Some Q&As to myself

Here are a few questions that I’m still trying to figure out (w/ my answers attached). If you think yours are better, let me know!

What makes a stock move?

My take: The incremental & expressed opinion (w/ real $, thoughts don’t count) accompanying discovery of new, incremental information (could be knowledge, news, or the stock price itself) that is not reflected by the current assumptions baked into the framework. Due to the (1) consensus of valuation framework (DCF), (2) ability to actual ownership & entitlement to cash flows to company via stock, and (3) a desire to profit, the stock price should revolve around the best-guess intrinsic value derived from cash-flow analysis.

Would love to hear a more articulate thought.

The Outsiders by William Thorndike, what do you think of it?

My take: Hopefully you have read it. It’s a pretty good book that delves into capital allocation decisions and how management should approaching funding / deployment decisions. It’s crucial how a company thinks about cash-flow in (operation + financing funding + asset sales) vs. cash-flow out (CapEx, acquisition, delever, buyback + dividend) because it is the multiplier that enhances an already sound operation. With the sound operation, a company is good; but alongside good capital allocation decisions & capital structure, a company can be great. The candidate should speak fluently about each of these funding/outflow aspects and what their merits / demerits are. For example, when should a company do CapEx projects vs. acquisition? When should a company fund by debt? Etc

One caveat the candidate should point out is that The Outsider is a very selective set of samples. Sacrificing flexibility & conservatism to pursue extra returns disregarding dangerous underlying dynamics could ruin a company, and the book is set out to inspire & preach, rather than discussing how this set of tools should / should not apply to different industries. John Malone’s playbook, for example, should under no circumstance be employed by a cyclical industry like paper & packaging.

How do you think about share buybacks? Do you like it when companies do them?

My take: Share buyback is just one way the company allocates the capital and essentially is a “project” w/ the return-on-investment = earnings yield. So a company buying back shares @ 20x PE is essentially earning 5% on the capital deployed, with the return clearly higher if using cheap debt. I will be highly skeptical of the candidate’s ability if he thinks share buyback is always a good thing, because such activity is always open to abuse regarding (1) mgmt’s option exercise & stock-based comp w/ dilution, (2) bonus plans w/ metric anchored on EPS growth, and (3) at expensive multiples, essentially synonymous to investing in low return projects and thus destroying returns. A good management is always strategic in their buyback decisions.

How do you think about risk/reward? What is risk in your mind?

My take: When it comes to risk/reward, in my mind there are actually 2 sets of boundaries. The 1^st set of R/R has to do with bottom-line and exuberance. It’s where, operationally speaking, positions where an investor cannot lose regardless of the outcome and what the company is worth when everything goes right @ a reasonably multiple. The 2^nd set of R/R is where a logical investor, knowing the 1^st set of R/R, should get involved to achieve alpha or leave enough room to exit liquidity. For example, If stock is $100, the 1^st set gives downside to $50 and upside to $150, the 2^nd set may be somewhere around $80 and $130, because (a) @ $80, the risk/reward of entry is really down 30 vs. up 50-70, a 2-to-1 risk-reward and may be worth getting involved. In a rational situation, the stock should find support unless something else goes wrong and thus lowering upside / exacerbating downside; (b) @ $130, assuming fundamentals is playing out, there will be buyers shooting for $150 to capture the additional 15% return, the risk-reward for entry may not be very favorable, thus a good time for exit. In other words, the more fair way to look at stocks is (1) What’s it worth in the craziest situations and (2) what could it be worth if investors have some sense and expects a decent return for entry.

Risk: In my mind, risk is the possibility for permanent capital loss, the magnitude of loss, and the variance / uncertainty within my assumptions (thus wide valuation range). A stock is risky if I’m not only not confident in my estimates / assumptions, but also if such uncertainty leads to a wide range of outcomes where the loss-tail signifies a sizable loss. One can mitigate such by position sizing (but will run into the problem of shallow research as situations balloon, and thus fuzzy risk-reward range and thus poor alpha), or avoid such situations completely (which could lead to missing alpha since these situations are amongst the most mispriced, or having nothing to look at and underperform at bull markets)

What are the few things you’d look in a proxy?

1. Compensation hurdle - What metric(s) is the CEO being paid on? I've seen the metric jump around to suit a CEOs strategy or maximize the liklihood of getting paid. I've also seen useless metrics like being paid on non-GAAP operating income dollar growth. You could essentially buy all sorts of terrible businesses, destroy shareholder value, and still get paid. Normally, I would like comp to be tied to some sort of ROIC metric, but it depends on the industry. At the end of the day, I don't want metrics that incentivize people to take excessive risks.

2. Director compensation & composition - I want to know how entrenched is management. I want to know how many board members are ex-employees, dinosaurs (been on the board for decades), professional directors (people who are on multiple boards and appear to make a living as a director), and college buddies of the CEO. I also want to see if they have someone familiar with capital allocation on the board.

3. Peer group - Every company discloses who their compensation peer group is. Has that group changed and is it a reasonable peer group.

4. Options/RSU grants - How is the CEO getting paid. Is vesting tied to performance or time? Have they been consistent in the way they value the grants and the type of awards given out? Are the grants consistently done around the same time of year? Has management exercised many options before their expiration? I don't like seeing drastic changes in long term comp (i.e. from granting RSU to Options when the stock tanks).

5. Audit fees

What does a multiple stand for? How do you think about it? Why do multiples (Let’s say EV/EBITDA) break?

My take: Mathematically, multiples serve as a close substitute to the DCF. In practice, most investors use multiples as a shortcut to DCFs, because they are simple to do and easier to compare with other assets. Done right, using the multiple approach can effectively replicate the results of using the more theoretically correct (and usually more complex/time consuming) DCF. In essence, multiples are a reflection of the growth, return, and risk profile of industries/sectors. To me, returns are the biggest driver of value. When you see material changes in valuation/multiple, it is usually the result of changes in returns. Most of the value created in Private Equity is driven by improving an asset's returns (i.e. cutting bloated cost structure, disciplined capital allocation, etc.).

Multiples (like EV/EBITDA) don’t really work / deserves adjustment if (1) there’s significant minority interests, pension, etc items below the line consistently, (2) When the cash-flow / business profile is very sporadic cyclical, (3) when the asset don’t actually generate cash-flow, thus the multiple method understates the value, or when there is massive hidden liabilities, (4) when simplistic comparisons don’t take into account of growth & returns.

What are your favorite metrics and why? What are the 1^st 3 things you look at in financial statements?

My take: A few things I like: somewhat normalized ROIC, EV/uFCF, EV / Invested Capital, basically goes down to how much a corporate can generate (whether it’s a good business) and how does a market perceive it, all in below-the-line items. I like them because it’s a consistent and real yardstick, vs. the other metrics we invent because there are no other ways to value the business. Do need to make sure those numbers are true though (i.e. not working capital adjustments, tax breaks, amortization / depreciation, etc)

I usually start with the Balance sheet – Net Debt, Operating Cash-flow, and D&A vs. CapEx are the 1^st 3 things I look for. There is no wrong answer as long as they think like owners.