Preston Pysh  1:31  

Like we always do here, we always try to figure out who’s going to be the first victim in the queue. Do we have any volunteers and if not, I guess I can go?

Tobias Carlisle  1:41  

Why don’t you take it away, Preston?

Preston Pysh  1:43  

Oh boy. I anchored that one. 

I want to start off by talking about the last time we were in the MasterMind. I made a bold call with a short on the S&P 500. As ugly as… what was it like? A 17% to 18% bounce that we’ve seen since Christmas Eve. This play worked out fairly well for me because I offloaded some of the positions there around Christmas. 

Literally, the day after Christmas, I was up quite a bit, I’d say 15% in the position or something like that. I took a little bit of money off the table and as it kept coming back up after that point, man, it was painful to watch a bounce. I was expecting maybe a 5% to 10% bounce on the S&P 500 but it came back and literally went back to my entry point. 

At that point, I literally sold the remaining position that was still on there. Although I made a little bit of money on the position, I can’t say it was like a cash cow by any means. 

Man, you don’t fight the market. I’ve learned that. I did not keep the position on after it went past my entry point. Just kind of an interesting experience. I think I was a little lucky when I put it on and was ahead in the position and it was easier to kind of keep it on. Then, after we had such a huge movement because that’s just how I was playing, especially because it was a short. I took some gains while I had them.

Unfortunately, I don’t have the position that even though I still have a bearish sentiment across the market. With all that said, I’m here to pitch a new stock pick. I sent a message to the guys really late last night and I said, “Here I am. It’s late and I’m recommending a retail company that we have recommended in the past.” It just does not feel right to recommend this company, but I’m going to do it anyway. It is Bed, Bath and Beyond.

We have talked about this pick multiple times on the show. Every time it comes up, it just sounds uglier and uglier. When I look at this pick from when we talked about it the first time, the price has come down tremendously. It’s around $16.70 today. 

The thing that I am impressed with with this company… There are some things that I like and then there are some things that I don’t. One thing that I like is that the revenue has not gone down. When you look at the top line of the company’s performance, this company is still banging out $12 billion a year and it hasn’t gone down. 

Let me just spout off some numbers here, you go back to 2014. They were at $11.5 billion. The year after that they were at $11.8 billion, the year after that, $12.1, $12.2, $12.3, billion, and the last 12 months was $12.4 billion. 

When you look at the company’s ability to keep earning revenues, they’re definitely not growing in a major way. If anything, they’re just sustaining what they’ve got. However, what I really like about the company is they’re still kicking off decent cash flows. I would argue that the last year was probably not one of their best, but they’re still kicking off very meaningful cash flows.

Whenever I go in and I do an intrinsic value on this, I mean, my intrinsic value assessment is extremely pessimistic to the point where I have factored in that the free cash flow is going to continue to diminish by negative 5% for a majority of my estimate. 80% of my estimate was that the cash flows were going to go down by 5%. 

So with this negative trending free cash flow model that I’ve come up with, and the price that you can buy this for at $16.69, I’m getting an IRR, and I hate to say this, but I’m getting an IRR over 15% on this. That’s extremely high with a very pessimistic view of the future cash flows on it. That’s kind of my narrative on why I think that this is going to perform better than cash. 

If we look at how Buffett’s allocating a lot of his investments these days, almost everything’s going into cash. So this is my bold call for retailers. 

Last thing I want to talk about is the trend or the momentum of the company. When you look at the momentum on this one, you’re really starting to see what appears to be price stability. 

I’m not going to say that you’re out of the woods yet here on this one, but I think when you’re looking at the price momentum, typically the volatility on this is around 20%. 

If you’re looking at the volatility over an annualized basis, it will move around 20-25%. When we look at where the price kind of bottomed out, it hits like the mid $10 range, 10.50-ish. Somewhere around in there. Now, it’s at $16.70. It hit that bottom. It looks like December 17. Right around the Christmas timeframe is when it bottomed out at about $10. 

This thing’s already up 60% since December. I mean, you’ve seen the market bounce 17%. This thing’s jumped nearly 60%. I think that that’s a pretty strong bounce above the volatility range. I’m saying that the momentum in the trend might be seeing a break. With that said, I’m very curious to hear your comments.

Tobias Carlisle  7:01  

It’s just way too cheap. Acquirer’s Multiple of about five for something that’s got revenue growth like that. Yeah, I really like it. I think it’s a good pick.

Preston Pysh  7:08  

You know what is painful for me is I was talking to Jesse, I want to say December timeframe. I can’t remember when we had our conversation, but he brought up this pick again. It had completely dropped off my radar from when we were talking about it on the show, because we talked about it last, it was a screaming buy. 

In my opinion, it was a great buyback when we were talking about it on the show. Then the price, just the market was saying, “Nope, it’s going lower.” Sure enough it did.

When Jesse had mentioned that he was buying it back in December or November or something, I thought, “Oh, this company just continues to abuse everybody who talks about it, and here I am talking about it. Sure enough, when Jesse entered this thing, he’s already up 60% in a month.

Stig, I really want to hear your thoughts on it because I know you’ve played with this thing before.

Stig Brodersen  8:00  

Well, I used to play with it. I used to own it back when it was in the 60s or 70s. I think purely by chance, some divine powers, probably Jesse, told me to sell it because even though the numbers look good, it was not.

I think I pitched it back in 2017, something like the second quarter and we will make sure to link to that pitch in the show notes. The stock was trading in the low 20s. For me that was just so obvious to buy that. Luckily, we were accompanied by some smart guys. Jesse said, “Stig, minus five or minus ten,” or whatever I put into my sheet, he said, “No. This is not a good business.”

You know what? It is an ugly business. The price is so good. Oh my god, the price is good. So this is just the balance here we are looking at. If we look at some of the numbers that you also pointed out, Preston. For example, the top line is around 12 billion, you would expect that to slide but what we have seen with retail and almost everyone in retail is that they have lower margins. The same is the case for Bed, Bath and Beyond.

If you go back to 2016, the revenue was $12.1 billion, trading 12 months is $12.4. But today, the operating margin is 4.4, whereas it was 11.7 a few years ago. 

There are a few reasons for that. One of the reasons is that to sustain that revenue, they’re providing more and more discounts like coupons. That’s kind of like *inaudible* them. Then they had been doing massive investments in North Carolina and the data centers because they are slowly moving into e-commerce, which they’re not doing that well when the margins were also lower. 

I was doing some of the numbers too and I think I was even more pessimistic than Preston. I think you put in minus 10 and I even allowed from minus 20 in the model. It still looks like a decent pick. If you do that, which is like minus, I think I have 12% return or something. 

There are quite a few things to be said about that. Perhaps we’re doing the calculations wrong. Perhaps it’s not a… if I had to play devil’s advocate, it’s not a minus five. It’s not a minus 10 or 15, it’s a company that really experienced negative cash flows. I think what I don’t like about Bed, Bath and Beyond, and obviously, when something is trading at the price Bed, Bath and Beyond is at compared to the earnings, there is always something wrong. 

I think the management of the company is something I am quite worried about. I think they’re compensated massively and they have been for quite a few years. I don’t think they have performed and they’re still making a ton of money. 

There are just a few weird decisions in terms of capital allocation. Back in 2015, when they took on $1.5 billion in debt. Why were they doing that? Then, they started paying out dividends at a time when they should have been buying a lot more stock. 

It seems a bit silly the way they’ve been allocating the capital over the past five or seven years, which is just more of a general concern about the management. I can easily see why Preston would pitch this. I mean, it is a very, very attractive pick and I don’t know if it’s a value trap today. 

Preston Pysh  10:58  

Your discussion about the margin, I think is really the key point that if you’re looking just at the top line, it’s going to be like, “Oh, well, it’s hanging in there. It’s still doing good.” 

But you’re not talking about all the extra marketing dollars, all the things that they’re doing that’s chewing into the free cash flow with the business relative to three, four years ago or five years ago. It’s taking a lot more effort and a lot of friction for them to continue to generate that top line.  

I think that’s maybe why it’s been penalised so much in the last couple years and it’s yet to be determined whether this trend continues to persist. Maybe we’re just seeing a quick bounce in the price because maybe the selling got ahead of itself. Maybe the trend is that the price is going to keep getting punished, moving forward. I don’t know. 

I just think that it’s something that is worthy of assessment for somebody else out there to kind of dig into the financials. Come up with your own assessment of whether you think that this trend is going to override the current bounce that we’ve seen in the price since December. I find it interesting and I think that the momentum is just a little bit different than when we looked at it previously.

Hari Ramachandra  12:00  

I’m assuming that this is not a long term recommendation. I’m just wondering about your timeline for this. 

Preston Pysh  12:06  

I don’t know how to answer that. I mean, when I look at it, and I look at the revenues… If the revenues weren’t growing, I probably wouldn’t even recommend the company. I can’t even say that they’re growing. I’d say that they’re remaining flat. I think that’s what makes this so tricky is you’re seeing them devour their margin and the trend on the margin is not good. 

I think the next thing that you’re going to start to see, maybe start trending in the negative direction is the revenues. That’s where it’s really hard to be able to say whether they’re out of the woods or not. I don’t know, Hari.

Stig Brodersen  12:37  

Last time when we discussed this and Toby, I’m sorry to put you on the spot here. I think you said that you put that in the basket of very cheap stocks. It was not a qualitative assessment of Bed, Bath and Beyond, more that it would be a mean reversion type of bet that you would put in with all the retail picks for that matter.

Tobias Carlisle  12:58  

Something like Bed, Bath and Beyond that is left in the bargain pile, the revenues are still pretty good for Bed, Bath and Beyond. So that’s a positive in its favor. There’s clearly some discounting going on to get people because it’s much, much easier to buy everything on Amazon. However, it is very cheap on the sort of multiples that I like to look at. 

It’s one of those things that I would put it on as a small position and not worry about it too much. Just look at it in a quarter or a year and you’ll probably find that it’s had a little bounce, reassess it then.

Preston Pysh  13:27  

Sell your loss at that point. Is that what you’re saying?

Stig Brodersen  13:32  

It’s a tricky thing to figure out. One of the things I was pretty excited about was when they wanted to enter e-commerce and invest all that money into it. It just didn’t seem to have panned out and I’m not really sure what the strategy is or what they can do. I mean, I know what the strategy is. I just don’t think that their new e-commerce strategy is really going to make a lot of sense. 

Why would you be able to ask Bed, Bath and Beyond to compete with Amazon? They used to have that mode and perhaps you might argue that still do in terms of brick and mortar.

Amazon is coming to that. They have close to 600 physical locations now. It’s all better data driven. It’s not only the online part of it, but also the offline part of it. They have all the data that they need in terms of making the best stores which I just don’t see Bed, Bath and beyond keeping up. 

Another thing, and I know I’m just not the target group here, but it’s not a good experience to enter a store. I even went into one with Preston.

Preston Pysh  14:23  

I always feel like after I go there, I kind of feel like I’m getting ripped off or that I’m paying a higher price than what I could get somewhere else. It’s always anytime I have gone there. It’s because I needed whatever it was I was getting that day. 

I would also say I think a lot of people go there for bedding. They go there for something that they kind of need to see instead of ordering online. I don’t know. The numbers. I just can’t get over the numbers when I’m looking at the intrinsic value and I’m using such a terrible future cash flow yet I’m still coming up with 15%.

Stig Brodersen  15:00  

I will make sure it’s linked to the episode where we pitched it. We also created a stock analysis back in 2018 about Bed, Bath and Beyond, you can check that out. Also, we’re also going to link to that. Everyone can sign up at TIPEmail.com if they would like these to be sent directly. Alright, guys. Any volunteers?

Tobias Carlisle  15:19  

I’m happy to give it a lash. I’ll let you guys laugh at this one. I was running my screens and the thing that really stands out to me is how many steel companies have popped up in the screens. It’s a pretty long list: US Steel, ArcelorMittal, Ternium, Nucor, Steel Dynamics. 

I went through and I found my two favorites out of that list. I’ll talk a little bit about steel and why these two in particular are my favorites from that list. 

My two favorites are Nucor, NUE, and Steel Dynamics, which is STLD. I will start with Steel Dynamics because it’s in my opinion, it’s the cheaper of the two but it is also the smaller of the two.

To start, steel is an incredibly cyclical business that moves around a lot. If you look at the steel price at the moment, they do look like they’re at the higher end of the range, then at the lower end of the range, so that might give you some pause. 

The other thing to mention is that at the moment is there’s this trade war going on. That’s the 25% tariff that’s been slapped on Chinese imports about a year ago.  I think that might start turning up in the financials sometime soon. 

The reason I like Nucor and Steel Dynamics, partially it’s because I think the downside is a little bit more protected than other companies like US Steel or ArcelorMittal. The main reason for that is that Nucor and Steel Dynamics use these electric arc furnaces, which is a technology that basically uses electricity to make steel. 

So, the smaller mills that blast furnaces are a little bit less efficient at this lower level. They can turn them on and off more easily. So if the steel cycle goes down, there’s a little bit of protection there. 

The two companies that I lik, particularly Steel Dynamics, enterprise value is $9.7 billion, market cap is $8.5 billion. There’s a modest amount of debt in there. Nucor is a little bit bigger. Its enterprise value is around $21.7 billion, market cap is about $18 billion. Both of them are trading on Acquirer’s Multiples. Nucor is about 6.4, Steel Dynamics is a little bit cheaper at about 5.5. 

Both the balance sheets look really good. Lots of free cash flow at this point. I think it’s just it’s a way to play any sort of… if a whole lot of infrastructure spending comes in, I think these two are going to perform very well. I think they’re undervalued where they are right now.

I don’t mind a little basket of steel stocks. Nucor and Steel Dynamics are my two favorites but you could also look at US Steel, ArcelorMittal, Ternium, and various others that I mentioned there. That’s my macro pick.

Preston Pysh  17:56  

That’s what I was thinking that this is a very macro-centric play. Is your expectation that these prices are going to keep going up? I’m assuming.

Tobias Carlisle  18:05  

At the moment they’re priced, they’re all priced at the very lowest multiples that they have had over the last decade or so. It’s low multiples on peak earnings or high earnings. I appreciate that. So that’s the risk. Everybody sort of assumes that there’s going to be a pretty significant downturn here. 

If the five year average, and that’s true for all its ratios, is cheap on a ratio basis relative to its price sales, 0.75 versus 0.8 for its five-year average. So the question is, if the steel price is sort of maintained or rises from here, then is it going to be way too cheap? 

If steel prices go down and these two are the better ones to be in because they’re going to be able to. It’s a cyclical business, then they can sort of switch off their mills, which gives them some protection on the downside.

Stig Brodersen  18:48  

Could you talk to us a bit more about the trade war? You talked about tariffs that are about to be imposed. Is that even a competitive advantage, given that you have so many steel producers in China, some of the biggest in the world, and typically state-owned? It’s so important for the Chinese economy to just keep on producing steel, whether or not they need it. How can I look at this trade war?

Tobias Carlisle  19:14  

That’s a great question. I don’t think there’s any competitive advantage in these businesses. They are commodity businesses. It’s just a matter of being reasonably priced relative to where their operating income is right now. My view that steel prices are probably maintained a little bit higher than this in a year or so.

Hari Ramachandra  19:30  

I was curious to know, are these picks based on just valuation or based on their location in terms of where they’re headquartered because of, obviously, the trade war? There are companies like ParsCo which are not in your basket, so I want to know and understand how you’re picking them.

Tobias Carlisle  19:47  

I was using the Acquirer’s Multiple screens. If you look at the screens that they filled the moment with these steel and steel-input type companies, so when I see a whole industry and its inputs are getting cheap,  I think that’s interesting. I think that means that there’s some potential for something to happen.

Preston Pysh  20:04  

It’s something that I’m seeing that’s interesting with this pick is you’ve seen the topline increased by a substantial margin in the last four to five years. Through that same period of time, their operating margin has also gone up, which typically you’re not seeing. Just to kind of put apples-to-apples here, in 2015, the operating margin was 6.8. Today, it’s at 13.7%. 

I mean, you’ve practically doubled the operating margin, as the revenues have grown tremendously over that same period of time. They went from $16 billion to $25 billion. So that’s not something you typically see, I don’t think, with such robust growth on the topline to see the margin go with it. Is that something that’s specific to the steel industry? 

Tobias Carlisle  20:48  

Yeah, steel prices are up a little bit over the last five years, although they’re down over the last, like close to a year and six months. That might be short term. That’s the risk of something like the way that I do my valuation is that the underlying is just not sustainable. 

We go back to pricing. It was more like in 2015 when the entire steel industry was really struggling. At the moment I think that is cheap, based on where the steel prices… I’ve got no real view on the steel price other than there are tariffs and some plans for infrastructure spending in the states. It’s just one way to capture that.

Preston Pysh  21:20  

Just so people know, in my mind I was looking at Nucor and I was just talking the numbers and I know you had recommended multiple things, but the numbers that I was quoting there just so people know was Nucor. NUE is the ticker.

Tobias Carlisle  21:32  

NUE and STLD are my two favorites.

Preston Pysh  21:35  

All right, Stig. I’m curious to hear about your pick.

Stig Brodersen  21:39  

My pick is Alibaba. Ticker is BABA, traded as an ADR in the States. It’s a huge Chinese conglomerate. The market cap is $480 billion. So it’s just massive. Just to give you some numbers, Apple is $850 billion, Amazon $800 billion. Facebook actually is slightly smaller at $460 billion. It’s a massive company. 

Most of that revenue comes from ecommerce and just primarily in China, the market share is 58% of all online retail in China. They really have a dominant position there. 

Other than that, they’re also known for Alipay. Together with Tencent, they are doing all the mobile payments more or less in China. That is through a company called Ant Financial, which is an affiliate company of Alibaba, it is owned by 33% of Alibaba. It’s controlled by the founder, Jack Ma. It is also the highest valued FinTech company in the world, twice the size of Goldman Sachs, just to give you an idea of how massive It really is. 

Then the very interesting segment is the cloud business. We’re going to talk more about the cloud here later with Hari’s pick also, but it’s a very interesting business unit that Alibaba is investing heavily in. 

That’s also why we see some of the hidden margins. Alibaba is already the fourth or fifth largest globally, depending how you measure it after Amazon, Microsoft, IBM, Google. But by far, they are the largest Chinese provider. Very interesting, especially now that we can expect China to go into the cloud as well. 

We saw this grow with 84% year over year. Very, very interesting that we might go back to later.

Talking about the industry and business model. Alibaba is typically referred to as the Amazon of China, which is partly true, but not quite. It’s primarily selling through Taobao. The site Taobao means search for treasure. It is probably not a very known site in the West, but it’s the largest in China and it’s ranked eighth most popular website in the world. So, there is massive traffic there.

It was launched in 2003. There are just hundreds of millions of products and services from millions of sellers. The interesting thing is that Taobao doesn’t charge transaction fees and it’s free for merchants to join. 

The way that Alibaba makes money is through advertising and different features. To boost sales, for instance, you can message the vendor directly through the Alibaba system. If you look at some of the competitors and threats, you might say that Alibaba has close to no threats, given the size. 

Just to give you a comparison, Amazon claims up towards 50% of all online retail in the US. I would say that they do, or at least they can expect to get into trouble. Primarily from Tencent, the other Chinese huge conglomerate. 

We had John Huber from Base Hit Investing who pitched that not too long ago, and we will make sure to link to that episode.

Tencent is slowly moving into the retail space, not only through the estate of JD.com which is 16% of market share in China. But simply just through their size. You can kind of compare this to the states where back in the day, Apple did this. Facebook did another thing. Google did a third thing, and now, they’re slowly starting to compete with each other like in the same space. We see the same thing with Alibaba and Tencent. So for me, that is the main threat. 

The other reason why I’m saying that is I think that data is really going to be the key in the decades to come. Data is the main driver of AI. You have no other country in the world that has more data than China and no other companies in China than Alibaba and Tencent. 

I think that those two companies are going to compete on the retail market. Amazon in China, less than 1% market share. I think it will be very difficult for a Western companies to compete in China. Quite a few companies have tried and failed. 

If you talk about the moat, one of the moats I would like to talk about is that Alibaba has sort of its own universe. You don’t go to Alibaba for something else, not like what we have in the states that you have Facebook’s app and you can get that through Apple or through Google. No, it’s their own closed system. 

To give you an example of that Baidu, which is, can be referred to as the Google of China. So it’s China’s leading search engine. Alibaba purposefully Baidu spiders from indexing Taobao. So it doesn’t display in the search rankings. You might say, “That’s stupid. Why wouldn’t they do that exposure?”

However, it is simply to force people to stop everything on Alibaba website. I think it would be very difficult for Amazon to do to Google but it has been a successful strategy for Alibaba. 

Another type of moat that’s being highlighted is that it’s much cheaper to retain software engineers for Alibaba than it is in Silicon Valley. I think those are actually companies that are competing. They’re competing with Tencent and they’re competing with the American conglomerates, even though we talk commerce. That’s really where the next battle: cloud, video streaming, whatever you want to call it. 

It’s a very interesting thing. They have a very different cost structure primarily because the input of the labor is much cheaper. It’s 10 times cheaper and to make sure that they can retain the employees. They’re not in Beijing. They’re not in Shanghai, they’re in *inaudible*. It was purposefully done by Jack Ma so he wouldn’t lose his employees because there are not too many competitors around.

To talk about valuation. This is tricky. I have been looking at Alibaba for quite some time and it pains me to say that while I’ve been looking at Alibaba, the price is just starting to climb, leading up to this mass divide meaning, which obviously also means less return. 

I did manage to take a position luckily, but not with as much as I wanted to because this stock is right now trading just short of $184. If I put in my inputs here, the most likely scenario is 15% growth. I also assigned 20% probability to 30% down to zero percent. If I’m negative, I get around 9% expected to return for Alibaba. 

I know that 15% sounds extremely generous. Just like to highlight the growth of this company. It’s just massive. We’re looking at more than 50% here from 2017 to 2018, 58%, and the year before was 56% growth in topline. It’s absolutely amazing. Though guys, I’m ready to get beaten up, especially about the price and my growth assumptions here.

Tobias Carlisle  28:09  

That’s the first thing that occurs to me that you said a 15% growth rate gets you a 9% return. 

Stig Brodersen  28:14  

Yes.

Tobias Carlisle  28:15  

That’s just my bias. As always, that makes me very nervous. Just so full and frank disclosure, these sort of companies are going to be always too hard for me to kind of get any view on because I don’t trust really high growth. That’s just a bias of mine so you can take all of my comments with a grain of salt. Just ignore the models that come through. 

The other thing that always makes me a little bit nervous about Alibaba and I’ve looked at this a few years ago, haven’t looked at it more recently, but they score was *inaudible* manipulator on the *inaudible* score, which looks at earnings manipulation. 

Then if you dig into the filings, which are always a little bit odd, they create huge numbers of subsidiaries, which I just don’t really know. I think they create a subsidiary at a rate faster than one a day, which just seems to me… 

Like I get it’s a very big business, but it’s just a way for us to create sort of some accounting shenanigans if their intentions are bad. If their intentions are good, then it just kind of complicates the financial situation. So those are my two comments just that the growth rate is very, very high and the financials are a little bit opaque.

Preston Pysh  29:10  

In a country like China, do you think that some of that stuff even matters? Because whenever I’m looking at this, I just think… And a lot of it’s based on the events that have kind of unfolded more recently with the highway company in the US with a mobile company. 

Seeing how the government responded to the CFO of that company getting held in Canada, just for me when I’m looking at any type of large cap, and you can’t get any bigger than Alibaba in China… When you’re looking at a large cap company in China, I see it as just a total complete indoctrination with the government at this point. 

This business, people at the highest level are borderline government officials. This is an arm of the government as far as I’m concerned. When you look at the growth rate on the top line revenue, I mean, the thing is exploding, like Stig said 50%. 

Can we as investors treat our analysis of this company the same way as looking at Apple or Google here in the United States, where you don’t necessarily have that complete buy-in from the government? 

I just think that it’s an advantage, personally, for ownership of this business as an outsider. I agree with what you’re saying that the earnings or whatever numbers they’re producing might be manipulated, but it’s kind of like so what? What impact does that actually going to have? Maybe that’s a strength instead of a weakness for owning it.

Stig Brodersen  30:46  

I think it’s an interesting point you bring up. I think for most investors out there that might be thinking, “China. No. It’s too risky because it’s China.” I’m kind of on the side with Preston here. I don’t know if it’s good or bad. 

If anything, I think it’s a good thing for Alibaba. Please allow me to elaborate on that, because it might seem a bit odd. I read through this interview with Kai-Fu Lee, a very interesting person. He used to be the CEO of Google China. He talks about the competitive advantage of being one of those big Chinese conglomerates. 

He’s saying in the States, everyone talks about antitrust. You don’t have them here, not the same way.

Preston Pysh  31:22  

They are talking about the opposite. 

Stig Brodersen  31:23  

Yeah. It’s not like, “We’re gonna break this up into  five different companies. You’re making too much money.” That’s not what’s going to happen, if that’s not what the government wants. This is sort of like a protection here. 

I think Google also experienced that when they tried the first time to go to China. I know they are trying here again. It’s just very difficult to deal with the authorities. Let me just give you one simple example. 

Sites that are hosted outside of China, they’re slower to load, just by definition compared to Chinese companies. To me, that’s just very interesting. I think if anything, it might be an advantage. 

It’s a Chinese company made by Chinese for Chinese people. I think that is bound to be an advantage, if anything. Perhaps it doesn’t matter but I don’t see that as a disadvantage. I really liked your comment about perhaps we can’t use our conventional thoughts in terms of thinking about the risk of a company like this.

Tobias Carlisle  32:14  

Through the looking glass, fellas. They are not using conventional metrics anyway. Look, I have no real view, I think it’s very expensive. So the only way you justify that valuation is if you have very high rates of growth. It seems to be delivering very high rates of growth, but I have a little bit of trouble with the financials, but I’ve been wrong on this for a long time. My two cents aren’t worth much here.

Stig Brodersen  32:36  

Toby, please don’t get me wrong. When I say conventional measures, in terms of private policy, for instance. It is a big deal for Facebook in the States. It’s only an advantage for Alibaba and there is no criticism terms of how much data they have in terms of the customers. 

That is what I mean about the conventional metrics that it’s more, as Preston said, an arm of the government. If anything it is fueling growth, it’s not stopping it, like we would conventionally see in the States.

Preston Pysh  33:05  

Stig, I think that your big buying opportunity on this one was back in December, the price had come off significantly from a tie. I think what was the high here? Let me see real fast. It was around $208 in December, this past December when it cleared on the $132.

I would tell you, my expectation on this one is that the revenue just keeps exploding to the upside. I really believe that China is in a boom. This is the Golden Child of quote-unquote capitalism over there. I don’t see anything slowing this train down anytime soon. 

What it really comes down to is, as long as that growth continues to chug away, it’s really the magnitude of the multiple that you’re paying. Kind of looking at the range of that multiple of what it’s performed at over the last five years and when you’re at the lower end of that multiple, I would say this is probably a buying opportunity. When you’re at the high end of that multiple and maybe you offload a little bit of it to minimize risk or whatever. But I’m with you, I think that this thing has room to go.

Stig Brodersen  34:06  

Just to give you some numbers on that. We’re seeing here in the States and we’re talking about how online retail is just taking over. At least, that’s the impression that I have and perhaps a few others online retail in the states is like 10%. Although recently, it’s not a lot. If you’re thinking about it, it’s up from 7.3% in 2015, and I expect to be 11.1% in 2019. It seems like it’s just growing so fast. 

Let’s talk about China. Back in 2015, it was 15.9. In 2018, it was 28.6 and 2019, it was 33.6. Think about that. It’s massive, just the tail when they’re getting for people just falling the trend.

Preston Pysh  34:44  

You’re also not even talking about the amount of the population that’s coming into an urban setting and all of that. I think you combine those two things to the point that you’re making and then you just look at how many cities in China are coming into a very modern type of setting. It’s happening very aggressively.

Stig Brodersen  35:06  

China for all intents and purposes is still an extremely rural country, given the size of development they’re in. We’re still seeing more and more urbanization in China. The reason why we really haven’t seen that to a full extent is because you can’t necessarily just move from the rural area into the city. You will lose privileges and there are quite a few things that the Chinese government has put in place so we just don’t see all this flocking to the big cities.

Tobias Carlisle  35:28  

Well, one thing in your favor, I did just look this up. Li Lu, Charlie Munger’s right hand man in China,  his Himalaya Capital Management has two holdings, Baidu and Alibaba. It’s like 87% Alibaba. That’s a conviction bet by a man who should know.

Stig Brodersen  35:49  

It’s interesting that you bring up Baidu, the Google of China, whatever you want to call it. It has the most AI scientists in China in number. They haven’t had the best results with AI. I also think I’d like to bring that up.

Again, I know I’m quoting Kai-Fu Lee and he might be wrong on this. However, he’s talking about those seven conglomerates who are just looking to be in a pole position to kind of like crack the AI code. In the States, you would have Google, Amazon, Apple and Facebook. 

In China, you have Tencent, Alibaba and Baidu. I think this is also a bet on AI, really more than anything. They have so much data on retail, so that’s why I’m thinking that the tailwind just from falling general trend might be already double digits. Though for them to more efficiently make money, based on AI is just that massive. Then I won’t say more positive things about Alibaba for now.

Preston Pysh  36:42  

Stig, I think that last point is your strongest point of all. If we’re buying into this idea or this narrative that they’re totally indoctrinated with the government. So whether you agree with that or not, I think it’s important whether you do. But if you do buy into that argument, and they are a leading expert in artificial intelligence and big data, and what big data is able to predict through all these neural network models. The government is absolutely nuts to not sustain that relationship or ensure the success of this growth. 

From what I understand, the government is just completely reliant on understanding everything that they can possibly understand about every single citizen within the country. So what better arm than Alibaba? Who’s processing financial payments? Who’s basically your entire commerce arm for the entire country for online purchases? The government can’t afford to allow this company to fail to succeed. I can say one thing, this is way better than my pick. That’s for sure.

Stig Brodersen  37:48  

It is also way more expensive. We’re talking about 50% growth rate and not like how much is this company going to contract?

Preston Pysh  37:54  

Yeah, no, I agree, but look at the trend. Look at this trend. My expectation for that trend change is this is not changing in a year. That’s for sure. If this trend does change, I mean, I would say, at a minimum, you’re five years out from now. The minimum, I don’t know. I like it, though. I can tell you that I like it a lot.

Hari Ramachandra  38:17  

This was a really interesting discussion, guys. I see Alibaba a bit differently. What do you see in the price is what we all talked about. They’re indoctrinated with the government, they’re massive e-commerce platforms. In fact, their revenues are bigger than Amazon and eBay combined today. Their model is different from Amazon, but still, they’re in the same space. So all that is baked in. 

What is the optionality we are getting with Alibaba and also the risk there is I see them more like a venture capital company than just an e-commerce company. If you look at all the investments they make in companies across Asia, they’re betting on every startup and many startups: India, Thailand, Philippines. You name it. They have their venture capital arm, which is much more aggressive. Same with Tencent. 

Since one shares in Tesla, for example, they’re just a popular one, but they weren’t part of many companies. 

The other part is that that can sometimes backfire. Also that can give you upside that is not seen in price today. So, that’s the drawback. Unlike, for example, the big Alphabet operates wherein they also do a lot of ventures but they’re more organic. The model that Alibaba and Tencent follow is different. 

The second thing is I want to be a little bit skeptical too, even though I drink the kool-aid of cloud, big data, and everything. What I fear is not just about Alibaba, but in general players. It almost feels like dot-com or like anything dot-com, we kind of spend over critical analysis for a while and said, “No, AI is coming. They’re very strong in AI.” 

If they have machine learning, or if they have a big data platform, they have to be a little bit careful. I’m not saying that applies to Alibaba, but I’m just in general saying that just because somebody is good in AI, it doesn’t mean it’ll translate into gains.

Everybody is into AI right now. Any company you take, they will have AI within their company. That’s where we have to be a bit careful because we don’t know what they’re doing. Of course, they’re doing a lot of stuff. For example, Alipay is also giving scores to the customers now, based on their purchasing habit and based on their transactions. 

They’re reshaping the way the Chinese society operates. There is really high growth right now and their growth depends on the growth of Chinese economy. Their growth depends on how the Chinese economy does in the short term as well as in the long term. If you believe that China might be twice the size of the US economy one day, then Alibaba is probably well-suited to capitalize on that growth.

Stig Brodersen  41:07  

I think you bring up some good points and thank you for being a bit more skeptical. I think that that’s much needed. 

It’s interesting what you said about the venture capital. Well, they do operate, like Tencent, they’re buying a lot, but also to talk about the difference… Tencent would buy stakes in various companies or even take the more but they don’t really do anything with it. 

Whereas Alibaba has a very operating mindset. The thing is because of the data, but again, I’m not the one to say that Alibaba’s approach is smarter than Tencent or the other. I think that’s a very interesting dynamic that they’re trying to really include those companies in the different ways that a company like Berkshire Hathaway, whatever you might say. This is now a part of this data machine that they are doing. 

I think you’re right then it’s a bet on China, but it’s also a bet on the world. It is really embedded into Alibaba from the very beginning. Jack Ma publicly stated that 24-hour delivery in all of China. If you’ve been to China you would know how insane that sounds and then 72 hours delivery worldwide. They are already in 200 different countries. Not that efficiently, not the same way as they are in China, but that is definitely the goal. 

Also I think that Toby is right when he’s talking about *inaudible*. It’s difficult to value a company of this size and its worth. 

Let me just give you one example. We talked about Ant Financial. They own Alipay. They also run the biggest money market fund in the world, one in $200 billion. This is really the go-to place for so many Chinese. They have so many different things that they’re doing and they’ll be primarily talking about e-commerce which is really the driver. However, there’s a good chance that they might start making the money somewhere else. 

I would like to talk about the cloud here and throw it over to you, Hari. Perhaps you have a comment or you want to talk about your own pick afterwards, but it seems to me, if I’m looking at the cloud, and I’m sitting here with my company, I might be considering Amazon, Google, Microsoft whatnot. I don’t think I would ever think about Alibaba. I think there might just be some kind of a cultural barrier there. I feel that way and perhaps I’m wrong. 

Is it the other way around? Like if I’m sitting here in China’s booming economy, and it’s growing so fast, would my go-to place just be Alibaba or potentially Tencent who is also starting up cloud? Would you even consider moving to Amazon or Google? In your shoes, is that the way to look at the cloud market in the future?

Hari Ramachandra  43:28  

The way I see it is most companies in the West will find it really hard to choose Alibaba or Tencent as their cloud pick, as we have Microsoft Azure or Google Compute GCP over here. 

Also, most of the companies would never stick to one cloud vendor. They would always try to diversify, just to make sure that you don’t have vendor lock-ins. That is my understanding, at least at this current stage. However, the story might be different in Asia. There might be countries who are more willing to try Alibaba and Tencent cloud offerings.

Preston Pysh  44:05  

Alright guys, well let’s go ahead and transition over to Hari’s pick here. Hari, you were bouncing around on the email. I’m curious what you’re going to come up with here.

Hari Ramachandra  44:15  

I already spoke about it during the beginning of the podcast that I’m really not so comfortable with the valuations today, in any asset class recently. I think Howard Marks has come up with the book, in his interviews, he has famously said that this is probably one of the longest recovery cycles, almost 10 years now. 

The time now is to be more defensive. He is not asking us to sell all our stocks, but he’s saying this is the time to think defensive and not play offensive. 

The reason I was bouncing around was as an individual investor today, my focus is to protect my downside, and not looking at too much of the upside. I remember a tweet, Preston, that you had some time back. The Fed is mulling over the part of making quantitative easing as a regular tool in their arsenal. That always makes me nervous holding the cash. 

It’s like the inverse of buyback. You’re holding a stock. So as an individual investor, since we are only talking about equities in this MasterMind, so I thought I want to take a pick that satisfies the following criteria. 

Number one, it has a reasonably strong moat and a proven track record to withstand recessions and competition over a period of time. It has a good strong balance sheet so that it can survive any financial disruptions or liquidity crunch. Also number three, it is not going to be adversely impacted by trade conflicts and is reasonably valued. I mean, it’s really hard to find bargains. Only Toby can do that.

I don’t have his magic screen and I was looking at one of my previous breaks back in 2016 and 2015, I pitched Union Pacific which is our railroad. Then I thought Microsoft might be a better pick after I saw Stig pitching Alibaba  in the email. So that’s why I’m going to talk about Microsoft, maybe Union Pacific later in some other MasterMind. 

Microsoft kind of fits all the five criterias I just laid out. I don’t know what the valuation is and that is where I will leave it to you guys or the experts. Think about Microsoft is that it’s a *inaudible*, tried and tested. It has gone through many cycles. It has an 88% market share in Office and Productivity. That’s their biggest moat. Every Fortune 500 company pretty much uses Microsoft Office.

With Satya coming on board in 2014, they went through a long period where they lost the direction that’s all behind them. What the team has done is put Azure, or cloud, front and center. He is using the current trends and assets very well. 

For example, Microsoft getting into Zulu, which is a music player, their misadventure. Whereas cloud is right in their circle of competence. The reason being there are already so many premise installations, whether it is their servers or databases, that it’s much easier for them to migrate their customers to cloud.

Number two. A lot of customers trust them more compared to AWS because of some of the competitive dynamics. Those tail winds, and Azure is growing at a rate of 75%. annually. 

Of course, it’s a small waist now, $5-7 billion, but it’s expected to grow. When I say Azine, I’m only talking about their infrastructure as a service. If you talk about what they call an intelligent cloud, which is their entire cloud business, which includes both Infrastructure as a Service, Software as a Service and Platform as a Service, that is $32 billion today. 

They’re actually the leaders in SAS today with 22% market share. The SAAS business for a period of next few years by 2022, just a SAS business, is according to Gartner is projected to be around  $114 billion in terms of *inaudible* and the overall cloud is expected to be around $280-300 billion in total addressable market. I’m talking about infrastructure, software, platform and business process as a service. 

Microsoft is in the market. They have a really good pricing power, both in their traditional market, and productivity by acquisition. They’re acquiring LinkedIn and now GitHub. They’re also closing in on their developer tools. Gaming is kind of their 90% of their revenue, not a big deal, but still now 56 monthly active users for Xbox Live. 

I mean, just to give you a context in 2016, when LinkedIn was still public, monthly active users was around 100 million. 

In terms of valuation, I think so far in the past 10 years, their revenues have grown close to 7%. I expect the current tailwinds. With Azure, it will be definitely more than 6-7%. I have no idea how much it will be. 

Their operating margins are close to 30% now, but as you scale… The reason I’m expecting the operating margin to improve over the next 5 to 10 years is that as Azure scales, they’re building a lot of data centers. They’re putting in a lot of capital to do that. Their operating margins should improve with scale. 

Based on all this information, I believe price to sales is around seven, compared to say Amazon, 82 price to earnings. Based on all these factors, I feel safer parking my cash in Microsoft compared to say just having it in cash. 

I’m not expecting huge returns. I’m expecting decent returns that will beat inflation. That’s on the downside. On the upside if my hypothesis of more than 8%, either in terms of revenue and margin improvement all holds true, it might give me some pleasant surprises in the next five years.

Tobias Carlisle  50:08  

Microsoft has spectacular business, there’s no question about that. The issue for me is the valuation on all the ratios are really expensive. It’s got very high rates of growth. So that might compensate you for but I kind of struggled to get to evaluation where it is. 

I think fair value could be kind of half where it is, to say that it’s kind of assuming very high rates of growth, but deep value guys are struggling a little bit in this market. I’m one of them. I freely admit that this is, once again, I just don’t trust those high rates of growth. That’s my two cents.

Preston Pysh  50:43  

Hari, I didn’t get much of a return on this one either. I echo Toby’s comment where this is a fantastic business. It’s hard to find a business that can fire on all cylinders and produce the stability that they have at the gross rate that they have. The market cap that they have, I find it quite impressive. 

Unfortunately, there’s a lot of people in the market that agree with that opinion and they’re bidding the price higher, which is pushing your yield a lot lower. When I did the intrinsic value on this, I’m assuming that the company grows at about a 5% growth rate. I’m getting a similar IRR to what I think you’d get out of the S&P 500. 

My analysis is if I feel like I’m going to get the same return of an individual stock that I would get out of the S&P 500, it’s lower risk, in my opinion, to just own the S&P 500, than to push myself into an individual company that I expect the same return out of. That’s kind of where it’s hard for me to buy into it.

You might be right. If we would go into a correction, a company like Microsoft might outperform the market because it’s not going to be penalized as bad because it is so consistent in its revenues. 

It’s so consistent in its net income and its cash flows that it might bear a downturn better than other businesses. In that case, you beat the market. So that’s something that somebody’s going to have to analyze themselves of whether that’s worth it or not. I would tell you that’s a coin toss, whether that’s a true statement or not. 

Hari Ramachandra  52:14  

On the valuation side, Toby and Preston, you guys pointed out that your fair value, if I’m correct, will be half of what it is today. So around in the 60s or 70s. The question I have for you is, let’s say you got it at 60 or 70, what would you do? Would you keep it at these levels or sell it?

Preston Pysh  52:33  

I mean, that’s a really tricky question, because it comes down to what your capital gains is. If you realize that as a long term gain, then you’re going to be in a lower tax bracket. You got to figure out that friction of how much you’re going to lose in your tax bill.

Then more importantly, what asset are you then shoving that the capital that you generated from the sale? What return are you getting on what your opportunity is? It’s an opportunity cost kind of question after you account for the friction of paying your tax bill for that gain. Without knowing the yield that I would expect to get on the buy side after the sale of that company, I can’t intelligently answer that question.

Tobias Carlisle  53:12  

Yeah, it’s probably a hold. If you bought it cheaply and you’ve got it here, I’d probably still be reasonable. You don’t want to pay those taxes. I’d keep on holding. I think Preston points are right. 

Preston Pysh  53:21  

Let’s say you’re making a venture capital investment with the money and you have a lot of faith in whatever you’re doing and you’re getting a high yield. Your expectation is you’re getting a high yield for low risk. 

That’s where you would say, “Okay, this thing’s only going to yield at 3%. The tax that I’m going to have to pay is substantial for something like that, especially if it’s a short term gain.” But you have to do all that mental gymnastics and all that math to kind of figure out whether that’d be a good decision or not.

Hari Ramachandra  53:45  

Alright, thanks, Stig. You had a question?

Stig Brodersen  53:48  

I really like your thought process about saying, “Oh, is this just a placeholder for cash?” I think that’s worth a note. I also did the numbers on Microsoft. I think I probably get around just short of a 4% return. This is not super attractive. It’s not too much more than what I expect out of the S&P 500, as Preston mentioned.

One might argue, should I do that? Should I get the 500 stocks instead? I have been considering my own portfolio, just what you mentioned there, instead of just holding it in cash, which just seems to be you’re paying for opportunity costs on that… 

Would it make sense to while you wait, hold them in, 10 or 20 different high quality stocks that might be at slightly more than the market, knowing the that if the market does take a hit, as I think most of us expect, will it then just not slide as much and you can take some of that cash and put into a different company? Is that a good approach? 

I think it is an interesting discussion you bring up. I don’t think there’s anything wrong with that, especially if you’re not actively or too actively looking at the market. You have a very long time horizon. You just want to take that monthly cash flow because of that strategy. Just always plow that into something.

Doing something like Microsoft might not be too bad if you feel that 3-4% is not too much of a downside is what you’re looking for. I don’t see this pick, for obvious reasons, going anywhere. 

You mentioned Microsoft’s position in the cloud right now is just the cloud itself, it’s just the growth rate you see is just amazing. Who do you think is positioned the best? Do you think that is Microsoft? Also given the results you’ve seen from Microsoft in the cloud business over the past 12 to 14 months.

Hari Ramachandra  55:26  

I’ve been looking into who are the major players and the way cloud, unfortunately, it’s a very heterogeneous market in the sense that Software as a Service or Infrastructure as a Service. AWS is by far the dominant leading player in Infrastructure as a Service with almost 50% market share. Microsoft is around 18% market share. That’s number two. Google is a distant third with 3- 4% market share. 

In fact in 2017, Alibaba and Google were kind of tied. The third spot, IBM has completely lost its IAAS position. Of course, it’s distant fourth or so.

When I see that tailwinds, I see Microsoft as one of the leading players because of their presence in all the stacks, whether it’s infrastructure. When I say Infrastructure as a Service, it is basically thinking of it as like computers for hire on the cloud. Basically, it is storage and computer, that is CPUs. When I say Platform as a Service, it is add-ons on top of these infrastructure like whether you have a virtualization or an operating platform on top of this basic computer infrastructure. 

Then on top of that, when you provide certain software, whether it can be CRM, like the way Salesforce and all these guys do, or ERP… Or even Productivity Suite like Office365 that Microsoft is providing. 

Then there is also Data as a Service. There’s a new category that Gartner introduced recently where Oracle, Microsoft and other companies, even AWS. They are providing their data infrastructure or think of it like a database on the cloud to be simplistic. This is so you don’t have to maintain the big data infrastructure on premise. I have seen that it is a huge consolidation in this market in the last two to three years. 

Google, Amazon and Microsoft are emerging as the three players of significance. In that order.

Preston Pysh  57:30  

We’re just always so thankful to have Toby and Hari on the show. 

Guys, I want to give you the opportunity to tell our audience about where they can learn more about you. I think it’s really important to highlight Toby’s got a new podcast that he’s going to be starting. I don’t know what kind of consistency he plans on doing shows, but Toby, tell us about that and tell the audience where they can learn more about you guys.

Tobias Carlisle  57:52  

I’ve got a new podcast called the Acquirer’s Podcast. It will be popping up on the Acquirer’s Multiple website: acquirersmultiple.com/podcast. 

First episode goes out March 11. We’re going to be recording on video and put onto YouTube and on audio, distributed for all of your favorite podcast platforms. 

Basically, I’m going to be interviewing other entrepreneurs, investors, authors to see if I can figure out that little insight that they’ve had that helps them to beat the market or to beat their competitors or to manage risk. 

So it’s going to be the type of stuff that I’m focused on, deep value investing, buyouts, activism, special situations. I want to know how to pick stocks, how to manage risk, how to deal with bad luck, how to maximize success, if you can get any of it. It’s been a long time between drinks for me. Let me make a fool of myself on my new podcast.

Hari Ramachandra  58:42  

bitsbusiness.com that’s my blog, and on Twitter, my handle is @HariRama. I look forward to the conversation. 

Preston Pysh  58:48  

All right, guys. Well, we really appreciate you guys coming on the show and sharing your comments, your feedback and your knowledge. We just always look forward to these.

Stig Brodersen  58:57  

Alright guys, so before I let you go, please remember to sign up to our newsletter at TIPEmail.com. We will automatically send all our intrinsic value assessments directly to your inbox. 

Guys, that was all that Preston and I have for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  59:17  

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