Discover more from CaveatEmptor’s Substack
The ARK VS the BRK
Review of January
The advent of the year of the Tiger has been a mauling for stock and crypto investors as volatility spiked up. The inflation worries impacted the high valuation of stocks in Dec. The Federal Reserve signalling of the tapering of QE and the intent to increase interest rates to control inflation in Jan sent a rude awakening to investors whom focus at the narratives instead of the financial numbers, and sent a hit among the technology and growth labeled stocks. The various surprises of the earnings releases in Feb led to huge adjustments in the valuations of the winners in the Covid season. And now, the potential breakout of war between US and Russia over the independence of Ukraine led to sour sentiment especially if armed conflict breaks out between 2 nuclear powers.
From a discounted cash flow perspective, the terminal cash flows / multiples of the companies with cash flows well into the future (growth orientated companies) will be more uncertain with the interest rate hikes. The spike in the interest rates will increase the discount rates on the DCF analysis and lead to a large correction in the calculated valuation of the company. Sell side analysts will take this opportunity to adjust the terminal value of the cash flows / terminal multiple (which is the largest contributor of the DCF valuation) in the fear mongering environment to generate trading churn.
From a corporate finance perspective however, asset light companies with lightly leveraged balanced sheets, sticky products and strong pricing power will have less severe impairments to the cash flows and competitive position. Without any tangible assets to replace or huge capex required to reinvest in maintenance capex, they are largely spared from required business borrowings in their business cycle. Companies with lightly leveraged balance sheets do not need to heavily tap on the bonds and bank borrowing to refinance their capital structure. Companies with strong pricing power and share of mind can easily pass on the increased cost of business to willing and able buyers, and also acts as a strong defense against inflationary pressures in the global economy.
In my personal readings about the fed announcement, my interpretation about the present state is that the fed is merely lowering the speed of the money printer and will eventually switch it off. The BRRR does not transit to RRRB until the economy is in full traction to recovery. To temper the wild valuations and speculative excesses of the housing and stock markets, as well as to manage inflation expectations, the fed set a strong intention ed tone to increase interest rates multiple times in a year. Because of the highly leveraged nature of the companies in the SandP 500 Constituents, I believe the higher frequency of the proposed hikes will be tempered by a lower absolute hike amount, as the fed cannot haphazardly crush its companies and force them to mass default on their debt obligations. The first hike might be mild or severe depending on how heavy the fed wants to step on the breaks, but they are burdened by the conflicting goals of balancing economic growth and price stability. Ultimately, the US is still dependent on companies to drive economic growth and job creation, to fund the deficit spending of the government and the economy. Moreover with the huge vested interest of fed officials and senate politicians in the stock and asset markets, the fed may have powerful tools to manage the mood and momentum of the market but limited precision and influence to curb the fiscal policies of the government.
The ARK VS the BRK
The perpetual debate between growth and value investing can be condensed as the performance of the ARK VS the BRK. The recent macro events set a multiples correction among the high growth stocks and spooked out the newly minted investors / speculators into the stock market. The speculative / narrative stocks in the ARK ETFs has fallen to an all time low. Among the chaos and bloodbath, the BRK investment vehicle has proven to be a safe refuge (the real ark) with its well capitalized balance sheet, huge warchest position and profitable cash flow generative businesses. Contrasting BRK to the ARK ETFs, Cathy woods investment vehicle is highly vulnerable to investor withdrawal and ETF redemption, which poses severe pricing volatility to the relative illiquid underlying companies, the ETF trading liquidity, as well as the ability of market markers to conduct ETF creation / redemption profitably. Most of the ARK holdings are still money losing companies, and Cathy Wood do not have access to permanent capital to ride the momentum driven stocks downwards. This is a stern reminder that every investment methodology has its good days and horrific ones, and every investor must match his investment horizon and personality with his investment style.
Dinner with Candles
Decisions from Jan to Feb
I personally believe that this is a golden opportunity to accumulate my positions and allocated heavily down in Dec. Unfortunately, the Dip keeps on dipping (unlike Mar 2020) and I decided to stick on a more disciplined accumulation averaging approach so that my system can trump over ill-informed investor emotions. My initial enthusiasm towards heavily allocating into beaten down growth companies lost some of its momentum as some of the higher growth companies do not have strong moats and I am unable to distinguish whether the previous high valuations is simply an objective assessment about their competitive position and advantages and I am buying at a discount, or simply the herd racing wildly in a drunken stupor and I was caught up on it.
I started an initiating position on Disney on 12 Jan 2022 at USD 156.60 after doing some behind the scenes analysis on hot-hitting Movies like Spider-man No way home, and took a deep look at its movie production resources and tools. Unlike Hollywood productions of the past, Disney managed to perfect CGI and Green screen technology in its franchise shows and movies and managed to convince viewers it is perfectly acceptable to pay up for this <New normal>. With modern facial scanning and movement mapping technology, Disney is able to map and copyright Actor features and exert stronger control over costs and execution around its filming conditions and IP, and also the recruitment of <premium actors>. Disney is also successfully executing its premium-isation strategy in its Disney plus (family Friendly) Hulu (Mixed Adult and Family) and ESPN (sports and competitive events), and is even partnering with Korean production studios to increase its IP of premium content. Disney most importantly is trying to execute on its internal flywheel by transforming its premium streaming and movie content into Disney Land rides in expectations of the pent up demand of outdoor entertainment after quarantine restrictions are relaxed.
The bear case of Disney is that the creative arts business is characterized by huge hits and misses throughout history and even the best production studios cannot consistently generate production hits and profitability metrics even with exceptional talent onboard. Movie productions is almost certainly a loss leader in most scenarios and streaming is at its high CAPEX phase. The balance sheet of Disney is acceptable but not great and high dependent on Disney parks to regain profitability, which I believe is a scenario with many moving parts and a low risk high uncertainty position. The earnings beat on Feb is a pleasant surprise and I might seek to average up/down among the companies in my portfolio as I figure out what to do next.
I averaged down on Microsoft on 29 Jan at the price of USD 299.84 as my understanding about the synergies between cloud gaming and cloud computing led to my assessment of the growth rates of Microsoft to be above most conventional estimates. An analysis of Amazon's history revealed that although Amazon is in an low margin ecommerce business, its cloud division from 2015 to now is immensely profitable to the point that its free cash flows from cloud computing way exceeded the past decades of ecommerce growth and is directly subsidizing the various bets that Amazon is incubating. Cloud is the miracle worker that is the true cash generative business funding the other Amazon bets. However, I am unable to determine whether Amazon Lateral expansion strategy to capital intensive areas beyond its core competence is diversification or diwosification. Its toxic hiring culture of mass hiring and mistreatment of blue collar employees and severe burnout and turnover among the white collars does not incentivize long term contributors and ownership of the business. I am also unable to assess if the Day 1 culture and capital allocation ability is scalable as the company attempts to disrupt areas beyond its ecommerce roots. Comparing to Microsoft which is focused on its roots, hiring tech engineers and focusing on capital light businesses, monetizing captive users and core product strengths, and expanding high potential blue oceans like Cloud Computing and gaming, I find it easier to bet on focused performers than diffused high variance bets.
Writing up a follow up blog post while monitoring the earnings releases of my watch-list and portfolio companies is taxing and led to delays for weeks. Fortunately (or unfortunately), I had more spare time to focus on Valentines day and managed to flesh out the final pieces. I will strive to remain opportunistic as interesting opportunities await!