Sunday Finds + 3 Thoughts From Last Week
Yeti + Spotify + Winmark
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. Incentives and the new buyback tax.
There could be some interesting incentives that pop up from this proposed (has it been passed? I can never follow those things) buyback tax:
The tax is on net buybacks — total shares repurchased offset by the number of shares issued during the year, for example as part of a stock-based compensation program or because employees exercise stock options.
Yes, the tax rate is only 1%, but I still think it is worth talking about. From an investor’s perspective, I obviously don’t like the move because it means less cash available to me as a shareholder and more cash going to the government. But it also sets up a bad incentive for management teams.
The key part is that companies can offset the buyback tax if they dilute shareholders at the same pace. In other words, if the share count doesn’t go down, they don’t get taxed. This means management teams are incentivized to not shrink their share count, which means they are incrementally disincentivized to not grow free cash flow per share. Not great.
However, I can see why people like this from a societal perspective. This could mean more stock ownership among the employee/labor classes and better funding for government infrastructure initiatives. But as a shareholder, it makes me a bit nervous. If this ever gets bumped to a meaningful rate (say, 10%), it will be interesting to see how it changes capital allocation strategies.
2. Can position sizing take care of itself?
There was a really interesting tweet from Chris Mayer this week (also linked below) outlining how position sizing can change if you have a major winner in your portfolio.
Here was the simple math done to illustrate the point:
You start out with 20 positions at $1,000 each (so 5% allocation)
19 of the positions increase in value to $2,000
One of the positions (i.e. your huge winner) increases in value to $25,000
By the end of the scenario, that one position would be approximately 40% of your portfolio. Most people would sell down the stock for diversification purposes. But unless the stock is in a huge bubble, it is likely a really high-quality business that has proven it can execute time and time again. Why else would it be up 25x in value? So do you sell it down (realizing gains, I might add) and try to find five or six stocks to replace it? Or do you rebalance among your existing holdings? The problem with rebalancing is that you are adding to your losers, which doesn’t seem like the optimal move most of the time. And unless you can find a ton of high-quality ideas each year, it might just be best to sit tight and let your winners ride, no matter how “risky” the allocation looks.
Just think if you are a long-time shareholder of something like Constellation Software, Berkshire Hathaway, or Amazon. Is it riskier to keep it at such a large % of your portfolio, or to sell it and buy something new? I think most of the time investors would be served better just sitting still.
I tend to like the philosophy of making 8 - 12 bets (maybe 15) across a portfolio with different weightings based on risk/valuation assessments. But maybe just keeping it simple and letting position sizing take care of itself is the better move? This is definitely something I am pondering. Because in the end, If you are a “buy-and-hold for 10+ years” investor, meticulous position sizing is going to matter very little.
3. Quality investing book recommendation.
I recently read Quality Investing by the team over at AKO Capital. For anyone looking to invest in high-quality companies (or better learn how to identify high-quality companies), I’d recommend picking up a copy. It is less than 200 pages but was jam-packed with tons of cool case studies and frameworks.
Here are some of my favorite quotes from the book:
Red flags such as diversification, scale, and rapidity often accompany ill-fated acquisitions. We worry especially about acquisitions whereby companies are expanding into new areas: management’s relative lack of expertise and a clumsy business fit usually prove costly.
Whatever one’s preferred way to measure returns, the challenge reamins that future incremental returns on capital may differ from historical returns on capital. While tempting to look at short-term incremental return as a proxy, this can be misleading. Often capital spent today will only deliver meaningful retruns years later.
Add a few more competitors - make the market an oligopoly - and participants often think differently. Beating multiple competitors all of the team is impossible, so caompanies tend to focus on fighting weakter competitors whilst leaving the stronger ones alone.
When we study industry participants, we look to see if thereare any particularly weak members, whom we call share donators. These are businesses that help rivals by ceding market share and profits on a recurring basis. Amid the ebb and flow of most industries, we ocassionally see clear patterns of share donators.
Industries where educational training is paramount, therefore, are swiftly left with a narrow range of providers. Products become entrenched in educational programs, which leads to adoption outside academia. The embedding of these products in the workplace adds strength to the dynamic, because retraining staff can be expensive.
One way of assessing the durability of a competitive advantage is to invert the analysis. Instead of looking at what supports a competitive advantage, we analyze what it would take for a newcomer to replicate the buisness and remove the advantage. Such analysis often reveals idiosyncrasies that can be instructive in assessing a businesses’s quality.
An acute probelm with no-cyclicality arguments, however, is that they are the most dangerous when they look most reasonable. When expansionary periods last longer than before, companeis exposed to the cycle will look the most compelling. Their five-year and even ten-year track records can look so strong as to make it seem illogical to consider what occurred 20 years earlier.
Troubled firms and problem-riddled industries are far more likely to stay that way than to recover and scale new heights. Managers and their advisors who strive for a turnaround and present compelling strategies, however, are often convincing enough to induce investor optimism.
Many investing mistakes arise from an illusion of predictability, which are especialy acute in any rapidly-changing industry, such as technology. An investor may command considerable knowledge of a given tech-driven industry — whether artificall intelligence or robotitcs - that facilitates reliable evaluation of the short-term performance and prospects of the companies operating within that sector. Beyond that, factors of dynamism and fluidity degrade forecasting reliability.
A perennial challenge that investors face is earnings management, which a 2012 academic study found is pervasive: one-in-five public companies misrepresent earnings by an average of 10%.
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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Catch up on Our Shows From Last Week
Deep Dive: Jim Gillies Discusses Winmark Stock (Ticker: WINA)
Investing Power Hour #19: Perverse Buyback Incentives, Musk Dumps $TSLA, Acquisitions in a Downturn
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3 Good Reads
Should You Die With Zero? - Nick Magguilli
One of the most common personal finance questions I get asked is, “Am I saving enough?” Whether we are discussing saving for retirement, a child’s education, or something else entirely, many people are worried about the size of their nest egg. In fact, 48% of U.S. adults experienced “high” or “moderate” levels of anxiety around their level of savings according to Northwestern Mutual’s 2018 Planning & Progress Study.
Despite this anxiety, the evidence suggests that the opposite seems to be true—many individuals seem to be saving too much
Remote work creates such powerful cognitive dissonance because it takes away the performative part of the narrative of the successful. Gladwell and his fanbase of the single least-informed executives in the world have all told themselves that their success came from being in boardrooms and saying cool stuff that makes people think. When you break down their narratives, many of these successful people were privileged and lucky - born at a time when there was less competition for jobs, or able to borrow money from their parents (see: Elon Musk and Jeff Bezos), or able to get into an ivy league school, or just happened to meet the right person (Wozniak and Jobs at HP). Their hard work is not irrelevant, nor is their intellect, but if they have to admit that their successes were a creation of them being in the right place at the right time and able to perform the necessary thing to progress, suddenly everything feels less satisfying.
Three Things I Think I Think - Pragmatic Capitalism
In fact, I’ve recently argued that the more likely outcome in the coming years is deflation relative to hyperinflation. I don’t think either one is a high probability outcome, but the downward pressure on prices is going to become more apparent as we progress through this year.
1 Good Listen
Last year, somebody explained the problem of climate change to me with a metaphor that I’ve never been able to forget. They said: Imagine a bathtub. The bathtub is the planet’s atmosphere. The faucet is on full blast and it’s quickly filling with water. The gushing faucet represents every source of global carbon emissions, from "Big Agriculture" and energy companies to cars and cow farts. The water is carbon itself. The challenge of climate change mitigation is straightforward: Stop the water from filling the tub, spilling over the edge, and destroying the planet. There are a lot of environmentalists and federal policies that focus on one part of the picture. They want to turn the tap to reduce emissions. This is what wind, solar, and geothermal energy does. This is what electric cars do. It is an absolutely essential goal. But a very full tub can still overflow even with a slower-dripping faucet. So we need to think bigger to save the world. We need a plan that goes beyond the faucet. We need to drain water from the basin by pulling the plug at the bottom of the tub—that is, to suck a huge amount of carbon dioxide out of the atmosphere and flush them away. So, how do you pull the plug?
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