The Smattering Podcast 75: Should Stock Investors Lower Their Expectations?

The Smattering Podcast 75: Should Stock Investors Lower Their Expectations?

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Jason Hall: Hey, everybody. Welcome back to the smattering where we ask the hard questions about investing. I'm Jason Hall joined by the voice of the people, Jeff Santoro. Hey, Jeff.

Jeff Santoro: Hello, sir. How are you this fine day?

Jason Hall: I am, I am doing wonderful. I've started my project that, you know, I've been planning for a while to build a little bus stop for my son.

I live pretty far up north. It's a pretty bad weather. I've started it. I started it. So I'm using a chainsaw to rip trees, rip logs, full logs into timbers. It's been a lot of fun. .

Jeff Santoro: My favorite thing is when I'm waiting for you to do something for this podcast and you respond with a picture of you cutting trees down to build a bus stop. So.

Jason Hall: Yeah, it's my thinking time. It's my thinking time. I think everybody should have some thinking time. Maybe this podcast is part of people's thinking time, maybe taking the time to give us a review, be part of your thinking time.

Jeff Santoro: Look at... You know what, I take back my [00:01:00] snarky comment because that was a professional segue.

So we do want to thank the people who've been leaving us ratings and reviews on the podcast apps. Since the last time I mentioned this which was two episodes ago, we got three more reviews on Apple Podcasts. Thank you to DavidThompsonSC. Thank you to filmorea Is that how you think, how you pronounce that username? And thank you to Bigbangsmile. All three of y'all left us five star ratings and nice reviews about how you're enjoying the podcast.

So if you want to be just as cool as those three listeners, feel free to smash that star button and leave us a review on the Apple podcast app. Do the same thing on Spotify and any other podcast app that has ratings. Uh, we really appreciate it.

Jason Hall: Okay. Onto this week's episode. This is something, Jeff, that's been bothering me for a while. You know, it's, I shouldn't say bothering, but it's something I've been thinking about for a while. And we've kind of danced around that we've touched on it and [00:02:00] prior episodes that we've done.

The title this week is, should stock investors lower their expectations? And I want to take it a step further and maybe the title should be do investors have messed up expectations about stocks?

Jeff Santoro: Yeah, and this all this is going to be a conversation that really kind of starts and ends with interest rates. The fact that we've lived in basically a zero interest rate environment for a very, you know, a pretty long time up until recently, although historically, it's a small amount of time. Interest rates being near zero is not a normal thing. But I think the younger you are, or the newer you are to investing you, there's a higher chance that you have no recollection of being a stock investor in a time when interest rates weren't near zero.

And I used to think that's a macroeconomic thing that I don't need to worry about, but I think we're going to talk [00:03:00] about the ways that even if you're not interested in macroeconomics or how the economy works writ large, this is something that I think all investors should at least understand and be aware of because I think it can impact the decisions we make.

Jason Hall: And it should impact the decisions that we make because it's impacting the decisions that are being made by the people that are running the companies that you invest in. The decisions that their vendors are making. That their customers are making. It's, it's a pretty big sea change.

Jeff Santoro: Yeah. And I think it's, we have yet to see the impact of it trickled down. And we're going to talk about that a little bit more. But, you know, we've been, we've lived in this world of higher interest rates now for a little bit of time and everyone sort of is used to the fact that interest rates are higher. Anyone who's tried to get a loan in the past six or ten months has probably seen that it's a lot higher.

And it's easy to think that, oh, well, interest rates are higher, but the companies in my portfolio are doing okay. I don't think we've seen the impact of this sort of trickled down through the [00:04:00] system yet. So we'll talk through all those things. So I guess a place to start, Jason, is let's, let's lay out the basics in case someone hasn't been paying attention to this. You know, the, the, the investing environment is different.

So, so what has changed? What is driving all of this?

Jason Hall: So I think there's three words that really sum it up, and that's cost of capital. If you are starting a business, you're, you have an existing business, you're taking it public. You want to grow the business. You want to expand, you want to acquire a competitor. You want to build a factory. You need to lease a truck.

All of, all of those things, that costs money. And for a business, there's really basically three ways to get money. You make it, you generate a profit from your business, right? And you have, operating cash. That's after you've paid all your vendors, paid all your employees, paid your utility bills, all that kind of stuff. Operating cash is what's left over after you've paid everything. And then you make capital expenditures. Again, you buy that, that van. You buy a tractor, you're a farmer. You build [00:05:00] a factory, you make an acquisition, you spend some of the operating cash for that. Whatever's left after that is free cashflow, right?

That's the cash that's left over after you've done all the things that you have to do with the money, and you've done the things you want to do with the money, all right.

So if you don't have free cashflow, and you have a new thing that you want to do, you have to go to the capital markets to get money. And you're going to do one of, go ahead.

Jeff Santoro: I was going to say, let's define what it means to go to the capital markets. Because I think that's an insider term that's not always super clear to everyone.

Jason Hall: It is, and the simple thing is you're raising capital. That's really what it means. You're raising capital, and capital markets are either, you're going to borrow money from somebody or you're going to sell part of your business. You're going to sell an interest in your business, okay, it's that simple. And this is exactly the same way it works if you, if it's a private company or it's a publicly traded company, it works exactly the same.

Jeff Santoro: But let me break it down even more, right. So when you say go to the capital markets, you're, you're talking about things like borrow money from a bank or issue a bond. Right. Which [00:06:00] is when people buy a bond from you and then or give you money, they get the bond and you pay them interest over the course of the bond. Or when, uh, you sell more stock, right? That's the way that's the selling part. So get a loan from a bank, sell bonds, or go sell more stock on the public market. So those are like the really layman's ways of saying those three things, right?

Jason Hall: And there's, I don't want to get too deep into the weeds on all of the different ways you can do it because like with a, with selling stock, it's called a secondary offering. There's a couple of ways you can do it. You can do an at the market, which is where you're literally selling the stock into the secondary market, you're selling it to retail investors.

Most larger companies they'll do a private placement where they already have a large institutional investor lined up, like a pension fund or a group of a group of large investors where they negotiate a deal and they sell that stock in a private placement to those investors, right?

So those are the two ways you can do it. You can either do it at the market and you're subject to whatever the market's gonna bear for the stock. The advantage of a private placement is you might, you may not get what the market's bearing [00:07:00] that day. You may discount a little bit, but you know exactly what you're gonna get, right? So, you know, you need to raise $2 billion. You can get exactly that $2 billion versus if you do at the market and you have a certain amount of shares to issue, you might not get what you're trying to get, right? So that's with secondaries, selling more of your stock, right?

Jeff Santoro: Obviously, regardless of which of those three that you do, the end result is you have more cash now to go do the thing you need to do.

Jason Hall: There you go. There you go. And, and again, it gets, so that's the capital part, right? The cost is just that. What is the cost of that money?

And if you're borrowing money, it's simply the cost of interest, right? It's the interest rate that you're going to get. And if you've tried to buy a house or you know, anybody that's tried to buy a house recently. I think it was today, this is we're recording this on October 18th. I think today, um, 30 year mortgage rates hit 8 percent. This is the first time in a couple decades. I think you got to get back to the, was it 2005? [00:08:00] I mean that 2002, maybe 2003 last time mortgage rates were 8%.

Jeff Santoro: Yeah. And if you're a regular person, you're the way you think of cost of capital in your regular life is things like. A mortgage rate, if you have a 8 percent mortgage, your cost of capital is 8%, right?

That's just a way to kind of translate it into personal finance.

Jason Hall: I think it is. And I think it's a really good example to show how much, so you can go back to 2020, 2021, that mortgage it's 8 percent today was probably 2.75 percent at the lowest, roughly 2.75%.

And you might think, well, 2.75 percent to 8%, that doesn't really sound like a lot of extra dollars. But again, everybody knows how much more an 8 percent mortgage costs than a 2.75 percent mortgage. If you're a business borrowing money, essentially you see the same thing. The cost of that capital is substantially higher.

Now there's another important part of the formula [00:09:00] that matters. When a company is going to invest that money. Again, they're going to buy a delivery van because maybe they're expanding their delivery area or they've grown fast enough that they need that extra capacity and it's going to generate X number of dollars in revenue that's going to generate whatever the rate of return is.

Let's say it's going to generate a 10 percent incremental return on the revenue that they're going to be able to pick up by adding that delivery van to cover all their operating costs. And it's going to cost, it's going to, it's going to generate 10 percent rate of return. Depending on how good your credit rating is, depends on what your cost of money is, your average high yield, junk bond again, junk, meaning that it's not investor, investment grade, they're over 9 percent now. So all of a sudden you're talking-

Jeff Santoro: So if you're like a smaller business or a business that doesn't have like, you know, a 30 year track record of financial of great financial records and you go to try to borrow money, you're going to get, you're not going to get the [00:10:00] same great, the same your cost is going to be higher.

You're not going to get the same rate as Apple or Google or these companies that have billions of dollars on their balance sheet. Like you're not in that ballpark. So it actually disadvantages to a higher degree, less established companies.

Jason Hall: Yeah, absolutely, oh, by far.

Well, it's the old, it's the old saying, you know, the people that can get money, the cheapest are the ones that need it the least. And it's, it's the reality, because it's all about risk. If you're a lender, you're going to give the least risky borrowers, the most amenable terms, and you're going to charge the highest rates to the borrowers that are the least safe.

So again, that's the reality. So again, you're looking at to carry this over back to the public markets. You're looking at businesses that were getting 4%, four and a half percent, four or five years ago that are now looking at 9 percent plus cost of money.

And if you're looking at a 10 percent rate of return and you're borrowing money at 9%, there's really not much left over. Right? So that's the issue.

Now on [00:11:00] issuing equity, you have to start thinking about the valuation of your business, right? And what, how much dilution or existing shareholders going to take? Price to book value, for example, maybe you're having to discount below the book value of the assets of your business to issue the secondary. So there's cost of capital things kind of come into play and you have to consider them.

Jeff Santoro: And by the way, how much is your stock going to go down when it's announced that you're issuing and doing a secondary offering? Because usually there's a little bit of a hit there.

Jason Hall: Yeah, absolutely. So all of these things, you know, come into play and you have to decide is whatever is it going to cost you to raise that capital versus the return you're going to get with whatever you do with it. Is it going to generate an incremental return? Right?

So that's, so that's substantially changed.

And for a lot of businesses, deals that they did in 2018 or 2019, they would not do today because they would not be profitable issuing debt under the current regime, interest rate regime.

Jeff Santoro: Right. And I think it's, there are probably, this is me, speculating. So you can [00:12:00] tell me if you think I'm wrong, but I would imagine there are more business decisions that companies make that are not a 10 percent return on investment. There are probably more things that are more like a two, three, 4 percent return on investment. And if money is zero or close to it, you know, or it's a five or 6 percent return on investment and your cost of capital is two, three, 4%, that margin is pretty tight.

So now when you think about how much higher your cost of capital is, those deals that were marginal deals are now not even able to be considered. You know, the only deals that are now left for you to consider are ones that would have been a huge return on investment because maybe there's still some margin there, you know, some difference between the cost and, and the return.

So I think that's going to really change the outlook for a lot of investment that a lot of companies want to make.

Jason Hall: Yeah, so we'll talk through, I'd like to maybe talk to some companies and give some examples, um, as, as we talk through [00:13:00] this Jeff, but, but one of the things that we'll talk about too is there's also, it's also changed their investing, like the profile of who might consider investing in them.

Because for example, if you're a higher yield dividend investment, one of those blue chip companies, maybe like the yieldcos, I've done a lot of videos with Tyler on our YouTube channel, looking at the yieldcos that some things have certainly changed there as well. Because a lot of their lenders that have done those notes and you hear it, like, you'll look through a company's 10 K or 10 Q and you might see like unsecured notes, senior notes, convertible notes, notes. That's that's bonds. Basically what that is, right? That's bonds that they've been issued. Convertible means that they can convert it to stock under certain terms. Unsecured means just that it's not, it's an unsecured loan. It's not secured by any of the companies [00:14:00] assets. And it might be junior to other types of debt in the capital stack that stand at the head of in front of it in the line of the worst case scenario the company goes, it has to file bankruptcy who gets paid first, right? That's what all of that stuff means.

So the other thing that's changed is because now you've seen interest rates come up. Treasuries, right? So that federal funds rate. You know, we say interest rates have gone up or down, the Fed changed its target rate. That's like the benchmark rate. That's borrowing or lending money to the federal government, right?

That's the zero risk rate of return. The reality is if you, like, we've talked about this before, Jeff, I think you and I did a video on our, that we've talked about it. You can get 5 percent in your brokerage account on money markets, right. Which are short term treasuries.

There's so much access to high yield, safer investments now than equities, why would... Investors are having to consider, why would I stand at the very end [00:15:00] of the risk line if I'm not capturing a higher yield that I know is going to be dependable, right?

So now the valuations of these companies is starting to be pressured by the reality for institutional investors, like pension funds and, and large money managers that are now starting to realize, well, I have these minimum thresholds that I have to reach to generate income. Like an endowment, you know, they have to spend a certain amount of money every year and they need to try to maintain some value. A lot of that money went into equities because they couldn't meet their minimum spending thresholds in bonds because the yields were so low. They were eating through their endowment.

Jeff Santoro: Right. And now that there's more options to get that yield, there's less incentive to put it all into equities.

Jason Hall: Right, exactly. Exactly.

Jeff Santoro: So it seems like, so I'm thinking of this now in like kind [00:16:00] of two buckets, right? There's, there's the pressure that on stocks that you just talked about, right? So, as we've been talking through what's been happening-

Jason Hall: The actual pressure, I want to take the word stocks out of the pressures on the businesses.

Jeff Santoro: Right. But I'm just saying, there's pressure on all stocks in the sense that all stocks are now looking riskier compared to the fact that you can get 4 or 5 percent relatively risk free or completely risk free if it's a government bond.

So, but that's like the global thing, but then I think this is where we want to go next, which is there are specific companies that are going to probably be mostly okay and some others that are really going to struggle when we go back to the original part of our conversation, which is how they're going to handle cost of capital, because it's not only making decisions on new investments, it's also about what happens when debt that you already have issued under easier terms now needs to be addressed, rolled over, right? So that's like another thing we can talk through.

Jason Hall: Yeah, that's, you really summed it up well, right. [00:17:00] There's the, from what we were talking about at the beginning, there's the pressure on the businesses about access to liquidity and access to capital, which is one of the things that's creating the pressure on the stock.

And then the other thing that's putting pressure on the stock is what you're talking about. Large investors have more choices. Now, all of these things are putting pressure on stock multiples, right? Driving valuations down. So that's the key.

Um, let's, let's talk a little bit about the company side of it as an investor, maybe where you may wanna think about looking for safety, understanding which companies are better positions and which companies might be more exposed.

Jeff Santoro: Yeah. So I'll, I know you have some examples, but let me, I'll ask a question or something that I've learned to do and it's just a very basic way to start looking at this. So one thing that I've done is I'll look at a company's, two things that you can find on a lot of the aggregator sites. But you can just look into the financial statements that come with press releases at earnings time or sec filings.

Go to the balance sheet, look at [00:18:00] cash and short term investments. And compare that to long term debt. Those are two things that are on every balance sheet. There's sometimes there's variation with what the cash and short term investments are listed as, but those are going to be the things at the top, right? Cause the asset side of the balance sheet is listed top to bottom in order of how quickly things can be turned into cash. And compare that to long term debt, just to kind of get a sense of where the company stands. Is that a good starting place, do you think? And what else should we be looking for?

Jason Hall: Yeah, I think it's definitely just a good starting point. And again, this can vary substantially from industry to industry. So for example, you look at Microsoft. Microsoft has a lot more debt than people realize, but it also has an absolute mountain of cash and it is an incredibly cash generative business.

Apple's the same way. Apple has gobs of debt. I believe, was it over a hundred billion dollars in debt I believe at this point.

Jeff Santoro: Yeah, we looked, we looked at Apple, and maybe you can pull it up while I'm talking, but we looked at it the other day when we were [00:19:00] planning the show, and it was, yeah, a hundred, I guess it was, was it a billion or a hundred million? There's a lot of-

Jason Hall: $109 billion.

Jeff Santoro: But then I asked you, well, what was their free cash flow over the trailing 12 months? And it was not much less than that.

Jason Hall: Yeah, so about $100, about $101 billion in free cash flow over the past year. But more, just maybe more importantly, it has about $28 billion in cash and equivalents cash and short term investments is about $62 billion. And then if you look at long term investments, because it actually has a book of long term investments too that's worth another $104 billion. You know, this is their net, relatively quickly, assets that they could turn into cash relatively quickly, dwarfs the amount of debt that it has. So-

Jeff Santoro: And they're a company that if they did need to go to the capital markets could do so at probably the, if not the best, [00:20:00] one of the best rates any company could ever get at any given time.

Jason Hall: Well, and the reality is that the, all of that debt, I shouldn't say all, but the vast majority of, of Apple's debt has been put on the balance sheet in the past... let me pull it up. I'm curious to see. Yeah, you go back to 2014 and it had, I don't know, maybe $20 billion in debt. And now it has $109, and it was over $120, it was almost, I think, $130 back in 2021, and it's paid some of that down.

The reason Apple took on that debt was because it was able to get insanely good terms on that debt, and leverage that debt to generate better cash flows. A really smart example of a company leveraging cheap debt in a smart way, that they could, they could write a check to pay it all off by the end of next month.

Jeff Santoro: And you know that they are going to be keeping an eye on interest rates, keeping an eye on when debt is maturing, and will [00:21:00] likely pay off that debt that's on really good terms to whatever degree they feel is financially smart to do so, rather than get caught off guard and all of a sudden have to, you know, roll that debt over into 6% interest rate.

That, you know, so they are a company that, the winner that keeps on winning, so to speak. They, they've always been in a good financial situation and, and were able to use that to their advantage back when we were still at, in the zero interest rate environment.

Jason Hall: Yeah, I want to, I want to hit on one thing though, that I do think is important. Because what we're talking about here, Jeff, is we're talking about a business that is very sound.

We're talking about a business that despite having what seems like an insanely large amount of debt, which it is, but again, as a portion of its total balance sheet is a very reasonable amount of debt. And its ability to pay it off and service the debt and not have to worry about rolling it over like so many companies will is a very safe, safe business.

[00:22:00] Now, there's a safe business and then there's concerns about the stock. And I wanted to bring this up, I just thought it was so very important that if you look at Apple stock, the stock price has gone up 218 percent um, over the past 5 years. You know, that's not plus the dividend, that's just the stock price.

That's a triple. That's a wonderful return. At the same time, Apple's multiple, earnings multiple, P. E. ratio has gone up 60%. And it now trades for roughly 30 times, 30 times earnings. Here's another thing. I think this is really important too.

At the same time that the stock price has gone up that much, its earnings have roughly have left roughly doubled. And if you look at since the beginning of 2022, actually let's look at 2021. Earnings per [00:23:00] share have not grown at the same, at the same rate. As a matter of fact, earnings per share down over the past almost two years.

So there's a business that's in perfectly fine shape. Investors need to be really cognizant of is that going to be the same thing as a stock that is safe? And I think that's one of the risks that a lot of investors are potentially walking right into.

Jeff Santoro: Yeah. Just because we're sitting here saying Apple's one of the least likely companies in the world to be super adversely impacted by all the higher interest rates, it doesn't necessarily mean that it is a back the truck up and load up on Apple stock kind of a moment. For the exact reason that you just explained.

Jason Hall: Yeah. It's because of the company has gotten so large and there's, it's, it has levers for growth. We've talked about that before. I don't think we need to spend a lot of time on it, but I want to think about [00:24:00] making the case for investing in Apple.

One other thing. Apple was it 80%, I believe of the float is owned by institutional investors.

Jeff Santoro: Yeah. It's a lot.

Jason Hall: It's a substantial amount, right? And these investors tend to be slow to move. Apple yields about 0.5%. Now, long term holders are getting a lot better yield on their cost, right? Which is, which is a consideration that they, that they will make.

But again, in this environment, if you're a large institutional investor and you're looking for a minimum threshold of returns and you've held Apple for 10 years and you've done very, very well and you're looking forward and you're looking at Apple, and you're looking at 10 year treasuries that can get you a 4 percent yield. Maybe that 4 percent yield is enough that you begin to start selling down that Apple [00:25:00] position and moving more and more into a ladder of bonds maybe.

Again, 8 percent interest rates on 30 year mortgages. Mortgage backed securities are a lot more attractive now, and that's an asset class that institutional investors love. A great way to get yield. Credit, uh, scores are very high, tons of, like loan to value looks really good compared to like during the financial crisis, it's a completely different environment.

The point is that there are so many significantly more attractive and investments when it comes to generating income. And stable and holding value that even the...

Apple's out there trading at 30 times earnings. Warren Buffett paid 15 times earnings for Apple.

Jeff Santoro: So I think we should pivot to maybe if not a specific company, the types of companies that might be on the other side of this interest rate environment in terms of ones that are a little bit more at risk or a lot more at risk. But before we do, I thought of an analogy maybe for, [00:26:00] that I want to see if you think holds water.

So the idea that Apple was smart and got really good debt on really good terms back when debt was cheap, it reminds me of a friend of mine years ago who had to buy a new car and had the cash on hand to pay for the car, right? It was just going to write a check and buy the car, but the dealer was offering 0 percent financing.

And this is not recent. This is like 2003 ish, right? So like a while back. So he just took out the loan and parked the, whatever it was, $30,000, $40,000 for the car in an interest, you know, a savings account, which was probably at the time getting, I don't know, 1, 2, 3%, like not a lot, and just paid the monthly check, you know, paid the car every month at 0 percent and made money on the deal because he kept the money in his savings account.

It's, is that kind of what Apple was able to do here? Because now they can take their cash and put it in their own, you know, find their own high yield savings account or the [00:27:00] equivalent and make four or five percent on it while they're paying off debt at zero or one percent.

Jason Hall: Yeah, that was actually part of Tim Cook's strategy, right? And the best time to borrow money is when you don't need it, right?

And Apple certainly took advantage of that. And there was more to it than that because Apple does and has for years at this point, does, generates the vast majority of its revenue and income outside of the U. S. And has lots of international subsidiaries where a lot of its cash sits, right? So it took advantage of the opportunity, the fact that at the time, and the laws have changed, about repatriating cash from international subsidiaries back into the U. S.

It's more tax favorable now than it was in the past. But when Tim Cook started doing this with Apple, the idea, a lot of that debt was issued in Europe and other markets to leverage those strong international balance sheets and to generate even more cash that they could use in [00:28:00] ways, to invest, to generate exactly what you're talking about, better returns.

It's a really, really smart use of leverage. It absolutely, absolutely holds weight.

Jeff Santoro: So if we turn to the other side of the coin here, maybe you have specific companies in mind. But I'm just going to generalize and explain the way I think of how companies could really be hurt by this new environment.

So during 2020 and 2021, a lot of the companies that were really bid up in, in that post pandemic bubble that we all lived through were the ones that were growing top line, growing revenue and also, subscribers and customers and dollar net retention rates.

All those things were crazy good, 60, 80, 100 percent year over year growth in those areas. But a lot of those companies were also sustainably unprofitable with no progress being made towards profitability, [00:29:00] and burning, just lighting cash on fire.

And the market didn't care because as soon as that company would theoretically run out of cash, they could just go a issue more stock with their super inflated stock price or go get more debt for 0 percent or 1 percent whatever the crazy low rates were.

And then that all changed when reates went up. Because now when those companies inevitably run out of cash because they're burning it like crazy and they're unprofitable, to your earlier point when we started off, they don't have the operating cash to make the capital investments and they don't have the free cash to do anything either.

So now all of a sudden they either have to quickly pivot to profitability, which is going to hurt margins. At the same time they're probably seeing growth rates slow down because the economy itself is getting a little bit slower. People are a little bit more cautious. Businesses are a little bit more cautious. Now, all of a sudden, these companies that looked unstoppable are really going to have to show [00:30:00] that they can turn the corner quickly enough before they run out of money. Or they're going to run out of money.

Like that's the way I think of it. And you know, I think about the, not to crap on the same specific companies, but just in the world of stocks that I know and keep an eye on I'm thinking of like Twilio, Asana, you know, those like cloud SaaS companies are really the ones that kind of fit that profile. So just as a way of kind of level setting the way I'm thinking of it, that's the kind of company I would be worried about. So I want to know what you think about that.

Jason Hall: Yeah, I think that's, I think that's exactly right. Because again, it gets back to the Apple example. You know, the best time to borrow money is when you don't need it. And what's changed for so many of these companies is a lot of them went public, not even capable of being profitable. Something else that, you and I've talked about before is we love the businesses like CrowdStrike, I think is our constant refrain, is this is a [00:31:00] company that for a long time was burning cash because they chose to. Because they knew that their best path for the long term was going to be aggressively spending money to build scale, acquire customers, expand those customer relationships. And when it got to a certain critical mass, then it would start throwing off free cashflow like crazy and that number would, I don't want to say exponentially, but very close to being exponentially grow year on year from there. And we've seen that it's exactly played out too, as the company's management told us that it would.

Now, again, there's a lot of companies that they just can't, right? They would pretty much have to gut their businesses to get to just a breakeven point on cashflow. And the ones that have weaker balance sheets that didn't aggressively raise money, those are the ones that could be in trouble over the next couple of years. [00:32:00] 

Jeff Santoro: And it could be a further self fulfilling prophecy for some of these companies. If they, if their only way of gaining market share and putting up those 30, 40, 50% year over year revenue growth quarters was to burn cash and spend on sales and marketing, and, you know, do everything possible to grow at all costs. If in the absence of that, they cannot continue to capture market share, this could just for some of these companies, it could just spiral, right?

They don't have the cash to get their name out there. Therefore, revenue slows. Therefore, they don't have the revenue to try to turn towards profitability. Therefore, they need to go to the capital markets. You know, it just, you can just play this out in a world where their whole business plan was built on low interest rates.

You know, you would hope a management team would burn cash, but always know if I push this button, I can, we can still survive and not burn cash this much. But we're going to do it while we can.

You [00:33:00] know, I don't necessarily blame a company for burning cash when debt was free. But I think you have to have some understanding that if this does come to an end, if this free money ends, what do we do? And I don't know how many companies really had that plan. I guess we're going to find out.

Jason Hall: I've got, I've got an example of another company I want to share.

This is kind of a smaller, lesser known, not as covered in the financial markets, by the financial media and that's Stem. So Stem is kind of like a hybrid hardware technology play, and they're in renewable energy. And the two parts of their business, number one is, is batteries for energy storage. And these are large scale projects, right? So utilities are their customers or grid operators are their customers or Google, right? Alphabet, these large industrial power users that need energy storage either because you're a power producer [00:34:00] and you have, variable production assets like wind or solar that you want to capture, or you want to capture power from your other, you're, like your natural gas plant.

You want to capture power from that so that you can use during peak demand to offset, right? So you get these big energy storage, batteries and you roll those out to be able to do that. So Stem does that. They work with the battery manufacturers to sell and install the batteries.

But they're... The hook is Athena, which is software as a service. It's an AI powered- here we are throwing AI around- this, but they've been around 10 years, right? This isn't something they didn't just drop this in their, in their investor presentations, when, ChatGPT launched. This has been the core of their business for a long time.

But they do these like, 20 year contracts to use AI to manage the power, the power resources from these batteries to manage the power coming into store and going out. Whether they're selling the power or you're a user and you're [00:35:00] using it to offset your use of power from the grid. And they're, they're like a leader in this.

So the problem, it's going to sound kind of familiar. They went public via SPAC. They raised a certain amount of cash and then they've kind of blown through it. They, they did. And they've been cash burn and they did, they did an acquisition.

It's a smart acquisition, like the, it made sense what they bought. They bought a company that kind of sits on the other side with software to manage solar assets, like to make sure all the solar assets. So you've got a big utility scale or you're a Walmart or some other, you have lots of distributed solar all over the place and you want to try to manage it all. It's like an AI powered software to help manage those assets. It's a good fit, right? It's a really good fit within the business.

But they used most of their cash to do it. And you look at their balance sheet and there's concerns, you know. Six months into the year, they've decreased their cash and [00:36:00] short term investments by, I don't know, 120 million, they've got less than 150 million in cash. Now they've gone through about half the cash and equivalents they had left.

They've added a lot of inventory, so hopefully they can generate cash from that, but then you start looking at their operating results and $35 million operating loss last quarter. Bigger than the year before. $78 million operating loss for the first half of the year, bigger than 2022.

And then you start looking at operating cash and they burned $200 million in operating cash halfway through the year. Year ago, they burned $32 million. It's going the wrong way in this environment.

And again, the hope is the other stuff they're doing, like they've grown their backlog. They've bought this inventory of batteries. They've bought it because they have customers lined up, ready to deploy. They're going to do those deals and they're going to recognize the revenue and they're going to get cashflow and it's going to be fine.

But it's an environment where you [00:37:00] look at their stock price, and the market saying, wow, you guys are about to run out of money. And we're selling the stock because we don't want to get hammered when there's a secondary and guess what? It makes it worse because the stock price keeps going down, right? Which means you got to sell even more shares to get the same amount of money.

So maybe Stem can turn it around. I own some, disclosure. But it's a, it's like a perfect example of a company that's kind of caught up in this whirlwind of cost of capital when it's when it was trying to get to that point of critical mass where it can make enough money to live out of its own operations.

Jeff Santoro: And the next several quarters, I think, are going to continue to be really informative for companies in their position, to see how they're able to navigate it.

I want to turn in a minute to how we as individual investors should kind of think about this, what this means for us and our portfolios. I think it's worth pointing out all of this stuff we're talking about sounds like [00:38:00] this awful scenario. Like why would the government raise interest rates and can, you know, make the stock market not be as better, you know, good for investors.

But this is exactly the point. They want, you know, inflation goes up because the economy is too hot, too many people buying too many things all at the same time. So you raise interest rates. You force companies to not spend as much money for all the reasons we talked about earlier. It's not worth it. You're going to lose money on the deal. You're not going to build that factory. You don't build that factory. Then all the companies that do factory building also have their businesses slow down. And this is like, it eventually seeps its way through the whole economy, right?

Jason Hall: The general contractor, the subcontractors, all, the company that makes the robots that goes inside the factory that builds the widgets, the company that sells paint that they use to paint their products, right?

All of that stuff downstream, right? All of it.

Jeff Santoro: The goal being to bring down inflation. You know, and the target is to get inflation around 2%, right? I think [00:39:00] that's where the federal government's looking to kind of get it to. So just for those of you that don't follow macroeconomics, like that's the point of all this.

This is on purpose. The balancing act the federal government's trying to do is how do you do this slow enough and carefully enough that you don't just crash the economy and start a huge recession. Because if that gets bad enough, you know what they're going to do. They're going to cut interest rates to stimulate spending and we're going to be right back where we were.

Jason Hall: And you whipsaw things right to, to coin, uh, Ron White. The Fed does not want to, or not Ron White. This is Larry the Cable Guy, excuse me, Larry the Cable Guy, but the Fed does not want to crash the truck to get the insurance money to make the truck payment. That's not what they're trying to do. Yeah.

They're trying to just slow things down.

Jeff Santoro: So let's talk us. Individual investors, listeners to this podcast, and what this means for us.

My, my first question, and it's not one we planned for, but it popped into my head while we were talking through this. So if you're, if you're [00:40:00] listening to this podcast, and this is interesting to you, and you're thinking, I want to keep an eye on this.

I want to see how the companies, my portfolio, are doing. What types of financial metrics we, you know, cause every time a company reports earnings, you get all the regular stuff, right? You get revenue and gross margins and operating margins, and net income or net loss and cashflow and all those things.

What are things that people should keep an eye on to, if they feel like a company might be one of those ones that could be negatively hurt, you know, negatively impacted by all of this. Are there certain things you would suggest we kind of keep an eye on?

Jason Hall: Yeah, I think as a starting point look at the companies that you own, that are very asset heavy that have used a lot of debt or use a lot of debt to acquire and build.

So utilities It's an obvious one. Anything in real estate, real estate investment trusts, obviously use a tremendous amount of debt. Industrial manufacturers. We talked about the yieldcos, which are basically utilities. These are businesses that use a [00:41:00] substantial amount of debt.

And I think especially the ones that have really been aggressive growing with debt over the past 10 years are, these are the kinds of businesses that you definitely want to start peeling back the layers on, right? So just start there.

So for example, Chart Industries (GTLS) is one that we can use. This is a company that has aggressively grown. They do cryogenic gas processing and storage. So you think about liquid nitrogen, liquefied natural gas. Their growth markets are things like energy. So like LNG exports is a big thing. LNG is a transportation fuel. Biology, um, biomedical is a big client of theirs. Food manufacturing is a big thing that they, that their business gets used for. But energy is like the big one. That's the kind of the big lever.

So they've really been aggressive about M&A over the past decade, lots of acquisitions. They just made a really, really big one. Bought a company that I think in revenue actually did more revenue than Chart did.

So when you find those companies in your portfolio, [00:42:00] you go find the interest expense line. On their 10K, um, or their quarterly reports. And you look at it and, and if it's a pretty sizable number, or you look at the debt number too. Like, they have a pretty sizable amount of debt. Then you start finding in the annual report where it starts breaking up apart their debt and show you when their debt matures, start showing you interest rates for what they're paying.

And if those companies have a lot of debt under substantially low interest rates, I'll give you an example. And Tyler Crowe and I did a video that I think, I think I'm going to run the video this Sunday.

So it'll come out the day after this podcast does looking at NextEra Energy Partners, tickers NEP. Got about six and a half billion dollars in debt. They ended ended last year with five and a half billion. Of that five and a half billion, about a third of it. $1.7 billion is point is at 0.78 [00:43:00] percent interest rate. And it matures between 2024 and 2026. So over the next two and a half years, they have a third of their debt that's going to go from less than 1 percent yield to probably 7 percent or more. It's convertible debt.

Jeff Santoro: Can you explain, yeah, explain what that, explain why when it matures, all of a sudden it has to be, you know, renewed at a higher rate. Just for anyone who sort of struggles to understand how all this works.

Jason Hall: Yeah. So this is one thing a lot, you know, if you have a small business and you go get a bank loan, the bank loan is, might be amortized where it's a 10 year term and you make a payment every month, and after 10 years, it's paid off. There's no balloon at the end.

But corporate debt, these notes, all that stuff that we're talking about for public companies, it's bonds, okay? If you've ever had a savings bond when you were a kid, you you get interest twice a year, right? And then when the bond matures, then you get your money back.

That's the way all of this corporate debt is structured. These are interest only loans. [00:44:00] So all of the back of the napkin math, that NextEra Energy Partners did with that 0.78%, $1.6 billion on the return that they would be able to get from that money, is vastly changed. They're not gonna have $1.7 billion to write a check to pay all that off. They're gonna have to refinance that debt.

Jeff Santoro: Right. So they, so they, at the end of the term, they owe that $1.6 billion to the people who bought bonds.

Jason Hall: And it doesn't come do all at one time. It was done over multiple tranches.

Jeff Santoro: Right. But just to use a big number to explain. Like when, when the bond is, it comes due, they gotta pay those investors back. But if they don't have the cash to do that, they're borrowing money to pay it off, and that money they're borrowing is going to be at a much higher interest rate. So that's where the rolling over of debt becomes an issue.

Jason Hall: You remember that conversation about the best time to borrow money is when you don't need the money?

Jeff Santoro: Yeah.

Jason Hall: They're going to need the money.

And they're going to generate cash flow, right, to pay some of it. And they've announced this big change to their growth [00:45:00] structure. They've cut their dividend growth plans in half. And they said, well, we're not going to do secondary offerings to raise money.

They couldn't afford to now because the dividend yields like 12%, but the point is they don't have a lot of good options for how they're going to be able to to, to deal with that debt that don't include paying substantially more in interest rate, right?

And that, the money has to come from somewhere. And where this is really concerning for a company like NextEra Energy Partners is like the cornerstone of this is an investment is the dividend, right? It's they've paid a dividend and they've been able to grow it aggressively since, um, NextEra, energy created NextEra Partners.

And the example that I gave on the video and I'll share it here, I think it's really useful. Kinder Morgan back in 2014, the end of 2014, Kinder Morgan told investors "our dividend is safe." The energy market was going through a downturn. It was ugly. Oil prices fell, way, like they fell like into the twenties.

Kinder Morgan said, [00:46:00] everything's fine. We're fine. We've got plenty of cash flows. Our credit rating is solid. We're going to be able to fund our growth initiatives and support our dividend.

What they left out of that conversation was that their lenders, these large institutional investors that buy these notes, when they came to capital markets to raise more capital said, we're uncomfortable with the margin of safety in your cash flows. You need to show you need to unlever some cash flow.

And they cut their dividend by like 70 percent. And the dividend, this is nine years ago, and the dividend is still lower than it was before that. They may not, management may not be able to make the decision here, Jeff.

Jeff Santoro: Right. And that's an important thing to remember. So, if they don't want to go out to get, to borrow more money to pay the bonds as they come due, they could use their cash flow. They could, but that would require it for, in a lot of cases, okay, we can pay this out of, with our cash. But we have to stop paying this dividend.

Now, all of a sudden the millions and millions of [00:47:00] people and the big institutional investors and the pension funds are going, well, we were in this for the yield and now the yield's gone. We're selling, which is going to drive the stock price down, which is going to hurt-

Jason Hall: Already down 70% percent. But I mean, that's a lot of that is because of exactly that.

Jeff Santoro: Right, exactly. Yeah.

So one of the, so one of the other things I, there's a couple of things I'm going to keep an eye on in terms of like how this is going to impact me as an investor. So one thing I'm interested in looking for is if I see more mentions in earnings releases about companies taking their cash to pay that off.

You know, sometimes you'll see that mentioned in a press release. They'll they'll talk about how much stock they they bought back, how much dividends they paid. And sometimes I'll have a line in there and we paid off, you know, whatever, $700 million in debt. I'm interested to see if I see more of those mentions along the way, as some of these companies Are starting to try to get ahead of exactly what we're talking about.

But I'm [00:48:00] also interested in a couple other things. Like, I wonder if we're going to start to see more companies just go under. Maybe not for another year, year and a half, but I feel like there's got to be some of that happening. I think we're going to see a lot of companies start to get acquired.

Because when they get to that desperate point of there's really not much else we can do, but they have still have a good product or a good service I think you're going to see the companies that are positioned much more strongly, start gobbling some of those companies up. Um, so I think those are two things I'm going to keep an eye on.

But I'm also curious to see what companies in my portfolio kind of thrive in this environment or become more advantaged by virtue of the fact that their competitors are now disadvantaged. Does that make sense? You know what I'm trying to say?

Jason Hall: It does, and from all of those things.

So let me start with the first one on the companies going under. I think so. And part of part of that is because [00:49:00] capital markets have frozen up already right? We've seen with, um, VCs with everything that happened with Silicon Valley Bank in March, you know. VC funding has frozen up. They're not doing down rounds or not a lot of, um, series next series of investments that are, are happening .

And part of it is because they're being patient. Private equity has already started making acquisitions. We've seen a lot of those SaaS softwarey kind of companies that it was questionable whether, is this really a standalone business or is it just a great product that needs to be part of a bigger suite of software that's part of a bigger company? We've already seen some of that has begun to happen.

Jeff Santoro: Yeah. I should say in the bucket of companies being acquired, I think you're going hand in hand with that as companies just being taken private.

Jason Hall: Yeah. Oh, absolutely. Yeah.

No, it's, it's not just acquired by public companies. Private equities buying these and bundling them together in some cases. And we might see them start spinning them out [00:50:00] as public companies that are a combination of these, of these products down the road. So yeah, I, I think that's, that's very realistic.

And it's definitely going to be, if you're an Alphabet with a massive cash balance sheet. Or if you're a Tesla, right, with very, very little debt, and strong cash flows. And all of these EV

startups are so disadvantaged against that. Even some of the big automakers, right? They're, they're just still generating good fresh cash flows that they still, they have a lot of debt to deal with that is not, they're not as advantaged as a Tesla is. So even their ability to take share back and expand may be more limited. Those are, those are realities.

I think I want to say this, Jeff, I think it's just really important to note. I'm not making some prediction of a market crash here. I think what people are maybe underestimating is the market's potential to kind of go sideways or just bleed off [00:51:00] like multiple gains. You know, the PE ratio having moved higher.

Over the next, you know, four or five years, as stocks value down as more of that large money moves into fixed income, right? You're it's not, it's not all going to move next week, you know, it's going to move over the next four or five years. And I think that's something investors have to consider.

You mentioned stock buybacks. You know how companies did a lot of the stock buybacks they've done over the past decade. Jeff?

Jeff Santoro: By borrowing money at really low interest rates and using it to buy back stock?

Jason Hall: We have a winner. Got it in one. That's exactly, exactly right.

Jeff Santoro: So you're going to see less stock buybacks probably as a result.

Jason Hall: Yeah. I think that's, that's absolutely the case.

So you put all of those things together, we talk, I don't know how many times over the past two months I've, I've said that the CAGR, the S&P 500 over the past dozen years or so has been over 14%, right? 40 percent better average returns per year [00:52:00] than the market's long term.

I think it's, we've seen it historically coming out of these very, very good bull market runs that we see substantial underperformance. And I think we could see, we could see that happen going forward for a number of reasons.

And that's, that gets back to the whole messed up expectations thing to me. Is why investors need to have the right expectations. If you think you're going to get 10, 12, 15 percent returns, like even if you just think you're going to get, Oh, I'm going to get 10 percent returns for the next decade because that's what the market's averaged. I think maybe you're setting your expectations, maybe a little bit too high.

Jeff Santoro: Yeah. And I think that's a perfect way to sort of wrap up the conversation, which is to think, let's bring it back to what we can actually do. Do or how to actually think about this, right?

Jason Hall: Get into the toolbox.

Jeff Santoro: So I think the first thing that I'm thinking of is what you just said, which is not to be pessimistic, not to be bummed out, not to be sad that you've decided to spend time listening to an investing podcast, right as it's time to stop investing. That's not [00:53:00] what we're saying.

But having realistic expectations, or at least conservative expectations of what could could be the next several years is, it's just, I think it's just smart generally. Like, even if we were in a great bull market, it's probably still smart to just temper your expectations because you do never know what could happen. But yeah, are we going to see a 14 percent CAGR for the next? 10, 15 years. I, with you, I would doubt it. You know, so I think that's smart.

You know, if you're building your retirement expectations or if your number, quote unquote, that you need to hit for financial independence is based on X percent a year from your stock investments. Maybe it's just time to, you know, think about that a little bit more.

And by the way, don't listen to us. I talked to someone who's actually a qualified financial advisor, but that's something to think about. But what are some other things that we can actually do, Jason, like to kind of navigate through this?

Jason Hall: I think it's one of the things that you always need to be doing. [00:54:00] And that's, you kind of work backwards.

Thinking about something, Jeff, you and I both can relate to. Paying for your kids college. Have a number in mind that you want to have when they're a senior in high school.

You want to retire. Okay, well, how much do you need to generate income. Back out your Social Security. If you have a pension, if you're lucky enough to have a pension lined up, back those sources of income out. Okay, how much income do you need to have? And this is one of those things where you sit down with a certified financial planner to hash it out. And then you work backwards and say, okay, well, I need to Save another million dollars by then.

Obviously you're not going to save a million dollars. You're going to invest to get to a million dollars. And then you look at your monthly, quarterly, however much money you save every year that you put into your investing accounts. Okay, this is how much I put in right now. What rate of return do I need to get on that money-

Jeff Santoro: To get to the million dollars.

Jason Hall: To get to the million dollars?

Jeff Santoro: Yeah. [00:55:00] 

Jason Hall: And if you're betting on getting 10 or 12 percent returns you're probably going to come up short, right? So you increase the amount that you're contributing.

Maybe, maybe you're a very conservative investor. I know, we have a few that, that send us, send us messages and have questions that have taken a very, very conservative approach to like, they have really low expectations for returns. So they are pleasantly surprised when they do those, those calculations, right?

So I think that's a smart way to start, is you empower yourself to do the math, really be meaning- mindful about thinking about your goals, the amount of money you're going to need to attain those goals, and then just do some math, and then you can reset and you can move forward with a plan, right?

You can build a framework that's going to support getting you to whatever your goals are and you're just, you're not going to stress about it as much.

Jeff Santoro: How do you think? Do you, are you thinking differently? Maybe let's just talk about the way you're looking at it

. [00:56:00] Are you thinking differently about your... Allocation and diversification within your portfolio. I'm not talking stocks, like are you buying less tech stocks and more blue chips or anything like that. But are you thinking about the amount you have in, in like non investable cash? Or, or do you, are you thinking about buying treasuries or increasing your bond exposure?

Like, do you think about your overall, I know you're a hundred percent stock investor in terms of your, you know, invested wealth, that's how you do it. Whereas I'm a mix of index funds and stocks.

But is this higher interest rate environment have you thinking any differently about where you, where you're putting your investment money?

Jason Hall: It does. And number one, in terms of my equity exposure, that's going to stay individual stocks. I'm going to continue to pick individual stocks.

And, but, but I would say that right now I'm 90 percent stocks, 10 percent cash. That's, that's become, again, I've talked a little bit about how that's evolved. For a long time it was 5%, (cash) but you know, in that zero interest rate environment, cash [00:57:00] generated such a low return, that it, that the drag on my portfolio didn't make sense to carry more than 5 percent for me. So now I've moved, I've increased that up to 10 percent is my target amount. I'm getting 5 percent on that cash. So I'm getting paid a decent amount for that optionality.

And I am going to start really looking more closely at bonds over the next year. I'm not going to do anything until sometime in 2024, and I'm really going to start exploring it. Partly because I want to get a better idea of kind of where the Fed's going.

But I do think I'm closing in on wanting to maybe every year, 'cause again, I'm in my late forties at this point. Scary to say it, but I am at a point where I need to start thinking about maybe putting 1 percent of my wealth into bonds every year. And by the time I get to, you know, into my early sixties, I will have built up a pretty good portfolio of bond exposure.

And again, not bond [00:58:00] funds where you're exposed to the ups and downs of interest rates as they remark the bonds to market every day. But owning the bonds itself. So I get the capital back at the end of when the bond matures and I get my yield. And it's safe and it's secure. So I'm really beginning to start thinking that if we're going to see persistently higher interest rates, maybe that's, maybe that's going to be the approach for me to take.

Jeff Santoro: Yeah, I think that's a good way to think about it. I, one other thing I've thought about is, I feel better about my dollar cost averaging way of investing when, when interest rates are higher. Because, you know, I know that the data is out there that, there is data out there that show lump sum buying ends up doing better over time.

I just can't. That's not what works for me. I would be too nervous that I'm picking the wrong time. I would want to time the market. I would drive myself nuts. But you know, this, the fact that I buy every week, and buy what I think is the best investment I can every day, every week when I do it. I feel like I'm [00:59:00] going to, it's going to make me feel a little bit better about buying really good companies that are still strong.

Like we talked about Apple at the top, that might be see some compression and lower returns over time. But it's just like I've been contributing to my 403b retirement fund blindly for 20 something years now. I'm buying at all different points, right? So that's one thing that I'm going to do. That's a personal thing for me that I feel pretty good about.

And then I guess the last thing I want to ask you before we stop here is I think it's probably, or this is my thinking, I'm going to get your thoughts too. I think it's probably good for investors, if you're buying individual stocks, if you don't already spend some time understanding and looking at balance sheets and cashflow statements and an income statements. You know, Google, do a little research on some basics of how they work, because you really can get a lot of information.

Like we talked earlier, just knowing short term assets versus long term debt is [01:00:00] a quick and dirty way to at least get an idea of where a company is. So that's just one more thing that I think is important, more important now than it was back when debt was cheaper.

Jason Hall: Yeah, and this is my last, my last thought on this, Jeff, is I think particularly for younger investors. Investors that have a longer timeline, you're still trying to grow your wealth and create wealth. You have to remember stocks are still advantaged.

Even if we do go into a sustained period of below average returns for stocks, the 30 year treasury and the 10 year treasury, both are yielding less than 5%. I still think stocks are going to do better than that over the next 10 years, over the next 30 years.

So this is, the stock market is still the best way to create longterm wealth. I don't think that that math has changed at all. And I want, I want investors to continue to think about that. If you want to create wealth for your family, stocks are still the way to do it. Just now there's more options and [01:01:00] you're getting paid to be patient.

. Okay. Jeff, we did it again, buddy.

Jeff Santoro: We did it. This was a fun one.

Jason Hall: Yeah, I enjoyed it. And I hope, I hope some listeners out there. I hope you walk away with this feeling good about your finances and more empowered to continue to build and create wealth.

Of course, Jeff and I love to give our answers to these hard investing questions out there, but it is up to you. It's up to you to find your own answers. You can do it. I believe in you. All right, Jeff, we'll see you next time.

Jeff Santoro: See you next time.

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