Welcome back everyone. We have another exciting episode
of the Joseph Carlson show and this time it's centered around
an investor named Terry Smith. If your listener of the Joseph
Carlson show you've heard of Terry Smith before, but if
you're new, Terry Smith is a great investor.
Not only is it great investor, but I think he's overall just a
cool guy. He's someone that's outspoken.
He really speaks his mind on any topic.
He's beat the market. Since the Inception of his Fund
in 2010, he has an investing strategy.
That's both rational focal. This is strongly on
risk-adjusted. Returns, doesn't try to time the
market and overall, I just think he's a very sensible
well-adjusted investor. That will likely beat the market
for a long period of time. He categorises his strategy into
three parts, buying good companies, not overpaying and
then doing nothing. Now, the strategy is a little
bit more complex when you dive into it.
But that's the three basic pillars.
One thing that you may not know about Carrie Smith unless you've
read about him, is that he's incredibly competitive.
This guy is competitive. He Likes to win.
He likes to come in first place and you can see that with how he
conducts himself, and he's also very outspoken.
And I would say even a ruthless when he finds incompetence in
companies that he's investing in companies in the market or
incompetent management teams in his latest investor letter, he
is ruthless. He calls out companies directly
he calls out management teams directly he calls him out for
poor management. He calls him out for deceptive
accounting practices and he even calls him out for virtuous
signaling. When the letter is an outright
tongue-lashing for these companies, I think there's a
good chance that some Executives will be fired, as a result of
this shareholder letter. And that would not be the first
time that Terry Smith has gotten Executives fired.
He also dives into a topic that I spent some time thinking about
that I've made episode after episode about the topic of
stock-based compensation. Now, there's nothing wrong with
stock-based compensation in and of itself.
But the problem is how these companies account for
stock-based compensation. In many cases is highly
deceptive and now after making multiple videos on the subject,
we have Carrie, Smith weighing in and he does.
So in his manner of being, extremely detailed and
straightforward. So Terry Smith has a lot to say
in this letter and he says a lot, this is going to be an
exciting episode. It's jam-packed with
information, we have a lot to get to.
So let's go ahead and Jump Right In.
Now, part of the reason I like Carrie Smith is because he views
investing very similar to the way I do not the same, but Terry
Smith is one of those investors. That I do, give some inspiration
and I get some thoughts from him on investing in different
potential companies. When I'm looking at my
portfolio, I'm always concerned with buying companies that have
high returns companies that can reinvest back into their
business and get very high returns.
As a result, these are high-quality companies and this
is specifically what Terry Smith looks at companies that you can
buy in to hit your wagon to and year after year.
After year, they will produce a tremendous economics for the
investor. They'll be able to pay
dividends, they'll be able to do by packs.
They'll be able to reinvest at high rates of return and they
also have incredibly low downside risk.
These are the type of companies I'm looking for, I call them
Compounders Terry Smith calls, them, good companies.
So even though I don't marry his portfolio and I don't invest in
all the companies he does, I will look at his 13f filings and
see what he's doing. Try to keep track of it because
when Terry Smith buys a company, it's already gone through an
extensive screening process. So I know that he's already
looked at some things with a company and that can spark some
ideas for future research. Now, we have his portfolio hair
and he has made changes to it. And that's what he talks about
in his latest letter. Dear fellow investor, this is
the 13th annual letter from fun Smith, equities fund, our funds
performance in 2022 will give Credence to those who suffer
from tricycle, Deca phobia. Now, I don't know what this word
was. I didn't know what it meant.
I looked it up and it means a fear of the number 13, which
makes sense sir. But to start off, he goes over
the performance of the fund. The table below shows, the
performance figures for the last calendar year and the cumulative
and annualized performance since Inception on November 1st, 2010
and various comparators, we have the total percent return of
funds, Miss Equity, Fund, it underperformed, its Benchmark
index last year, the Benchmark, which he compares to, as down
7.8%. He was down 13.8.
He did go through a period of under performance.
Now, the annualized performance and cumulative performance is
much better. Better.
He's made about double the gains of his Benchmark index.
So, overall, since the start, he's doing well, but last year
was not a great year and he addresses underperforming last
year whilst a period of under performance against the index is
never, welcome. It is nonetheless, inevitable.
We have consistently warned that no investment strategy will
outperform in every reporting and every type of Market
condition. So, he says, as much as we may
not like it, we can expect some periods of under performance,
which is entirely reasonable. To performing the msci.
World index is one issue. Registering a fallen value is
another in 2022, unless you restricted your Equity
Investments to the energy sector you were almost certainly to
have experienced a drop in value.
If we look at this performance chart of the different sectors
in 2022, energy is the only sector that in aggregate went
up, and it went up a lot 59%. So Berkshire with their huge,
massive energy Holdings did well in 2022.
But everyone else to as exposure to all these other Industries,
probably lost money for most investors, I would say 99% of
investors, they lost money in 2022.
Utilities was down Consumer Staples is down Healthcare
Industrials. Materials Bank software and
services. Real estate was down except for
Vici. Shout out to Vici.
There was up, 12%, consumer, discretionary, communication
Services, all of that was down. So basically, don't feel too bad
if you lost money in 2022. That's the way the market works
now. Next part of this letter, he
gives a history lesson and it's like five pages long.
I'm not going to go over all of this but you can read the letter
if you're interested in the long history lesson on interest rates
because it does explain his funds performance I would
summarize this history lesson in this one paragraph he says it is
inevitable that when interest rates rise as they have now to
combat inflation, longer-dated bonds fall more than shorter
dated bonds. And so it is with equities with
more highly rated shares, meaning higher Multiple
companies, which are discounting earnings or cash, flows, further
into the future. Highly rated companies, suffer
more in a downturn than lowly rated ones are so-called value
stocks. Now, he doesn't entirely blame
interest rates. He also notes that meta had some
big problems with competition with the Apple changes and with
them going all in on the metaverse that spooked
investors. So he brings up other things.
He's not making excuses, but he does note that longer duration
assets, which are highly rated companies, they do get a Acted
more in downturns than value stocks which have their cash
flows coming to you almost immediately and then right off
the bat, Carrie Smith starts to dig in to individual companies.
He first starts off with PayPal saying that PayPal seems intent
on snatching defeat from the jaws of Victory.
It is taken a leading position in online payments and parlayed
that until lamentable share price performance.
The elements of this would appear to be a disregard for
engagement with customers, newly acquired during the pandemic and
no obvious attention to or control of costs.
So he's pointing out two things there for PayPal, but he doesn't
end there. He continues on an even
intensifies, his criticisms towards PayPal.
This is hardly surprising given the attention devoted to
pursuing some clearly overpriced Acquisitions.
That is what happens when management starts to conclude
that Investments do not need to earn an adequate return in this
line, I think is spot-on. This is a huge problem right
now. Companies doing merger and
acquisition after merger and acquisition and Hit at horrible
prices, horrible rates of return.
I just did an entire episode on my other channel going over,
Disney's acquisition a fox and how overpriced that was.
So, this is something that's a problem with more than just
PayPal. If one word could be used to
describe last year's winners, it would be defensive out of his
biggest winners last year to or fast-moving consumer goods
companies and one is a drug company.
So interest rates did play a part in the valuation, collapse
of a lot of companies. The higher valued one's, Got
further discounted as interest rates went up, but he notes that
that's not the only thing going on.
There's a lot of Shifting economics here, the cyclic ality
of tech spending an online advertising is probably about to
become evident as the economy slows and maybe falls into
recession. It may be greater than in the
past, simply because Tech spending has become a much
larger portion of the overall corporate and personal spending.
However, there may be a silver lining In This Cloud as this
pressure on Revenue growth may cause Some companies, some of
their tech companies that they invest in to behave as though
money is not free and the halt, some of the less promising
projects outside of their core businesses, so he's finding some
upside and what's going on right now as interest rates go up,
companies can no longer make as many stupid decisions without
consequence. So it's actually forcing
companies to become more prudent and well managed by them, having
a cost attached to Capital and this is something that I really
do enjoy. Enjoy.
I like the investing environment today more than I did two years
ago, two years ago, bad companies were going up in stock
price for no apparent reason other than Dreams by investors
companies were not being accurately priced and now we're
getting to an environment where companies are actually being
priced based on their current cash flows.
And realistic assumptions about the future gains from companies
is going to be much harder earned in today's environment,
and that is something that I think is better for the economy.
He names three companies that are actually.
Adapting to this new environment, alphabet, which
I've noted many times, has a bloated corporate structure, a
lot of overpaid employees, a lot of bloat, they also have a huge
money-losing, other bets. He notes that lightning does not
strike twice alphabet struck, lightning with their search
business and that's unlikely to be replicated.
No matter how much money they throw at it Amazon, they're also
cost-cutting. It's already withdrawn from its
food, delivery and Technical education, and India, and it has
highly successful e-commerce and cloud computing.
Shooting business on which to focus and then we have Meta Meta
stock price would have been fine if it didn't torpedo Itself by
focusing. So intently on the metaverse,
they say, without the spend on the metaverse, they would own a
leading communication and digital advertising business on
a single figure PE ratio. So you get the best of both
worlds, a high quality company at a low valuation, this brings
back to their strategy of buying, good companies, not
overpaying and doing nothing in. This is where they go through
each leg of the Strategy. One of my favorite things in
Terry Smith's updates is this look through portfolio.
And what they basically do, is they take all of these metrics,
like, the Returns on Capital employed, gross margins and they
combine it into one company. So you can see their entire
portfolio mush together into one company and then you get an
overall idea of how powerful a company it is.
If it was a single company and then he Compares that against
the S&P 500. As if the S&P 500 was one big
company and he ill The streets by this comparison that his
company is a better company than the aggregate of the S&P 500.
So we look at the Returns on Capital employed, which is
always number one. The first thing Terry Smith
looks for 32% for his portfolio in 2022, 18% for the S&P, 500,
gross, margins 64 percent for his portfolio. 45% for the S&P
500 operating margins 28 percent against 18, cash conversion.
That's the only one that's identical between In the two and
then interest coverage, this is the amount of Leverage, the
higher, the number, the better. That means that you cover your
interest payments by a higher degree, which just means he has
less levered companies. They have roughly half the
amount of Leverage then the companies in the S&P 500.
So he beat them on returns. He beat the company's on Gross
margins operating margins. He had a tie with cash
conversion and then he beat them by double on Leverage overall.
Terry, Smith's portfolio is much stronger, much stronger than the
S&P 500. Oh, oh, and Terry Smith has
consistently worked to try to highlight the differences.
This makes in the total returns and the long-term returns of
companies. Consistently High Returns on
capital r, one sign we look for when seeking companies to invest
in another is a source of growth High returns are not much of a
use. If the business is not able to
grow and deploy more Capital at these high rates.
So the perfect business is one that has high Returns on Capital
employed and a lot of opportunities to employ Capital.
Now, he shows how Companies did economically in 2022.
They grew their Cash Flow by 1% so barely any growth.
He didn't have much growth in cash flow.
They barely edged up 1%, but if we compare that against the
index, the index had the cash flows Fall by four percent last
year. So the S&P 500.
Cash flows went down his cash flows, went up and this is
especially impressive because Terry Smith's portfolio, grew
cash flows by 20% in 2021. So basically they grew cash
flows, a ton two years ago and then they still were able to
grow cash, flows ever, so slightly the following gear.
There's no huge regression. The S&P 500 is not growing cash
flows. As fast as Carrie Smith
portfolio, and the growth of cash.
Flows is an incredibly important ingredient in valuation.
In this is where we get to the second part of the strategy
valuation. Not overpaying for companies.
This is probably the most common criticism I receive as an
investor. I, by good companies.
I'm just over paying for all of them.
Any company that I'm buying because they're in the high 20s
PE ratio. I'm overpaying for those
companies in this is something that Terry Smith is also aware
of and he's fought against throughout the entirety of
running his fund. People wondering why he's
overpaying for these high multiple companies even though
he's outperform the market for 13 years, the weighted average
free cash flow yield of his portfolio is 3.2%.
The year-end medium free cash flow yield of the S&P 500 was
3.4%. And roughly in line with his
portfolio. And this is important because
basically right now they have similar free cash flow yields in
terms of free cash flow. His portfolio selling for around
the same price as the S&P 500. So the big determining Factor
here of which one will do better.
Terry Smith's portfolio or the S&P 500, it will be determined
by their free cash flow, growth rate, whatever one can grow
free, cash flow, the quickest over the next five years because
they have roughly the same Point.
And if I had a bet between the two, I think there's much better
odds. That Terry Smith's portfolio
will grow free cash flows faster than the totality of the S&P
500. Because his portfolio consists
of companies that are fundamentally a lot better than
the average of those, either in the index or valued fractionally
higher than the average of the S&P 500.
He buys better companies that are simply better at
consistently growing cash flows. So I'm looking at valuation on
any company, I'm looking at this starting point.
Of the valuation. The starting point is the yield
of the company. Texas Roadhouse has a free cash
flow yield of four point one six percent.
And like we just saw the S&P 500's, current free cash flow
yield in aggregate, is 3.4 percent.
So we have a better valuation starting off with Texas
Roadhouse but not only is the starting valuation cheaper for
Texas Roadhouse but I also believe it will outgrow the S&P
500. I think the free cash flows will
grow quicker, so that Of way of trying to outperform.
Yes and P. 500, finding companies have starting yields
as high around the same as the S&P 500 but which can grow their
future cash flows at a faster rate than the S&P 500.
Now, the third part of this strategy is one that I think I
struggle with the most, which is to do nothing.
I think this is just mentally the most difficult part and
investing in individual companies, which is to truly
have a long-term mindset. I think doing analysis is fun.
Doing analysis is Viv and I could do that for hours on end
and really dissect and learn everything there is to learn
about a company. I can find out the valuation, I
can look at the future cash flow.
I can look at the downside risk of the company, I can assess the
moat and I enjoy doing that. But doing nothing is something.
I struggle with have a very difficult time, just sitting
back and watching my portfolio from afar and doing nothing.
So this is an area that I'm really trying to get better at
this year. A real Focus trying to hold my
companies for longer periods of time and only Then if things
have really materially gotten worse for the company.
Now, Terry Smith tries to do this as well, minimizing
portfolio, turnover remains one of their objectives and he says
that they had a turnover of 7.4% that was around the same.
As me around eight percent turnover last year.
Now Terry Smith did sell and buy a number of names and this is
where we get in to some of the juicy details of his criticisms
about different companies. He says that we sold our steaks
and Johnson & Johnson. Chuck's cone into it and PayPal.
The only company that I own is Starbucks and I've recently
trimmed around half of this position because the price has
surged up past $100 very close to its fair value.
So, I've made some gains in Starbucks, but I still hold this
company. Now, he purchased mettler
Toledo, Adobe, Otis and apple. He sold a number of companies
and he purchased a basket of new companies.
And this is where the spicy criticisms start.
Terry Smith starts to dig into these companies and he gives A
tongue-lashing. He really does not hold back and
this is something that I appreciate he says last year I
wrote about Unilever and attracted a virtual tsunami of
comments and remarks about the company events soon.
Overtook this commentary insofar as Nelson Peltz tree, and
partners announced that it had bought a stake in Unilever and
he was invited to join the board.
Now, this is interesting, Nelson Peltz is the one that just
purchased a steak and Disney and he's trying to get a board seat
on Disney because the company's doing so poorly, I want Nelson
Peltz. To get on the board of Disney.
I want somebody to get in there and to try to hold this
executive team and these directors that have
underperformed for a decade accountable.
So I'm actually in favor of Nelson Peltz.
I think Terry Smith is too but he's frustrated with how these
companies are conducting themselves.
He says, once contact had been established with Unilever, we
then tried to make some points about what we saw as problems
with the performance of the business, and the focus of the
management, which were duly ignored.
This is a business making A non-capital in the mid to low
teens below, the market average, where you could measure annual
growth. If you could only count to three
and which missed every Target, it set out when summarily
rejected the Kraft Heinz B approach.
So it's not like there weren't some questions to be answered
now. He says, I don't know how long
tree and held its take before mr.
Pelts was invited to join the board or how big of that steak
was, but I would guess that they held it for far fewer months
than we held it in terms of years.
He says, we have no objection to mr.
Pelts involvement. But here is where Terry Smith
gets to his biggest. Complaint, what I find
questionable is that companies mouth platitudes about wanting
to attract a long-term shareholders yet based on our
experience, we tend to get ignored whereas an activist who
has held the shares for far fewer months and we've held
years gets invited to board meetings.
That is the big problem here, they're not paying attention to
their long-term shareholders. They only pay attention to
activists because activists muscle their way into companies.
They do fights and Roxy fights, they force companies to pay
attention to them. And meanwhile these companies
are ignoring their long-term shareholders.
One example, may just represent an outlier but what about
PayPal? We had held PayPal shares since
it was spun off from eBay. In 2015, we tried to engage with
PayPal as we identified. Seemingly long before the
management that their lack of Engagement.
With new customers was a problem as was cost control and that
their Acquisitions were value destroying.
In particular, we pointed out that the value Value destroying
Acquisitions, might be avoided if management are enumerated.
Incentives, included, some measure of Returns on Capital, a
representative of the board kindly told us, they would think
about it and again, it requires muscle, it requires fair, and it
requires power for them to actually pay attention.
Whilst they were allegedly thinking about it.
Elliott management who, by the way, it's ran by Paul singer.
Who's one of the scariest guys in the capital markets.
He's not like Nelson Peltz. He's not a friend.
Work with Management in the same type of way.
He's one of the most feared investors in the entire Market.
May be the most feared we have Carl Icahn and Elliott
management right there. Kind of neck and neck is the
most feared investors. He bought a stake in which led
to them being given a board seat and information sharing
agreement. Please don't misunderstand the
criticism. I'm leveling here, I'm not
envious. I do not want a seat on the
board of Unilever, PayPal, or any other listed company, nor do
I want an information sharing agreement, I think our research
has been able to identify the problems of PayPal and Unilever,
better than the management. And without the need for access
to any unpublished information, even without their inside
information. They're saying that they can
better identify problems with these companies.
And then Terry Smith put together this table, that shows
the reporting of Unilever and their different Acquisitions,
and what they're showing and what they're not showing, for
example, off to the right here. We have all these different
products that they've purchased Time.
And the check mark means that there including the performance
of these new companies. They've purchased the X means
that they've decided to not leave that in the earnings
reports over time. This companies leaving out more
and more products that Terry Smith is saying basically, the
only reason a company would do this and not give investors
insight to what's going on is because the Acquisitions they're
doing are not giving good returns.
So over time this company is becoming less and less
transparent. Now, Terry Smith has been
calling out these companies for a number of Years, their
business practices Acquisitions. And of course, he's getting a
lot of people that agree with them, but also a lot of pushback
e, says amongst the outpouring of comets last year where a
number of apologists for Unilever, who are at the pains
to point out that the elands brand has been growing revenues.
Well, and that this was proof, that quote purpose works.
Of course, there is no control for that experiment.
We do not know how well it has grown, without the quote
purpose. And then he literally Strikes
Out virtue signaling. He's calling this Signaling to
further illustrate. This this year.
We're moving onto soap when I last checked, it was for
washing. However, Apparently that is not
the purpose of Lux, the Unilever brand, which apparently is all
about inspiring women to rise above everyday sexist, judgments
and express, their beauty and femininity unapologetically.
I'm not making this up, you can read it.
Here we go to the Lux Brand's website and that is the the top
statement there. This brand of soap, inspires
women above of sexist judgments and to express their beauty and
femininity unapologetically. Keep in mind, this is soap.
I will leave you to draw your own conclusions about the
utility of this. Now, moving on, we have, what I
think is the most important topic in this entire
presentation is share based compensation, and especially its
removal from the non-gaap generally, accepted accounting
principles profit figures. So share base.
Compensation is stock-based compensation.
This is something that I've talked about routinely on my
channel. To help investors understand
this and how it works with companies, and how in many
cases, it misrepresents the earnings potential and the true
profitability and the true cash flows of a company share based
compensation has become an increasingly prominent part of
some companies expenses in recent years, especially among
companies in the technology sector share based compensation
expense expressed as a percentage of the revenue has
gone from 2.2 percent in 2011. To 4.1% in 2021.
So, over that 10-year, period, the percentage of stock-based
compensation doubled in these companies, this may not seem
like much of an increase, but keep in mind that during this
period, revenue for the set of companies had almost quintuple
Don average. So, not only is the percentage
of stock-based Compton Revenue doubling, but also the company's
revenues are going up four times and these companies make up a
much bigger and bigger percentage of the index.
So this is Literally a growing issue and he agrees with me that
there's nothing wrong with stock-based compensation.
If you get paid that way, I'm not saying you shouldn't get
paid that way. What's wrong here?
Is how investors are being misled about their Investments.
I want to focus on how share based compensation is accounted
for and more accurately, how it is not accounted for.
In these companies in this is where we get to some alarming
statistics among the 75 companies in the technology
sector, 45 of them, remove their stock, Base compensation from
non-gaap versions of their earnings per share operating
income or both in plain English. They remove the amount of their
debit for share based compensation which boost their
profits that is about 26 billion of expenses that have been
adjusted out in reporting, the 2021 profits in their, non-gaap
results of these 45 companies this amounts to an average of
600 million dollars in share based compensation for Company,
which is excluded or added back and reaching their non Gap.
Earnings, that is massive. These companies aren't only
moving this out of the free cash flow statement.
But they're literally reporting their non-gaap earnings, and
they're not including their stock based compensation.
This makes some companies look dramatically cheaper than they
actually are. Now not only that, but the
companies that are participating in this accounting, trickery are
the ones that have the most stock-based compensation.
So, the ones that have this as a big problem, Um, in their
companies, a big expense. They're the ones removing it as
an expense, making it look like it's just nothing.
It doesn't exist in their profitability.
Now he actually goes on to give an example of specific companies
that are participating, and I think, I think it's accounting
trickery, I really think the intentions and purposes of
companies doing this is to trick investors into believing.
Their companies are more profitable than they really are
and that is where I offer a solution and call trim with
this. You And see the real effects of
stock-based compensation. We have the example of
Salesforce has free cash flow hair.
This is what it looks like when not factoring in stock-based
compensation. It looks like they're making 5.3
billion dollars in free cash flow.
But then you add in the financing expense of paying
their employees and you have two point seven, eight billion
dollars in stock based compost so I can clearly and easily see
how much free cash flow in excess of stock-based
compensation. Up this company is making
without a tool like this without something that clearly
illustrates that you have no way of knowing how profitable your
company. Is it looks like it's twice as
profitable and even in the free cash flow yield of the company
sales force, really, doesn't have a true 3.74 percent free
cash flow yield because again, stock-based campese out roughly
half of what their free cash. Flows are.
So the real free cash flow yield is instead around 1.8%, but
unless you have a specific tool like cual trim specific charts,
Lay this out, side by side, most people are being tricked by this
and Terry Smith gives a very specific example of it.
He says take the example of Microsoft and into it into it is
a company that's tricking. Investors, Microsoft is a
company that's not tricking investors.
Microsoft shares are currently being valued at a PE ratio of 25
times the consensus CPS estimates for the fiscal year
looking forward into 2023. So, basically a 25 for PE ratio,
meanwhile, into it is being valued at twenty eight times.
It's forward earnings. So we have Microsoft at 25 and
into it at 28 and a lot of investors would simply just
compare these two PE ratios and that's the relative valuation.
You can either buy Microsoft at a 25 or into it at a 28.
That's where most investors would stop with their valuation.
But if you dig into the numbers here this is highly inaccurate.
For example, if you include stock-based compensation, which
would make it more of an apple, To Apples comparison.
Then you can actually see how Microsoft's valuation Stacks up
with into its this would mean that the shares of into it would
be trading around 43 times. So by including stock-based,
compensation to show the true profitability of the company it
went from 28 times forward. P/E 243 times forward.
Earnings. He says, I think investors and
analysts may find a premium of 14% for into it over Microsoft
to be reasonable. I'm not sure they're fully
aware. Are that into its Shares are
actually trading at a premium of 73%.
If share based compensation is treated the same manner between
the two companies. This is a massive problem and
how investors are valuing. These companies that have a lot
of stock-based compensation and I've seen investors get burned
by this over and over again. It's something that I've been
trying to warn about four months.
Many investors and analysts including us look at the cash
flow metrics more than the accrual profits.
That's the same way that I'm looking at.
Most of these companies, not through the lens of PE, but
mostly Their free cash flow yield and their expected cash
flow growth. He says, unfortunately, share
based compensation may cause distortions in cash flow metrics
as well. Even when they follow gaap under
gaap share based compensation is added back in the cash flow from
operating activities which in turn is used in the computation
of the free cash flow. Some researchers and
commentators argue that share base compensation should be
reclassified from the operating activities section to the
financing activities section. All of the cash flow statement
for analytical purposes. We agree after all the decision
to fund, compensation to employees with shares, rather
than cash is a financing decision rather than one
pertaining to the operations of a company.
This is something that I 100% agree with.
I think these companies should not be adding this back to the
free cash flow. Now, one thing that I can do in
the meantime is even though we see the big free cash flow
numbers of these companies, we can look at it with these
stock-based compensation. Lined up right next to it and
I'm going to even add in a new chart that does exactly what
Terry Smith is saying that Gap accounting should do it.
Nets out the difference. We take out the stock-based
compensation from the free cash flow.
So you see the raw numbers of how much they're actually
generating and cash counting, the stock based compensation as
a financing activity and again, just to illustrate how much of a
problem this is and how it creates apples to oranges
comparisons, Salesforce has half of their free cash flow.
Eaten up by stock-based compensation.
Other companies, like SP Global that also generate a large
amount of free cash flow. They have barely any stock-based
compensation. So when you're looking at these
numbers depending on the stock based compensation, you can draw
very different conclusions when this company actually generates
3.5 billion dollars of cash flow.
That's really about 3.4 billion dollars of real cash flows, it's
much more meaningful. And I've been highlighting the
example of Salesforce here, Terry Smith is highlighting the
example of into it. We look at their free cash flow
statement. We can see the same thing.
Looks beautiful growing free, cash flows.
I think into it's actually a great company but then we flip
over to the stock based compensation.
Stock-based compensation has accounted for 1.3 billion
dollars of the free cash flow. So if you net that out you get a
very different valuation which is exactly what Terry Smith
does. If we apply this concept to the
case of into it, it would imply that the company is not, in
fact, trading at a trailing 12-month, free cash flow yield.
Of 3.5%. So right now, it looks like the
company has a free cash flow yield of 3.5 and he saying that
simply not the case. If you net out the stock-based
compensation, the free cash flow yield goes from three point five
to two point two. So different companies are using
this to trick investors and make their companies look more
profitable than they actually are.
And I don't think this is going to change until the Gap
accounting. Rules are updated and then
finally after Terry Smith highlights these numerous abuses
of stock-based compensation accounting, he signs off for the
year. That's his letter for the year.
And in summary, like I said, from the very start, I viewed
this letter overall is just angry.
I think he's just upset at a lot of things.
These companies are doing not communicating, what the
long-term shareholders hiding their performance with
Acquisitions. Having bloated cost, structures
bloated performance. Investing in things with low
Returns on Capital employed and then doing accounting trickery
to make companies appear cheaper than they actually are.
There's a lot of abuse has a lot of frustration a lot.
A lot of things highlighted in a single letter and I agree with
basically all of it. One of the things I've done with
my portfolio, over the past year, is better understood how
the accounting Works, how these companies report their profits
so that I can actually get the true numbers.
So, that's my thoughts for this episode.
I hope it was informative and helpful, but that's all for now.
And I'll see you in the next one.