November 2019 Reader Mailbag – Part 2/2

Thank you to everyone who submitted questions for this blog’s first ever “Reader Mailbag.” Below is the second half of this month’s 10 questions and answers. 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) and I will publish the next round after we get enough submissions.

Question #1: “I am wondering how you think about the renewal risk to Wynn Macau with respect to valuing Wynn Resorts. I am also curious how you view the relative merits of investing in Wynn Macau vs. Wynn Resorts particularly at this point.”

There is a lot of market chatter about the risk of the current U.S./China trade war impacting how Macau officials will approach the process of allowing U.S. resort operators, such as Wynn Resorts (WYNN) to renew their gaming licenses.

My view is that Macau is very unlikely to conclude that it is in their best interest to kick out the U.S. operators, either directly or by making renewal costs overly burdensome. Firms like WYNN have great long-term track records of building attractions that Macau wants and has asked for (more entertainment, less focus on gaming) and they have access to relatively low-cost capital to continue to build and improve their resorts. Forcing them to sell to less financially secure and less experienced operators (to exit the market) would probably not benefit the region. If renewals costs are so big that they materially reduce returns in the region, companies will invest less as a result. I am betting they make an economic decision in 2022 with respect to gaming license renewals, as opposed to a politically motivated one.

In terms of investing in WYNN vs their Macau subsidiary, I think it really depends on what exposure you are looking for. If someone wanted to get international equity exposure and chooses a Macau gaming stock to check the box for that region, that seems logical. Since I invest mostly in U.S. businesses, I prefer having the diversity of WYNN’s exposure to Las Vegas, Boston, and Macau, especially since the company only has 5 resorts in their total portfolio. They are concentrated enough as it is, leaving little reason for me to go further and invest only in 2 instead of 5.

Full disclosure: I am long WYNN personally and for my clients, as I expect free cash flow to ramp materially beginning in 2020 and the stock looks cheap relative to where I see cash flow going on a per-share basis over the next few years.

Question #2: “Within the U.S. do you expect active value investing to make a comeback over passive investing?”

Much like the economy and the financial markets, I think passive investing is also cyclical. This decade the S&P 500 has averaged about +13.5% annually. Active managers can’t really keep up with that kind of bull market, hence passive investing has exploded in the last 10 years.

But what happens when the market stops going up so impressively? Will people still throw all their savings in index funds, assume low double-digit annual returns forever, and plan early retirements (as some folks in their 30’s are doing this cycle)? Seems unlikely to me.

History also supports this view. Were people piling into index funds and singing the praises of passive investing during the decade that immediately preceded the current one? Was Warren Buffett telling people to buy index funds while at the same time doing the exact opposite himself (and hiring active managers to eventually replace him)? Certainly not, but the important question is why?

There is only one reason that I can see; because the S&P 500 started trading at 1,469 in January 2000 and closed out December 2009 at 1,115. That’s a 24% loss that even an entire decade of dividends could not completely offset.

I suspect the next secular bear market will disappoint a lot of people who relied too much on the passive investing concept. The combination of inadequate thoroughness in strategic planning and some bad luck with respect to their timing will inflict plenty of pain in that scenario.

Question #3: “Charles Schwab is up quite a bit since you wrote about it. Are you selling or still holding long-term?”

Talk about a perfect example of how the daily Wall Street pricing mechanism is inefficient in the short term, even for well-followed, large cap companies (that many believe “the market” gets mostly right most of the time).

I wrote about Charles Schwab (SCHW) on October 10th, after the stock dropped 15% after voluntarily giving up about 4% of revenue by cutting trading commissions to zero. Not only was that downward stock move excessive, but the chatter after every competitor followed suit was that more industry consolidation was coming. In that case, why would Schwab not participate? I was in the majority camp that thought AMTD would buy ETFC, but SCHW jumping in first and grabbing the former, if the deal winds up closing, is a brilliant move.

As for the stock, when the news of the AMTD bid hit the wires on November 21st, SCHW stock topped $50 and I hit the sell button quickly (unfortunately, it was a relatively small position so I was only mildly thrilled). A reasonable fair value was probably in the 40’s and if the AMTD deal is 15-20% accretive by (as they have guided to), then $50-ish today seems about right to me.

Looking at the bigger picture: when a stock jumps 40% in 6 weeks, it really can change my thinking as to whether to continue to hold it or not. If you get 2-3 years’ worth of gains in less than 2 months, there are probably better uses for that capital. Since I had other stocks that I liked better than SCHW (at that $50 quote), I didn’t hesitate to sell and move on. Just because a company would be a good long-term holding does not mean that price does not play a role in that characterization. And when prices change dramatically, so could/should your plan.

Question #4: “I know from your writings that you bought Amazon at a great price several years back, trimmed it back on the way up, and completely exited last year. With the shares moving sideways for a while now, are you looking for a re-entry point? If so, at what approximate level?”

Good memory. I wrote about paring back the position at around $1,425 and exited completed in Q2 2018 at $1,700. The stock peaked last year at $2,050 and has been marking time ever since, fetching mid $1,700’s these days.

While I would certainly buy it back if another good opportunity presented itself, I am not paying closer attention to that stock than any other. I am a big fan and customer of Amazon, but even as the stock has been moving sideways, I am not compelled to buy at current prices.

My strategy for valuing Amazon has always been to assume a certain profit margin and valuation once the company reaches maturity, which gives me a good idea of what price-to-sales ratio I feel is appropriate. As long as they are growing 20% annually and spending so much money, current year or even forward 12-month earnings seems like a tricky way to value the stock.

At current prices, AMZN trades for about 3.2 times 2019 revenue. That is about as high as the valuation has gotten in recent years and it seems rather rich to me. Put another way, if they can ever reach 10% net profit margins, would I be a willing investor at a 32x P/E ratio? Probably not. I might answer differently if they were earning 10% margins today, as 20% growth coupled with a 32x P/E seems like a more than reasonable price for a high growth company. But they are not earning much money even nowadays.

In fact, it looks like 2019 free cash flow, adjusted for stock based compensation (I know many of my readers hate that I deduct SBC from free cash flow to arrive at my view of AMZN’s underlying profitability, but I have no plans to abandon that calculation) will come in around $8 billion, or about 3% of sales. At today’s prices, that puts AMZN’s shares at more than 100 times free cash flow. No matter how much I like the company and the business, I cannot come to the conclusion that such a price is an attractive entry point. For comparative purposes, my purchases in 2014 were made at less than 2x sales.

Question #5: “How about a new stock idea, one that you have yet to write about? Breaking news!”

Okay, you win, I can’t resist.

EnLink Midstream (ENLC) is an energy pipeline company that has been crushed lately, falling from $11 to under $5 so far this year. Lower oil prices and less drilling activity from their customers has constrained cash flow growth and the dividend ($1.13 per year) now looks strained. The 23% current yield tells me that the market is going to force the company to cut the payout.

Investors realize this, but as recently as early November, the CEO stated that the board still believes the dividend is appropriately sized. Not surprisingly, investors are betting on a dividend cut and despite the fact that some people repeatedly insist that stocks should rally on such news, that is rarely true in the short term because plenty of people own stocks solely (and mistakenly in my view) because of a high dividend yield.

The end result here looks to me like the stock is being priced off a dividend cut and not the underlying business. Stocks should be valued on profits, not on the distribution of such cash flow. A dividend cut is warranted and ENLC almost certainly will cut it (absent a buyout offer from someone). While a cut will impact near-term price action, it does not change the value of the business.

To me, this appears to be a classic case of near-term market inefficiency. Investors are valuing the stock based on near-term events, not long-term earnings power. While there may be some more weakness immediately following a payout reduction, the company is likely materially undervalued unless the business itself gets significantly worse. As for what intrinsic value might be, I will leave that exercise to you.

Full disclosure: I am long ENLC personally and for my clients.

Leave a Reply

Your email address will not be published. Required fields are marked *