Exclusive Partners Update
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1.1 Keeping an Eye on Your Money
June 7, 2021
I was recently speaking with a friend who commented that his financial advisor 'doesn't do anything, I don't know why I pay him.' I cannot speak to what exactly his advisor does, but it did get me thinking that I hope that my partners do not think the same of me. Isaac Newton's has a lesser-known law of physics - investment returns decrease as activity increases. He didn't really say that, but if he applied his massive intellect to capitalism, I am sure he would have arrived at that conclusion as well. Because I believe in that rule, I trade infrequently. After working in the boiler room known as Calamos Investments for more than a decade, my belief in this rule has only been reinforced after leaving that awful place.
I decided to start a quarterly newsletter that is for my partners only. There are dozens of readers on my monthly newsletter however I am reserving my best work for only those who trust me with their money. I believe an advisor should have skin in the game and that we should share a common destiny. Therefore, I intend to be fully transparent with my investments and that our portfolios be closely aligned while adjusting for each person's risk tolerance. You may not have my exact portfolio at this time and that is because while I hold certain companies, I presently do not believe they are worthy of investment at current prices. I watch these businesses very closely and will not hesitate to purchase additional shares when the time is right.
Wills Family Portfolio as of 5.31.21
*Total Return is an approximation - weights have varied slightly over the past year across several accounts
Verizon (VZ)
Why Own Verizon?
Verizon is in the portfolio as a proxy for bonds. The Vanguard Long-term investment grade bond fund has an indicated yield of 3.30%. Bonds carry two risks: first, the loans are defaulted and you do not get your money back. Second, and larger risk is rising interest rates. When rates go up the price of bonds goes down. Through the first quarter of the year the Vanguard bond fund is -9.56%. If rates hold steady from here, investors will make up for their losses in about three years. We purchased Verizon because of its 4.5% dividend yield and stable free cash flow generation. I estimate Verizon is capable of producing $4.65 a share in cash flow which works out to about 8.5% yield. So, we have a stable business with an estimated 8.5% cash flow yield with the potential to grow with the proliferation of 5G service vs. investment grade bonds with a 3.30% yield that will not go up unless rates go higher but that will bring more losses to the principle.
What Will Make Our Investment in Verizon Work?
Verizon needs to keep growing its earnings a few percent per year and our investment will do just fine. This can be achieved by growing subscribers, increasing price and adding new services. AT&T, T-Mobile and Verizon have all made the decision to make 5G service only available on their highest tier plans. Currently 35% of users are not on an unlimited data plan and only 25% are on the premium unlimited plan. When consumers upgrade or choose a new service the majority have chosen the top-tier plans driving a 1-2% lift in revenue per year. Growing subscribers is more challenged with cellular service reaching saturation. The pandemic has brought a shift to a mobile workforce which in turn may drive more corporate subscriptions and mobile hotspots. 5G service will bring numerous new use cases such as 5G in-home wireless broadband.
How did Verizon the business do this quarter?
I would consider Verizon's performance this quarter as mediocre. Earnings grew 4% year-over-year consistent with our required growth rate however they posted a loss of 178,000 wireless subscribers. Earnings growth was driven by consumer upgrades to higher-tier plans and adoption of broadband services. In isolation the results were reasonable however AT&T posted 823,000 new wireless subscribers over the same time period aided by an aggressive new phone subsidy program. Verizon management made it clear they did not intend to respond to AT&T's promotional program with equally aggressive measures. And yet a month later they did exactly what they said they wouldn't do, smartphones are free again at Verizon. Cutting prices to attract customers in a low growth oligopoly industry structure can have destructive consequences for all parties and requires careful attention. In business, you are only as smart as your dumbest competitor. For years, I have regarded the management at AT&T as dumb as you can get, they have masterly turned dollar bills into 75 cents over the past decade. Look no further than the company purchasing DirecTV for $67 billion and selling it a few years later for $16 billion. The recent sale of Time Warner four years after its purchase is yet another sign of their stunningly low IQ. Careful attention is required to these developments and if the 3-4% earnings growth outlook is threatened by the subsidy program, we may have to cut bait.
Key Risks to Monitor
- Loss of subscribers to AT&T and T-Mobile: Verizon has a reputation of having the strongest nationwide network thanks to its aggressive 4G LTE investments over the past decade. With 5G, it is currently in 3rd place with T-Mobile in the lead and AT&T rated second. Verizon is working to bridge the gap and recently purchased half of the 5G spectrum the US Government made available for $45 billion.
- Dish Network: Dish network has been acquiring spectrum over the past few years and claims it can create a 5G nationwide network for a fraction of the cost of what Verizon, T-Mobile and AT&T have spent. Dish Network is still in the assembly phase and is targeting a launch in 2023. It remains to be seen if Dish will be successful and if they are we will likely exit our position. However, the threat is not immediate, customers are slow to change carriers and an unknown network/brand will take time before materially impacting the three main carriers.
What is Verizon Worth?
I estimate Verizon is worth $60 a share which is based on my outlook that cash flow generated by the business will grow 2-3% per year. If 5G service is successful in creating new revenue streams and cash flow grows 5% per year, I estimate the value of the business could go as high as $70 per share. Conversely if competition with Dish Network and the other carriers increases and earnings do not grow the stock could fall to $35 per share. These valuation scenarios take into consideration the proposed tax increase by President Biden.
How did it perform?
Since the purchase in the first quarter Verizon stock is +1.16% through May 31st. The return is inclusive of a $0.63 per share dividend and we are due to receive another in a month. This compares favorably to the -3.89% return of investment grade bonds. This investment has performed in line with expectations thus far.
Berkshire Hathaway (BRK.B)
Why Own Berkshire Hathaway
Berkshire Hathaway is the conglomerate run by Warren Buffet. I think of it as an index fund made up of businesses that are better than the S&P 500 on average. Until recently following a 45% increase in the stock price over the past 12 months, I thought the company was trading at a valuation well below my estimated fair value. There are a couple of structural advantages the business has built over the past 50 years that will be difficult, if not impossible to replicate. Within Berkshire's collection of companies, there are some that are thriving, some that are mediocre and some that are declining. Because they are all held under a single umbrella, Berkshire can take the cash from the average and underperforming businesses and invest in the growers without incurring taxes. For the rest of us who want to take the cash out of one busines and invest in another, we would incur capital gains or a dividend tax. This allows Mr. Buffett to earn a few extra points of return per annum and has helped him achieve the greatest investment track record in history.
The business is also operated very conservatively, typically holding more than $100 billion of cash. When the economy runs into trouble and large companies need money, Omaha and Washington DC are the only two places they can go, and DC typically won't listen until a call to Omaha has been made. Berkshire's cash reserves and sterling reputation allowed it to acquire Burlington Northern Santa Fe Railroad and issue tens of billions of dollars of loans to GE, Goldman Sachs, Bank or America, Harley Davidsons and Mars Candy at loan shark rates. To me Berkshire Hathaway is the business equivalent of the hydra monster from Greek mythology. When Hercules cut the head of the hydra monster, two grew back in its place. When trouble emerges in the economy or the stock market, Berkshire emerges stronger.
Key Risks to Monitor
- At age 90, we have to accept Mr. Buffett will not be running Berkshire Hathaway for much longer. Although, he jokes his successor has a Ouija board. I am sure the stock will drop upon his passing; however, I do not believe there presently any "Buffet Premium" in the share price. If the stock falls too far, you can count on the company using its war chest of cash to repurchase shares.
- Competition for investments - With the enormous monetary and fiscal stimulus, the market is awash with liquidity making it harder for Berkshire to invest its capital at attractive rates.
What is Berkshire Worth?
After making Berkshire the largest single position in my portfolio earlier this year, I no longer feel it is a bargain. I will be curious how much stock Warren Buffet will have bought over the past few months in the next company filing. My current fair value estimate for Berkshire Hathaway is $275 per B share. For the past few years, I have been able periodically purchase Berkshire shares at a 10% discount to my fair value estimate. The company is expected to make approximately $27.5 billion this year. My valuation factors a 7% hit to earnings in 2022 for the proposed Biden tax increase and growing a conservative 3% annually afterward. The company has a $300 billion stock portfolio which contains $115 billion of Apple stock, $45 billion of Bank of America, $25 billion of American Express and $22 billion of Coca Cola. Essentially each share of Berkshire contains 1/5th of a share of Apple and 1/20th of a share of Bank of America and so forth. Add in $165 billion of cash and subtract out its liabilities and I get an all in valuation of $630 billion vs. the current $670 billion market cap. Because there are so many pieces to Berkshire, it is a difficult business to value. My valuation and purchases have been coincidentally aligned with Mr. Buffet's buying patterns.
How has it Performed?
Through May 31st, Berkshire is up 24.83% well above the 13.3% return for the S&P 500 over the same time period. Mr. Buffet has purchased $29.5 billion of Berkshire stock over the past 12 months. While Berkshire was repurchasing its shares, the stock has risen 46%, again besting the 34.5% return for the market.
Apple (AAPL)
Why Own Apple?
This one is simple, ask a teenager if they would rather give up their smartphone or their car. The iPhone has become an integral part of our daily lives and it keeps getting more and more engrained each year. With more than 1 billion iPhones in active use we can make reasonable assumptions about how often they will be replaced/upgraded and see that Apple has a steady stream of cash coming in for a very long time. Add in iPads, computers, watches, airpods and apps with its large network of users and see the captive users base that will generate more sales each year.
Key Risks to Monitor
- Antitrust: With great success comes jealousy and criticism. Apple is actively litigating a case to break up its App Store and is being investigated by the Department of Justice along with the other tech giants (Amazon, Google and Facebook). Antitrust regulations is in very early stages and often takes several years before a settlement is reached. It is far too early in the process to be able to accurately assess any potential impact.
- Taxes: The devil is in the details of the tax proposal from President Biden. While the headline has an increase to 28% from the current 21% is still well below the 35% prior to President Trump's tax cut. However, within the proposal is a doubling of taxes on international income which could result in a tax bill 4x greater than the amount Apple saved from the Trump tax cut. The US is the only country in the world that taxes international income, a doubling of the overseas tax rate is a big deal.
What is Apple Worth?
I think a fair valuation for Apple is $120 and that is factoring in a higher tax rate for both the Biden administration and globally. That assumes Apple continues to earn around $100 billion per year in the future. $100 billion dollars of annual profit seems like a ridiculous number that is hard to grasp, and it is. But we need to break it down. Apple has 1 billion active users and 1.65 billion active devices. If we assume the average users upgrades their phone every five years that generates $175 of revenue per user per year which works out to 60% of Apple's device revenue. The 650 million installed base of computers, iPads and watches generates approximately $112 of revenue per user per year. Add in another $70 per user for software and services, think about the revenue generated from apps, cloud storage, Apple care and its subscription services. With Apple's 22% average profit margin over the past decade suddenly $100 billion seems very achievable and we are not factoring in any new products the company will inevitably become a must have for its user base. The biggest risk is an anti-trust breakup of Apple's app store. It is really hard project what would happen but let's hypothetically assume they have to cut their 30% take-rate of apps to 15%. With a very rough estimate because Apple does not disclose its revenue from 3rd party apps would result in a loss of $17 billion of revenue. This would drop Apple's valuation to $100.
How did it Perform?
Apple stock is down 5.6% through May 31st which has underperformed the +13.3% return for the S&P 500. Over the past 12 months Apple stock is +52.9% vs. a 34.5% return for the S&P 500. The recent underperformance has put Apple high on my list of companies to buy.
Amazon (AMZN)
Why Own Amazon
I live in a small town in the mountains that has a grocery store, a gas-station, a liquor store and a casino (it is Nevada). If we need something that doesn't fit into those four categories, or we don't want to pay the mountain prices it means we need to gather the family and go-over the mountain to Reno, or we order from Amazon. I have noticed since the start of the pandemic firsthand at our post office the growth of Amazon. We are no longer allowed to enter the lobby of our post-office because it is filled with Amazon packages. The post-office has run out of storage space and the new protocol is to walk in the front door tell the clerk your PO box and they bring your packages outside.
The business model is to provide a vast selection of goods at cheap prices with fast convenient delivery. I doubt consumers will ever want the opposite. While Amazon is mostly known as a retailer, its computing service is even more valuable. Amazon Web Services (AWS) has similar economics to the retail business. A disproportionate share will be aggregated to the company with the most scale. After building out an enormous IT infrastructure to support Amazon.com it started offering companies access for a fee. The result was an entirely new industry that as changing the tech landscape. Any company now has access to world class IT systems via the internet for a fraction of the cost it would take to build the infrastructure themselves. As AWS has grown, the scale has resulted is a decline in the cost of operating the business. Amazon has in turn passed a portion of the scale benefits on to its customers through more than 50 price cuts over the past 15 years. Few businesses can compete with Amazon on cost and functionality, Microsoft, Google and Ali Baba that is about it. Because Amazon started the industry, its lead is considerable over these firms.
Build scale, lower per unit costs and pass a portion on to the customer. Amazon's extreme focus on delivering value to the customer is a very difficult model to beat.
Key Risks to monitor
- Like Apple, success brings jealousy and criticism. When a previously successful business finds itself hopelessly outflanked by Amazon, the last resort is to bribe - oops I mean donate to a politician. Amazon is presently facing a lawsuit over its policy requiring 3rd party sellers, utilizing its logistics service, to set prices on Amazon's site equal to or lower than other sites. Amazon's policy, using some backward logic, is considered detrimental to the consumer according to an attorney general in Washington DC.
- I'll repeat a section of Jeff Bezos' latest letter to shareholders about their anticompetitive behavior.
- "Customers complete 28% of purchases on Amazon in three minutes or less, and half of all purchases are finished in less than 15 minutes. Compare that to the typical shopping trip to a physical store - driving, parking, searching store aisles, waiting in the checkout line, finding your car, and driving home. Research suggests the typical physical store trip takes about an hour. If you assume that a typical Amazon purchase takes 15 minutes and that it saves you a couple of trips to the physical store a week, that's more than 75 hours a year saved. That's important. We're all busy in the early 21st century."
- "So that we can get a dollar figure, let's value the time savings at $10 per hour, which is conservative. Seventy-five hours multiplied by $10 per hour and subtracting the cost of Prime gives you value creation for each Prime member of about $630. We have 200 million Prime members, for a total in 2020 of $126 billion of value creation."
What is Amazon Worth?
The present valuation of Amazon implies the company will hit $1 trillion in sales in the next 6-7 years and generate more than $100 billion a year in cash. Amazon's growth over the past decade has been phenomenal and accelerated last year in the pandemic. I have a difficult time grasping how the company will go from $390 billion in sales last year to $1 trillion over the next 6-7 years, but if anyone can do it is Amazon. I would not add to Amazon at this time, my level of conviction, the $1 trillion sales hurdle can be achieved, is not strong enough to justify adding additional capital.
How did it Perform?
Amazon stock is down 1.5% through May 31st which has underperformed the +13.3% return for the S&P 500. Over the past 12 months Amazon stock is +29.1% vs. a 34.5% return for the S&P 500.
Lam Research Corporation (LRCX)
Why Own Lam Research?
Lam Research might be my favorite business for a very simple reason. Every year people consume more and more data, and that data needs to be stored on memory devices. Lam Research has a near monopoly on the machines that make memory chips. The company estimates it has >90% market share of all flash memory and greater than 50% of all DRAM memory. On top of that the company has been steadily taking market share with logic semiconductors. In short, you basically cannot make a semiconductor without Lam Research. Why is that? The degree of precision needed to make a semiconductor is almost unfathomable, today's leading chips can fit 6 million transistors in a space the size of the period at the end of this sentence. Once a piece of Lam's equipment is placed into service, it will never be replaced by another vendor locking in a lucrative parts and service business.
The shortage of semiconductors provides a very favorable backdrop for LRCX. For more than a decade companies kept minimal inventory of chips on hand and when the pandemic caused disruption to chip manufacturing, an acute shortage has resulted that has idled auto and electronics factories worldwide. Orders for Lam's equipment are at record levels and the growing nationalistic attitude in the US and Europe could bring strong demand for the next few years.
Key Risks to monitor
- Trade Dispute with China: China accounts for approximately 30% of sales and the US has prohibited sales of leading semiconductor technology to certain Chinese companies. The Trump administration took a hard stance, that has been mostly adopted by the Biden administration. To date the blacklist has not had a material impact, however if the dispute escalates, LRCX runs the risk of losing a major revenue source. While it would be disruptive, I am not overly concerned about a more restrictive ban. Demand for data, memory and semiconductors keeps marching higher and Lam's machines needed to fill that demand will be purchased by someone.
- Lam's customer base is highly concentrated, and the business is prone to boom-and-bust cycles. The stock can sell off sharply when demand ebbs. That will likely be a buying opportunity. I watched LRCX stock for years before making a purchase. Some of you do not own the stock, patience is required, we will buy when the time is right.
What is Lam Research Worth?
I think a fair value for LRCX is $550 which does not compare favorably to the current $650 price. My $550 estimate assumes LRCX will grow its revenue 5% per year over the next decade. I use 5% growth, because semiconductors have historically grown a couple percentage points above GDP. LRCX is a volatile stock, and it presently is on a large upswing with valuation implying sustained sales growth of 10% per year for the next decade with record profit margins. I would not be a buyer of the stock at these levels but would not sell either. I waited years for the opportunity to purchase LRCX and think selling it because it’s a little overvalued would be a mistake.
How did it Perform?
LRCX stock is +39.1% through May 31st which has outperformed the +13.3% return for the S&P 500. Over the past 12 months Lam stock is +117.6% vs. a 34.5% return for the S&P 500.
