An Announcement and Then Some Words

Announcement!!

This Friday, November 3, we’re trying something new.

It’s called “First Fridays” and it’s a LIVE recording of The Smattering Podcast at 4pm (EST) that day. Here’s how it works:

As a subscriber to this newsletter (thanks!) you’ll get a newsletter that afternoon with a link to join the live recording. The link is for Riverside, the platform we use to record the show. All you should need to do it click the link and once we hit the record button, you should be able to see and hear us. There are chat functions to ask questions, and a way to request to come on to the show live to ask a question.

DISCLAIMER!

We have no idea how well this will work, so please consider this a beta test. But we thought it would be fun to give it a try. If it works, we’ll try to do it on the first Friday of every month.

So save the date: Friday, November 3 at 4:00 PM (EST) and join us live!

Jason & Jeff

Jeff’s Random Words

One of the things I want to write about occasionally is stocks that I own. I’m not talking about formal, 2,000-page write-ups, but rather some of the simple frameworks I use to make buying decisions. I’ve mentioned it before on the podcast but I like to watch trends and I track a bunch of different metrics so I can visually see where things are going. This helps me understand the narrative in the near term, but it also helps me keep perspective when I am able to zoom out.

Today I want to share my thoughts about Amazon (AMZN). It’s one of the three stocks I picked in the Smattering Portfolio Contest and it just reported earnings on Thursday. It’s also a pretty good example of how I watch trends.

When I picked Amazon for the portfolio back in December, the stock was beaten down (rightfully, to some degree) because of recent results. The most recent results I had at the time were from Q3 of 2022, so about a year ago from right now. Things weren’t looking great.

• Free Cash flow (on a trailing 12-month basis) was down 871% year over year*

• Operating income for the quarter was down 48% year over year

• Net income was down 9% year over year

*Jason is of the opinion that free cash flow can’t drop more than 100% but I got that figure from the Amazon earnings presentation, so he can take it up with Andy Jassy. The point remains the same, it dropped a lot.

Digging a little deeper, the majority of the issue was with the operating income for the North America and International segments, which is mostly the Amazon e-commerce part of the business. The North America segment operating loss was $(412) million, down 147% and the International segment operating loss was $(2.5) billion, down 171%. So...not great.

As a result, the stock had gotten hammered and Amazon was pretty cheap. On the day we recorded the episode where we picked the stocks for the portfolio, Amazon was trading for 1.7 times trailing sales. Just about the lowest valuation it had traded for since 2015!

My simple investing brain kept thinking the following:

• Amazon is still the absolute first choice for shopping online for almost everything I buy

• Everything is weird because of the pandemic (Amazon doubled its distribution footprint in like 2 years)

• They still have the leading cloud infrastructure business in AWS.

The market HAD to have this wrong…

Here we are almost a year later and the stock is up 52% year to date (including a nice post-earnings pop on Friday). I don’t know what the future will hold, but I am pretty comfortable saying I was right about this one, at least so far. Consider the three metrics I cited above; free cash flow, operating income, and net income over the past year (all images are from the Amazon Q3 2023 investor presentation)

Not bad progress. Now, I’m still going to read the press release, earnings transcript, and 10-Q to make sure there’s nothing I’m missing. And there are other things I’m watching (like the growth of Amazon’s advertising business). But essentially this post sums up my thoughts on the business. The stock was cheap, I thought the market was overreacting to a temporary challenging period, and as I watched the trends over the ensuing quarters, I saw good trends. Thursday’s results were the latest piece of evidence that things are trending in a good direction for Amazon.

What do you think? Is that too simple? I see things trending in a good direction, thesis intact, move on, and buy more. What am I missing?

Jeff

Jason’s Random Words

If you've followed me for a few years or listened to our "How We Invest" series on the podcast, then you probably know about my framework around cash, and when I usually put that cash to work. For the uninitiated, I'll summarize it:

• I try to keep about 5% of my portfolio value in cash. This is just invested wealth, not emergency savings or short-term cash.

• My guidelines around when I will invest that cash is thus:

  • If the stock market falls 10% from a recent high, I will take half of my "dry powder" and invest it. My reasoning: We get these "corrections" about once a year on average, and there are almost always great stocks that have sold off more than the market on sale. It's a good way to boost returns.

  • If the market falls 20% from a recent high, I invest half of the remaining cash I have. Bear Markets are far more rare, happening about once every four or five years on average.

  • If we see a 25% or more selloff, I get really aggressive with any spare cash I have, and will usually increase my investment contributions to take advantage of opportunities like these.

A longtime Twitter follower asked me this week if, since the S&P 500 is now down 10% from a recent high, this triggered my "rule" or not. I gave a short reply:

https://twitter.com/TheSmattering/status/1717595048479539463

I thought that this was a good opportunity to both expand on my thoughts around cash, and talk about the importance of frameworks versus rules, and being willing to change and reframe your thinking when things change in the real world.

Let's start with frameworks versus rules, something Jeff and I have talked about a lot. Rules tell you what to do, while a framework is a system that helps you make decisions. As investors, being able to make the best decisions is often a product of creating a system that supports better decisions. Or to put it another – maybe more accurate – way, a good framework helps you not make bad decisions. Or at least, to make them less often.

For me, my cash framework has evolved to help prevent me from making bad decisions. During my early investing years, I would try to stay fully invested. I didn't keep spare cash, probably because I read somewhere that someone I admired like David Gardner or Peter Lynch stayed fully invested. So I would try to do the same, and it didn't work for me. It led to doing things like selling off perfectly good stocks to raise cash to buy other stocks, often more imperfect ones that have gotten cheap usually for good reasons that aren't actually good reasons.

I learned the hard way that I needed to keep some cash. Not only would I have my regular contributions to steadily invest, but that spare cash would give me something to use when I saw additional opportunities. My framework above evolved out of my experience and mistakes, and then stealing from Morgan Housel.

I settled on 5% because, at the time, interest rates were extremely low. The yield on even high-yield money markets barely kept up with inflation for most of the past two decades. Considering my age and the very low-yield environment, it just didn't make much sense to have more of my portfolio in an unproductive asset like cash for extended periods of time. 5% was a small enough amount to not weigh on my total returns while being large enough to be meaningful when opportunities arose.

Things have changed, so it's time to change my framework. Moving forward, my goal is to gradually build up toward 10% in cash.

It's not just higher interest rates that now generate more wealth-building yield. Sure, that's a factor. At recent inflation levels, a 5% yield beats inflation by a few percentage points a year. For the first time in nearly a generation, cash savings are actually growing in spending power. That's a meaningful change that makes cash and cash-like holdings like short-term Treasuries far more valuable and useful. Don't get me wrong; stocks should remain the core long-term wealth creator for most people. They are for me.

But that's not all that's changed. As I've written, I believe that stocks as an asset class will generate below-average returns in the coming years. I expect that this will be a product of two things:

• Higher interest rates will mean higher cost of capital for businesses. Both to fund growth (acquisition and expansion) and to refinance existing capital. This will mean lower returns on capital than we've enjoyed.

• Higher interest rates make fixed income more attractive to more investors. This "competition" will erode the multiple expansion stock investors have profited from over the past couple of decades.

Lower returns on capital and lower multiples will mean lower stock price appreciation and slower dividend growth. Maybe we still get 8%-10% annualized returns for stocks, maybe it's 5%-6% returns. I don't know. But I don't expect it will be the 14%+ wave we have enjoyed over the past dozen-plus years.

One more thing has changed: I'm not as young as I was when I first built my cash rules, and I have become more patient, and I believe, a better investor.

But it's also put me in a bit of a conundrum. I am committed to holding around 10% cash. But at the same time, I am starting to see some compelling opportunities. Stocks like Enphase Energy (ENPH), which is down 75% from its all-time high, for example. Plenty of solid REITs are probably more beaten down than they deserve. Boston Omaha (BOC) –as much as it's underperformed and its co-CEOs haven't delivered great returns so far – now trades for a discount to book value. For a cash-positive business with essentially no debt, that's a bargain.

So I'm having to find the middle path. Continue to act aggressively when the opportunities are clear while being more patient generally.

This much I can tell you: I'll definitely be less likely to buy companies with negative triple-digit cash flow growth. That means it's a company that used to make positive cash flow but is now burning cash. Have fun being poor, Jeff.

Jason