As April 22 approaches and COVID recedes, I’ve started thinking a lot more about taxes and owning businesses for the long-term.
This newsletter started in April 2020, which other than the financial crisis in my lifetime has been the most interesting time to be a stock market participant. A lot of my pitches then and now were what I’d classify as trades due to market dislocations. The market got too bearish on Company X (throw in NCMI, CHEF, YELP) as it priced in staying at home forever. Alternatively, I’ve pitched COVID creating longer term tailwinds for specific businesses (NOW, AZO, TRTN) where the pitch is that a part or all of the business should re-rate.
I think there is a time and place for trades like this, but I’ve been thinking recently the best companies are the ones you want to own in any environment due to the certainty of cash flows long-term. Sure, price factors in a lot, and supply chain crises and pandemics will give you discounts in plain sight, but over a 20 year time horizon if a stock trades at $100 in Year 20, I’m not going to shed too many tears if I bought at $5 instead of $1 in Year 1.
While 20 year models probably are garbage, I have been considering how much the following question should weigh on my buy and sell decisions:
What is the probability in Year 20 this company could produce more cash in a year than what I bought it for?
This will be obvious to many readers, but this is effectively the value of P/E ratios. Something that trades at 20x tells you that if you use earnings as a proxy for free cash flow (which has its own issues I’ve written about before, but let’s table that for now), the company will earn more cash in Year 20 than what you bought it for. If it pays a dividend and the pay out ratio is ~30% (about the market average per this Wiki article in the 2000s), you’re getting $30 (20x $1.50 EPS) in dividends. For a flat stock price, this is the return of the dividend (1.5%):
If the company grows at 10%, this picture gets sweeter because bumps in EPS (which could come through more absolute earnings or buybacks) get you a higher dollar amount for the same payout. When you take growth to just 5%, your IRR increases to 2.6% on a flat stock price and your dividend in Year 20 is now 4% ($1.50 on dividend in year 1 versus $3.98 in the out year):
We’re nowhere close here to producing more cash in a single year than what you bought the stock here ($100 v. $13.27 in 2041 EPS), but if you buy the stock at 2.7x in year 1 you get there:
This is obviously a contrived example; there aren’t cos trading at 2.7 except in extraordinary value trap situations for the most part. However, let’s look at 7x (more realistic – TRTN cough cough) with 10% growth. Remember that growth doesn’t have to come from just more dollars in the door. I’m talking about per share growth, which means a 5% buyback and 5% in increased earnings dollars gets you 10% (not unrealistic IMO for TRTN):
This surprised me when I did the math:
A company growing at 10% for 20 years produces nearly more cash in Year 20 than what you bought it for if you buy it at 7x EPS. Somebody check me on that if I’m wrong, but the simple check I did here was 5*(1.1)^20 = ~35. Buying stock at $35 at $5 in EPS is 7x.
In that example, I assumed a flat stock price, which is stupid. No company except something in dire straights would trade at 1x earnings. What if we make the multiple constant at 7x?
My IRR now goes up to 15.4% from 10%. That is your yearly return for 20 years. The average return for the S&P is about 10%ish.
Once again, not breaking news, but buying companies at cheap multiples that can grow reasonably for 20 years pays huge. You’re getting a 29% dividend in year 20 on your original investment with a market average payout ratio. You are not relying on multiple expansion (re-rating).
My point here is investing doesn’t need to be complicated. It doesn’t require looking at box office results every week and doing a bulleted writeup of the movie industry or looking at freight rate movement quarter by quarter. If you can find companies that can grow reasonably (5-10%, remember share count counts for as much as absolute dollar growth) and purchase them at reasonable prices, you don’t need to rely on multiple expansion through re-rating. You can just bank on a return of cash to you through dividends + buybacks and the business being seen the same way as when you bought it.
The final thing I want to point out is if you can stay the course for 20 years, you don’t need to pay taxes for two decades (except on dividends – as an aside this is why all else equal I always prefer buybacks). Even better, if you can hold forever, you never need to pay taxes. I never want to be a forced seller and taxes are yet another annoying draw on liquidity. Let’s not pay em if we don’t have to.