s not going to be value investing. So just keep that in mind when they’re I’m going to pick my awful, awful pick. That’s a very classical value pick afterwards. Just keep that in mind, guys, but that’s definitely a concern that I have. 

However,  I do buy into some of the good things you’re saying there with the margins, Toby. The biggest expense they have is when they do perform well. You have the hedge there. They have no CAPEX, more or less. It is a great business. 

When I look here, I could probably find a generous 8% to 10% return. Again, that’s very dependent on if I think value investing takes off, if that’s what I think. It’s higher if we continue being in this environment where now I can easily see that return go *inaudible* simply because there are no takers for that.

Tobias Carlisle  9:35  

Let’s talk a little bit about valuation and about how value has performed. So the valuation of this thing is $140, paying a $12 special dividend for stockholders on record November 25. It pays $1 quarterly dividend as well on top of that. They just throw off so much free cash and it’s just the nature of that business. You can’t reinvest it. It’s going to be a very cash generative business. 

Whether the cash is reinvested in the business or not is sort of… that’s not how they drive their growth. The growth is driven by the AUM going up, which is a matter of performance and a matter of to some extent marketing. 

It’s a business that I understand because it’s my business as well. I’m very comfortable with this business and I think that they’re doing a very good job. 

The question that you’re talking about is a little bit more macro, what happens if value doesn’t stop performing again?

When I look at value now… So this is the extraordinary thing that’s happened. The way that I think about valuation is you basically get the dividend. You get the yield however that’s manifested in either stock buybacks or special dividends. Then on top of that, you get any underlying growth in the business. 

The way that I look at growth is I just look at what is this thing returning on invested capital? How much capital is being reinvested in this business? Then how does the market treat that money that reinvests that incremental growth? That’s how I think about it. 

When I look across the valley portfolios now, and I’m shocked at some of the names that have been squashed down into the small and micro because I know there’s no *inaudible* bigger companies, it’s just the evaluations have fallen so far than us [who are] regarded as small and micro companies.

The portfolio has a greater yield than the S&P 500 index, the Russell 2000 index and the Russell 3000 index. The yield and value portfolios are much higher. I mean, with the tenure at 80 bits. The yield across some of these portfolios is like 3% to 4%. Then on top of that, the return on invested capital is higher across the portfolio. They’re reinvesting more. The growth rates that manifested out of that are higher too. 

I just think it’s a matter of time now before the rest of the world wakes up to the fact that these portfolios are much better than anything else that’s out there, including big tech. When the performance comes, then the multiple expansion comes too, but without the multiple expansion, this thing I still think will likely outperform.

Preston Pysh  11:47  

Toby, I’m with Stig on the valuation. I think the valuation is screaming by. I’m getting double digit returns based on the earnings that it’s kicking off for the money. I think the dividend is massive. It’s a 6%, based on the current price, right?

Tobias Carlisle  12:04  

It’s $1 a quarter. The current price is $140. They’re paying about $1 a quarter, but they’re also paying a special dividend, $16 on $140.

Preston Pysh  12:14  

Yeah, that’s crazy. What’s interesting is you’re still seeing their book value for the business grow. Payout ratio is like 56% last year.

Tobias Carlisle  12:25  

The business growth is almost independent of that too because of the nature of the business. They can scale assets at almost no cost. All they need is a little turnaround in value. 

Preston Pysh  12:35  

You know what I’m blown away by, I’m looking at our momentum indicator, and this thing is still red. It’s up 70% since March.

Tobias Carlisle  12:44  

I look across my portfolio. When I look at ZIG, it scores high and everything except for momentum. When I look at DEEP, it scores high on everything except for momentum.

Preston Pysh  12:52  

This is an interesting pick. The numbers are screaming there’s value here, no doubt. I’m just concerned like Stig is concerned that there is so much momentum and so much more expectation for more printing and more of the same of what we’ve seen to date. 

That’s my concern is it almost seems like value investing has been penalised based on policy. It seems like the policy is getting ready to be doubled down on, which should, I guess in the back of my mind is suggesting that value is going to get punished even worse if they continue to do what they’ve been doing, policy wise.

Tobias Carlisle  13:27  

As an investor, I don’t really care so much about what the stock price has been doing because I think the stock price is just the marginal buyer and seller getting together. The way I think about return, like the return that I’m going to get is, as I described it before, it’s going to be the yield. Plus, whatever underlying growth. 

When I say underlying growth, it’s going to be whatever yield they pay out, plus the return on equity multiplied by the amount of money that they reinvest in that business, multiplied by the way that the market treats that reinvested capital. You can look at a very simple calculation to do. 

I really never care about the actual trajectory of the stock price. I think that that’s something that’s out of your control. The only thing that’s in your control is your own analysis of the business. 

When I do those things, the returns to value are as good as I’ve ever seen. To small cap, small and micro versus what just what’s happening in small and micro, well, that’s all crushed.

Stig Brodersen  14:21  

One quick question for you here, Toby, about the asset management industry as a whole. That’s one thing I can’t help but ask now that we are talking about this pick and we’re talking with you. 

With everything that’s been going on under those low heels we have now, I’m looking at some of the old well-renowned value investing companies. It doesn’t necessarily have to be value investing, but for the sake of argument, let’s just say this. They’re all built around doing close to 1% in fees and they’re not performing. 

Even if they did perform, that’s the benchmark. It’s like 3% and with all that money just going into passive ETFs from Vanguard, seven basis points, it is a company like Diamond Hill Investment Group, are they seeing if they can get the same investors on board or suggesting a completely different ballgame who are not so much interested in fees? 

Also, perhaps the seller products through banks and different types of investors who are just not looking into this whole, “Hey, why don’t we just index”?

Tobias Carlisle  15:18  

If you look at the index and you did the same calculation that I did, which was a yield plus a return on invested capital, multiplied by and so on, just the way that I was describing… What you’d find, looking at the index, is that the return over the next decade is likely to be between zero and 2%, including dividends. 

I think that that means that it’s negative on a real basis. The amount of money that we’re going to print over the next decade, probably that’s going to dwarf anything that’s ever been printed before. You’re going to earn a big discount to that if you’re in the index.

It really doesn’t matter if you’re paying seven basis points or zero basis points, I think you’re going to get any return. 

In order to get a return, you’re going to have to buy things. I mean, this is what the Fed does. They push guys out on a risk spectrum. You’re going to be down in the small and micro cap value world to get some decent return. 

I don’t mind all that money flooding into the indexes, because it distorts prices. it distorts valuations. I’m a value guy. That’s the best thing in the world that can happen to me. I love that kind of stuff.

Preston Pysh  16:18  

Do you plan on holding it in the long term? So your opinion is that it’s in the markets and eventually realize what the real value is, which we’re all looking at and saying there’s value. The numbers are screaming.

Tobias Carlisle  16:30  

I don’t need the market to recognize the value in these things because I always calculate the return without the market having any more. If I can get a return that is bigger than sitting in a 10-Year or whatever the comparable kind of my other cash alternative is then… When I look at these things that are 10 to 15 times the tenure, the return is enormous. I’m very comfortable holding these things.

Preston Pysh  16:55  

Well, Toby, the dividend alone is double the return you get out of the S&P 500 based on its PE. 

All right, let’s go to another one. 

Hari, do you have anything for Toby’s or you want to roll to the next thing?

Hari Ramachandra  17:07  

This is way out of my circle of competence. Sounds very interesting. 

Preston Pysh  17:13  

I’m going to go next, if you don’t mind, Stig.

Stig Brodersen  17:15  

Please go ahead.

Preston Pysh  17:17  

It’s not that I have two picks. I just want to emphasize that my pick on the first quarter of 2020 was Bitcoin. It was at 8600 back then. Today, it’s at 15,260 for a 77% gain over the last 250 days. If you analyze that, that’d be 131%.  

I am doubling down on that right now. I think that the next 12 months are going to not just be better, but way better than what we’ve seen since the previous selection. Back then, I suggested that I was looking for a price of around 20,000 by the end of the year. I think that that’s still possible. I kind of suspect it might be pushing into the first quarter of 21 for that previous all-time high to get hit. It might get there by the end of the year. We’ll see what happens. 

My expectation for the end of 21 or 12 months from now is I think it’s going to be at 100,000 or maybe even higher. I really like this pick. I like the direction this is going. I like where the fundamentals are going. I like the people that are entering, the Paul Tudor Jones of the world that are now starting to pile into this and talk about it on CNBC. 

I do want to emphasize something that I think is really important. It’s extremely volatile, to the point where if you don’t have the temperament to own something that’s very volatile, it’s probably going to scare the bejesus out of you. 

If you do want to take a position in something like this, for all the technical reasons, and I’m not going to get into all the technical reasons here, unless you guys got questions about something specific, I can talk it, because I’ve done plenty of interviews that people can kind of go to if they want to hear my opinions on all the deep reasons why I like this so much. 

Though I would recommend that a person if they do want to take a position in this and they’re worried about the volatility, do it through dollar cost averaging, where you say, “I’m going to buy a little bit over this period of time, call it three months, and I’m going to buy a little bit each week in whatever position size,” whether it’s 1% of your portfolio, 5% of your portfolio…

Fidelity has sent out an email recommending that people have 5% of their portfolio in Bitcoin, surprisingly enough, which I wouldn’t have ever expected something like that from a company like Fidelity. But they’re on board so my whole point in bringing this up as if you do want to take a position, I recommend that you do it through dollar cost averaging probably over a three month period of time to get yourself into the position, even though it’s super volatile. Yes, I’m very excited about it.

Stig Brodersen  19:49  

I hope you’re right so don’t get me wrong when I’m saying this. One of the things that you’re so engaging on Twitter is also that you want to hear why you are wrong. I’m sure you had a lot of people tell you why they’re wrong. Some of them probably had good points. Some of them didn’t have good points. However, I don’t necessarily know if the mastermind group is the best place for you to get a lot of pushback and sort of like to provide the bad case. 

I’m going to give you a very ungrateful question. I’m going to ask you, could you tell me, what is the best argument why you are wrong on this, call it 7x return that we’re going to see for 12 months? There must be a really good bear case. As you know, Preston, we really like here on the show to argue from both sides so please be your own devil’s advocate.

Preston Pysh  20:37  

The best argument that I’ve heard of it not being able to do what I’m talking about is if elected officials become fiscally responsible, because then the dollar and all these fiat currencies aren’t going to be debasing it at breakneck speed. There would then be no reason to own Bitcoin. 

It really comes down to your opinion on what you think is going to happen with the alternative. Your opportunity costs, from a currency standpoint, do you think that governments around the world are going to continue to debase at a breakneck pace? I think that they will. 

I’m looking at something that can’t be debased and saying that’s going to do really well, especially when you look at the market cap.That would be the counter argument, if you don’t buy into this narrative that I buy into, that might be an issue for you.

Hari Ramachandra  21:30  

There’s a very good point. What I’m curious about is why is there a divergence in terms of price increase in gold versus Bitcoin? The follow up question to that is, is Biden going to be better for Bitcoin than Trump? 

The reason I’m asking that is because usually supporters of Biden are in Silicon Valley. Many of them and they are all huge backers of Bitcoin. Supporters of Trump traditionally have been gold bugs. 

When they lose trust in the government, the gold bugs go to gold. When the Silicon Valley folks lose trust in the government, they go to Bitcoin. Now their guy might be in the White House. So will they now go easy on Bitcoin? Or will the gold bugs go more into gold?

Preston Pysh  22:23  

I look at this question as being really straightforward. When you look at gold, the market cap on gold most will argue is around $10 trillion. When you look at Bitcoin today, it’s at around $250 billion. 

When you’re looking at something that is literally 40 times less in its market cap, but can serve the same purpose. I would argue even more than what gold can serve simply because you can actually put this on your smartphone and go to a store and spend it, unlike carrying around ounces of gold and making them divisible in order to conduct transactions. 

I look at the utility on this as being way more superior than gold. Not only that, when you look at gold, you have to conduct a purity test. If I deliver a lot of gold to you, you have to somehow determine whether that’s actually real or not. This is really easy. You just run a full node and you can see that it’s authentic. It’s part of the protocol, right? 

When I’m looking at that and accounting for the upside of where this is potentially going, this is like a slam dunk, as far as why the upside is there. It really kind of comes down to market cap and utility. 

When looking at the Biden portion of your comment, the thing that Biden has said that he’s going to do is way different than Trump is taxes, specifically capital gains for high net worth people. 

When you look at where this is going, right now, Bitcoin is treated like anything else and you have to pay capital gains for any type of gain that you have on it. I would argue that if you increase taxes on this, that is very bullish for Bitcoin, because people aren’t going to want to sell it. They’re going to want to hold it longer, which then reduces the supply that’s being put on the market for buying, which makes the number go up. 

Therefore, I think that that aspect of it is probably how I’m viewing it just from a numbers and mathematical standpoint. I think the higher that they put the taxes on this thing, the less you’re going to see people dropping it onto the market.

Stig Brodersen  24:23  

The question is also do you feel, to Preston’s argument really, what’s the bear case? Do you feel that this time is different? Do you feel that we will go back to a period like we have been where there’ll be more or less no inflation? Or is what you see now here to stay? I guess that’s up to people for themselves to decide.

Preston Pysh  24:43  

I think the inflation piece is really important to talk about, because, in my opinion, 99% of the people I’ve ever talked to in finance don’t even understand what inflation is. They say the word and there’s really no meaning behind it.

Whenever I think of inflation, I’ve got to break it out into monetary inflation. Are we talking about how many more dollars we’re adding into the system? Because if we are, the dollar was debased by 20%, this year, based on printing alone.

Now, did we see that show up in the price of oil? Did we see that show up in the price of you name it, a commodity that’s measuring this basket that everyone likes to call inflation because it’s published by governments? No, I would tell you that all that printing pretty much went into the capitalization of assets, right? 

Think about it, most of it goes straight into QE, which is bidding the bond market. So when you’re looking at something that’s massive and it’s getting printed like that, I would challenge people to, especially when you look at how we’re valuing things, because what we’re doing is we’re valuing things based off of a 10-Year “risk free rate” in a premium above that, based on inflation, right? That’s all how risk free rates are priced is they’re accounting for “inflation.” 

I think that a lot of that is getting mutilated and destroyed in such a way that it’s not even making sense for a lot of economists until they actually take their paradigm and flip it on its head to fully understand what in the world is actually happening. I think that also makes it an extremely bullish case, because most people don’t even know what inflation is. 

Let’s go to the pick. Hari, I need your help on this. I’m not an expert on Oracle. Everyone knows what Oracle is. They know it’s a business-to-business type company. That’s why I think we’re just not intimately familiar like we are with Apple or Amazon or something like that.

Behind the scenes, when you look at their revenues, 66% of their revenues comes from cloud services and licensing support. Another 19% comes from cloud licenses, and on premise licenses, only 8% comes from hardware, and 7% comes from services. This is all about their intellectual property for software and on site labor, as it appears.

Looking at their numbers from 2019 to 2020, their numbers are slightly down. I want to start off by saying that I’m bringing this pick up because it is showing up in our value filter, not at the top of our value filter, but it’s demonstrating that it is kicking off a decent amount of profit. The momentum on this is good. When you look at the long term of this thing, clear back to the 2000s, this thing has just really had a very steady climb, just year after year.

When you look at their margin in a per share kind of way, it’s very high double digits. When I’m doing an intrinsic value assessment and doing it in a conservative way, I’m getting in excess of like 6% or 7% on an annualized basis for the company. 

Not nearly as good as what Toby had, but decent numbers. I really like the network effect and the fact that they’re in this technology space, because that really kind of seems to be where all this printing is manifesting itself is in anything with a network effect that’s tech related. So I’m looking at it from that vantage point but I’m kind of curious to hear your thoughts out in the Valley of what people think of Oracle.

Hari Ramachandra  28:14  

From a valuation perspective, I do agree with you that it is not something that is on the radar of many growth investors, at least. 

My opinion about Oracle is that just to give some context, their main strength is their relational database. This is like how IBM had their mainframes. What mainframes were basically was a system of records for many companies. It was really, really at the core of many businesses that was hard to replace. 

I have been in many companies, I’m not going to name them. I think you can guess where we had attempted to replace Oracle. These were companies with good technical talent. It was a Herculean task. It took many years. In fact, Amazon has their own databases in AWS. Only last year is when they were able to get out of Oracle and even then they had a lot of trouble doing so. It’s not easy for people to get rid of the Oracle database. 

Having said that, the challenge I see with Oracle is the same as IBM. They have a cash cow, which is deeply entrenched in some of the existing businesses, but they are not able to innovate like Microsoft and get good at other stuff that is relevant today for most companies and businesses. That has shown up in the way they have failed to capture the cloud and how they were slow. 

In fact, I put IBM and Oracle in the same bucket. They both are old, soggy companies, which none of the brand new top talent, not even top… If you can’t get into any of the companies, you will probably join Oracle or IBM. If you are from Oracle and IBM, I mean, I’m talking today… 10 years back, 15 years back, 20 years back, really good engineers used to go to Oracle. I’m not saying people in Oracle now are bad, or bad engineers.

It is just that today, if you ask any new college grad, Oracle will probably not be in their list at all. I’m worried that it is number one. 

Number two, they made a couple of investments, which were like buying… Some really didn’t pan out. In your numbers, you just said 7% of their revenue comes from hardware. Basically, the *inaudible* Sun and Sun was already the hardware business was not great. Java was not making money. So it was not really apparent why they bought Sun Microsystems and whether it really panned out for them.

It’s like how IBM made some acquisitions that really didn’t pan out well for them. I just put them both in the same box. 

In the short term, yes, they are a cash cow. In the long term, I would be worried about their ability to execute. Also we have to keep in mind Larry Ellison, the founder and CEO, he is gradually disengaging because of age and his tenure there. I believe *inaudible* was one of the CEOs who passed away. They have leadership issues as well going forward. 

When I look at their ability to attract talent, when I look at their product portfolio, which apart from  RDBMS, that is the database, they don’t have much to show. 

When I look at the competition, they’re slowly eating away at the fringes. This is exactly what happened to IBM, basically, because their ARP solutions are not best of the breed. A lot of companies like Workday, Salesforce, Amazon, with their AWS offering and Microsoft, of course. They’re all eating away Oracle’s lunch on the fringes, but getting to their core. Especially the new companies are not going to Oracle for databases, because most of them will build the software on the cloud and Oracle is nowhere in the cloud.

Preston Pysh  32:28  

I like how you’re comparing it to IBM. The only thing that I would push back on with that comparison is when you do look at the top line between IBM and Oracle. IBM’s top line is withering away. It’s getting eroded. 

When you look at Oracle, it appears that it’s been holding steady. I mean, just as an example, in 2011, their top line was $35 billion. Today, it’s $39 billion. When you look at the trend through those last 10 years, it’s just been this really slow, gradual-like climb up. It is not very volatile when you look at their top line. It goes to this network effect that I think that we’re both agreeing they have. 

That would be the only thing that I push back on. This is not a sexy pick. This is not an exciting pick. I get the same impression as you that they’re just riding this IP that they have this digital, intangible IP.  

I just don’t see a lot of creativity like how they’re going to take their company to the next level or how they’re going to take market share from anybody else. The valuation isn’t great, but it’s not terrible. It’s a lot better than you’d see in the S&P 500. I think it’s going to do fine but it’s not something that I’m really excited about. I don’t own it. I’m just pitching it to kind of see what your thoughts would be.

Hari Ramachandra  33:47  

In the short term, in the next five years, I wouldn’t be worried about Oracle. They’re not going to go anywhere. I’m thinking longer term, if I want to own it for the long haul, they will have *inaudible* for a period of time.

Stig Brodersen  34:01  

I think it’s an interesting pick also because we spoke with Evan, the CEO of NetSuite here on the podcast. If this pick and I think they’re up like 30%, right? Organically NetSuite. 

If this was NetSuite in itself, you would just see that rocket fuel growth that you see with cloud computing right now. Then you see Oracle, and well… It’s called flat or slightly positive. It’s not what you would expect with a cloud computing company. 

The margins are great, but it’s one of those where you’re like, it generates a lot of cash. You’d probably much rather hold it than cash. It’s just one of those where I’m like, being in that middle range, if we can call Oracle with that, with the huge market cap. If you can call a company of $170 billion a middle sized company, it’s not.

However, if we compare it to huge cloud computing companies, those who actually do have *inaudible* three, who would that be? That’s Amazon, Microsoft and Google. Who can even compete in that space? 

To send it back to you, Hari, you talked a bit about big tech now eating their lunch. This relationship thing that obviously has a lot of stickiness to it and won’t go anywhere, anytime soon. With all the investments that go into cloud computing right now, why won’t they take on that as the next thing before those big three in tech? Why would that still be with Oracle? I’m not completely sure I understand that.

Hari Ramachandra  35:16  

There’s a really good point, Stig. I think one of the difficulties in removing the database from any application or workflows for companies is that they have to refactor or reimplement most of their software to adjust to that. 

Even for example, if somebody is going from their on-prem to cloud, they would still prefer to keep their database the same. They don’t want to change too many things at the same time. They might move to say integrators, but they will say, “I still need an Oracle database. Alright, we are not sure. I will keep my database as Oracle, because that’s how my system has been working for many, many years. I just don’t want to change immediately.”

However, over a period of time, they might change for some of their non-critical flows. That’s how it starts. Once a customer gets confidence that some of the non-critical flows can go through non-Oracle stuff, they can replace some of the critical flows as well. That might be the reason why a lot of companies face challenges in migrating away from Oracle.

Preston Pysh  36:28  

When you look at their margin, this has to be one of the fattest margins of a company for this size on the planet. I mean, their margin is 25% after tax. After they pay their tax, they’re banging out 25% margins.

Hari Ramachandra  36:46  

They’re popular for being extortionists because they know they have a captive customer. 

Preston Pysh  36:56  

Toby, what are your thoughts?

Tobias Carlisle  36:58  

I’m just kind of fascinated listening to Hari’s discussion, because I think I guess when I look at these big legacy tech companies, that is the concern. That’s always the concern because they’re cheap. There’s a few of them around at the moment: Cisco, eBay, slightly different sorts of consumers rather than businesses. 

But there are quite a few of these older line tech companies that have got to that mature stage and that are ignored completely by the tech investors. That does make me a little bit concerned when I look at something like this. 

What does this look like over 5 or 10 years as competitors compete for those big fat margins and people who are trying to escape? 

When you’ve got that prisoner’s dilemma type relationship with your customer where you’re gouging them every single time they’re looking for an opportunity to get away, I just wonder what that does.

Preston Pysh  37:45  

Hari, you had mentioned that AWS had gotten away from them in the last year. When I’m looking at the numbers from 2019 into 2020, it seems like there might have been a little bit of an impact but not nearly the impact of an Amazon AWS stepping away. So did they only break themselves a little bit or you have more details on that?

Hari Ramachandra  38:06  

I don’t have all the details but what I meant by AWS or Amazon stepping away from that rather than AWS because AWS doesn’t really control what their customers will be using. They give them all choices. Starbucks on AWS, for example. They can still go ahead and use Oracle. It wouldn’t be a big impact because my understanding is it’s just Amazon-related so it must be just one customer

Stig Brodersen  38:35  

Alright guys, so before we started recording, it was just Preston me talking for a few minutes before we dialed in Hari and Toby.

Preston’s comment was “You have a very bold pick.” When Preston is saying bold, it sometimes means bold, most often means stupid. He’s just a very polite person. So just keep that in mind as we go into this pick. 

My pick is Foot Locker, the stock ticker is FL. I usually pitch one or two things here, either it’s a stock pic with promising growth prospects that are just not having high current earnings, at least compared to the price. 

I previously pitched Google, Spotify and Alibaba here on the Mastermind Group. The three of them have worked out pretty well and are positions that I still hold.

Then I also picked stocks that are castling really well, but the prospects are just very modest. Examples would include AT&T and All-State, companies with a very narrow moat, just like Foot Locker.

We’re writing 2020 and trading at a low price to free cash flow is just not in fashion anymore. The promise of earnings in the distant future is really all that this game is about, or so it seems. I really can’t help myself, but I am still going to take one of those ugly picks and you can already criticize me for all the same things that I criticized Toby for with like value underperforming and all the horrible things about value.

I am a slow learner. I have been keeping up with a few tech stocks but at the end of the day, I like these ugly but cash flowing stocks like Foot Locker. Most of you out there probably already know the company with 3100 stores in 27 countries. It’s a well-known brand and they’re selling primarily footwear but they also have *inaudible* or minor lines. 

Most of the stores are owned by Foot Locker themselves. 139 of them are franchise businesses and the vast majority of products are from Nike. Actually, up to 70% of revenue comes from selling Nike. 

I can already sense someone saying, “What about Amazon?” We’ve been talking here about GameStop before and Bed, Bath and Beyond. Often it comes back to Amazon. I thought long and hard about Amazon before making this pitch. 

At first glance, it definitely seems like just another retailer that is going  to be crushed by Amazon, right? Well, Amazon sure is a competitor with close to half of all margin of e-commerce there in the States. It seems like companies like Nike would go to and then stop working with Foot Locker. But I would argue that is not as dangerous as it may seem.

Actually, Nike started working with Amazon because of this reason back in 2017. After facing all types of problems, they actually stopped working with them in 2019. 

The reason for that is actually pretty simple. Amazon’s platforms with all the great things they can do also have some issues, not just copycats and fake reviews. Amazon is not good at building communities. It’s not good at building brand loyalty for the seller, especially not if that seller is a company like Nike. 

I’m not supposed to pitch Nike, so please forgive me for talking about it. But it is after all 70% of the revenue. It’s really important to understand that company to understand Foot Locker. 

I think you should see Foot Locker to some extent as an extension for many footwear companies because whenever you enter a Foot Locker is not a great experience. I hope I don’t offend anyone when I say that. 

In many ways it feels like it’s a supermarket for shoes and that’s great. That’s also the advantage for Foot Locker. It’s a much more approachable showroom and distribution system for another target group that primarily would shop in Nike’s own stores. 

You can even say that for the second most important partner that Foot Locker has that would be Adidas, followed by New Balance and Under Armour. You can really say that and it’s very much integrated. 

Just one anecdotal example. Foot Locker is integrated into the Nike app so if you have your Nike Plus loyalty program, you’ll get the benefits. You can even access and pick up your shoes in the closest Foot Locker store. So it’s very much an extension of that. 

All of that being said, Foot Locker clearly has a very *inaudible* moat. I think that’s quite obvious but I also think there are a few things that’s a bit different to understand for something like footwear. It’s just controlled in a different way than say, mass apparel. 

It’s not as fragmented and the competitive situation is actually more fierce. It’s just constructed differently with the way you have a few huge producers. The price competition is not the same thing because the pricing of sneakers is very similar across many different distribution channels. It’s tightly controlled by these massive companies like Nike.

Foot Locker is the biggest independence sneaker seller in the US. Whenever we think of size, we typically think well, that means they have a lot of pricing power. They can go in like Walmart and go in and negotiate with the supplier. 

Well, they can’t do that with a company like Nike, but what is in that deal, just using that as an example, but it’s prevalent in that industry is that you will not compete on price. 

You have a store like Foot Locker that will target mid and low income families, not so much the *inaudible* markets that Nike can do in their own stores. A company like Foot Locker gets the preferred treatment that they will get their own collections and they will get just after Nike.

If you’re going to *inaudible* or Finish Line that’s now being acquired by JD Sports, you won’t get the same thing. So that moat if you like comes from the collection in itself and where to go. 

When I look at some of the valuation, I tried to justify this narrow moat that I’m trying to excuse myself in so many ways by saying that this is a company that’s probably not going to grow a lot. It has in the past and it has also not taken the same beating as you see many other retailers have lately. 

Whenever you look at the bottom line, and even the profits, it’s been shrinking. It’s been a bit of a pain here during the pandemic even though 2020 is still going to be a profitable year, but it still sustains their top line and they’re still making other decent profits. 

I find a double digit return for a company like Foot Locker. If I just say flat growth, I come up with 12.5%, I think you definitely can make the argument that it can be hard enough in itself, especially over the coming year. But that is my pitch for the *inaudible* of value investing picks right now. 

If I had to throw it back to you what, whenever I’m pitching these stocks and I don’t want to put words in your mouth, but it often comes down to Preston saying, “Dude, we’re in a new world. Stop doing that.” 

Toby would say, “I really liked the valuation and the cash flows on that one.” So I’m very curious to see how this discussion is going to go.

Tobias Carlisle  45:38  

Yeah, so that’s roughly where I was going to go.

I just have a look at the shares. They’ve been pretty good buying back stock. As a result, the revenue per share has grown pretty well for like the last decade, which I was kind of surprised by. It’s remarkably consistent. I guess they’re engineering some of that growth through buybacks. It’s a surprisingly good business, on its financials. Given what we know about it, it is retail. It’s typically in malls. It’s got a 70% customer, or 70% supply in Nike. Sometimes they get a little bit concerned with something like this. What if their interests become adverse to Nike’s? What happens then?

Does Nike need them?

Stig Brodersen  46:22  

Great question. I would argue that Nike needs them because they can do what they can. It would be really bad for their brand if they start attacking the same people. But there are a lot of people who are buying Nike products who just do not feel good about going into a Nike store. 

I think it’s quite evident whenever you walk past the Nike store, and then another place in the mall, you have Foot Locker. I wouldn’t call Nike stores intimidating at all. That’s not what I’m saying but how do you like to shop? For most people who are not only brand conscious, but also price conscious, you would go to Foot Locker instead of Nike. 

Instead of rebranding and having like a more approachable Nike product, I would say they would need a company like Foot Locker to do that for them. To me, it seems like a win-win to do that. 

You are right that this is a narrow moat. They can’t just flip the switch and say, “You know what? We got to do like 70% Adidas instead.” I mean, that’s just not how the business works, unfortunately.

Preston Pysh  47:19  

Stig, the thing I’m looking at right now is the management because when I look at the numbers, to me the number screen that you have very competent management in place and you’ve had it there for a while, especially for a business that… Let’s face the facts. Everyone in the mall is getting clobbered.

When you look at Foot Locker’s top line, they’re doing great. I mean, the march event, the whole COVID thing, that quarter was disastrous for them. They were literally down 50%. But this past quarter that they just closed out was right back to where they had been historically for the last 10 years. 

That tells me that there is some type of customer, I don’t get it. Like I personally don’t get the whole sneaker thing. I know there’s a lot of men that go out there and this is their thing. They collect shoes, like what my wife does. They’re into it. 

I don’t understand it but I think that there is a fairly large market of guys that like to go to these Foot Locker shoe stores and try on these new Air Jordans or whatever. Based on the numbers, that doesn’t seem to be getting impaired in any type of way, which to me just does not make sense. 

I would suspect that because of the traffic at the mall, the foot traffic at the mall is down significantly, that businesses like this would be suffering. However, the numbers are telling me that that is not true. That is false. 

When I look at the valuation on it, I mean, come on. It’s priced to perform, there’s no doubt about it. It’s packing in a lot of profit for the price you pay. The margins are  marginal. They’re at 6% after tax. I don’t think that the margin is anything that’s that exciting. 

However, I do think that the market has penalized the price significantly and that’s where the value is, as you’re getting it because the rest of the market has,… I think I had the same opinion that I’m having at a superficial level without doing the deeper dive into the financials. They’re just saying, “Well, the traffic in the malls is down. So why in the world would you ever run this?” 

I’m sure when people heard you pitch Foot Locker, they might think, “Are you even serious right now?” Because intuitively it just doesn’t seem like it’d be doing well but I’m telling you, look at the top line of this company and the top line is rock steady. 

I do find it an interesting pick. I don’t like it long term. Is this something that I think is going to do well, 10 or 15 years from now? I don’t know. I’m not so convinced but over the next three years, do I think the price could come back because it’s just so cheap for the profit that they’re kicking off? Sure. 

I don’t own it. I don’t think that the momentum on it’s that great but it’s a surprising one to me. I think you know how I would describe this. If somebody’s listening to this and they’re in like grad school or they’re getting an MBA or a finance degree, I would tell you this is a really interesting pick to look into and to study from the financial statements, because you can see how well this company is being managed. 

You can see my first point there about the CEO. The CEO has been there for a long time. He was the CEO from 2012 and has just basically climbed up the ladder. He’s now the CEO. He’s been there for a long time. I think that this guy really has a good understanding of just business. Those are my thoughts.

Stig Brodersen  50:39  

I think you put it extremely well, Preston. I definitely have the same concerns as you. The reason why I do consider it is because of the same reasons as Toby talked about. The financials are just rock solid. We have a quick ratio, even close to one here during the pandemic. 

They don’t even need to sell shoes. They’re still cash neutral. Obviously, they will sell footwear. That’s not what I’m saying at all but it’s rock solid. They have more than a billion dollars in cash. It won’t be the first one to go. 

To me, the reason why I found it so interesting, I was looking from the sidelines and everything that was happening with Nike and Amazon. It just didn’t work. Nike is not going back and trying out Amazon anytime soon. 

What’s going to happen in 10 or 15 years, like you mentioned, Preston? I don’t know. We will see some major disruption here probably. Can I make my money back before then? I think you can. 

I think that Toby has said this quite a few times for some of the ugliest picks that I’ve had here and I had a lot of really, really ugly picks by basket. There are a lot of these stocks out there where I think market cap is $4 billion. Not major companies. They’re generating a ton of cash. 

We previously talked about GameStop and thank God only I was stupid enough to invest in that. We talked about Bed, Bath, and Beyond. We talked about a lot of different companies. Companies that are cash flowing, but just facing a lot of headwinds. 

Sometimes you see a crazy surge in the stock price because of an *inaudible* management or someone like that would go in and to get active in that position. That might be an approach for you. 

I think the volatility for a stock like this can be a bit brutal. I also think it’s important to say whenever you do your intrinsic value assessment that they’re not going to be a huge growth potential for something like that. 

Whenever you read through the strategy, like how they want to grow, they talk about they want to target Asia and how they are opening stores up. They now have a distribution center in Singapore. 

They talk about the new loyalty programs, pushing for women’s shoes. I think all of that sounds good. I think in reality, it’s like corporate cliche for we’re supposed to say that we’re growing. I think a lot of that would be really difficult. Also having been in Asia and know the brand of Foot Locker… I’m sure they can rebrand and hopefully they can.

A brand like Foot Locker is not going to be attractive in almost any part of Asia, if you ask me. Unless they’re really good in terms of rebranding that. 

Alright, guys, that was my pick. Any other comments? Great. 

Hari, I think you’re up next.

Hari Ramachandra  53:05  

It’s been almost a year since I pitched Reliance Industries. And at that time, I didn’t have all the information but I did know that they had put in a lot of investment and effort into building out Jio, which has now become India’s largest carrier for cell phones. They were putting in effort. 

However, the major issue then I think Toby had pointed that out was their debt. One of the major concerns we had was they’re close to more than $20 billion in debt because their cash flow is their oil business. They were transitioning into being a technology business and Jio was their technology arm. They were neck deep in debt, because they had to build out those infrastructure. 

What Jio has done is you have the cheapest data on as a wireless carrier in the world today. It also has an optical fiber across the country, even like *inaudible* and not just the major cities, but also the smaller cities. They’re basically becoming pretty much a monopoly in India. 

Now, in the last six months, there have been significant developments where Facebook paid them close to $9-10 billion. I forget, or $7 billion. I guess $7 billion for a close to 9% stake in Jio business. Then Google came in and they built another for Qualcomm. The list goes on and on. Many Silicon Valley venture partners also invested. 

Within a year, they have raised $22 billion or more. Just to give you context, the entire VC funding in India in 2019 was $10 billion. This one company raised $22 billion and they gave away 22% or 24% of their stake in Jio, their technology arm. They are now making a phone, the cheapest smartphone is what they’re calling it with the help of Google. 

They are entering into a partnership with Facebook where they’re going to use WhatsApp and make it into WeChat for India. To that, they want to compete with Amazon because they already have a retail arm, Reliance Retail. They are taking a different approach than Amazon where they are essentially trying to compete with Amazon for online retail. 

Preston Pysh  55:48  

I thought I read something this week that showed that this was happening over in India where they were incorporating WeChat with payment mechanisms, so that you are going to be able to pay by phone through the WeChat app. Is this the same deal that you’re talking about, Hari?

Hari Ramachandra  56:04  

WhatsApp. WeChat is banned in India.

Preston Pysh  56:07  

That’s what I meant to say, WhatsApp.

Hari Ramachandra  56:10  

Yes, that’s the deal. So Facebook and Reliance have entered a deal. Facebook, I believe has been trying to turn WhatsApp into WeChat and monetize it. I don’t think they have succeeded that much in the US but in India, Whatsapp is really, really popular. Online payments are also very popular. That’s the deal that Reliance and Facebook entered. 

Just one last thing I’ll say and then we can talk about your question, Preston is, as of last month, Reliance became zero debt. They announced that they cleared their $20 plus billion in debt. That’s why I wanted to bring it back in.

Preston Pysh  56:52  

It sounds to me like they’re going to achieve a major network effect over there.

Hari Ramachandra  56:57  

Yeah and also I think in India, there are a lot of regulatory hurdles. I mean, building out wireless towers, laying out all the pyro *inaudible* cables require a lot of permissions and regulatory approvals and stuff like that.

The way I think about it is Facebook and Google, instead of navigating all the regulatory hurdles, they’re paying a toll to Mukesh Ambani, the CEO of Reliance, to do the job for them in a way. They are going to be partnering with him and it’s a huge network effort that way.

Preston Pysh  57:34  

You were saying that you only have the ticker on the Indian exchange? Is there any way to get access to this on a US based exchange that you know of?

Hari Ramachandra  57:41  

Yeah, the ticker symbol is RLNIY.  I just want to add one note here that last year when I talked about this pick, I had a hunch that trying to transform their business from being an oil and gas company to being a high tech company. 

However, all year, what has given me more confidence is their execution and their ability to attract capital. Their ambition also has grown. A lot of analysts in India are now talking about them being the Alibaba of India. That’s a long pending and awaited event to happen in India, where as the Indian market is going and as the economy is now reaching $3 trillion and projected to grow to $5 trillion, it really needs banks and technology companies that can scale and support that kind of an economy. Reliance is well positioned.

Their past year of track record and their overall CAGR for the past 10 years has been up north of 20%. They have been without the support of all these investments, they have been growing quite fast in terms of their top line. They’re expensive, they’re not cheap but I believe that most market participants still don’t appreciate the transformation that is happening and the opportunity and the market size they have. 

The total addressable market they have. They’re pretty much like a combination of Verizon, Amazon, and you add in Facebook, like WhatsApp, basically, or WeChat. So they’re a combination of these three: online retail, social networking, and the infrastructure of a wireless carrier. 

That’s what makes it interesting because there can be a lot of network effects. They are the toll. They control a lot of traffic that can get into these destinations and they can leverage those relationships they have.

Stig Brodersen  59:53  

Hari, when I look at the company and when you do explain the all networking effects, as you mentioned, you think of could this be the next Alibaba, just a lot cheaper? 

You definitely see some moves there on the top line, even though you don’t see the same consistency. I can’t help but think how much of this is what Alibaba did that meant China had the infrastructure. 

I’m not necessarily talking about roads here, even though that also plays a role, but like the digital infrastructure to make those moves. Is India ready for a company like Reliance to make the same moves?

Hari Ramachandra  1:00:29  

That’s a good question, Stig. What I see in India is, I think somewhat similar to what China was in the 80s or the early 90s. It’s really hard for somebody to imagine that an Alibaba-like company can exist in India now. That’s also the risk because it might not pan out. That’s the reason I wanted to bring it back because one year back, I was less confident. I just had a hunch, one year since I pitched this.

I see those things pan out, for example, Indians are leapfrogging landlines. Everybody has a cell phone now. The penetration is humongous to the point where every street vendor has multiple smartphones. 

Everybody’s using QR codes, which for folks in the US, when you go and buy vegetables, you buy from a street vendor in India, unlike in the US, where groceries all happen on the street. Earlier, I had to pay cash. Now, I have to just flash my phone and use QR code. That’s it. I don’t have to use cash at all. 

COVID has accelerated that. When I was in India for some time now, Amazon and Flipkart, now reliance is coming into that market as well. So the infrastructure is much better than it was.

My friends and relatives in India use Reliance for their cell phone as well as the Internet there, if not better, at least the same as the US. People are migrating to Jio really fast. These are all like, based on my personal experience. Also, they are anecdotal obviously. Those things give me confidence that the next five years, their growth will accelerate.

Preston Pysh  1:02:21  

Alright guys, that’s all we have for this Mastermind. I love doing these by the way. I’m going to throw it over to Toby. 

Toby, if people want to learn more about you give me a hand off.

Tobias Carlisle  1:02:32  

I’ve got a website called acquirersmultiple.com, which has got all the books and links through to a screen and it’s got some of the stock picks that I discussed. The two funds that I manage are the Acquirers Funds ZIG. It’s long, short, deep value in the US. 

The new one is DEEP.. It’s a small and micro same process as the other stuff.  I have my own podcast too where I talk to various folks about value investing. It’s called the Acquirers Podcast or on all podcast platforms. Thanks.

Hari Ramachandra  1:03:05  

You can find me on my blog, bitsbusiness.com or talk to me on Twitter, @HariRama.

Preston Pysh  1:03:13  

Guys, we can’t thank you enough for always making time for us in the community to come on the show.

Tobias Carlisle  1:03:18  

I love being here. Thanks for having me. 

Hari Ramachandra  1:03:20  

Yeah, same here. Thank you guys.

Stig Brodersen  1:03:23  

Alright, so as we’re letting Tobi and Hari go, let’s play a question from the audience. This question comes from Daniel.

Daniel  1:03:31  

Hi, Preston and Stig. I love the podcast. When valuing companies, you often talk about the internal rate of return. I was wondering how you decide upon the expected growth rate of the company’s cash flows over the next few years. Also how do you decide on the discount rate to use? Thanks.

Stig Brodersen  1:03:55  

Daniel, the discount rate and the internal rate of return are sort of two sides of the same coin. You can even bring the growth assumption into that, but I’ll get to it here shortly. 

Let’s just take the example of Foot Locker that I pitched here in the episode. The stock today is trading at $36. If you discount the future cash flows back to what the stock price is today, you have your internal rate of return. 

If the stock price is high, say $50, the internal rate of return will be correspondingly lower, meaning your potential return will be lower. It’s the same thing and that makes sense because if you think about it, expensive stuff today will then yield a lower return because you’re paying more for the same amount of discounted cash flow. 

If the stock price then dropped to $20 today, well, then your turn rate of return would be higher because now you’re paying a lower price for the same amount of discounted cash flow in the future. 

The question for you as an investor to ask yourself is, am I happy with the expected return for that stock compared to the risk. You can’t put the same number at risk. So we have to make a qualitative evaluation of that, how risky is it?

The other thing to consider is, do I really think that Foot Locker will continue to have a flat growth? When you ask about how we decide what the expected growth rate is, it’s a tricky question. 

Preston might be more or less concerned if Nike stopped working with Foot Locker anytime soon, compared to my assessment. Depending on those assumptions, we’ll come up with different growth rates. You have to make the decision that of all the stocks that you know how to value or what we call our circle of competence, which internal rate of return is highest? Meaning, where’s your expected return the highest. 

When you do that, always consider how conservative you should be in your assumptions. You might have learned to use a high discount rate, if it’s a more risky investment. That’s true. 

On the other side of that, which mathematically is the same to your question about this current internal rate of return is if it’s a risky investment, you can simply be more conservative in new growth assumptions, or use a lower starting point for normalized cash flow. You will end up with the same result. 

I hope this was helpful, Daniel.  Before I throw it over to Preston, make sure to subscribe to the TIP email that comes out once a month. I can even say that 2021, it will come out once a week. With regard to the free cash flows and discounting them back for stock picks that we found interesting and that might complement the answer to have right here.

Sometimes when we see something being graphed out, it might be slightly more intuitive to look at. I also want to say if you don’t want a free newsletter in your inbox, it is completely understandable. You can just go into theinvestorspodcast.com and you can find all our intrinsic value assessments for free just right there on the front page.

Preston Pysh  1:06:42  

Daniel, I really like this question. The reason I like this question is because it really gets to the essence of what we talked about on the show all the time when we’re doing these calculations. 

For somebody who’s not intimately familiar with the equations that govern these valuations, it might sound really confusing. It might just sound like a bunch of gobbledygook. 

Let me just try to explain this in the simplest way that I can, when you’re doing these calculations to determine the value of a company, it really comes down to three main variables. Three.

The first main variable is trying to figure out what the future free cash flows look like. So if the company’s making, and I’m just going to use really small numbers, so it’s simple to understand, let’s just say that a company has $10 of free cash flows profit. They’re able to retain that and they don’t have to spend it on anything. It’s all the money that they retain after their after they pay all their expenses. 

Stig and I are trying to make an estimate of what those future free cash flows look like if they made $10. Today, are they going to make $11 next year, $12 the year after that, $13, the year after that. Whatever that number is, we’re trying to estimate what it’s going to be. We’re trying to do it in a conservative manner. 

The root of your question was the growth rate, right? How much are those free cash flows growing? When we look at how the free cash flows have grown in the past, that can kind of give you a trajectory or an idea of where they could potentially go in the future. 

However, that doesn’t mean that they are going to go there in the future. So it’s really important that as you’re making trend lines as saying, “Well, the last 10 years, the free cash flows have grown by about 5% a year or whatever it might be,” you can project that out. Then, you can say, “I think that the company is going to continue to do that.”

Now, if you say something like that and you project those out, you need to go into the qualitative analysis of are they remaining competitive. Who are their competitors and what does their top line look like? Is it descending? 

All those kinds of things or where you’re going to go in and dig to try to understand whether those projections that you’re making for the future free cash flows should be growing, should be flat, or maybe even descending, depending on what the company is and what it’s doing. 

When we were looking at the one that Stig was talking about with Foot Locker, for me,  I didn’t really grow the free cash flows at all. I just kind of kept them constant across the board, because I just didn’t really have a good feeling of saying that they could grow from here. 

Now, the first variable is that estimate of the future free cash flows. 

The second variable, and this is the one I really like to talk about, is the price. When you go to grad school, they always want you to solve for this variable. For me, it’s a little frustrating to solve for this variable because it’s a given. As a person with an undergrad in engineering, the first thing you do when you’re solving a problem is you say, “Well, what’s my givens and what’s my unknowns?” 

When you’re dealing with publicly traded companies, like Foot Locker for example, you know the price today. If I want to take a position in Foot Locker, I know exactly what I can buy it for. It’s right there. It’s published for me so I treat that as a given. 

Why would I solve for something that I know what it is, and I know what it’s going to cost me in order to buy it? That’s where I get a little frustrated with academia is because they’re always making you solve for the given. It just doesn’t make any sense to me.

That’s the second variable is the price. 

The third variable is the discount rate. We talked about the discount rate a lot. So when you have these future free cash flows, everyone has probably heard at some point in time that $10 next year is not the same as $10 today.

What we really mean by that is you have to take future money, and you have to discount it back into today’s value. When you do that, you have to choose a rate. If you use a really high rate, if I take $10 next year, and I discounted back to today’s value with a 30% discount rate, what is going to do is it’s going to push the value today into a much smaller number. 

If I use 1%, let’s say I discount $10 from the future into today, it’s going to make the valuation way higher. 

What we do when we’re doing an IRR, an internal rate of return, is we’re actually solving for that discount rate. We’re saying this is what we think the future free cash flows look like. We’re making an estimate of that. We’re saying this is the price. We know what it is, tell me what that discount rate is. 

When we look at that, and we say, “Hey, the discount rate is 7%,” what we’re really telling ourselves is if those free future free cash flows that we estimated are correct, and they actually become that, and I can buy it at this price that I know is published today, my expectation is that I can get a 7% return by buying it if all of those future free cash flows keep happening. 

That’s how we’re doing our evaluation. It’s those three critical elements.

When we do a discounted cash flow, or when we do an IRR on a company, and it’s coming out with a 15% IRR, that’s telling me that there’s a lot of value to potentially be captured in a company, if my estimate of my future free cash flows are correct.

If I’m doing a really conservative estimate with those future free cash flows, and it’s coming back with a really high discount rate, that tells me there’s something there and that there’s something to dig into. 

On our TIP Finance tool, which we’re going to give you free access to, for asking this awesome question, we do all of this. We make this all automated for you and we make this way simple so that you can just look at a chart of the previous free cash flows. You can just kind of draw it out graphically of what you think the future free cash flows might look like and what that growth rate might look like. Then it’ll calculate that IRR.

For me, prior to us building this tool, which I use all the time, I would have to go in there and excel and try to calculate all this stuff. It was very time consuming. Then, you’d have to plot out the previous free cash flow to see what you think maybe the trajectory in the future is and all that kind of stuff. It’s really helpful.  

Stig and I are definitely eating their own cooking here with the TIP Finance tool. We’re excited to be able to give this to you for free for asking this awesome question. 

Daniel, thank you so much. For anybody else out there, if you want to get your question played on the show go to asktheinvestors.com. There’s a little button there. You can click and record your question. It’s super easy. If it gets played on the show, you can get access to TIP Finance just like Daniel.

Stig Brodersen  1:13:50  

All right, guys. Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro 1:13:58  

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