November 2019 Reader Mailbag – Part 1/2

Thank you to everyone who submitted questions for this blog’s first ever “Reader Mailbag” post. This month I will answer 10 reader questions, split across two separate posts. If you would like to submit a question for the next mailbag series, you can leave a message in the comments or send a direct message via Twitter (@peridotcapital).

Alright, here we go…

Question #1: “Are we heading for a 2001-type correction for “revenue growth at all costs” companies that do not generate consistent EBITDA?”

For those who do not recall, or were not investing nearly 20 years ago, the internet bubble of the late 1990’s (peak in early 2000) resulted in the Nasdaq dropping 80% from peak to trough. The main culprit was simply a reversion to mean valuations, which for large tech companies had reached north of 100 times earnings. Many telecom related firms were booking losses as they tried to build out and sell network capacity, etc.

The good news is that the market today is not really being propped up at exorbitant valuations by the tech sector. Twenty years ago the P/E for the S&P 500 was north of 30x because tech comprised 30% of the index. Interestingly, today’s biggest tech companies, which make up a large portion of the S&P 500, are actually not the most overpriced. Think Apple, Microsoft, Google, etc. So I don’t see the tech sector bringing down the market all by itself.

On a more micro level, there are certainly certain pockets of tech that remind me a lot of 1999, namely cloud software stocks that fetch 10-20 times revenues and aren’t showing any profits. The valuations of these stocks look extended, though perhaps not “bubblish.” The good news is that selling software is not a flawed business model, in the sense that these companies could make money if they needed to. They would simply scale back sales and marketing expenses and stop hiring new employees. All of the sudden a 10 or 20% negative operating margin could become a positive number very quickly. Of course, revenue growth would slow if they opted for that route and the valuation multiple would contract.

More likely than a bubble popping, where software stocks fall 80% as a group within a matter of six months or a year (a la 2000-2001), I suspect these stocks will simply mark time and provide unimpressive returns for investors while the actual businesses catch up to the valuations. Consider a company that is growing 25% annually and trades for 10 times sales. Maybe a normalized valuation is really 5x sales. Sure, if the stock was cut in half overnight, the valuation issue would be solved, but more likely we will watch the stock flatline for 3 years while the business continues to grow at 25% per annum. After 3 years, that 10x sales multiple would be down to 5x as sales double and the stock remains the same.

This is not to say that none of these stocks will fall 50-75% or that none of them can keep going higher from here. What is a fairly safe assumption, however, is that on average, stock prices will rise more slowly than the underlying business, which will allow for valuations to mean revert to more sane levels.

Question 2: “What are your thoughts on long-term care cost preparation? Long term care insurance vs whole life with a long-term care rider?

I have never seen a whole life insurance policy or annuity contract that I have liked for the customer. The problem with financial products that combine insurance with investments is that too many people need to get paid before the customer ever has a chance to make a good return on their investment. The salesperson needs to make their commission when the product is sold, the insurance company gets an annual fee for guaranteeing the payouts, and the investment manager gets their annual fee to manage the upfront and/or regular premiums coming in the door before claims are paid. By the time all three parties take their cut, the customer is typically left with meager scraps relative to what they should earn.

So, I am not a fan of whole life policies with LTC riders. Buying a straight LTC policy is generally a better move (fewer people are taking a cut), but those policies are not cheap, especially since many underwriters have mispriced them over the last 20 years and are now paying the price with an influx of claims.

I like to remind folks that you do not need to buy coverage that covers the entire monthly cost of LTC. After all, if you are forced into a facility, many of your current expenses are covered in part or in full, and in general you will have savings and assets to use to help fund part of the expense. So, if you are looking for coverage of $5K or $6K a month or more, and get sticker shock (even though oftentimes policies only pay for up to 3 years of care), take a close look at your budget and nest egg and figure out how much of that monthly cost you could actually cover yourself from reallocating living expenses and/or selling assets that would no longer be needed (cars, your home, etc). Many times people realize they only need to buy coverage for a portion of the expected LTC monthly cost, which is far more doable for one’s budget.

Question 3: “When should investors believe the hype and when should they not? What are some markers that show hype vs substance?”

Hype is a hard thing to quantify and analyze. I would distinguish between business hype and financial hype. The latter is easier to pinpoint because it is relatively easy to figure out if a valuation implies a future scenario that is impossible, or just a stretch. For instance, regardless of your view on the plant-based meat alternative sector, when BeyondMeat stock fetched a $15B equity valuation, there was absolutely no way to justify that, even if you took a very rosy scenario on the market size and BYND’s market share. A food company simply cannot justify a forward P/E of 700x or a forward price to sales ratio of 30x. With only 3% of the population identifying as vegetarian, there is no way BYND could be worth 50% of KraftHeinz.

Business hype is a lot harder, though, because a lot can evolve over 10 or 20 years. First, I think you need to understand the space somewhat before ever dipping your toe into a hyped-sector. Never simply take someone’s opinion as being enough to convince you of something. If you know about a company or an industry and the idea seems reasonably promising to you, and other smart people you respect agree, then you can move on to the valuation question.

And for hyped, high growth, long-term businesses, the current valuation does not have to be super attractive, or in-line with the market. It just can’t be absolutely untenable. There is a difference between buying a money-losing company like Beyond Meat for 30 times sales and buying a money-losing software firm for 10x sales. It is pretty much impossible to make money on a food company at 30x sales over a 5-year period because food stocks trade for somewhere between 0.5 and 2 times sales.

Finally, be on the lookout for companies that do one thing but claim they are special. WeWork was overhyped in part because they claimed to be a tech company, not a commercial landlord leasing out office space. Investors in Tesla today can’t think it is solely a car company, because it is worth more than General Motors. If Tesla is just a car company, the stock is setup to be a dud from here. If it is something more, like Amazon was more than just a book seller in hindsight, then maybe the stock can work over the next 5 years.

Overall, there is no magic thing to look for to identify overhyped stocks. If the valuation makes sense using optimistic BUT reasonable assumptions, and you know enough about the business to understand and believe that it has real promise, then you can begin to consider an investment. If not, I would be concerned there is more hype than underlying business and investment potential.

Question 4: “What do you think of Howard Hughes Corp (HHC) now that the strategic review is over and they failed to find a buyer?

As I wrote back in June when the strategic review was announced, I thought the prudent move was to trim back my long position on the heels of the surge. What was most surprising to me about the end of the strategic review was that they were most interested in selling the entire company to a single party. Given the wide geographic footprint of HHC’s assets, finding a single buyer seemed unlikely. I was hoping they would be able to accomplish something more realistic, such as selling the Hawaii assets and/or the South Street Seaport. Focusing on MPCs in Maryland, Nevada, and Texas likely would have been welcomed by investors.

Instead we are left with a company that will simply sell off non-core assets, trim G&A (which was way too high), and perhaps implement a modest buyback. Is that scenario super exciting? Not exactly. While I don’t think the stock is excessively priced now (around $110), I do not believe the market will assign a market price anywhere near the purported NAV (between $150 and $200 per share if you ask the bulls). In order to get to such a valuation, you need to assign full value to land that will be sold and/or redeveloped far in the future, and I suspect public investors will continue to heavily discount those non-guaranteed projected future cash flows. If you focus on the assets that are leased today, or under construction, and discount the land holdings a bit, it is not hard to arrive at an NAV of $130-$140 per share, which is essentially where the stock was trading during the review process.

While I still like the HHC assets and the investment thesis, and will continue to hold some for the long-term, it does not strike me as a super compelling option for fresh money right now, as my upside base case has been tempered in recent years. The biggest disappointment has been the failure of the company to truly deliver on the idea that land and condo sales would fund operating asset development, making outside financing needs minimal. That business model would truly be unique in the real estate development sector and allow for outsized value creation, as most other firms are structured as REITs and have to borrow a lot of money for each and every project.

Unfortunately, HHC’s debt has been on the rise for years now. Consider the path of total debt: $700M in 2012, $1.5B in 2013, $2B in 2014, $2.4B in 2015, $2.7B in 2016, $2.9B in 2017, $3.2B in 2018, and $3.6B as of September 2019. In 7 years HHC has increased its debt load by 5.15x, while annual operating asset revenue has grown from $170M to $450M, or by 2.65x. That is not the kind of capital recycling that many, myself included, were hoping for when we initially bought shares. Unless that changes, it will be a tough task for HHC to close the gap to supposed NAV.

Question 5: “Are there any “busted IPOs” that have come down enough you are starting to get interested, even if they are money-losing right now?

I have written a lot of negative stuff about money-losing tech companies that raise a bunch of money via IPOs, which will fund their loss-making businesses for a long time, and help them pay their employees more and more in stock (which also serves to limit cash burn). I did make a point to mention that I do not have a hard and fast “no loss-making companies in a portfolio” rule when I discussed the potential of Teladoc (TDOC) over the next decade.

Since stock prices should reflect the present value of future free cash flow, losses now are not always the end of the analysis. If I can find a dominant business, that I think will continue to grow and has the ability to make money a few years down the road, I will consider investing provided I am not paying too much for the privilege. So while that usually eliminates things fetching 15 or 20 times sales, other times you can find interesting situations that fetch reasonable prices.

Recently, I have been looking closely at Uber (UBER), as an example. The stock is trading around $26 after pricing the IPO at $45. In the near-term there are concerns about the lock-up expiration and insider selling, which could pressure the stock in the short term, but I don’t care too much about the short-term.

In Uber I see a dominant franchise with a sustainable business that is not just U.S. focused (like Lyft). They have an experienced CEO now, which should help them make the transition from start-up to large cap public company. And I think they have a lot of pricing power that has yet to be run through their business yet. A few extra dollars per ride is not likely to result in customers digging out their phone books and calling their local yellow cab franchise. Simply put, it appears that Uber is here to stay.

In terms of valuation, the current consensus for 2020 is revenue is north of $18B, versus the current market cap of $44B. Call me crazy given their current losses, but I don’t see a 2.5x price to sales ratio as being overly demanding. And they have $12B of cash in the bank to bridge the gap from now to profitability. If one were to assume a terminal P/E ratio of 20x, and work backwards to figure out what kind of margins they ultimately have to earn to make the stock a good value today, I don’t think the assumptions required are overly aggressive (though of course are far from assured). Now, obviously a company losing $1B of EBITDA a quarter comes with plenty of risks, but I would choose Uber at 2.5x sales over a cloud software company at 15x sales on most days of the week.

2 thoughts on “November 2019 Reader Mailbag – Part 1/2”

  1. I had 2 questions:
    1) Do you see global investment returns trouncing US stock market returns in the coming decade?
    2) Within the US do you expect active value investing making a comeback over passive investing?

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