Friday File: Annual Review Part 3 (plus PANIC, SPCE and more)

by Travis Johnson, Stock Gumshoe | February 7, 2020 4:43 pm

Checking in on more Real Money Portfolio holdings, including thoughts on GOOG, TTD, SPCE, MKL, DIS, COR and SLP

Here’s the scenario of a week ago: China is in the midst of an epidemic of possibly explosive proportions, with fear gripping much of the country (and the world) as a coronavirus spreads and seems to have a pretty high mortality rate, with conspiracy theories abounding and the fear of social unrest as whole cities seem to be abandoned in an attempt to quell the viral outbreak… and while that’s happening, we’re also at the conclusion of the Chinese New Year celebrations that had everyone on holiday… and were extended to keep more people from traveling, and to keep the Chinese stock markets closed.

All that’s about to come to a head, the Chinese stock market will reopen to possibly catastrophic losses on Monday morning… and indeed, that’s how it turns out, with more travel bans and border closings announced over the weekend and the Chinese markets down roughly 8% on their first day of trading after the holiday, the worst drop in 4+ years (and the worst open in more than a decade). So is that the black swan that sends the global economy into a tailspin? Is this what’s needed to send the “Goldilocks” economy running away from the three bears?

Well, that’s the narrative we heard a lot last weekend, and the financial media is forever trying to forge a narrative to explain where things will go… but when Europe and the US started trading on Monday, that narrative of impending doom was swept quickly away by more buying. Halfway through the day, the S&P 500 was up 1%… with the story being either that the market liked China’s more aggressive response to the coronavirus, or that the coronavirus was being shrugged off because we’ve seen things like this before and they didn’t end up having a long term impact (like SARS or Swine Flu), or, for the few honest pundits out there, a simple “I have no idea what’s going on.”

Being prepared is important, and thinking about personal reactions for your safety and well-being is important — but that doesn’t mean panicking and shifting your investment strategy every time a headline scares you (scaring you is the point, remember, otherwise you won’t click through and read the rest of the article and see their ads), it means things that are more mundane — having a plan for what to do if you lose electricity for two weeks, or have to evacuate your town because of an air strike threat, having a couple week’s worth of food in case your town is quarantined, have your important documents easy to grab, know how to find your family members if cell networks go down.

Being prepared for epidemics or natural disasters on some level is good, and it gives you reassurance. Letting those kinds of existential fears of war or pestilence drive your investment portfolio is a recipe for financial disaster — if you need to react, react with more preparedness in your personal life, then when genuinely terrible things don’t happen (since they almost always don’t), you’ll feel overprepared but you won’t be broke or unable to retire.

No one likes to see their portfolio lose value in a panic or a crash, so we are hard-wired to try to predict when those will occur — but the reason that people make movies out of speculators who successfully predict those events is that it’s almost impossible to do so accurately (or to get lucky more than once with your timing). So try to worry about something else instead. It’s not like you need the money in your brokerage account in six months or a year, anyway — and really, I’d say that if you’re going to need to spend the money in the next five years, it shouldn’t be in stocks in the first place. My oldest daughter will probably be going to college in two or three years, and the savings I’m putting aside today to help her aren’t going into Amazon or even Berkshire Hathaway shares, regardless of the fact that I’m pretty sure those stocks will be higher in five years… they’re going into a money market fund and earning one or two percent because I don’t need an 80% or 90% certainty that the money will be there in three years, I need 100% certainty. The cost of losing half of that money, which can happen in any given year in the stock market and certainly can happen in any specific stock with no warning at all, is much more important to me than the benefit I’d get from seeing that balance rise by 20 or 30% instead of the safe ~5% over a few years.

I don’t know what’s going to happen with this epidemic, of course, it sounds awful on a human scale, at the very least, and it seems guaranteed to impact China’s economy for at least several months even if they get it contained and it peaks pretty soon… but investing in a stock is not really about the money that company is making today, it’s about all the money they’ll make over the next 20 years (or whatever time frame you wish), and whether the price of the stock reflects those future profits in a way that seems optimistic or pessimistic to you. If you think investors are overestimating what that company will earn in the future, you think it’s overvalued and you sell — if you think they’re underestimating, you think it’s a value and you buy… the differences among investors are mostly in how you do that estimating of future profits, and in how far into the future you’re willing to wait for them.

I expect Chinese consumers in 2021 to be a lot like Chinese consumers in 2019, with a little more money but the same general tendencies, and with this particular crisis in the rear view mirror… so I’d bet on Chinese consumer stocks if people panic and begin to believe that travel and tourism and restaurant dining will grind to a halt in the Middle Kingdom not just for these next three months, but for the next three years… but that’s not really the case yet. The stock market is mostly shrugging off the long-term impact, as far as I can tell, which seems unusually rational for the markets — maybe there will be a real financial panic before this epidemic is under control, but for now I’d say the panic is on the streets and in the sales of masks, not in the stock market.

But anyway, what I’m really focusing on these days is checking in on all the investments in the Real Money Portfolio[1]… so let’s continue that Annual Review exercise.


First, I should let you know about the newest little position in the Real Money Portfolio[2] — when researching my piece about “Q Shares” yesterday[3] I found myself intrigued by the steady growth opportunity and rational management of Simulations Plus (SLP), a small software and consulting company in the drug discovery space… so I bought some shares.

What’s to like? It’s a long-established firm with a good base of clients who rely on their consulting work or, more importantly, buy their software that helps with drug discovery and modeling in very specific disease states… in some cases, enabling rapid initial testing of compounds without using animal models. There isn’t any meaningful analyst coverage, but they have gone through some acquisitions in the past couple years and are building on those businesses and hiring more salespeople and consultants, with a goal of generating revenue growth of 15-20% a year… and I think they’re likely to grow faster than that (as they did last quarter). The combination of 20% revenue growth and a 25% profit margin can drive very fast earnings growth, particularly if you’re also small enough to make bolt-on acquisitions that are immediately accretive, as they’ve done. They are also pretty careful with money, they pay a small dividend that currently represents about half of their net income, but they also have no debt and generally make small acquisitions with cash — which is unusual for a very small company. They have grown revenues by 10X in the past 20 years, but have only grown the share count by about 20%.

What’s not to like? Well, the valuation is pretty rich — they trade at almost 70X trailing earnings and 17X sales… the leverage of high-margin software sales growing at 20% a year can eat into that pretty quickly, but it’s still a rich valuation and they don’t have nosebleed 50-80% revenue growth like we’ve often seen with the cloud software stocks. And there’s certainly a risk that they could go back to the doldrums that they were in for 15 years or so, with growth that wasn’t impressive enough to really do anything for investors… but I really like the way the new management team is setting goals, and it’s interesting to see a company really embracing a growth strategy after being safely profitable for 20 years. I also think the growing demand for faster and novel drug development has a good chance of spurring more demand for their software and consulting work — certainly the demand is there now, and their biggest challenge has been hiring enough people.

The immediate risk is that they had a great quarter when they reported in January, and they implied that there’s some possibility their 25% revenue growth in that quarter could have pulled forward some of the growth they expect in the current quarter… which means they could “disappoint” with slower revenue growth next time they report (which should be in the second week of April). It’s a small company without much coverage or trading volume, so it doesn’t take much of a sentiment shift to bump the share price around. Earnings per share growth has averaged about 25% over the past five years, but moves around wildly quarter to quarter and we’re going into their two seasonally strongest quarters right now. I’ll likely be quite patient with this one, but I’m looking forward to seeing if they can continue to build a larger company and bump up those high-margin software sales to help earnings grow substantially faster than revenue… it goes into the portfolio at about a 0.5% position at $35 a share.


And now, on to more Annual Review….

Alphabet (GOOG) 7% position, $518 cost basis. Buy up to $1,650, which would be 30X forward earnings for the real “blue chip” internet infrastructure company — current prices (around $1,475) provide a little margin of safety and growth potential.

Alphabet (GOOG) recently joined Apple, Amazon and Microsoft in the trillion-dollar club, as their stock price bumped the market cap above that level, but they also posted an earnings miss this week, sort of similar to Facebook last week (though really, Google gives so little guidance to analysts that it’s probably fairer to say that the analysts guessed wrong than that Alphabet “missed”). So what to think now?

Well, Alphabet is by far my longest-held technology stock, and that’s largely because it’s an irreplaceable utility for the internet — other wonderful tools exist, of course, but it’s hard to imagine getting through a day without Google search.

The interesting thing to watch, beyond the steady and high-margin growth of their advertising business, is the growth of their “other bets” and their other maturing businesses that are also becoming core internet utilities, like Google Maps and YouTube. This quarter was the first time they disclosed their ad revenues from YouTube, which surprised a little bit because it was a little lower than analysts had been guessing, and the Google Cloud revenue, which was about what was guessed… and because the company began to talk about the possibility of getting outside investors for some of their “other bet” businesses — they’ve talked about that for the Waymo self-driving cars business, in the past, but are now really considering opening up more of their “moonshot” ideas to other investors. That might create a real boost if it happens by way of a partial spin-off or something like that of a larger business like Waymo — estimates in the past have put the value of Waymo at as much as $100 billion, but it’s presumably at least $20 billion (guesses were up to $200 billion a couple years ago, but as self-driving seems to get further pushed out into the future and cash-burning companies become less popular, the valuation has dropped), and all of those “other bets” are very much hidden inside Alphabet.

Alphabet also has a tremendous amount of cash, roughly $120 billion and with operations that can pull in close to $50 billion a year at this point (though they invest half of that in CapEx, including lots of data centers and equipment, and have lately been using the other half to buy back shares so the cash balance has remained pretty stable). If you back out that cash ($175/share), then GOOG is trading at about 23X 2020 earnings estimates. If you don’t to deal with estimates, and I wouldn’t blame you since Alphabet doesn’t give analysts a lot to work with, then that’s 26X trailing GAAP earnings. Given their likely ability to grow earnings at least at 10-15% a year, likely substantially more given the growing spending trends in online and video advertising, that’s a very reasonable valuation.

I think you can buy Google up to 30X forward earnings given their dominant position, still-strong growth, and possible “value creation” upcoming from more disclosures and perhaps some value recognition in the “other bets” businesses, so if you want to be aggressive and back out the cash that would be $1825… if you want to be a bit more cautious, that’s $1,650. At $1,475 you get a great business, likely to continue to lead in many different technologies, at a valuation that still provides some growth potential and some margin of safety if they have a bad regulatory outcome or a major fine — and we’re going into a year that should see the most ludicrous political ad spending you’ve ever seen, which will mean a boost in revenue for both Alphabet and Facebook. And if the most dramatic political posturing comes to anything, and Alphabet is actually forced to be “broken up” at some point because of antitrust concerns, I would actually wager that would lead to a rise in the value of the parts. Alphabet, Microsoft, Apple and Amazon are a huge portion of the market, so if the market crashes or falls they will certainly fall… but Alphabet remains, I think, the large cap tech stock with the most easily justified valuation.

CoreSite (COR) 1.5% position, average cost $37. Hold due to lack of growth, both revenue and FFO likely to be flat in 2020 following a pretty weak 2019. I’m inclined to sell given the lack of dividend growth potential (they’re already paying out 95% of FFO, and FFO will likely grow only 1% in 2020), but the strength of their core urban data center locations and my general resistance to selling decent dividend payers has me holding for now with a 4.4% yield that will probably provide all of the return this year, like it did last year. I expect the downside is limited to $110 or so and the upside $140 in the next year, with a pretty flat year most likely.

CoreSite (COR) announced results that were more or less in line with expectations, but they guided to essentially no growth again (they didn’t grow much in 2019, either). That drove the shares down.

We can’t go back in time, but we can look at the situation as it now exists: COR is a reasonably levered data center REIT, with fairly limited organic growth as their construction and development program for 2020 will likely bring in a little bit less capacity than 2019 did, and they’re bringing in new customers but pricing is not very firm in most places and they’re also losing some older-business-model enterprise customers and hoping that new cloud services will continue to fill the gap. They guided investors to expect funds from operations to be somewhere in the flat to up 2% neighborhood, between $5.10 and $5.20 for 2020.

So the stock, after the 5% dip on that disappointing guidance, trades at about 22X FFO. They did not increase the dividend in December as they have every year for the past several years, so the last dividend hike now is from May of 2019, meaning that they’ll need to raise the payout again in the next few quarters if they’re going to keep the “dividend grower” reputation that REIT investors like. And that will be a little tough, since at the current pace they’re paying out $4.88 in dividends out of their expected $5.15 in FFO, which means they have a 95% payout ratio. They could raise the dividend a few cents, but nothing like the large dividend hikes that fueled CoreSite’s incredible advance from 2012 to 2018 (I sold more than half of my position in early 2018, when the leverage-fueled dividend increases seemed likely to top out).

The dividend yield today is relatively high for the segment, mostly because the stock has been pretty stagnant for the past two years as investors have begun to see the growth potential evaporate and have insisted on a higher yield to hold the stock. Digital Realty, their much larger competitor, has been growing its dividend more slowly but has a lower current yield of about 3.5%, and growth is in the low single digits there as well right now… but they also only pay out $4.32 in dividends on about $6.60 in FFO per share and they’re acquiring InterXion this year which will be at least a little bit accretive to cash flow (assuming the deal goes through), so the dividend is likely a lot more sustainable and should be able to grow at a decent pace (the last two increases were in the 7-8% range, which is not huge but might be quite a bit more than COR can reasonably afford in the next year or two).

So what to do? I’m always reluctant to sell a dividend-paying stock that is compounding reasonably well and has a reasonable current yield, and CoreSite has been fine on that front (in the two years since I took profits on the position, dividends have increased the number of shares I own by about 8.5%)… but are there other reasons to hold on to a stock that is moribund and unlikely to grow meaningfully for yet another year?

Well, they think they’re doing pretty well — they’re bringing in a lot of new customers with their sales efforts, and are expecting churn of about 10% (meaning they’ll lose 10% of their customers and have to replace them), which is a little higher than it has been, and they seem to see some pricing challenges in the competitive markets (particularly places that are oversupplied, like Northern Virginia), so the “cash rent” growth is only going to be about 1% but they do also have capacity to grow beyond that a bit if demand picks up. And, since this is largely the reason why I liked the stock in the first place (back in 2011), it’s worth remembering that some of their data centers are really strategic — their downtown LA and Chicago properties can’t be easily replaced or supplanted, those areas are heavily built up so more edge capacity won’t likely be added by competitors… whereas the barriers to opening new data centers in Arizona or Northern Virginia or Texas are much less daunting. This is what the CEO said in response to one of the questions on the conference call[4] to sum up their optimism despite the likelihood that 2020 will be a flat year on the cash flow front and they think it’s still somewhat aspirational to get back to “high single digit” revenue growth in the next two or three years:

“I think we have more markets that we can grow in now relative to what we had historically. And I’ll reiterate what I said on other calls that pound-per-pound or share-for-share, I think we have a higher concentration of exposure to strong growth markets than probably any of our peers. So we feel good about where we are. We continue to look at and evaluate other opportunities but we believe these ongoing improvements in execution, coupled with the tailwinds, we believe, will be strong for a few years. Plus our scale and strong ecosystems in key markets is what makes us optimistic going forward, and I think what is showing up in our sales levels.”

I end up concluding that my CoreSite position is on death watch, particularly as it relates to their ability to reinvigorate top line and FFO growth beyond 2020… and the next dividend announcement will play into that as well, since it will signal their perception about the coming year and give investors a good idea of whether or not this is still a dividend grower (the next dividend announcement should come in about a month, but the key to me will be the May announcement, since that’s the anniversary of their last hike). A 4%+ current dividend is nothing to sneeze at, particularly if it can grow at 5-10% a year, but this is a long period of stagnation and I’m mindful of the risk of it continuing. I came very close to selling the stock, but have not yet sold — partly because I think the risk of the stock falling sharply is pretty low, the demand for dividend-paying stocks remains so strong now, with interest rates low and falling again, that it’s hard to imagine COR falling more than 10% from here unless they cut the dividend (which would be a shock)… the upside, though not particularly high-probability, would be if they see some better rates on new leases, can boost the dividend by 10% in the next two quarters, a little spurt of optimism from investors leads the stock to a 3.5% yield, more in line with Digital Realty — that could drive the shares up over $140 (there’s also always takeover chatter in this sector, and DLR or Equinix (EQIX) are acquisitive and big enough to swallow COR if they’re interested).

So I see a 10% downside risk/25% upside possibility, but what’s probably most likely is that the shares will chug along between $110 and $120 until they begin to give any indication about whether growth might be possible in 2021… unless, of course, there’s a dramatic change in the market or interest rate expectations. That’s enough to convince me to hold and let those dividends continue to compound for now, but the most likely outcome for COR is “meh” for this year so I’ll reserve the right to swap this one out for a more compelling opportunity if one comes along.

Disney (DIS) 2.4% position, $110 average cost. OK to nibble around $140, buy more aggressively if we get an opportunity in the $120s (market crash, release a flop movie, coronavirus cuts more into parks or films, etc.) — they’re the dominant entertainment brand in the world, they monetize content better than anyone, and their investments in Disney+ should pay off but 2020 will likely be a relatively weak year, with earnings dipping, so there might well be “buy the dip” opportunities.

The two big drivers for Disney over the past year have been their announcement about plans for the Disney+ streaming service, and the actual launch a couple months ago, which went quite well… so the big news watched this past quarter was the actual number, and as I’ve been saying all along those subscriber numbers are going to be a lot bigger than analysts were estimating six months ago (analysts thought they might hit 20 million subscribers by the end of 2020, they are above 28 million now). When I posted some thoughts back in November, this is what I said: “I still think Disney is a good long-term hold if you can buy in the 140s or below, but the bet on Disney+ is so substantial, and the launch will be followed so obsessively by investors, that it might be a bumpy ride.”

And that’s still true — though we can add on a little bit of coronavirus fear to that, since movie theaters in China are going to be pretty empty for a while and Disney’s Chinese theme parks are temporarily closed, and throw in the likelihood that the film slate in at least the first six months of 2020 is going to disappoint compared to the nonstop wave of blockbusters from Disney in 2019. This is a dominant entertainment company that monetizes its brands better than anyone, and it’s reasonably priced given that strength, but it’s not likely to be a fast grower — and earnings, particularly, will likely be down 5% or so in 2020 from the 2019 numbers before growth resumes.

I’m betting that continued subscriber growth for Disney+ will assuage investor fears about Disney having a weak earnings year, but a couple film flops or an extended coronavirus overhang could certainly drive those 2020 numbers down still further and send skittish investors to the exits. With a long-term view (5 years+), I’d still be happy to add around current prices but would be mindful that bad news could create a more compelling buying opportunity — I’ll likely be nibbling around $140, as I did over the past few months, but buying more aggressively if we get a dip to the $120s. There’s an outsize chance that Disney could get a really lofty valuation akin to other streaming providers, but that doesn’t seem very likely to me — Disney+ is important, and investors will likely be patient as Disney spends billions to build it out and create new content for their streaming services, but they’re probably not going to give Disney a Netflix-like valuation. Right now, Disney trades at about 26X the pretty depressed 2020 earnings estimates and 23X 2021 estimates, with high revenue growth thanks largely to the expensive Twentieth Century Fox acquisition that won’t really help earnings in the near future.

The Trade Desk (TTD) 5% position, $74 cost basis. My general sentiment is to hold into earnings in a couple weeks, since huge swings on earnings are the norm for TTD and they’re near all-time highs both on price and on price/sales valuation, but the position has advanced so rapidly that I’m taking a little profit off the table in the $290s and selling about 10% of my position. Very much like the long-term potential still, but whether we see $200 or $400 next is almost a coin flip.

One of the challenges of assessing the potential of The Trade Desk is that you can readily see the wide-open revenue opportunity they have, and the potential that they could grow earnings at 25% per year for a long time before they begin to eat into the size of the opportunity… but that if earnings growth disappoints at all, and they post something like 15-20% earnings growth instead of 25-40%, you’re paying a ludicrous premium for the stock. TTD right now trades at 86X what analysts think their 2019 earnings will be, and at a forward PE of 77… they’ve been profitable since day one, which is admirable, and they have fantastic margins (gross margin of 76%, software companies are easy to love, and return on equity of 22%), but they’ve never been quite this expensive. How do you handle owning a large chunk of a very expensive stock, one where the share price could be cut and half it it would still be trading at a substantial premium to the market? After all, you could buy Alphabet, exposed to these same growth trends (digital advertising, broadly speaking), and get probably 15% earnings growth at a forward PE of only about 23 or 24. So why would you pay 3X the valuation for a smaller company, with more competition?

Well, mostly just because The Trade Desk has captured investors’ imagination because of their ability to fill that open space for “digital advertising stock” that’s NOT confined to the Facebook and Alphabet silos. They are leaning heavily on video advertising and helping advertisers reach and program digital ads outside of YouTube or Facebook, including in all the various streaming services, and that’s a huge market that is still growing very fast. That’s why investors seem to love The Trade Desk — they’re still small enough, in a fast-growing industry, that you can dream of greatness… kind of like Shopify (SHOP), with whom they share both a huge Motley Fool fan club and a nosebleed valuation (23X sales for TTD, an insane 37X sales for SHOP).

So what do we do going into earnings for The Trade Desk? Well, the first thing to do is resolve yourself to expect volatility – expectations are very, very high, and that means the earnings number they report will be watched very closely… but far more importantly, the tone they take and any forecasts they make for the year ahead, or even the quarter ahead, will be the fuel for what’s often a vast overreaction in either direction.

For me, the key with The Trade Desk is that this is a software platform that enables connections to lots of advertising inventory — including regular old internet and mobile ads as well as connected TV, mobile video, in-App ads, all the stuff that pays for the internet as we know it. That means they should continue to have great leverage and a strong network effect — the more customers they sign up (advertisers and ad agencies), the more inventory they’re going to get access to… and the more inventory and data they have, the better their programmatic systems will be, and the more customers they’ll get. If they do this right, it’s hard for a “better mousetrap” to come along and take their customers (far from impossible, and there are lots of other advertising management software systems, but hard)… and if they can continue to grow revenues at a rapid clip while they invest in expanding their network, the potential earnings leverage when things normalize could be fantastic because eventually the spending on overhead, R&D and customer acquisition just won’t be able to keep up with the pace of revenue growth.

That’s really the only way you can justify the current valuation — either the analyst estimates are way too low because TTD is just growing too fast for them to keep up (which has been true most quarters, though not always), or the end game opportunity in a few years (or five or ten, I don’t know when) is so much stronger that it’s worth paying premium prices today. This time of year is always particularly fraught for TTD shareholders, because we’re headed into the most important earnings release of the year — TTD’s fourth quarter is much larger than the other three, mostly because advertising is heaviest in the holiday quarter, so a “beat” or “miss” here has a huge impact on annual numbers and on sentiment. Right now, analysts expect $1.16 in earnings per share for that quarter (it’s actually their fiscal first quarter) when the report comes out in late February, representing earnings growth of just over 50% from the year-ago quarter. Last year, TTD posted a strong quarter and jumped about 20% on the news… but the shares also dipped 20% or so on the May earnings report, mostly ignored the August report but still dipped with all the expensive stocks by 20% or so going into October, and then surged by about 30% in the weeks after a strong November report. It’s a wild ride.

Which means I can’t in good conscience think about buying it at all-time highs near $300 ahead of earnings, or suggesting it to you. My inclination is to hold, given my understanding that the addressable market remains huge and the revenue growth remarkable, with the clear understanding that the stock could easily be at either $200 or $400 in a month, and try not to hold my breath as we await earnings — but because this position has now grown so large in my portfolio, I’ll shave off a little bit of profit here, selling about 10% of the position, as I’ve done with some highfliers in the past (including Shopify).

If all stays rosy, of course, that will turn out to have been a mistake — selling any momentum stock in a wild bull market is always a mistake — but my general preference is to both buy and sell gradually and it seems irresponsible not to take a little bit of profit out of TTD given the huge surge we’ve seen in the past few years, even if “hold your winners” tends to be the best long term strategy. It’s still a huge position for me, but will be easier to handle emotionally now.

The stop loss trigger I watch is now up to $180, which would be the clear indication that the stock is outside its “normal” trading swing, though if you’re more cautious a simple 25% stop loss would be around $227. If the thought of the stock reaching $227 terrifies you, you should probably shave off enough profits to let you sleep at night.


And that’s all I’ll get to from the big list this week, but I do have a few other notes for you that have been popping to mind throughout the week…

I updated my thoughts about Markel (MKL) in a previous missive, but they reported this week and came out with a very strong quarter, as expected — 2019 was a relatively low-catastrophe year for insurers, we already knew that similar insurance companies had reported good underwriting, and the stock market surged in the fourth quarter so the gains on the investment portfolio get reported as net income (even though they aren’t generally realizing those gains by selling). That bumps the book value per share up to $802.59, from $769 a quarter ago.

Markel has still benefitted more from multiple expansion than from actual growth in the past five years (who hasn’t, really), but book value growth is starting to catch up a little — their book value per share has compounded at 8% a year for that time period, but the stock price has increased at 11% a year. Their employee stock incentives are based on that five year book value growth rate, which is one of the things I really like about Markel management (the focus on building the business rather than boosting the stock price), but that is still the one thing that gives me pause.

That is, it gives me pause… until I compare it to other insurance companies in similar businesses, who have generally had the same kind of multiple expansion (or more), much like the overall market (the market is hear all-time highs only partly because of underlying profit growth in the companies, most of the gain in recent years has come from investors driving the PE ratio higher, not from the E actually rising).

So that quarterly update bumps up the reasonable buy prices for Markel — the “nibble” level of 1.5x book value that I’m watching is now about $50 higher at $1204, the “buy more aggressively” level moves up to $1124. We’re above that now, but probably won’t be forever.


And for those paying attention to the smaller options speculations I dabble in, the bet on NortonLifeLock (NLOK) on their special dividend announcement worked out well. The stock did not surge into the special dividend, but once the dividend was paid and they reported a very good earnings report there was a strong bounceback — and options are always adjusted for large special dividends, so the net result was a nice 600% return in a few weeks (I held onto 20% of the position, just in case it surges still higher in the next couple weeks before expiration). I get a lot of 100% losses with speculative options that expire worthless, so on balance I’d probably do just as well avoiding options at all, and I don’t emphasize them when writing to you, but they give me an outlet for the short-term and gambling-oriented tendencies I have without bringing big risks into the core of the portfolio.


Speaking of derivatives and levered bets, there was a question from a reader recently about Virgin Galactic (SPCE) warrants and the redemption rights the company has, which are similar to those you’ll see with most SPACs — I had noted that once the stock stays over $18 or so, the warrants lose a lot of their leverage over the common stock, and a reader asked why that was so.

That’s because the company can force a redemption of the warrants if the stock is above $18 for 20 days out of any 30-day period. They could technically force you to actually exercise those warrants, but more likely would be a cashless exercise — which means they essentially take the current value of the warrants (the stock price minus $11.50) and give you that amount worth of common stock in exchange. So yes, you’d still have exposure to the stock… but it’s less levered than it was since you would actually own the shares instead of owning the right to buy the shares at $11.50 and you “control” a much smaller number of shares.

Of course, the warrants are also largely held by insiders and they could opt not to redeem them — it’s at the company’s option — but generally with SPACs that begin to mature you’ll find analysts and investors beginning to worry about the dilutive impact of all those warrants floating around, so companies often try to redeem or otherwise negotiate the warrants away well before the five year term is up. This is an odd situation, since it’s such a momentum-driven “story” stock at this point and it’s got big catalysts coming in the next few years before the warrant expiration (which will be late 2024). You won’t be cheated out of the warrants, they will still enjoy the full impact of the stock price appreciation if the stock does go up… they might just not enjoy the full leverage you might hope for. If the stock stays in rarefied air for a while close to $20, I’d be surprised if they don’t do a cashless redemption, and from that point forward your returns are those of any regular shareholder.

Here’s the math for a couple scenarios:

1. You have 100 warrants you bought at $1.50 each. Without forced redemption, Virgin Galactic goes to $50 in three years and you sell the warrants.

That means you spent $150 on warrants, and you can exercise them in 2023 for shares at $11.50 each. You then effectively bought shares for $13, $1.50 of which you put up in year zero (last Fall) and $11.50 you put up in year three, and you sell at $50 for a profit of $37. That’s a total return of 285%, plus whatever you were able to earn from the $11.50 while you were holding it for those three years. Not bad. If you just sell the warrant and don’t confuse things by putting the $11.50 in to exercise them, the warrant should be worth $50-11.50, so you just sell your 100 warrants for $38.50 each, netting $3,850 and a return of 2,467%.

It’s possible you could get a little more, since the warrant might still have a little premium value in 2023, but it will be so deeply in the money and the expiration date will be only a year away so the premium would probably be very low and maybe nonexistent.

2. With forced redemption at $20 this year, Virgin Galactic goes to $50 in three years.

If the redemption is at $20, then your $150 worth of warrants would be worth $8.50 each, for a total of $850, and that would be converted to shares at $20 each… so instead of 100 warrants, you will have 42.5 shares of Virgin Galactic at $20 and you’ve put in no additional funds. That stock rises to $50 and you sell in three years, for a total value at the end of $2,125 and a return of about 1,317% on your initial $150 investment.

It still works out well either way for those who bought the warrants before the stock shot up, but if you use today as a starting point and buy the warrants right now, or just reset your mindset for the current value of the warrants, the story is different.

The warrants are trading at pretty much their real “in the money” value right now, probably because folks are aware of that warrant redemption right. The stock is at about $18.50, the warrants are at about $7. If that stays true for the next few weeks and Virgin Galactic shares are still at $18.50 in a month and they opt to do a cashless redemption, then your 100 warrants that are worth $700 today just turn into $700 worth of shares… meaning that it doesn’t really matter whether you buy shares or warrants today, your return will be essentially the same.

Assuming, of course that Virgin Galactic opts to do that cashless redemption — they could also force you to exercise your warrants (in which case you could always sell them for a fair value instead, if you don’t want to put up the $11.50 per share), or they could do nothing and let the leverage continue for a while. They could also incentivize warrant holders to exercise by offering them a little bonus of some kind, if it turns out that they need the cash. I think the most likely outcome is that they’ll do a cashless redemption at some point if the stock stays in the $18-20 range for a few months, which would mean that if you’re interested in holding the stock because of the three or four year potential then you’ll get essentially the same performance whether you buy the warrants or the common stock at current prices… but that’s just what I think will happen, it’s far from guaranteed. And yes, I’m still holding the balance of my warrants, after selling a small portion to guarantee I’ll have a profit on this SPCE speculation regardless of what the future holds.


And I’ll close with a question I got from a reader this week:

Just joined your site and am finding helpful information, especially in the debunking of ”hot tips”. I see the annual portfolio report has proven stocks with good returns. My question is if there are recommendations for new stocks, since most in the portfolio have already had quite a run up?
I’m looking to invest about $40k, with another $40k in about 6 months.
In the past I spent a lot of time researching and was very early in AMD, TTD, NVDA, SQ and others. I’ve tended to let fear get in my way and end up selling too early. I don’t know all the ins and outs of this site, but will there be stock ideas that are more entry or mid level? In other words, ones that aren’t currently at the ATH?

Here’s my response:

Thanks for joining us! You’re recently seeing mostly reports and analysis about stocks I’ve held for a while, since I’m in the middle of the annual review, but there are always new ones floating in and out as well (including this week).

I don’t know what the future will hold. I usually make new investments with some regularity and report on those to the Irregulars in the Friday File each week, both in add-on purchases to stocks I already own and in new additions to the portfolio (I’ve added three stocks to the portfolio in the last month, for example — Fastly (FSLY), Simulations Plus (SLP) and Teladoc (TDOC), which is more than is typical, but it’s no coincidence that those are all at the bottom of the portfolio… I like to start small when buying). Over the past dozen years I’ve also been through some multi-month periods when I didn’t make any substantial buys or sells in the portfolio. I make no attempt to “recommend” a new stock each month, I just relate the decisions I’m making with my real money portfolio — I found years ago that choosing a “stock of the month” was not nearly as honest a representation of my analysis and opinion as just sharing with readers what I’m actually doing with my money.

Actually, I just went and checked — and though there are plenty of stocks I’ve held for well over five years, 18 of the 47 stocks that are in the Real Money Portfolio today were new positions added within the past year. I’d guess most years are lighter than that, but we’ll see what the future holds — given my tendency to hold strong companies and sometimes be overly stubborn, it’s likely that most of the largest holdings in the portfolio will tend to be stocks that I’ve owned for many years (none of my current top ten holdings were new to the portfolio in the past year, though I’ve added to several of them during that time).

Over the past few years, some of the stronger performers have really overwhelmed the portfolio, and in some cases I’ve “let it ride” with those holdings (like TTD, for example, though I did shave off a little profit with that one today), while taking partial profits in others. In the long run, I find locating interesting small cap stocks to be the most interesting exercise, and I often make small purchases in small stocks and write about those, but because this is a real portfolio it usually takes time for me to build meaningful positions that rise to the top of the holdings list — mostly because there are some very large long-term positions that I’m very unlikely to sell. And lately, small caps in general have performed poorly.

And while it is hard to do, and it goes against logic, throughout stock market history buying at “all time highs” has usually been a spectacular idea. That has certainly been true for the past decade… and yes, it makes me nervous and it should make you nervous, because at some point there will be meaningful corrections in a lot of growth stocks, but you could have said the same thing about Amazon, to give a high-profile example, at its all-time highs of $400 in 2014, or $800 in 2016. If you feared $800 in 2016 and thought a correction was inevitable, you were right — but the correction didn’t come until after the stock topped $2,000, and the drop was just to $1,400 or so and was recovered quickly.

I am concerned about valuation with many of my holdings, and with many of the stocks I research — eventually rationality will come to many of these names and they’ll trade based on their profits instead of based on future dreams of revenue growth… but for some strong companies it could well be that profits will have climbed enough by then that the market was right and today’s price turns out to be reasonable. It’s very possible for popular stocks with good stories to be “expensive” for a very, very long time. Stocks that people want to own go up in price, and sometimes you just have to shrug your shoulders and let the market tell you, through stop losses, when a stock loses its popularity and has to be re-considered based on your assessment of the foundation provided by the actual earnings and the actual business.

Thanks for joining us… and thanks to all of the rest of you for being here and supporting Stock Gumshoe, I’ll keep writing about the decisions I make with my portfolio, and will keep sniffing out those teasers for you. Have an excellent weekend!

Disclosure: Among the companies mentioned above I have equity and/or call option or warrant positions in Facebook, Shopify, Virgin Galactic, Fastly, Simulations Plus, Alphabet, CoreSite, Disney, Markel, NortonLifeLock, The Trade Desk and Teladoc. I will not trade in any stock covered for at least three days after publication, per Stock Gumshoe’s trading rules.

  1. Real Money Portfolio:
  2. Real Money Portfolio:
  3. my piece about “Q Shares” yesterday:
  4. on the conference call:

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