The next long read later in this edition discusses the Softbank effect on the tech stock rally this year and how it could unravel. This blog whilst not defending the rally, is an attempt to address common misperceptions underlying the criticism of owning the popular big technology companies – consensus trade, popular stocks, too expensive, too big to grow, etc. Some of these criticisms are sometimes directed at Marcellus too. Rather than brushing them aside or worse, let it degenerate into a destructive argument as most discussions tend to these days, the author recommends focusing the debate on data and first principles than conclusions to make it constructive. Three aspects of the blog worth highlighting:
Position sizing vs consensus trade: The author starts this section by reminding us about our primary objective: “First and foremost the job of an any professional investor is preservation of capital and a delivery of satisfactory long-term compounded returns relative to the amount of risk taken…..[there is no place] for contrarianism [for the sake of it] yet failing to deliver for years on end, while continuing to charge hefty management fees and exposing clients to tax inefficiencies from the continued dashing from one proposition to another.”
Investment management is not just about stock selection but also portfolio construction i.e, it is not just about what you own, it is also about how much you allocate to what you own and what you don’t own. He shows how simply by position sizing, you can demonstrate significant active management despite owning only the ‘popular’ stocks.
“If you run the numbers, you will find that a theoretical portfolio that is simply long Apple, Microsoft, Amazon, Facebook and Google and nothing else (i.e. 20% AAPL, 20% MSFT, 20% AMZN, 20% FB and 20% GOOG or GOOGL) has an active share of 75.9, which is considered pretty damned ‘active’ [a score above 60 on this measure is considered active]. I believe for most professional investors, psychologically and from a business perspective it is very challenging to maintain a portfolio with this level of concentration and active share.
Imagine that tomorrow everyone in the investment business is reset to a starting pot of $100 million cash and is asked to construct a portfolio using the 500 constituents of the S&P500. Of course, the ultimate investment results of any investor will depend not just on which of the 500 stocks he/she picks, but also how he/she decides to weight them. And somehow, even if some of the investors pick mainly large-cap Internet beneficiary stocks like Microsoft or Facebook and weigh their picks in such a manner that the active share is high, there will always be a contingent of critics on the sidelines dismissing these investors as lazy, unoriginal consensus thinkers.”
Valuations vs Business quality: Even if you buy a fully valued business, growth in intrinsic value can drive reasonable returns. The author shows that you could have still made outsized returns in tech stocks even without the maniacal rally, provided you picked the right ones thereby diverting the debate to business quality than valuation:
“it is reasonable to concede that most of these businesses have experienced significant multiple expansion in recent years. But if these businesses were rather cheap a few years ago, just because the multiples have expanded does not mean that the businesses are not cheap still.
…if we remove the multiple expansion component of the returns of the top 5 S&P 500 weights (Microsoft, Apple, Amazon, Facebook and Google), their returns still have beaten the S&P 500 by a wide margin… their profit growth, inefficiently underlevered capital structures (for Apple especially) and low starting multiples were sufficient to drive rather good returns, even if you had not relied on multiple expansion. This is not to say that returns starting from today will be as good as they have been in the past 5 years.
…the critic will probably take issue with the exit multiple assumption unless you already are baking in significant contraction. Here the discussion must necessarily shift to the qualitative specifics of the business model and sustainability of the economic rent that it is extracting. While the exact % ROCE metric 10 or even 5 years from now is difficult to predict, there is research that supports persistence of return on capital metrics by business quartiles. But the bulk of the discussion probably has to be business and industry-specific.”
Too big to grow and the internet’s power to consolidate:
“Microsoft is already worth north of $1.5 trillion, how much bigger can it get”, or so goes the refrain. To a certain extent, I think we all struggle to adequately picture very big numbers and everyone is susceptible to over-extrapolating high growth rates too far into the future. That said, nothing changes the truth that a business is worth its long-term discounted future cash flows. Thus, if the cash-flows are not expected to rapidly decay (due to still substantial growth or thanks to very low reinvestment needs) or the discount rate is low due to higher-than-average levels of certainty into those cash flows, the business can be worth a lot more than an average business. Especially if the business in question is leveraged to the Internet, is attacking very large addressable markets, or is displacing very large existing spend yet can sustainably extract greater margins and return on capital than the current competing businesses whose spend it is displacing due to a superior business model, certain virtuous cycles in operation and ability to constantly pass on some new surplus to the consumer. Another way to look at it: a $100 billion of revenue currently owned by a total of many smaller, more fragmented competitors operating an inferior business model converts to a lower aggregate EBIT and lower % ROCE than what an Internet platform business will generate once that $100 billion of revenue is siphoned off by the platform. The platform will also have greater ability to cross-sell and the incremental EBIT that is being spat out by the extra $100 billion of revenue earned by the platform should be capitalized at a higher multiple. There were probably some seeds of truth in the DotCom mania before it went too crazy. The world is a big place, and the Internet and software business models have proven to be more powerful than many people thought even a few years ago.”
Position sizing vs consensus trade: The author starts this section by reminding us about our primary objective: “First and foremost the job of an any professional investor is preservation of capital and a delivery of satisfactory long-term compounded returns relative to the amount of risk taken…..[there is no place] for contrarianism [for the sake of it] yet failing to deliver for years on end, while continuing to charge hefty management fees and exposing clients to tax inefficiencies from the continued dashing from one proposition to another.”
Investment management is not just about stock selection but also portfolio construction i.e, it is not just about what you own, it is also about how much you allocate to what you own and what you don’t own. He shows how simply by position sizing, you can demonstrate significant active management despite owning only the ‘popular’ stocks.
“If you run the numbers, you will find that a theoretical portfolio that is simply long Apple, Microsoft, Amazon, Facebook and Google and nothing else (i.e. 20% AAPL, 20% MSFT, 20% AMZN, 20% FB and 20% GOOG or GOOGL) has an active share of 75.9, which is considered pretty damned ‘active’ [a score above 60 on this measure is considered active]. I believe for most professional investors, psychologically and from a business perspective it is very challenging to maintain a portfolio with this level of concentration and active share.
Imagine that tomorrow everyone in the investment business is reset to a starting pot of $100 million cash and is asked to construct a portfolio using the 500 constituents of the S&P500. Of course, the ultimate investment results of any investor will depend not just on which of the 500 stocks he/she picks, but also how he/she decides to weight them. And somehow, even if some of the investors pick mainly large-cap Internet beneficiary stocks like Microsoft or Facebook and weigh their picks in such a manner that the active share is high, there will always be a contingent of critics on the sidelines dismissing these investors as lazy, unoriginal consensus thinkers.”
Valuations vs Business quality: Even if you buy a fully valued business, growth in intrinsic value can drive reasonable returns. The author shows that you could have still made outsized returns in tech stocks even without the maniacal rally, provided you picked the right ones thereby diverting the debate to business quality than valuation:
“it is reasonable to concede that most of these businesses have experienced significant multiple expansion in recent years. But if these businesses were rather cheap a few years ago, just because the multiples have expanded does not mean that the businesses are not cheap still.
…if we remove the multiple expansion component of the returns of the top 5 S&P 500 weights (Microsoft, Apple, Amazon, Facebook and Google), their returns still have beaten the S&P 500 by a wide margin… their profit growth, inefficiently underlevered capital structures (for Apple especially) and low starting multiples were sufficient to drive rather good returns, even if you had not relied on multiple expansion. This is not to say that returns starting from today will be as good as they have been in the past 5 years.
…the critic will probably take issue with the exit multiple assumption unless you already are baking in significant contraction. Here the discussion must necessarily shift to the qualitative specifics of the business model and sustainability of the economic rent that it is extracting. While the exact % ROCE metric 10 or even 5 years from now is difficult to predict, there is research that supports persistence of return on capital metrics by business quartiles. But the bulk of the discussion probably has to be business and industry-specific.”
Too big to grow and the internet’s power to consolidate:
“Microsoft is already worth north of $1.5 trillion, how much bigger can it get”, or so goes the refrain. To a certain extent, I think we all struggle to adequately picture very big numbers and everyone is susceptible to over-extrapolating high growth rates too far into the future. That said, nothing changes the truth that a business is worth its long-term discounted future cash flows. Thus, if the cash-flows are not expected to rapidly decay (due to still substantial growth or thanks to very low reinvestment needs) or the discount rate is low due to higher-than-average levels of certainty into those cash flows, the business can be worth a lot more than an average business. Especially if the business in question is leveraged to the Internet, is attacking very large addressable markets, or is displacing very large existing spend yet can sustainably extract greater margins and return on capital than the current competing businesses whose spend it is displacing due to a superior business model, certain virtuous cycles in operation and ability to constantly pass on some new surplus to the consumer. Another way to look at it: a $100 billion of revenue currently owned by a total of many smaller, more fragmented competitors operating an inferior business model converts to a lower aggregate EBIT and lower % ROCE than what an Internet platform business will generate once that $100 billion of revenue is siphoned off by the platform. The platform will also have greater ability to cross-sell and the incremental EBIT that is being spat out by the extra $100 billion of revenue earned by the platform should be capitalized at a higher multiple. There were probably some seeds of truth in the DotCom mania before it went too crazy. The world is a big place, and the Internet and software business models have proven to be more powerful than many people thought even a few years ago.”
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
