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AGB #1 Starbucks (SBUX)

AGB #2 Vail Resorts (MTN)

AGB #3 Roku (ROKU)

AGB #4 TransDigm (TDG)

AGB #5 Bright Horizons (BFAM)

AGB #6 Illumina (ILMN)

AGB #7 Tyler Technologies (TYL)

AGB #8 Dollar General (DG)

AGB #9 Workday (WDAY)

AGB #10 Broadcom (AVGO)

AGB #11 Domino’s Pizza (DPZ)

Long Term Equity Returns

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

I found a great explanation of long term equity returns on Twitter that I’d like explore with you. It involves math, but I promise it’s not that difficult if you take it step by step.

So before we go through the steps, what’s the punchline? ROE drives stock returns over the long-term (actually it’s ROE x Reinvestment Rate, given you can’t assume that Reinvestment Rate = 100%). The price you pay for a stock also matters, but it has less of an impact the longer you hold the stock. Below are the formulas that you need to understand.

Step 1: That’s the formula for annual returns. r = the price you sell divided by the price you pay, annualized.

Step 2: Price is the same as the EPS multiplied by the P/E ratio.

Step 3: Earnings in the future is the same as earnings now multiplied by the annual growth rate.

Step 4: Today’s earnings cancel each other out.

Step 5: Growth can also be expressed as the ROE multiplied the reinvestment rate.

Step 6: Here, the creator assumed that Reinvestment Rate was = 100%, which is impossible. I would leave that variable in. Also, just some quick math and you can separate out the multiples and the ROE.

Step 7: The left side is the final formula. Instead of ROE, it should be ROE x Reinvestment Rate. The most interesting thing here is that as T gets larger the M1/M2 gets closer to 1, meaning the P/E ratio matters less the longer the time horizon.

Takeaways: There are three things that matter when calculating long-term equity returns.

The first and most important is the return on equity or return on capital of the business. This comes back to quality. A quality company can achieve high rates of return over a long period of time, even as more competition comes in the market. The way the quality company does this is by having a long standing moat that can be sustained over the long term.

The second and equally as important is reinvestment rate. The reason that good companies see their stock prices compound at lower rates of return as they get larger is that the reinvestment opportunity gets smaller over time. They still maintain high ROE, but the growth rate slows due to fewer profitable projects. This usually leads to companies allocating capital to dividends and stock buybacks.

The third and slightly less important is price. What you pay matters but it matters less over time. So it’s always better to buy a stock of a quality company at a fair to high price than to buy a low quality company at any price. Now, if you can find a high quality company at a low price, that’s when you get to 100x returns over many years.

Happy investing to all!

What if the Recent Rally is Just Beginning?

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

I wrote this post last week but hadn’t posted it because I wanted to edit it some more. After yesterday’s stock market drop of 6%, we may be in the middle of a pullback. But I still think the outcome discussed below is still likely.

We’ve almost come back full circle since the March 23 lows. The Nasdaq is actually near all time highs. So what happens from here? There’s a lot of technical “evidence” that we may be due for a pullback.

The put/call ratio is the lowest in many years as we’re about to hit the euphoria stage of the rally. Robinhood traders are trading as if the market only goes up. Puts are being sold at cheap prices while calls are distorted from normal trading ranges.

So you might be thinking, well, maybe this guy has seen a chart or two and it’s impacting his opinion of the market. My current best estimate of what’s happened and what’s about to happen to the market is this: The Fed, the government, the market and everyone else overestimated how impactful the Covid-19 outbreak would be to the economy. And I predict that the result of the stimulus will be a massive run up in equities not seen since the dotcom bubble.

First, the fiscal stimulus was unprecedented in scale. The one time checks plus the increase in unemployment was more than enough for most Americans, especially because everything was closed and people couldn’t spend money anymore. So you have results like this:

The savings rate was the biggest on record.

U.S. savings rate hits record 33% as coronavirus causes Americans ...

Many Americans are making more staying home than at the job they got laid off from.

Second, fed policy to purchase investment grade and high yield bonds (including some corporate bonds) stabilized the market, allowing companies to raise a record amount of debt at very attractive prices. Airbnb may have raised capital a week too early.

Third, Americans are going to do whatever they always do. A virus that has a death rate of below 1% isn’t going to stop people from living their lives. Only in America do you see people flooding casino floors with no masks on while an outbreak is still happening.

Las Vegas reopens with tourists, jackpots, and pools galore | Las ...

All this together has led to an incredible rally into stay at home stocks (video conferencing, e-commerce, video games, groceries, etc.) and then now a rally into reopening stocks (airlines, hotels, casinos, autos, etc). The stay at home stocks are holding steady while the others play catch-up. This would indicate that new money is continuing to flow into the equity markets.

Here’s why it’s happening. The fed has pumped so much money into the debt markets and there was so much money on the sidelines in money market funds that the money has to flood into equities. And let’s not forget the Robinhood day traders taking their stimulus checks to go all in.

So here’s my prediction. The markets pullback a small amount, less than 5% over the next two weeks and then rally hard breaking all time highs. Remember the fed? The $4 trillion in stimulus is 4x the size of the bailout of the Great Recession.

We have been forced into a Fed bubble. I think some participants in the market thought that we may be headed towards a Fed bubble in 2014-2015 but the valuations never got out of control. In fact, because of the tax cut, valuations have looked good since 2017.

I predict that we’re currently in a combination of 1998 and 2008/2009, where we have a drawdown, the fed intervenes and then the market rallies after that. The real economy will not recover as quickly as the equity markets and so we’re going to see some high flying valuations not seen since 2000 by the time we’re done with the rally.

The events that could facilitate this to happen include (1) a second stimulus bill to help small businesses and get back people to work, (2) Trump gets re-elected (I’m not hoping for this by the way), (3) there’s a big market rally in 2021 and continued by an infrastructure bill, (4) the economy and the market rally loses steam sometime in 2022.

Oh and there’s a Covid-19. We’ll see spikes here and there but it’ll just become part of everyday life for Americans. An effective vaccine or treatment could be discovered over the next 12 months. The market will push forward like it always does.

Happy investing to all!

Why Drop Shipping Works

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Drop shipping has taken off over the past few years and it has social media, Shopify and AliExpress to thank. Each of these are important players to dropshipping’s success.

But first let’s take a step back and discuss what dropshipping is. At a very high level, drop shipping is buying really low and selling high. (1) A savvy teenager finds a supplier of a product on AliExpress for a couple dollars per unit. These products are made in China and are sold for a few dollars per unit. (2) The teenager then builds a website through Shopify for just a few dollars. Depending on familiarity, expertise and YouTube videos, the site is up in less than a day. The product is listed for $20-$40/unit. (3) The teenager then leverages social media (Instagram, Facebook and maybe Twitter?) to promote said product. (S)he runs ad campaigns that are highly targeted.

At the end of the ad campaigns, (s)he has either made a profit or a loss depending on how many units (s)he sells and how much money was spent on advertising. Because the unit margins are so high at 80%-90%, there is a lot of leeway in how successful an ad campaign needs to be.

Take traditional e-commerce in contrast. Seller buys product from the supplier for $X per unit and sells it at 25% higher than $X to make a gross margin of 20%. Without massive scale, advertising campaigns don’t have high ROI and there is very little left to spend in total ad dollars.

So let’s analyze why drop shipping works. Typically, in a capitalistic society high margins leads to more competition, which lowers margin. Jeff Bezos, the CEO of Amazon, once said “your margin is my opportunity.”

So why does drop shipping still work? I can narrow it down to three main factors. The first is that there is value created along the entire value chain by each player. The supplier knows how to make the product for cheap and typically even fulfills the orders for cheap. Shopify sells tools and services to facilitate e-commerce for cheap. And the owner of the drop shipping operation knows how to market for cheap using social media.

Let’s dig into that third point. How does the owner market for cheap? Social media or influencer marketing is still massively misunderstood by most people. Instagram allows the owner to reach so many people that have self reported an interest in the product category and with careful testing, the marketing ROI can be huge on some pages that are solely dedicate to the product category.

Furthermore, Facebook has so much granular data on each user that the ROI still leads the industry even though pricing is rising rapidly to catch up to the high ROI. Facebook is one of the only places (Google too) where you can directly analyze if your marketing campaign was a success or a failure.

The second factor of why drop shipping still works is that the U.S. consumer is used to shopping online to the point where a decent website with a good enough user interface will lead to a sale. PayPal has a lot to do with this. Because of the buyer guarantee, a buyer is less reluctant to buy a product from a new vendor. As long as the U.S. consumer can be advertised to and said advertisement leads to a sale, the model works.

The third reason this works is because none of the three players in the value chain can circumvent the other. Shopify and the drop shipping operation owner can’t produce products on the cheap. The Ali Express supplier and the drop shipping owner can’t create a website with all the features necessary for e-commerce in short time. And the Ali Express supplier and Shopify can’t run as efficient marketing schemes as the drop shipper.

So there you have it. It’s a decent ecosystem where all parties win.

Happy investing to all!

Why Day Trading Doesn’t Beat Buy and Hold

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Day trading was popularized during the dotcom bubble when the average person could start trading stocks from the comfort of their own home with just a computer and an Internet connection. Back then, it was dial-up service with the various modem models determining connection speeds.

Then came the discount brokers and things really got interesting with the price of trades coming down dramatically. People quit their jobs because day trading was just too easy. Amazon IPOd in May 1997 at $18/share only to see it double by September 1997 and double again before a year had passed.

Now, we all know how the story ends for most high flying IPOs from the dotcom era. Amazon is a rare exception that has been able to grow past its dotcom bubble highs by a meaningful margin.

But how have the day traders fared? What is it exactly and how does it differ from traditional investing? Day trading typically involves viewing lots of stock charts and maybe some technical analysis on high flying, momentum stocks. Think of the stocks that are moving by wide margins today. Tesla, Zoom Video, Shopify, Wayfair, Beyond Meat, Virgin Galactic, Draft Kings, etc.

The idea is that a successful day trader can catch some of these big daily moves (higher and lower) enough to make a decent profit. Day traders typically don’t hold many positions overnight as they don’t have a feel for where markets will open the next day.

But then look at this chart below that shows the SPY moves separated by regular hours trading and after hours trading. The regular hours trading was big in the late 90s/early 00s, but has tapered off since then. Day trading cumulatively has led to almost no profit over 27 years.

Returns from trading outside regular hours has dominated the regular hours trading, up almost 600% since 1993. Of course the buy and hold investors benefit from (and get hurt by) these after hours moves, hence the long-term out performance.

But why is that the case? If you think about it a little, you first come to realize that big news about companies are rarely given out during market hours. Earnings releases and M&A announcements are done either before or aftermarket. This is done for a reason. It gives the market time to digest the information before having to trade around the new information. Furthermore, when big news is released during market hours (which is rare), the exchanges typically halt trading on the stock until the market has time to digest the information. Again, this is to ensure that trading activity is normal during regular hours.

So for those of you that think they can benefit from the market moves while not being in the market overnight, I have some bad news for you. That’s a tough game to play and there are very few winners (at least enough to do it for a living). Instead, I would suggest (like I always do) to buy quality companies for the long-term. Then you benefit from the upside surprises that tend to happen outside of market hours. It also takes much less of your time and you won’t be watching the market’s every move all day.

Happy investing to all!

Trend Following the Index Doesn’t Work

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Wouldn’t it be great if you could have all the upside of investing in the stock market without much of the downside? This is what trend following may look like to you at first glance. In your head it sounds like it could actually work. Just remove the -30% draw downs and the long-term returns for the S&P 500 or the NASDAQ Composite look amazing. This way you could avoid the dotcom crash, the great financial crisis and the current corona virus recession.

I’m not saying that trend following as a whole doesn’t work. It sure does. Momentum is one of the most persistent factors within equities and other securities. The point I’m making is that taking the buy/sell signal from the actual security that you’re trying to trade is a losing game.

The reason is simple.

Take a short period of time within the chart below. Let’s look at the bottom of the Eurozone crisis in October 2011 and then trade using a simple trend following strategy of owning the SPY when it’s above its 200d EMA and selling it to zero on days following a close lower than the 200d EMA. As you can see from below, you end up missing the first leg up from the bottom and you also participate in the first leg down before the next drawdown.

I graphed the performance of the simple trend following strategy over the past 10 years done with the SPY and graphed that against just owning SPY the entire time. As you can see, the trend following strategy has periods where there is no movement (during market drawdowns) but doesn’t participate in the move up until much later.

There are, however, trend following strategies using the broader index as a signal and then trading the securities within the index that have proven to be big winners over time. There the idea is that the index is the signal and the trades (if done correctly) express the trend in a larger way.

I don’t practice trend following professionally, but I thought I’d warn those that think that buying and selling the index using momentum indicators is a good investing strategy.

Happy investing everyone!

Shopify and E-commerce

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

The average retail investor knows Shopify (SHOP) because it’s been one of the best performing stocks since its IPO in 2015. Almost everyone that has started an online store in the past 5 years knows about Shopify. Anyone that’s trying to drop ship products from Alibaba leveraging Facebook marketing campaigns knows about Shopify. (Really, just find any dropping “tutorial” on YouTube).

This company and stock have been missed by so many traditional institutional investors because (1) it’s a Canadian company, (2) it sounds like Spotify – which these investors also don’t like, (3) it’s expensive at 38x next years revenue, and (4) it’s related to e-commerce.

There’s commonality among all these reasons, laziness. Shopify has always been Canadian, the company hasn’t changed its name, it’s always been very expensive (look at the chart below – the green line is the next year’s revenue multiple), and it’s always helped companies build e-commerce stores.

Typically, every successful stock that compounds at this rate annually needs to have a strong a lasting tailwind behind them. Think of Visa/MasterCard/PayPal (cash to digital payments), Google/Facebook (print to online advertising), Take Two/Activision/EA (physical to digital interactive entertainment), any enterprise SaaS company, and Domino’s Pizza (just better pizza?).

So what’s going on with Shopify recently? The bounce from the March lows has been dramatic. On April 2, the stock was trading at $346. It closed today at $802, or a gain of +130% in a month and a half.

Here is my attempt at explaining the dramatic move higher.

(1) Shopify directly benefits from the growth in e-commerce, especially away from Amazon. Look at the chart below. The shift from physical retail to e-commerce was pulled forward about 6 years in the span of three months. Shopify was the tool that most of the new online retail stores used. And with those merchants on the Shopify platform comes recurring revenues.

(2) The fundamental outlook got much better with a few recent announcements. Shopify announced a partnership with Facebook, which allows merchants to create a customized shop on Facebook and Instagram. Shopify also released the Shop app which allows consumers to shop and discover new merchants on the Shopify platform. The company also started to allow consumers to shop using installment payment plans.

(3) Retail investors are piling on at more and more expensive levels. This is a chart of users on Robinhood that are holders of Shopify. That dip in March didn’t deter many of these shareholders and that number has only gone up as the stock has rallied.

So now what? I don’t have a position or an opinion on the stock. But I will say, it’s nice to admire success stories in the public markets. Who says that public market investors can’t make multiples on their investments anymore?

Happy investing to all!

Recent Equity Offerings

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

As the market rebounds from the lows in March, companies are now beginning to issue equity to take advantage of higher stock prices. Companies like Equinix, Danaher and Zillow to name a few, have recently issued stock to shore up their balance sheets.

According to Goldman Sachs, global equity issuances have gone up in deal count and in dollar value to reach the highest levels in a few years. I would expect this trend to continue as the market reaches newer local highs.

Let’s try to answer a few questions about the recent equity offerings.

(1) Why are companies doing this?

Well, the short answer is that many companies are under capitalized right now. Due to the direct impact from the lock down measures across the world, most companies have seen revenues and earnings fall from their 2019 levels. Even a company with a strong balance sheet has seen some of it weaken vs. internal estimates heading into the year.

Companies were also operating under the assumption that 2020 would be another great year with little business interruption. As we headed into the 12th year since the Great Recession, more companies became lax about the health of their balance sheets and ran their business lean. Lots of the excess cash generated went to buybacks/dividends and M&A. Now companies are reversing course.

(2) Why are they doing this now?

Companies see that their stocks have bounced from the lows and are taking advantage of a fed induced run up. There’s no guarantee that the market will remain near these levels for long and companies are taking advantage of being able to sell “expensive” equity to shareholders.

There’s also new incentive from the market to improve the strength of balance shseets. The market has gone from rewarding companies with thin balance sheets with debt fueled buybacks to favoring strong balance sheet companies.

Below is the YTD equity performance, separated by credit rating. AAA credit rated stocks have rebounded back to near their 2020 highs, while B credit rated stocks have remained near their 2020 lows. Companies in the middle are raising cash so they can see a credit rating upgrade.

(3) Why didn’t they do it before when equity prices were even higher?

There was no incentive to do an equity offering earlier. Remember when we talked about how companies were running under the assumption that nothing could go wrong? Excess cash was sent out the door and these companies and executives were being rewarded for this type of corporate strategy.

In hindsight it may seem that an equity offering in February would have been the best case, but we all know that hindsight is 20/20. And the market may have punished companies doing secondary offerings for being too “negative” about the potential impact from the pandemic.

As for me, I don’t mind it at all. I think management teams and boards will act according to their self interests and doing an equity raise now is more favorable than not. Just keep that in mind as you search for the next quality investment for your portfolios.

Happy investing to all!

Recovery or Bear Market Rally?

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

The S&P 500 has rebounded nicely since the March 23rd bottom, up +27%. The Nasdaq Composite index has done even better at +30%. If we look at the 200D EMA, the S&P 500 has crossed it intra-day but has yet to close above it. The Nasdaq Composite closed above it on April 14th and has continued to trend above it.

Many experts are claiming that the rally is a bear market one, meaning that it’s just a bounce after a precipitous fall. This implies that the fundamentals of what caused the market to decline in the first place (Covid-19 and the subsequent disruption to the economy) are little changed, but the market rallied because we’ve just come down too far, too quickly.

Others are calling for a March bottom, implying that we’re in bull market territory. This means that the fundamentals looking ahead are much better and that a reopening of the economy and an eventual normalization is just around the corner.

So which one is it? It’s hard to say for certain (or we’d be rich buying out of the money put or call options). But let’s discuss four possible future outcomes and what that means for the market.

(1) A vaccine is discovered. This is the best case you can make for the rally to continue. If one of the many vaccines being researched/undergoing clinical trials actually has efficacy and is safe, we’re off to the races. I would argue that we would rally to more than 10% higher than the prior highs because there’s so much pent up demand over the past 2 months and the fiscal stimulus has helped consumers keep their personal balance sheet in tact. The monetary stimulus from the fed has kept the large companies afloat and most should recover or do better.

(2) Reopening the country doesn’t lead to a meaningful spike in cases. This would mean that the lock down from March to May did actually slow the spread of the virus enough that the hospital system isn’t over run. In this scenario, a vaccine is obviously a big help but it would imply that we have the potential to reach herd immunity, eventually. If we are able to return to semi normal life while keeping active cases steady, it’s a win. In this scenario, the market is probably close to where it should be.

(3) States reopen but demand doesn’t come back. Consumer foot traffic at stores and other brick and mortar establishments don’t return back to normal. So far, early signs point to a muted recovery in many industries across states that have started to reopen. Miles driven is rising but public transportation is still near the lows. It’s still too early to tell what “normal” will be, but all signs point to a very slow recovery. In this scenario, the market drifts lower.

(4) Reopening leads to recurring outbreaks and we have to stay inside until next year. More fiscal stimulus is needed for those that have run out of unemployment insurance. Some workers have been asked to come back off of furlough but choose not to due to health concerns. In this scenario, the markets most likely move much lower for longer. Shutting down the economy for more than 6 months will lead to devastating economic outcomes that could take years to recover from.

If you look at these scenarios collectively, the government has no choice but to try to reopen. While we can probably all agree that the policy response from a health perspective has been poor, we’re here with the hand that’s been dealt. The government can either shut down until a vaccine is found, which would be devastating economically, or try to reopen. If we get a spike in cases and states shut down again, the country is down the same path anyway.

Let me know if there is another probable outcome that I’ve missed. Happy investing to all!.

Buffett’s Airlines

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Berkshire Hathaway held its annual shareholder’s meeting over the weekend. Typically the ballroom is packed with reporters, investors and shareholders that travel to Omaha, NE to experience Berkshire weekend. On this Saturday, it was just Warren Buffett talking to a camera while getting interviewed by Becky Quick remotely.

One of the big revelations from the meeting was the fact that Berkshire sold all of its airline stock in April. The market already knew that Berkshire Hathaway sold some of its stake in Delta and Southwest on April 3rd due to the regulatory requirement of disclosing any sales from a 10+% holder. The following day, the airline stocks traded lower, but the market subsequently brushed it off. Many people were saying that Berkshire wanted flexibility to sell remaining shares without having to disclose further sales.

Well, it looks like most were wrong about that. It’s likely the case that Berkshire quickly sold out of all four airline stocks over the next few days. Since that day, the airlines have traded sideways including Monday’s move.

So what happened? Let’s step back a little. Berkshire acquired large stakes (9% to 11%) of the four largest airlines in the U.S. (American, Delta, United and Southwest) over several months starting in 2016. They paid around $7B-$8B for the shares.

The thesis was that the airline industry in the U.S. had consolidated and returns on capital were much higher than it had been in the past. The reason behind this was that costs were become streamlined, aircrafts had become much easier and less costly to maintain and price competition would be limited with only 4 airlines competing for 90% of air travel.

So as these stock prices were falling in March, there was always some hope baked in that either Berkshire would step in to provide creative financing (preferred or convertible shares) or outright acquire the remaining shares of the companies.

However, the lower prices didn’t entice Berskshire to pull the trigger. Instead, Warren and Charlie determined that taking a loss of $1B-$2B on the stocks was much better risk/reward than doubling down or just holding on. That sent the stocks much lower on Monday. The M&A premium is all but gone and while the airlines have grounded all their aircraft and generate almost no revenue, a potential source of financing is no longer available.

What could that imply? The worst is not yet behind us for the fundamentals of the airlines. We can’t say what the stock prices will do since that depends on many things that are unknown. But Berkshire believes that the fundamentals will be bad for long and that the post-crisis fundamentals won’t look nearly as attractive as what it was prior.

So Berkshire took the loss and moved on. That’s similar to its long standing position in IBM. Berkshire sold the shares and then rolled the proceeds into Apple, which has done very well since then. Perhaps Berkshire will roll over the proceeds from the airline stock sales into something with a better future.

Happy investing everyone!