It ultimately comes down to free cash flow yield

0:10Travis Koldus from KCI Research and the investing group The Contrarian. Great to have you back on Investing Experts. Thanks for taking the time.

0:18Travis Koldus:You're welcome, Rena. I really enjoyed the last time we talked. It's been a while, but I was looking forward to speaking to you again. Yes, we enjoyed having you. I can speak for the audience and say that they enjoyed having you. enjoyed your insight so we're very happy to have you back on we'll leave a link to your last episode for those interested it was way back in january of 2024 which honestly every year seems like a different century at this point does it not if you could ground us in this moment as we're turning the corner on 2025 how are you approaching these markets and i guess maybe even before that if if you could give a brief refresher on what it is you exactly focus on and what your strategy is predicated on.

1:02Travis Koldus:Yeah, sure. And when you said January of 24, I was like, I actually thought it was longer ago. So it's weird how time melds together. But we've been doing this a long time now. I think I've been writing publicly on Seeking Alpha since 2013, if I'm accurate in that. And the contrarian has been going since December of 2015. We've got a long track record. We are generalists by nature, so we'll go anywhere. You know, we have a contrarian, you know, in that nomenclature, it kind of means you're going against the herd. I like to say, and we've learned this through experience, you kind of, it's really important to be contrarian probably 20 % of the time at major turning points.

1:44Travis Koldus:And then you want to ride with the herd, at times too, which is hard to do when you're used to going against things. So it takes some discipline. And we're looking for market trends. We're looking for things that are mispriced. We look forward to price discovery, which is one of the things we harp on. And I actually think that we've been in the golden age or a golden age of active investing since 2020. It's hidden a little bit because you've had these dominant market cap companies, particularly large cap technology companies that have dominated the indices and the passive investing today is just it's worlds apart from even what it was, you know, 25 years ago, it dominates, you know, the investing landscape.

2:32Travis Koldus:So we're looking for opportunities, you know, kind of under the surface. And it's really been a target rich environment, you know, the last five years, including the last year and a half or so. What would you say has made it the golden age of active investing the past five years? I mean, I would guess that ETFs are a big part of that, but what else would you put to that? Yeah, I think it's largely attributed to, because passive mining by nature is price insensitive, valuation insensitive. And so it distorts the market. And these companies are so big now. I mean, NVIDIA approached or got to 5 trillion a market cap.

3:09Travis Koldus:You have some 4 trillion market cap companies with Microsoft and Apple. And then you look, you know, I was looking like a month ago when the smallest company, the S &P 500 was American Airlines. And guess what the market cap of American Airlines was at the time? Keep in mind that so the big ones, you know, 4 trillion plus, it was 15 billion. So there's just an enormous gap between the largest companies. And it's not only, you know, the NVIDIAs and the Microsofts and the Apples and the Alphabets, you know, but even, you know, the next tier, like the Broadcoms are, you know, it's like$1.7 trillion now.

3:49Travis Koldus:And you go down to the, so that's just within the S &P 500. And those are, you know, 500 of the largest companies. I mean, there's a little gray area there, but the bottom of the S &P 500, you know, that size difference is huge. And then if you go outside of that, you know, there's just there's, you know, enormous opportunity in the smaller market cap securities. And that includes, I think, international stocks. Like I actually traveled. I went to Europe this summer. You know, we spent time in different countries. But, you know, like if you look this year, the ETF for Italy is up. I just looked tonight before we came on this podcast, but it was it's up 52.7 percent.

4:31Travis Koldus:You know, and I'm pretty sure most people wouldn't know that. You know, international banks have done really well this year, like Deutsche Bank is up over 100%. So, you know, we've had this rip-roaring bull market, you know, but, you know, people kind of gravitate to the NASDAQ and the, you know, Invesco QQ Trust, which, or QQQ Trust, which have had, you know, that's up 19.4 % this year. But there's a lot of things outside that that are outperforming. And I'm pretty sure most people don't know that. To your point quickly about the mispricings and small caps, we had Courage and Conviction investing on who specializes in small and mid cap stocks.

5:16And he was talking about all the mispricings there are for those stocks and how difficult it is to stay in those names sometime, even if you have the conviction. I'd also be curious to that point, if I may ask about what you said is doing well outside of the obvious names in tech, what would you attribute that to? Is that sector specific or those names specific? What would you say have been the reasons behind their rise?

5:44Travis Koldus:Yeah, there's various reasons. I actually know Courage and Conviction Investing. I haven't talked to him for a while, you know, because I've been I haven't written very much and sticking off. I'm going to write more here in the next few months. But he's a very good investor. Well, you're both fantastic. Sorry, I didn't mean to cut you off. I was going to say you're both fantastic people to be in touch with. I would encourage you. Yeah, yeah. And I used to read his work. I haven't for a while, but he's very good, like you said, as combing through kind of the underbelly of the market and finding securities that are mispriced.

6:16Travis Koldus:And, you know, so there's various things that drive that. I always think it comes down to ultimately free cash flow. And that's obviously driven by, you know, the profitability or revenue growth. And if you look at a lot of the stocks that have done really well, I was talking about this in our group the other day, but, you know, like Apple had a double digit free. I wrote a piece for Seeking Alpha on Apple in 2016 saying Apple was at the cheapest valuation in a decade. And if you look into that piece, Apple had a double digit free cash flow yield. Right. And, you know, the free cash flow yield for Apple today is, you know, maybe two percent.

6:57Travis Koldus:Microsoft in 2012, you know, same thing, had a double digit free cash flow yield. Same thing today. Microsoft, you know, is in the one and a half percent range. So there's a lot of companies that, you know, maybe, you know, people may know them, but, you know, the top of the market, those free cash flow yields are very low right now, even though they're still in dollar terms, they can generate a lot of free cash flow because they're so big. But there's a lot of companies that are yielding 10%, 12%, 15 % free cash flow yields. And one example of that is the precious metal equities right now. They've had a really good run this year.

7:37Travis Koldus:Newmont is the largest market cap precious metal name. But the free cash flow yield for Newmont is very attractive here. Now, people would say, well, gold's gone from$2 ,000 to over$4 ,000 an ounce. That may not be sustainable. But even if gold would pull back, you know, Newmont, even at thirty five hundred or thirty two hundred dollar gold would have a double digit free cash flow yield. And, you know, vis a via the relative to the, you know, these large cap technology names, which are all low single digit, sometimes even, you know, Amazon and Meta are actually negative free cash flow yields here.

8:12Travis Koldus:So that's that's very attractive. And Newmont's not a small company, you know, like Courage and Conviction. I know that he is in some very small market cap companies, and we are too, to be fair, smaller ones. But that's just an example of there's opportunity, and you just have to look beyond what the biggest holdings in the popular indices are. Which is difficult to do these days when that's all it seems anybody is talking about when it comes to investing. It's hard to look outside of the main names that are constantly being talked about and discussed. Last time you were on, you were talking about REITs and how that was a space that you're looking at.

8:56With all the conversation about lowered rates, and maybe that may not happen at the next meeting because of what's happening with the economy, What would you say about the REIT side of things, real estate maybe, and how interest rates are figuring into your investing lens?

9:14Travis Koldus:Yeah, that's a great question. I've written almost, not every year, but I've written a piece like around August or something for Seeking Alpha. I haven't done it the last couple, but I've written it on realty income. And, you know, my thesis there was that, you know, it had really gone nowhere for a long time. And if you look back on my, you know, series of articles there, I was just saying that when the starting valuation, and it goes back all the way, you know, seven or eight years ago, they started writing about it. I said the starting valuation was high and, you know, the interest rate environment at that time was the zero interest rate environment and it wasn't conducive to total returns.

9:59And so if you look over the series of those articles, realty income has underperformed.

10:05Travis Koldus:Ultimately, starting valuation is incredibly important, right? So if you went back, you know, realty income, you know, I'm getting older now. You can see gray in my beard and I've been doing this a long time. But when I started, you know, one of my first jobs working at Charles Schwab as a investment analyst, senior investment analyst giving at that time was one of the first time that registered brokers at Schwab gave advice. and that was you know schwab was um because i started american united life and then schwab like around 2000 99 2000 and it was interesting because we were recommending realty income at the time and reits and nobody wanted them right because reits had really gone through a period of underperformance and as you know in in the markets people kind of even you know back then people will chase performance and they look back what's done the best over the last five or ten years and REITs hadn't done well.

11:03Travis Koldus:Well, REITs did really well. Realty income grew into what we know it is today, which is one of the largest market cap REITs. And it's got a cult following almost, right? But it had this tremendous price appreciation and that occurred over the next 15 years or so. But what had happened is when you were buying realty income circa 2000, It was, you know, unloved, under-owned. And, you know, the starting valuation was very compelling. It had a long runway, you know, to grow into. But by the time you got to, you know, 2016, 17, 18, you know, a lot of people loved real income. REITs had done pretty well, you know, because you had been in a low interest rate environment.

11:50Travis Koldus:And what ended up happening was a lot of the good news was priced in then, you know, at that point. And really on a total return basis, you know, realty income has dramatically underperformed the market, you know, the S &P 500. But the interesting thing is, is when you go through a long period of underperformance, you know, that kind of, you know, sentiment, you know, goes from bullish to bearish. It resets, valuation gets reset, you know. And so you had this long consolidation period where realty income, just to use that as one specific example, representative of REITs, it's really underperformed.

12:28Travis Koldus:But that's setting the stage for the next period potentially of outperformance. So you could make the argument today that something like realty income, because it's gone largely nowhere for a long period of time, it's a lot more attractively priced from a starting valuation standpoint. And, you know, it's interesting because we've been in, I would say, like a muddle through economy since 2022 in the U.S. And but you are going to see rates come down here and there is, you know, leading indicators of construction activity are really high. You know, obviously the housing market, I think there right now there's a downturn in 39 out of 50 states for housing prices.

13:10Travis Koldus:So we're going through this, you know, it's a buyer's environment now in the housing market. You're seeing, you know, rental rates or rate increases for rentals are coming in, you know, but it's setting the stage for what would be the next bull market in REITs, you know, including something like realty income. So, but you've gone through a long period of underperformance for that. And what else would you add to the macro conversation? What else do you think that investors should be thinking about when it comes to the macro conversation? Looking at a few things today, and I was surprised because you look at the P-E ratio today for the S &P 500, it's high, but it's not unreasonable.

13:59Travis Koldus:Now, you're looking at like a 31 PE ratio for the S &P 500. In November of 1999, it was 29. And so of 1999, it was 29. So pretty high. But other measures of valuation for the broader market, like the Shiller-KPE ratio, today it's 40.4. In November of 1999, it was 44.2. I think that's actually a little understated today because the largest capitalization technology companies, you can make an argument that they're not taking, they're extending their depreciation schedules. That's what Michael Burry of The Big Short famously has articulated here. And, you know, very timely because, you know, he just has closed his fund.

14:49Travis Koldus:Right. And he closed his fund in 2008. It reminds me a lot of Julian Robertson closing his hedge fund, you know, two weeks after the market topped in March of 2000. So, you know, valuations are high. You know, Buffett's market cap to GDP in November 99 is 163 percent. Today, it's 216 percent. I was actually surprised, you know, just researching it before we talked. But in 2021, it got to 220 percent. So we, I would say we've kind of had like an echo bubble. You know, the first bubble peak was, was 21, you know, when you had a lot of SPACs come out and there was just kind of euphoria in the market and people were speculating, you know, with their stimulus checks and so forth.

15:36And then, you know, we had to decline into 2022, you know, the market bottom in October of 2022.

15:43Travis Koldus:And it just so happened that, you know, OpenAI released ChatGPT in November of 2022. And then NVIDIA famously came out in May of 23 and said, hey, there's going to be another huge wave of spending. And they were right, you know, and it was concentrated right at the top of the equity market, you know, with these, you know, People talk about circular spending with OpenAI doing a deal with Oracle, which does a deal with NVIDIA or NVIDIA invest in OpenAI and OpenAI does something. And so we've had this, I call it an echo bubble, you know, in the broader equity markets. And it's driven principally by, you know, the artificial intelligence.

16:29Travis Koldus:You know, people are wanting to commit capital to that and they're doing it in a record way. And NVIDIA has actually been the leading player there. And they rocketed to the largest market capitalization company in the world. So, but that seems to be, there's some skepticism now. And just recently, I would say the last month or so, some of that speculative froth, especially in the second tier names, under the surface, is starting to dissipate. And there's questions like, I was thinking about this too. So, you know, like if you go back and, you know, like when Microsoft came public, you know, the valuation wasn't that high from a, you know, from a traditional valuation basis, P ratio, peg ratio, price to book, you know, and a market cap.

17:19Travis Koldus:It wasn't a big market cap. And even, you know, even when Alphabet came out, not a big market cap. You know, NVIDIA, the same thing. NVIDIA was$19.99. So if you were an investor in those IPOs, there was just a tremendously long runway. But if you talk about things like OpenAI today, they're talking about coming out maybe a$1.5 trillion IPO or SpaceX, similar. There are enormous market caps. And so just, again, the starting valuation is because investors, there's so much more venture capital today and there's pre-IPO capital and seed money and things like that. But, you know, you're not going to have the opportunity to have these runways that, you know, if you invested in Amazon or Microsoft or Alphabet, you know, which was Google when it came out, they, you know, they were much smaller, you know.

18:09Travis Koldus:So, but the function of, you know, these private companies like OpenAI having such high valuations is I think we're at the top of that echo bubble, you know, from a macro standpoint. But very similar to 2000, you know, 1999, 2000, there was a dichotomy because, you know, you have these companies that on one hand, and today they're in the biggest company, they're trading at, you know, high multiple valuations. I think the best thing to look at is price to sales. And remember Scott McNeely from Sun Microsystems said, you know, if you're trading above 10 times price to sales, you just basically cannot make a positive return as an equity investor.

18:50Travis Koldus:Well, like Palantir is trading at 100 times price to sales today, you know, and Robinhood was 40 times price to sales here recently. And, you know, even NVIDIA, you know, the price to sales multiple is way above, you know, the 10 times and it's the largest market cap stock in the world. So the starting valuations are just so high, but the dichotomy or the bifurcation is on the other side. you have a lot of stocks that are really cheap, you know, and they could be, you know, things like Campbell's Soup or Hormel, which have really come down. Those are staple type companies. You know, they could be energy companies, you know, which are, you know, energies, even today, a record small amount, you know, it's like 2.5 % in S &P 500, smaller than even it was in 2020 or 2021.

19:38Travis Koldus:So you have to look beyond, again, the largest companies. But some of these companies are still big. Like we mentioned Newmont earlier, it's got a very healthy free cash flow yield. It's not small, but it's just different. And it's small. $100 billion market cap for Newmont is small compared to the$4 trillion plus market caps for the large tech companies. Yeah, that's kind of the macro overview. And I'll add one more thing to that. The last thing I'll say is, and I was thinking about this, something I want to write about more. But, you know, Japan, at their peak, they were 42 % of the world's market cap in 1989.

20:19Travis Koldus:You know, and Japan has a smaller population than the US, you know, and it did back then. But if you looked at the biggest companies in the world, you know, at that time, they were all Japanese. Right. Well, you know, we kind of similarly, I didn't even realize it. But in in 2021, the U.S. was like 62 percent of the world's equity market cap. you know, we had the biggest companies and then they've, those biggest companies have all gotten much bigger, but we peaked somewhere around 65 % earlier this year. We're back to like 62, 63%. That's partly because the rest of the world has outperformed, but very similar to how Japan was in 1989 when capital from the rest of the world was flowing into Japanese equities.

21:04Travis Koldus:You know, we've had that here in the U S the last couple of years. And if you go to like the South Korea Stock Exchange and look at their most traded by volume issues, it's like two times Tesla product or a Nvidia product. If you go to Mexico, it's the same thing. So the rest of the world, because our market had really outperformed for a long time, capital has gravitated towards the US. And again, very similar to what happened in Japan. But the key thing with Japan is they peaked at 42 % of the world's total equity market capitalization. But then today they're around 6%. So the Japanese companies are still excellent in many regards.

21:50Travis Koldus:But we didn't know it at the time, but it was just this once in a lifetime type thing. But I always say in the equity markets, once in a lifetime happens every two or three years. But in this case, I think the U.S. looks very similar, in my opinion, to how Japan looked in the late 1980s. And obviously, like in 1985, you had the Plaza Accord and it altered the currency market. This year, the U.S. dollar is down 8.6 % versus a basket of international currency. So that's helped. You know, and that's why things like the, you know, it's helped returns across the board because most things are priced in dollars.

22:36Travis Koldus:But then, you know, the Italian stock market is at 52.7 percent. The emerging, you know, market ETF, EEM is up 32.6. The developed market, you know, Europe and Asia. So EFA is up 28.5. They've all outperformed the U.S. But part of that is you've got some depreciation in the dollar. So that's the last point I just wanted to highlight from a macro perspective. I think that's very instructive. There's also this conversation with all the conversation around bubbles and are we in a bubble? When is it going to blow up? Is this time different? And I think there are many opinions that it doesn't feel instructive to be looking backwards or looking at past bubbles.

23:20And I think you've brought up many points why it is instructive to look at the past and see what we can learn from it. Yeah. Is there anything you would want to add to that?

23:30Travis Koldus:Yeah. And I would just say that sometimes, you know, that Japan that took a long time to ultimately it was like a wave that crested for a long time and peaked. We don't know if we're at, you know, I would have said if you could go back in a time machine to 2021, I would have said, hey, this feels like a peak. right? Because the market cap to GDP, the Buffett ratio was higher than it is even today. You had all these SPACs that were coming out. You had tremendous speculation. It felt like a peak, right? And then you had the decline into 2022. And then, you know, we had another bubble, I call it the echo bubble that came out of, you know, ChatGPT OpenAI, which came out in November 22.

24:10Travis Koldus:And then NVIDIA famously came out in May of 23 and said, hey, there's going to be another huge investment wave. They were right. So you don't know if we're peaking now and then there's going to be one more wave after this. It's hard to tell when you're in the moment. We just said how fast time goes by. It does go by fast, but it also can go by slow when you're actually living through it. So you have to be cautious because, again, a lot of people would have said 2021 was the peak, but we're actually the market cap of the biggest companies today. They dwarf what they were in 2021. Hard for me to imagine that it could keep going, but you just don't know.

24:48Travis Koldus:Now, the positive sign is that, again, outside top market capitalization companies in the major industries, there's tremendous opportunity. And so that should be the takeaway because it's always hard to time the top of a bubble. But I think as an active stock picker, you should just say, hey, be aware of the environment. The last time we saw something like this was Japan in the 1980s, I would say. Be aware of it. To me, it's kind of a hybrid of tech and telecom bubble that peaked in 2000 and then the nifty 50 in the 1970s because similar to the nifty 50, you know, the top 10 companies in the S &P are 40 % of the market capitalization.

25:24Travis Koldus:That's how the nifty 50 was. So it rhymes with those eras and it rhymes with Japan, you know, but it took a while for the price discovery process to play out. And in both of those eras, in 2000 to 2002 in the US, value really outperformed. There was a lot of opportunities, even with the S &P was down 42 % from 2000 to 2002, but a lot of value stocks were up. Same thing in the 1970s. There were a lot of things that really outperformed. You had a big correction from 73 and 74, but a lot of value, small cap, commodity-oriented names really did well in that environment. Japan was a little little different because it was harder to pick stocks, you know, against the tide.