Mailbag: incl. Andrew answers a Bitcoin question - concisely! November 19, 2023

28:26Don't just swallow the good news because you want to believe that this might happen. Again, it might. So I'm not saying it won't. I'm just saying just be really careful because the market's telling you this thing is a very, very, very, very low probability outcome. Just because you can put it in a DCF and say, if they did a billion dollars in profit in five years time, it's worth this much. That's true. As I like to say, if my grandmother had wheels, she'd be a bicycle. And so, you know, the if thing is the biggest small word in the English language, as I like to say, just be a little bit careful about that as well.

28:56It's such an excellent point. I mean, by the way, it feels crazy when you do some of this analysis and you kind of go,$50 a share, it's$1.40, what gives? And that can actually create another problem. Well, actually, I'll go back to my Pointero example, because as it was going to the moon, I was sitting there with a valuation on straw man that would be, I don't know what, 20 cents and here it is trading at 70 cents. And you feel, am I that wrong? Is the market that wrong? Well, I guess they could have a bit more of a market share and maybe I've been too conservative on the margin and maybe I could do this.

29:32And I don't think you consciously do it, but you definitely subconsciously, you sort of curve fit your valuation. That's so true, mate. Especially when you want to keep it. And it's really, really tricky. But the point I was originally going to get it is that is actually absolutely the upside potential, if and if, right? Your point and underscore that is the fact that there is such a discount, that there is a near, what is it, 30 to 40 bagger in plain sight, is that the market doesn't, I wouldn't say doesn't think it's going to happen, but understands the very significant risks between now and that outcome.

30:12And that is something that I think you articulated well because just statistically, not this specific example, but statistically most of these kinds of companies don't end up making it. Not because they're cheats, not because they're liars, just because it's just really, really, really hard and a million things can go wrong with the best of intentions. So I'll just come back to my original point, which is this is why you have to be super honest with yourself with conviction. 25 % I'll be honest right now I don't want to say what it is and it wasn't through design but my largest position is more than 25 % of my portfolio right now and so I'm going through the exact same thing it's like can I really I mean come on that is ridiculous but I'm super high conviction on it so it's a very real thing but that I will I am the kind of person who is pretty happy with a very solid weighting on something that is high conviction but I'm certainly not blind to the the risks that is very much a lot.

31:03There's a lot of eggs in that one basket and you, you, it's very exciting when things are going up, but things can change really rapidly on, on the downside as well. So I think you've just got to walk that fine line. I wish I had, I wish I had a clear answer. I'm going to say one last thing, Matt, really quickly, because you made a great point about conviction. And I think, I think the investment community writ large, not Matt, but the risk of large overuses conviction. It's like when we say, if you've got a valuation, yeah, I did a DCF. I put some numbers in the spreadsheet and that's what came out.

31:34So I've now got a number. Or have you got conviction? Yeah, I do. And I like to say that conviction needs to be based in some sort of objective reality. And it should be by definition, but often for a lot of investors, it's not, right? The investor who wants to believe says, management says this is worth a billion dollars in a few years' time. Therefore, I'm going to use that number and i would say other than because you want it to be true how much conviction do you have in management's ability to forecast that result in other words what have you done to prove out your thoughts in terms of that conviction you know can you really have conviction or do you go to the management saying oh we're gonna try and do this is that is that conviction can you have conviction now if the manager has done it 15 times before then probably yeah if it's a startup or a relative young company or a loss-making company and managers promising to do the x y and well okay you know how much conviction can you genuinely have in that ram says tomorrow strongman's gonna be a billion dollar business by christmas now we all know ram so of course we have high conviction in his view on that because he's a trustworthy sensible guy who's you know to the moon baby running his business to the moon but if i said hey i've started up a handbag company i know nothing about handbags but i'm gonna sell a billion of them by christmas and you do the maths and say well, hang on, Scott's trying to sell a billion$5 ,000 handbags and they cost 25 cents each to make.

32:58So by Christmas, this should be$100 stock. It's fair to say, I don't think you should have conviction just because I said it was a thing. And so I guess I just want to make that last point because it's, you know, conviction, it's easy to say I have conviction. I think if you could objectively, you know, substantiate that conviction, then you're much, much closer. Don't fall into the trap of wanting to believe and so convincing yourself you have conviction because you just want it to be true and management said something or a broker said something or if things go well, this could be this. If is doing a lot of heavy lifting in all those sentences.

33:35Yeah, it sure is. And I guess too, you can kind of have it a little bit each way. It's not as though the choice is 50 % holding or 2 % holding. That's the point. And this is kind of where I've personally got to. I feel as though I'm getting to a point where it's like maybe I'll just sell a little bit, but still maintain a very heavy holding. I don't think I'd actually, if I was just, the way I've often framed it before, which I think is a useful mental exercise is just to say, if I, if my entire portfolio was converted to cash right now, would I, what would I buy? Would I buy the exact same shares in the exact same way?

34:08And it's just like someone waved a magic wand and there's no tax considerations. There's nothing. It says, whoops, stockbroker made a mistake and liquidated everything. We can press a button and make it whole again, or do you want to put it somewhere else? and it shouldn't make any difference, but I think all of us would agree it would. You just, for whatever reason you do that. So I don't think I would go in with such a heavy weighting,

34:31but it's still a little bit of a way to have your cake and eat it too, even if it continues to moon, right? And it goes up and it goes up and it goes up and you've only sold down when you got to, say a 30 % weighting, you're still doing extraordinarily well, right? Not as well as you could have if you held every last share. But yeah, yeah. It's a tough one though. That goes to the crux of his questions. I think it's perfect. Motley Fool Money. For more, subscribe to the free newsletter at fool.com.au forward slash listener.

35:05Mate, I'm a little bit concerned. I don't know what shilling you've been doing on Straw Man to get people to send questions saying nice things about you, but I don't appreciate it. And it needs to stop. Bring it on. What have we got? Greetings, Scott and Ram. I found Ram's simple analysis on Domino's a few weeks back very useful in trying to value the future growth of a company into today's share price. He used assumptions of 5-year time horizon, 15 % EPS growth, 10 % expected return, and a 25 PE ratio. It basically determined the share price on the day was higher than the value he calculated, so he implied that he would wait for a better entry point.

35:43I put this to the test on some of my current holdings, like Domino's, LaVisa, CSL, and also to some I'm interested in buying at some point, like TechnologyOne, ARB, and Macquarie. That's a great list of companies, by the way. It's good, isn't it? Looking at a 10-plus year investing horizon, which I also really appreciate. My question is, in applying RAM's theory, I also included a margin of safety of between 20 % and 30 % on top of the analysis. So is it correct to do this, or do you just tweak the assumptions based on more specific company and or industry averages? I don't want to overanalyze it, but I'd appreciate your thoughts and tips if Ram could, as he always does, quote, square that circle, end quote, for me.

36:25I have to say, I've listened to a lot of investing podcasts over the years and that was the simplest, most practical example I've heard to analyze a company's growth prospects using some simple assumptions. So I appreciate all that you do for us, quotes, retail investors, end quote. Regards, Anthony. Well, Anthony Page, thank you for writing in. It's very nice of you to give Uncle Andrew a bit of a wrap there. No. Thanks, Anthony. Mate, it was and always is a great summary, mate. You've done a fantastic job and our listeners are absolutely spot on to give you a wrap for it, mate. So, well done.

36:57My head gets super big. How do you apply a margin of safety when doing this sort of DCF? and I'm going to embellish Anthony's question because you can do not enough and everything looks cheap. You can do too much and buy nothing because, well, I want an 80 % margin of safety. Well, you're never going to buy anything. Or you say, well, I want a margin of safety on margins and I want a margin of safety on sales growth and I want a margin of safety on valuation. I want a margin of safety on discount rate. You can layer these things so that, you know, Berkshire at$20 isn't worth buying because you've convinced yourself it's only worth 10 if you assume that all these things.

37:33So how do you think about marginal safety when it comes to your DCF work, mate? First of all, thanks for the really kind words, but also margin of safety, what Ben Graham has said, the three most important words in investing. And I think it's pretty much up there. They're all guesses, right? And the other thing is any of these models, whatever model you want to use, is very sensitive. So, you know, you and I could get into big debate as to whether we should use a discount rate of 12 % or 9%. Yeah. Is it really that big a difference? We get remarkable outcomes on that. We would get very different outcomes though, right?

38:09And then we might have a slight difference on your point on net profit margin or other little things. It seems like you would look at it ordinarily and go, oh, these guys are basically in the same ballpark with all their assumptions. And yet you think it's worth$21.83.6 and I think it's worth$85, you know. And it's sort of, well, who's right? So it's, I mean, this is the crux of where Anthony's coming from, right? Like I get it. It's tricky. So, I mean, there's no, again, there's no right answer as long as you've got some kind of margin of safety in there. I tend to do it the way, I'm not sure if I mentioned this when we were talking about the particular example, but one way I try to sort of mitigate it is to do a spread of valuations rather than just one.

38:52And it doesn't have to be super complicated. I just have my, here's the best case scenario. As much as I can imagine within the realm of possibilities, this is the best profit growth they'll get. This is the best multiple that the market will trade at. And I only want a 9 % return per annum because I'm so high conviction in it or whatever it is. What number does that give me? It might be my sort of silly valuation, but it gives me some kind of ceiling as to what might be plausible. Then my best case and then my worst case. Like actually all of these assumptions, I mean, I don't think anyone thinks Domino's is going out of business tomorrow, but I can put some pessimistic numbers in there, right?

39:30I can say, well, earnings drop in half and they stay there for three years and this happens and that happens. And what does that number kind of look like? So that, and then don't apply any sort of margin of safety, just use your best guesses. And then you would sort of say the share price itself offers a margin of safety if that even the more bearish assumptions aren't miles away. the valuation using your most various assumptions still doesn't doesn't look too bad in the context of of the current share price in other words maybe you could get something similar to that does that make sense in which case you think okay that's that's pretty good alternatively you don't even have to change what growth rates or anything you're assuming but as i said before just just the discount rate and i tend to do this a bit for something that is a bit spicier a bit earlier stage do i re would i really i mean why am i valuing this thing basing it on a 10 discount rate is that is that my idea of success i take all of this risk in an early stage company and it delivers on my my expectations of earnings growth and multiple and the rest of it i get a 10 return per annum i can probably get that with an etf so i think in those kinds of cases it's not unreasonable to sort of say well maybe i want 12 13 15 even um i mean can i unpack that because Because, yeah, I think it's really important because I don't – I was going to say, up until you finished that comment, I don't use different discount rates because I don't believe in it conceptually as a different discount rate.

40:58But what you've done, and I think it's a really, really good idea and really thoughtful way to do it, is it's not really a discount rate in the traditional way that you do a weighted average cost of capital, blah, blah, blah. you insert, instead of a weighted average cost of capital or risk-free rate plus an equity risk premium, all the usual jargon, you've used that to basically make that your hurdle rate. And you've said, I want this sort of return. So to get that sort of return, we're going to have to pay this price. And I think that's a really, really, really smart way to use discount rates.

41:28Because I never change the discount rate on the basis of risk adjustment of anything. But when you start to think about, actually, as you say, I can buy will you get a 10 % return. Why would I buy, you know, Philips's handbags and get a 10 % return, given that every possibility is not going to go well? I would like a higher return. In other words, I need a cheaper price to allow for that amount of risk. I think that is what you've explained it beautifully. It's a really, really nice thing. I hope our listeners take away. I'm glad you picked up on that, actually, because it is worth emphasizing.

41:58When you, and I mean, I think we've both been on this path. You first get into this and they do give these highly technical descriptions of what discount rate is appropriate. And you do have things like the risk-free rate of return. And by the way, this is why we always, you and I, talk about interest rates nonstop every Friday, right? Because it matters. And it matters for sort of when people are calculating discount rates and how they look at the valuations of shares and bonds and every financial asset in the world. So it's sort of massively important. But it is at the same time a mugs game because I have no idea what the interest rate is going to be next month, let alone what's going to be five years hence.

42:32And also what size risk premium does Mr. Market want in the year 2026? I don't know. Maybe not much. Maybe a hell of a lot. So it's just, yeah, I've always, long ago just thought, well, I don't really care what the technical version is. Given the risk that I feel as though I'm taking, what's an adequate return for me? and the way that the maths works, because I'm really just, I'm forecasting a price in the future and then saying, well, to get from today to there and the desired return, you know, how does the maths kind of work out? And it needs to work out that if I'm buying a pre-profit small cap, well, it needs to be more than it does if it's buying CSL or something like that.

43:12Right, right. To allow for that uncertainty. Yeah. But again, again, you know, you will find, this is the great thing about, spreadsheets are the greatest invention ever. I'm an unashamed nerd when it comes to them. But the fact that I can actually set everything up and then just change the variables and everything recalculates is so cool. So just build a really basic, just put a few formulas into some cells and then just change it. What's the discount rate look like? 11.5%, 12%. And again, test a variety of different things. You'll get a skew going out into the future and the range will be really wide.

43:48but you just know that you've got, well, you don't know, but you, I certainly feel better about myself when I do these exercises and the share price is currently towards the lower end of all that range. In other words, if, if my wildest dreams come true, I'm going to make a fortune. If, if it goes as expected, I'm going to get an above market average return. If it doesn't go quite as good as I want, there's probably not too much downside from here. Like that's, that's it. And I just, I know I repeat myself on that, that kind of idea, but that's, That's what I'm trying to do. That's what I'm trying to do.

44:20And I'll do it over and over and over and over and over again until, in fact, knowing that a bunch of it's not going to work out, but the math tends to work out when you roll the dice enough, provided they're loaded dice. And they will be loaded if you skew things in that manner, where the market is giving you a price that accounting for all this uncertainty in the future, at least positions you in a good spot to benefit really nicely if things go well, but to avoid the worst of it if things don't go exactly to plan. As Katniss would say, mate, may the odds be forever in your favor. Exactly. Hey, let's finish with a philosophical question, Ram.

44:58This one's from Juan who says, hi, Andrew and Scott, brackets in alphabetical order. I'll have you know that I don't appreciate it. Thank you for the amazing job that you two do with the rants, deep, deep tangents and rabbit holes and educating us a little more every day you should be pleased to know that by doing that and us doing the same with our families you are cultivating prosperity for future australia so not a small thing that's very kind one thank you very much he says i'm one of the lucky ones that has had questions answered on the podcast before but that time they were more the tactical type this time i'm aiming for more of a debate oh dear and one i think deep philosophical one so here's the two questions around i think i'm a little bit nervous a little bit shorter i know in answering another listener's question recently you were talking about what could threaten heavyweights like the fangs so that's facebook apple amazon netflix and google well you make a good point that any resemblance of competition they would just buy it out in my mind there is one big threat governments wouldn't an anti-monopoly policy like the ones that have been explored in the past already be a big threat to these companies.

46:07I'll jump this one first, mate, because I've made you go first. Yeah, please. Two things. Most of the purchases will be done while these companies are small enough not to attract competition watchdogs. If Microsoft bought Amazon, there'd be some issues. If Amazon buys a little online store shop that's doing something or a bit of technology that does a particular thing, they're less likely to attract the ire of competition. czars, but it's absolutely possible. Second thing I would say, though, is in the case in the past where things have been broken up, the most famous example is AT &T, the telecom company in the US, was broken up in the early 1980s.

46:46The combined value of all the broken up bits went on to be extraordinarily large. And so I don't think you, as a shareholder, if they are broken up at some future point, there's a decent chance you're actually standing to do as well or better, having those broken up eventually than the businesses that they own currently in a holistic level. So I'm not worried about either. How about you, Rem? Yeah, not in the slightest. I mean, this is speaking of philosophy. I have a pretty sort of pessimistic, cynical philosophy when it comes to these kinds of things. And that's because big companies that are, if you're at the stage where you've got like antitrust regulation looking over your shoulder, you're big and powerful enough and can afford the best lobbyists.

47:29i mean i am so depressed saying that sentence i would love to have the world different way and i'm going to endorse it in fact i'm very much against it it sickens me to my core but i mean look at microsoft it's one of the biggest companies in the world they had all that antitrust uh stuff that's right ancient history you know you you internet explorer i imagine yes i had regulators saying michael you can't use it is who used to explore anymore but at the time it was it was seen as a big deal and they've gone a huge things yeah I'm sure it had an impact on the share price at the time like I'm sure it was a it was a big deal in in in markets but I think when you step back from it it's just sort of like again you you ask yourself you don't say this is what I think is going to happen you say well what could happen what does that look like if that happens and what it looks like if it happens is you'll get well a little bit of a slap on the wrist they'll change the rules a little bit you'll pay a fine and you'll go on making scolions of that's what's probably going to happen right and again that's that's super depressing but it's yeah these kinds of things don't don't keep me i mean that is a risk when i look at some of these businesses don't don't worry me too much i think that's it i think actually that's the point is it is it a risk yes uh do i feel like i would invest in them anyway yes at least i'm i own i own shares in amazon i own shares in alphabet which owns google so for full disclosure while we're there uh mate one goes on brace brace brace this is when you should get nervous here is the philosophical observation and it is around your many many conversations around the concept of money i would just like to throw a couple of spanners in the works god and nations if you would rather refrain from making any comments about god that is fine but wouldn't you agree that nations he says and gods are like money in the sense they are simply ideas accepted by enough people to make things work how crazy is the concept of the australian economy when both australia and money are just made up ideas i'd love to hear your thoughts thank you as always from a fan that listens to your pod at one time speed the only pod i cannot fast track while actually running in the morning that's for one i love that question thank you it's a really nice one and i'm glad you get some value out of it while you're running uh just don't run off the road um what do you reckon mate how i mean we've talked about these sorts of things before how crazy is it uh having a Australian economy when both Australia and the economy are just figments of our collective imaginations yeah i mean actually i i 100 % agree i mean it's all made up this this is the thesis behind sapiens which i really enjoyed it's a few years old now uh who was it harari uh um Israeli author, an academic, wrote this book.

50:13Anyway, it's fantastic. And there are things like our political structures, our laws, money. There's all just a shared narrative. I mean, it doesn't mean anything to anyone except those that choose to believe in it. So, I mean, it makes it sound, oh, therefore, it's not important. It's like, well, no, it's actually super important to the ape species that happens to use it as a tool. And so, yeah, I think I can agree with that as a statement saying, yeah, it's all made up. But then, you know, so is the Bill of Rights. So many human rights, right? Human rights don't exist, okay? By the way, I'm a big staunch believer in this thing, even though it's a made up thing and some people got together and we sort of over the years, we've got this idea of what it means to be a human.

51:02But there's no tangible objective reality of what that means or the rule of law or any other kinds of things. So I have a foot firmly and happily in both camps and read Sapiens and he'll explain it much better than me. But yeah, it's all made up. But yeah, it's massively important. Yeah, I think it's a frame of reference thing. I think I completely agree with you, mate. I think firstly, as you say, it is the thing that separates us from the rest of the animal kingdom. Not from animals. We are animals. but we're just a particularly evolved type of animal. We'd be in small tribes without these shared narratives.

51:37Well, even though small tribes require those narratives, mate, because they even require loyalty or love or trust. I mean, anything that is interpersonal is literally made up. I mean, what is loyalty? What is trust? What is love? What is fear? What is envy? These things are all emotional constructs that we either restrain or don't restrain, that we either combine and coordinate or we don't. That's kind of how they work. You know, you trust your partner not to be unfaithful. What's faithfulness? What is trust? What is monogamy? Again, we can, you know. You did say it was going to get philosophical.

52:14Right? Well, that's what I'm saying. We're supposed to say about something like 15 ,000 drinks and, you know, talk about this at the bar all night. But given it's 8 o 'clock in the morning, we shouldn't. But, you know, it's that kind of idea. And I think it's a perfectly good question. and i think but i think it's it's you've kind of alluded to this matter maybe you've even just said it outright but i think what i'd say to hawaiian from from that perspective is it's not the bug it's the feature you know yes it's the thing that animates us as a species and i think you can absolutely say it's crazy i would actually say on the same thing and this is befitting my personality i think it's wonderful i think it's incredible i think it's amazing i think it's astonishing um and crazy but i think the positive of it is is it crazy yes but if it was too crazy then we wouldn't have got this far because we would have blown ourselves up literally literally metaphorically at some at some previous point um because of exactly that and i think we still run the risk of that right because we are reliant on shared norms and values As you said, Bill of Rights, laws, you know, there are police forces, but most of us just accept that driving on the left-hand side of the road is probably a good idea in Australia because if we don't, we're probably going to die and probably kill someone else.

53:29Yep. So that's crazy. Driving down the road, driving down the road in peak hour on a six-lane freeway and assuming or hoping that no one's going to come the other way on your lane. That's, I mean, you know, that's crazy. That's mad. That is absolutely madness, right? but we do nothing to stop there's nothing to stop you to doing that though right is there you could someone could just be driving yeah yeah why wouldn't you because you know laws are made up and and well go on well i i was that's a lovely tee up because that's exactly why it's sort of all crazy but still not well a very useful it's not useless at all but it's also practical i think as an investor when you're looking at a lot of these things what you tend to find is that they've they have utility and they tend to have more utility the more people that use them a great example would be english this weird right i think it was a nordic kind of splinter language that you know spoke by like 10 000 people you know a few thousand years ago and now it's the global language of earth you've got that you've got spanish chinese and there's a whole range there's tens of thousands of languages that we'll never know and have been lost because English is useless if no one speaks it and it's really useful if everyone speaks it so that's why I'm always crapping on about network effects like it's it's the all it's it's the network effect this is why the US everyone uses the US dollar at this point and why Russia and China are saying we want out and can't get out because the network effect is is massive again are they stories yeah could we have a better one yeah sure let's all speak esperanto it's much easier language to learn and was created by linguists in the 70s you know it's like why don't we do that because there's no network effect there's no there's too much the barrier to get over so you can sort of look at these things and recognize them for what they are i.e shared narratives but they are the bedrock of of civilization and you know good luck trying to change some of these no they do they do obviously change over history gradually and then suddenly, as they say.

55:36But, you know, that isn't a platform to launch into Bitcoin, although is it? I don't know. No, it's definitely not. But yeah, anyway, that's my two cents. Yeah, I think that's right, mate. I think it's 100 % spot on. I don't know that we need to do anything meaningfully different with that. I think it's worth recognizing, as you made the point before, there are no inherent cast-iron laws or rules accordingly because we can change our belief systems, we can change the interactions, we can change the interplay of all these things. I think that's worth calling out really loud and really clear, right, which is this is not a guarantee, this is not something that we can assume won't ever be a problem again.

56:19but in that context uh we can also say that the the power of the shared narrative the power of that coordination is the superpower and that's that's where it comes from yes your point has a great one right because and here's the i'm not getting into bitcoin either but one of the things worth thinking about is it's it's the better mousetrap thing or the build it and they will come thing yeah i built a better mousetrap why did no one buy it because they just weren't convinced that was a better mousetrap or they didn't want to pay for a better mousetrap or they didn't know they wanted a better mousetrap.

56:51Don't, I guess my kind of corollary at one point is don't be too rational. We talked about on Friday, we talked about cults and brands and stuff. I don't know. I love Coke. I'm not entirely sure there is a rational basis to pay 40 % more for Coke than Pepsi or whatever the margin is these days. I mean, I think I like it. I tell myself it's worthwhile. Is it really worthwhile? Should I pay$4 ,000 for a handbag? Of course not. I mean, it's ridiculous. Fashion. the whole thing is ridiculous absolutely 100 ridiculous except people do and so as an investor take it back to investing as we finish off i think the challenge is to see the world as it is because i've had people who say i wouldn't buy company x so i don't use its products well mate millions of people do so maybe you're right maybe you're on the forum maybe these people are going to stop using the product eventually maybe sure but maybe it's a taste thing and and And again, meeting the world where it is, is that idea of people use, like, do these things.

57:50You may consider it irrational, but as an investor, your only job is to say, will they continue to do those things? And if they will, then there's your prize. If they won't, that's cool too, so you know how to avoid them. But that's the process, not should it rationally be true that we all speak English rather than Esperanto? I don't know, but it's not going to change anytime soon. So I can buy Esperanto shares, that'd be a bit crazy and I could buy them because I'd said it's obviously a better language therefore I'm going to buy shares if no one else agrees with you your point about network effects mate or other competitive advantages if no one else agrees with you or not enough people agree with you then you're not going to get across the line nice yep I agree alright mate I think we're probably done for this podcast thank you for joining me this Sunday mate after your free diving mountain climbing hang gliding abseiling well when you get up at 2am man you've got a lot of you've got a lot of hours to fit all that in.

58:44So happy, happy to be here. Someone's got to do it. Until next Friday, join us then. But Fool on. Cheers. The Motley Fool and people appearing in this program may have positions in the companies mentioned. General advice only. Please speak to your financial professional to understand how it may pertain to your situation. Subscribe to the free newsletter at fool.com.au forward slash listener. The Motley Fool operates under Financial Services Licence 400691.