NEWS
Roku Ain’t Broku, Just a Tad Overvalued
Roku (NASDAQ:ROKU 126.25 -0.24%) is a name effectively synonymous with streaming. Controlling approximately 39% of the streaming box market, according to data from Parks Associates, it’s the clear leader in the sector, and when combined with Amazon Fire TV, the runner up, it accounts for almost 70% of the installed base of streaming media players in the United States.
Roku has had a whirlwind year. As a proxy for the health of the streaming market, it’s up approximately 175% since the end of January 2019 as consumers cut the cord and move towards streaming. But the company has had other kinds of ups and downs throughout the year. When Apple (NASDAQ:APPL) announced its aggressive Apple TV+ pricing, Roku’s stock plummeted almost 30% throughout September as investors wrongly thought that Apple TV+ would be a walled garden exclusive to iOS -- when in fact it’s available on all platforms.
NEWSLETTER
Summer 2020
June 29, 2020
In our previous newsletter, we spent some time discussing our inclination over the past few decades to make investments in what we believe to be strong secular trends. We continuously develop and evolve our convictions regarding ... READ MORE
Pace of Change
May 26, 2020
It seems almost ironic that our last newsletter was sent to you on Friday the 13th in March. The topic of that communication is now all too familiar to anyone living on planet earth with even modest access to media and/or a facemask ... READ MORE
Our Approach to Coronavirus
March 13, 2020
As of the writing of this newsletter there were 3,967 deaths caused by Cornonavirus around the world. Of those deaths, 3,120 have been reported in China. According to a study done by Medicine Net, approximately 646,000 people die globally from ... READ MORE
The Most Powerful Force in the Universe “Compound Interest”
February 25, 2020
Albert Einstein once said: “Compound interest is the most powerful force in the universe. It is the eighth wonder of the world. He who understands it, earns it; he who doesn’t ... READ MORE
Observations on International Investing
February 10, 2020
Over the years, clients who have participated in our Focus Equity strategy have come to realize that on the surface, our portfolio does not check all of the typical diversification boxes that many asset allocators prefer. We have never invested for the sake of diversification ... READ MORE
Many Reasons to be Thankful
November 25, 2019
This week we all give thanks. We are thankful for many things; it has been a record-breaking year at Spence Asset Management, our hard-working team is healthy and happy, and our client base is larger and more loyal than ever. We are also thankful for ... READ MORE
Major Price Changes
October 01, 2019
Last week we received news that should reduce the cost of investing for our clients. In addition, thanks to these new efficiencies, we will be able to explore a broader array of sensible investment choices ... READ MORE
Summer 2020
June 29, 2020
In our previous newsletter, we spent some time discussing our inclination over the past few decades to make investments in what we believe to be strong secular trends. We continuously develop and evolve our convictions regarding secular trends. Entering 2020, we already had commitments to what we believed were investable trends that were in place long prior to the Coronavirus outbreak. We also suggested in our last communication that many of the trends we were committed to appeared to be accelerating. This is particularly true of the aggregate demand for remote inter-connectivity, cloud-based computing, and improved mission critical data management. The outbreak of Coronavirus has made these areas of interest more urgent priorities for consumers, governments, and businesses alike.
Coronavirus pandemic or not, in managing your money, we have three central challenges. Nobody gets these challenges right 100% of the time, but we need to get it right more than we get it wrong. In 2020 these challenges have become even more imperative but also much more difficult:
1. Decipher between what is temporary and what is permanent
2. Decipher between what is noise and what is relevant
3. Decipher between luck and discipline
Is it Temporary?
It is important to understand we have identified many successful investments over the years by identifying and avoiding “popular” but “temporary” phenomenon. Trendy has never been our game and likely never will be. Trying to identify the next great dating app or the “must have” shoes for teenagers next year could not be further from our wheelhouse.
However, “temporary” can also be a friend to investors. From February 2020 until the third week of March, the markets under-delivered. This was due to widespread fear and panic. Back in March, we offered reminders that the widespread fear and panic we were seeing, was in fact, a long-term investor’s best friend and would likely subside. Temporary created opportunity.
One of the great ironies of successful investing is that while fear and panic produces incredible investment opportunities, exuberance and unbridled optimism regarding any market segment does diminish performance opportunities in the short run and can also be transient. Here is where we find ourselves today. Some might say 2020 has been a little “too good.” So, while we are pleased with our 2020 results thus far, we are tempering our near-term expectations for the time being.
Is it Noise?
The media can also be a friend to an investor bringing notice to companies whose stocks are performing well, encouraging even further price appreciation. But often what the media brings to the investment community is a whole lot of noise.
We find it easier to comprehend the “impact” of the whims of the news media rather than predict them. Media reporting on secular trend accelerations have not been lost on the reporters and anchors in the financial news media over the last three months. Accordingly, as we watch this odd period in history unfold, we are reminded of the remarkable proliferation in financial news broadcasts during the last few decades. News networks dedicated to covering the financial markets now broadcast information to consumer/investors practically 24 hours a day, seven days each week. If one is interested in information regarding financial markets, the ad-driven TV vendor choices include CNBC, Fox Business Channel, Bloomberg, and Cheddar. There is simply more financial information and so-called analysis available on television now, than ever before. When taking into consideration the mountains of information available on the internet and from subscription-based publications, investors are literally swimming in a sea of sometimes relevant, but mostly irrelevant, information. Deciphering noise from relevance has never been more onerous.
Considering all the positive media interpretations regarding areas of the markets where we have made significant commitments, we have no plans to alter our methods simply because many of our companies have become “popular” with the media. We expect this to occur from time to time, however, it rarely happens as rapidly as it has in 2020. As we look ahead to the third and fourth quarters of 2020, we are inclined to be somewhat more cautious about the short run.
Is it luck?
The stock market, over time, does an excellent job of humbling even the most brilliant investors. It is easy to extrapolate short- term success infinitely and attribute a few surprising pops in a stock price to investing prowess. However, short-term success often draws investors away from their core discipline and philosophy which can ultimately be very costly. As Warren Buffett often says, “Once the tide goes back out, you see who is swimming naked.” When market volatility subsides and investors return to watching the fundamentals of sectors and individual companies, those who abandoned their discipline will be greatly impacted. Those who got lucky will be suddenly feeling very unlucky.
Therefore, when it is most difficult to stick to your core philosophy is when it is most important to do so. It can be tempting to wade into dot com companies with no revenue, no profits, no competitive moat, and a very green management team when everyone else is. It can be mouthwatering to see energy companies and cruise companies trading for pennies on the dollar. But these are the times it is most crucial to stick to the investing tenets that have brought us success for 20 years, not for 20 days.
Is it realistic?
We have one additional challenge when it comes to managing your money and that is managing your expectations. Sometimes, when we are in the right companies for the long run and there is an abrupt recognition by the media of the trends these companies address, our investment performance rewards can come extraordinarily fast. This has been the case since the third week of March 2020. We find ourselves in an enviable position. While in the aggregate, the financial markets have experienced extraordinary turmoil in 2020, we are grateful that our mature Focus Equity accounts have, by and large, bucked strong overall market headwinds and registered exceptional results. And with this reality, we feel it is important to recognize that grossly out-sized short-term performance rewards are quite unsustainable.
Since we understand the fickle nature of the “short run,” our methods will continue to center around our core beliefs regarding long-term secular trends. We are laser-focused on identifying companies benefitting from secular trends that are investable. We do so while understanding the short-term whims of the markets constantly provide psychological obstacles. Because fickle markets can either over-deliver or under-deliver performance for our accounts, we remain committed to psychologically girding ourselves against reacting to what is temporary and what is noise. Despite unprecedented times, we will remain steadfast in our discipline. But in the short run, be prepared for a volatile ride. And, as always, we are honored to be on the ride with you.
Pace of Change
May 26, 2020
It seems almost ironic that our last newsletter was sent to you on Friday the 13th in March. The topic of that communication is now all too familiar to anyone living on planet earth with even modest access to media and/or a facemask.
No doubt the pandemic has dominated not just the attention of the media and the politicians, but also day-to-day life for all of us. Events have transpired in ways that seemed hard to imagine on New Year’s Day, which seems like a very long time ago.
In times of uncertainty and market volatility, we try to place even more emphasis on being both students and teachers of relevant points in the ever-lengthening time span involving “recorded” history. This time, however, we want to go back farther in time than we usually do.
The Neolithic Age predates much of recorded human history. It began roughly 12,000 years ago when human beings first began to engage in agriculture. The Neolithic Age marked the end of the Paleolithic Age when hunting and gathering dominated the sustenance activities of our species. Methods in agriculture and other basic areas of life improved during the Neolithic era. However, most noteworthy from our modern perspective is the fact that the advances in agriculture were extremely slow…..hence the reality that most scientists believe the Neolithic Age lasted approximately 11,750 years.
The Industrial Revolution marked the end of the Neolithic Age. And with it the Industrial Revolution changed the pace of technological advances in ways that would seem unfathomable to people as recently as the 17th century. So fast have things changed over the last years, that if the poorest Americans only had the day-to-day niceties of Britain’s King James in 1620, they would be considered third world citizens. Simply put, kings and queens from 400 years ago had very few of the qualities of life we now routinely refer to as necessities. Steel magnate Andrew Carnegie properly characterized progress in our living standards during the Industrial Revolution as “a process of turning luxuries into necessities.”
With the onset of the Digital Age, which is still considered by most economic historians as part of the Industrial Revolution, the pace of change has been continuously accelerating and necessities now include internet access. There are virtually no industries today that are not deeply impacted by the advancements in digital technologies.
Most important to this discussion is the fact that since the beginning of the Industrial Revolution, there have been bell-weather global events that truly turbo-charged the pace of change. Many of these events were horrific wars involving widespread global military conflicts. Other events involve scientific discoveries by geniuses such as James Clerk Maxwell, Albert Einstein, Neils Bohr, and Alan Turing.
Of course, many others contributed to the shared wisdom of our species, developing cures for a wide range of diseases that used to be fatal. The result has been longer life expectancies and higher living standards. And oh yes, incredible wealth creation along with it.
We view the current event in human history (the pandemic) as another astonishing bell-weather global event. The consequences of this event will trigger rapid changes in human behavior, many of which are just beginning to emerge.
A close look at our equity portfolio reflects what we believed were important trends that were underway BEFORE this global pandemic. Never shy about familiarizing ourselves with advancing technologies, we have made many technology-related investments for which we continue to have high hopes. If we were/are correct about the implications, which we have reason to believe we will be, the companies in our portfolio should benefit from a sudden acceleration in trends that were already in place.
These accelerations include millions more workers engaged in their efforts via remote digital technology with more flexible schedules, more use of remote technology for medical monitoring and basic health care, more demand for advanced data base software, more online purchases that reflects the benefits of social distancing, at-home digital fitness, food delivery, gaming, biotech innovation and of course more electronic financial transactions versus the use of physical currencies.
The applications for technology to facilitate these changes might well be breathtaking. And as sure as night follows day, increased competition will come to all digital products and services as the Industrial Revolution continues to evolve into an even more digitally focused future.
Accordingly, eternal vigilance will be required by professional investors who hope to capture some of the economic benefits associated with these accelerating trends. Most surely there will be new winners as well as new losers as the competitive landscape evolves, just as it always has.
As we emerge from this crisis, we want to thank everyone for supporting our efforts. We feel almost sheepish in that our business has continued to thrive and prosper, while so many others with hard working people on their teams, have suffered and struggled, through no fault of their own.
We vow to remain eternally vigilant and grateful for the abundance we enjoy as we emerge from the darkest days of the pandemic.
Our Approach to Coronavirus
March 13, 2020
As of the writing of this newsletter there were 3,967 deaths caused by Cornonavirus around the world. Of those deaths, 3,120 have been reported in China. According to a study done by Medicine Net, approximately 646,000 people die globally from flu and flu-like symptoms each year. Another study found that approximately 3,700 people are killed EVERY DAY in world-wide traffic accidents. Still, Coronavirus is different in that we already know about the dangers of the flu, particularly dangers to the elderly. We also know that we take a risk every time we get in an automobile to go somewhere.
Only a fool wouldn’t be somewhat frightened by the unknown risks and threat of Coronavirus. Fortunately, there is plenty of good information out there about precautions that can be taken. Reduced travel and events will slow the transmission. And also, with the advances in medical technology, armies of scientists are working around the clock in labs in many locations to develop treatment solutions to the risks this virus presents. Just as has been the case with Smallpox, Polio, Measles, Mumps, Diptheria, Whooping Cough, Rotavirus, Asian Flu, Ebola, H1N1, Swine Flu, Zikavirus, and Bird Flu, we feel confident that medical science will prevail over Cornonavirus.
Although it is easy to get swallowed in the negative news and panic, let’s approach this situation like our favorite Prussian mathematician Carl Jacobi, (1804-1851). Jacobi loved to solve problems by “inverting,” meaning he looked at problems from opposite points of view to make sure he was not missing something. Since the dangers of Cornonavirus are obvious to everyone, let’s consider what sort of opportunities might present themselves as a result of this latest market panic.
Perhaps the best way to approach a frightening panic is to review what legendary investor Warren Buffett has said on many occasions:
"The years ahead will occasionally deliver major market declines -- even panics -- that will affect virtually all stocks. No one can tell you when these traumas will occur.”
While what Buffett says above is all well and good, what about all the fear out there? When will it end? When will the market stop going down? When will it ever start to advance again?
Again, let’s turn to Buffett who said on many occasions, “Widespread fear is your friend as an investor because it serves up bargain purchases.”
For decades we have come to work each business day with the understanding that there is no reliable way to predict overall stock market movements. Instead, we focus only on individual companies. Accordingly, our approach to investing is to think about the portions of outstanding businesses we own in the same way we would when buying a house. We buy a house only if we understand it, like it, and would be content to own it in the absence of any market in which to buy or sell it. We buy stock in a business if we understand it, like it and would be content to be an owner in it if there were no market to sell its shares.
On this mission to find outstanding businesses, decades of experience in this rough game have taught us that the most important quality we can possess is an all-weather temperament. Though market declines and nasty looking monthly statements are not as fun as rising market experiences, we are always ready for them and you should be too. We are mentally prepared to not panic during downward moves in stock prices. Instead we commit to bargain-hunting for additional shares when our favorite companies go on sale.
Market crashes and steep market corrections should be thought of as buying opportunities, not as reasons to panic or despair because the statements are not as pretty. And although we cannot foresee how long this “buying opportunity” will last, we are looking for great investments for the next 10 years, not the next 10 days. We feel very confident in asserting that some of the most outstanding investment opportunities of this decade will be presenting themselves as a result of this current Cornonavirus panic.
Over the long haul, successful investing is often counter-intuitive. As equity investors, this current climate of fear is our best friend. The best companies with outstanding managements, top market share and solid financials are 20% cheaper this week. Only a climate of severe fear means everything is on sale in the equity markets, including all of the biggest winners of the future.
The Most Powerful Force in the Universe “Compound Interest”
February 25, 2020
Albert Einstein once said: “Compound interest is the most powerful force in the universe. It is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Perhaps when applied to the human condition, the most difficult aspect of harnessing the compound interest force is that money must be set aside for investment; it MUST BE LEFT ALONE. Or put another way, money cannot have the immediate pleasure of being spent and exposed the beneficial force of compounding simultaneously.
An easy way to understand the basic math of compound interest is to know that given a seven percent rate of return, account values will roughly double every ten years. Again, the most important factor is that the money is left alone to grow. Likewise, taking advantage of retirement plan tax laws is important because money that is in a retirement account is shielded from taxes. Essentially tax-sheltered accounts are balances that are more likely to be LEFT ALONE.
The math farther out on the time horizon is also simple. If funds are left alone for 20 years and compounding at 7%, the account values roughly quadruple. If the same funds are left alone for thirty years at 7%, the account value will increase roughly eight-fold…….and so on.
Many pension funds increase their return expectations to enhance the force of compounding and meet their obligations. The results are even more impressive when we use higher rates of return in the assumptions. A $10,000 account left alone for 30 years and compounding at 9% grows to $132,676.78 versus $76,122.55 at 7% and $32,433.98 at 4%. However, with the lower interest rates we have now experienced for an extended length of time and will likely continue to experience, we must lower our long-term return expectations. With treasury returns below 2%, we are more likely to see equity returns lower than their historical annualized returns. LOWER RETURN EXPECTATIONS MAKE THE FORCE OF COMPOUNDING EVEN MORE IMPORTANT.
Now let’s assume the investor takes an annual withdrawal from her account of $1,000. At a 7% rate of return, the investor is left with $5,855.07 after 10 years instead of the $19,671.51 she would have had without withdrawals. And even if the investor stops taking withdrawals after that 10th year and leaves the money to compound, she will have $22,657.26 after 30 years instead of $76,122.55 without any withdrawals. The annual “splurge” that the investor withdrew from the account early on greatly cost her in the long run.
And when we talk with our youngest investors, we always like to demonstrate the power of compounding by showing them the outcome if they start saving for retirement now versus the outcome if they wait 10 years. A 22 year-old college graduate starting their job and putting away $200 per month and earning a 7% rate of return will have $594,663.59 at 65 years old. However, if they wait 10 years to start until they are 32 years old: $285,440.22. Time is a young investor’s greatest asset when it comes to compounding.
These simple illustrations show why Einstein said that compound interest is the most powerful force in the universe and the eighth wonder of the world.
Let’s finish the compound interest theme with a real-world example. We will use our investment experience in shares of Mastercard, which is easily the best investment we have made in our careers in our equity accounts. Our initial investment decision on Mastercard shares was made in August of 2006 (for accounts with available cash and an aggressive investment objective). Much analysis and discussion led to the decision. But when it came down to it, we liked the financial characteristics and future prospects of Mastercard. We were thinking that Mastercard shares could produce a decent compound rate of return.
Since August of 2006, Mastercard has grown annual revenues at a rate of over 13%. Much more importantly, on a per share basis, Mastercard has grown its net income per share at a lofty rate of 29.98% since August of 2006.
The results for investors who put $5,000 in Mastercard shares in August of 2006 and left the investment alone for fourteen years are staggering, simply because they reflect the effects of higher compounding rates. A $5,000 investment made in 2006 and left alone in Mastercard shares for fourteen years have increased 56-fold to approximately $283,863.63 in value today. The annual compound rate of return for Mastercard shares of 29.2% since August 2006 almost mirrors the growth rate of Mastercard’s earnings per share growth of just under 30%.
No doubt the Mastercard investment results since 2006 represent a rare “holy grail” outcome. And, unfortunately, we trimmed this position in our accounts instead of letting the force of compounding take full effect. Even with trimming, Mastercard has been an outlier investment result and such “home runs” are very few and far between. Still, this provides an amazing illustration of why we continue to search for companies that exhibit similar characteristics and why we think about longer holding periods instead of quick trades.
The most important takeaways from this compound interest discussion are these:
1) Compound interest is, in a financial sense, precisely what Einstein said it was: the most powerful force in the universe and the eighth wonder of the world.
2) The real power of compound interest is realized over time, not in the short run.
3) When money is removed from an account and spent, the force of compounding is cut short and not allowed to take full effect, the implied costs to the end balance multiply geometrically over time.
There are many ways to view what an investor might have done with Mastercard in 2006. For those who decided to withdraw $2,000 from their account to purchase a big screen television just before we bought Mastercard shares would have enjoyed that big screen television while there would only be $3,000 left to invest in Mastercard. Fourteen years later the balance in the account would be lower by more than $113,000 and the big screen TV would have long ago been rendered obsolete.
The Mastercard example, though radical, is real. The implications of compounding, even at lower rates of return, are still inescapable. While spending is admittedly more fun than investing in the short run, eschewing the powerful force of compound interest produces enormous opportunity costs in the long run.
Observations on International Investing
February 10, 2020
Over the years, clients who have participated in our Focus Equity strategy have come to realize that on the surface, our portfolio does not check all of the typical diversification boxes that many asset allocators prefer. We have never invested for the sake of diversification across industries or across geographies. In our investment meetings, you won’t hear the committee say that we need to find a utility or an industrial stock because we don’t have one. You won’t find our analysts scouring lists of companies based in Germany for more European exposure and you won’t find us settling for subpar performance from one of our holdings because it diversifies us away from technology. We don’t own companies in our equity portfolios because of their market sector or because of their geographic footprint.
Still, at a minimum, several times each year we will get questions from clients or prospective clients about our views on “international investing.” It is a fair question; it is a smaller world these days, and there is unquestionably a great inter-connection between domestic businesses and businesses abroad. So, here is why our equity portfolio does not match up with the standard asset allocation pie chart that has a noticeable slice labeled as “International”:
First, our preference and our priority is for certain types of business models that tend to transcend any particular border boundary. We greatly prefer a low capital spending requirement for our growing businesses. We look for companies that are capable of generating high rates of return on shareholder’s equity. And we surely favor shareholder-oriented management teams, operating in industries they can dominate now and for the foreseeable future.
Next, when we look for companies to invest in, we are mindful of the countless barriers to success. These risks, regardless of geography, fall into many categories including competitive risks, cyclical risks, interest rate risks, and technological risks. However, the additional risks that arise for international investments include: poor sovereign governance, substandard accounting mandates, poor relations with governing bodies, and ever-changing rules, being just a few. The list of barriers to success is almost endless, and there is no jurisdiction anywhere, that is close to perfect in this regard. However, the greatest risk to international investments that can be avoided is the risk of unstable currencies. The U.S. dollar is the world’s reserve currency. And the dollar looks to continue in this role for the foreseeable future. The vast majority of nations prefer this reality, and so do we as investors. It creates distinct advantages too numerous to delve into.
Finally, it is narrow minded to assume that strong domestic performance automatically will translate to strong international performance. Successful global companies usually have painstakingly incorporated cultural, geographic and demographic differences into their international strategy. These companies often have a local presence in various geographies to ensure success which also adds to cost. In addition, it is important to understand that, although international sales can offer large volume growth opportunities, international pricing is often substantially less than in the United States which can make a company’s international operations a lower margin endeavor.
All of this being said, it is a complete misnomer to think that our Focus Equity strategy ignores the amazing opportunities to do business overseas. At least quarterly, we review our portfolio to determine approximately how much of the total revenue our companies bring in that comes from outside the United States and the growth of that revenue. We do so despite the fact that every single name we own is headquartered here in America. Within our Focus Equity portfolio of companies, the average percentage of revenue derived from international sales was approximately 39.03%. The “weighted average,” which is a slightly different measure, was even higher at 40.84%. Simply put, our exposure to overseas business opportunities is quite substantial.
It is important to emphasize again, that we do not begin our search for solid equity investments by looking for overseas exposure and/or opportunities. Our search begins with sophisticated screens that tend to identify business dominators with the most beneficial financial characteristics for shareholders. If a company fits these descriptions, we will neither add extra credit for international revenues nor will we subtract credit as we vet the idea more deeply.
This approach has served us well and we expect to continue it for the foreseeable future.
Many Reasons to be Thankful
November 25, 2019
This week we all give thanks. We are thankful for many things; it has been a record-breaking year at Spence Asset Management, our hard-working team is healthy and happy, and our client base is larger and more loyal than ever. We are also thankful for a conversation we had recently with one of our longest standing clients. This client made an astute observation that was very thought-provoking. He said: "You've changed."
When pressed to elaborate on how he felt we had changed, he said he was referring to our willingness over the last decade or more to buy stakes in companies that are not yet reporting operating profits based on Generally Accepted Accounting Principles (GAAP).
Almost immediately, the name Amazon came up in the conversation. Amazon provides an excellent example of a company that, for many years, was too busy taking market share and growing revenues, to worry about reporting bottom line earnings to investors.
We wished we had bought shares of Amazon many years ago. We couldn’t even begin to count how many times the company has been part of a heated argument at our bi-weekly investment meetings. We passed on Amazon for several reasons: after taking a close look at Amazon’s fundamental business and financial statements after the turn of the century, there were two primary reasons why we missed Amazon’s huge share price run. First, we believe, and still do, that retailing is a very difficult business in which to compete. In retail, management must be smart every single day. Empty shopping malls all over the nation suggest it has not been easy to survive in retail and to stay out in front of consumer trends. Running a retail operation remains, perhaps, the most complex management challenge we know of and when tough management conditions interact repeatedly with retail management teams, it is the tough management conditions that tend to prevail.
Second, Amazon shares always looked wildly expensive to us. Sometimes truly dynamic companies that “look” wildly expensive turn out to be big winners. Others will flounder when it turns out they were not truly dynamic after all. We are reminded of a couple of conversations we had with our favorite finance professor more than a decade ago. We pointed to Mastercard (and later Visa) as examples of dynamically superior businesses that we preferred to own. He passed on Mastercard and then passed again on Visa. When asked many years later if he had ever bought a stake in Mastercard or Visa, his response was, "No, I could never get past the high valuation. The price to earnings ratios just always looked too high for me."
Of course, both Mastercard and Visa shares have been sensational performers. We believe for many reasons that both companies have been dynamic since going public. We recall the income statement on Mastercard was a bit “muddy” back in 2006. The company was showing very little, if any, GAAP earnings per share at the time we purchased an initial stake for clients. As Mastercard emerged from its process of consolidating from private ownership by a consortium of banks to a public company, there were simply too many unique expenses offsetting reported income. We chose to ignore those expenses as being irrelevant to the larger picture. We thought Mastercard had the chance to be extraordinarily dynamic.
Although Mastercard has been a success, we have honed and modified our list of reasons for passing on companies to reflect what we have learned from both our successes and our failures. Over the last decade or so, we have decided that under certain circumstances, when we think we have a dynamic business with huge micro or macro-economic tailwinds as well as a talented management team, we will not pass simply because the shares “look expensive.” Instead, we will remain open to making an investment if sufficiently compelling factors are present that can help us see past the current shortfalls on an income statement. Specifically, if an income statement suggests that a dynamic company COULD BE PROFITABLE immediately, if management felt compelled to report net income right now but instead management chooses to invest aggressively to take additional market share in a growing market, we won’t disqualify it from consideration.
When considering investments, there are certain fundamental truths always at work when it comes to astute analysis of income statements. There are simply no short cuts. A one size fits all mindset simply won’t work as well as an adaptive mindset will. We remind ourselves regularly that NOT all earnings per share are created "equally,” and not all expense types are "equal" either. With mature companies, where management is required to make heavy capital expenditures, these outlays are not made with pre-tax dollars, and usually they do not assist the company with taking market share. Instead, they are required to simply hold a position in the marketplace. Generally speaking, spending heavily to hold your position does not produce superior returns.
Alternatively, exciting companies with disruptive products and services, can and do produce phenomenal residual values under certain circumstances. A good example of this is the Software as a Service or SaaS industry. As the digital age has proceeded virtually non-stop, we have made ourselves very familiar with the unique aspects of subscription-based software companies, particularly the nuances in accounting rules associated with the industry. Some of these admittedly complex rules have literally changed the calculus of profitability.
As we move to the second decade of the 21st Century, dynamic SaaS companies have the potential to be far more profitable than they appear at first or even second glance. This is true because truly exceptional subscription-based software companies are not only growing their customer bases, but are building truly valuable assets on their balance sheets. One of these assets is called a “deferred revenue balance.” The growth in deferred revenue, which can sometimes increase by a significant percentage every year, essentially builds revenues that will be recognized without substantial additional costs in the future. This is a classic example of engaging in a short-term sacrifice for long term gain; the balance of which is the ultimate challenge for today’s CEO as well as the ultimate reward for a successful investor.
And with that all being said, successful investing also involves admitting your failures and revisiting your “Amazons” frequently, no matter how heated the disagreement becomes. We continue to closely monitor the evolution of Amazon, its financial statements and its challenges along with many other dynamic companies. We are thankful that the digital age and the advent of 24 hour per day financial news broadcasts that have produced mountains of data and raw information through which investors must sift. It is in addressing the sifting process where proper conclusions must be drawn, and in that we are afforded the opportunity to enjoy the enormous abundance that dynamic companies can provide for patient shareholders.
Best wishes from our families to your family for a safe, happy, and healthy holiday season, and a prosperous second decade of the 21st Century.
Major Price Changes
October 01, 2019
Last week we received news that should reduce the cost of investing for our clients. In addition, thanks to these new efficiencies, we will be able to explore a broader array of sensible investment choices.
Charles Schwab, Inc. the stock brokerage custodian firm we chose to custody with long ago, has decided to slash equity-trading commissions to zero. This move by Schwab continues a trend in the industry of reducing transaction costs that has been ongoing for several decades.
Schwab continues to be an ultra-competitive stock brokerage firm. The company is very well capitalized and large. It provides custody services for $3.7 trillion in client assets.
Here is a brief history of Schwab’s role in the pricing wars in the brokerage industry:
1971: The firm became a broker/dealer.
1975: The SEC mandates negotiated commissions for all securities and Schwab opened a discount brokerage branch in Sacramento, California.
1996: Web trading on Schwab.com became available.
2006: Schwab introduced flat commissions of $12.95, down from a top tier of $19.95
2010: Schwab cut equity commissions to $8.95 from $12.95
2013: Schwab launched ETF OneSource, featuring commission-free ETF trades.
2017: Schwab cut equity commissions to $4.95 from $8.95.
2019: In early October, Schwab eliminated commissions for equity trades ETFs, and options.
Though we were surprised that the pricing on equity trades has now gone all the way to zero at Schwab (only for clients taking electronic delivery of confirmations and statements), this decision by Schwab is much more complex than it might seem. As is often the case with an announcement that something we used to pay for is now “free,” there is much more to this story than meets the eye in financial news media reports. One of the most basic principles we learned in our Economics courses is the acronym TINSTAAFL which stands for: There Is No Such Thing As A Free Lunch. In other words, Schwab is able to make up for this loss of transaction fees from other revenue sources.
Some background seems in order. When we left the traditional stock brokerage industry decades ago, we did so because we knew we could better serve our clients by performing the tedious task of negotiating with the brokerage industry on our client’s behalf, instead of straddling the competing interests of our clients and our brokerage firm. We have never for a moment regretted the decision to leave the traditional brokerage business, go independent and sit only on the client’s side of the table. Accordingly, since 1992, we have not been employees of any brokerage firm including Charles Schwab Inc.
Instead, our firm functions as the entity that coordinates processes at Schwab on behalf of our clients. We chose Charles Schwab long ago to be our custodian for many reasons. Those reasons continue to be affirmed and validated.
Still, the responsibility for navigating the ever-changing brokerage landscape including strategies Schwab employs to generate income from client accounts are ours. Many things we do daily as a matter of routine, are tedious details that may not be clear to most clients who have countless other things in their lives to keep track of.
There are other trends in place in addition to a reduction in trading costs that are related to falling trading costs. When trading costs fell from $8.95 to $4.95 in 2017, virtually all stock brokerage firms turned towards less transparent strategies to generate higher levels of net interest income on customer cash. While the trading cost reduction helped all of us save money on trades, the new and much less publicized rules related to managing cash require time consuming manual processes to earn market rates of return on cash. It is important to understand that at many traditional brokerage firms, most processes that help clients earn market rates of return on cash are either prohibited or frowned upon. While the headlines point out that pricing on stock trades is coming down, the financial news media is NOT doing much reporting on how much less convenient it is for customers to use money-market funds in brokerage sweep accounts. The reality is the stock brokerage industry, including Schwab, has eliminated money markets for sweep purposes. This means unless you or your non-brokerage money manager (Spence Asset Management, Inc.) is willing to take on the inconvenience of manual processing, the brokerage houses and not the customers, will earn the lion’s share of the market rate of interest on cash.
Another less transparent aspect of many stock brokerage firm’s revenue strategies is known as collecting “payment for order flow.” This revenue stream comes to brokerage firms when they sell their customer’s stock orders to market makers. Often market makers have ties to high frequency trading operations whose sole purpose is to take advantage of the information contained in purchased order flow. It is certainly an open debate as to whether this practice represents a conflict of interest. Conflicts of interest seem to continue to be the bugaboo facing all investors as they navigate the complex landscape known as stock brokerage firm profit strategies.
Again, as a matter of daily routine at Spence Asset Management, Inc. we assume the role of doing our very best to navigate the complex obstacles associated with obtaining “best price execution” on trades that are now “free.” We continue to be convinced that Schwab’s platform offers the strongest suites of tools and software packages in the Registered Investment Advisor industry as well as superior client service. And we are very happy that the trends in the stock brokerage game we identified in 1992 that caused us to alter our approach, seem to be continuing unabated.
With all of these trends in place, we believe it is very good news that Charles Schwab Inc. continues to choose to be a pricing leader in their industry. Their move to slash trading costs to zero affirms our confidence in choosing Schwab to provide custodial services for our clients and reminds us to be ever vigilant in understanding how our custodian is deriving its revenue.
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