MI Rewind: Growth Investing Stock Analysis w/ Simon Erickson

22:39Momentum is the market reinforcing what it believes. This goes both ways. Let's start with the positive spin on it first, which is Tesla. Tesla has become a virtual feedback loop of positive news. Elon can do no wrong right now because Tesla stock is, by most traditional metrics, pretty egregiously overvalued. But what does that mean for the longer term? Tesla is in a very capital-intensive business, and it can raise a lot of money right now, even diluting shareholders less than 10%. Say that Tesla says, okay, we're going to go out and we're going to dilute 10 % of our equity and raise$80 billion.

23:14$800 billion valuation is going to raise$80 billion to build out supercharger network, to build out gigafactories across the world, whatever it wants to do with$80 billion. That is something that Tesla's other automaker competitors cannot do. Ford is not going to be able to raise$80 billion right now. GM is not going to be able to raise that kind of money. And so this is a huge head start that a company like that gets because of the momentum that its stock price has had. And so if Elon does go out and do that, I think the market would reward him further and even applaud a move like that because long-term sustainability of the business, that's a stronger competitive advantage in a capital-intensive industry.

23:52Let's take this the opposite direction and put the negative spin on it. If a company is losing momentum, if its stock price is falling, it gets harder for it to attract investors. It gets harder for it to get loans from banks that have covenants built into those debts that they're going to be loaning to them. Nobody wants convertible debt because the stock price keeps falling. I mean, there's a zillion bad impacts that happens from the other way around. And so I think the question about momentum is an interesting one. We tend to want to buy stocks when they're low and then sell them when they're high, that's at least kind of a traditional adage.

24:27But in reality, it's kind of the opposite of that, right? You've got a lot more options available for you as a CEO when your stock price is high, which is kind of an interesting spin on the momentum idea. I really like the idea that you mentioned of Tesla issuing new stock. And I'm not sure if you saw Michael Burry talking about this. And for those who are listening that don't know who Michael Burry is, he is the main character or the successful investor who shorted the housing crisis. He's the main guy in the movie, The Big Short. Of course, he is a real investor that the movie is based on. But basically, Michael Burry is very, very pessimistic on Tesla and even short the company.

25:07But what he did was he mentioned to Elon Musk, he said, listen, I'm very short your stock. I'm very pessimistic on your valuation and your company. But if I can give you one piece of advice, I highly recommend you go and raise as much capital at absurd valuation as you can, because that will be to the benefit of shareholders. So I love that you mentioned that. I think this also goes with this idea of people wonder why investors add to their winners and why winners keep on winning. And it's this idea that what you just said is, as their stock price grows, it's almost a self-fulfilling prophecy because Tesla's doing better.

25:38The stock price does better, then Tesla can dilute shareholders a little bit, raise a bunch of capital, reinvest that in the business, do better. Then its share price goes up. That dilution gets erased because the value of the stock has gone up so much. And it's self-fulfilling from there. And it just continues to win and win and win. And you see that time and time again with a bunch of companies. And that's why the stock price going up matters for companies in the long run. And the key piece of that too is that you have somebody who's executing really well. Elon has a lot of confidence from the market because he has done so well with every program that he's put in front of Tesla.

26:10He's not raising money and lighting on a fire and say, oops, I did it again. This is when Elon puts his mind to something. He is all in on it. Sorry for the Texas Hold 'em reference again. I guess I'm stuck on thinking about cards on this. But I mean, he's somebody that's going to execute. He's going to make it happen. And the market has a lot of confidence in him right now. This goes the other way, that if you've made bad acquisitions, shareholder capital on fire, the market's not going to have any confidence in you. But rising stock price plus great CEO is a pretty formal combination. I want to ask you about a relatively abstract concept that I've been kind of tossing around in my head the last few weeks, especially as I think about what's going on with Tesla and just some other companies with great leaders that I follow and even invest in.

26:53When we think about evaluation, we often start with a discounted cash flow model or some sort of multiple, break that down to a per share basis. Say we add, just for round numbers,$10 of share value for the future cash flows through a discounted cash flow model. Do you think it's possible to add a value for the shareholder based on the CEO? So can we say that each Tesla stock has an intrinsic value of$50 per share because Elon's a great CEO? Or if it's a less optimal CEO, if it's a less successful CEO, maybe that's only worth$10 a share. Or if they're even more successful than Elon, maybe that's worth$100 a share.

27:32And it's a very qualitative thing. And you could think a CEO is worth$10 a share. I could think they're worth$50 a share, and we'll have a disconnect in terms of what we think that valuation is. But is that even a valid way to think about potentially a valuation model? Yes, it is very valid. A discounted cash flow analysis is basically if you take a snapshot of what the business looks like today, and you forecast it out into the future, however many years you want to, and then you have a terminal value at the end of that too. And you discount all of those cash flows, not revenues, but cash flows that you're getting from those business lines back to the present.

28:05What is the business worth today? And so the results of your spreadsheet says this company is worth$5 billion in equity market valuation. That company sells today for $10 billion, double what your DCF says. Does that mean that this company is a screaming sell because it's overvalued, double what the discounted cashflow analysis says? Well, maybe not because to your point, Robert, there's optionality that is represented in the market cap of every company out there. And it's based on what is this company going to unlock that is not currently being appreciated by the market. And so a perfect example of this is Jeff Bezos.

28:40Jeff Bezos continues to find ways to unlock value that shareholders had no idea was going to be as well as what he saw the vision of the future being. Kiva Robotics, when they first started looking at these cute little robot spinning around in his warehouse factories,$750 million acquisition. Everyone said, Jeff, this is way too soon. The cost of these are going to come way down. You're overpaying for this acquisition. We don't think it's a good idea. And now look at Amazon today, two-day delivery, much faster than that fulfillment in the centers. And it's saving billions of dollars every single year that has been enabled by having robotics in its distribution facilities.

29:16And so something like that, there's no way that if you went back right before that acquisition, no one was saying, hey, let's just throw in the idea of having robots and Amazon's fulfillment facilities into the DCF. That is an optionality premium that you pay for Jeff Bezos that is now worth a lot of money per share. We'll have to get back in the nitty gritty of determining how much per share that's worth, but that has unlocked equity value. And so your point, I think, is the premium that you want to pay should be related to the track record of how good a company or its leadership team is at unlocking value.

29:50And that's not easy. We might say that that sounds easy, but you've got to kind of stick your neck out there and do things that your competitors are not doing and be right on your vision at the same time. And so this is where you start getting into process. You start looking at every time Jeff Bezos calls a management meeting, he demands everybody has a one pager that they're going to read for any decisions. It would inevitably happen at the end of the meeting. I mean, this is the interesting kind of art form of investing that's much more difficult than just saying, oh, it's a valuation of this, and DCF said it's worth this, and Price Target says it's worth this.

30:23That's where the street gets it wrong. That's where you cannot pin down a quantitative value on something qualitative like visionary management. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle. Just go into your podcast app and type in We Study Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more.

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33:50That's theinvestorspodcast.com slash tip-finance. All right, back to the show. The art of investing is exactly where I've been really focusing a lot because when I first started investing, I was purely quantitative. I did a discounted cashflow model. If the number said it was undervalued, I'd buy it. If it wasn't, I wouldn't. And I didn't add any value for the qualitative factors. And I quickly learned that that was not going to be a successful way to invest. Maybe Benjamin Graham back in the 40s, 50s, 60s could invest that way, but that was a very different market than we have today. And for me, somebody asked me the other day, Robert, I thought you were a value investor.

34:27How can you invest in Square? And I said, you're right, but if I think Square is undervalued, why am I not a value investor? Just because a company grows fast, why can't that be considered value? Maybe on a discounted cashflow model, it's not undervalued. But what if I think the network effect or the moat or various different things that Square may have going for it, what if I think that those have immense value more than what the valuation in the market says? Then it's an undervalued pick for me and I still am acting as an undervalued or value investor. So for me, I try to think about these more abstract and art side of investing a lot more lately.

35:04And the CEO, the value that they provide, Jeff Bezos provided as an example, is a perfect one. Because if a company is worth$5 billion and they have Jeff Bezos and they're selling for$10 billion, is he worth more than$5 billion to that company? You could argue he is, and then it's undervalued. Or you could argue he isn't, and it's overvalued. It's getting easier to unlock value now too. You talk about Benjamin Graham and Warren Buffett. A lot of these manufacturing companies from the 60s and 70s, they didn't have cloud computing. They didn't have artificial intelligence. They didn't have a lot of the benefits that companies today are enjoying.

35:37For them, it was how cheaply can you access capital and how quickly can you build a physical empire of infrastructure off of that capital that you raise. And so I think that a lot of times back then, value investing really was the way to go. You were able to get into the nitty gritty. We didn't even have the internet back then. So most people couldn't get access to that information. But today, looking at things like return on invested capital versus weighted average cost of capital, These are kind of like the creed of investing. These are like the fundamentals of investing. But I think the game has changed, Robert.

36:07I think that much more now is how quickly can you capture and unlock value for an organization in those early years of the DCF? How fast are cybersecurity companies growing right now? Because they've got people throwing money at them right now because there's so many problems. And that's incredible business. If you can take that business, borrow as much money as you can to get recurring growth for a cloud-based product that's throwing off 90 % gross margins for you. And so I think this is all related, but when we're saying terms like value investing or growth investing, it's really all a continuum that's looking at how can you borrow capital and how are you deploying that capital and what's the return that you're getting for your shareholders off of that.

36:46Robert Leonard I think if we only purely look at investments from a quantitative perspective, there are supercomputers today that will instantly make any arbitration available go away. Back in of the day, Benjamin Graham, if there was a disconnect in value and price based on a fundamental metric or key ratio, they had to find it themselves. Humans had to do the research, make the investment, and then wait for the market to close that gap. Now, there are supercomputers that can do that in milliseconds. So I don't think that those types of situations exist as much anymore as they used to. Now, I think as an investor, you really have to unlock the alpha or your gain over others by being more right about the qualitative factors of a business and unlocking the value that way.

37:30Robert Leonard Yeah, I agree. And I mean, so many of those price targets and institutional investors right now, it's really hard, the system that they're in to stick their neck out. Four years ago, it was saying that Tesla was going to be worth$800 billion in three years. People would kind of look at that with a strange look in their face, raise an eyebrow. But I mean, that's exactly what happened, right? And it's hard to predict those things and issue sell-side price targets that are just completely different than what anybody else was issuing out there. Now, as individual investors, we can benefit from those same disconnects.

38:03We can go out there and invest in companies that are showing qualitative signs of moving in the right direction, hitting the right operating metrics we want to, and have the great leadership in place at the top. Things like that are hard to capture in a discounted cash flow analysis model. So we've talked quite a bit about buying stocks, which a lot of people would argue is where your money is made. But what about selling a stock? When is the right time to sell? Does this play into your principle of upgrading your portfolio? Yeah. And the principle of upgrading your portfolio is something I believe in.

38:34It's a little contrarian to what others might say, but I always think that you should sell a stock if you have a better opportunity. There are obvious ones, like we were talking about management turnover, things like that that are the deal breakers. But maybe on a more subtle note or something that's not quite as pronounced. If you have a better opportunity, why not upgrade your portfolio to the better quality business? Now, make sure you're right. Don't just on a whim say, I'm going to sell this position and buy this one because I think this maybe is a better idea. I mean, have conviction in your decisions.

39:00But personally, as an investor, I've looked at some positions I've held on for years and I ask myself, well, why is that still around? Why am I still holding on to that stock? Why don't I sell that for something over here that I've done a lot more research and I'm a lot more confident in? That's upgrading your portfolio and you'll unlock better returns if you're investing in higher quality businesses that the market is appreciating, rather than some of that legacy deadweight that you forget about. We always want to be buy and hold. We won't have the intention of holding a company forever, but things do change out there.

39:30And I think it's a good idea to optimize over time and be mindful of what's going on out there in the market. Robert Leonard Warren Buffett has famously said that he doesn't let economic outlooks impact his investing. How about you? Do you adjust your investing based on macro data? Robert Leonard I mean, those are inputs for financial modeling. What's the GDP growth rate of the country? What are interest rates? Things like that are inputs that go into discount rates and everything else that we would use for financial model. I'm more interested in the bigger picture of what seems to be sustainable and what's happening out there.

40:01Zero interest rate policies right now are very interesting because capital is very cheap. Working from home is definitely a trend that's catching on and that's really benefiting technology stocks. A lot of stuff going on internationally is really interesting. That's where it really gets interesting, Robert, is looking at not just the United States, but you want to start putting money to work overseas, trying to figure out the cultural differences of what's happening in China right now. But things like this, the bigger picture macro trends that are taking shape, which are, in my opinion, what's the penetration of internet connectivity in a region?

40:32How many people are actually signed up that have a bank account or have a smartphone? I mean, things like that are enabling and unlocking these next waves of technology that we've seen happen in the US, and there are analogs to those overseas as well. And so I guess to answer your question, I don't obsess over the numbers quite as much. I'd like to know where GDP stands over time and where interest rates stand over time, but I'm much more interested in the bigger picture of what's taking shape and what that is going to enable. Robert Leonard How do you differentiate today's market conditions from those present during the 2000 and 2001 markets?

41:11How is today's growth investing different than back then? Robert Leonard Yeah. So the dot-com bubble was based on advertising, really rapid growth of revenue that was based upon advertising over the internet. And so everybody was starting their website. The jokes about pets.com are all over the place now, but it was all built upon advertising that was increasing incredibly quickly. Not sustainable. You can't have those kinds of growth rates in that short amount of time. And the euphoria eventually hit the wall and it came crashing down because it wasn't a sustainable business. And so you saw this shift of companies that did have an online presence to realize that they couldn't keep making their top line entirely off of advertising.

41:49They shifted to subscriptions. And even now we're seeing another shift where AI is coming into the picture. And it's rather than just per seat subscription basis, a lot of it's actually usage-based models, which is making cloud software platforms really interesting too. But so the difference between today's market and the dot-com market of 2000 and 2001 is that this is a much more sustainable business. This is something that's locked in, is becoming a crucial part of these businesses and how they operate because they're built in the cloud. They need the infrastructure of the cloud. They're vital components of businesses that are using them.

42:28And that locks them in. There's switching costs that are a part of that. You're paying on a monthly basis for a subscription rather than something that could vary wildly through advertising like we saw in 2000. From time to time, I get asked for book recommendations on growth investing. And I'm not typically a growth investor, so I don't usually have many good recommendations for this. I usually just say, hey, go follow Simon Erickson on Twitter or Jason Moser. These are some of the guys that I look for for growth investing. That's the best way that I've learned growth investing. But for someone who really wants a book or a few different books that they can go read about growth, what do you recommend and where can they find them?

43:08I've always been a huge fan of Clayton Christensen, who is a Harvard professor on strategy, fantastic investor too. I don't think he was given enough credit. He was an academic, but I don't think he was given enough credit for the contributions that he was making to the private markets too. And so he wrote a book, gosh, I guess it was 1997, if I'm not mistaken, The Innovator's Dilemma, which talks about disruptive innovation. He created the concept of disruptive innovation to explain why big firms will fail. And so this looks at companies like GE and IBM and why don't they in Cisco and why don't they just keep getting bigger and bigger and higher and higher margins and just kind of conquer the world?

43:43There's something that disrupts them. They have their comfortable way of doing things and their golden goose business lines that they don't want to mess up. And yet smaller companies have the opportunity because this giant juggernaut of a ship is heading in this direction to be a much smaller boat that goes in a different direction and can offer as technology improves more value to customers that are interested in that. So I would highly recommend the innovators dilemma. We lost Clayton Christensen just recently, a huge mentor of mine, unfortunately passed away, but his investing knowledge has kind of lived on through my investing style.

44:18And I have a great deal of respect still for everything that was presented in that book. I have actually had that book on my bookshelf for quite a while. I haven't read it yet. So I think based on your recommendation, I'm going to have to go downstairs and pull that book off the bookshelf and give it a read in the next couple of weeks. I have a long list of to read books, but I think I might have to move that one up towards the top. Robert, you give me a call when you get done reading it. Let's grab a beer and talk about it. Book club. Robert Leonard Yeah, you're down in Texas. You know I love Texas, so I might have to just take you up on that.

44:49It's getting cold here in the Northeast. It's nice and warm down there. I'll definitely take you up on that. Robert Leonard Anytime. Sounds fantastic. Robert Leonard As we wrap up the show, what's one piece of advice you'd like to leave the audience with that could be about investing, business, maybe even just life in general? Robert Leonard This is a great question. I love this one. I would say find things that compound. We talk about this in terms of investing because you want to compound your returns and build wealth. But my takeaway is compound your time too. As investors, there's no way to start at the top.

45:19This is a lifelong venture that you continue to learn things all along the way. And so when you're learning things, think about a knowledge base, have a journal, write things down, have something you can refer to in the future, and then build upon that. When you start looking at technology companies, you want to have the basis of growth style investing. And then on top of that, you want to have the basis of how companies are allocating their money. And so we talked earlier in the program about understanding the time value of money, understanding compounding, understanding different types of investing, figuring out what type of investor you want to be.

45:51All that builds upon a layer that's right before that. And so not only in investing, which we kind of talk about compounding knowledge there, but also in your career. I think that the way that you differentiate yourself professionally is you find something you're really good at and you become the expert in that. you build upon layer after layer after layer, you compound your knowledge in a certain field, and that really pays off for you in your professional endeavors too. So compounding, I guess, is my one key takeaway that I'd pass along. Simon, thanks so much for joining me again on the show.

46:21For anyone who wants to hear our last conversation together, you can check that out on episode 40. If people want to connect with you more directly, where can everyone go listening to check you out? So I'm at 7innovator on Twitter is probably one of the best ways to get ahold of me. 7investing.com, either typing that out or just using the number seven, we'll get you there. Or if you want to see our top stock ideas every month. And then if you want to talk to anyone on the team, we're info at 7investing.com or at 7investing, they're on Twitter as well. I'll be sure to put a link to that in the show notes below so everybody can go connect with Simon.

47:00Thank you again, Simon. Robert Leonard Real pleasure to be here. Thanks for having me, Robert. Robert Leonard All right, guys. That's all I had for this week's episode of Millennial Investing. I'll see you again next week.

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