Value Investor Daily #11

Terry Smith Gives Masterclass on Compounding, Wall Street Shrugs Off Boeing Incident, Inflation Fears Subsiding

In Today's Edition:

Terry Smith on the Magic of Compounding

This recent Algy’s Investment Podcast interview with billionaire fund manager Terry Smith is absolute gold.

In it, he covers:

  • Stocks are unique in the investment world as the only option that can compound earnings with retained earnings. 

  • Bonds give your money back. Real estate, there’s no more building to buy with the rent.

  • How the math behind compounding is simple.

  • Why does he own businesses with 30%+ ROIC that can retain and reinvest half their profits? Because it leads to compound gains of 15% per year across your portfolio.

  • The companies in his fund’s portfolio have grown share price by 16% per year, so the math checks out.

  • Return on equity is roughly = profit/amount of capital employed (equity + debt). There are multiple ways to calculate it, but you must look at the return on capital in one form or another.

  • Twenty companies is enough for a properly diversified portfolio. Once you get beyond that, you won't get much more diversification benefits.

  • His turnover is very low, around 5%, and that's on purpose. You need to give compounding time to work its magic.

  • The average company in his portfolio is over 100 years old. He likes companies that can survive wars, depressions, and pandemics.

  • He sticks with just three sectors with the best economics for compounding—consumer, healthcare, and technology.

  • He avoids airlines, biotech, highly leveraged companies, and just about everything else.

  • He prefers US companies as a hunting ground for the best opportunities because it’s historically been the greatest economy in the world for the last 100+ years.

  • His rule of thumb for quickly predicting the long-term returns from any company = FCF or earnings yield + growth rate. It never works out that way because things always change, but it’s a quick and simple rule to gauge the current situation in any stock.

  • When should we really double down and aggressively buy a company based on FCF yield valuation? When FCF yield is 3-4x government bonds, and there’s nothing fundamentally wrong with the company.

  • Sometimes, Mr. Market gives you temporary opportunities like this, and you have to make a move. That’s how he decided to buy Microsoft hand-over-fist when the free cash flow yield was 12%.

That’s just in the first half.

Go watch it twice—you’ll be a smarter investor for it.

Be sure to read his book, too.

Berkshire Hathaway Settles Pilot Travel Claims

Warren Buffett's Berkshire Hathaway has settled claims that it violated the terms of its buyout of truck-stop-chain Pilot Travel Centers.

Berkshire previously acquired an 80% stake in Pilot Travel for over $10 billion from Cleveland Browns owner Jimmy Haslam. Haslam accused Berkshire of improperly changing accounting methods to shortchange the Haslam family on the final 20% purchase.

According to Haslam's spokesperson, the settlement means both sides will dismiss all claims against each other. Although details of the settlement have not yet been made public, it is expected to pave the way for Buffett to complete the original acquisition.

The settlement resolves a case that set up a bitter legal battle between the two billionaires. Buffett had accused Haslam of bribing executives to pump up the value of his remaining stake.

Walgreens Down 70%, CEO Buys 10,000 Shares

Walgreens stock is down over 73% from levels not seen since 2015.

Revenue has grown from $76 billion (before it completed its merger with British drug chain Alliance Boots) to $142 billion in the last 12 months.

But cash flow peaked in 2016 at $5.9 billion, down to just $435 million in the last 12 months.

Could the bottom be in? CEO Timothy Wentworth thinks so.

According to a recent SEC filing, Wentworth acquired 10,000 shares of the company. This purchase is part of a pattern of insider activity, including three insider buys and one insider sell over the past year.

The stock was trading at $24.22 on the latest stated transaction date. It closed yesterday at $25.63.

Analysts expect earnings to fall over 16% this year to $3.31 per share. But they estimate EPS will rebound to $4.72 by 2028. They expect revenue to grow modestly at 3-4% CAGR and reach $170 billion by then.

But there are risks:

  • Walgreens now faces stiff competition from retailers like Costco and Walmart, where consumers can get their prescriptions filled, losing the store trip Walgreens typically gains on a pharmacy visit.

  • Amazon and Mark Cuban’s new now take online prescription orders.

  • The balance sheet is debt-heavy, with over $7.5 billion in long-term debt and $43 billion in total long-term liabilities, amounting to over 71% of total assets.

  • Walgreens reported earnings last Thursday. Operating cash flow was -$281 million, and free cash flow was -$788 million. With only $784 million of cash, it led to a dividend cut of about 50%.

  • The dividend cut and price performance may cause the stock to be dropped from the Dow.

  • CVS continues to cast a shadow over Walgreens, with over $346 billion of revenue, just under $12 billion of free cash flow, and over 9,400 stores, albeit with their own debt overhang of over $95 billion.

So it’s uncertain if Walgreens can turn the ship. The moat is certainly under pressure.

Walgreens (WBA) trades for 38x earnings. CVS trades at 12x earnings.

Wall Street is used to Boeing's headline risk now. No one was hurt in the incident.

Wall Street Stays Bullish on Boeing Stock

They say, “Buy when there’s blood in the streets.” What about when there’s a massive hole in the air(plane)?

Boeing's stock experienced a significant drop, falling over 8% in morning trading, following the temporary grounding of some Boeing 737 Max 9 jets by the Federal Aviation Administration (FAA). This decision was made after a door plug flew off an Alaskan Airlines plane in midair on Friday.

The FAA believes the same condition that led to this incident likely exists on other Max 9 aircraft. Despite this setback, some Wall Street analysts believe the event will not negatively impact Boeing's stock in the long term.

RBC Capital Markets analyst Ken Herbert stated that the accident did not change their positive view on the company and that investing in Boeing required "thick skin" due to headline risk. JPMorgan analyst Seth Seifman echoed these sentiments, stating that it is too early to determine the extent of the setback and how regulators will handle it.

The key issue moving forward will be how regulators address the incident and the timeline for when all planes can return to service. This incident is not the first time the 737 Max has faced scrutiny, as two fatal crashes in recent years led to a 20-month grounding of the planes.

Boeing trades for 25x TTM cash flow.

Competitor, Airbus, trades for 23x TTM cash flow.

America’s inflation fears are starting to subside

America’s Inflation Worries Hit 3-Year Low

A recent New York Federal Reserve survey reveals that Americans' inflation expectations have fallen to a three-year low.

Consumers expect inflation to rise by 3% next year, down from a high of 7.1% in June 2022.

The survey also found that Americans expect the cost of food and rent to decrease but the cost of college education to increase.

While inflation rates are expected to slow down in the long term, they are still projected to remain above the Federal Reserve's target of 2%, suggesting that sticky inflation may persist.

The survey's results are crucial to Fed policymakers in addressing the inflation crisis, and Chairman Jerome Powell has emphasized the Fed's commitment to its 2% target goal.

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