Good & Bad Losses, Effective Forecasting, SemiDesign Renaissance, and Instagram Walking Back on Changes
Market Talk, Edition 55, July 31st 2022
Market Talk is a bi-weekly Sunday issue, where I curate the best things I have consumed during the last two weeks. Every second Sunday I will share the following segments:
• 6x Must-Reads: The 6 readings I found most insightful, with commentary.
• Other Items of Interest: A collection of other readings I found enjoyable.
• Great Listens: Podcasts, interviews, or videos I enjoyed.
• Something Interesting: A palate cleanser to round off the issue.
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Comments from Me
I spent much of the last fortnight in Amsterdam, where I visited for a week. The weather was fantastic, the city was bustling, and it was pleasant to disconnect from markets, emails, and life’s responsibilities for a short space of time. I didn’t capture many photographs, but I did snap one of the Amsterdam stock exchange, founded all the way back in 1602. That’s 420 years ago and seems fitting for a city that is famed for its coffee shop culture.
Being so disconnected, I realised how little I miss being separated from the constant noise and pontification on Twitter. In fact, upon my return, I felt my thoughts were as clear as they have been for years, not littered with the thoughts of hundreds of others. Whilst the connections that can be found there are otherworldly, I find myself gathering less useful insight from the feed these days. Bearporn and macro are mostly what my feed consists of today, and less of individuals having meaningful two-sides discussions about companies. As someone who cares more about the fundamentals, and less about what the stock market is doing on a day-to-day basis, I hope this is just a phase, indicative of the current environment. Nonetheless, being away I didn’t get much opportunity to write. So expect a couple of items between now and the next instalment of Market Talk.
Recent Publications: Memos I have shared since the last Market Talk.
6x Must Reads
In every edition of Market Talk, I share a sizeable number of readings that I have consumed over the past two weeks. Here are the 6 that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.
To access the suggested article, click the purple link after the source subheading.
1) Good Losses, Bad Losses
Source: (Counterpoint Global)
Accounting methodology is not sacrosanct. That is to say, there is more to be derived from a company’s financials than the entries and ratios that are prescribed by the accounting bodies. With over 95% of S&P 500 listed companies reporting non-GAAP metrics in their filings today, there exists a secondary language from which investors can seek to understand the numbers presented to them, in ways that deviate from the enforced presentation methods. Take a peak at the below chart, outlining the performance of $1 invested across unprofitable firms by GAAP standards, profitable firms and real losers (businesses that have expenses unrelated to investment that exceed sales). The CAGR of each cohort is 11.5%, 7.5% and 2.3% respectively.
But perhaps the biggest omission is the well-established trend that intangibles have overtaken tangible investments on the aggregate balance sheets of companies in recent decades. Take the below table of companies, and rank these three (A, B, and C) companies in order of value from highest to lowest. Would you be surprised to learn that companies A and B are of equal value and that company C is worth considerable less?
Companies A and B have identical free cash flows, but this is obscured due to the way each business has to account for its investments (company A via the balance sheet and Company B through the income statement). The primary difference here is that company B is a firm that invests primarily in intangible assets, that are accounted for much differently than that of the tangible capital expenditure that company A invests in. The authors of this memo walk the reader through the calculations necessary to ascertain this outcome after dealing with accounting aphasia (definition quoted below). This is a great practical memo with insights into how to more efficiently ascertain the return on investment, and profitability, of the companies you study.
“Aphasia is a condition that breaks the link between thought and language. It is the result of damage to specific regions in the brain and is usually caused by a stroke. Patients who suffer from aphasia understand images, ideas, or concepts but cannot convey them in words. The term comes from the Greek aphatos, or “speechless.” Accounting is commonly called the language of business. It is how a company communicates its economic results and financial position to current and prospective stakeholders, including shareholders, creditors, suppliers, and employees. These stakeholders want to know whether the company has a good business. Core considerations include the company’s growth, profitability, return on investment, and financial strength. Accounting can be aphasic. In many cases, the bottom-line figures that are consistent with generally accepted accounting principles (GAAP) fail to communicate the essence of a company’s economics.”
2) Schroders Equity Lens Q3 Outlook
A neat presentation put together by the folks over at Schroders looking to provide a blast of insight into how markets are fairing this year, covering regional performance, fundamentals, sectors and styles, and index composition.
An appropriate resource to replenish your knowledge of the global market happenings as we head into the latter half of 2022.
“Sustainable investing came under fire this quarter. Our research shows that more sustainable companies generally command higher valuations than their less sustainable peers. This is more pronounced in some sectors than others. Globally, value stocks continue to outperform growth. Much of the rotation reflects the sharp de-rating of expensive tech or consumer companies, whose valuations are sensitive to high interest rates and whose share prices had baked in very high growth expectations.”
3) The Dark Side Of The Semiconductor Design Renaissance
Source: (Semi Analysis)
A succinct memo about an industry I know little about, semiconductors. Despite my lack of knowledge, I read Dylan’s work often to bolster my understanding. This one, which talks about the “renaissance” of semiconductor design, whereby fixed costs are rising on account of major companies’ decisions to begin manufacturing and/or designing their own chips, was particularly interesting.
“The industry is rapidly shifting away from using Intel CPUs for everything. As Moore’s law slows, design is flocking towards heterogeneous architectures which are more specialized for their specific task. Specialized chips massively outperform CPUs if software challenges are solved, but there is a dark side to this specialization strategy. Fixed cost are exploding, and volumes are driven down massively for these designs. Semiconductors are an industry of economies of scale, and this is only becoming more apparent with each new technology generation.”
4) 6 Rules for Effective Forecasting
Source: (Harvard Business Review)
I happened to come across this article from Paul Saffo, written in 2007, about the trials and tribulations of forecasting, and how to become more effective at it. In this article, he demystifies the idea that forecasters are known to be predictors. Rather, forecasting is more so concerned with mapping uncertainty and identifying the full range of possibilities, not a small set of illusory certainties.
The findings can be applied to one’s investing philosophy, or even in other aspects of life (managing expectations, project planning, et al) and I found it to be an insightful and thought-provoking read. Perhaps my favourite of the 6 rules, is “hold strong opinions weekly”. Failing to do so, as Paul puts it can lead to the classic mistake of over-relying “on one piece of seemingly strong information because it happens to reinforce the conclusion he or she has already reached”. I believe they call that confirmatory bias in the investing world.
“People at cocktail parties are always asking me for stock tips, and then they want to know how my predictions have turned out. Their requests reveal the common but fundamentally erroneous perception that forecasters make predictions. We don’t, of course: Prediction is possible only in a world in which events are preordained and no amount of action in the present can influence future outcomes. That world is the stuff of myth and superstition. The one we inhabit is quite different—little is certain, nothing is preordained, and what we do in the present affects how events unfold, often in significant, unexpected ways.”
5) Ensemble Capital Q2 Letter
Source: (Ensemble Capital)
I enjoy reading Ensemble’s letters because their style somewhat resonates with my own, and shows a preference for ignoring the noise. With their fund being down ~33% YTD, the five-year CAGR has been squashed to ~10%, below that of the S&P 500 over the same time frame. As such, the fund is now underperforming and I, as a novice investor myself, find it highly educational to view how more experienced investors handle periods of underperformance. The first ~3 pages or so are largely macro-related, so investors who have had their fill of macro can skip to the middle of page 4, where Ensemble begins to reflect on their positioning, portfolio companies, and their thoughts for the years ahead. Amongst the discussion of individual names, the letter repeatedly presses on the idea that mass dislocation that now exists between quality businesses, their fundamentals, and their stock prices. As I mused last week on Twitter, investors oft preach that they wish to buy at reasonable valuations - until the time when those reasonable valuations present themselves.
On the way up, it’s all about “averaging up” into strong earnings, it’s “the stock market isn’t the economy”, “pay up for quality” and “I wish I could buy at cheaper prices”. As soon as shit hits the fan, those platitudes about searching for great companies at reasonable prices fade quicker than the taxman’s prospects of earning meaningful capital gains tax inflows. Investors go silent, retreating into their comfort zones, waiting for the market to turn up again. The mantra is that there is only one reason a stock goes up (genius stock picking ability), but thousands of reasons why it goes down (macro, thesis broken, competition). It feels comforting to receive immediate gratification during the good times, you buy a stock and it goes up. Repeat that several times, and it can alter one’s behaviour. If you are investing on a 5+ year time horizon, then we shouldn’t take too much from the price action in the following year.
“This rapid reduction in investors’ time horizons is characteristic of market panics. When humans become highly stressed, their mental focus shifts away from long-term considerations to prioritize short term considerations. For instance, even bearish economic forecasters today generally agree that the economy will recover in the years ahead. Recessions are not typically long events. Yet today, investors are ignoring the level of earnings that companies are likely to generate over the next 3-5 years and instead focusing on whether the coming quarter or year will generate results that are weaker than expected. This is a mistake that investors make time and again. It is such a repetitive behavior that psychologists have given it a name; “hyperbolic discounting”
6) 65-Years Worth of Buffett’s Partnership & Berkshire Letters, Articles, Annual Meetings and Memos
Length: Dense AF
Source: (Google Doc)
Nothing too much to say about this one, it’s mostly a case of sharing for those who are interested in storing it somewhere for later reading. The folks over at @InvestmentBook1 compiled a Giga Berkshire Hathway PDF that contains Buffett’s old partnership letters, as well as every single Berkshire shareholder meeting, annual meeting, memo, and a host of external Buffett articles from over the decades. It’s over 5,300 pages long, so perhaps something to appease your bathroom reading appetite for the next decade or so.
Other Items of Interest
Note: ($) indicates there is a paywall on this content.
• Reddit: A List of Fund Q2 Letters
• 1Main Capital: Q2 Letter
• Farnham Street: July Shareholder Letter
• Oak Tree Capital: I Beg to Differ
• Alta Fox: Q2 Letter
• Blackstone: It’s All in the Fed’s Hands Now
• Ensemble Capital: Seeking Treasures from the Storm
• 310 Value: Acquisition Accounting and Financial Analysis
• SemiAnalysis: The Dark Side Of The Semiconductor Design Renaissance
• McKinsey & Co: Balancing digital and physical channels in retail banking
🕵️ Company Related 🕵️
• Brad Freeman (PYPL): PayPal Write-up
• AlphaSense (AAPL): The Rise of Apple Bank
• Behind the Numbers (PEP): Pepsi Q2 Earnings Write-Up
• Stock Opine (BKNG): Booking Holdings Write-up
• Macro Ops (POWW): Sentiment Reversal Memo from a former bull
• MBI Deep Dives (SPOT): Spotify Q2 Earnings Write-up
• MBI Deep Dives (GOOG): Google Q2 Earnings Write-up
• MBI Deep Dives (SHOP): Shopify Q2 Earnings Write-up
• MBI Deep Dives (META): Meta Q2 Earnings Write-up
• The Verge (META): Zuck Turns up the Heat
• MBI Deep Dives (AMZN): Amazon Q2 Earnings Write-up
• Musings on Markets (ZOMATO): Zomato Write-Up
• SemiAnalysis (INTC): Intel Cuts Fab Buildout by $4B To Pay Billions In Dividends
• Canuck Analyst (HD): Write-up on Home Depot Struggled during the 2001-2005 Housing Boom
Here, I will share some audio/video materials I listened to during the last two weeks, that I feel are worth your time.
(1) Transdigm: Foundations with Nick Howley
A new podcast entry this week, the 50x podcast, from the folks over at Colossus, whom you may know from the Business Breakdowns and Invest Like the Best series. This series, 50x, is like Business Breakdowns on steroids, discussing the anatomy of extraordinary long-term investments that went on to generate 50-Bagger status. The maiden episode features a multi-part discussion with Transdigm’s Nick Howley and Rob Small. Unlike the relatively shallow introduction to businesses that can be found on podcasts like Business Breakdowns, this series has all the likenings of serious breakdowns of successful case studies, alongside the individuals who were instrumental in those successes. I think there is as much value in studying past case studies as there is in examining companies that exist today. I imagine this series will assist in that endeavour.
The first episode, musing over the earliest years at Trandisgm, the aerospace components manufacturer, is a fascinating conversation about roll-up M&A, in which Nick Howley would aim to acquire businesses at 5x EBITDA, sell them for 10x, and shoot for 20% IRR over 5 years. Of the ~50 or so businesses they have acquired, none have faced impairments, which is a mind-blowing statistic. Shaping up to be one of my favourite podcast concepts to date.
Guest: Nick Howley
(2) Going Deep on Payments
A fun conversation between Liberty, of Liberty’s Highlights, and Abdullah from Mostly Borrowed Ideas about the payments space, of which MBI has written numerous deep dives. Ayden, PayPal, Stripe, Square, Amazon, Apple Pay, Google Pay, Visa, and Mastercard are but a few of the companies and offerings discussed in this episode.
Guest: Abdullah from Mostly Borrowed Ideas
Just days after Adam Mosseri, head of Instagram, shared a video about how Meta would be sticking to their guns on the Instagram updates that received backlash from fans, he would sit down with the Platformer and walk back on the changes. Instagram users had publicly lamented the full-screen (TikTok-Esque) view that IG was testing on some users, as well as the acceleration of recommended content in their feeds, most of which were Reels. This had the Kardashians, one of IG’s earliest adopters for commercial purposes and most prolific users, circulate the below outcry, calling for Meta to “make Instagram Instagram again”.
Mosseri quickly folded, remarking that “we definitely need to take a big step back and regroup”. This means pulling back on the number of recommended posts making their way into a user’s feed, as well as phasing out a full-screen feed that has been tested amongst a small portion of users this year. It seems that users prefer the fact that Instagram is for friends, and TikTok is for discovering short-form video content not related to their social circle. However, Mosseri also acknowledged that it wasn’t just the complaints that stimulated a withdrawal, arguing that “usage data isn’t great” for the new feed designs. For the recommended posts (~15% of the content in a user’s feed and previously expected to climb to 30% by 2023) there was no word on exactly how aggressively Instagram would scale them back.
Thus, in their plight to become more like TikTok, fans of IG scorn them the second they begin to “lean in” to comparable functionality. It’s a rock and hard place situation for Instagram, but it does make me wonder how fans of TikTok will react as their platform inevitably begins to diversify outside of pure video-centric feeds and perhaps leans into social. The two social behemoths are bound to continue merging into one another’s space as time passes, and whilst consumers tend to use the apps for different reasons today (IG for friends and photos, TikTok for random hilarity and video), it feels as though that won’t be the case for too much longer. Meta has proven in the past its ability to quickly play catch up (and copy cat) and control the fire of competitive forces, but TikTok feels like a different beast. Back to the drawing board for now.
• Platformer (META): Instagram Walks Back Its Changes
Author of Investment Talk
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Tickers Mentioned in this issue: GOOGL PYPL V MA AMZN SQ AAPL HD TDG INTC SQ SPOT SHOP META PEP BKNG POWW