Portfolio Manager Nate Weisshaar started 2017 with a quartet of tough reader questions.
Each month we answer questions from our audience of readers and shareholders. We enjoy doing it, and would love to answer any questions you might have. Please write to firstname.lastname@example.org and let us know what's on your mind! Here are our reader questions for January:
1. Calling utlities overpriced while saying stocks like UA are "value stocks" makes little sense to me. The market has done the exact opposite of what you say. Had you forseen the trend that would have created value for the shareholders today?
Like judging an elephant beauty contest, it’s all a matter of where you’re standing.
Under Armour is a company we’ve owned from the very start of our funds, and from the inception of the Independence Fund (June 16, 2009) until this writing (Dec. 28, 2016), Under Armour has returned over 900% on a split-adjusted basis (Under Armour has split its shares 2-for-1 three times during our holding period). Over the same period, the iShares US Utility ETF has returned 144% on a dividend-adjusted basis.
Now if we shrink the scope a bit, we see a different story. Over the past one-, two-, and three-year periods, the utility ETF outperformed Under Armour by 43, 25, and 7 percentage points, respectively.
However, if you bump that performance period out a bit, we see Under Armour outperformed the utility ETF by 79 percentage points over a four-year period and 162 percentage points over the past five years.
So over the past three years, yes, it would have been better to hold a basket of utilities than Under Armour. However, the game doesn’t stop today, and while we believe Under Armour has some operational issues it needs to get fixed, the brand -- which we believe is a true driver of value for the company -- remains strong. Whether this is a good place for money going forward remains to be seen.
We’re not market timers, and we try to invest in companies that will deliver strong returns on investment over the course of many years. This approach means we won’t win over every measurement period, but we believe it will result in strong returns over the long run.
As an aside, I generally dislike utilities because the cash-flow economics aren’t very reassuring. If I look at the top five utilities in the iShares US Utility ETF (NextEra, Duke Energy, Southern Company, Dominion Resources, and Exelon – which make up a third of the ETF), none of them is able to cover its dividend payment out of cash flows (which I’m defining as operating cash flow less capital expenditure). They all make up the difference by issuing debt and new shares.
For a group of companies that attract investors mainly through dividend payments, this isn’t the greatest position in which to be. We saw in 2015 what happened to energy infrastructure master limited partnerships (MLPs) when their access to capital dried up. (In case you missed it, the stocks got brutally punished.)
I’m not forecasting this for utilities — just pointing out a potential point of pain and a reason I don’t think utilities are as much of a no-brainer as some assume.
2. It's never easy to watch stock portfolio go down in value, but it's (relatively) easier to watch $10,000 go down to $5,000 than watching $500,000 go down to $250,000, especially if you're older (near or in retirement). What do you recommend if that happens like it did in 2008? Allocation solves some of the problems, but gold and silver aren't necessarily the answer, since when market went down so much in 2008, so did they.
This is a tough one to answer, because everyone’s situation is different, but I tend to fall back on the advice that the right portfolio is the one that lets you sleep at night.
If you can’t handle a 50% drop in the value of your portfolio (short term, we hope), then you should consider a more conservative allocation, which uses more bonds and cash to provide more certainty for your principal.
I know the potential returns on cash and bonds aren’t very attractive these days, but what price do you put on peace of mind?
3. Can you explain your holding of Amazon from a valuation perspective? How do you justify it?
Can you explain your holding of Amazon from a valuation perspective? How do you justify it?
This is a pretty common question, and I took a shot at answering it about six months ago (here – scroll to the bottom), but I’ll take another approach to try to explain the value potential we see in Amazon today.
We view Amazon as a company with two distinct but increasingly more similar lines of business: Amazon.com and Amazon Web Services. I say they’re coming more similar because Amazon has gained the scale to operate both parts of its business as outsourcing operations. Impressively, Amazon appears to us to be the best in class in both of these realms, and both of them have attractive runways.
I think most people understand the impressive economics of Amazon Web Services (AWS) – Amazon is maximizing the use of its massive technology infrastructure by renting space to other users. This helps Amazon improve the return on its investment, but it also provides an amazing service to start-ups.
By using public cloud services (AWS, Microsoft’s Azure, and Google’s Cloud Platform, for example), it is far easier for a tech start-up to get going because it just needs to rent space on some of the most powerful computing structures in the world. Doing so lowers the amount of money the start-up needs to get started, which opens up a world of possibilities.
And Amazon gets a piece of those possibilities just for renting out space on infrastructure it would be using anyway. Amazon won’t get all of that new business, but we think it’ll get more than its fair share.
Similarly, Amazon.com is often considered a retail operation, but I propose that a better way to think about it going forward is as outsourced logistics. Amazon has the distribution network to get people all the things they could possibly want, almost on demand. It does so through massive investment in warehouses and computing (and planes and trucks more recently, and eventually drones). And it is a level of investment that few other companies can match.
As a result, we believe Amazon will essentially act as a retailer’s online presence and its order fulfillment operations via Amazon’s Fulfillment by Amazon (FBA) offering. FBA allows retailers to store their inventory in Amazon’s warehouses and have Amazon handle all the packing, shipping, and returns.
In 2014, 43% of the units sold by Amazon were third-party items, and 40% of those took advantage of FBA. In 2015, those numbers increased to 47% and nearly 50%, respectively. And remember, unit sales grew 26% in 2015 – meaning more of the meaningfully higher unit sales are coming from third parties and more of them are utilizing FBA, which increases the turnover in Amazon’s warehouses and increases returns on investments in distribution centers.
Having a partner with top-notch worldwide inventory management and distribution capabilities makes it far simpler for a new retail operation to reach a global audience early in its lifecycle, and it’s radically changing the competitive landscape. I’m not talking about just brick-and-mortar retailers, but also the brands that fill those stores with their wares.
Why do you think Unilever paid $1 billion for Dollar Shave Club? I think it’s because Dollar Shave Club jumped over Unilever’s Maginot Line-like grip on store shelves. It didn’t need to fight for space in Walgreens or Kroger or spend a fortune on TV advertisements, because it had ready access to consumers through social media and non-traditional retail distribution systems.
This is the power that Amazon gives to small retail businesses – and this is why we think most people still undervalue the retail side of Amazon. We believe Amazon will continue to add to its share of total retail sales – e-commerce is growing 7 times as fast as traditional retail yet is still less than 8.5% of total U.S. retail sales, according to the U.S. Census Bureau. E-commerce is growing around 15% per year – which compares with Amazon’s sales growth of over 25%, indicating that Amazon is taking more of a solidly growing e-commerce pie. Keep in mind that total U.S. retail sales are in the neighborhood of $5 trillion per year.
And Amazon’s international sales are likely to be over $40 billion this year, growing more than 20% per year. So we don’t believe it is unreasonable to think Amazon.com could see its sales double, and then double again, within the next 10 years.
But what about profit? Well, Amazon.com’s North American operations are posting operating margin just shy of 3% so far this year, but we got a sneak peek at what things could be like in an era of lower infrastructure investment when the region’s operating margin hit 4%. That’s not a huge number, but on the volume Amazon puts through (and could put through), it is meaningful.
These are lofty visions and assumptions, but not, I think, completely unreasonable. Of course they don’t provide a clean stock price calculation, but they do provide a framework for thinking about Amazon’s current $336 billion market cap.
I can completely understand why a company that struggles to post positive earnings or free cash flow from quarter to quarter and has openly stated that others’ margins are its opportunities could be tough to value – particularly if you come from the Warren Buffett school of investing.
However, I think it is vital when considering Amazon to think of it not as simply an online retailer, but as a platform (yes, I cringed writing that) that will enable business start-ups in the coming years, and which has the potential to displace several large incumbents and reorder the consumer and business world as we know it.
4. The Independence Fund is an IRA for my husband. My question is: When he reaches the age of 70 1/2 and has to start taking RMDs, does The Motley Fool let us know the amount that will be required? Also if we don’t want to sell our shares in the fund, can we take the RMD and just transfer those shares into a taxable account?
I’ll admit this is a bit outside my area of expertise, so I’m tapping in Ross Anderson, my co-worker and a Certified Financial Planner, to provide an intelligent answer.
It is possible to transfer shares to satisfy an RMD (required minimum distribution) but typically not worth the effort. The transaction is taxable. and moving shares provides no additional utility unless there are transaction costs that can be avoided.
In most cases. the simpler transaction would be to sell shares, take the distribution, and then buy the fund again in a taxable account.
The additional hang-up may come if the fund is held direct at BNY or in a brokerage account. It would be much easier to move shares in a brokerage account than at BNY.
Note: This information is not intended to be a substitute for specific tax documents or specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, we recommend consultation with a qualified tax advisor, CPA, or Financial Planner.
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