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NEWS UPDATE ON ALPHABET

There are few other companies out there in the world that possess an investment thesis like Alphabet Inc.’s (GOOG, GOOGL), as the tech giant is attractive on a valuation basis, has tremendous growth prospects, great free cash flow generation, free cash flow conversion rates that are consistently 100%+ of net income, an enormous net cash position, and the firm is likely much more profitable than it first appears due to the losses in its "Other Bets" segment. Alphabet is listed as a top holding, but we want to highlight that we recently reduced our fair value estimate for Alphabet, as its revenue growth rate is slowing down, while traffic acquisition cost increases contain operating margins. That doesn’t mean we aren’t still optimistic on Alphabet as a long investment opportunity.

Rock-Solid Financials

At the end of the first quarter of 2019, Alphabet had $113.5 billion in total cash, cash equivalents, and marketable securities. That is an enormous amount of money, equal to over 14% of the company’s market capitalization as of this writing. With just $4.1 billion in long-term debt, Alphabet’s net cash position of $109.4 billion provides the firm with multiple avenues for upside. For now, the company is mainly using its large net cash position to generate additional profits by investing its hoard into income-generating properties. Last quarter, Alphabet generated over $1.5 billion in other income.

(Image Shown: Alphabet generates a meaningful amount of other income which pads its sizable operating income streams. Image Source: Alphabet 10-Q for the first quarter of 2019)

The vast majority of Alphabet’s marketable securities are debt securities, with only $2.1 billion held in marketable equity securities and $0.2 billion held in mutual funds at the end of last quarter. Keep in mind that some of its marketable equity securities were previously classified as non-marketable, as Lyft Inc. (LYFT) had its IPO last quarter. Alphabet’s CapitalG, its venture capital arm for late-stage companies, invested $0.5 billion in Lyft in late 2017. Note that Alphabet’s GV, a venture capital firm for early-stage companies, invested $0.25 billion in Uber Technologies Inc. (UBER) in 2013, and later on, due to a series of lawsuits, Alphabet’s "Waymo" now owns a stake in Uber Technologies. Those stakes turned out to be quite lucrative investments. However, over the long haul, it’s the income from Alphabet’s debt securities that will provide the most consistent other income generation via interest income.

(Image Shown: A look at the vast majority of Alphabet’s marketable securities, which are primarily debt securities. Image Source: Alphabet 10-Q for the first quarter of 2019.)

Due to the company not paying out a dividend, a large chunk of its free cash flow is retained on the balance sheet. Alphabet generated $12.0 billion in net operating cash flow less $4.6 billion in capital expenditures, good for $7.4 billion in free cash flow during its first quarter of 2019. The firm spent $3.0 billion on share buybacks, largely to offset dilution from share-based compensation, which is very material for a large tech company. Here is an excerpt from its latest quarterly conference call:

“Stock-based compensation totaled $2.8 billion. Headcount at the end of the quarter was 103,459 up 4,688 from last quarter. Consistent with prior quarters, the majority of new hires were engineers and product managers. In terms of product areas, the most sizable headcount increases were in Cloud for both technical and sales roles.”

In regard to the company’s net income to free cash flow conversion, note Alphabet earned $6.7 billion in GAAP net income last quarter (indicating a conversion rate of roughly 110% for that period). As an aside, the company recorded a USD$1.7 billion charge from the European Commission relating to its AdSense business in Europe during the first quarter. That fine was non-tax deductible.

Alphabet’s top line grew by 17% year over year during the first quarter, and most importantly, it appears that the company is entering a new phase. Its next phase will be represented by a period of strong but slower revenue growth than in the past. Over the past three full fiscal years, Alphabet’s revenue has grown by over 22% CAGR, but going forward, we estimate that the growth rate will slow down to just over 14% CAGR. To be clear, that’s still a solid growth rate, especially for a company of Alphabet’s size. Growing a very large business by double digits is no easy task. However, slower expected growth rates generally have a material impact on a firm’s fair value estimate.

Covering Fair Value

We define the fair value of a publicly traded company’s stock price as the discounted sum of its estimated enterprise free cash flows into perpetuity through a multi-stage growth model, less its net debt or plus its net cash position, divided by its diluted shares outstanding. Enterprise free cash flows are estimated by modeling the company’s future revenue streams, expenses, margins, capital expenditures, and other factors that drive financial performance.

As of this writing, we estimate shares of Alphabet have a fair value range of $1,051-1,751 per share, resulting in a fair value estimate of $1,401 per share. While lower than our previous midpoint, we are still optimistic on it as a long investment opportunity. Here is a concise summary of our thoughts on the company from our 16-page stock report:

Known for its search dominance that it maintains, Alphabet is a tech company focused on a number of things: Android, ads, YouTube, Chrome, and research. We think the company will have some megahits in the years ahead. It reported an operating loss of ~$3.4 billion in 'Other Bets' in 2018, suggesting core levels of profitability are higher than reported. Alphabet offers investors a compelling combination of attractive valuation, growth potential, cash-flow generation and competitive profile.

Very few firms are more attractive on a fundamental basis, in our view, and its impressive free cash flow conversion rates (consistently above 100%) speak to this. Alphabet is pleased with momentum in its mobile division, particularly within mobile advertising. The mobile Internet space will be key for the firm. Facebook Inc (FB) is not backing down, and Amazon Inc (AMZN) may be entering digital advertising in a big way. YouTube and programmatic advertising offer upside potential, but we're watching spending levels, which have spiked due in part to higher traffic acquisition costs.

Alphabet has a strong future in search, and we continue to be in awe of the strength in this division. Its massive net cash position (standing at almost $110 billion as of its latest quarterly report) gives the company a substantial cushion to fall back on as it invests in high-return opportunities and new concepts such as smart home features, Glass, Fiber, or other innovative ideas. Alphabet has three different stock classes with two different tickers. GOOGL is Class A stock, and GOOG represents the non-voting Class C stock that was created by a stock split in 2014.

THE STEPS THAT GOT US HERE

1. Know your competition. Be prepared to name them and tell what makes you different from (and better than) each of them. But do not disparage your competition.

2. Know your audience. You’ll probably want several versions of your business plan—one for bankers or venture capitalists, one for individual investors, one for companies that may want to do a joint venture with you rather than fund you, etc.

3. Have proof to back up every claim you make. If you expect to be the leader in your field in six months, you have to say why you think so. If you say your product will take the market by storm, you have to support this statement with facts. If you say your management team is fully qualified to make the business a success, be sure staff resumes demonstrate the experience needed.

4. Be conservative in all financial estimates and projections. If you feel certain you'll capture 50 percent of the market in the first year, you can say why you think so and hint at what those numbers may be. But make your financial projections more conservative—for example, a 10 percent market share is much more credible.

5. Be realistic with time and resources available. If you're working with a big company now, you may think things will happen faster than they will once you have to buy the supplies, write the checks and answer the phones yourself. Being overly optimistic with time and resources is a common error entrepreneurs make. Being realistic is important because it lends credibility to your presentation. Always assume things will take 15 percent longer than you anticipated. Therefore, 20 weeks is now 23 weeks.

6. Be logical. Think like a banker, and write what they would want to see.

7. Have a strong management team. Make sure it has good credentials and expertise. Your team members don’t have to have worked in the field, but you do need to draw parallels between what they've done and the skills needed to make your venture succeed. Don’t have all the skills you need? Consider adding an advisory board of people skilled in your field, and include their resumes.

8. Document why your idea will work. Have others done something similar that was successful? Have you made a prototype? Include all the variables that can have an impact on the result or outcome of your idea. Show why some of the variables don’t apply to your situation or explain how you intend to overcome them or make them better.

9. Describe your facilities and location for performing the work. If you'll need to expand, discuss when, where and why.

10. Discuss payout options for the investors. Some investors want a hands-on role; some want to put associates on your board of directors; some don’t want to be involved in day-to-day activities. All investors want to know when they can get their money back and at what rate of return. Most want out within three to five years. Provide a brief description of options for investors, or at least mention that you're ready to discuss options with any serious prospect.

~ The business head

Some things to watch out for

The first part of this article is pretty straight forward; stay away from centralized systems. Any coin that is “issued” by either a person or a company, as opposed to minted via decentralized means, is suspect. There have been a couple of coins which have tried to capitalize on Bitcoin's success and have masked themselves to appear decentralized, Ripple is an early example of this.

The success or failure of these types of endeavors is beyond the scope of this article, but I would argue that these are not “true” cryptocurrencies, and can not be evaluated as such; a more fair way to evaluate Ripple or similar centralized ledgers, is as a startup, where it may be both innovative and successful, but it is not a “true” cryptocurrency. Any time you have to relinquish control of either your funds or identity to a third party, you are getting rid of the key advantages of Bitcoin and its successors, in exchange for, well, perhaps a flashy login page. And that’s the rub, if you don’t control the private keys, you don’t own it. If it can be taken away, frozen, or otherwise interfered with without your consent; it is not a true cryptocurrency. The upside to this is that these sorts of “fake crypto’s” are easy to identify; they will rarely have wallets in a similar vein to the Bitcoin core wallet, a standalone piece of software, but will most often be hosted on the web.

I also find distributed ledger coins, but whose coins have been created from thin air, to be suspect. These coins are distributed via giveaways and other methods, and they suffer from the same weaknesses as do centralized ledgers, they lack the intrinsic value of minting. Minting a Bitcoin costs time, know­how, equipment, and electricity; as opposed to the conjuring of coins which costs nothing. Stay away from centralized systems.

A pre­mine is where a coins lead developer (and others) mine the genesis block and subsequent blocks in secret for a period of time, prior to publicly launching their new cryptocurrency. These are almost always scams and one should stay away from such coins. Identifying them can be tricky at first, but they are usually unmasked within a couple of days. These coins are usually part of a pump and dump scheme, where a coin that just launched is quickly added to an exchange, hyped and pumped to a certain level and then all the pre­mined coins are dumped, leaving bagholders with worthless crypto. This is one of the core reasons why, contrary to popular wisdom of “get in early,” I advocate not investing in a new crypto currency at least for the first 180 days of its life cycle. Yes, there are great advantages to getting into the next great thing early, mainly cheap coins, but these sorts of scams are common enough that in the long run you are better off waiting to see if a coin grabs a foothold on land before sending your hard earned money in after it.

The instamine follows a similar logic as the pre­mine, it refers to a person or group, who, by the time the coin is publicly released, have knowingly or unknowingly introduced a flaw in the code that will allow them to mine a large number of coins (sometimes as much as 35%) in a matter of hours or days. It is important to note that the cabal that introduced the flaw is not the only one which can mine by abusing this flaw, but rather anyone can, as by definition the instamine happens after release. The end result is the same however, people “in the know” tend to profit. When a cryptocurrency is instamined, and it shows the progression of the instamine during the first few hours of the coins existence; notice how distribution is low until it skyrockets, almost vertically.

An interesting question comes up here. So if it is not okay to pre­mine a coin, and it is not okay to instamine it, how can a developer rightly profit from his efforts? The developer is in a prime position, he knows things you do not, at least at the outset. He knows what his skills are, he knows how much time and money he has to deploy on this new project, and he knows what his endgame is. The endgame will range from “make money fast and get out,” to “change the world with my wonderful new crypto,” so he can do exactly what I just advised you not to do, that is, buy early.

There is a subset of miners that dedicate themselves to mining new coins, and they are known for quickly dumping them on any exchange that will take them; in addition to trading them via PM (private message) and forum posts. This is one way developers can get their hands on their own coins, to buy them cheap from miners (as well as mine them themselves), during the first few days and weeks after launch.

As a matter of fact, if you see a developer buying a large number of newly minted coins, this is a good sign that you might want to keep this crypto in your radar. A developer with “skin in the game” is always best. It is important to stay away from both instamined and pre­mined coins; they are highly suggestive of pump and dump schemes.

WASH TRADES, MC, AND CURRENT PRICE

Inline with crypto liquidity, you should also be aware of “WashTrading ”and how it can affect your investment opportunities on any given exchange. Wash trading can happen with both high and low volume coins (although it is easier to do in low volume markets), and it is something to watch out for. Exchanges will often execute transactions where the accounts associated on the “bid” and “ask” sides, are both controlled by the exchange, or, in some cases, by very large stake holders. This happens so that the exchange can artificially inflate its trading volume and appear more attractive to traders who are always on the lookout for higher liquidity. It is not always obvious which exchanges are faking their liquidity through wash trading, if you are not familiar with that particular exchanges history. One good indicator is when you see an exchanges volume increasing without a corresponding movement on price. This is because the bots the exchange (or others) use to execute wash trades, are set to bid plus or minus cents, or fractions of a cent in relationship to last trade; so although volume picks up, price remains unaffected. This makes sense when you consider that if the exchange actually decided to purposefully affect pricing, it stands to lose substantially if the market does not move in the direction that they need it to move. Even the most established crypto exchanges have been known to use wash trading cycles to increase their volumes, but you should try to stay away from them even if you do so only when they are going through such a cycle. Wash trading can, although it not always is, be a sign of deeper problems; so it is best to be on the safe side and park your money on calmer shores while this is going on. If wash trading is going on in an exchange you need to use for any particular reason (like it provides special features), move over to another exchange until the dust settles. Crypto investment is about minimizing risk.
Market capitalization is determined by a simple formula (number of coins available X current market price = MC). It is important to note this formula works with “coins available” (already mined) as opposed to the potential future total supply of coins. Current Price is another one of those indicators that seems straightforward but is tricky to get right. It is a good indicator of current perceived value but not much else. As a matter of fact, p​rice should not be heavily weighted when evaluating a new coin;​ the crypto market is so immature and laden with manipulation, that the current price of a budding altcoin is nothing more than a place holder of a value that is yet to be determined. C​onsiderations of price should never outweigh those of technical potential. It is also important to view market capitalization as easy to manipulate. Sometimes miners will issue a huge number of coins, in the hundreds of millions, or even billions; because a rogue developer may engage in wash trading, these coins may reflect higher perceived value than their actually is, and because of the sheer number of coins, market capitalization may also reflect a vastly inflated figure. This is hard to do on high volume coins, but easy to fake on low volume markets, you have to watch out for this. It is generally a good idea to evaluate market capitalization in context with daily trading volume, as opposed to price. If you see a coin with low daily volume but high market capitalization, you are most likely seeing a manipulation of that coins price.

Bear Market Rally Or Sustained Bull Market?

After a steep decline in the last quarter of 2018, global markets are rising strongly in the first few months of 2019. Many investors are wondering if this is just a bear market rally or a continued bull market for stocks. Quantitative strategies based on momentum can be remarkably effective at outperforming the market in terms of both risk and return. These strategies buy strongly performing sectors, so they gravitate towards safety or risk depending on how risk appetite is fluctuating in the market. As of the time of this writing, high-risk sectors such as software, capital markets, and semiconductors are leading the markets higher. This bodes well for the bulls over the mid term.

Global stock markets delivered dreadful losses in the fourth quarter of 2018, with many of the most relevant market indexes falling by 20-30% in a short period of time. But things turned around abruptly in 2019, with stocks all over the world producing massive gains and recovering a considerable share of the ground they lost in 2018.

In this context, it makes sense for investors to wonder if we are just seeing a short-term rebound in a bear market or a renewed long-term bull market. In other words, should we be selling the rips or buying the dips in this market?

There is no way to know for sure what the future will bring, we are always dealing with probabilities as opposed to certainties in the stock market. Nevertheless, some quantitative indicators have a solid track record of performance in terms of evaluating the market environment and positioning the portfolio accordingly.

The statistical data has proven that strategies based on trend following and momentum tend to produce market-beating returns over long periods of time. Importantly, we can also evaluate the market context by looking at the main momentum indicators in order to tell how different areas are performing and what this means in terms of risk appetite.

The following paragraphs will be introducing a quantitative strategy that rotates among multiple ETFs representing different asset classes and sectors. The strategy has produced solid backtested performance over the long term by focusing on high-risk assets when risk appetite is rising and protecting the portfolio when risk appetite is declining.

A quantitative strategy such as this one is not only valuable for investors who implement quantitative investment methods in the market, but the information that the strategy generates can be an effective tool to evaluate the market environment.

The system is called The Global Rotation System. The system basically rotates among a wide variety of ETFs that represent different asset classes and sectors based on risk-adjusted momentum.

Some important ETFs are:

  • SPDR S&P 500 (SPY) for big stocks in the U.S.
  • iShares Russell 2000 Index Fund (IWM) for small U.S. stocks
  • iShares MSCI EAFE (EFA) for international stocks in developed markets
  • iShares MSCI Emerging Markets (EEM) for international stocks in emerging markets
  • Invesco DB Commodity (DBC) for a basket of commodities
  • SPDR Gold Trust (GLD) for gold
  • Vanguard Real Estate (VNQ) for REITs
  • iShares 20+ Year Treasury Bond (TLT) for long-term Treasury bonds
  • iShares 1-3 Year Treasury Bond (SHY) for short-term Treasury bonds
  • First Trust Dow Jones Internet Index (FDN)
  • iShares Nasdaq Biotechnology ETF (IBB)
  • iShares U.S. Oil Equipment & Services (IEZ)
  • iShares Expanded Tech-Software Sector (IGV)
  • iShares U.S. Pharmaceuticals ETF (IHE)
  • iShares U.S. Healthcare Providers (IHF)
  • iShares U.S. Medical Devices ETF (IHI)
  • iShares U.S. Aerospace & Defense (ITA)
  • iShares U.S. Home Construction ETF (ITB)
  • iShares US Industrials ETF (IYJ)
  • iShares Transportation Average ETF (IYT)
  • iShares US Technology ETF (IYW)
  • iShares US Telecommunications ETF (IYZ)
  • SPDR S&P Bank ETF (KBE)
  • SPDR S&P Capital Markets ETF (KCE)
  • SPDR S&P Insurance ETF (KIE)
  • Invesco Dynamic Food & Beverage ETF (PBJ)
  • Invesco Dynamic Media ETF (PBS)
  • VanEck Vectors Semiconductor ETF (SMH)
  • Materials Select Sector SPDR Fund (XLB)
  • Consumer Staples Select Sector SPDR (XLP)
  • Utilities Select Sector SPDR Fund (XLU)
  • SPDR Series Trust S&P Oil & Gas Exploration (XOP)
  • SPDR Series Trust S&P Retail ETF (XRT)

The system is basically buying the ETFs with superior risk-adjusted returns over 3 and 6 months. This strategy does not work all the time and buying outperforming sectors can easily backfire when there is a reversal in the main market trends. But backtested performance has been quite strong over the long term.

Since January of 2007, the Global Rotation System produced a cumulative gain of 541.4% versus 156.1% for the SPDR S&P 500 in the same period. In annual terms, the system gained 16.5% versus 8% for the SPDR S&P 500.

The system substantially outperformed the SPDR S&P 500 in terms of downside risk too. The maximum drawdown was 18.4% for the Global Rotation System versus 55.2% for the SPDR S&P 500 in the same period. Drawdown is calculated as the greatest percentage drop from the high.

Providing more details, the table below shows the annual return numbers for the quantitative strategy versus the SPDR S&P 500 in recent years.

It's important to keep in mind that a strategy such as this one has both strengths and weaknesses. These kinds of strategies are remarkably effective in times of well-defined trends in the market, either up or down. However, when markets are moving sideways and trends are reversing, the strategy will most probably deliver disappointing returns.

For example, in 2008, the system gained 15.5% versus a decline of -36.8% for SPDR S&P 500 because the quantitative portfolio was mostly allocated to safe-haven assets such as Treasuries and gold.

Similarly, in 2017 when high-risk stocks were booming, the portfolio was carrying a high allocation to tech and software stocks, so it gained 30.8% versus 21.7% for the S&P 500.

On the other hand, the quantitative strategy is underperforming so far in 2019, gaining only 2.3% versus 13.4% for the SPDR S&P 500 on a year to date basis. This is because the quantitative portfolio was positioned for safety at the end of December of 2018. As markets rallied in January of 2019, the strategy lagged the market.

This recent underperformance shows that it takes some time for the quantitative strategy to incorporate the incoming information about price momentum for different sectors. When there is a quick reversal in price action, a strategy like this one will most probably underperform.

That is an unavoidable weakness due to the nature of the strategy. Performance should be strong over long periods of time and, especially, in well-defined bull and bear markets. However, when markets are transitioning and trends are weak, a system such as this one can be expected to produce a mediocre performance.

Interestingly, we can look at the data provided by the quantitative system as a tool to evaluate overall market trends. Some sectors and asset classes tend to rally when risk appetite is increasing, while others are a refuge in times of risk aversion. For this reason, performance in different segments says a lot about the broad market environment for stocks.

When looking at the portfolio positioning, the quantitative strategy is currently recommending software, capital markets, and semiconductors. These are clearly highly cyclical sectors and they tend to do well when risk appetite is rising.

It's one thing to see the S&P 500 being led by low-risk sectors such as pharmaceuticals or food. In such a scenario, you could say that the price action under the surface is not very supportive for stocks in general because the stocks that are outperforming are the ones that tend to do well when investors are looking for safety.

However, software, capital markets, and semiconductors are highly volatile and cyclical sectors. This is telling us that investors are embracing risk and focusing on the industries with superior potential for returns when markets do well.

Looking at the price action in different segments, the momentum indicators show that risk appetite is on the rise, and this bodes well for the stock market in general over the middle term.

NURSERY AND KIDS ROOMS

When I get to design or decorate a nursery, I get excited. No other room in the house can take on such whimsy and youthfulness. But it can also make clients uneasy. After all, babies grow into toddlers in a flash, so why spend money on something you’ll just have to change in a couple of years? That’s why when I brainstorm a design for a nursery, I think about the phases ahead and how I can ensure the room will grow with them.

I also often ask clients to consider the space not only for the baby, but for themselves. I believe the baby’s room is for adults to enjoy as well. It’s a space baby and parents use together in the first year or two of the child’s life — think late-night feedings or afternoon play times. Designing a nursery with equal parts baby and adult decor means you can have a nursery that lives beyond the infancy stage, through the toddler years and even into the tweens.

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Thought of the Day

The critical importance of recognizing the direction of the general market cannot be ignored. I’ve realized a 33% loss in a portfolio of stocks requires a 50% gain just to recover to your break-even point.

For example, if a $10,000 portfolio is allowed to decline to $6,666 (a 33% decline), the portfolio has to rise $3,333 (or 50%) just to get you even. Therefore, it is essential to try to preserve as much of the profit you have built up as possible rather than to ride most investments up and down through difficult cycles like many people do.

I generally have not had much problem recognizing and acting upon the early signs of bear markets. However, twice I made the mistake of buying back too early. When you make a mistake in the stock market, the only sound thing to do is correct it. Pride doesn’t pay.

Most typical bear markets (some aren’t typical) tend to have three separate phases, or legs, of decline that are interrupted by a couple rallies that last just long enough to convince investors to begin buying. Such rallies can last 15 weeks.

Many institutional investors, like myself, love to “bottom fish.” Which is when we start buying stocks off the bottom and help make the rally convincing enough to draw you in. In conclusion, any investor will usually be better off staying on the sidelines in cash and avoiding short-term counterfeit rallies during the first few legs of a bear market.

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