Transcript
Hello and welcome to the Download. I'm your host, Dave Richardson. It’s a little overcast. You can't see it but by the way, next week we're going to finally get to video. And in preparation for that, Stu has his new headset so that his sound will be crystal clear. Stu, you look like you're about to look out your window there. And you probably can look out the window over the city of Toronto and give us a traffic report on an afternoon drive home.
Traffic is looking good on the Gardiner this afternoon. Normal times. Ten minutes. Probably nine right now, I'd say.
There we go. So traffic on the tens with Stu. And actually, we don't have a Stu for the traffic. Straffic? I'm a little excited today, Stu, because for the first time, only the third time ever in Canada, McRib goes on sale. For those of you who haven't listened in the past, I'm a devotee of the fake pork sandwich that McDonald's brings out about once a year in the US but has only offered us in the original version in 1982, 2008 and then now. Our producer Nancy did not know that McRib was available. So yes, starting today across Canada, McRib. And then Tim Hortons, they got their classic donuts out. Maybe more your style. The walnut crunch was always my favorite. They discontinued it and it's available now. My diet is done.
Well, we better keep it brief today then.
That was actually part of my thinking, Stu, because I am hungry. It is lunchtime. Anything that you particularly like from a food perspective that you don't get all the time, but really like it when you get it?
The old donuts. I used to love a maple glazed and they don't have those as frequently as they used to. I was never one for the dutchie or the apple fritter or anything like that. But a maple glazed, yes.
Yeah. Apparently, the apple fritter... I shouldn't say that. We never want to get in trouble with any of the companies that you might invest in, Stu. Along with a lot of great food items that we could rush out and get, we continue to see strong performance in this handful of stocks that we've been talking about; the Magnificent Seven. Maybe it's a couple more than that, but we've talked a lot over the last year about the concentration in some of these large cap, somewhat technology names. We can always talk about the excitement of a dividend growth stock that might have a 5% yield and is going to double over the next five or six years. But it's a lot more exciting to think about one of these stocks that seemingly doubles every six months. But you get to a certain point with some of these stocks, do you not, where they start to look really expensive, despite the strong prospects for the business. Is that something you see?
Yeah. People get so excited about what they call the TAM, which is the total addressable market. That is the big line, Dave. So when you get into these periods of time around artificial intelligence and cloud computing, it almost seems like the sky is the limit on some of these total addressable markets. So it's a backdrop that allows for a lot of dreaming around the future of revenue growth and how exciting that might be. And in many cases, some of these businesses do grow their revenues at pretty high rates. But one of the things that we like to do is to go look at history, because there's been a handful of situations where you do get really exciting stories. Internet, the first time along, ecommerce, you name it. One of the databases we have here, we have every company in North America that hit a billion dollars in sales and then we track them forward for the next ten years and look at their compound annual growth rate in sales over that time period. I haven't run this just frequently, but the last time I did it, there was only two companies that compounded their revenue at over 30% a year for ten years after they hit a billion dollars in sales, and that was Walmart and Google. And both of them, they didn't do it every year for 30% for a year, but that was the ten-year total. Microsoft was fantastic. It was quite close to that, but not quite at 30%. And the thing that we know over time is that when we get these elevated stock prices and these elevated expectations, people expect not only for the growth to be very strong, but it for to be very linear. It's even amazing, looking at a big company like Microsoft — today, valuation is approaching its higher level; it's growing its revenue north of 10%; it's been a great revenue grower — but even in the last six months we've seen what some people might call the enterprise value. So in the case of Microsoft, there's not really debt, but the market cap say to sales on a forward expectation basis is back over ten times. In the middle of last year, it was as low as seven and a half. So, as you can see, the actual underlying business is compounding away for you at that double digit rate, but what creates the real move in the stock price in a short period of time is the change in valuation. So what we tend to do when we get into these time periods is say, how much growth does there need to be for this business still to compound the share price for us over a longer period of time? In other words, can we accept the volatility that undoubtedly will come our way at these higher valuations than maybe what we saw last fall? In some cases, the answer is yes. And in some cases, the answer is no. What becomes really important in that analysis is the income statement, because many of these businesses generate cash, they don't have debt. But what becomes really important, you look at the revenue and you say, what portion of that revenue might be recurring versus cyclical? The more recurring the better. I don't know if anyone has Office 365 or has their Apple iCloud or things like this where you're just paying every month and they increase the price on you and they add features to it, and you tend to just carry on. So the revenue is pretty recurring. The next thing we look at is the gross margin. So you’re subtracting the cost of goods sold. And the higher the gross margin, the better, because that means as revenues grow, an incremental amount flows through to a company's cash flow or earnings. We take all these stocks, and we say some of them trade at elevated valuations. Do we think the revenue can keep growing, yes or no? If that revenue keeps going, does it have the characteristics in the income statement, a wide gross margin? Then you look at the next line. Does it have sales and general admin costs that are leverageable so that if revenue keeps growing, margins can expand and there'll be even more cash flow. So cash flow will grow faster than that revenue down the road. And you can wind that all up in a five- or ten-year financial model that you could almost do in the back of an envelope and get you in the right ballpark to say yes, even at this valuation, I'm willing to withstand any volatility that might come my way, because the share price can still get there on what we otherwise know to be a very good business.
I know one of the things that I often end up talking about with investors, when they're looking at maybe doing something like buying a portfolio — and you can plug your ear, Stu, you're not going to like this — but dull, boring dividend stocks, I can just buy a portfolio of those. Or is it more exciting for me to buy this high growth tech stock? And you start to get into the valuation discussion and the future and where it sits right now. You've got to have a model to properly evaluate that high growth stock because it's always going to be expensive by a lot of traditional measures, but there are companies that you're going to want to own that are expensive at a particular point in time. You need a way to identify, or at least see, as you say, realistically, given a certain set of circumstances, can their stock continue to appreciate? Does it continue to be a good investment? Because otherwise you just toss it to the side. You mentioned Walmart, Google, Microsoft. You would have tossed them to the side, and you would have missed great opportunities to invest even after they became pretty significant companies.
I think that's 100% correct, because there's two things you do as an investor. You can bet on the share price just going up in the short term and there's a speculative component to that activity. But who's kidding who? That's part of the markets and I get it. And you have a different toolkit for that. But if you're going to sit there and say, I'm going to buy this, and even if I end up paying the high for the year, can I still make money a number of years from now? And that's really where you want to get into the math of the revenue growth and the income statement and what have you. In the very short term, almost anything can happen. We look at some of these businesses today. You can say Microsoft trades at ten times its sales in a couple of years. In the very peak of the technology bubble, Cisco was the biggest company in the Nasdaq. It traded at twenty times its sales in the peak of 2000. As exciting as this has been, it's not nearly at the levels that we saw during the tech bubble. Plus, the businesses are much different. There's more recurring revenue, the margins are wider than they were at the time. But nevertheless, you always want to ask yourself, if I was going to buy this today and I was going to put it in a lockbox for ten years, can I make that high single digit to double digit return? What has to happen? And is that possible? And is it not only possible, but is it probable? And that's a real pretty good sanity check in today's market. And there's lots of those highly valued companies that still fit that bill, and there's some that don't.
Yeah, I had Marcello Montanari on a couple of weeks ago, and we got into this around some of these big technology stocks. And the idea that in technology, you look really over the technological era where you categorize tech stocks more over the last thirty to thirty-five years, and as you see these companies come up in a new industry and evolve, and you tend to have pretty high concentration of a small number of winners and losers, and then there's usually one big winner. But some of these companies that we're talking about have gone even beyond that because they've already been big winners in several different areas of technology. But because they're so large and they can devote so much cash to research and development, to be on the cutting edge, or to just buy some of these smaller companies with emerging technologies, just their overall market position allows them to add new businesses, as you say, new cash flow streams that they can eventually dominate and continue to grow at these astounding rates. And like you say, you need a way to measure just how reasonably valued they are relative to where you're going to be five or ten years from now and whether it's a good time to invest.
Yeah, scale plays, to your point, a bigger role than maybe it has in the past, because when we talk about artificial intelligence, the amount of money required for language models and things like this, to build server farms and data centers, these are big tickets, and they benefit the largest players who have that extra free cash to just keep on keeping on.
So I remember a number of years ago — I'm going to guess it's about seven or eight years ago, if we put a timeframe, maybe you'll remember — I had a conversation along the same lines with you about a Canadian company, Shopify. And we were looking at that, and it was hitting all-time highs. I believe at the time, it had just become the largest stock on the TSX, or it was approaching that level. And we talked about this very thing in terms of how to value that company relative to your database of companies that had grown to a certain size. And you highlighted at the time that perhaps Shopify had gotten ahead of itself a little bit. When you look at a company like that now — and we've got to be careful, we're not recommending or picking individual stocks — but just looking at, in this case, how valuations have shifted seven or eight years later, how has Shopify evolved through that period. And what does it look like now? Was it a stock at any point in time that you may have held in one of your portfolios?
Well, in some of the portfolios, we hold it, in more healthy positions today than we certainly did. But it's a great illustration of what we just talked about. So in late 2020, Shopify traded at almost thirty-five times its forward sales. Today it trades at ten times sales. You still need growth to make ten times sales work, but the level of growth is a lot different than thirty-five times sales. And if, in fact, you go look at their financial results in the last four or five years, I bet their revenue has more than doubled. If we sit here today and we say in 2020 they had revenue of 3 billion, this year they'll probably have revenue north of 8 billion. So you have a very strong growth business, but it's a great point that the stock market's enthusiasm for that growth got a little bit ahead of what still ended up to be a fantastic actual experience. Today, we sit here at ten times, and you're hoping for high teens to 20% growth. You look at the gross margins, it still has a pretty high set of expectations in it, but it's really changed quite dramatically since the last four years. It's great math as you bring up, but you've got a stock that was $150 or $160 us at its peak. Today it's around $80. It's lost half its value. Meanwhile, its sales have more than doubled, but its price to sales ratio has fallen from thirty-five to ten. If you add all that together, that's how you get the share price declining in half. You almost feel for management of the business, because if you could double revenue every four years, that would be pretty spectacular. It's just that the stock market got super exuberant in front of it.
And this is an expression that you've used with me and on this podcast: there's the business and there's the stock. You can have a spectacular business, but the stock reaches a certain point, at some point in its history, where the exuberance around it has just gotten too much and the price has gone too high. No matter how successful the business is from that point on, there's no way it can sustain that level of valuation.
Yeah, there's two really important things which you just said. The first is the law of large numbers. So just having to grow 20% every year requires an awful lot of revenue, ten years from now. And the second is business is competitive. When you look at the other company growing really quickly, you start copying them, you start trying to do things. And that gets you into the old Warren Buffett comment around moat. The stronger your moat, the harder it is to compete. And Shopify has a pretty good moat. But people will try and chisel away at it over time and figure out any weakness they can. And that's the great thing about evaluating and analyzing businesses over time, watching all the changes that take place.
Excellent. Well, that's an interesting primer again for the kind of market that we've been in, because we have talked a lot, if we look at the S&P 500, the Magnificent Seven, and then the other 493. And looking at the other 493 and what needs to happen for them to start to catch up. Or they have the economic backdrop and how that affects those companies. But I think a lot of people like to take a look at those seven. They get pretty excited about it and need to think about, have I missed the boat or is this something I need to think about? And then over what timeframe and what kind of metrics can I use to make some calls around that and whether or not they fit in the portfolio? So this was once again, Stu, just fantastic. Almost like knowing a special route through the traffic because you're pointing it. Switch lanes here and move, accelerate, move up, get over and cut that drive home from forty minutes to twenty with Stu.
Right, with my new headset. Sounds like it's time for a maple dip, Dave.
Sounds like it's time for a McRib. I'll be a bit heavier. And again, look for us. We think we are almost positively going to be on video next week, along with audio. So don't skip the audio. Other than our mothers, most people might suggest we should stay on audio, but we're going to try video anyways. And Stu, we'll catch up with you next week.
Great. Thanks, Dave.