On today’s show, I bring back Simon Erickson to review the growth investing strategy, and how investors can get started with growth investing. During this interview, we went into detail about where to start on finding potential investments, what are the biggest deal breakers in a company, portfolio allocation, and finding the right time to sell your stocks. Simon also gave insight in regard to his investing principles, how they impact his choices, and his recommended resources for anyone who wants to learn more about growth investing. Now without further delay, let’s get right into this week’s episode with fan favorite and my favorite, Simon Erickson.
You’re listening to Millennial Investing by The Investor’s Podcast Network, where your host, Robert Leonard, interviews successful entrepreneurs, business leaders, and investors, to help educate and inspire the millennial generation.
Hey, everyone. Welcome back to the Millennial Investing podcast. As always, I’m your host Robert Leonard, and with me today, I bring back one of my personal favorite guests, Simon Erickson. Welcome back to the show, Simon.
Robert you are too kind. I love being a part of your show. Thanks for having me.
For those who didn’t hear our episode together back on Episode 40, tell us a bit about yourself and how you got to where you are today.
I’ve just always been a guy that’s been obsessed with innovation, Robert. I started as a sales rep in my twenties. I was going around shaking hands and flying across the country trying to sell specialty chemicals. But whether it was agriculture and organic farming, or it was the emulsifiers for oil and gas and hydraulic fracturing, every industry out there wanted to be at the forefront of what was new, that they could charge more money to develop new products for.
Simon Erickson (01:47):
And I coupled that with a couple of years later, went back and got an MBA. Started working for a large oil company developing their renewable energy strategy, strategy and development role. And then I worked for seven years at The Motley Fool, most recently with them running a service called Motley Fool Explorer, which rather than looking at businesses from the inside where they were developing cool new innovative products, looking at it from an external lens where you’re kind of trying to understand where businesses were going and taking care or taking advantage of these future trends that were out there. And now here I am, founder and CEO of 7investing. We just launched in March of 2020, and we’re coming up on our 12 month anniversary. And our mission now is to find the market’s greatest opportunities in the stock market for $17 a month. And I have a fantastic team of lead advisors that are helping me to achieve that mission of empowering people to invest in their future.
Robert Leonard (02:40):
As an investor, you have an investing principle that says to buy companies, not tickers. And I completely agree with this, but I see this as a big disconnect for a lot of new investors. Why do you think that is? And what does it actually mean to buy companies, not tickers?
Simon Erickson (02:56):
I think that one thing that when you’re new to investing, you tend to focus almost obsessively on the stock price. You look at it, you see it going up, you see it going down. “This is up 30%. It’s down 30%.” And you try to do some kind of maybe mini technical analysis where you say, “I think it’s going to go up this much because it went up this much in the past.” And really, I think that the more interesting thing is realizing that stock prices are a representation of business fundamentals. So the more time that you spend analyzing stock prices, you realize maybe it’s more interesting to start looking at the company behind those stocks.
Simon Erickson (03:28):
And so then, the focus tends to shift on well, how is the business itself doing? From an operational perspective, is this company doing really well, growing its revenue? Is it investing in interesting projects from an R&D perspective? Is it scaling up its profits over time? And the market tends to respect companies that are performing admirably, with a higher and higher multiple of those fundamentals.
Simon Erickson (03:50):
So I think that this principle of ours which we do have seven principles to kind of guide our investing, is to really focus on the metrics that matter to the business itself. And don’t become too overly concerned over the stock price at any given time. You want to find great companies invest in those for the longterm.
Robert Leonard (04:07):
Yeah. I think you hit the nail on the head. Too many people are focused on the price of the stock. And I love having these conversations with new investors because they’ll pinpoint Amazon or Shopify who are in the thousands of dollars. And they’ll say that that’s too expensive. And they might be right, depending on how you want to value a company. You could argue that its value is too high, but not because of the stock price. And I like to typically blow their mind by pulling up BRK.A. And I’ll pull up BRK.A. And I’ll say, well, is this sock overpriced? “Is this too expensive stock?” And everybody’s always shocked. And I say, “Well, the price of the stock doesn’t matter. You can slice a pie a million different ways or you can slice it one way. And that’s going to determine how much the stock price is.” So the price doesn’t matter. It’s what the underlying value is. But I still see that as a huge disconnect for new investors.
Simon Erickson (04:53):
Yeah. One I think key takeaway, if people only remember one thing from this podcast, maybe remember this thing that I said. Which is that stock prices really go up for one of three reasons. One, the business itself has improving fundamentals. Two, the valuation multiple of those fundamentals increases. Or three, the stock pays a dividend. So ignoring the third of those for a minute, you are either getting an increase in your stock price. If the multiple stays the same, we’re still paying 20 times sales or whatever it is for the company. But those sales keep increasing and it keeps a consistent multiple. That’s the first reason. Or like we said, the second one, the market is rewarding those increasing sales, or profits, or cash flows, whatever it is with the higher multiple. Now it’s going to give it 25 times sales. Now it’s going to give it 30 times sales.
Simon Erickson (05:38):
But that’s going to be the market doing what the market’s going to do. We don’t have any control over what the mass market wants to do with its money or value stock. We can focus much more on whether a business is doing the right things internally operating, margins operating leverage. Things like this is where I tend to look for as an investor, find the best opportunities.
Robert Leonard (05:58):
Let’s assume somebody listening to the show has little bit of cash to invest, but they have no watch list. They have no initial ideas to start with. Where do they begin? What is the first step to take when they’re looking for potential investments?
Simon Erickson (06:11):
The very first step I would take would be understanding the time value of money and the power of compounding returns. Because that will be what will define what type of investing you are most comfortable with. The reason this is so important is businesses are giant compounding machines for our money. They can take our capital, which is us investing in their stocks, or when they issue more stock to raise more money. And they can turn it into projects that will return a higher net present value for those projects that they’re investing. Or acquisitions if they’re making for other companies, or they just want to pay it out as a dividend. There are things that companies can do that we cannot do as individuals. So this compounds your capital over time. This is what builds wealth in the stock market.
Simon Erickson (06:52):
And the reason I say this kind of defines what type of investor you are is a lot of companies are wanting to plow that money right back into the growth of the company. They see a lot of opportunity, right? Facebook has put all this money right back into growing that platform as quickly as it can. Cloud computing, artificial intelligence. These companies see the market opportunity, and they’re going to go get it. So they’re going to put as much capital back into the business, reinvesting into the business’ growth.
Simon Erickson (07:17):
Versus there are much larger companies that are more established in their company life cycle. They have a higher percentage market share of whatever market they’re competing again versus their competitors. And they might not have as many reinvestment opportunities. So they can share those cash flows that they’re creating back with their shareholders through dividends or through share buybacks. That would be considered more of an income or a value investor.
Simon Erickson (07:41):
But again, I hate the title sometimes Robert. I don’t want to call anybody just a growth company or just a value or income company. But to me, it’s all about that capital allocation, which goes back to how are companies spending their money, and how are they compounding that for you over time?
Robert Leonard (07:56):
Once you found one of those companies and you’ve started analyzing it, what are the biggest deal breakers for you? What are things that you come across during your research that turn you away from that company almost right away?
Simon Erickson (08:08):
Bad behavior. Bad spending, right? Companies that are paying way too much excessive compensation, or have a really terrible way of spending it on the rod projects that blow up. Hewlett Packard did this. Terrible acquisitions years ago. Just lighting shareholder money on fire with some of the acquisitions it had been making.
Simon Erickson (08:26):
The other one I really hate to see is management turnover. If you see a C-suite that is just kind of rotating, the CEO, or even the board of directors is getting mixed up. Nuance Communications was a company that did this for years and just couldn’t get any traction because everybody would come in with their two or three year plan. They’d leave. The business tries to adjust to that plan. Then somebody else would come in with a new plan. You can’t build five, 10, 20 year returns of an empire of a business when you’re consistently thinking short-term. So the two big no-nos for me is spending money inappropriately on projects that go nowhere, or companies that really have more HR problems of turnover at the C-suite.
Robert Leonard (09:06):
The salary or overcompensation of management teams and executives has been something that I focused on for a little bit. But what really drove the point home for me was there’s this TV show called The Profit with Marcus Lemonis if you’re familiar with it. And I was watching an episode not too long ago, and he went in to help this business. And the business was generating about say 900,000 in revenue. And the CEO at the time was making I believe 100 to 120,000. And when Marcus was talking to the CEO, the CEO is talking to Marcus as if he only got paid 120,000. And Marcus was like, “Is 120,000 a lot for a CEO? Maybe not. But when you think about 120,000 in relation to what the company is generating in revenue, 120,000 per salary in comparison to 900,000 in revenue, that’s more than 10%. That’s more than 12% of the company’s total revenue going to just one person’s salary. To me, that’s not a good use of capital, and that’s not a good indication for where that business might go.”
Simon Erickson (10:04):
Yeah. And even taking it a step further, investors that do their homework dig into the definitive proxy statement, right? This is something that is required to be filed with the SEC for any publicly traded company. DEF 14A is the document if you’re looking for them.
Simon Erickson (10:17):
But within that, it’s got a section that talks about compensation. How are those guys like you just described Robert, getting paid and compensated? A lot of them of the good companies are really interested in long-term equity grants, where they’re getting vested stock that’s granted to them over four or five year period of times. Of course, another part of it is a short term compensation piece, right? Sometimes, executives are making $10 million off of something silly like just top line revenue growth. So what are they going to do? They’re going to go overpay for acquisitions to boost the top line as quickly as possible. That might sink the ship over the long-term, but it doesn’t matter to them because if they’re going to get a great bonus out of it, then more power to their pocketbook. But really, we think that there should be an incentive compensation plan that’s aligned with long-term equity shareholders. And that’s where you start seeing things like return on invested capital sometimes, you see adjusted earnings growth. Something that values the bottom line of the business, rather than just the top line.
Robert Leonard (11:12):
How do you think about portfolio allocation for a new and young investor? What do you think about someone going all in on a position when they’re young?
Simon Erickson (11:21):
I kind of have two views on this that are kind of conflicting I suppose. I wouldn’t recommend going all in if you’re new to investing. Because every investor is going to make mistakes. I don’t know any investor ever that hasn’t made mistakes and bought companies they probably shouldn’t have. Definitely myself included. I’ve made plenty of mistakes and I’m willing to admit them. But you don’t want one of those mistakes to be 100% of your portfolio, especially when you’re new, right? If it’s 2% of your portfolio, you recover from that. If you lose your entire 401(k) because you went all in on one stock, that’s really hard to recover from.
Simon Erickson (11:55):
So I tend to think of when you’re new, don’t go all in on something, unless you’re just supremely confident in it. But then I say that I kind of conflict with this because I also think that we sometimes are restricting our own portfolio gains by imposing these hard and fast rules on allocation. Like I will not let any position go higher than 10%, or I want to be only 50% allocated to stocks and 50% allocated to bonds. I’m going to rebalance this every month.
Simon Erickson (12:22):
When we do stuff like this, we’re really capping the upside of the really great companies that you do find out there. I mean, imagine trying to rebalance your Netflixs and your Amazons over the last 20 years and not letting them grow because they’re going to be the ones that are going to make the huge returns on a portfolio. And the venture capital industry is one that has shown us this time and time again. That there’s a lot of risk that VC investors take, but what are they looking for? They’re looking for the Twitters. They’re looking for the Facebooks. They’re looking for those long tail far-right of the graph ones that just shoot to the moon and makes up for all the losses of the rest of their investments.
Simon Erickson (12:56):
So when you do the math on this, the compounding effect of the biggest winners will more than make up for the biggest losers. Because you can only lose 100% on a stock, but you can gain much more than 100% on a winner. So my investing style tends to be kind of a little bit of both of those. You don’t want to just jump in before you really know what you’re getting into. Cannonball into the deep end, so to speak. But I do think that if you’re going to cut a position, it has to be for a reason other than valuation or other than it’s too large of a percentage in your portfolio. Otherwise, you’re hampering your overall returns.
Robert Leonard (13:29):
How does the dynamic of not having a lot of money to invest play into that? I agree. If you’re new to investing, you don’t want to throw all your money into one position because you’re new. You don’t know what you don’t know. Everybody makes mistakes, yada, yada, yada. I mean, there’s so many reasons as to why. But when you’re young, you could argue that you don’t have a lot of money to invest. Maybe only $1,000, $2,000, something like that. If you go all in and you lose $1,000, $2,000, I mean it stinks. Nobody wants to lose that money, all of their money that they’ve saved. But in the grand scheme of things, in the grand scheme of your life ideally, 1,000, $2,000 should be immaterial if you’ve saved and invested appropriately for the long term. So maybe that could be a relatively cheap form of education. If I could pay $1,000, $2,000 instead of hundreds of thousands to go to college, maybe that’s worth it.
Simon Erickson (14:18):
Education’s the right piece. I think that’s the right key word to describe the first couple of years of investing. You will make mistakes. How much do you want to pay for them if you’re wrong? I don’t think that $2,000 upfront in your first years of investing is going to make a huge impact compared to maybe several times that what you’re investing 20 years in the future from that.
Simon Erickson (14:35):
But I tend to think of it as kind of a learning curve. If you’re investing in a company, you’re going to follow that company much more closely. Because you have skin in the game. You got real money on the line. So you’re going to really start following the earnings calls and the reports. It’s something that over time, you’re going to get to build on top of that. So maybe you do think about the early years of investing as education, and then you really want to pack more of a punch later on.
Robert Leonard (14:57):
To get to our optimal portfolio allocation, we have to actually enter our investments. So how do you enter your investments? Do you typically go by straight to your allocation percentage, or do you buy in chunks until you get there?
Simon Erickson (15:10):
Chunks. Always chunks. I never go all in on the first bite. I tend to like to ease into it. And then when I learn more about it, I get more comfortable. I get more information, then I add to it. So Robert, I’m from Texas. So we play a lot of Texas hold ’em down here. I don’t know if you’re also a cards fan.
Robert Leonard (15:25):
I am typically 21 and Blackjack, but I play a little hold ’em.
Simon Erickson (15:29):
Perfect. Okay. So this is kind of do you want to go all in before the flop before you see any cards on the table because you’re so supremely confident in your hand? Or do you want to wait until you kind of see a little bit more information? Then when the time is right to push, your chips stack in. So it’s kind of the same thing about investing in the question that you’re asking. Do you want to do this in chunks or do you want to go all in before the flop?
Simon Erickson (15:48):
If you feel like you’ve got enough information to make a really informed investment decision, then yeah, maybe that is okay. But I tend to like to ease into it over time. I tend to like to see how a company’s performing, get a little bit more information. Maybe I start doing some competitive analysis, learn more about the track record of the CEO. Look into the proxy of how the executive compensation is structured. Once I kind of start compiling these pieces, I become more and more comfortable with how my hand looks versus the rest of the hands that might be out there. And that’s how I tend to do my investing as well.
Robert Leonard (16:20):
Is there a benchmark that you use that you’ve created to enter into these positions? Do you initially start with 1% then add another percentage each time you add into the stock? Or how are you entering those trades in what increments?
Simon Erickson (16:32):
Totally personal. So case-by-case basis. Please don’t follow my advice on this as something that anybody else should do. But I tend to think of it for me personally, as a full position as 8 to 10% by cost of my portfolio. So $100 portfolio, $10 of that would be a full position. And maybe we add about a 2% stakes up to 10% by cost. And then I won’t trim it if it goes up from there. So if I’ve got something that was 6% by cost but is now 25% of the portfolio, that’s great. That’s something I’m going to let it ride. But I tend to look at it in terms of how much money did I put into this thing at the beginning as a percentage of total capital?
Robert Leonard (17:11):
What’s an indication to you that you might want to start adding to the position? Are there different milestones, or metrics, or things that you’re looking for to say, “Okay, now it’s time to add a little bit more to this position”? Or do you just become more comfortable with the company and the thesis that you have for it?
Simon Erickson (17:26):
I’m definitely more comfortable with the company and the thesis. Without naming the company specifically, my recommendation for January at 7investing is a business that I’m personally investing in. But I think there’s a disconnect between the operating results of the company and the stock market investment results. I see really, really good performance. And there’s some things I really liked on how the business itself performing. But I don’t think it’s being represented in the stock price right now. So a dynamic like that where you see a disconnect, I think that’s kind of like a coiled spring that good businesses if they continue to be good businesses and execute really well out there, are going to be appreciated over time.
Simon Erickson (18:07):
So to your question, what do you look for? You look for the operating performance of the business itself. Great companies aren’t just going to disappear. If they’re making the right moves and they have the right leadership team, it’s going to come back around to investors.
Robert Leonard (18:19):
So does momentum play a role in when you’re entering these trades? And the reason I asked this is because when I was younger … and I’m still young, I’m only 25. So I’m not old by any means. But when I was a younger investor, a little more inexperienced, I typically found myself catching falling knives. Because I said, “This is a great valuation. I like the business. I’m going to buy in.” But if you looked at the stock chart or looked at the momentum, you could see that it was clearly trending down. And maybe if you layer in some sort of momentum strategy where you wait for a reversal in the momentum, you could actually miss out on some of that falling knife impact or concept, if you will. Do you consider that at all in your investments?
Simon Erickson (18:57):
Well first of all Robert, I’m surprised to hear that you’re 25. I think that you are much older than that in terms of wisdom and knowledge. So that kind of caught me off guard first and foremost.
Simon Erickson (19:05):
Momentum is the market reinforcing what it believes. This goes both ways. Let’s start with the positive spin on it first, which is Tesla. Tesla has become a virtual feedback loop of positive news. Elan can do no wrong right now because Tesla stock is by most traditional metrics, pretty egregiously overvalued.
Simon Erickson (19:23):
But what does that mean for the longer term? Tesla is in a very capital intensive business. And it can raise a lot of money right now, even diluting shareholders less than 10%. Say the Tesla says, “Okay, we’re going to go out and we’re going to dilute 10% of our equity and raise $80 billion.” $800 billion valuation. It’s going to raise $80 billion to build out supercharger network, to build our Gigafactories across the world. Whatever it wants to do with $80 billion. That is something that Tesla’s other automaker competitors cannot do. Ford is not going to be able to raise $80 billion right now. GM is not going to be able to raise that kind of money. So this is a huge headstart that a company like that gets because of the momentum that its stock price has had.
Simon Erickson (20:06):
So if Elon does go out and do that, I think the market would reward him further and even applaud a move like that. Because longterm sustainability of the business, that’s a stronger competitive advantage in a capital intensive industry.
Simon Erickson (20:18):
Let’s take this the opposite direction, put the negative spin on it. If a company is losing momentum, if its stock price is falling, it gets harder for it to attract investors. It gets harder for it to get loans from banks that have covenants built into those debts that they’re going to be loaning to them. Nobody wants convertible debt, because the stock price keeps falling. I mean, there’s a zillion bad impacts that happens from the other way around.
Simon Erickson (20:41):
So I think the question about momentum is an interesting one. We tend to want to buy stocks when they’re low and then sell them when they’re high. That’s at least kind of the traditional adage. But in reality, it’s kind of the opposite of that, right? You’ve got a lot more options available for you as a CEO when your stock price is high, which is kind of an interesting spin on the momentum idea.
Robert Leonard (21:04):
I really like the idea that you mentioned of Tesla issuing new stock. And I’m not sure if you saw Michael Burry talking about this. And for those who are listening that don’t know who Michael Burry is, he is the main character or the successful investor who shorted the housing crisis. He’s the main guy in the movie The Big Short. Of course, he is a real investor that the movie is based on. But basically, Michael Burry is very, very pessimistic on Tesla and even short the company. But what he did was he mentioned to Elon Musk, he said, “Listen, I’m very short your stock. I’m very pessimistic on your valuation and your company. But if I can give you one piece of advice, I highly recommend you go out and raise as much capital at absurd valuation as you can, because that will be to the benefit of shareholders.” So I love that you mentioned that.
Robert Leonard (21:50):
I think this also goes with this idea of people wonder why investors add to their winners and why winners keep on winning. And it’s this idea that what you just said is as their stock price grows, it’s almost a self-fulfilling prophecy. Because Tesla is doing better, the stock price does better. Then Tesla can dilute shareholders a little bit, raise a bunch of capital, reinvest that in the business, do better, then its share price goes up. That dilution gets erased because the value of the stock has gone up so much. And it’s self-fulfilling from there. And it just continues to win, and win, and win. And you see that time and time again with a bunch of companies. And that’s why the stock price going up matters for companies in the long run.
Simon Erickson (22:27):
And the key piece of that too is that you have somebody who’s executing really well. Elan has a lot of confidence from the market because he has done so well with every program that he’s put in front of Tesla. He’s not raising money and lighting on fire and say, “Oops, I did it again.” When Elon puts his mind to something, he is all in on it.
Simon Erickson (22:44):
Sorry for the Texas hold ’em reference again. I guess I’m stuck on thinking about cards on this. But I mean he’s somebody that’s going to execute. He’s going to make it happen. And the market has a lot of confidence in him right now. This goes the other way that if you’ve made bad acquisitions, shareholder capital on fire, the market’s not going to have any confidence in you. But rising stock price plus great CEO is pretty formal combination.
Robert Leonard (23:05):
I want to ask you about a relatively abstract concept that I’ve been kind of tossing around in my head the last few weeks, especially as I think about what’s going on with Tesla and just some other companies with great leaders that I follow and even invest in.
Robert Leonard (23:19):
When we think about evaluation, we often start with a discounted cashflow model or some sort of multiple, break that down to a per share basis. Say we add just for round numbers, $10 of share value for the future cash flows through a discounted cashflow model.
Robert Leonard (23:34):
Do you think it’s possible to add a value for the shareholder based on the CEO? So can we say that each Tesla stock has an intrinsic value of $50 per share because Elon’s a great CEO? Or if it’s a less optimal CEO, if it’s a less successful CEO, maybe that’s only worth $10 a share. Or if they’re even more successful than Elon, maybe that’s worth $100 a share. And it’s a very qualitative thing. And you could think a CEO’s worth $10 a share. I could think they’re worth $50 a share, and we’ll have a disconnect in terms of what we think that valuation is. But is that even a valid way to think about potentially a valuation model?
Simon Erickson (24:12):
Yes, it is very valid. A discounted cash flow analysis is basically if you take a snapshot of what the business looks like today and you forecast it out into the future how many years you want to, and then you have a terminal value at the end of that too. And you discount all of those cash flows. Not revenues, but cash flows that you’re getting from those business lines back to the present, what is the business worth today? Right? So the results of your spreadsheet says this company is worth $5 billion in equity market valuation. That company sells today for $10 billion. Double what your DCF says. Does that mean that this company is a screaming sell because it’s overvalued double what the discounted cashflow analysis says? Well, maybe not. Because to your point Robert, there’s optionality that is represented in the market cap of every company out there. And it’s based on what is this company going to unlock that is not currently being appreciated by the market.
Simon Erickson (25:05):
So perfect example is Jeff Bezos. Jeff Bezos continues to find ways to unlock value that shareholders had no idea was going to be as well as what he saw the vision of the future being. Kiva Robotics. When they first started looking at these cute little robots spinning around in his warehouse factories, $750 million acquisition. Everyone said, “Jeff, this is way too soon. The cost of these are going to come way down. You’re overpaying for this acquisition. We don’t think it’s a good idea.” And now look at Amazon today. Two day delivery, much faster than that fulfillment in the centers. And it’s saving billions of dollars every single year that has been enabled by having robotics in its distribution facilities.
Simon Erickson (25:42):
So something like that, there’s no way that if you went back right before that acquisition, no one was saying, “Hey, let’s just throw in the idea of having robots in Amazon’s fulfillment facilities into the DCF.” That is an optionality premium that you pay for Jeff Bezos that is now worth a lot of money per share. And we’ll have to get back into the nitty-gritty of determining how much per share that’s worth. But that has unlocked equity value.
Simon Erickson (26:06):
So your point I think is the premium that you want to pay should be related to the track record of how good a company or its leadership team is at unlocking value. And that’s not easy. We might say that that sounds easy, but you’ve got to kind of stick your neck out there and do things that your competitors are not doing, and be right on your vision at the same time. So this is where you start getting into process. You start looking at every time Jeff Bezos calls a management meeting, he demands everybody has a one pager that they’re going to read for any decisions that would inevitably happen at the end of the meeting. I mean, this is the interesting kind of art form of investing that’s more difficult than just saying, “It’s an evaluation of this. DCF said it’s worth this. And price target says it’s worth this.” That’s where the street gets it wrong. That’s where you cannot pin down a quantitative value on something qualitative like visionary management.
Robert Leonard (26:58):
The art of investing is exactly where I’ve been really focusing a lot. Because when I first started investing, I was purely quantitative. I did a discounted cashflow model. If the numbers said it was undervalued, I’d buy it. If it wasn’t, I wouldn’t. And I didn’t add any value for the qualitative factors. And I quickly learned that that was not going to be a successful way to invest. Maybe Benjamin Graham back in the ’40s, ’50s, ’60s could invest that way, but that was a very different market than we have today. And for me, somebody asked me the other day, “Robert, I thought you were a value investor. How can you invest in Square?” And I said, “You’re right. But if I think Square is undervalued, why am I not a value investor?” Just because a company grows fast, why can’t that be considered value? Right? Maybe on a discounted cashflow model, it’s not undervalued? But what if I think the network effect, or the moat, or various different things that Square may have going for it, what if I think that those have immense value more than what the valuation in the market says? Then it’s an undervalued pick for me. And I still am acting as an undervalued or value investor, right?
Robert Leonard (27:59):
So for me, I try to think about these more abstract and art side of investing a lot more lately. And the CEO, the value that they provide. Jeff Bezos provided as an example is a perfect one. Because if a company is worth 5 billion and they have Jeff Bezos, and they’re selling for 10 billion, is he worth more than 5 billion to that company? You could argue he is, and then it’s undervalued. Or you could argue he isn’t, and it’s overvalued.
Simon Erickson (28:21):
It’s getting easier to unlock value now too. You talk about Benjamin Graham and Warren Buffett. A lot of these manufacturing companies in the ’60s and ’70s, they didn’t have cloud computing. They didn’t have artificial intelligence. They didn’t have a lot of the benefits that companies today are enjoying. For them, it was how cheaply can you access capital, and how quickly can you build a physical empire of infrastructure off of that capital that you raise?
Simon Erickson (28:44):
So I think that a lot of times back then, value investing really was the way to go. You were able to get into the nitty gritty. We didn’t even have the internet back then. So most people couldn’t get access to that information. But today, looking at things like return on invested capital versus weighted average cost of capital, these are kind of like the creed of investing. These are like the fundamentals of investing. But I think the game has changed, Robert. I think that much more now is how quickly can you capture an unlock value for an organization in those early years of the DCF? How fast are cybersecurity companies growing right now? Because they’ve got people throwing money at them right now because there’s so many problems. And that’s incredible business. If you can take that business, borrow as much money as you can to get recurring growth for a cloud-based product that’s throwing off 90% gross margins for you.
Simon Erickson (29:32):
So I think this is all related. But when we’re saying terms like value investing or growth investing, it’s really all a continuum that’s looking at how can you borrow, and how are you deploying that capital? And what’s the return that you’re getting for your shareholders off of that?
Robert Leonard (29:46):
I think if we only purely look at investments from a quantitative perspective, there are supercomputers today that will instantly make any arbitration available go away. Back in the day, Benjamin Graham, if there was a disconnect in value in price based on a fundamental metric or key ratio, they had to find it themselves. Humans had to do the research, make the investment, and then wait for the market to close that gap. Now, there are supercomputers that can do that in milliseconds.
Robert Leonard (30:13):
So I don’t think that those types of situations exist as much anymore as they used to. Now I think as an investor, you really have to unlock the alpha or your gain over others by being more right about the qualitative factors of a business, and unlocking the value that way.
Simon Erickson (30:30):
Yeah, I agree. And so many of those price targets and institutional investors right now, it’s really hard the system that they’re in to stick their neck out. Four years ago was saying that Tesla was going to be worth $800 billion in three years. People would kind of look at that with a strange look in their face, raise an eyebrow. But I mean, that’s exactly what happened, right? And it’s hard to predict those things and issue sell-side price targets that are just completely different than what anybody else was issuing out there.
Simon Erickson (30:58):
Now as individual investors, we can benefit from those same disconnects. We can go out there and invest in companies that are showing qualitative signs of moving in the right direction, hitting the right operating metrics we want to, and have the great leadership in place at the top. Things like that are hard to capture in a discounted cashflow analysis model.
Robert Leonard (31:17):
We’ve talked quite a bit about buying stocks, which a lot of people would argue is where your money is made. But what about selling a stock? When is the right time to sell? Does this play into your principle of upgrading your portfolio?
Simon Erickson (31:29):
Yeah. And the principle of upgrading your portfolio is something I believe in. It’s a little contrarian to what others might say. But I always think that you should sell a stock if you have a better opportunity. There are obvious ones. Like we were talking about management turnover, things like that that are the deal breakers. But maybe on a more subtle note or something that’s not quite as pronounced, if you have a better opportunity, why not upgrade your portfolio to the better quality business?
Simon Erickson (31:51):
Now make sure you’re right. Don’t just on a whim say, “I’m going to sell this position and buy this one because I think this maybe is a better idea.” I mean, have conviction in your decisions. But personally as an investor, I’ve looked at some positions I’ve held on for years. And I asked myself, “well, why is that still around? Why am I still holding on to that stock? Why don’t I sell that for something over here that I’ve done a lot more research and I’m a lot more confident in?” That’s upgrading your portfolio. And you’ll unlock better returns if you’re investing in higher quality businesses that the market is appreciating rather than some of that legacy dead weight that you forget about. We always want to be buy and hold. We want to have the intention of holding a company forever. But things do change out there. And I think it’s a good idea to optimize over time and be mindful of what’s going on out there in the market.
Robert Leonard (32:35):
Warren Buffett has famously said that he doesn’t let economic outlooks impact his investing. How about you? Do you adjust your investing based on macro data?
Simon Erickson (32:45):
I mean, those are inputs for financial modeling. What’s the GDP growth rate of the country? What are interest rates, things like that, or inputs that go into discount rates and everything else that we would use for financial model? I’m more interested in the bigger picture of what seems to be sustainable and what’s happening out there. Zero interest rate policies right now are very interesting, because capital is very cheap. Working from home is definitely a trend that’s catching on, and that’s really benefiting technology stocks. A lot of stuff going on internationally is really interesting. That’s where it really gets interesting Robert is looking at not just the United States. But you want to start putting money to work overseas, trying to figure out the cultural differences of what’s happening in China right now.
Simon Erickson (33:23):
But things like this are bigger picture macro trends that are taking shape, which are in my opinion what’s the penetration of internet conductivity in a region? How many people are actually signed up that have a bank account or have a smartphone? I mean, things like that are enabling and unlocking these next waves of technology that we’ve seen happen in the U.S. And there are analogs to those overseas as well.
Simon Erickson (33:47):
So I guess to answer your question, I don’t obsess over the numbers quite as much. I like to kind of know where GDP stands over time and where interest rates kind of stand over time. But I’m much more interested in the bigger picture of what’s taking shape and what that is going to enable.
Robert Leonard (34:04):
How do you differentiate today’s market conditions from those present during the 2000 and 2001 markets? How is today’s growth investing different than back then?
Simon Erickson (34:14):
Yeah, so the dot-com bubble was based on advertising. Really rapid growth of revenue that was based upon advertising over the internet. So everybody was starting their website. The jokes about pets.com are all over the place now. But it was all built upon advertising that was increasing incredibly quickly. Not sustainable. You can’t have those kinds of growth rates in that short amount of time. And the euphoria eventually hit the wall and it came crashing down, because it wasn’t a sustainable business. So you saw this shift of companies that did have an online presence to realize that they couldn’t keep making their top line entirely off of advertising. They shifted to subscriptions. And even now, we’re seeing another shift where AI is coming into the picture. And it’s rather than just per seat subscription basis, a lot of it’s actually usage based models in, which is making cloud software platforms really interesting too.
Simon Erickson (35:05):
So the difference between today’s market and the dot-com market of 2000 and 2001 is that this is a much more sustainable business. This is something that’s locked in, is becoming a crucial part of these businesses and how they operate. Because they’re built in the cloud. They need the infrastructure of the cloud. They’re vital components of businesses that are using them. And that locks them in. They’re switching costs that are a part of that. You’re paying on a monthly basis for a subscription rather than something that could vary wildly through advertising like we saw in 2000.
Robert Leonard (35:40):
From time to time, I get asked for book recommendations on growth investing. And I’m not typically a growth investor. So I don’t usually have many good recommendations for this. I usually just say, “Hey, go follow Simon Erickson on Twitter, or Jason Moser.” These are some of the guys that I look for for growth investing. That’s the best way that I’ve learned growth investing. But for someone who really wants a book or a few different books that they can go read about growth, what do you recommend, and where can they find them?
Simon Erickson (36:08):
I’ve always been a huge fan of Clayton Christensen who was a Harvard professor on strategy. Fantastic investor too. I don’t think he was given enough credit. He was an academic, but I don’t think he was given enough credit for the contributions that he was making to the private markets too. So he wrote a book, gosh, I guess it was 1997 if I’m not mistaken, The Innovator’s Dilemma, which talks about disruptive innovation. He created the concept of disruptive innovation to explain why big firms will fail. So this looks at companies like GE and IBM, and Cisco. And why don’t they just keep getting bigger and bigger at higher and higher margins, and just kind of conquer the world? There’s something that disrupts them. They have their comfortable way of doing things. And there are golden goose business lines that they don’t want to mess up.
Simon Erickson (36:53):
And yet smaller companies have the opportunity because this giant juggernaut of a ship is heading in this direction, to be a much smaller boat that goes in a different direction, and can offer as technology improves, more value to customers that are interested in that. So I would highly recommend The Innovator’s Dilemma. We lost Clayton Christensen just recently. Huge mentor of mine, unfortunately passed away. But his investing knowledge has kind of lived on through my investing style, and I have a great deal of respect still for everything that was presented in that book.
Robert Leonard (37:23):
I have actually had that book on my bookshelf for quite a while. I haven’t read it yet. So I think based on your recommendation, I’m going to have to go downstairs and pull that book off the bookshelf, and give it a read in the next couple of weeks. I have a long list of to read books, but I think I might have to move that one up towards the top.
Simon Erickson (37:39):
Robert, give me a call when you get done reading it. Let’s grab a beer and talk about it. Book club.
Robert Leonard (37:45):
Yeah. You’re down in Texas. You know I love Texas. So I might have to just take you up on that. It’s getting cold here in the Northeast. It’s nice and warm down there. I’ll definitely take you up on that.
Simon Erickson (37:53):
Anytime. Sounds fantastic.
Robert Leonard (37:56):
As we wrap up the show, what’s one piece of advice you’d like to leave the audience with? It could be about investing, business. Maybe even just life in general.
Simon Erickson (38:05):
This is a great question. I love this one. I would say find things that compound. We talk about this in terms of investing, because you want to compound your returns and build wealth. But my takeaway is compound your time too. As investors, there’s no way to start at the top. This is a lifelong venture that you continue to learn things all along the way. So when you’re learning things, think about a knowledge base. Have a journal, write things down. Have something you can refer to in the future. And then build upon that. When you start looking at technology companies, you want to have the basis of growth style investing. And then on top of that, you want to have the basis of how companies are allocating their money.
Simon Erickson (38:41):
So we talked earlier in the program about kind of understanding the time value of money, understanding compounding, understanding different types of investing, figuring out what type of investor you want to be. All of that builds upon a layer that’s right before that. So not only in investing which we kind of talk about compounding knowledge there. But also in your career, I think that the way that you differentiate yourself professionally is you find something you’re really good at, and you become the expert in that. You build upon layer, after layer, after layer. You compound your knowledge in a certain field, and that really pays off for you in your professional endeavors too. So compounding I guess is my one key takeaway that I’d pass along
Robert Leonard (39:18):
Simon, thanks so much for joining me again on the show. For anyone who wants to hear our last conversation together, you can check that out on episode 40. If people want to connect with you more directly, where can everyone go listening to check you out?
Simon Erickson (39:33):
So I’m @7Innovator on Twitter is probably one of the best ways to get ahold of me. 7investing.com. Either typing that out or just using the number seven will get you there. But if you want to see our top stock ideas every month. And then if you want to talk to anyone on the team, we’re firstname.lastname@example.org. Or @7investing. They’re on Twitter as well.
Robert Leonard (39:54):
I’ll be sure to put a link to that in the show notes below so everybody can go connect with Simon. Thank you again, Simon.
Simon Erickson (40:00):
Real pleasure to be here. Thanks for having me, Robert.
Robert Leonard (40:03):
All right, guys. That’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.
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