Fading the noise and trying to set myself up for success in drawdowns

A happy New Year to all!

I’m excited to kick off a great 2021 for Stock Talking – have some exciting guests lined up for the pod and my watch list is long enough to last me for years of research. All that research will go on this newsletter and https://postcoronastocks.com. As 2021 got going in (predictably?) crazy fashion, I wanted to offer one idea I keep revisiting:

Headlines do not matter; expectations baked into stock prices do. Say that first part with me again – headlines do not matter.

There is a massive amount of cynical commentary out there on the state of human civilization, more so than I can probably ever remember. As far as my portfolio is concerned, I’m not paying attention to any of it. Some of things I am paying attention to:

– CHEF and NCMI free cash flow based on various reopening outcomes
– What NTDOY’s free cash will look like based on the success of Nintendo’s new theme parks and Nintendo Switch Online memberships
– AZO’s shares outstanding as buybacks continue and how much cash will be available for building shareholder value in the quarters ahead (whether through growth capex, buybacks, acquisitions, etc.)
– … any analysis that I could do based on publicly available management commentary and SEC filings

You get the picture – in the long run, your portfolio is the companies you own (specifically the cash they produce and prospects for cash they could produce) and not the news. My goal is to become a better investor, and reading news actively harms me instead of helps me in that respect. It takes time away from finding out more about the companies I own and companies I could own.

I’ve had some discussions with members of this newsletter about what the current state of the market is. My answer is it depends on what stocks you’re looking at. At a high level, the average stock appears to have higher than normal expectations baked in based on historical P/E.

A quick word on P/E – it’s a terrible metric compared to free cash flow yield (basically, (one year forward EBITDA – forward capex) / (Equity + Debt – Cash). The only reason I’m using it is it’s readily available – analysts quote their aggregate market expectations in earnings rather than cash. The short story is earnings are not cash. Earnings factor in non cash expenses like depreciation and amortization and don’t factor in capex, which is a real expense. Cash is king and what companies can use to buy back stock, invest in the business, pay dividends, make acquisitions, etc. Jeff Bezos wrote an entire letter on this that is a trillion times better than whatever I can say here and I recommend reading it.

All that said, averages are not a good statistic to look at when you don’t have a distribution where things are equally weighted. 7 stocks make up more than half of the S&P 500. TSLA is one of those stocks (valuation is totally speculative in my opinion), and the others are big cap tech, which is growing faster with more reliable cash flows than the average stock.

So 50% of the market is non-representative. In the other 50%, it’s worth noting that SaaS trades completely differently than financials or energy. The stocks that have come to dominate market discussion and even my podcast – names like CRWD, DDOG, SHOP, SNOW, TWLO, OKTA – are the exceptions now and not the rule. Thanks to Jamin Ball for this great graphic:


Just because a section of the market trades at ~50x sales does not mean the entire market is in a bubble. I urge everyone to be extremely wary of market opinions that don’t have supporting data and are clear about how this data is or isn’t representative. When people say “we’re in a bubble”, I think they’re talking about SaaS, crypto, EVs and other stocks that don’t have the cash flow to support big valuations.

Let’s compare all of this to one stock I’ve spent some time thinking about – AutoZone. The company based on its existing $32bn enterprise value (28.5bn market cap, 3.8bn net debt) and ~$2bn free cash flow ($3.1bn EBITDA – $1.1bn in capex, change in net working capital, cash interest and cash taxes) from the last twelve months has a 6% *trailing* free cash flow yield. It’s growing sales by double digits and opening new stores – management is paid based on its ability to open these new stores at high returns on equity. The forward free cash flow yield in my opinion would go to 10%+ in several years if the stock price remained the same because they will have more assets (stores) to collect cash from and are paying down debt (lower interest expense).

A 10% FCF yield you could think of a 10x P/E, with the important caveat that cash is distributable to shareholders and earnings might not be (additionally, P is only price and doesn’t include debt – a ton of companies use debt to produce earnings, and debt has to be paid back). In 10 years, AZO will have earned its entire enterprise value back in cash – the end result is that you, the shareholder, have an enterprise worth 2x as much assuming the cash is deployed in ways that aren’t value destructive.

In a drawdown where AZO’s ability to produce cash isn’t impacted (which is almost always the case in a technical market correction), the FCF yield goes even higher. If FCF draws down by 40%, your yield goes to 13% and payback period is now 6.5 years (note it’s not 1 to 1 with stock price because of debt being part of enterprise value). This is why buying great companies during drawdowns is so important – the cash necessary to pay you back as a shareholder gets smaller, and depending on the type of drawdown, the amount of cash the company produces doesn’t change.

You just can’t do this math with companies trading at 20x sales. You can definitely try to figure out ways they can get to a 10% FCF yield, but it’s going to take mental gymnastics and highly optimistic views of the future. If I recommend stocks in this newsletter that require those, please call me on it.

Overall, cash is what matters at the end of the day. No amount of headlines or general market forecasting matters when it comes to computing how much cash a company can produce. What does matter is doing the hard work at looking at financials and management commentary to create a picture of the future.

Happy trading,

Ben