Mailbag: incl. Four investing concepts you need to know. October 29, 2023

26:51I'll give you some return. I'm like a, I'm going to calculate my return because I want to cover inflation and I want a return on the risk because, you know, I trust you and you're a good bloke, but, you know, things happen. So, I want a bit more than that. You might not be able to pay me back. I need to be compensated for that risk. Right. It's huge. So, that's what you put into the formula and say, if I'm going to give you my$100, I want this much in a year's time. And that's how I work out the value or the net present value of the potential investment. Improve on that for me, Right. You've done a great job.

27:25It doesn't have to be too complicated. I mean, the math is actually simple. So just how much do I think this thing is worth in, say, three years? Let's say I think a company is worth, you know, a million dollars in three years' time. And then the next question is, well, what rate of return do I need to lock my money up for that period of time? You might say 10%. I tend to say about 10 % for all else being equal because it's about the long-term market average. but I will increase it if it's riskier. But then I just, well, I just divide it by 1.1. Well, one plus whatever return I want. So I go one, two, three.

28:04It says, well, if I put 750, if I buy the whole thing for 751 ,000 today, I will by definition get a 10 % return over the next three years because I think it's going to be worth a million in three years time. So that's all it's doing. So it's just, and the question then is, well, what is the appropriate kind of rate? You've mentioned inflation. Opportunity cost is the other big one. It's not like maybe I can get 3 % here or 10 % here, but it's just like, well, you probably get 10%. Risk-free rate is the other one, mate. Your risk-free rate, right? Well, so this, we touched on this in a recent pod as well.

28:39I'm getting 5 % plus in a government bond. It's like notionally the risk-free rate. So it's like, well, it definitely has to be better than that. Why would I make any investment on the share market if I thought I was going to get less than that when I'm guaranteed to get this return over there. So it's as simple as that, really. When it comes to, I'm going to make a hyperbolic statement. When it comes to investing, if I was to say, what are the most important concepts that you need to deeply understand? I would put net present value certainly in the top five concepts, you know, and opportunity costs right alongside of it.

29:13If you understand net present value and opportunity cost, you're ahead of 80 % of investors, right? because it's just, that is, I am allocating money today and I want the one that's going to have the most attractive net present value. How do I possibly compare, say this is good value? You hear people say it all the time. Oh, share X, Y, and Z is really good value today. They usually say that because it's fallen and they're anchoring on a prior price, what they mean by good value. No, it's good value if the net present value is above what the market price is, i.e. the market in all its genius is saying that this share is worth a dollar each, I think on a net present value basis, it's worth at least$1.50.

29:54So I'm now getting an opportunity to buy$1.50 in today's money for$1. You almost axiomatically cannot buy a share without having at least some notion of net present value, even in vague terms. And then to contrast that with what other alternatives might be out there, which is where opportunity cost comes in. So as an investor, my bottom line raison d 'etre here is I am trying to buy stocks that are the most attractive on a value and risk adjusted basis that give me the biggest discount to their true net present value. That's what I'm trying to do. Nice, mate. Love it. I'm going to add a bit more to this and we'll move on.

30:37It's intrinsically linked with discounted cash flow analysis. Yes. And effectively, what the discounted cash flow analysis does is gives you the net present value. So if you hear DCF thrown around or NPV, they're kind of the same. One's the answer, one's the process. But effectively, it's the same thing writ large. It's also, just a really quick couple of points, mate. You said, how do you know a stock is cheap? People say, well, I looked at the PE and it's cheap. That's not necessarily wrong, except that what the discounted cash flow process does, either if you literally do it line for line or you just think about it is two companies today have a PE of 10.

31:14They're not as cheap as each other. And you don't have to have one to disappear entirely to make that case. You might say, right, a PE of 10 is cheap. Okay, fine. One company that was going to grow up 15 % a year for the next 10 years, the other company is going to grow up 1 % a year for the next 10 years. Now, as soon as I say that, everyone says, well, obviously the company is going to grow faster or cheaper. I say, exactly. The difference between those two isn't apparent until you either, again, just conceptually go through it or literally put it in your DCF because that gives you a much higher net present value for the growing business.

31:45There is more cash flows coming to you for a business that's growing its profits more quickly. So at the same PE, by the way, it also means a company with a PE of 20, the great 15 % a year is probably cheaper than a company with a PE of 10 not growing at all. So again, which is cheaper? The PE of 20. Hang on, how is that possible? Well, PE looked backwards at one year's profit. A discounted cash flow analysis or an mpv again i say analysis even just to conceptually think it through um that will give you a very different sense so when ram says how can you see a company's cheap i'm just mindful mate that people would have said well obviously look at the pe and what the mpv process is it absolutely it it it takes it takes peter parker's pe and and bites it with a spider right the the net present value idea takes you from ostensibly on the face of it looks not overly expensive to oh my god 20p is cheapest chips and 10 is really expensive or vice versa yes or again even around support opportunity cost wise one is obviously better value than the other because you're thinking about it my last point on this one yeah i just sorry that is pe you remember that you people will be familiar with this meme you know it's that the bell curve and you sort of got the dunce on one side the jedi genius on the other and in the middle and the dance is basically saying it's all about pe in the middle it's like no it's net present value internal rate of return And at the end, the Jedi are saying, no, it's all about PE.

33:09I think there's a lot of truth to that in the sense that PE is very flawed and very easily misread. But once you understand all of those other concepts, it's a useful heuristic. And this is what Buffett, I think, as someone of his capacity, can make a very quick judgment based on PE. Not because he's just stupidly applying, well, below this is low and above this is high. It's like in the context of my growth expectations, this is high or low. And that's why PE is so powerful once you've gone through that journey and understood the other kind of concepts. You actually work at some point on a four-quadrant chart or a series of curves or a table because - I tried to do that once actually.

33:53Did you? Yeah. Because mathematically it's not that hard, right? You go from a PE of zero to 100 or one to 100, I suppose, and you get growth of zero to 100 % a year. And there are orange, red, green. This is your point of what Buffett does. He doesn't say, well, they're both P of 15, but I like that one better. I think he just instinctively has memorized conceptually the idea of a P of 15 is cheap if it's going to go up 15 % a year. Yeah. Or 20 is cheap if it's going to go up 25 % a year. Or eight is expensive if the business is going to die next year. And once you've kind of, this is the benefit we said before, mate.

34:26We've all gone through that. Do your formulas. and then eventually kind of say i can move on and that's that's the moving from the dunce to i won't say we're jedis but to from dunce to experience is once you've done that you kind of just can can kind of almost you kind of remember a few of the bit of the maths a bit of the directional stuff and be like okay well p of 18 seems a bit expensive but gee it's got a lot of time left to grow at whatever percent yeah and so if that's if that's true this is this is cheap not because we kind of assume it is just somewhere in the back of our heads we've kind of internalized the shape of that curve uh and that kind of table of red green yellow to kind of work out what's roughly good roughly bad and what's dodgy and close and whatever a company of p of 10 doesn't have to grow to give you a good give you a good result oh insane insanely good even if i'm steady stating or i'm just keeping up with inflation think about it i'll buy a business for 10 years worth of its earnings in other words it pays itself back in 10 years and then forever i'm getting that return for you mean it's just think about it in those terms it's fantastic Cash flow is amazing.

35:24The last point I want to make on this one, mate, is just to, this is why markets roughly write more often than not. And a lot of tech stocks got smashed over the last 18, 24 months because interest rates went up. And again, I'm not going to bore you with the algebra, but effectively imagine a world, I'm going to just do inflation because it's easier than people think about it more easily. Imagine a world where you think you're going to get money in 10 years' time. There's this great new business. It's got a great new idea. It's going to be successful. Let's assume it's going to be successful. It's going to work.

35:53and you're there but it's going to take 10 years to start paying a profit in 10 years time you get some money now if inflation is zero just for fun and the risk rate was zero just for fun you might say okay well i'll pay 100 bucks in 10 years time i mean any gain is a gain right if i get 101 back in 10 years time i'm ahead because there's no inflation there's no opportunity cost there's no risk-free rate so i'm going to make some money now again stupid example but work with take a different world where the inflation rate is 10 for the next 10 years so every year the $100 starts at$100. I'm going to try and do this in my head, so I work with you.

36:23Count the numbers. It goes from$100 to$90 to$81 to$73 to$66 to$55. $9,$10. $38 it gets to. Thank you. Eventually, so that$100 is now worth$38 in 10 years' time with nothing other than 10 % inflation. So think about unprofitable companies and think about the way the market thought about this. You'd pay$100 for$100 worth of value in 10 years' time, but you wouldn't. You'd want something, but you know what I mean. Work with it conceptually. you don't need you don't know so you kind of go oh the profits are quite teeny that's okay i'm happy to wait there's not nothing else going on anyway i can't earn any other money anywhere else um i can't get any other return anywhere else in the bank because interest rates are at zero anyway so i'll put some money in shares because in 10 years time at least i'll get something back for it now all of a sudden you're like well hang on and again i'm used 10 because it's easy um i inflationary attempts any of the next decade i'm gonna get 38 back i need i need more return now for that i want a higher return or i want more return or i want profit sooner because i'm not waiting 10 years for those money to start coming in.

37:20I want the cash right now. And so that's why if you're a loss-making business or a low-profit business that hopefully has higher profits in years to come, those out years, the discount part of this kind of cash flow penalizes those for multiple years of inflation before we get there. And that's part of why tech stocks in particular got smashed over the last couple of years when people went, I'm not going to wait forever now. I actually want a return. I want it sooner. And that's part of why we saw the dynamic exchange in the market well i just it's so with the benefit of hindsight and a bit of distance like i just i'm i'm just floored by the expectation that the market had right and i said to you before is that what really just throws me onto the floor is just the fact that people would lend like the u.s government money for 30 years at one percent like what 30 years i think there were a hundred 100-year bonds being issued in Europe somewhere.

38:16Virtually negative interest rates. Just sort of think about that for a second. Like it is the height of madness. And this is the smartest guys in the room, right? Like unbelievable. Yeah, exactly. Yeah, it's bizarre. Let's move on to internal rate of return. Now, this gets even more academic pretty quickly, but you're a smart bloke and you'll be able to do this one. So explain to our listeners what internal rate of return is. So I said before that there were, what, you know, 10 concepts I'd say are really important. I'd put IRR in there. Would you really? Yeah. I would have put like 85, so tell me why.

38:56Well, it's very hard to calculate. There's no spreadsheet easily to do it. And maybe I'm getting too far ahead of myself here. The formal definition and why it threw me for ages, IRR, is because it's the return required to make all future cash flows equal to zero. In other words, money goes, let's say I'm starting a business. I'm starting a lemonade stand. All this money goes out. I put$100 to buy the box and the lemons and the juicer and all that kind of stuff. So on my ledger, negative$100. Yep. Now, hopefully, I'll make$10 in year one and$20 in year two, whatever it happens to be. And this is why NPV is really handy that we did this one first, right?

39:41So we need to talk about what's the net present value of all of those future cash flows. The next year is discounted by one year. Two years out, discounted by two years. 100 years out, whatever timeframe we sort of want to work at here. We have to know what those future cash flows are going to be. and assuming that we do it, we have an estimate for it, we now have to work out the discount rate that makes everything add up to zero, that initial$100 out and then all the other positive ones after that. Now that's the formal definition. And it's like, what does that mean? Why equal to zero, mate? It's effectively paying back the upfront cost, right?

40:20It's trying to say, we'll put it this way, the higher, the better. You want an IRR that is really, really high because it means for you to get to zero, your returns have to be very, very high. Each year's cash flow has to be discounted at a very high rate. In other words, you have to expect a really high rate of return. So if the internal rate of return – this is probably oversharing, but you're very flamboyant in how you like to sort of present strongman. And we've had a couple of years where we're making money, which is really nice, right? Because it was started more than five, six years ago.

41:01Gosh, no, 70. Fair, mate. If you hadn't had the fleet of Lambos, you probably would have made some more money earlier. Probably. It's partly an up-righted decision, but yes, keep it. But the internal rate of return is negative. If you add up the amount of – I'm not trying – I'm not after sympathy or anything. It's just a really good example, right? So when you look at any kind of business, I'm using mine as an example, and you go, oh, here's the FY 2023 financials. Here are the assets, the balance sheet, the liabilities. Here's the income statement. Here's your revenue. Here's your cost. Oh, there's a profit at the end of it.

41:31Oh, that's really nice. Well, I hope, yeah, it's better than it was. But in terms of if I put a bullet in it today, the entire enterprise was a cash killing operation. Because what I need to factor in, and when you're starting a business, I think this is why internal rate of return is so important. When you're even investing on a business on the ASX, that's why it's such an important concept. It's because it might be that in a few years' time, the profit is fantastic, and the EPS looks fantastic, and the PE is brilliant. But if the entire cashflow experience has been negative over that period, well, it hasn't been a really great investment, has it?

42:13And that's so far the case with Stroman. Hopefully, we're still kicking in 10 years' time and that that calculus shifts but it gives you a lens on an enterprise over its expected life that says whether or not this is economically worthwhile perfect that's that's why i put it that's why that's why i put it in the top 10 yep lovely description i think that's great um it's yes it measures the ability of a a project or a company or whatever to deliver a return on the investment required to make that project work um the business is a great example it's probably an even better one might well not better one in the context but to help illustrate how it works to imagine a imagine how long it takes you to get a get to zero as you say from a from a particular project that has an end date potentially or has a response?

43:12Because it actually can include some projects or some investments. It can include the sale price as well. So you kind of got this, you borrow some money, you buy it, PA use it all the time. You borrow money, you buy a business, you pay yourself some dividends over time, then you pay it back. And so that whole project, you start with$100, you buy the business, you get some cash flows, you sell it in 10 years time for$115. You've made 10 bucks a year on the way through. And so you're asking yourself, okay, well what sort of return did we get or to your point mate it's the definition is to make it equal to zero but effectively to pay back the money uh what rate of return would have been and it's just it's just a useful way of thinking about that now at a business level it's a little bit harder because they tend to be hopefully the best ones are timeless uh so the discounting matters because again like you know straw man um andrew spent you know 100 million dollars setting this thing up and now it's a billion dollars a year so it's it's a it's a business but you know it it if it goes forever, that gets more difficult to kind of use as a concept because you get to zero, but at some point you almost blow past that because the capital has been spent.

44:15You're now in the harvest period. There's obviously ongoing capital to spend. I'm not as bullish. I like it conceptually. I like it conceptually. Yes. A great building block for thinking about how to invest. Brenthouse is similar to return on equity. It kind of is. It's calculated differently because of the way you are trying to work out as ram said how in what can you get when you get to zero where the cash flows are made back uh roe is kind of more an ongoing metric i personally prefer roe to ira mate do you have a do you have a league table for those two uh oh it ir roe is more practical yeah ir is too fuzzy is too fuzzy i i like the concept of ira internal rate of return better but it's It's too far because I have to know exactly what the cash flows are going to be from here until kingdom come.

45:08And where it's all the cash. That's the challenge of the DCF in general. But it's more where I find it really useful. I think it's a very, if ever you're at an AGM or an investor briefing and a management team is embarking on a big CapEx program. We're going to expand into the US. We're going to build a new distribution center. We're going to do this. The question you want to ask is what's the IRR? Now, they won't know because they have to guess it. But if they don't have an answer, that is a worry. Because that is the lens through which every decision a management team should be making should be looked at through that lens.

45:47Now, you want to make sure that they're using what are reasonable assumptions. but if the IRR is forecast to be 5 % or 6 % or 7%, I would be saying you'd be better off just taking shareholder money and buying an index fund. Like what, why are you guys spending? Give me the bloody dividend, right? You give it to someone who knows what they're doing because you clearly don't. If you are making any internal projects or any internal investment decisions and the return isn't 10%, like you need to stop doing it, you idiots. And by the way, that's probably more often than not internal corporate projects are less than that.

46:26Do you know? So I know I've gone a bit off your point there, but that is when a business has established operations and hopefully some kind of competitive advantages where they can keep the money that they have made on my behalf, on my behalf and other shareholders behalf. my my strong desire and preference is if you can take this and get something that's probably 15 or more by investing it in this company in your business by expanding products by doing r &d by going into other market for the love of god do not give it to me don't buy back shares don't give it to me because i'm going to struggle to but if you can do it because you know you're the only one in the world that can make iphones or you're the only person in the world that can do this you know special thing do it right so they any management team that doesn't have that lens does not deserve to be a management team and you should run a mile because they will eventually kill the business yeah i think that's um i think that's that's really important my last one um brent asks about is actually almost it's a crowded field almost my least favorite uh acronym in investing and it is whack the weighted average cost of capital never use it me either and uh i was i think were you there we we've been a couple of berkshire meetings charlie munger was asked once what berkshire's whack was he said i have no idea i don't bother working it out and that's not that was that was the nail in the coffin for that one for me because if charlie munger doesn't bother with it i'm i'm okay to say i don't need to worry about it either yeah some people do use it and use it a lot and And I think, so this will be critical.

48:12Some people will love this concept and will not like me talking about it this way. And I apologize in advance, not for telling the truth, or my truth anyway, but for sounding like I'm being dismissive. I think there is too much, like we talked about before, about every, you know, once upon a time, Andrew and I would calculate every possible investment ratio that was accessible to an investor to try and calculate stuff. Because once you realize there are some formulas for stuff, and this is, I mentioned economics before. Economics went off the rails when maths turned up, when econometrics turned up, when they realized they could put things in a computer and try and model them out.

48:42And what happened is the beauty, in quotes, of the model and the limitation of the model became inherent in the conversation, i.e. if you can calculate it, you should. And once you can calculate it, therefore you should do something with the answer. And the answer must therefore be useful and necessary and illustrative, informative for an investment decision. Now, these two are related. And I imagine this is why Brent's asked it, because WAC does kind of lean on internal rates of return a little bit. And so we should probably mention that. Effectively, what it's designed to do, and it goes back to enterprise value actually as well, is it goes back to trying to work out the cost of running the business based on the fact that all of the sources of funding have a cost.

49:28Now, we know debt has a cost, right? Because debt's cost is the interest rate and you've got to pay it back. So that's relatively straightforward. It also tries to apply a cost to equity. Yeah, that's the tricky part. And I think it's pretty useless. Yeah. On one level, equity holders want a return. And so again, maybe conceptually like internal rate of return, it has some validity because you're saying, well, if I need to pay my debt, if I need to pay off my or pay back my shareholders, If I need to return some capital to shares and they want a certain return, then the cost of running the business is, again, weighted.

50:07So if it's, let's say, this is half debt, half equity, because it makes my life easier. The cost of the debt might be 5%, and investors want a return of 10%. So that's an average weighted average cost of capital of 7.5%, right? Half of 5%, half of 10%, whack them together, you get 5.75. I'll say 7.5. That's kind of the broadest concept. and there is supposed to be an understandable and applicable cost of equity. I don't buy it. I think it's kind of someone who wanted to say, if I could put this in a spreadsheet, what would it look like? Now, if you're asking me what the cost of capital is for any stock I own, it's a million percent because I want all of my companies to earn a squillion dollars on the equity, right?

50:51So a company that says, actually, I only want you to earn 5 % on your equity scale, I'm going, well, get stuffed. Now, if it's only 10%, well, get stuffed. I want 15. If 15, well, I want 20. And so it kind of, it ends up being cover to calculate something that doesn't need to be calculated and to explain away something that needs to be explained away. People do use it as a discount rate in this, again, in the discounted cash flows. And if you just choose 10 % because that's the average market return, I do the same because I want to get the market return or buy an ETF. For me, it's really, really simple.

51:19It's that simple. It's opportunity cost 101. I could buy an ETF that gets me an average of 10, I mean, probably nine, but you know, nine or 10%. I can buy that ETF tomorrow. So if I'm going to forego that, I want more than that. It's just really, really simple. Saying the way your cost of capital is this because this much debt, this much equity, and this much return for equity is required. It's like, well, if it was 9.7 % your weighted average cost of capital, but you still get 10 on the market, you'd still go to the market. If it's 11%, great, buy the shares. And again, to Ram's point, it is opportunity cost.

51:48So if I get 12 % somewhere else, I'm going to take that as well. Calculating a number just so you can put it in a spreadsheet is, I think, where a lot of people go wrong, frankly. It leads to false precision. It leads to false confidence. So that's what it is. That's how it works, and a real better job of explaining it. But I don't mean to dismiss it out of hand. Again, like IRR, it's kind of, I mean, it makes sense, right? There is a cost of debt, and shareholders do want a return. And so there is a, you know, as an entity, looked at at arm's length from the funding sources, again, a bit like enterprise value as well.

52:19You know, if a business with a weight average cost of capital is 7 % or another one's 10%. Well, I guess, you know, you want the one with a lower cost of capital because then you can have bigger excess returns, I guess. I just don't know what's particularly useful. Go on, Ram, tell me why I'm right and wrong. No, I mean, so it's like IRR in the sense that I think conceptually it's important, but it's more from the management perspective than the investor perspective. I would love to think, I mean, it's a nonsense to try and think that there is a real and true and objective value for it out there because of the cost of equity component of it, which is going to be based on some kind of guesswork anyway.

52:58But if I'm a steward of an enterprise and I have ambitions and opportunities and I have positive ones. So again, I've got a bunch of stuff on my desk. My team has come to me and said, boss, here are all these investment opportunities that are going to make us rich. You go, great. Question one, what's the IRR of each of those projects? Yes. I could do this. I could do that. The opportunity cost, it always comes back to the same core principle. So I've got so much money right now that we've raised from shareholders or we've raised from debt to go right back to the first concept. I've got money. I've got money right now.

53:39What am I going to spend it on? I think we should go to China. Okay. I think we should invent, you know, version 2.0. Okay. And then the next question is, well, what's the IRR? Well, thumbs up. I think this is it. Great. I'm going to obviously pick the highest IRR because I'm not an idiot, right? I want the best rate of return. Again, I'll adjust that. I'll adjust for a bit of risk in all of that. Now it might be that I actually don't have enough capital to do all of the things that I want to do. So now weighted average cost of capital is where things that get really important from a management standpoint.

54:13Because I can just go to the bank, say, Mr. Bank Manager, can I have some money please? Yep, sure. Interest rate for a corporate loan for a company of your size and status is, well, I saw one the other day was 12 % plus the bank bill swap rates. Pretty high cost of debt, but small cap company that's cashflow negative. Guess what? Beggars can't be choosers, that's what it is. But they took that deal, right? They took that deal. Let's say it was a 15%. Okay. Now I'm going to consider raising money on the market because 15 % is a very high cost of capital. Oh, our share price is in the bin. So that's even worse.

54:50And that's why it's important. Sometimes shareholders get really upset because management teams are opportunistic. The share price runs really high and hot for some reason. And then sure enough, they go, oh, we're raising capital for working capital purposes. Oh, I hate that. I actually don't. I'm more, I'm increasingly sympathetic to it. Are you? Yes. The generic working capital is my issue though. They're doing it for the sake of it rather than actually because they have a genuine use for it. That's, yes. No, we agree there. Working capital is just so we can pay the bills. Like working capital is literally the overdraft account or the transaction account that we've individually got.

55:26My working capital is, you know, the money goes up and down to my savings account where the money comes in and then goes back out a bit. Yes. Having more in there just for the sake of it, you're a little bit safer, but maybe by definition. but raising capital deluding shareholders for that purpose, honey, we're going to sell one of the kids so we can increase our working capital. So you're 100 % right. So the big proviso here is that, well, look, there's 100 things we would love to do if only we had really cheap funding to do it. Now, it might be a world where debt is really cheap for us, and this is the advantage of size, right?

55:54It's because Woolworths does not borrow at 15%. I can promise you that, right? But this is why management needs to have a clear understanding of it. Share price rallies super high. It's another way of saying the cost of capital, cost of equity capital is really cheap, actually. And in fact, if there is a big burning opportunity here that's, you know, not an especially risky thing to do. We just never really had the funds to do it. Raise capital. I 100 % agree with that too. You know, that is, you would be stupid not to take the opportunity where the share price has gotten to such an extent. Whereas, frankly, you're all around the board table going, it's kind of a bit silly.

56:32I mean, we're confident of the business, but the market's really running hot here. And, well, there are all these things that we could do. And what's the cost of equity? Well, on our assumptions here, we're actually raising money here at like 1 % interest rate. Fill your boots and go and do the thing, right? And so that's why – so I'm going to try and tie this in a knot because I've been blathering all over the place here. For an investor's standpoint, I don't know if it really means – the whack really means much. And if you're using capital asset pricing models, you're trying too hard. It's a waste of time.

57:02And don't worry about it. But I do hope that management teams are very seriously looking at it in context of the projects that they have available. If you've got things that you can do that you've got a high confidence of making money on, and there is a low cost of capital funding solution, whether that be through equity or debt. And that's why it is important to have some guess as to what your whack might be, your weighted average cost of capital. Useful in that conceptual context. What do I do with it on a spreadsheet when I'm deciding what share to buy? Nothing, really. Does that make sense?

57:34Am I talking out of two sides of my mouth? No, you did right. Even knowing the WAC is not as relevant as – I mean, if it's so – here's the other thing. If it's so limbo you're not sure if you're going to cover your cost, don't do it because you just know it's probably going to be wrong anyway. If your WAC is 3 % or 5 % or 7%, you don't make a 15 % return. It doesn't matter. Like, you know, there's some element of, you know, it only matters if you're so close to that line, you're trying to work it out, in which case, don't do it. And it doesn't matter if your returns are going to be so good, then it doesn't matter what the cost is, in which case, just do it anyway.

58:04And I don't mean that flippantly, but I do mean, you know, how many infrastructure projects don't go over budget, right? So if someone sat down with a state treasurer and said, we should do this because our average cost of capital is 7%, we think we get 7.5%. I'm like, you know what, dude? Firstly, your average cost of capital is a guess. Secondly, your returns are a guess. And thirdly, those numbers are so close together that fair dinkum - There's no margin of safety. There's no flex whatsoever. So again, important conceptually, but if the numbers are that close that you have to be able to calculate accurately, then to my mind, you're too close to line.

58:35Go and give the money back to shareholders. You're not in the business of taking risk that may or may not have a positive return. Either it's a strongly positive return or give me the money back because I don't want you to have that extra cash. I'm not paying you to make 50-50 bets. Yep. Let me put it in the small business context again. So let's say for whatever reason, it's 2021 again and money's just gushing, falling from the sky. And some silly VC decides that straw man is worth$10 million, right? And it's like, this is not me being humble. It is not worth$10 million. By the way, if anyone wants to - Don't be so fast.

59:12I mean, it is. It is. You should totally buy me out for 10 minutes. Look, it's totally, it never will be right. But let's say that, by the way, this is the kind of crazy stuff that was happening a couple of years ago, right? Silly little startup ideas with nothing more than a pitch deck and two kids fresh out of uni. We're getting valued at these kinds of prices. So anyway, let's say that it is. I am going to take the goddamn money. I'm going to take that money because the cost of capital is so ridiculously low. I can almost, even if it's just like, I tell you what, I'm going to raise money at that valuation.

59:42Correct, correct. And I'm going to buy a government bond with it. Yeah, exactly. And all shareholders are going to be really, you know, maybe not the ones that tipped in that high valuation, but the existing shareholders. Everybody else gets free money. We're getting free money. We're getting free money to do it. And that is why, again, from the lens of the capital allocator, the key decision makers in the business, you really do need to have an opinion. It's going to be nothing more than an opinion, but you do need to have an opinion of your cost of capital and the opportunities that you have for that.

1:00:16Because if you ever have a low cost of capital opportunity and a good investment, sorry, let me phrase that. If you have a low cost of capital source of funds, whether that be through debt or equity, and you have a high return project that you're reasonably confident on, do it. That's why we're here. That's why we're here, right? Fill your boots. In all other circumstances, don't do a damn thing. Motley Fool Money. For more, subscribe to the free newsletter at fool.com.au forward slash listener.

1:00:52I'm going to finish with, this is a Motley Fool Money mailbag episode. And the mailbags generally are questions, although in keeping with the Motley Fool Money format, there is occasionally a mailbag rant. Oh, I love it. And so I wanted to share this rant because I think it is ridiculous. And I would hope you agree. You're welcome not to agree, mate. But our questioner, or our ranter, writes in and says, Hello, Scott and Andrew. Love the show and tune in to both shows every week. Thank you all for your shared knowledge and your lean-in to discussion on government policy, which feeds into my question slash rant related to New South Wales police superannuation.

1:01:31I'm the wife of a police officer, says our ranter. We have both worked extremely hard to get where we are in our respective careers and have three children under four. I decided to return to work full-time after baby number three, and while that has afforded me an opportunity to increase our family income, it of course comes with sacrifice, spending time away from the kids. For childcare, we pay around$2 ,000 per fortnight out of pocket, and I've been fortunate to get some subsidy to avoid having to pay the full fees. Given my promotion and working full-time, we were close to the childcare subsidy cap last financial year.

1:02:05When we came to June 30, we had kept our family income within the cap. happy days as didn't impact our subsidy that we had received or so i thought unbeknownst to me was a substantial impact my husband's super would have new south wales police and i believe the only workforce in australia with this arrangement have legislated insurance increases in insurance premiums have been substantial this past financial year the insurance premium was somewhere in the vicinity get this mate of thirty thousand dollars what i know right legislated the ato consider this part of an individual's concessional contribution cap to super so before you even consider his actual super contributions he exceeds the cap and he cannot opt out of the scheme as it's legislated you can see where this go is this is going says our ranter in short it's resulted in adjusted income of more than$20 ,000.

1:03:04This has a flow-on effect. For us, it means we have to pay back our childcare subsidy as we are no longer eligible. You get a tax bill, increased Medicare levy, and there are other flow-on effects, i.e. we cannot make concessional contributions to help boost his super because the insurance absorbs the entire cap and beyond. She says, I would love to hear your thoughts on this, and hopefully this can bring it to the attention of listeners who may be serving officers or partners of officers as i was caught unawares new south wales police association and new south wales police have tried to have changes made so the insurance would not be considered as part of the cap but this effort has been occurring for years to no avail situation has just become so much more significant basically impacting officers through all levels including our probationary officer she says because of how substantial the insurance premiums have become thanks for listening to my gripe the situation really has us reworking our expenses and evaluating if it is worth us both working full time and it's not she says isn't that the most completely screwed up thing you've ever heard i'm flabbergasted yeah i actually honestly i thought show that cover i did a bit digging this one came through a couple weeks ago and i did tweet about that um a couple weeks ago as well it is so firstly the fact that coppers have a 30 000 life insurance premium i'm glad for them they have it or probably total to permit a disability as well because it's a it's a rough gig right it's a it's a risky occupation 100 yeah but to have it i and and also too by the way as much as um as much as our question says he can't opt out i'm glad he can't you know our police officer should be covered frankly it probably should be a government scheme rather than a bloody private insurance offering anyway because if you're a copper or a fire or an ember or something you get hurt in the line of duty you're kind of entitled to have the government look after you right you're serving us um so so frankly i'd start there but it's legislated he can't opt out it's a thirty thousand dollar premium which is in excess of the contribution cap which i think is 27 odd grand right now um so not only is don't have has it increased their take home income for welfare and child care and other you know calculations he also can't add more money to his super to actually help his own retirement because that that money is completely absorbing the concessional contributions cap so we're going to incentivize you to work less right how bananas is that whole just on about 85 different levels that is the most ridiculous thing i think i've ever heard yeah there's there's a whole bunch of stuff like that um i can see how it's not so such a grand conspiracy it's just people make decisions that feel good at the time we haven't thought through the second and third and fourth order effects and they just because you know it's my mother-in-law's on a disability sort of pension And it's like, she really wants to work and contribute.

1:05:43But it gets to a point where it's like, I'm actually at a – the more I contribute to society, the more disadvantaged I am. So I guess I'll just suck on the public teeth. So messed up. That is madness. I remember when our kids were younger, it was my wife worked purely because she wanted to work. Financially, it was a wash. Yeah. whatever because you know she she was she was a phd in immunology right so she she's she's trying to like cure diseases and stuff and just in our society it's not an occupation that pays very well despite all of that study and talk about internal rate of return you talk about the education expense and the and the time value of money that has been a woeful but you know thank god there are people out there who sort of try to pursue these kinds of things.

1:06:33But my point being is that it's similar in that I always try to, I always find a way to make it about me, don't I? So here I am making it about me. But it's the same kind of point though, where it's just sort of like, it is a really good idea to have subsidies for childcare. It is a really good idea to have proper insurance for the coppers. It is really good idea for all of these kinds of things. But But when it drives incentives in the opposite direction to where you want it to be, it's sort of like something is fundamentally broken. And what always – the most frustrating thing of it all is – and as I said, I'm not going to take the conspiratorial angle here because I don't think there is any malevolence.

1:07:14It just – you know, things evolve that way. Bureaucracy is a big, slow-moving beast. but it's sort of like it's so once a system is entrenched it is so hard to move and you can point to and go that's really dumb someone should do something about that yeah yeah we should and it doesn't and like you know it's i i don't know why it is maybe there is some other argument to be had it's like well we do it that way because of x y and z and if we didn't i'm open to that possibility although i can't possibly understand what it what it would be because it feels as though some poly just needs to come in and make a change on that stroke of a pen kind of stuff, because that's an easy fix.

1:07:56So yes, I don't... Making the individual offices have insurance outside a government compensation scheme generally, and then have that on their own individual books is just bananas to me. I'm not surprised that... By the way, I'd be pretty keen to work out who's paying for the insurance and who's providing the insurance, whether they're making a squillion dollars because even allowing for conspiratorial angle but yeah no i'm with you that's what i was trying not to say like yeah there's always someone with the grift going on here like someone's it's good for someone legislator provider there's you know it's when you're a monopoly provider of something it's there's a chance your margins creep up a little bit travel insurance is stupidly expensive yeah stupidly profitable for example whereas car insurance isn't and just just the way these things tend to work it's just a harder thing to do i um so look yeah treasurer uh um premier do something about it fix it up for us um they don't deserve that kind of crap um worth also just a slight tangent but not far mate is um i i'm i love superannuation i love the super scheme i love the compulsory nature of it these things are really really really really important um it does go back to how much we should contribute and how much we pay tax on contributions and earnings in super it also though i'm going to stick my neck out and say that i'm not entirely sure that insurance should be available inside super as a as a mechanism i think insurance is really important i think anyone of working age with dependents should have life insurance and temporary and permanent disability insurance because if it always happens to you you want your partner and kids to be looked after uh and yes there are social safety nets but do yourself and those people a favor if you can afford to have that insurance i think you absolutely should um that it really should be it really should just be the most basic boring industry in the planet right you know i just change solving problems of the world here it's like everyone i would say this is the socialist in me after i've had my free market rants i would i would say yeah and i can do that i can somehow square these circles free market Socialism, I love it.

1:10:05It's going to catch you on. In the sense that I feel as though things like life insurance, TPD, these are kind of almost basic human rights, I would sort of say. And it's just that the trouble is there's too many for-profits sort of in there. It feels like it's like things that the actuaries can work out with high degrees of certainty. That's right. This is a natural monopoly, right? And so this should really just sort of be we have one national scheme. We all tip into it according to our means. and if the worst happens you get paid out now if you want to take advantage of that by like putting yourself in a wheelchair or like dying early then you know it's not it's a very difficult system to exploit and you know and so it just sort of and it should just be very very basic we we all know that we pay into this thing most of us won't need it and we'll be happy that we never call upon it those that do have it either way it's a great outcome and when we run it it's a great low right and when there's like it's everyone wins it's so easy so easy hey just quietly uh speaking of uh taking those to free market socialism to its to its end result uh even if you're talking about it almost i would i would almost i'm on record as this i would go a step further and i would say that's a very very very strong case for universal basic income i wouldn't use that term because it's loaded but yeah yeah well it's definitely loaded but But that idea of if you get crook, then you can't work, you get a payment.

1:11:33Yes. And if you die and your kids need looking after, they get a payment. Yes. It literally is almost the very definition of, you know, the combination of these welfare safety nets across the board. If you're literally taking the risk to inclusion of, hang on, well, the government pays it. We put a little bit of money in it. It's like, well, yeah, that kind of sounds like universal basic income. Literally, if you can't work, you get it. If you don't want to work or you have to do the mutual obligation thing, but you can get it. if you're looking after sick relatives you can get it it's if you're not earning enough you can get it it's almost you know again we won't open this candle at this point in the podcast but if you kind of follow that through logically you put outside the ideologies and the the loaded terms as you say and the you know general views and start with as we said many many times a blank slate and say so hang on we've got all this bureaucracy and all these programs for all these things or we could just have a payment that covered death disability you know inability to work caring for adult you know care for adults care for kids um it kind of all comes full circle to actually we've invented this ridiculously complex apparatus to a very very simple thing that could be resolved otherwise i i actually oh man it's such an interesting conversation it's your fault you took me there i strongly disagree on one angle and i strongly disagree on another so i would say i love it and strongly agree on everything you just said provided it is all uh paid for collectively by if you if you frame it more as in a a national insurance scheme that like um who's the comedian is like you shouldn't call it insurance you should call it in case shit happens basically and in case it's an in case fund that we all fund collectively we all pay a few dollars a day and if ever we need it it's there that's that's um what i am strongly against is if this is something that is funded through ongoing government deficit because that is highly inflationary and destructive and all kinds of ways which would lead.

1:13:26So I think a lot of UBI proponents, that's what they miss. There's a strong correlation with the modern monetary theorists in the UBI group as well. You're a million percent right, mate. So two things quickly. Firstly, I would trial it. I wouldn't just roll it out. You want to trial it and make sure it works. And you know what gets me? When you say we should trial this, people say, no, you can't. It'll never work. so the trial would show that yeah we shouldn't trial it what it might work like the ideological opposition to trialing something i think is bananas about it's like the inject it's like the injecting rooms like we should try no no no no no okay finally we do it like oh it's really effective what's our goal here we're trying to reduce like minimize harm yeah that's the goal well it works yeah that's what we should we should expand and roll it out more no because drugs are bad exactly that's why we're trying to minimize you know it is madness yeah the only thing i would say is it absolutely should be revenue neutral and my again we're going to heaps of detail but you can you can frame it in such a way that people who are in a job effectively pay tax to the equivalent of the ubi payment so that they don't get any net benefit from it those who are currently on any of these other payments who have to have a massive bureaucracy of government workers and programs and reporting all kind of stuff they get the same amount of money anyway so you just take away the bureaucracy it's not exactly self-funding but you can do it in a really really really really easy way uh that minimizes the the cost is by the way it also recognizes the value of parents largely mums who stay at home and work by looking after kids you know that kind of they're like it's actually it's actually a social benefit um it is a productivity enhancing endeavor correct because it enables revenue neutral if i did it tomorrow i would yeah if you have to raise taxes frankly so be it you probably don't because you probably again i i get i would get the ubi but i'd pay exactly that in extra tax so i get money pay it back no no harm um the you have to line up at the at the ces or whatever they call it these days um you'd have to qualify for it if you lose your job you don't have to wait and go back to another job makes changing jobs easier people particularly some of the freer market ideologues talk about labor mobility um if you're going to change towns change countries change states change jobs you're out of work for a while you're trying to find another job.

1:15:35Knowing you can leave a job on Friday, still get paid UBI on Monday and then join another company on the following Monday after that. It's honestly, if you're a free marketeer, it's a no-brainer. If you're a bleeding heart socialist, it's a no-brainer. Anyway, a whole different tangent, a whole different topic. It's so interesting though, isn't it? Yeah, but it won't happen because, oh, we don't do it that way and that's too hard and there's probably a few vested interests and there's probably someone out in there, in the mix, who's doing just fine. Thank you with this arrangement. This is working out really well for us.

1:16:01Plus the Dole Blodger is the usual target of scorn. As soon as someone thinks that someone might get money they didn't, air quotes, earn, the envy and jealousy hits the surface and it goes pretty ugly from there. By the way, if you want to ever say, is there real economic value in the stay-at-home parent that looks after the kids? All you have to know is that the car, I just Googled it, the childcare services industry in Australia generates$15 billion in revenue each year. Now, I reckon if you went back 30 years, that was even in inflation adjusted terms, that figure is nowhere near that. Was the same job very deliberately using that term done back then?

1:16:41Someone was looking after the kids. As you say, it was probably mum and it was probably at home, but it was never recognised as economic value. Now, because there's an industry sprung up around it, it is recognised. It goes to show you that not everything that matters can be measured, not everything that is measured can be that matters type thing. So it's sort of, yeah, these are, oh man, I reckon we get a six-week intensive retreat somewhere nice, go to Hamilton Island or whatever. Nice. And we'll restructure the entire economy, superannuation scheme, government spending, and we'll usher in a new golden era for Australia.

1:17:21What do you reckon? Mate, if Strawman wants to have a conference, I'm happy to attend as a guest of Strawman with the combination of food paid for. That's a lovely idea. Thank you for the offer. It feels we'll be back in seven weeks' time after I ran into I've been sent six weeks in Hamilton Island. I don't know what the IRR on that is, but I'm sure it'll be great. We'll get it later. What you know is you fudge the budget. Look, I'm sure we're going to create billions of dollars worth of value. So, and only in six weeks, you know, so the IRR is through the roof. Pays for itself. So, no brainer.

1:17:48And then some, yep. Hey, I'm going to finish very quickly, but it's like another slight tangent, only because I feel like I desperately need to because I'm that sort of bloke. Okay. I'm just going to add, and I know you didn't mean this otherwise, or maybe you didn't, in which case feel free to say that. But having friends, very good friends, and others who work in the early childhood education industry, while there is a massive grift around profiting from childcare, there's also huge amounts of value from early childhood education that aren't just looking after the kid while mum and dad are at work.

1:18:18We know from research in the US, there's a great Australian organisation, let me give a massive plug, Thrive by Five. Jay Weatherill, the former South Australian Premier, heads them up these days. I think they're funded a little bit by Minderoo, which is Twiggy's charity, Anchors and Fortescue. So I have a tiny indirect interest, but not really because they give the money away, not making it. Thrive by Five is excellent. The value of early childhood education is extraordinary. So I absolutely, you know, institutionalizing childcare for its own sake so we can, you know, somehow create economic value in quotes by sending mums and dads back to work early.

1:18:51I think, frankly, It's just a shell game. It just wasn't measured before. Now it is. And look at this. but but um i'd also don't want to there is there is educational value in that not just looking after kids so mom can get back in the workforce there's genuine kind of you know developmental value as well so again more way off the tangent uh but i one of my one of my favorite twitter bugbears people talk about child care i'm like no it's early childhood education there's a bit of child care in there as well but don't don't forget the other bit so i just had to uh because i can't help myself had to mention that as well yeah yeah as somebody who works from home i have increasingly come to the view that like just school in general is institutionalized daycare because it's sort of like I'm really glad that the kids are learning how to read and write while they're there.

1:19:39But it's just like my day would not be nearly as productive if I were home all day every day and I had to teach them how to do all this stuff, it would be much, much trickier. You also see why rich people and all those with governance has got education done in an hour and a half a day because for all the, you know, one teacher having to deal with 30 kids and manage all that stuff. As you say, it's institutional shock here with education kind of interspersed where they can find some room. I've got some, my young-luck's got some great school teachers, but yeah, man, that's corralling 30 kids for six and a half hours a day is a tough ask.

1:20:09Oh, man. So, so tough. Look, we've gone so far over time now. It doesn't matter at this point, but there was a report released this week into the state of teaching in New South Wales and it's disastrous. And one of the funny things, not funny thing, it's funny because it's either cry or laugh, is that of all the things that's going wrong, is it chronically, chronically understaffed, like desperately.

1:20:39And one of the points made, and it was like, we knew this was coming like 20 years ago. It's like a lot, it's like, I want to say climate change. I want to say a lot of these things that are sort of coming down the track are all sort of like really just like there's a little guesswork involved. We talk about the difficulty of investing and trying to predict cash flows. Some things are just easier to predict than others. And anything around demographics is usually very easy to predict because you just push forward from where you are at the moment. And it's a classic example of the whole thing just ending up in a disastrous train wreck where you had like 10 years to swerve and you didn't and and and just the solutions that are being offered right now because it's all band-aids around it and it's just that the broader point here is you know there is there is oh i think as a society we'd be a lot better off if more of our decision makers and agencies thought like investors in the terms of internal rates of return and cost of capital Yeah, it's a good point, actually.

1:21:47Just to sort of bring it all together. And knowing that none of these things are necessarily dollar values, but they're insanely good returns, quote unquote, from a whole bunch of other sort of endeavours that we could do. That's really the basis of good policy decision, really, is like we as a nation and as a government that looks after the nation have so much money, we have so much opportunity. Really, we want to make sure that we maximise value for everyone in the country. And to do that, we need to have some kind of thinking about long-term internal rates of returns on all of these projects, the opportunity set that's in front of us, and how we can fund it.

1:22:21You made the point recently, many times, in fact, was it, well, not so long ago, where it's like, why wasn't the government borrowing like a drunken sailor when it could have raised funds at 1%, 2 % for 30 years? And then the key part here, not, you know, done something dumb with it, but really invested that sensibly. Gosh, the - Mate, the New South Wales government talks about borrowing money and investing in equities, which would have been a spectacularly good idea. Genius. Genius. And it's kind of thing, you know, why would you do that? Well, because I can arbitrate. Oh, dumb if they were paying 10 % interest.

1:22:59Right. That's the stupidest thing in the world. 1 % in the world. 1%, yeah, take my money. Exactly, exactly. Yeah. Anyway. Way off. All right. Way, way, way off the reservation here. Surprisingly enough for us because it's a first time for everything. And apparently today's that first time we've gone off on a tangent. So if you're still listening by now, maybe you finished your, well, you're almost 90 minutes into your run or your ocean swim or whatever. So thank you for spending a bit of time with us on a Sunday or a Monday, which is whenever you do listen to this for our mothers who are still listening and nobody else who gave up half an hour ago.

1:23:31Mates, we should try and short this one up next time. What do you reckon? Should we come back on Friday and have another go? Yep. Try and stop me. Hey, if you do want a question answered in the mailbag, hit us up, info at fool.com.au. We're on all the socials. Andrew is on at strawmaninvest or at sage underscore simeon on Twitter. I am on Twitter and Insta and threads at tmfscottp. I can't remember my master on account. No one cares. Andrew just thinks it's funny. If you're on Facebook, go to facebook.com forward slash scottphillipsmoney. We will see you on Friday. Enjoy the rest of your weekend and fool on.

1:24:05Cheers. 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.