April 22, 2019– Zoom and Pinterest rocket higher on their stock market debuts. Is the IPO pop justified?
China economic growth stabilizes. Is it smooth sailing from here?
Canopy Growth to buy Acreage in $3.4 billion acquisition. What makes this deal unique?
Qualcomm shares rise +40% on the week. What happened?
Why is it bad to invest based solely on dividends?
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian: Welcome investors to Episode 10 of the Absolute Return Podcast. I’m your host Julian Klymochko.
Mike: And I’m Mike Kesslering.
Julian: And it is Friday April 19th and that’s good Friday. Markets are closed today. In fact, it’s a great Friday for us to be in the office going through all the major events, news, global macro data and investment research we’ve done over the week summarizing it for you guys. So, let’s get into it.
Julian: Off the top – Zoom and Pinterest, they rocketed higher on their stock market IPOs. Are these pops justified? Chinese economic growth stabilizes in the first quarter, is its smooth sailing from here? Canopy growth to buy Acreage Holdings in a three point four billion dollar cannabis acquisition, what makes this deal so unique? Qualcomm shares rise 40 percent on the week. We’re going to talk about what happened there and finally why is it bad to invest based solely on dividends.
Couple of interesting initial public offerings in the market this week with both Pinterest and Zoom having IPOs on Thursday. Pinterest shares the popular social networking site, they rose 20% on their first day of trading and Zoom, the video conferencing company rocketed 72 percent which makes it the biggest first-day IPO pop of the year thus far. Historically tech IPOs have opened at an average premium or first day pop of 23% since 2010. What’s interesting some dynamics behind these IPOs, they both priced the IPO pricing above their initial price ranges. What we saw was from when they’re out marketing the IPOs to investors, it was pretty substantial demand. So, they both ended up raising the IPO price and this was in the face of Lyft’s IPO, which hasn’t gone so well. It had its one-day pop from about 72 bucks a share to 80. Now I believe it’s in the sub $60 range isn’t it? Yeah so it’s dropped nearly 20 percent from its IPO price and probably more than 30 percent since its peak on the first day of trading. In addition to that, another interesting dynamic on Pinterest is that where they price the IPO is actually 12% below the price that it at last sold shares in the private market two years ago. What happened there is you had a bunch of late-stage venture investors getting into the private round and actually not really making any money on the IPO they could have held off on that and bought it into the IPO. What are your thoughts on these two new issues coming to the market?
Mike: Yeah I guess starting with Pinterest what you’re seeing with them is that they’re having a little bit of saturation in their core us market. So, they have about 82 million users in the us and it’s growing at a slower pace than their overall user base including international.
Julian: It’s largely women too right?
Mike: Yes, yeah something that was interesting is that 80% of the women in the us that aged 60 to 64 are already users.
Julian: It’s wild.
Mike: Yeah so in terms of I guess you know looking at it from a monetization standpoint is some of the worry is that most of the monetization has been in the us. So, their ARPU their average revenue per user is around $3 in the us. Whereas internationally it’s only 25 cents. So, there is quite a bit of room for them to bring up those numbers. But if you’re marketing to women you have to be on that platform with 80% of your market there, so it’s makes sense right.
Julian: Yeah and people are wondering are they going to take the same route that Facebook did in terms of really harvesting all of their data and I heard comments from the CEO that they’re not going to be nearly as aggressive with respect to data harvesting, advertising to their units and things of that nature. A couple of other interesting dynamics behind these IPOs, I want to get a bit technical. So, on the Zoom front the IPO twenty four million shares which was only 10% of the shares outstanding. This implies a very little amount of the company was up for trading – only 10% of the shares as float and if you look at the day one volume where twenty five point seven million shares, so effectively over the entire float of the entire company traded on the first day and this is what we talked about a lot of people getting, a lot of investors getting into these deals just to sell out after the first day and you’ve really seen this cycle. I mean the entire shares of the float – more than the entire float has cycled throughout the first day and if we look at Pinterest, they offered seventy-five million shares only fourteen percent of the company and these technology companies only offer a really slim chunk of the business up for sale. So, they create these supply and demand dynamics, such that demand far exceeds supply for the shares and they get this really nice lift on the first day. One-day volume on Pinterest of 87.1 million shares which again exceeded the entire float of 75 million shares. Not necessarily a lot of long-term shareholders into the IPO, I figure it’s mostly short-term speculators and speaking of speculators, there’s a really interesting example of inefficient markets with this. There’s a company called Zoom Technologies which is penny stock and trading over-the-counter. But as you can see the ticker is ZOOM and some people must have mistaken that to be the Zoom Video Communications, which is this new hot IPO with ticker ZM. Nonetheless this Chinese company ZOOM which was a very very small micro-cap penny stock.
Mike: I think like 8 million dollar market cap.
Julian: Well now that’s after 27,000 percent year-to-date return. So, it went from I believe fractions of a penny in price prior to this other Zoom’s IPO to now nearly $3 per share, eight million market cap up from you know a few thousand dollars. So, market’s inefficient but interesting to see how these things play out.
Mike: Well yeah and the interesting aspect as well is that, they actually the other Zoom actually had their first pop when Zoom actually filed their S1; which at that point in time it’s just filing for their prospectus for an initial public offering. It’s not even a trading yet right? Which is kind of funny. The other interesting aspect of Zoom just from their roadshow that I thought was kind of cool was that their CFO was the only one in person for the roadshow whereas their CEO stayed back at their offices and used their technology to conference in. So, I found that kind of interesting.
Julian: Yeah good display of their service. I read another interesting story on the CEO, so he’s a Chinese immigrant and his visa got rejected I believe eight times over two years and he finally made it into the U.S. and now happens to be a billionaire technology entrepreneur. So really cool story behind the scenes going on Zoom and Pinterest has a cool story as well.
On to some global macro. Chinese economic growth bounces back in Q1. It experienced six point four percent annualized GDP growth, beating the consensus estimate of six point three percent and this is a really big bounce back from Q4. As you recall we previously discussed a few podcasts ago of pretty unimpressive economic data coming out of China. There seemed to be quite the slowdown there. As you remember markets really tanked on fear of a potential global recession into Q4. We saw some economic numbers of the U.S. and potentially Germany start to turn around. But now it seems to have come to China where their economy seems to be rocking. I mean six point four percent growth, that’s right between their target economic growth range of 6% to six and a half percent. Although below the six point six percent rate of expansion last year. Which already happens to be China’s slowest annual growth in nearly three decades. To put this into context six percent growth of a thirteen point four trillion GDP economy, that’s basically adding the annual economic output of Switzerland every year just to put that in some context. It really is a huge number. So how do they do it? Well on the positive Q1 economic growth in China was largely driven by strong manufacturing production and greater consumer spending by Chinese consumers, which is positive. One thing that we saw after the 08-09 credit crisis was this massive fiscal stimulus out of China. A lot of it which went into fixed asset investments. You saw a lot of build out of infrastructure, roads and bridges to nowhere unproductive infrastructure such as empty shopping malls, these giant ghost cities with no one living in them and it was largely wasteful investment, fixed asset investment just because they needed to put people to work, they needed to invest this money and they needed to hit their economic growth numbers. So, it’s nice to see some more positive drivers out of the Chinese economy. What are your thoughts on this?
Mike: Yeah I just wanted to point out as well that you know you mentioned some of that fixed asset investment that perhaps wasn’t as productive, but still a lot of their growth still is stimulus driven. So, there’s two types of stimulus that a government can provide. So fiscal and monetary. Fiscal stimulus they’ve had tax cuts, so reducing their value-added tax from 16 percent to 13 percent. On the fiscal side they’ve also issued another 300 billion worth of bonds for infrastructure projects. So hopefully those will be productive projects and then on the monetary stimulus side they’ve reduced the reserve requirements for the banks to try to encourage more lending for small to medium-sized enterprises.
Julian: Yeah that’s not necessarily positive given that many of the loans going out are not good loans and they just need to roll them over, because these companies can’t necessarily pay them back.
Mike: Absolutely and that’s been a major concern of the Chinese economy is kind of well it used to be the shadow banking sector, but now looking at some of the banks that could be some cause for concern as you know messing with reserve requirements you know that could be quite problematic.
Julian: It’s an issue of malinvestment. Investors were concerned about this fixed asset investment, but now those concerns have moved more towards bad credit and a potential credit crisis down the line as more and more bad debt builds up in the financial system.
Mike: Absolutely and so in terms of their overall economic strategy it seems to be quite stimulus driven. You know do you see that as a strategy it being sustainable?
Julian: Well it’s an economic experiment whose outcome is yet to be determined. You’ve never seen a centrally driven economy such as this that is as the government so heavily involved. So, the Chinese economy is certainly extremely unique. A lot of people have been talking or calling for a Chinese bubble to burst over the past decade thus far we haven’t seen it happen. A couple things I wanted to touch on with respect to the Chinese economic growth numbers, now you really need to take the numbers coming out of China with a grain of salt. Analysts for years have questioned the authenticity of the economic data coming out of China. They suspect China’s National Bureau of Statistics, which reports much of the country’s data, they’re more focused on looking or making the government look good as opposed to giving an accurate reflection of the country’s economic health. Obviously they’re very well aware that the Chinese government has given these strict mandates to grow between six and six and a half percent and so the people behind producing the economic data really know that they’re not allowed to report anything sub 6%. Kind of interesting and pretty hilarious quote out of a gentleman named Leland Miller, the CEO of an advisory firm China Beige Book. He stated the Chinese published GDP numbers are absolute garbage. It’s certainly the consensus that these numbers are not reliable. So, there you have it, a lot of people, a lot of economists and analysts quite skeptical that being said you’ve got to take these Chinese numbers with a grain of salt and just continue monitoring this situation out there.
Interesting deal in the cannabis space with Canopy Growth agreeing to buy acreage holdings in a three point four billion dollar deal. What happened here was Canopy reached an acquisition agreement to buy the New York-based Acreage Holdings. Well that company is a multi-state operator of dispensaries, cultivation sites and processing facilities throughout the U.S. Some of the terms behind the deal and the structure is very interesting, which is why we’re going to talk about. The way it works is Canopy will make an upfront payment of $300 million once they get shareholder approval and what this means is Canopy is effectively buying an option to buy Acreage, because they won’t take them over right away. What they’re going to do is pay them these 300 million dollars and once they execute their option in the future, they’ll do a share exchange where Canopy will exchange their shares for Acreage shares effectively take it over by issuing more shares at a ratio of 0.5818. The reason they’re doing this is just to, it’s effectively a loophole. Canopy wants to expand into the U.S, but as you remember in the U.S cannabis is still illegal on the federal level. So, they’re in fact not allowed to buy Acreage and they would definitely lose their TSX listing if they did have any U.S. operations. What Canopy Growth is looking to do here is really establish a leadership position in the U.S prior to legalization. A really interesting strategy. I bet we’re going to see a lot of copycats. Clearly some creative legal structuring behind this deal. We’ve got a quote from the CEO of canopy, Bruce Linton; he says our right to acquire acreage secures our entrance strategy into the United States as soon as a federally permissible pathway exists. When this is going to happen is up to anyone’s guess. But it seems globally that cannabis certainly is becoming slowly approved in different jurisdictions. What are your thoughts on this deal?
Mike: Yeah I think that expansion to the U.S. by Canopy was always seen as inevitable. The next item that I guess I would be looking for is a partnership with a large pharma company similar to what tilleray did. But as well you mentioned you know the likelihood of copycats with this sort of strategy into the U.S, I think they’ll do similar deals themselves. I think their CEO was quoted that they had been in talks with about six other companies with similar deal structures.
Julian: Yes, just a crazy amount of deals happening in the space. A lot of consolidation and when you’re dealing with such highly valued shares, they’re smart to issue as many of those shares as possible. Obviously in the future this will be bad for shareholders, because it’s substantial dilution and they really are paying crazy valuations. I mean this is a three point four billion dollar deal for Acreage. But if we look at the fundamental financial performance of acreage, last year they only had sales of 21 million and generated a net loss of 220 million dollars. What does that look on a multiple basis? Well Canopy Growth is buying Acreage for roughly a hundred and fifty times sales, which is a pretty obscene valuation. But they are using cash and Canopy can make the argument that their shares are wildly overvalued as well.
A lot of people talk about this type of deal as using their shares as monopoly money. If you are a person and you have monopoly money and someone’s willing to accept it, well you spend as much as you can. Because you know it’s not going to hold up its value forever. We saw an interesting dynamic back in the technology bubble and I remember a specific deal when Yahoo bought Broadcast.Com for five billion, which made Mark Cuban a billionaire. But that deal, and Yahoo shares were so overvalued, not just that luckily Mark Cuban was smart enough to recognize that. He sold out as quickly as he could. But you look at what happened to Broadcast.Com and Yahoo wrote that off to zero shortly thereafter. Another interesting aspect of Acreage is they have some real heavyweights on their board of directors, including former Canadian Prime Minister Brian Mulroney and former speaker of the U.S. House of Representatives, John Boehner. So definitely a lot of interesting characters behind that company. Looking like a big win for everyone involved.
Mike: Yeah absolutely and in terms of Acreage, I definitely see the rationale from their side. They’re getting a cash injection where they were looking for capital to scale up their operations. So, it definitely makes for sense from their side. Another interesting deal point was that Constellation Brands through their investment in Canopy, their prior investment in Canopy actually had veto rights on the transaction. But they did agree to waive these rights subject to Canopy extending the expiry dates on the warrants that they had for Canopy shares. So, exercising some of their influence to make the makes of their shares a little bit better.
Julian: Yeah I think Constellation structured their investment such that they want to take control of Canopy at some point. Full ownership and if you look at Canopy’s strategic direction they really want to maintain that their leadership in the global cannabis space and if that’s the case then they certainly need to be a leader in the U.S; hence this Acreage deal.
Big gains for QUALCOMM shareholders with the shares rising forty percent on the week as it settles a patent dispute with Apple. Now this legal battle which became very contentious between these two Silicon Valley heavyweight tech companies, it was really centered around chips as specifically for use in the iPhone. Apple thought they’re paying way too much to QUALCOMM and they had to pay QUALCOMM a royalty on some of that intellectual property that they own. This has been a battle going on for about two years and went to trial last week and the companies ended up settling. So, Apple will buy QUALCOMM chips again, QUALCOMM coming out said it expected to see $2 per share increase in earnings and both companies were asking for billions in damages. Net result big rally in QUALCOMM shares this week, Apple roughly unaffected by the trial results what are your thoughts on this situation?
Mike: Yeah so the UBS equity research analyst actually has some estimates into it how much Apple paid to settle this litigation. It’s in the five to six billion dollar range and likely what that is are the royalty payments that they had stopped paying as soon as the litigation surfaced a couple years ago. But as well the other interesting aspect is that those royalty payments which are made on a per phone basis have likely increased from seven dollars and fifty cents to the eight to nine dollar range. So, another kind of you know win for QUALCOMM. But as well we talked last week about Apple’s strategic shift to services and basically that this is to reduce their reliance on iPhone sales, but really iPhone sales are still 63% of Apple’s revenues. So, this was something that they had to take care of and when you factor in some of the concerns on intel’s ability to deliver that I think there is a lot of incentive for Apple to get this settled.
Julian: Yeah it’s an interesting situation, I remember Tim Cook complaining feeling like they’re getting robbed by QUALCOMM. Nothing’s actually going into the phones, this is just a straight payment. Because it’s a royalty for intellectual property. Obviously extremely positive for a QUALCOMM. If you think about what royalty income is it goes straight from the top line to the bottom line, there’s effectively no expenses associated with it. Very very good news for QUALCOMM and like you said Apple is still highly reliant on its iPhone sales as they seek to make the transition from a hardware producer and somewhat a company heavily reliant on devices to company more earning steady growing income from services. So, we’ll see what Apple comes up with here. Intel announcing they’re dropping their pursuit of 5g chips. So, it looks like QUALCOMM has quite the bright future here.
Put out some interesting research on a blog this week entitled Whatever You Do Don’t Invest Based On Dividend Yield. We did this because we constantly see this mistake over and over again of investors putting their money into stocks based solely on the dividend yield. We presented some interesting analysis on why that is a bad idea. Off the top let’s just get into what dividends are from a real fundamental perspective. A corporation has five main areas in which they can allocate. Number one, capital expenditures. Number two, research and development. Number three, mergers and acquisitions. Lastly dividends and then share buybacks. Now the first three capex, R&D and M&A; are I would consider growth initiatives. They undertake those in order to attempt to grow their sales and grow the company. The last two being dividends and share buybacks are alternative capital allocation decisions that seeks to return capital to shareholders. Either in terms of payments on their shares dividends or going into the market repurchasing shares via you know everyday purchases in the market or by a tender offer if they want to take out a large chunk. Now from an investor’s perspective dividends and share buybacks are both the company returning capital. However, I always prefer share buybacks because they are more tax efficient.
A big change in dynamic has happened over the past few decades, specifically since 1982. Because prior to 1982 share buybacks were actually illegal. But after 1982 the SEC passed a new rule allowing for companies to repurchase their shares. That gave birth to a notion call the shareholder yield. Now shareholder yield is basically adding the dividend yield plus the share buyback yield. Prior to 1982 the shareholder yield was just the dividend yield and dividends were pretty good proxies for corporation’s free cash flow. But if we looked over the past say 20 years; a shareholder yield has steadily grown back way back when dividends were two percent and now total shareholder yield is about six percent in the S&P 500. That six percent is made up of four percent buyback yield, two percent dividend yield. My point here being that buyback yield is now two-thirds of total shareholder yield. Many investors are making the mistake of focusing on dividends when buybacks are twice as important when it comes to capital being returned to shareholders. So that’s one major thing to consider.
Another major thing to consider in terms of dividends, dividend yield is that the dividend yield is very easy to manipulate. I give the example of closed-end funds. Effectively a company can set their dividend policy as whatever they want. Especially if they have cash line of credit or highly liquid assets that they can liquidate. It’s just if they can’t afford it then each dividend payment it’s effectively a small liquidation of the entity. A lot of closed-end funds do this, where a significant portion of the dividend that they’re paying is actually return of capital. So, they are paying you back your own money instead of net income from their underlying portfolio or underlying businesses.
Another interesting model that used to be in the Canadian market is that of the income trust and the royalty trust. Now many of these followed the business model of paying out artificially high dividend yield in order to attract investors and a premium multiple and now that worked for a while and they cover these dividends by continuously raising more and more equity diluting their shareholders even more. Now the business model of utilizing new investors to pay off old investors is known as a Ponzi scheme. I’m not calling any of these businesses Ponzi schemes. But you know you get the analogy here that you know I’m trying to make the point that dividends are easy to manipulate. So, you should not necessarily trust that the dividend yield is reflecting the company’s underlying fundamental strength or underlying cash flows.
I can give another example, a specific company called BP Prudhoe Bay Royalty Trust; which is a trust with one asset. Effectively they get a royalty from BP Prudhoe bay oil field on the north slope of Alaska. Wanted to point this one is that this company recently cut its dividend, because it’s variable. So, the dividend went from above $1 down to 35 cents per share and on the day that they announced the cut, the shares dropped 14%. Now this is completely non fundamental, it’s just technical trading. Because unsophisticated investors bought the stock expecting a high dividend and then do the underlying fundamental analysis of cash flows to truly determine the intrinsic value which would help determine whether or not the stock is a good investment.
So how do you do this a fundamental analysis to determine if the stock is a good investment? Well a dividend is a poor way of doing it. A much better way is looking at either valuation. Like look at free cash flow or quality in terms of return on capital would be one example of a quality factor. But together some analysis here we did a simulation over the past 20 years on Canadian stocks.
So, if we look at the top 10 percent dividend yielders, the compounded are returned about 8 percent annually over the past 20 years and also the bottom 10 percent dividend yielders having pretty much the exact same returns. So, there’s no alpha from a long short portfolio of highest dividend yielders versus lowest dividend yielders. Yes, they did outperform the TSX Composite, the benchmark index by 1% over the year, 1 percent per year. But if we compare that to say valuation-based factors such as free cash flow to enterprise value, the top 10% i.e. lowest valuation stocks in Canada compounded at 16% annualized. On that portfolio $100,000 investment would be 2 million bucks by the end of 20 years and the bottom 10% decile lost nearly 5% annually. So that’s over a 60% loss over the 20 years. If we look at a long short portfolio where you’re going long of the top 10% lowest valuation stocks of Canada versus short the bottom highest valuation stocks in Canada, it’s actually 21% long short alpha right there versus effectively zero on the dividend yield and that divergence between top and bottom decile really shows the strength of the underlying factor in stock performance.
We looked also at quality in terms of return on capital. A similar performance to the valuation measures. So top 10% of quality stocks in Canada over the past 20 years compounded at 15% annually. A $100,000 investment would have turned into 1.7 million dollars over that time frame. Now the bottom 10% actually dropped 8% annually losing 80 percent of investor’s portfolio over the 20 years. A long short portfolio going long the top quality companies by return on capital in Canada while shorting the bottom lowest quality companies returned 23% long short alpha over the 20 years. So truly exceptional performance, again you’re seeing a nice divergence between top decile and bottom decile. Really showing that looking at value and return on capital are far superior than looking at a company’s dividend.
One last point I wanted to make is many people choose to invest in dividend stocks because they want to yield but you can create your own yield by selling shares for how much money you need every month. I mean there’s nothing wrong with generating your own income through capital gains and best of all it is much more tax efficient. Did you have any comments on the blog this week?
Mike: Yes, so I guess given just a question is that given that dividend yield is a suboptimal factor what has been driving the popularity of dividend investing.
Julian: Well unfortunately a lot of even professional investors are promoting it. The idea I had I got this from was an article in the Globe and Mail just last week. A big mutual fund firm promoting income investing which just had to facepalm after that because it’s just bad advice. Unfortunately, a lot of investors, professional investors giving bad advice. There’s a lot of hype and catch phrases like “get paid to wait” or “income investing” and people like getting paid each month passively right. But unfortunately, many unsophisticated investors misunderstand it. They’d be much better looking at total return which considers capital gains and dividends.
Now if you can create a portfolio that attains a higher total return, your net worth and your retirement income will ultimately thank you. Because they’ll be far higher by considering capital gains as well and you can self-manufacture your own dividend out of capital gains and that’s a point that I really want to hammer home here is don’t focus on dividends. Focus on total return and creating your own dividend through capital gains.
And that’s its ladies and gents for Episode 10 of the Absolute Return Podcast. We hope you have a great Easter. You can check us out next week, www.Absolutereturnpodcast.Com. Follow us on twitter and any social media. Be sure to give us a rating. Send us any questions, comments, whatever it is; we will chat with you next week. Cheers.
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