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This week’s Fund Manager interview is with our friend Alex Pollak, the Chief Investment Officer and Founder of Loftus Peak.
Alex is specialist in investing in disruption, but I thought it was worth talking to him because obviously there’s been a lot of volatility lately; a big correction last year, and a terrible December. Most people have been describing that as due to either the US-China trade war or the Fed tightening monetary policy, but actually really a lot of the run-up before the correction was led by the big tech stocks of America.
They have been leading the correction and they’ve also been leading the bounce since Christmas, and so I thought it was worthwhile talking to Alex about how he’s seeing it and what stocks are doing well and how do we think about 2019 in this context.
A very interesting conversation now with Alex Pollak, the Chief Investment Officer and Founder of Loftus Peak Investment Management.
Alex, in a note recently you talked about the volatility that we’ve been seeing obviously for quite a while now. And you said it’s the longest period of volatility since the financial crisis, 2008. But you’re saying that it might be pointing to other issues rather than a crash, what are the other issues?
Well, I’ve delved a little further back into this – actually, it was the worst December since 1931, if I’ve read the Wall Street Journal correctly. But I think we’re moving out of this kind of love affair with disruptive companies right now. I think part of what’s going on is that we’ve got a number of floats coming up this year like Airbnb, Uber and Slack and a few others. I think the market is now kind of reassessing which companies have actually got viable business models, which companies are just disruptive for the sake of being disruptive and may or may not survive.
The case in point actually that I think is really interesting is Snapchat, which raised a bunch of money 18 months ago and is chewing through that money without actually having found a clear monetisation model yet. I think that and companies of this ilk have spooked the market a little bit. And so we’re seeing this now recutting, reweighting by the market where they’re saying, “Okay…” What it’s pointing to for me is this kind of decision by the market to cut those companies that are actually not viable because they haven’t kind of got their cash flow models working from those that are viable. Maybe their cash flows are not as high as they could be and maybe they’re overrated in terms of the pricing, but from those companies where the cashflow is actually coming through and I think we’re seeing a little bit of that happening right now.
What have you learnt in the bounce that’s occurred since Christmas Eve? Is it as simple as the companies that have cashflow are okay and the companies that don’t are not? Is that about as simple as it is or is there more to it?
It’s that, it’s absolutely those that have got cashflow and those that don’t. Then, for those that do, how much should we price it at? What are the multiples and what are the kind of discount rates we should use on the cashflow? But the market is now kind of saying, if you don’t have a cashflow model now, you’ve kind of missed the cut, so I think it’s that simple right now. If you get a rollicking run-up in the equity market that runs for four or five months, then as they say, even a turkey will fly in a following gale, and some of this stuff that looks pretty risky might have pretty big bounces up. But I think the market is kind of going, no, some things are not going to survive and we need to be on the right side of that.
Their biggest performer, the biggest rise since Christmas has been Netflix, which is up 50% or something – amazing! I mean, it is true that some of the others like Facebook, Amazon, Apple and so on have done pretty well, but Netflix has taken off.
I put all of those other companies except Netflix in that basket that I talked about before. Netflix is, in my view, in a slightly different category, where it is a dawning realisation on the part of the market, that the game that Netflix is really playing is the disintermediation of free to air television on a global basis. If you think about how important free-to-air television has been and cable television, so everybody in the world for the last 60 years, the game that Netflix is playing is actually one where they are basically chopping the entire valuations of any free-to-air licence to zero and harvesting all that value themselves.
Netflix is such a potentially high-growth business that people are saying, “Well, it is going to survive, it’s clearly got a monetisation model. The question is, just how much should we price it at?” Then, the second thing that came about was – and you don’t want to get too inductive from one example, but this movie, Birdbox, which is interesting – not a great movie, Sandra Bullock movie – had 45 million downloads in the first week out of a subscriber base of 150 million. I mean, if it was a movie that was released in cinemas like say, Avatar was, it would be a top 10 movie of all time, so it kind of is pointing to the power of the production company behind Netflix as a driver of subscriptions and the stickiness of those subscriptions because it’s just such a superior product.
$15 bucks a month for Netflix – they’ve just raised prices. Netflix, as most people would already know, is a vastly superior proposition than $110 dollars a month for a cable TV channel. It’s just way, way above in terms of quality. If Netflix solves for sport and news, and I think they’re certainly going to solve one of those things in the next five years, then there’ll be more than one Netflix. We used to be a bit negative on this but there’ll be more than one Netflix. There’ll be an Amazon Prime and there’ll be Netflix and there’ll be a couple of other sites. But the market, given that it’s disintermediating free-to-air television globally, is more than big enough to support half a dozen players.
We are going into a world where televisions themselves will be smart and have operating systems. They used to be, as it were, just dumb terminals, and in a world where televisions themselves have operating systems, it’s app-first, not channel-first. There’ll be half a dozen apps, Netflix will be one, Amazon will be another that dominate. I think one of the Netflix people recently said the most important challenger to Netflix actually is Pub G, which is the Tencent game where you get 45 minutes and you land in a plane – it’s a phone game, massively popular.
Right. I mean, you spent a lot of your life as a media analyst for Macquarie, and so you’re pretty familiar with what happens with disruption obviously, having seen it going on in media. Obviously, that is informing your view of Netflix and what it’s doing to free-to-air TV. But also, I presume it’s informing you of your general view of disruption as well?
Oh yes, the disruption that it started with, classified advertising and newspapers and stuff, has moved through television with Netflix, moved through retailing through Amazon, is moving through into the next big phase which is really about the use of the cloud as a kind of mechanism to speed things up.
It seems to me possible that what you learnt as an analyst at media companies is how difficult is it for legacy companies to incumbent companies to deal with disruptors.
Yeah, yeah, that’s exactly right. The way this works – and it’s just such a well-worn playbook, right – is it that boards and managements have specific remuneration policies by which they are going to pay their people and get paid themselves over the next two or three years. And so they inevitably get faced, when they see a new kind of model come through, with this idea about whether they should continue on their old model and that will get them paid and their immediate people paid, etcetera, or whether they should allow themselves to be cannibalised with the new model, which will take revenue away from their main business, so to speak, and suck value out of that main business, while at the same time, in the new business that they’re creating, not sufficiently creating enough value fast enough. This is the classic problem that the car companies are falling into, the banks are falling into, the retailers are falling into.
In the end, you wind up in this situation where you have to double-run your organisation. You have to run the old model with all the old costs and you have to pay all the people in that way, but the new model that you need to run because of disruption sucks customers and revenue out of the old model but you don’t get credit in a valuation sense for what is happening on the new model at the same rate. That is the classic problem that all these companies are falling into and that is why it is so difficult for 99% of companies to disrupt themselves.
If not impossible, Alex?
Actually, I almost have never seen it, and I have been looking for a very long time, I’ve almost never seen it.
The question is, what do investors do as we begin 2019? As you say, we’ve had all this volatility, some of it’s gone up. Do we simply say, “Okay, well, disruptors have got cashflow, yes, tick; disruptors that don’t, it’s a cross”? I mean, surely that’s a bit simplistic because in some cases it’s just a matter of timing.
It is pretty simplistic actually. They don’t have to necessarily have a lot of cashflow. There’s a continuum there, right? You might have just got to scale and so your cashflow – and Tesla’s a classic example, you’re just getting to scale and you’re just moving from negative cashflow to positive cashflow. But it does ultimately boil down to whether there is an acceptable and a visible cashflow model not necessarily at this moment but clearly visible within the next 12-18 months. Then the critical question is how you price it.
That is the whole game right now, the whole game is who will survive and how do we price them? Because we know that companies are not going back to diesel engine cars, we know that companies are not going back to chopping down trees and distributing newspapers. We know all those things are gone, the question is, how should we price the things that are going to replace them and which ones of those things will be viable?
What’s the answer, Alex, how do you go about pricing those companies?
Well, that’s what we spend all our day doing, is looking for datapoints to understand what the pricing could be and should be and trying to work out the comps and attach discount rates and scrutinise the balance sheets and understand the measurement and the regulatory framework in which they operate. That’s what we do, that’s what asset managers do. We find the stuff that can work and will work, and work out how to price it and move forward.
But I presume in engaging in all that process, that the normal rules of PE, that is to say, is it a premium to the market PE, how much is the premium and that sort of thing, don’t really apply?
PEs are an incredibly blunt instrument. You really need to put all your energy into multi-year cashflows. You need sort of five, six, seven-year cashflows. I’ve said this before and it’s the way we operate, we look at companies like, if we take Apple for example, we know that the smartphone market is declining, or at least it’s not growing. Therefore, we expect that Apple’s revenues in the next five years are not really going to grow. So, we sort of have a picture of what the revenues are going to do and we can make certain assumptions about what the cash flows are going to do, what the profits are going to do, what the capex is going to do, etcetera, etcetera…
That’s one thing that we can – but then there are other companies in there, for example, like Nvidia, where we see that their revenue growth because of what is happening in the world in data centres, is going to be 30% this year, 40% next year, 50% the next year, and then maybe in three or four or five years it will start to decline, 40%, 30%, 20%, 10%… That’s a very different revenue curve, and so when you look at the kind of inputs at that level, then you can make certain assumptions about the way the cashflows are going to work out of that and what the reinvestment rate is. You know you won’t be right because it’s impossible statistically to be right, but you will get a closer picture through using the discounted cashflows over four or five years of what these companies are actually worth.
Using a PE, you get less with this thing about, well it’s on a PE of 10 or 20 or 50 or 70 – those things don’t mean anything because it’s not about the PE, it’s about the growth that the company generates year on year on year. The company might be on a PE of about 70 today, but if it’s growing at 100% per annum, it’d therefore go from 70 to 35, to 17.5, to 9. So it’s kind of meaningless to then sort of say, “Well, it will be on a PE of 9 in four years’ time.” You’re much better off having a look at what you think the revenue curve is going to be over a protracted period of time, sucking out the costs and the capex and the cashflow, and then appropriately discounting it back by the use of the discount rates, etcetera, etcetera… That’s the way we do it, that’s our process.
You mentioned Snapchat at the start of our discussion, our chat, and I just wondered in looking at a company like that, which as you point out is having trouble finding a monetisation route, do you at some point just say, “Well, it’s never going to do that.”? And does that apply to companies like Twitter and Square and so on where they’re certainly having problems?
No, no…
Do you just kind of say, “Well, okay, we’ll just write them off, they’re never going to get there”?
No, no, you’ve got to watch them every moment of the day – certainly on a quarterly basis, but more frequently than that – because companies like Snapchat can find a monetisation model in a quarter and they’re off to the races suddenly. If you look at Amazon as an excellent example, four years ago they just started rolling out this cloud-based services business and before we had any numbers on it, we knew we could see because we saw the number of corporates on a global basis that were adopting Amazon web services as a core. Netflix used AWS as the mechanism to store and case all its movies and distribute all its movies. We saw the use of AWS and in a matter of a quarter, they then disclosed that they had revenue of a billion dollars in a quarter which was growing at 100% per quarter ongoing, and the stock jumped literally 25-30% I think it was over the course of two or three weeks.
You can’t just write them off, companies can find cashflow models, and if Snapchat finds one and we need to watch that, then that will turn and that’s the business that we’re in, right? You have to be alert to the fact that you don’t write these companies off, they’re not dead, you continue to watch them because if you pick up in the quarterly cashflow statement that all of a sudden cashflow turned positive, it might look flat on the previous corresponding period and flat sequentially. But if you look at it closely, you can tell that in the last six weeks of that quarter, that it turned up off a previous trajectory, that’s your answer, right? That says, “Right, we need to be in that now.” Let’s be careful not to prematurely write things off, but that’s the game.
To what extent do you think that the volatility we’ve seen and the correction in October in particular and the terrible December and all that, to what extent was that all to do with what we’ve just been talking about? Because there’s a lot of commentary that, “Oh, it’s about the trade war between the US and China…” and, “It’s about the Fed maybe putting up interest rates…” and so on. Do you think what we’ve just been talking about, this technology thing, is really underlying it all? Because it was the tech stocks that led the rally.
Yes, I do think it’s about… Like I said, we’re not going back to a world where people throw your newspaper over your front door, we’re not going back to a cable-first bundle of channels at $100 dollars a month, we’re not going back to any of those things. There’s that, then the second things is, fundamentally the Chinese who are playing the long game of course, will wait Trump out in the end, because he’ll come and go and his policies will come and go, and even to the extent that there are operatives within the civil service in the US, they will be ensuring that things are kept going, secondly, and the Fed of course doesn’t want to bring this party to an end prematurely so there appears to be a moderately robust recovery in the US, and therefore, globally, led by a movement towards the new world paradigm.
I’m always careful about the phrase, ‘new world paradigm’, but because of everything that we know about the way business is run and all those things that we’ve just talked about, fundamentally the US is sound, interest rates are not in a hurry to go up, technology is going to fuel the next wave of change and that’s clear, the Chinese will out-wait Trump and there is really not actually that much to panic about. It’s probably likely in 12 or 18 months, interest rates won’t be all that much higher than they are now. Therefore, it’s going to be a carefully managed process globally.
We’ll leave it there, thanks very much, Alex.
Thanks, Alan.
That was Alex Pollak of Loftus Peak.
END OF TRANSCRIPT
The following interview was first published on https://www.investsmart.com.au and has been re-published with permission.
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