EIEIO…Basic Instincts
By: Michael Moe, CFA, Owen Ritz
“There are old pilots, and there are bold pilots but they’re not many old-bold pilots” — Unknown
“Percentage change in EPS is the single most important element in stock selection today. The greater the percentage increase, the better.” — William O’Neil
“Compound Interest is the eighth wonder in the World.” — Albert Einstein
We have no idea what the Stock Market is going to do in 2023. For that matter, we don’t have a clue what stocks will do in January, next week, or even Monday.
What we do know, is growth stocks overall are a lot less expensive than they were 18 months ago. Many of the fastest growing companies are down 50%, 60%, and even 90%. We also know that it’s cheaper to buy a bathing suit in January than it is in June.
We also know that over time, a companies revenue and earnings growth is highly correlated to its stock performance. In fact, in the long term, (and I know we are all dead in the really long term), there is basically 100% correlation between a company’s earnings growth and its stock CAGR.
History has also shown that when people are most pessimistic is often when stocks provide the best risk-reward dynamics and when people are most optimistic, it’s often when owning stocks are most perilous. Looming recession, uncontrollable inflation, a war in Europe, massive layoffs and a brutal 2022 all contribute to an extremely negative market sentiment.
All this is to say is my instincts smell opportunity.
Since my philosophy is that revenue and earnings growth is what drives prices over time, it would seem the simple solution would be to find companies with the highest growth rates, take a deep breath and hang on for the ride. While that’s actually true, investing in high-growth enterprises is even better than that due to the way compound interest works. Understanding the magic of compound interest and the power of earnings is critical to appreciating why growth investing has such huge potential rewards.
Compound interest, high earning growth rates, and time create a potent combination that leads to spectacular returns.
To understand the magic of compound interest, let me tell you a story. In 1626, Dutchman Peter Minuit purchased the entire island of Manhattan for $24 worth of trinkets from the Wappinger Indians. In other words, what it would cost to order a bagel and a cafe latte at a midtown hotel today, Monsieur Minuit owned the entire Big Apple.
While there are many outside of Gotham who would look at neither as a bargain, my point is to demonstrate the power of compound interest. So the $24 question is who got the better deal, Minuit or the Wappingers?
Obviously, the key variable to determine the answer is the interest rate that we apply to the $24…in other words, what could we have earned in an alternative investment?
The difference between a 5% return and 10% return isn’t a simple doubling but a compounding that becomes staggering over time. If the $24 had been invested at 5% interest over the past 396 years, it would have grown to $9.1 billion today. Not bad, given the Hudson Yards project alone cost $25 billion.
At a 10% return, however, the $24 doesn’t just double the 5% return to $18.2 billion. With compounding it magnifies it to $3,213,732,813,837,317,600!
Microsoft has a stock CAGR of 20.0% from its IPO, not coincidently, its EPS is up 19.9%. Apple has a stock CAGR of 17.5% from its IPO, its EPS has grown at a CAGR of 16.3% during that time. Starbucks has a stock CAGR of 20.4% from its $200 million IPO price, its earnings are up 20.8% from its IPO price.
A useful tool for comprehending the impact of compound interest and the doubling effect, but something they don’t teach you at Harvard Business School, is the Rule of 72. The rule says that if you divide an interest rate into 72, it will tell you how many years it will take to double your investment. At 9% interest, a dollar would double in 8 years (72 divided by 9 = 8). At 12% interest, a dollar will double in 6 years.
Another way to look at it is a company growing its EPS at 15% with a constant P/E multiple will double its share price in roughly 5 years; a company growing its earnings at 25% per year with a constant P/E will double its value in approximately 3 years.
To illustrate the dramatic impact compounding has over time, if you earned 3% on your funds for 30 years versus 12% (the average small cap return the past 100 years), you would have more than 12 times more money with a 12% return.
More spectacular, if we could invest in a company that grew its earnings at 25% for the next 30 years (admittedly very, very difficult) with a constant P/E, $1 invested would be worth $807.79.
To beat a dead horse, but hopefully cement the point, let me offer you two options. Suppose I offered you a job as a consultant for a month and you had your choice of being paid $10,000 a week, or a penny the first day, and having it double every day for the remainder of the month. Easy choice, right?
At $10,000 per week, you would make $40,000 for the month. On the other hand, making a penny the first day, two cents the second, four cents the third, eight cents the fourth, and so on, you actually end up making more than $10 million on the 31st day!
That’s the math and that’s the good news. There is the other side of the coin which is what is the effect of negative returns on compounding. Or in other words, what does a 2022 do to our compounding equation when NASDAQ is down -33% and a hyper growth fund like Ark was off -67%?
Just as compounding geometrically increases the value of positive returns, it also exacerbates the impact of negative returns. To illustrate this point, consider two imaginary portfolios.
Fund 1 is the New Century High Octane Fund. It’s average P/E is N/M (not meaningful) and annal turnover of the portfolios 2000%. Figuring out the top 10 holdings is difficult because theirs changes so often, but a reasonable proxy is to look at the stocks that are making new daily highs.
Fund 2, the American Eagle Stalwart Fund, invest in leading companies within their industries that have a growth rates of at least 20%, good margins and visibility of both revenues and profits.
Both portfolios start with $100K at the beginning of a year. New Century High Octane increases 100% in the first year, and then falls 30% in the second year. American Eagle Stalwart increases 20% in each year.
Question: Which fund had more money at the end of year 2?
Answer: The American Eagle Stalwart fund ($144K versus $140k).
Part of the secret of successful investing is the compounding of returns over a period of time. Sadly, negative returns drastically undermines the magic of compounding. For example, if you are down 50%, to get back to even, you don’t need a simple 50% rebound, but a 100% gain. The -67% negative return Ark experienced last year, investors in that fund need approximately a 200% return to get back to even.
Looking at the “Sexy Sixty,” which has sixty of the most innovative and disruptive growth businesses worldwide, this group of companies was down nearly 40% last year and is at roughly half the P/S multiple that it was the prior 12 years. While things can go lower, the fact of the matter is that many of the fastest growing companies are at a significant discount. Below are the key indicators of the index (all values below are medians)
- Revenue Growth: 28.2%
- Gross Margin: 72.4%
- Enterprise Value/NTM Revenue: 4.6x
- Enterprise Value/Revenue based on 2009/2021 Valuations : 9.1x
- Multiple Compression from 2009–2021 Valuations to Today: -68.6%
- 52 Week Performance: -39.4%
So going back to where we started, while we have no idea if the market is going to go up or down, we do think that buying great growth businesses that are already down significantly, and where sentiment reflects a very BEARISH outlook is what long term investors should be doing right now.
We believe in the power of growth. And buying swimsuits in January.
Market Performance
Stocks closed the week strong after the employment report showed signs of slowing wage growth. Investors took this as a sign that the Fed may slow its rate hikes soon…yet Minneapolis Fed President Neel Kashkari said this week that rate hikes should not pause until they hit 5.4%.
It was a tough week for the auto industry, as Tesla shares fell 12.4% on Tuesday in their worst day of trading since September 2020, while U.S. auto sales came in 2022 were the lowest they’ve been since 2011.
Microsoft is working to incorporate ChatGPT into Bing, Word, Powerpoint, and Outlook… a “Back to the Future” moment for those of us who used Clippy in Microsoft Office.
Clippy aside, OpenAI is no joke. The company is in talks with investors to sell existing shares at a $29 billion valuation, while Axios reports that Microsoft “has every reason to want to buy OpenAI.”
The Heart of a Hero
Last Monday night, after overdosing on college and professional football for much of the couple days before, the football addict that came back for more to watch the Bills play the Bengals….which was a matchup between two of the best teams with two of the best young quarterbacks in the league.
As we all know now, after a more-or-less normal tackle, 24 year old safety Damar Hamlin went into cardiac arrest. Medics spent over nine minutes performing CPR on the young Bill before he was rushed to the hospital.
What started as an impossibly horrific situation that of course, included the cancelation of the game, what transpired was truly inspirational. The outpouring of support, prayers and love across the Country was amazing with over $8 million raised for Damar’s charity. His #3 jersey became the hottest selling player uniform in the NFL with even opposing players wearing it around.
When Damar got over his coma, his first question was if the Bills won the game. Damar’s recovery has been an uplifting story of hope and spirit. We are all Buffalo Bills fans now….Go Bills!
GSV’s Four I’s of Investor Sentiment
GSV tracks four primary indicators of investor sentiment: inflows and outflows of mutual funds and ETFs, IPO activity, interest rates, and inflation. Here’s how these four signals performed this past week:
#1: Inflows and Outflows for Mutual Funds & ETFs
#2: IPO Market
The IPO Market continues to remain on hold…but we agree with the All In Pod’s prediction that Starlink’s rumored IPO later this year will be the “rocket fuel” required to restart the capital markets.
Source: Renaissance Capital
#3: Interest Rates
The big news this week was Minneapolis Fed President Neel Kashkari forecasting that rates will need to peak at 5.4%, more than twice the U.S. central bank’s 2% target. Kashkari is one of the Fed’s biggest hawks, and his 5.4% projection suggests he may be migrating to the center of the committee.
#4: Inflation
U.S. inflation shows signs of slowing…but it still remains too high for comfort. Next week’s CPI print will let us know if this trend will continue.
Articles of the Week
Two of our favorite sets of 2023 predictions…
EIEIO…Fast Facts
Entrepreneurship:
0.05% — amount of startups that get VC funding (Source)
Innovation:
2x — amount of time India is spending in upskilling vs. the rest of the world (Source)
Education:
14x — increase since 1910 in the percent of the U.S. population aged 25 or older with a bachelor’s degree (Source)
Impact:
71% — percent of surveyed founders who stated that a big motivator to start a business is the desire to make a difference in the world (Source)
Opportunity:
$6.7 billion — 2022 venture investment in aerospace and defense tech companies, up 3x since 2019 (Source)
