How February 2022 Has Enriched Our Portfolio
- Rupam Deb
- Mar 8, 2022
- 5 min read
If your definition of wealth is the Mark-to-Market value of your stock portfolio, then like most investors, we also lost a fair amount of M-2-M (we often prefer to call it ‘Mark-2-Madness’) in February.
We, however, slept like a baby through this correction, occasionally waking up to buy more and more of our favourite businesses at deep discounts to their ‘intrinsic value’, enhancing the long term expected returns from our investments.
Share Price As A Currency
While we celebrate share price corrections, there is however one downside of corrections which we should always take into consideration in our analysis. That is when the shares are being used as currency.
Mr. Buffett had elegantly explained in his 1982 shareholder letter, how an acquisition made with undervalued shares (market price below intrinsic value) destroys value for the shareholders. The depressed stock price forces the business to give up a higher percentage of its intrinsic value as part of the acquisition. In the process, the intrinsic value of the acquired business the acquirer receives, might be less than the value of what she parts with.
In a similar way, businesses that offer high share based compensations (SBC), end up parting with relatively larger slices of their intrinsic value during market corrections in order to offer the same ‘market value’ for the stock compensation.
On the other hand, a business can make wise use of capital by buying back stock when the market price is below the intrinsic value of the business.
In the month of Feb, we spent a considerable amount of time digging deeper into two different businesses.
Both are great businesses in our opinion and both of them are seriously undervalued, even though one has a market cap that is ~100X the other. Interestingly, one of them have been quietly making wise capital allocation decisions with the massive amounts of Free Cash Flow (FCF). Whereas the other, in spite of enjoying one of the ‘stickiest’ type of recurring revenues (their revenue retention numbers are among the best), finds itself stuck with a hefty SBC bill that is about the highest in the industry. One of these businesses is Meta (discussed later) and the other is Wix.
We have peeled off the surface layers for Wix and looked at the ‘good, bad and ugly’ aspects of the business. You can read our objective analysis on our blog.
In summary: Wix’s business looks undervalued even if they do not acquire a single new customer going forward. However, we would be keeping a close eye on their SBC.
Why Capital Allocation Matters
The capital allocation decisions of all the cash flow generating businesses play a big role in the long term shareholder returns. The easiest way to appreciate this is to understand the three components that make up the long-term shareholder returns:
Earnings Growth: As a business reinvests part of its profits into the operations, and generates a return on that reinvested capital, this results in earnings growth.
Capital Allocation: The main job of any CEO is capital allocation. As the business generates FCF year after year, unless this additional cash (which is not needed by the core operations of the business) is allocated appropriately, the long term returns on the shareholders will suffer. This cash would otherwise accumulate on the Balance Sheet and if left unallocated, will drag down the return on equity (ROE) of a business … even though the business might maintain a high return on invested capital (ROIC). The capital allocation can be in the form of dividends, share buybacks, debt repayments and also acquisitions.
Market Multiple Rerating: This is outside the control of the management. We do not worry much about this component and treat it as a bonus if it happens. We just focus on not paying too high a multiple while investing.
In Feb, we spent a lot of time thinking about the 2nd component above and dug into the Capital allocation records of our businesses. When the CEO is a good capital allocator, then even when the operating business matures and the revenue and earnings growth taper, the shareholder returns can still continue to be very satisfactory. Our most favourite form of capital allocation is share repurchases (buybacks).
We discussed repurchases along with some great examples in a Knowledge Series video on how share repurchases work.
When done right, share repurchases can be extremely value accretive to shareholders. Much of what we discussed was actually taught by Mr. Buffett over the years and he has again reminded us about this buyback wisdom in his just released shareholder letter. Don’t forget to read it.
Research Note: Meta (Formerly Facebook)
We have also just released our research note on our next business Meta, which also acts as a great case study for share repurchases. Recently there have been a lot of discussions (mostly noise) everywhere on Meta after their earnings release. We think while most of the investors are just busy speculating about a future that is ‘unknowable’, they are completely missing appreciating the positive future effects of Meta’s massive buybacks. This itself could significantly enhance investor returns going forward.
You can check out the free overview:
The full report including the valuation, is available only for our Multibagger Research Series (MRS) subscribers.
If you are not yet a subscriber, then this would be a fantastic time to subscribe considering the number of great businesses that we have covered under MRS (the most in depth research you will find anywhere).
Many of these businesses are available at hefty discounts to their intrinsic value. You can subscribe here NOW and also get to see the recording of the MRS Zoom Meetup, which happened on 3rd March.
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