April 8, 2019– Tradeweb goes public. Is it the future of bond trading?
Mixed jobs reports in Canada and the U.S. How to interpret the numbers.
Tesla first quarter disappoints. Can Musk get it back on track?
Andreessen Horowitz converts into a financial advisor. Will other VCs follow?
A discussion on the future of value investing, including why cash flow measures are superior to liquidation values.
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 ladies and gentlemen to Eepisode 8 of the Absolute Return Podcast. Today is April 5th, 2019. I’m your host Julian Klymochko.
Mike: And I’m Mike Kesslering.
Julian: And we have a lot of cool events to chat about this week. First of all, we’ll start off with Tradeweb and so it went public this week. It had an IPO and we were going to chat about, you know, what does this company do and is it the future of bond trading. We had some mixed job reports out of Canada and the U.S. We talk about how to interpret these numbers. We’re going to talk about Tesla and Elon Musk. Andreessen Horowitz, a venture capital firm converted into a financial advisor – are other VCs going to follow? And lastly a discussion on the future of value investing and why investing based on cash flow measures are superior to liquidation values.
Another big IPO hitting the markets this week with Tradeweb doing a 1.1 billion dollar raise at a six-billion-dollar valuation. So let’s talk about Tradeweb and it is a bond, electronic bond trading platform. So, it’s founded in 1998 to trade treasuries, treasury bonds over the internet and it’s an unusually mature company to go public. It’s been around for north of 20 years. So not necessarily a start-up. What it does, it handles over 500 billion in daily trading volume of government and corporate debt, swaps and mortgages. Some of the IPO dynamics, so initially they went out at a $24 to $26 per range and then they up size that I believe, and they up sized the amount as well and so after they set it at $27 per share the stock rallied 32.6% on the day to close up to almost $36. So quite the one-day IPO pop on that one. It’s the second largest tech listing of 2019 after Lyft and talk about voracious investor demand on this one, I mean we saw orders north of 17 times oversubscribed. So, another one with a lot of demand from investors and the company was actually owned about a number of financial firms including Blackstone, JP Morgan, Citi group, Goldman Sachs and Morgan Stanley. Who also happen to be the underwriters. So, interesting IPO what are your thoughts on this one?
Mike: Yeah you mentioned a lot of demand for this offering. Which makes sense when you put it in the context of some of the other tech IPOs that aren’t actually making any money. So, in terms of like where their business model, they’re on a boat you know 600 million or so of revenue six eighty-four, six hundred eighty-four million of revenue. Their net income of 160 million which works out to net income margins of 23%. They have even a margin of 40%. So, this is a very healthy business model. They have 40 percent of their gross revenue coming from reap recurring subscription fees. So, it adds some stability to that model where they’re getting paid off of both subscription fees as well as trade volume. But yeah as well and this is information that it was all glede from the S1 that I had the opportunity to go through prior to their IPO.
Julian: And the S1 being the filing that they present to investors prior to going public?
Mike: Yes, and so yeah you mentioned the controlling consortium that controls the majority of the company that includes Blackstone. But as well as CPPIB, so a little bit of Canadian flavor there. This was acquired and as part of from Thomson Reuters actually, their financial data business which I believe was last year. But another interesting aspect that I found from the S1 was that in the U.S treasuries market actually 40 percent of overall trading is still done through voice trades. Which is a pretty crazy statistic and you know the usual listeners of the program will recognize as well that we will go back to corporate governance. They do have a dual class structure. So, I guess in the aspect of actually having a thriving business model, it’s a little bit different from the Lyft offering. But they still do have that dual class voting structure.
Julian: Yeah we’re seeing that become really popular these days in terms of multiple votes per share for different share classes, specifically the controlling shareholders. But talk about Tradeweb in general I mean this business has a long runway to go as you say. Still the bulk of bond trading is done either over the phone or in chat rooms. Which is pretty antiquated and trading bonds historically myself it’s kind of weird having to call someone and chat about a price, you wish you could trade just like equities which are all done electronically obviously. So, it’s really strange. But we look at the reason why they did this IPO and looking at a quote from the CEO, he indicated that it’s pretty much the governance structure being mostly held by financial firms; it didn’t really allow the company to be flexible and as you indicated you had this Refinitiv used to be a portion of Thomson Reuters. So, it recently underwent leveraged buyout by Blackstone and CPPIB in addition to others I believe and so what they’re trying to do is monetize some non-core assets. Which I’m sure some of the other banks want to do here. But it’s a relatively high-quality company, great margins, good long-term upside in terms of growth and so it could be one worth looking at.
Mike: Yeah absolutely and then in terms of other IPO news, this week slack announced that they’re pursuing a direct listing as opposed to an IPO. Now this was something that Spotify also pursued. So, Julian what exactly is a direct listing in comparison to an IPO?
Julian: In contrast to an IPO which is initial public offering, a direct listing actually doesn’t entail an offering. They’re not actually offering any stock. They just list their shares for trading, get a ticker. Choose an exchange and shareholders can buy and sell it on there and so there’s no large raise of capital either by a treasury offering that goes to the company or a secondary where it goes to large shareholders of the company. So certainly, an interesting strategy. We haven’t really seen too many of these. But it’ll be interesting to see how that one trades on the first day.
Mike: And most notably the direct listing bypasses the investment banks. So, there’s a lot less commission revenue that the investment banks are able to get from a large offering in a traditional IPO.
Julian: Yeah certainly they don’t like that loss of commission.
Jobs number today in the U.S and Canada and so let’s start on the U.S. jobs report. So, after a lackluster performance in February the job market really bounced back in March. So, let’s get to the numbers, hundred ninety-six thousand jobs were added last month in the us. So, this is a big rebound of the 20,000 number that we talked about that happened last month. That was actually revised to 33,000 versus consensus estimates that 196,000 compares to a hundred and seventy thousand. Which is just an average poll of economists and what they expect. So, this represents a hundred and second straight month of job gains, which is pretty crazy in terms of length of this cycle. If we talk about wages, wages increased 3.2 percent year-over-year. Which is getting up there I think and then the unemployment rate was unchanged at 3.8 percent. What are your thoughts on this report here?
Mike: Yeah my only real comment is with regards to wage growth is that the common complaint over the last number of years has been that wages have not kept up the pace of inflate, kept up with the pace of inflation and so what basically the complaint there is that the wage growth really hasn’t increased the buying power of employees and so that’s kind of an issue when looking at the overall buying power of the populace. But yeah that’s really my only comment on that.
Julian: Yeah I saw interesting comments out of Trump, I believe he said them either today or yesterday he said quote “I think they should drop rates. I think they really slowed us down. There’s no inflation, it should actually now be quantitative easing” and Trump was referring to the federal reserve there and so while Obama was president he used to constantly bash the fed saying that they’re keeping rates artificially low and that quantitative easing would lead to runaway inflation. However now that he’s in the top spot he’s really harping on the fed to ease, so he can further juice the economy. But you know somewhat controversial because the fed is supposed to be independent and Trump is obviously trying to get them to juice the economy a little bit. Which is wild after the length of this cycle that we’ve had. A lot of people think that were late cycle and I mean after 102 months of job gains, it’s pretty hard to argue against that.
Mike: Yeah not only the juicing the overall economy but also his own assets which are leveraged and rely on debt, so any decrease in the overnight rate would be favorable for him?
Julian: Yes, certainly lower rates benefit a highly leveraged real estate investor.
So on to Canada let’s talk about those jobs’ numbers. So, employment actually fell by 7,200 jobs in March in Canada. This is the first drop in seven months. This is versus expectation of 6,000 job gain. So certainly, a miss on Canadian job numbers there. Canada’s unemployment rate remained at five-point eight percent on the interest rate cut side. Estimates nudged up to 40 percent of an interest rate cut this year. If we contrast Canada and the U.S. versus last month’s jobs report which we discussed a few episodes ago, the U.S numbers were very very weak, 20,000 the month before last month. In Canada it was super super strong, Canada had two back-to-back reports that were the strongest we’ve seen in a long time and I stressed at the time that these monthly job numbers they’re not set in stone. I called them WAG’s – wild ass guesses and so there’s a lot of guesswork that goes into it. Not to mention seasonal adjustments, they do this off of polling a relatively small amount of people. So, the best way to deal with this and I discussed this previously is you would likely want to look at say a three-month average, some sort of rolling average that considers these large swings to give you a better picture of coincident or perhaps even leading indicator on where the economy is going, and the jobs market really is a great indicator. A lot of people like looking at it if they want to get a sense of where the economy is heading, and I want to compare these numbers at Canada and U.S. The U.S. is obviously three-point eight percent unemployment rate, not exact exactly apples to apples. But Canada at five-point eight percent, wage growth higher in the U.S, jobs growth higher in the U.S. and so Canada is really seeming to be lagging behind its southern neighbor here.
Mike: Yeah absolutely. The one other aspect that I would like to point out is the ways to look at any of the revisions of previous estimates as they are just estimates there was upward revisions in the U.S for both the February and January months. So that’s something else to keep in mind when looking at the trend.
Julian: Sure, and that lends credence to my thoughts that these aren’t necessarily all that accurate when they’re getting revised by more than 50 percent, right. So absolutely keep an eye on it.
Big Tesla news this week as they released their Q1 results. In those results they announced their vehicle deliveries. So, they delivered 63 thousand vehicles. Which was actually quite a bit lower than the 73,500 as expected by analysts. Which were I believe reduced. They probably expected quite a bit more than that. So, these are really reduced expectations which they missed. These deliveries were down 31% versus Q4, which obviously isn’t really showing the growth required out of this stock. If we look at Tesla’s stock, it really is something I consider a glamour stock or a story stock. Where you really need to believe in the CEO Elon Musk and their overall mission and where they’re going to be. It’s kind of pie in the sky type growth that investors are expecting here. Because if you like to be underlying fundamentals, there really isn’t a strong case for being long the stock. What are your thoughts on it?
Mike: Yeah it’s definitely when you talk about the kind of the pie in the sky. With Elon Musk he’s very much an idea person and execution is a difficult aspect and so you know like you look at the planning of the company and some of it just seems kind of questionable with they had production held, they had delivery held. You know they had the announcement of closing down actual brick-and-mortar locations and then reversing that decision a couple weeks after the fact. So, there’s you know a little bit of disarray within the company. A little bit more than a traditional car manufacturer. As well you know you mentioned the valuation of the company and being considered a growth stock. But what your kind of seeing here with this quarter is declining growth numbers despite multiple price cuts and as well like in the forecast I don’t believe counts for any meaningful raise and capex in this year. So, all of this is waiting to you know that maybe it isn’t the growth stock that people think. Yeah it’s just something to consider when looking at the stock. Because it is very polarizing. Stock has a short camp and a long camp and it is very polarizing.
Julian: Certainly, Elon Musk is in a bit of a heap here and some controversy with the SEC, the securities exchange commission due to some of his tweets were a bit offside. You know as last year a real interesting tweet he released was supposed had an offer at 420 per share and he indicated that his funding was secured and when it in fact was not. It was the furthest thing from the truth and you really can’t as a public company CEO issue misleading statements like that which have a material effect on the stock at the time and obviously no buyout was even close to happening. So, after that the SEC really locked down his twitter account as he was supposed to. He apparently was supposed to have legal review of every tweet that he released, but he really just ignored that. He called the SEC the “short seller enrichment commission” and really just bashed them, said he didn’t respect them at all. So a very opinionated figure, obviously a passionate entrepreneur and leader but sometimes some of his actions really irk short sellers certainly and regulators as well and so we’ll see what happens with the current lawsuit or the court case the SEC is charging him with contempt. Because he recently released a tweet indicating I believe 500,000 vehicle deliveries this year when in fact their guidance was more so around the 360,000 to 400,000 range. They’re indicating that this was a misleading statement. He indicated that it was no big deal. So, we’ll see how these two parties figure it out.
Mike: Yeah and in terms of just to bring light to this situation you know he has been very antagonistic with the SEC. I feel like maybe he should focus his antagonizing efforts towards shorts as I believe it was to David Einhorn when he, I believe this was last year of the year before when he had sent him short shorts in the mail. Which I thought was a pretty funny move from regardless of which side of the issue you come on. But yeah antagonizing the SEC I don’t think is a very good long-term business decision.
Julian: Yeah and shorts and longs on the stock really have polarized opinions of Elon Musk obviously longs they absolutely love him. They think he’s a visionary. A legendary CEO perhaps comparable to Steve Jobs. Trying to save the world from climate change, promoting electric cars and then shorts believe he’s somewhat of a huckster, a promoter, hardcore stock promoter just really trying to get the stock price up and save Tesla from potential bankruptcy. So, what are your thoughts on Elon Musk?
Mike: Yeah I would lean more towards the latter personally. But yeah I mean he does have a vision of the world that he is trying to mold. He is trying to bring electric vehicles to the masses. Whether that’s an actual business strategy is up for debate. Because you know so far in Tesla’s you know in their experience they have not been able to on a sustainable level achieve profitability, just their unit economics. Perhaps they will prove the short sellers wrong in the future. But as of right now I would lean more towards the latter where he’s very willing to manipulate the stock price, not really concerned about that and is very promotional. There’s always a new shiny object.
Julian: Yeah I’d agree with that, I’d consider myself a little bit of an Elon fan. I think he’s accomplished a lot. He certainly takes quite a bit of a harassment from short sellers and on the short side I think those guys some of them certainly have become far too emotional. I think when you’re involved in a stock whether long or short just view it as a piece of a business and I mean when you’re short you’re obviously betting on it going down. But you shouldn’t get emotional about it. You never want to get emotional about a position like that. Because then it affects your thinking, it affects what you do with the stock. You can establish biases in terms of anchoring and just talking to people with similar points of views, not seeking alternative viewpoints, variant views, to see where perhaps your thesis is wrong.
Mike: I would definitely agree with that in terms of me personally. I would never invest you know long or short the security just because I am biased. I think that’s really important. That’s very important.
Julian: Yeah a lot of confirmation bias going on with these short seller circles especially on Tesla.
Mike: The other aspect is that, a lot of you mentioned the amount of mental capacity that’s going in to the position. For likelier position from portfolio managers that’s like 1 % of their portfolio. But they’re spending you know maybe 50 percent of their time on the name. It just doesn’t really add up.
Julian: Yeah it’s kind of funny longs and shorts pumping and bashing the stock with no net effect.
Interesting news in VC land with Andreessen Horowitz announcing that they’re registering their entire firm as a financial advisor and renouncing their status as a venture capital firm. The reason they’re doing this is because both of these VC and financial advisor, they’ve very specific regulations. So, they feel as a financial advisor really frees up them to take on different types of investments and clearly they’re trying to grow their firm. So, under these the new rules under being a financial advisor they can actually buy up shares from founders and early investors. So, this would be not directly from the company in which they’re restricted to do currently, and they would also this new change would allow them to trade public securities as well, which as a VC firm they’re not allowed to do. So, it’s an interesting move Andreessen Horovitz. They have really pioneered a number of things in the VC business and so it’ll be interesting to see if this is a new model and other firms follow them. What are your thoughts on it?
Mike: Yeah so the other aspect this enables them to pursue is crypto. So, you’ll remember that they did raise a 350-million-dollar fund to invest in crypto and blockchain companies. Which is massive for that space. But at the time it actually had to be a separate legal entity. Because VC funds can only hold 20% of their assets in liquid securities and crypto for regulatory purposes is considered a liquid security. So, Andreessen Horowitz so far they’ve invested in Coinbase, the crypto exchange as well as poly chain capital, one of the largest crypto hedge funds. But yeah overall that group is being led by Chris Dixon and Kathryn Hahn and so we actually had the opportunity a couple months ago at the startup grind conference to listen to Chris Dixon talk and he had a few interesting points about crypto. You know in his opinion the crypto space is still in its immature phase. He actually compared the current stage to that of the Apple 2, which predated the growth of PCs by about six years before 1983 and now looking into the future he actually saw the first wave as building the actual platform and sees the next wave in crypto as building killer apps on the platform. So, he still is seeing a lot of innovation in this space and I think this just allows Andreessen Horowitz to have a fully integrated model and pursue that crypto thesis as not just a separate entity.
Julian: We put out a blog post this week entitled “value investing is dead, hashtag fake news”. I wanted to get do a bit of a deeper dive into that blog post and kind of the major implications of our analysis and so to discuss what value investing is, it’s effectively buying a security below what’s known as intrinsic value. So, this typically involves buying a stock at a low multiple website. Book value, earnings, probably heard of price earnings multiple a free cash flow [inaudible] and these all convert to various multiples. Some of the ones we like looking at is enterprise value to free cash flow and by enterprise value we mean firm value that encapsulates market cap in addition to debt and preferred shares, minority interests and things like that.
And so where value investing really started, it was pioneered by a gentleman named Ben Graham, who was actively investing throughout the great depression in the 1930’s and the thing about the great depression obviously one of the worst recessions in modern history. The stock market had tanked I believe nearly 90 percent peak to trough. Peaked in 1929 and it didn’t really trough until a number of years later and throughout the 30s stocks became incredibly cheap. Well that’s what you get with a market declining almost 90 percent. So, the method that Ben Graham would use he had this metric, this value investing metric he referred to as net current asset value. And so what net current asset value is you take the company’s current assets, and these are all balance sheet measures. So current assets minus total liabilities and preferred shares. So what he was doing he was looking at a business not as a going concern operating entity, but he’s saying if we just take the liquid assets i.e. cash, inventory, accounts receivable, net off all the liabilities of the company, any payables, any debt and things such as that nature he’d want to see what’s left over and only buy the stock if he could get it for two thirds of that value. So that’s where value investing came from and Ben Graham was teaching a course at Columbia business school of which Warren Buffett took and Warren Buffett became one of his disciples. Obviously one of the greatest or if not the greatest investor of all time. Many others studied under Graham and had pretty astounding investment careers relying on this initial technique of value investing – which initially was on the balance sheet book value. So we call that the value factor.
And so a few decades ago quantitative analysts, the quants started researching and publishing analyses of these factors and one of them was a paper by Fama and French which really popularized book to market and their study entailed going long a portfolio of cheap stocks on book value; i.e. trading a significant discount to book value and shorting a portfolio of high valuation stocks trading at multiples of book value and what they discovered at the time, which was in the early 90s, is historically cheap stocks on a book value basis really outperformed expensive stocks on a book value basis. And so many investment firms really rolled with this/ established value investing principles as core to their business and many focused on book value, and that really continues to this day.
We discussed how many indices, ETFs still rely either solely on book value or some sort of composite with other value factors. What we did we analyzed the numbers, because we’re not a big fan of book value. Because the way book value and what it’s useful for is not really valuing a business as a going concern. Because typically businesses are worth a lot more than their liquidation value. So, we prefer to look at cash flow metrics, such as free cash flow and EBITDA. And so we ran the numbers on Canadian stocks over the past 20 years. We discovered that based on book to market are just book value if you went portfolio of cheap stocks based on book value and short a portfolio of high price-to-book stocks. Your portfolio would lose 50% over the past 20 years. Contrast that to both free cash flow and EBITDA, so those portfolios were long stocks that are cheap based on those cash flow metrics and short a portfolio that was expensive on those metrics. So, if we look at the results of those you actually had returns of north four hundred percent, which is almost nine percent compounded for a market neutral or 100 percent long, hundred percent short portfolio. So, the point of this study was basically to see that you know there’s north of a hundred billion in value ETFs that utilize price-to-book and review priced a book or also known as book to market as not really being applicable in this modern day and age. What are your thoughts on this?
Mike: Yeah I would agree, and you hit the nail on the head when you mentioned that you know it’s better used for estimating liquidation value or a distressed situation, with proper adjustments and not an entity that’s going to continue operating into the future. I don’t really think there’s a lot of value there. The other aspect that I wanted to touch on was you mentioned the origins of value investing. I didn’t want to mention the origins of EBITDA. So, this isn’t a metrics that has been around for all of history and actually it wasn’t around at the time of Ben Graham’s analysis. It’s actually attributable to John Malone who created the term while he was running TCI, a cable company in the 1970s and what he was trying to do was emphasize the business’s cash flow generation to lenders and investors and really just give a metric that provided insight into how much debt the company could handle and generate returns for investors. So, at the time peers were focused on net income. He wanted to minimize net income in order to minimize the taxes that he would pay and then fund the internal growth and acquisitions with pre-tax cash flow. So, a little bit of history on EBITDA.
Julian: Yeah I wanted to touch on one other thing regarding book value. What’s happened over the past few decades since Fama and French’s study is that number one, the accounting treatment and what we’ve seen a real proliferation of over the past number of decades is share buybacks. It’s been a ton of those and there’s been a lot of accounting changes. You see a lot of mergers and acquisitions activity in these. Two, corporate actions, buybacks and M&A. This has a pretty dramatic effect of making book value totally meaningless. If you take Moody’s Corp for example, the bond rating and financial services company, they actually have a very negative book value. Because they have bought back so much stock and so from a book value perspective it looks incredibly overvalued and I guess insolvent from a balance sheet perspective. But on a cash flow basis it’s a very attractive business that this book-to-market factor really doesn’t capture that.
The other thing I wanted to mention is that since the early 90’s or even prior the trend started is really the proliferation of more asset-light service-based businesses. Contrast that to when Ben Graham was investing throughout the great depression and a lot of industrial companies that had substantial balance sheet value that you could liquidate. In contrast these asset-light service-based businesses they typically earn income from valuable intangible assets. It could be software, there’s a lot of software and technology firms or it could be you know based on some sort of patents and those really aren’t accurately reflected in book value. Especially on a liquidation basis. So there’s a lot of accounting changes and really market structure changes that have happened over the past number of decades really negating the effectiveness of book value as a measure of a value indicator or a predictor of future returns and that’s really where these cash flow metrics, such as free cash flow, EBITDA or to lesser extent earnings per share have significantly better predictive value.
And that wraps it up for Episode 8 of the Absolute Return Podcast. If you liked it or if you loved it give us a review on any of the services such as Apple, Spotify Google Play, whatever it is. You can check us out at www.Absolutereturnpodcast.com. Follow us on twitter as well. Send us some questions and we’ll get to them and we look forward to chatting to you next week cheers.
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