Sunday Finds + 3 Thoughts From Last Week

Ubisoft + British American Tobacco

Sep 11, 2022

Welcome to Chit Chat Money’s Sunday Finds + 3 Thoughts From Last Week. In this newsletter you will find three topics I thought about last week, links to shows we’ve recently released, and links to some interesting articles, podcasts, and tweets. Check out the archive here.

1. Sandbagging guidance. Good or bad strategy?

We are in an interesting situation with a portfolio company right now, and I don’t know what to think of it. Last quarter, the management of said company significantly lowered its revenue guidance for the rest of 2022.

Originally, the company was expecting 15% - 20% growth for the full year but now says that revenue will be flat year-over-year in the third and fourth quarters. As you might expect, the stock didn’t react well, and shares are down significantly in the past month or so.

As investors in the company, we have been asking questions. Did we miss something with our research? Is our thesis wrong? Should we sell because the business is not growing at the rate we expected?

(side note: as full disclosure, we decided to do nothing and still hold the position)

The company has just hired a new CEO, who also decided to shake things up, firing a few underperforming managers and taking a write-down on an acquisition. The narrative turned quite negative on the stock after everyone started analyzing all this new information.

But just this week, the CFO was at an investment conference. When asked about the guidance, he essentially said “yeah, we sandbagged guidance because we wanted the new CEO to come in with low expectations and be able to put out some earnings beats in his first few quarters.”

I find this…a little bit annoying? I get where the CFO is coming from, but toying with your investor base just to reset expectations rubs me the wrong way. It is like the executive team wants to see investors (some of who are employees) go through as much volatility and stress as possible just so the new CEO can look good to analysts.

While not a red flag or sell signal, an executive team spending time and energy manipulating its shareholder base (which is what is happening here) is not a good look.

Would Berkshire Hathaway, Constellation Software, or Nelnet do this? I can confidently say all three of these companies would never use this tactic to make themselves look good in the short term.

2. An easy way to lower energy prices.

I think I’ve found a simple solution to help with the global energy shocks going on right now:

The White House announced on Thursday that crypto mining operations in the U.S. are on track to consume as much energy as all of the nation’s home computers, necessitating formalized measures for curbing the industry’s power demands…

And this likely doesn’t take into account all the energy needed to build the computer chips that power these mining rigs in the first place.

I understand that the United States is in one of the best positions energy-wise (due to fracking/shale productivity, from what I’ve read), but it still frustrates me to no end that a non-insignificant % of our energy resources are being used to mine magic beans.

Energy costs are always on a sliding scale, and we should collectively work to bring these costs down as low as possible so people have more money to spend on things that fulfill their lives.

Would banning crypto mining in the United States solve the global energy crisis or fix climate change? No. But will it incrementally help? Yes. And unlike other energy uses, stopping crypto mining requires no real sacrifices (as opposed to turning off the A/C, or other forms of energy use) from the average person.

3. Do interest rates affect stock prices?

We’ve all heard the narrative before: rising interest rates will cause stock prices to go down because investors won’t be forced up the risk curve for yield. Why buy a stock at 20x earnings when treasuries are yielding 6%? And on it goes.

I found a good Twitter thread this week (also linked below) sharing a study that might show this correlation is weak or nonexistent. In reference to the relationship between stock market returns and interest rates, here’s what it had to say:

I was looking for a correlation between those returns and 10-year yields at the beginning of the periods. I came up empty at the 95% confidence level that statisticians often use when determining if a pattern is real.

To be clear, I don’t think this means there is no correlation between P/E ratios and stock prices. The market P/E being around 10 in the early ’80s in conjunction with 15% treasury yields does not seem like a coincidence to me.

But I think we have to be careful with extrapolating an N=1 example here. As with a lot of business cycle data, our sample size might be too low and investors (in general) might over-emphasize the relationship between interest rates and stock price valuations.

So what to do about it? As I’ve mentioned before, we tend to treat interest rates as an unknown when making an investment decision. I think this study confirms we are correct to ignore interest rates (or find stocks where interest rates won’t matter to business performance) because it is too much of an unknown.

So what do we care about? We need to answer three questions before making an investment:

What is free cash flow yield today, or what could it be at the maintenance reinvestment rate?
How much cash can the business generate over the next three to five years?
Can we trust management?

For further reading, check out our 2021 annual letter.

See you next week,

Brett

***Our fund, Arch Capital, may own securities discussed in this newsletter. Check our holdings page and read our full disclosure to learn more.***

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3 Good Reads

American Workers Need lots and lots of Robots - Noahpinion

This attitude needs to do a 180, and we don’t have a moment to lose. U.S. unions need to look to their European peers, and understand that technology magnifies worker power rather than replacing it. And progressives need to realize that discouraging automation in the hopes of preserving jobs is really just a form of make-work — and if our industries get out-competed by China’s because we refuse to automate, there simply won’t be as much work to make.

Pandemic, Recession, Roaring Twenties…Repeat? - Investor Amnesia

During World War I, agricultural demand and production boomed to fulfill demand for wartime commodities like cotton, and replacing European production of things like wheat. Farmers took out mortgages and loans to expand their operations to meet this demand, and when prices fell, farmers could not meet their payments, which had knock-on effects to other parts of the supply chain. Southern banks with heavy exposure to commodity prices via loans to farmers were also impacted.
The drop in cotton prices was especially brutal, particularly for southern states. In 1910, the U.S. produced a staggering 54% of the world’s cotton supply, and just five states produced 25% of global cotton (Alabama, Florida, Georgia, Louisiana, Mississippi).

The Weakness of Xi Jinping - Foreign Affairs

Not long ago, Chinese President Xi Jinping was riding high. He had consolidated power within the Chinese Communist Party. He had elevated himself to the same official status as the CCP’s iconic leader, Mao Zedong, and done away with presidential term limits, freeing him to lead China for the rest of his life. At home, he boasted of having made huge strides in reducing poverty; abroad, he claimed to be raising his country’s international prestige to new heights. For many Chinese, Xi’s strongman tactics were the acceptable price of national revival.

1 Good Listen

Mitch Lasky: The Business of Gaming - Invest like the Best

My guest today is Mitch Lasky. Mitch is a partner at Benchmark and one of the leading figures in the video game industry. Over the last 30 years, he has built, led, and invested in a number of the best gaming companies in the world, including Activision, EA, Riot, Snapchat, and Discord. I couldn’t think of a better person to break down the anatomy of great gaming businesses and Mitch does not disappoint. His insights are remarkable. Please enjoy this excellent conversation with Mitch Lasky.