1 00:00:00,000 --> 00:00:02,800 Welcome back everyone. We have another exciting episode 2 00:00:02,800 --> 00:00:05,900 of the Joseph Carlson show and this time it's centered around 3 00:00:06,100 --> 00:00:09,300 an investor named Terry Smith. If your listener of the Joseph 4 00:00:09,300 --> 00:00:12,500 Carlson show you've heard of Terry Smith before, but if 5 00:00:12,500 --> 00:00:15,500 you're new, Terry Smith is a great investor. 6 00:00:15,600 --> 00:00:18,400 Not only is it great investor, but I think he's overall just a 7 00:00:18,400 --> 00:00:20,900 cool guy. He's someone that's outspoken. 8 00:00:21,000 --> 00:00:23,300 He really speaks his mind on any topic. 9 00:00:23,400 --> 00:00:25,700 He's beat the market. Since the Inception of his Fund 10 00:00:25,700 --> 00:00:28,400 in 2010, he has an investing strategy. 11 00:00:28,400 --> 00:00:30,900 That's both rational focal. This is strongly on 12 00:00:30,900 --> 00:00:33,200 risk-adjusted. Returns, doesn't try to time the 13 00:00:33,200 --> 00:00:37,100 market and overall, I just think he's a very sensible 14 00:00:37,500 --> 00:00:40,700 well-adjusted investor. That will likely beat the market 15 00:00:40,700 --> 00:00:43,800 for a long period of time. He categorises his strategy into 16 00:00:43,800 --> 00:00:46,900 three parts, buying good companies, not overpaying and 17 00:00:46,900 --> 00:00:48,800 then doing nothing. Now, the strategy is a little 18 00:00:48,800 --> 00:00:50,500 bit more complex when you dive into it. 19 00:00:50,500 --> 00:00:52,000 But that's the three basic pillars. 20 00:00:52,100 --> 00:00:54,500 One thing that you may not know about Carrie Smith unless you've 21 00:00:54,500 --> 00:00:57,700 read about him, is that he's incredibly competitive. 22 00:00:57,700 --> 00:01:00,900 This guy is competitive. He Likes to win. 23 00:01:01,000 --> 00:01:04,300 He likes to come in first place and you can see that with how he 24 00:01:04,300 --> 00:01:07,200 conducts himself, and he's also very outspoken. 25 00:01:07,200 --> 00:01:11,200 And I would say even a ruthless when he finds incompetence in 26 00:01:11,200 --> 00:01:14,400 companies that he's investing in companies in the market or 27 00:01:14,400 --> 00:01:18,000 incompetent management teams in his latest investor letter, he 28 00:01:18,000 --> 00:01:21,000 is ruthless. He calls out companies directly 29 00:01:21,100 --> 00:01:24,000 he calls out management teams directly he calls him out for 30 00:01:24,000 --> 00:01:26,300 poor management. He calls him out for deceptive 31 00:01:26,300 --> 00:01:29,400 accounting practices and he even calls him out for virtuous 32 00:01:29,400 --> 00:01:31,800 signaling. When the letter is an outright 33 00:01:31,800 --> 00:01:34,500 tongue-lashing for these companies, I think there's a 34 00:01:34,500 --> 00:01:37,700 good chance that some Executives will be fired, as a result of 35 00:01:37,700 --> 00:01:40,300 this shareholder letter. And that would not be the first 36 00:01:40,300 --> 00:01:42,700 time that Terry Smith has gotten Executives fired. 37 00:01:43,100 --> 00:01:46,500 He also dives into a topic that I spent some time thinking about 38 00:01:46,700 --> 00:01:50,300 that I've made episode after episode about the topic of 39 00:01:50,300 --> 00:01:53,200 stock-based compensation. Now, there's nothing wrong with 40 00:01:53,200 --> 00:01:55,400 stock-based compensation in and of itself. 41 00:01:55,400 --> 00:01:58,500 But the problem is how these companies account for 42 00:01:58,500 --> 00:02:01,800 stock-based compensation. In many cases is highly 43 00:02:01,800 --> 00:02:05,600 deceptive and now after making multiple videos on the subject, 44 00:02:05,600 --> 00:02:07,900 we have Carrie, Smith weighing in and he does. 45 00:02:07,900 --> 00:02:10,900 So in his manner of being, extremely detailed and 46 00:02:10,900 --> 00:02:13,900 straightforward. So Terry Smith has a lot to say 47 00:02:13,900 --> 00:02:16,400 in this letter and he says a lot, this is going to be an 48 00:02:16,400 --> 00:02:18,200 exciting episode. It's jam-packed with 49 00:02:18,200 --> 00:02:20,100 information, we have a lot to get to. 50 00:02:20,100 --> 00:02:21,500 So let's go ahead and Jump Right In. 51 00:02:21,600 --> 00:02:23,900 Now, part of the reason I like Carrie Smith is because he views 52 00:02:23,900 --> 00:02:28,100 investing very similar to the way I do not the same, but Terry 53 00:02:28,100 --> 00:02:31,800 Smith is one of those investors. That I do, give some inspiration 54 00:02:32,000 --> 00:02:34,600 and I get some thoughts from him on investing in different 55 00:02:34,600 --> 00:02:36,600 potential companies. When I'm looking at my 56 00:02:36,600 --> 00:02:41,500 portfolio, I'm always concerned with buying companies that have 57 00:02:41,500 --> 00:02:44,300 high returns companies that can reinvest back into their 58 00:02:44,300 --> 00:02:46,200 business and get very high returns. 59 00:02:46,200 --> 00:02:49,500 As a result, these are high-quality companies and this 60 00:02:49,500 --> 00:02:52,500 is specifically what Terry Smith looks at companies that you can 61 00:02:52,500 --> 00:02:56,100 buy in to hit your wagon to and year after year. 62 00:02:56,100 --> 00:02:59,300 After year, they will produce a tremendous economics for the 63 00:02:59,300 --> 00:03:00,800 investor. They'll be able to pay 64 00:03:00,800 --> 00:03:02,500 dividends, they'll be able to do by packs. 65 00:03:02,700 --> 00:03:05,700 They'll be able to reinvest at high rates of return and they 66 00:03:05,700 --> 00:03:08,500 also have incredibly low downside risk. 67 00:03:08,600 --> 00:03:11,400 These are the type of companies I'm looking for, I call them 68 00:03:11,400 --> 00:03:14,600 Compounders Terry Smith calls, them, good companies. 69 00:03:14,600 --> 00:03:17,700 So even though I don't marry his portfolio and I don't invest in 70 00:03:17,700 --> 00:03:21,600 all the companies he does, I will look at his 13f filings and 71 00:03:21,600 --> 00:03:24,200 see what he's doing. Try to keep track of it because 72 00:03:24,200 --> 00:03:26,800 when Terry Smith buys a company, it's already gone through an 73 00:03:26,800 --> 00:03:29,600 extensive screening process. So I know that he's already 74 00:03:29,600 --> 00:03:32,500 looked at some things with a company and that can spark some 75 00:03:32,500 --> 00:03:36,100 ideas for future research. Now, we have his portfolio hair 76 00:03:36,200 --> 00:03:39,000 and he has made changes to it. And that's what he talks about 77 00:03:39,100 --> 00:03:41,700 in his latest letter. Dear fellow investor, this is 78 00:03:41,700 --> 00:03:45,600 the 13th annual letter from fun Smith, equities fund, our funds 79 00:03:45,600 --> 00:03:49,000 performance in 2022 will give Credence to those who suffer 80 00:03:49,200 --> 00:03:52,600 from tricycle, Deca phobia. Now, I don't know what this word 81 00:03:52,600 --> 00:03:53,900 was. I didn't know what it meant. 82 00:03:54,000 --> 00:03:56,800 I looked it up and it means a fear of the number 13, which 83 00:03:56,800 --> 00:03:58,900 makes sense sir. But to start off, he goes over 84 00:03:58,900 --> 00:04:01,300 the performance of the fund. The table below shows, the 85 00:04:01,300 --> 00:04:05,000 performance figures for the last calendar year and the cumulative 86 00:04:05,000 --> 00:04:09,300 and annualized performance since Inception on November 1st, 2010 87 00:04:09,500 --> 00:04:13,400 and various comparators, we have the total percent return of 88 00:04:13,400 --> 00:04:17,500 funds, Miss Equity, Fund, it underperformed, its Benchmark 89 00:04:17,500 --> 00:04:21,100 index last year, the Benchmark, which he compares to, as down 90 00:04:21,100 --> 00:04:24,200 7.8%. He was down 13.8. 91 00:04:24,200 --> 00:04:26,500 He did go through a period of under performance. 92 00:04:26,600 --> 00:04:29,500 Now, the annualized performance and cumulative performance is 93 00:04:29,500 --> 00:04:30,200 much better. Better. 94 00:04:30,300 --> 00:04:32,900 He's made about double the gains of his Benchmark index. 95 00:04:32,900 --> 00:04:36,200 So, overall, since the start, he's doing well, but last year 96 00:04:36,200 --> 00:04:39,300 was not a great year and he addresses underperforming last 97 00:04:39,300 --> 00:04:42,600 year whilst a period of under performance against the index is 98 00:04:42,600 --> 00:04:45,300 never, welcome. It is nonetheless, inevitable. 99 00:04:45,600 --> 00:04:48,600 We have consistently warned that no investment strategy will 100 00:04:48,600 --> 00:04:52,400 outperform in every reporting and every type of Market 101 00:04:52,400 --> 00:04:54,700 condition. So, he says, as much as we may 102 00:04:54,700 --> 00:04:57,900 not like it, we can expect some periods of under performance, 103 00:04:57,900 --> 00:05:01,300 which is entirely reasonable. To performing the msci. 104 00:05:01,300 --> 00:05:05,000 World index is one issue. Registering a fallen value is 105 00:05:05,000 --> 00:05:09,300 another in 2022, unless you restricted your Equity 106 00:05:09,300 --> 00:05:13,100 Investments to the energy sector you were almost certainly to 107 00:05:13,100 --> 00:05:14,900 have experienced a drop in value. 108 00:05:14,900 --> 00:05:17,300 If we look at this performance chart of the different sectors 109 00:05:17,300 --> 00:05:22,200 in 2022, energy is the only sector that in aggregate went 110 00:05:22,200 --> 00:05:26,400 up, and it went up a lot 59%. So Berkshire with their huge, 111 00:05:26,400 --> 00:05:29,700 massive energy Holdings did well in 2022. 112 00:05:30,200 --> 00:05:33,200 But everyone else to as exposure to all these other Industries, 113 00:05:33,200 --> 00:05:38,300 probably lost money for most investors, I would say 99% of 114 00:05:38,300 --> 00:05:41,100 investors, they lost money in 2022. 115 00:05:41,300 --> 00:05:44,100 Utilities was down Consumer Staples is down Healthcare 116 00:05:44,100 --> 00:05:46,300 Industrials. Materials Bank software and 117 00:05:46,300 --> 00:05:48,800 services. Real estate was down except for 118 00:05:48,800 --> 00:05:50,000 Vici. Shout out to Vici. 119 00:05:50,000 --> 00:05:53,200 There was up, 12%, consumer, discretionary, communication 120 00:05:53,200 --> 00:05:56,400 Services, all of that was down. So basically, don't feel too bad 121 00:05:56,400 --> 00:05:59,600 if you lost money in 2022. That's the way the market works 122 00:05:59,600 --> 00:06:01,000 now. Next part of this letter, he 123 00:06:01,000 --> 00:06:03,900 gives a history lesson and it's like five pages long. 124 00:06:04,100 --> 00:06:06,500 I'm not going to go over all of this but you can read the letter 125 00:06:06,500 --> 00:06:10,100 if you're interested in the long history lesson on interest rates 126 00:06:10,300 --> 00:06:13,100 because it does explain his funds performance I would 127 00:06:13,100 --> 00:06:17,700 summarize this history lesson in this one paragraph he says it is 128 00:06:17,700 --> 00:06:21,600 inevitable that when interest rates rise as they have now to 129 00:06:21,600 --> 00:06:25,300 combat inflation, longer-dated bonds fall more than shorter 130 00:06:25,300 --> 00:06:27,800 dated bonds. And so it is with equities with 131 00:06:27,800 --> 00:06:30,100 more highly rated shares, meaning higher Multiple 132 00:06:30,100 --> 00:06:33,500 companies, which are discounting earnings or cash, flows, further 133 00:06:33,500 --> 00:06:36,300 into the future. Highly rated companies, suffer 134 00:06:36,300 --> 00:06:39,400 more in a downturn than lowly rated ones are so-called value 135 00:06:39,400 --> 00:06:41,400 stocks. Now, he doesn't entirely blame 136 00:06:41,400 --> 00:06:44,500 interest rates. He also notes that meta had some 137 00:06:44,500 --> 00:06:48,200 big problems with competition with the Apple changes and with 138 00:06:48,200 --> 00:06:50,300 them going all in on the metaverse that spooked 139 00:06:50,300 --> 00:06:52,700 investors. So he brings up other things. 140 00:06:52,700 --> 00:06:56,800 He's not making excuses, but he does note that longer duration 141 00:06:56,800 --> 00:07:00,200 assets, which are highly rated companies, they do get a Acted 142 00:07:00,200 --> 00:07:03,300 more in downturns than value stocks which have their cash 143 00:07:03,300 --> 00:07:05,900 flows coming to you almost immediately and then right off 144 00:07:05,900 --> 00:07:09,900 the bat, Carrie Smith starts to dig in to individual companies. 145 00:07:10,000 --> 00:07:13,500 He first starts off with PayPal saying that PayPal seems intent 146 00:07:13,500 --> 00:07:15,700 on snatching defeat from the jaws of Victory. 147 00:07:15,900 --> 00:07:19,000 It is taken a leading position in online payments and parlayed 148 00:07:19,000 --> 00:07:22,200 that until lamentable share price performance. 149 00:07:22,200 --> 00:07:24,600 The elements of this would appear to be a disregard for 150 00:07:24,600 --> 00:07:28,000 engagement with customers, newly acquired during the pandemic and 151 00:07:28,000 --> 00:07:30,800 no obvious attention to or control of costs. 152 00:07:31,300 --> 00:07:34,000 So he's pointing out two things there for PayPal, but he doesn't 153 00:07:34,000 --> 00:07:35,500 end there. He continues on an even 154 00:07:35,500 --> 00:07:38,500 intensifies, his criticisms towards PayPal. 155 00:07:38,800 --> 00:07:41,700 This is hardly surprising given the attention devoted to 156 00:07:41,700 --> 00:07:44,900 pursuing some clearly overpriced Acquisitions. 157 00:07:45,100 --> 00:07:47,900 That is what happens when management starts to conclude 158 00:07:47,900 --> 00:07:52,100 that Investments do not need to earn an adequate return in this 159 00:07:52,100 --> 00:07:55,400 line, I think is spot-on. This is a huge problem right 160 00:07:55,400 --> 00:07:57,100 now. Companies doing merger and 161 00:07:57,100 --> 00:08:00,900 acquisition after merger and acquisition and Hit at horrible 162 00:08:00,900 --> 00:08:03,000 prices, horrible rates of return. 163 00:08:03,200 --> 00:08:06,700 I just did an entire episode on my other channel going over, 164 00:08:06,700 --> 00:08:10,000 Disney's acquisition a fox and how overpriced that was. 165 00:08:10,400 --> 00:08:12,600 So, this is something that's a problem with more than just 166 00:08:12,600 --> 00:08:14,500 PayPal. If one word could be used to 167 00:08:14,508 --> 00:08:18,200 describe last year's winners, it would be defensive out of his 168 00:08:18,200 --> 00:08:21,600 biggest winners last year to or fast-moving consumer goods 169 00:08:21,600 --> 00:08:23,600 companies and one is a drug company. 170 00:08:23,600 --> 00:08:27,100 So interest rates did play a part in the valuation, collapse 171 00:08:27,100 --> 00:08:29,900 of a lot of companies. The higher valued one's, Got 172 00:08:29,900 --> 00:08:33,100 further discounted as interest rates went up, but he notes that 173 00:08:33,100 --> 00:08:34,700 that's not the only thing going on. 174 00:08:34,700 --> 00:08:38,299 There's a lot of Shifting economics here, the cyclic ality 175 00:08:38,299 --> 00:08:41,500 of tech spending an online advertising is probably about to 176 00:08:41,500 --> 00:08:44,800 become evident as the economy slows and maybe falls into 177 00:08:44,800 --> 00:08:47,000 recession. It may be greater than in the 178 00:08:47,000 --> 00:08:49,700 past, simply because Tech spending has become a much 179 00:08:49,700 --> 00:08:53,000 larger portion of the overall corporate and personal spending. 180 00:08:53,000 --> 00:08:57,600 However, there may be a silver lining In This Cloud as this 181 00:08:57,600 --> 00:09:01,200 pressure on Revenue growth may cause Some companies, some of 182 00:09:01,200 --> 00:09:04,500 their tech companies that they invest in to behave as though 183 00:09:04,500 --> 00:09:08,600 money is not free and the halt, some of the less promising 184 00:09:08,600 --> 00:09:12,500 projects outside of their core businesses, so he's finding some 185 00:09:12,500 --> 00:09:16,100 upside and what's going on right now as interest rates go up, 186 00:09:16,100 --> 00:09:20,000 companies can no longer make as many stupid decisions without 187 00:09:20,000 --> 00:09:22,300 consequence. So it's actually forcing 188 00:09:22,300 --> 00:09:25,900 companies to become more prudent and well managed by them, having 189 00:09:25,900 --> 00:09:29,300 a cost attached to Capital and this is something that I really 190 00:09:29,300 --> 00:09:30,400 do enjoy. Enjoy. 191 00:09:30,500 --> 00:09:34,300 I like the investing environment today more than I did two years 192 00:09:34,300 --> 00:09:38,100 ago, two years ago, bad companies were going up in stock 193 00:09:38,100 --> 00:09:41,300 price for no apparent reason other than Dreams by investors 194 00:09:41,500 --> 00:09:44,400 companies were not being accurately priced and now we're 195 00:09:44,400 --> 00:09:46,800 getting to an environment where companies are actually being 196 00:09:46,800 --> 00:09:48,700 priced based on their current cash flows. 197 00:09:48,900 --> 00:09:52,000 And realistic assumptions about the future gains from companies 198 00:09:52,000 --> 00:09:55,000 is going to be much harder earned in today's environment, 199 00:09:55,100 --> 00:09:57,600 and that is something that I think is better for the economy. 200 00:09:57,700 --> 00:09:59,700 He names three companies that are actually. 201 00:09:59,800 --> 00:10:02,500 Adapting to this new environment, alphabet, which 202 00:10:02,500 --> 00:10:05,700 I've noted many times, has a bloated corporate structure, a 203 00:10:05,700 --> 00:10:10,100 lot of overpaid employees, a lot of bloat, they also have a huge 204 00:10:10,100 --> 00:10:13,500 money-losing, other bets. He notes that lightning does not 205 00:10:13,500 --> 00:10:17,100 strike twice alphabet struck, lightning with their search 206 00:10:17,100 --> 00:10:19,200 business and that's unlikely to be replicated. 207 00:10:19,200 --> 00:10:22,500 No matter how much money they throw at it Amazon, they're also 208 00:10:22,500 --> 00:10:24,800 cost-cutting. It's already withdrawn from its 209 00:10:24,800 --> 00:10:27,800 food, delivery and Technical education, and India, and it has 210 00:10:27,800 --> 00:10:29,700 highly successful e-commerce and cloud computing. 211 00:10:29,800 --> 00:10:33,000 Shooting business on which to focus and then we have Meta Meta 212 00:10:33,000 --> 00:10:36,600 stock price would have been fine if it didn't torpedo Itself by 213 00:10:36,600 --> 00:10:39,000 focusing. So intently on the metaverse, 214 00:10:39,300 --> 00:10:42,300 they say, without the spend on the metaverse, they would own a 215 00:10:42,308 --> 00:10:45,400 leading communication and digital advertising business on 216 00:10:45,400 --> 00:10:49,200 a single figure PE ratio. So you get the best of both 217 00:10:49,200 --> 00:10:53,000 worlds, a high quality company at a low valuation, this brings 218 00:10:53,000 --> 00:10:56,100 back to their strategy of buying, good companies, not 219 00:10:56,100 --> 00:10:59,100 overpaying and doing nothing in. This is where they go through 220 00:10:59,100 --> 00:11:01,500 each leg of the Strategy. One of my favorite things in 221 00:11:01,500 --> 00:11:04,200 Terry Smith's updates is this look through portfolio. 222 00:11:04,700 --> 00:11:07,200 And what they basically do, is they take all of these metrics, 223 00:11:07,200 --> 00:11:10,400 like, the Returns on Capital employed, gross margins and they 224 00:11:10,400 --> 00:11:14,100 combine it into one company. So you can see their entire 225 00:11:14,100 --> 00:11:18,300 portfolio mush together into one company and then you get an 226 00:11:18,300 --> 00:11:21,000 overall idea of how powerful a company it is. 227 00:11:21,200 --> 00:11:24,400 If it was a single company and then he Compares that against 228 00:11:24,400 --> 00:11:28,000 the S&P 500. As if the S&P 500 was one big 229 00:11:28,000 --> 00:11:32,300 company and he ill The streets by this comparison that his 230 00:11:32,300 --> 00:11:36,800 company is a better company than the aggregate of the S&P 500. 231 00:11:37,000 --> 00:11:39,200 So we look at the Returns on Capital employed, which is 232 00:11:39,200 --> 00:11:41,800 always number one. The first thing Terry Smith 233 00:11:41,800 --> 00:11:48,600 looks for 32% for his portfolio in 2022, 18% for the S&P, 500, 234 00:11:48,800 --> 00:11:53,200 gross, margins 64 percent for his portfolio. 45% for the S&P 235 00:11:53,200 --> 00:11:57,900 500 operating margins 28 percent against 18, cash conversion. 236 00:11:57,900 --> 00:12:01,000 That's the only one that's identical between In the two and 237 00:12:01,000 --> 00:12:03,900 then interest coverage, this is the amount of Leverage, the 238 00:12:03,900 --> 00:12:06,800 higher, the number, the better. That means that you cover your 239 00:12:06,800 --> 00:12:09,900 interest payments by a higher degree, which just means he has 240 00:12:10,000 --> 00:12:12,700 less levered companies. They have roughly half the 241 00:12:12,700 --> 00:12:15,500 amount of Leverage then the companies in the S&P 500. 242 00:12:15,600 --> 00:12:18,900 So he beat them on returns. He beat the company's on Gross 243 00:12:18,900 --> 00:12:21,500 margins operating margins. He had a tie with cash 244 00:12:21,500 --> 00:12:24,800 conversion and then he beat them by double on Leverage overall. 245 00:12:24,800 --> 00:12:28,900 Terry, Smith's portfolio is much stronger, much stronger than the 246 00:12:28,900 --> 00:12:31,000 S&P 500. Oh, oh, and Terry Smith has 247 00:12:31,000 --> 00:12:34,200 consistently worked to try to highlight the differences. 248 00:12:34,200 --> 00:12:37,900 This makes in the total returns and the long-term returns of 249 00:12:37,900 --> 00:12:40,400 companies. Consistently High Returns on 250 00:12:40,400 --> 00:12:44,100 capital r, one sign we look for when seeking companies to invest 251 00:12:44,100 --> 00:12:47,100 in another is a source of growth High returns are not much of a 252 00:12:47,108 --> 00:12:48,700 use. If the business is not able to 253 00:12:48,700 --> 00:12:51,600 grow and deploy more Capital at these high rates. 254 00:12:52,000 --> 00:12:55,400 So the perfect business is one that has high Returns on Capital 255 00:12:55,400 --> 00:12:58,800 employed and a lot of opportunities to employ Capital. 256 00:12:58,800 --> 00:13:02,500 Now, he shows how Companies did economically in 2022. 257 00:13:02,700 --> 00:13:07,600 They grew their Cash Flow by 1% so barely any growth. 258 00:13:07,700 --> 00:13:09,700 He didn't have much growth in cash flow. 259 00:13:09,700 --> 00:13:12,900 They barely edged up 1%, but if we compare that against the 260 00:13:12,900 --> 00:13:16,800 index, the index had the cash flows Fall by four percent last 261 00:13:16,800 --> 00:13:18,500 year. So the S&P 500. 262 00:13:18,500 --> 00:13:22,200 Cash flows went down his cash flows, went up and this is 263 00:13:22,200 --> 00:13:25,800 especially impressive because Terry Smith's portfolio, grew 264 00:13:25,800 --> 00:13:31,100 cash flows by 20% in 2021. So basically they grew cash 265 00:13:31,100 --> 00:13:34,500 flows, a ton two years ago and then they still were able to 266 00:13:34,500 --> 00:13:37,600 grow cash, flows ever, so slightly the following gear. 267 00:13:37,900 --> 00:13:41,600 There's no huge regression. The S&P 500 is not growing cash 268 00:13:41,600 --> 00:13:43,100 flows. As fast as Carrie Smith 269 00:13:43,100 --> 00:13:45,200 portfolio, and the growth of cash. 270 00:13:45,200 --> 00:13:49,100 Flows is an incredibly important ingredient in valuation. 271 00:13:49,200 --> 00:13:51,700 In this is where we get to the second part of the strategy 272 00:13:51,800 --> 00:13:54,700 valuation. Not overpaying for companies. 273 00:13:54,800 --> 00:13:57,400 This is probably the most common criticism I receive as an 274 00:13:57,408 --> 00:13:59,600 investor. I, by good companies. 275 00:13:59,800 --> 00:14:01,300 I'm just over paying for all of them. 276 00:14:01,500 --> 00:14:04,300 Any company that I'm buying because they're in the high 20s 277 00:14:04,300 --> 00:14:06,600 PE ratio. I'm overpaying for those 278 00:14:06,600 --> 00:14:09,400 companies in this is something that Terry Smith is also aware 279 00:14:09,400 --> 00:14:12,100 of and he's fought against throughout the entirety of 280 00:14:12,100 --> 00:14:14,700 running his fund. People wondering why he's 281 00:14:14,700 --> 00:14:17,500 overpaying for these high multiple companies even though 282 00:14:17,500 --> 00:14:21,000 he's outperform the market for 13 years, the weighted average 283 00:14:21,000 --> 00:14:24,900 free cash flow yield of his portfolio is 3.2%. 284 00:14:24,900 --> 00:14:28,400 The year-end medium free cash flow yield of the S&P 500 was 285 00:14:28,400 --> 00:14:31,300 3.4%. And roughly in line with his 286 00:14:31,300 --> 00:14:34,000 portfolio. And this is important because 287 00:14:34,000 --> 00:14:39,000 basically right now they have similar free cash flow yields in 288 00:14:39,000 --> 00:14:42,100 terms of free cash flow. His portfolio selling for around 289 00:14:42,100 --> 00:14:45,300 the same price as the S&P 500. So the big determining Factor 290 00:14:45,300 --> 00:14:47,100 here of which one will do better. 291 00:14:47,300 --> 00:14:51,500 Terry Smith's portfolio or the S&P 500, it will be determined 292 00:14:51,600 --> 00:14:54,800 by their free cash flow, growth rate, whatever one can grow 293 00:14:54,800 --> 00:14:58,200 free, cash flow, the quickest over the next five years because 294 00:14:58,200 --> 00:15:00,200 they have roughly the same Point. 295 00:15:00,300 --> 00:15:03,200 And if I had a bet between the two, I think there's much better 296 00:15:03,200 --> 00:15:04,800 odds. That Terry Smith's portfolio 297 00:15:04,800 --> 00:15:08,200 will grow free cash flows faster than the totality of the S&P 298 00:15:08,200 --> 00:15:11,000 500. Because his portfolio consists 299 00:15:11,000 --> 00:15:13,500 of companies that are fundamentally a lot better than 300 00:15:13,500 --> 00:15:17,400 the average of those, either in the index or valued fractionally 301 00:15:17,400 --> 00:15:19,800 higher than the average of the S&P 500. 302 00:15:19,900 --> 00:15:22,900 He buys better companies that are simply better at 303 00:15:22,900 --> 00:15:26,500 consistently growing cash flows. So I'm looking at valuation on 304 00:15:26,500 --> 00:15:29,300 any company, I'm looking at this starting point. 305 00:15:29,700 --> 00:15:32,500 Of the valuation. The starting point is the yield 306 00:15:32,500 --> 00:15:35,200 of the company. Texas Roadhouse has a free cash 307 00:15:35,200 --> 00:15:38,500 flow yield of four point one six percent. 308 00:15:38,500 --> 00:15:41,900 And like we just saw the S&P 500's, current free cash flow 309 00:15:41,900 --> 00:15:45,300 yield in aggregate, is 3.4 percent. 310 00:15:45,500 --> 00:15:48,800 So we have a better valuation starting off with Texas 311 00:15:48,800 --> 00:15:52,000 Roadhouse but not only is the starting valuation cheaper for 312 00:15:52,000 --> 00:15:56,100 Texas Roadhouse but I also believe it will outgrow the S&P 313 00:15:56,100 --> 00:15:58,400 500. I think the free cash flows will 314 00:15:58,400 --> 00:16:01,400 grow quicker, so that Of way of trying to outperform. 315 00:16:01,400 --> 00:16:04,600 Yes and P. 500, finding companies have starting yields 316 00:16:04,900 --> 00:16:08,700 as high around the same as the S&P 500 but which can grow their 317 00:16:08,700 --> 00:16:11,800 future cash flows at a faster rate than the S&P 500. 318 00:16:11,900 --> 00:16:14,400 Now, the third part of this strategy is one that I think I 319 00:16:14,400 --> 00:16:17,600 struggle with the most, which is to do nothing. 320 00:16:17,800 --> 00:16:21,000 I think this is just mentally the most difficult part and 321 00:16:21,000 --> 00:16:23,800 investing in individual companies, which is to truly 322 00:16:23,800 --> 00:16:28,000 have a long-term mindset. I think doing analysis is fun. 323 00:16:28,100 --> 00:16:31,600 Doing analysis is Viv and I could do that for hours on end 324 00:16:31,600 --> 00:16:34,400 and really dissect and learn everything there is to learn 325 00:16:34,400 --> 00:16:37,100 about a company. I can find out the valuation, I 326 00:16:37,100 --> 00:16:38,600 can look at the future cash flow. 327 00:16:38,700 --> 00:16:41,900 I can look at the downside risk of the company, I can assess the 328 00:16:41,900 --> 00:16:45,700 moat and I enjoy doing that. But doing nothing is something. 329 00:16:45,700 --> 00:16:48,800 I struggle with have a very difficult time, just sitting 330 00:16:48,800 --> 00:16:52,300 back and watching my portfolio from afar and doing nothing. 331 00:16:52,300 --> 00:16:54,500 So this is an area that I'm really trying to get better at 332 00:16:54,500 --> 00:16:56,900 this year. A real Focus trying to hold my 333 00:16:56,900 --> 00:17:00,600 companies for longer periods of time and only Then if things 334 00:17:00,600 --> 00:17:03,100 have really materially gotten worse for the company. 335 00:17:03,500 --> 00:17:06,200 Now, Terry Smith tries to do this as well, minimizing 336 00:17:06,200 --> 00:17:09,700 portfolio, turnover remains one of their objectives and he says 337 00:17:09,700 --> 00:17:13,400 that they had a turnover of 7.4% that was around the same. 338 00:17:13,400 --> 00:17:16,099 As me around eight percent turnover last year. 339 00:17:16,099 --> 00:17:20,300 Now Terry Smith did sell and buy a number of names and this is 340 00:17:20,300 --> 00:17:24,099 where we get in to some of the juicy details of his criticisms 341 00:17:24,200 --> 00:17:27,700 about different companies. He says that we sold our steaks 342 00:17:27,700 --> 00:17:31,700 and Johnson & Johnson. Chuck's cone into it and PayPal. 343 00:17:31,900 --> 00:17:35,300 The only company that I own is Starbucks and I've recently 344 00:17:35,300 --> 00:17:38,700 trimmed around half of this position because the price has 345 00:17:38,700 --> 00:17:41,800 surged up past $100 very close to its fair value. 346 00:17:42,200 --> 00:17:44,900 So, I've made some gains in Starbucks, but I still hold this 347 00:17:44,900 --> 00:17:47,100 company. Now, he purchased mettler 348 00:17:47,100 --> 00:17:50,600 Toledo, Adobe, Otis and apple. He sold a number of companies 349 00:17:50,600 --> 00:17:52,700 and he purchased a basket of new companies. 350 00:17:52,800 --> 00:17:55,900 And this is where the spicy criticisms start. 351 00:17:56,000 --> 00:17:59,700 Terry Smith starts to dig into these companies and he gives A 352 00:17:59,708 --> 00:18:02,000 tongue-lashing. He really does not hold back and 353 00:18:02,000 --> 00:18:04,700 this is something that I appreciate he says last year I 354 00:18:04,700 --> 00:18:07,200 wrote about Unilever and attracted a virtual tsunami of 355 00:18:07,200 --> 00:18:10,000 comments and remarks about the company events soon. 356 00:18:10,000 --> 00:18:13,400 Overtook this commentary insofar as Nelson Peltz tree, and 357 00:18:13,400 --> 00:18:16,500 partners announced that it had bought a stake in Unilever and 358 00:18:16,500 --> 00:18:18,200 he was invited to join the board. 359 00:18:18,200 --> 00:18:21,900 Now, this is interesting, Nelson Peltz is the one that just 360 00:18:21,900 --> 00:18:25,200 purchased a steak and Disney and he's trying to get a board seat 361 00:18:25,200 --> 00:18:29,000 on Disney because the company's doing so poorly, I want Nelson 362 00:18:29,000 --> 00:18:31,000 Peltz. To get on the board of Disney. 363 00:18:31,100 --> 00:18:34,600 I want somebody to get in there and to try to hold this 364 00:18:34,600 --> 00:18:37,100 executive team and these directors that have 365 00:18:37,100 --> 00:18:39,500 underperformed for a decade accountable. 366 00:18:39,800 --> 00:18:42,200 So I'm actually in favor of Nelson Peltz. 367 00:18:42,200 --> 00:18:45,100 I think Terry Smith is too but he's frustrated with how these 368 00:18:45,100 --> 00:18:46,800 companies are conducting themselves. 369 00:18:46,900 --> 00:18:50,000 He says, once contact had been established with Unilever, we 370 00:18:50,000 --> 00:18:53,200 then tried to make some points about what we saw as problems 371 00:18:53,200 --> 00:18:55,600 with the performance of the business, and the focus of the 372 00:18:55,600 --> 00:18:57,800 management, which were duly ignored. 373 00:18:58,000 --> 00:19:01,300 This is a business making A non-capital in the mid to low 374 00:19:01,300 --> 00:19:05,000 teens below, the market average, where you could measure annual 375 00:19:05,000 --> 00:19:07,100 growth. If you could only count to three 376 00:19:07,500 --> 00:19:11,000 and which missed every Target, it set out when summarily 377 00:19:11,000 --> 00:19:13,300 rejected the Kraft Heinz B approach. 378 00:19:13,300 --> 00:19:15,400 So it's not like there weren't some questions to be answered 379 00:19:15,500 --> 00:19:16,900 now. He says, I don't know how long 380 00:19:16,900 --> 00:19:18,400 tree and held its take before mr. 381 00:19:18,400 --> 00:19:21,500 Pelts was invited to join the board or how big of that steak 382 00:19:21,500 --> 00:19:25,000 was, but I would guess that they held it for far fewer months 383 00:19:25,000 --> 00:19:26,800 than we held it in terms of years. 384 00:19:26,800 --> 00:19:28,500 He says, we have no objection to mr. 385 00:19:28,500 --> 00:19:31,000 Pelts involvement. But here is where Terry Smith 386 00:19:31,000 --> 00:19:33,800 gets to his biggest. Complaint, what I find 387 00:19:33,800 --> 00:19:37,600 questionable is that companies mouth platitudes about wanting 388 00:19:37,600 --> 00:19:40,800 to attract a long-term shareholders yet based on our 389 00:19:40,800 --> 00:19:44,100 experience, we tend to get ignored whereas an activist who 390 00:19:44,100 --> 00:19:46,300 has held the shares for far fewer months and we've held 391 00:19:46,300 --> 00:19:48,300 years gets invited to board meetings. 392 00:19:48,600 --> 00:19:51,000 That is the big problem here, they're not paying attention to 393 00:19:51,000 --> 00:19:54,100 their long-term shareholders. They only pay attention to 394 00:19:54,100 --> 00:19:58,100 activists because activists muscle their way into companies. 395 00:19:58,400 --> 00:20:01,900 They do fights and Roxy fights, they force companies to pay 396 00:20:01,900 --> 00:20:03,800 attention to them. And meanwhile these companies 397 00:20:03,800 --> 00:20:06,500 are ignoring their long-term shareholders. 398 00:20:06,600 --> 00:20:09,800 One example, may just represent an outlier but what about 399 00:20:09,800 --> 00:20:12,400 PayPal? We had held PayPal shares since 400 00:20:12,500 --> 00:20:16,500 it was spun off from eBay. In 2015, we tried to engage with 401 00:20:16,500 --> 00:20:19,900 PayPal as we identified. Seemingly long before the 402 00:20:19,900 --> 00:20:21,800 management that their lack of Engagement. 403 00:20:21,800 --> 00:20:25,400 With new customers was a problem as was cost control and that 404 00:20:25,400 --> 00:20:27,300 their Acquisitions were value destroying. 405 00:20:27,700 --> 00:20:30,100 In particular, we pointed out that the value Value destroying 406 00:20:30,100 --> 00:20:33,500 Acquisitions, might be avoided if management are enumerated. 407 00:20:33,500 --> 00:20:37,200 Incentives, included, some measure of Returns on Capital, a 408 00:20:37,200 --> 00:20:40,500 representative of the board kindly told us, they would think 409 00:20:40,500 --> 00:20:44,700 about it and again, it requires muscle, it requires fair, and it 410 00:20:44,700 --> 00:20:47,300 requires power for them to actually pay attention. 411 00:20:47,700 --> 00:20:49,900 Whilst they were allegedly thinking about it. 412 00:20:50,100 --> 00:20:53,400 Elliott management who, by the way, it's ran by Paul singer. 413 00:20:53,400 --> 00:20:55,900 Who's one of the scariest guys in the capital markets. 414 00:20:56,500 --> 00:20:59,400 He's not like Nelson Peltz. He's not a friend. 415 00:20:59,800 --> 00:21:02,000 Work with Management in the same type of way. 416 00:21:02,400 --> 00:21:05,900 He's one of the most feared investors in the entire Market. 417 00:21:05,900 --> 00:21:09,300 May be the most feared we have Carl Icahn and Elliott 418 00:21:09,300 --> 00:21:12,000 management right there. Kind of neck and neck is the 419 00:21:12,008 --> 00:21:15,500 most feared investors. He bought a stake in which led 420 00:21:15,500 --> 00:21:18,200 to them being given a board seat and information sharing 421 00:21:18,200 --> 00:21:19,900 agreement. Please don't misunderstand the 422 00:21:19,908 --> 00:21:22,200 criticism. I'm leveling here, I'm not 423 00:21:22,200 --> 00:21:24,100 envious. I do not want a seat on the 424 00:21:24,100 --> 00:21:27,400 board of Unilever, PayPal, or any other listed company, nor do 425 00:21:27,400 --> 00:21:30,100 I want an information sharing agreement, I think our research 426 00:21:30,100 --> 00:21:33,100 has been able to identify the problems of PayPal and Unilever, 427 00:21:33,100 --> 00:21:36,400 better than the management. And without the need for access 428 00:21:36,400 --> 00:21:40,200 to any unpublished information, even without their inside 429 00:21:40,200 --> 00:21:42,100 information. They're saying that they can 430 00:21:42,100 --> 00:21:45,000 better identify problems with these companies. 431 00:21:45,000 --> 00:21:48,700 And then Terry Smith put together this table, that shows 432 00:21:48,700 --> 00:21:52,400 the reporting of Unilever and their different Acquisitions, 433 00:21:52,400 --> 00:21:55,400 and what they're showing and what they're not showing, for 434 00:21:55,400 --> 00:21:57,800 example, off to the right here. We have all these different 435 00:21:57,800 --> 00:22:00,100 products that they've purchased Time. 436 00:22:00,500 --> 00:22:03,400 And the check mark means that there including the performance 437 00:22:03,400 --> 00:22:06,000 of these new companies. They've purchased the X means 438 00:22:06,000 --> 00:22:08,700 that they've decided to not leave that in the earnings 439 00:22:08,700 --> 00:22:12,600 reports over time. This companies leaving out more 440 00:22:12,600 --> 00:22:15,300 and more products that Terry Smith is saying basically, the 441 00:22:15,300 --> 00:22:17,800 only reason a company would do this and not give investors 442 00:22:17,800 --> 00:22:21,100 insight to what's going on is because the Acquisitions they're 443 00:22:21,100 --> 00:22:23,400 doing are not giving good returns. 444 00:22:23,400 --> 00:22:25,900 So over time this company is becoming less and less 445 00:22:25,900 --> 00:22:27,700 transparent. Now, Terry Smith has been 446 00:22:27,700 --> 00:22:30,100 calling out these companies for a number of Years, their 447 00:22:30,100 --> 00:22:33,100 business practices Acquisitions. And of course, he's getting a 448 00:22:33,108 --> 00:22:35,800 lot of people that agree with them, but also a lot of pushback 449 00:22:35,800 --> 00:22:38,200 e, says amongst the outpouring of comets last year where a 450 00:22:38,208 --> 00:22:41,600 number of apologists for Unilever, who are at the pains 451 00:22:41,600 --> 00:22:45,100 to point out that the elands brand has been growing revenues. 452 00:22:45,100 --> 00:22:48,700 Well, and that this was proof, that quote purpose works. 453 00:22:49,000 --> 00:22:51,500 Of course, there is no control for that experiment. 454 00:22:51,700 --> 00:22:55,300 We do not know how well it has grown, without the quote 455 00:22:55,300 --> 00:22:57,200 purpose. And then he literally Strikes 456 00:22:57,200 --> 00:23:00,300 Out virtue signaling. He's calling this Signaling to 457 00:23:00,300 --> 00:23:01,800 further illustrate. This this year. 458 00:23:01,800 --> 00:23:04,700 We're moving onto soap when I last checked, it was for 459 00:23:04,700 --> 00:23:07,000 washing. However, Apparently that is not 460 00:23:07,000 --> 00:23:10,900 the purpose of Lux, the Unilever brand, which apparently is all 461 00:23:10,900 --> 00:23:15,500 about inspiring women to rise above everyday sexist, judgments 462 00:23:15,600 --> 00:23:19,000 and express, their beauty and femininity unapologetically. 463 00:23:19,400 --> 00:23:21,300 I'm not making this up, you can read it. 464 00:23:21,300 --> 00:23:25,300 Here we go to the Lux Brand's website and that is the the top 465 00:23:25,300 --> 00:23:28,400 statement there. This brand of soap, inspires 466 00:23:28,400 --> 00:23:32,800 women above of sexist judgments and to express their beauty and 467 00:23:32,800 --> 00:23:36,500 femininity unapologetically. Keep in mind, this is soap. 468 00:23:36,600 --> 00:23:38,800 I will leave you to draw your own conclusions about the 469 00:23:38,800 --> 00:23:40,900 utility of this. Now, moving on, we have, what I 470 00:23:40,900 --> 00:23:43,600 think is the most important topic in this entire 471 00:23:43,600 --> 00:23:47,800 presentation is share based compensation, and especially its 472 00:23:47,800 --> 00:23:51,200 removal from the non-gaap generally, accepted accounting 473 00:23:51,200 --> 00:23:54,500 principles profit figures. So share base. 474 00:23:54,500 --> 00:23:56,600 Compensation is stock-based compensation. 475 00:23:56,600 --> 00:23:58,800 This is something that I've talked about routinely on my 476 00:23:58,800 --> 00:24:01,100 channel. To help investors understand 477 00:24:01,100 --> 00:24:04,200 this and how it works with companies, and how in many 478 00:24:04,200 --> 00:24:07,800 cases, it misrepresents the earnings potential and the true 479 00:24:07,800 --> 00:24:12,000 profitability and the true cash flows of a company share based 480 00:24:12,000 --> 00:24:15,800 compensation has become an increasingly prominent part of 481 00:24:15,800 --> 00:24:19,000 some companies expenses in recent years, especially among 482 00:24:19,000 --> 00:24:22,500 companies in the technology sector share based compensation 483 00:24:22,500 --> 00:24:26,000 expense expressed as a percentage of the revenue has 484 00:24:26,000 --> 00:24:32,100 gone from 2.2 percent in 2011. To 4.1% in 2021. 485 00:24:32,100 --> 00:24:35,000 So, over that 10-year, period, the percentage of stock-based 486 00:24:35,000 --> 00:24:38,700 compensation doubled in these companies, this may not seem 487 00:24:38,700 --> 00:24:42,100 like much of an increase, but keep in mind that during this 488 00:24:42,100 --> 00:24:45,700 period, revenue for the set of companies had almost quintuple 489 00:24:45,700 --> 00:24:48,900 Don average. So, not only is the percentage 490 00:24:48,900 --> 00:24:52,400 of stock-based Compton Revenue doubling, but also the company's 491 00:24:52,400 --> 00:24:55,700 revenues are going up four times and these companies make up a 492 00:24:55,700 --> 00:24:58,500 much bigger and bigger percentage of the index. 493 00:24:58,800 --> 00:25:02,700 So this is Literally a growing issue and he agrees with me that 494 00:25:02,700 --> 00:25:05,400 there's nothing wrong with stock-based compensation. 495 00:25:05,600 --> 00:25:08,000 If you get paid that way, I'm not saying you shouldn't get 496 00:25:08,000 --> 00:25:09,900 paid that way. What's wrong here? 497 00:25:09,900 --> 00:25:13,100 Is how investors are being misled about their Investments. 498 00:25:13,200 --> 00:25:16,300 I want to focus on how share based compensation is accounted 499 00:25:16,300 --> 00:25:19,600 for and more accurately, how it is not accounted for. 500 00:25:19,700 --> 00:25:22,500 In these companies in this is where we get to some alarming 501 00:25:22,500 --> 00:25:26,300 statistics among the 75 companies in the technology 502 00:25:26,300 --> 00:25:31,000 sector, 45 of them, remove their stock, Base compensation from 503 00:25:31,000 --> 00:25:34,300 non-gaap versions of their earnings per share operating 504 00:25:34,300 --> 00:25:39,500 income or both in plain English. They remove the amount of their 505 00:25:39,500 --> 00:25:42,900 debit for share based compensation which boost their 506 00:25:42,900 --> 00:25:47,300 profits that is about 26 billion of expenses that have been 507 00:25:47,300 --> 00:25:52,400 adjusted out in reporting, the 2021 profits in their, non-gaap 508 00:25:52,400 --> 00:25:55,700 results of these 45 companies this amounts to an average of 509 00:25:55,700 --> 00:26:00,100 600 million dollars in share based compensation for Company, 510 00:26:00,100 --> 00:26:03,400 which is excluded or added back and reaching their non Gap. 511 00:26:03,400 --> 00:26:06,900 Earnings, that is massive. These companies aren't only 512 00:26:06,900 --> 00:26:09,200 moving this out of the free cash flow statement. 513 00:26:09,200 --> 00:26:12,100 But they're literally reporting their non-gaap earnings, and 514 00:26:12,100 --> 00:26:14,800 they're not including their stock based compensation. 515 00:26:15,100 --> 00:26:18,100 This makes some companies look dramatically cheaper than they 516 00:26:18,100 --> 00:26:19,900 actually are. Now not only that, but the 517 00:26:19,900 --> 00:26:23,700 companies that are participating in this accounting, trickery are 518 00:26:23,700 --> 00:26:26,600 the ones that have the most stock-based compensation. 519 00:26:27,000 --> 00:26:29,900 So, the ones that have this as a big problem, Um, in their 520 00:26:29,900 --> 00:26:33,300 companies, a big expense. They're the ones removing it as 521 00:26:33,300 --> 00:26:35,700 an expense, making it look like it's just nothing. 522 00:26:35,700 --> 00:26:37,600 It doesn't exist in their profitability. 523 00:26:37,700 --> 00:26:41,300 Now he actually goes on to give an example of specific companies 524 00:26:41,600 --> 00:26:45,200 that are participating, and I think, I think it's accounting 525 00:26:45,300 --> 00:26:48,500 trickery, I really think the intentions and purposes of 526 00:26:48,500 --> 00:26:51,800 companies doing this is to trick investors into believing. 527 00:26:51,800 --> 00:26:54,700 Their companies are more profitable than they really are 528 00:26:54,900 --> 00:26:58,600 and that is where I offer a solution and call trim with 529 00:26:58,600 --> 00:27:01,500 this. You And see the real effects of 530 00:27:01,500 --> 00:27:04,600 stock-based compensation. We have the example of 531 00:27:04,600 --> 00:27:06,700 Salesforce has free cash flow hair. 532 00:27:07,100 --> 00:27:10,100 This is what it looks like when not factoring in stock-based 533 00:27:10,100 --> 00:27:13,400 compensation. It looks like they're making 5.3 534 00:27:13,400 --> 00:27:15,300 billion dollars in free cash flow. 535 00:27:15,700 --> 00:27:19,100 But then you add in the financing expense of paying 536 00:27:19,100 --> 00:27:21,600 their employees and you have two point seven, eight billion 537 00:27:21,600 --> 00:27:26,000 dollars in stock based compost so I can clearly and easily see 538 00:27:26,200 --> 00:27:29,100 how much free cash flow in excess of stock-based 539 00:27:29,100 --> 00:27:30,900 compensation. Up this company is making 540 00:27:31,400 --> 00:27:34,000 without a tool like this without something that clearly 541 00:27:34,000 --> 00:27:37,200 illustrates that you have no way of knowing how profitable your 542 00:27:37,200 --> 00:27:39,200 company. Is it looks like it's twice as 543 00:27:39,200 --> 00:27:42,300 profitable and even in the free cash flow yield of the company 544 00:27:42,300 --> 00:27:46,000 sales force, really, doesn't have a true 3.74 percent free 545 00:27:46,000 --> 00:27:49,400 cash flow yield because again, stock-based campese out roughly 546 00:27:49,400 --> 00:27:50,900 half of what their free cash. Flows are. 547 00:27:51,000 --> 00:27:55,000 So the real free cash flow yield is instead around 1.8%, but 548 00:27:55,000 --> 00:27:59,300 unless you have a specific tool like cual trim specific charts, 549 00:27:59,500 --> 00:28:03,300 Lay this out, side by side, most people are being tricked by this 550 00:28:03,700 --> 00:28:06,900 and Terry Smith gives a very specific example of it. 551 00:28:07,300 --> 00:28:12,000 He says take the example of Microsoft and into it into it is 552 00:28:12,000 --> 00:28:15,100 a company that's tricking. Investors, Microsoft is a 553 00:28:15,100 --> 00:28:16,800 company that's not tricking investors. 554 00:28:17,100 --> 00:28:21,100 Microsoft shares are currently being valued at a PE ratio of 25 555 00:28:21,100 --> 00:28:24,800 times the consensus CPS estimates for the fiscal year 556 00:28:24,800 --> 00:28:29,100 looking forward into 2023. So, basically a 25 for PE ratio, 557 00:28:29,600 --> 00:28:33,100 meanwhile, into it is being valued at twenty eight times. 558 00:28:33,200 --> 00:28:36,700 It's forward earnings. So we have Microsoft at 25 and 559 00:28:36,700 --> 00:28:40,400 into it at 28 and a lot of investors would simply just 560 00:28:40,400 --> 00:28:44,200 compare these two PE ratios and that's the relative valuation. 561 00:28:44,500 --> 00:28:48,300 You can either buy Microsoft at a 25 or into it at a 28. 562 00:28:48,500 --> 00:28:51,400 That's where most investors would stop with their valuation. 563 00:28:51,700 --> 00:28:55,100 But if you dig into the numbers here this is highly inaccurate. 564 00:28:55,200 --> 00:28:58,200 For example, if you include stock-based compensation, which 565 00:28:58,200 --> 00:29:00,800 would make it more of an apple, To Apples comparison. 566 00:29:01,000 --> 00:29:04,000 Then you can actually see how Microsoft's valuation Stacks up 567 00:29:04,000 --> 00:29:08,300 with into its this would mean that the shares of into it would 568 00:29:08,300 --> 00:29:13,000 be trading around 43 times. So by including stock-based, 569 00:29:13,000 --> 00:29:17,000 compensation to show the true profitability of the company it 570 00:29:17,000 --> 00:29:21,300 went from 28 times forward. P/E 243 times forward. 571 00:29:21,300 --> 00:29:23,300 Earnings. He says, I think investors and 572 00:29:23,300 --> 00:29:27,300 analysts may find a premium of 14% for into it over Microsoft 573 00:29:27,300 --> 00:29:29,100 to be reasonable. I'm not sure they're fully 574 00:29:29,100 --> 00:29:30,400 aware. Are that into its Shares are 575 00:29:30,400 --> 00:29:33,200 actually trading at a premium of 73%. 576 00:29:33,200 --> 00:29:36,000 If share based compensation is treated the same manner between 577 00:29:36,000 --> 00:29:38,400 the two companies. This is a massive problem and 578 00:29:38,400 --> 00:29:41,600 how investors are valuing. These companies that have a lot 579 00:29:41,600 --> 00:29:45,000 of stock-based compensation and I've seen investors get burned 580 00:29:45,000 --> 00:29:47,700 by this over and over again. It's something that I've been 581 00:29:47,700 --> 00:29:49,200 trying to warn about four months. 582 00:29:49,600 --> 00:29:52,600 Many investors and analysts including us look at the cash 583 00:29:52,600 --> 00:29:54,900 flow metrics more than the accrual profits. 584 00:29:55,200 --> 00:29:56,300 That's the same way that I'm looking at. 585 00:29:56,300 --> 00:29:58,900 Most of these companies, not through the lens of PE, but 586 00:29:58,900 --> 00:30:01,800 mostly Their free cash flow yield and their expected cash 587 00:30:01,800 --> 00:30:04,600 flow growth. He says, unfortunately, share 588 00:30:04,600 --> 00:30:08,200 based compensation may cause distortions in cash flow metrics 589 00:30:08,200 --> 00:30:11,200 as well. Even when they follow gaap under 590 00:30:11,200 --> 00:30:15,100 gaap share based compensation is added back in the cash flow from 591 00:30:15,100 --> 00:30:18,900 operating activities which in turn is used in the computation 592 00:30:18,900 --> 00:30:21,200 of the free cash flow. Some researchers and 593 00:30:21,200 --> 00:30:24,300 commentators argue that share base compensation should be 594 00:30:24,300 --> 00:30:27,700 reclassified from the operating activities section to the 595 00:30:27,700 --> 00:30:30,700 financing activities section. All of the cash flow statement 596 00:30:30,700 --> 00:30:34,400 for analytical purposes. We agree after all the decision 597 00:30:34,400 --> 00:30:37,600 to fund, compensation to employees with shares, rather 598 00:30:37,600 --> 00:30:40,700 than cash is a financing decision rather than one 599 00:30:40,700 --> 00:30:42,900 pertaining to the operations of a company. 600 00:30:43,200 --> 00:30:46,200 This is something that I 100% agree with. 601 00:30:46,600 --> 00:30:49,600 I think these companies should not be adding this back to the 602 00:30:49,600 --> 00:30:51,600 free cash flow. Now, one thing that I can do in 603 00:30:51,600 --> 00:30:54,600 the meantime is even though we see the big free cash flow 604 00:30:54,600 --> 00:30:57,800 numbers of these companies, we can look at it with these 605 00:30:57,800 --> 00:31:01,300 stock-based compensation. Lined up right next to it and 606 00:31:01,300 --> 00:31:05,000 I'm going to even add in a new chart that does exactly what 607 00:31:05,000 --> 00:31:08,700 Terry Smith is saying that Gap accounting should do it. 608 00:31:08,700 --> 00:31:11,800 Nets out the difference. We take out the stock-based 609 00:31:11,800 --> 00:31:14,100 compensation from the free cash flow. 610 00:31:14,100 --> 00:31:16,600 So you see the raw numbers of how much they're actually 611 00:31:16,600 --> 00:31:19,800 generating and cash counting, the stock based compensation as 612 00:31:19,800 --> 00:31:22,900 a financing activity and again, just to illustrate how much of a 613 00:31:22,908 --> 00:31:25,600 problem this is and how it creates apples to oranges 614 00:31:25,600 --> 00:31:29,200 comparisons, Salesforce has half of their free cash flow. 615 00:31:29,400 --> 00:31:31,500 Eaten up by stock-based compensation. 616 00:31:31,500 --> 00:31:35,000 Other companies, like SP Global that also generate a large 617 00:31:35,000 --> 00:31:38,000 amount of free cash flow. They have barely any stock-based 618 00:31:38,000 --> 00:31:40,300 compensation. So when you're looking at these 619 00:31:40,300 --> 00:31:43,700 numbers depending on the stock based compensation, you can draw 620 00:31:43,700 --> 00:31:46,900 very different conclusions when this company actually generates 621 00:31:47,000 --> 00:31:49,100 3.5 billion dollars of cash flow. 622 00:31:49,600 --> 00:31:53,700 That's really about 3.4 billion dollars of real cash flows, it's 623 00:31:53,700 --> 00:31:55,500 much more meaningful. And I've been highlighting the 624 00:31:55,508 --> 00:31:58,000 example of Salesforce here, Terry Smith is highlighting the 625 00:31:58,000 --> 00:32:00,400 example of into it. We look at their free cash flow 626 00:32:00,400 --> 00:32:02,400 statement. We can see the same thing. 627 00:32:02,700 --> 00:32:05,000 Looks beautiful growing free, cash flows. 628 00:32:05,200 --> 00:32:08,100 I think into it's actually a great company but then we flip 629 00:32:08,100 --> 00:32:10,000 over to the stock based compensation. 630 00:32:10,000 --> 00:32:13,500 Stock-based compensation has accounted for 1.3 billion 631 00:32:13,500 --> 00:32:16,700 dollars of the free cash flow. So if you net that out you get a 632 00:32:16,700 --> 00:32:19,700 very different valuation which is exactly what Terry Smith 633 00:32:19,700 --> 00:32:22,400 does. If we apply this concept to the 634 00:32:22,400 --> 00:32:25,800 case of into it, it would imply that the company is not, in 635 00:32:25,800 --> 00:32:29,200 fact, trading at a trailing 12-month, free cash flow yield. 636 00:32:29,300 --> 00:32:31,700 Of 3.5%. So right now, it looks like the 637 00:32:31,700 --> 00:32:35,300 company has a free cash flow yield of 3.5 and he saying that 638 00:32:35,300 --> 00:32:37,800 simply not the case. If you net out the stock-based 639 00:32:37,800 --> 00:32:40,900 compensation, the free cash flow yield goes from three point five 640 00:32:40,900 --> 00:32:43,400 to two point two. So different companies are using 641 00:32:43,400 --> 00:32:45,900 this to trick investors and make their companies look more 642 00:32:45,900 --> 00:32:47,700 profitable than they actually are. 643 00:32:48,000 --> 00:32:50,100 And I don't think this is going to change until the Gap 644 00:32:50,100 --> 00:32:51,900 accounting. Rules are updated and then 645 00:32:51,900 --> 00:32:54,900 finally after Terry Smith highlights these numerous abuses 646 00:32:54,900 --> 00:32:58,500 of stock-based compensation accounting, he signs off for the 647 00:32:58,500 --> 00:33:01,100 year. That's his letter for the year. 648 00:33:01,300 --> 00:33:04,600 And in summary, like I said, from the very start, I viewed 649 00:33:04,600 --> 00:33:07,200 this letter overall is just angry. 650 00:33:07,200 --> 00:33:09,500 I think he's just upset at a lot of things. 651 00:33:09,500 --> 00:33:12,400 These companies are doing not communicating, what the 652 00:33:12,400 --> 00:33:15,000 long-term shareholders hiding their performance with 653 00:33:15,000 --> 00:33:17,900 Acquisitions. Having bloated cost, structures 654 00:33:17,900 --> 00:33:20,600 bloated performance. Investing in things with low 655 00:33:20,600 --> 00:33:23,400 Returns on Capital employed and then doing accounting trickery 656 00:33:23,400 --> 00:33:26,000 to make companies appear cheaper than they actually are. 657 00:33:26,200 --> 00:33:29,200 There's a lot of abuse has a lot of frustration a lot. 658 00:33:29,300 --> 00:33:32,200 A lot of things highlighted in a single letter and I agree with 659 00:33:32,200 --> 00:33:34,600 basically all of it. One of the things I've done with 660 00:33:34,600 --> 00:33:37,900 my portfolio, over the past year, is better understood how 661 00:33:37,900 --> 00:33:41,200 the accounting Works, how these companies report their profits 662 00:33:41,500 --> 00:33:43,700 so that I can actually get the true numbers. 663 00:33:43,700 --> 00:33:45,400 So, that's my thoughts for this episode. 664 00:33:45,400 --> 00:33:48,500 I hope it was informative and helpful, but that's all for now. 665 00:33:48,500 --> 00:33:50,000 And I'll see you in the next one.