The Wooden Nickel is a collection of roughly a handful of recent topics that have caught our attention. Here you’ll find current, open-ended thoughts. We wish to use this piece as a way to think out loud in public rather than formal proclamations or projections.

1. Technicals… A Follow Up

Last month in this publication, we highlighted how technical analysis can be useful as a supplement to fundamental views and how it can help investors navigate some common scenarios.

If I could add a fourth type of situation, I would say that it can help delineate which “side” in a binary bull/bear debate is “winning”, i.e. what the market is pricing in. Rarely do bottoms-up, fundamental debates about the earnings power and trajectory of a business boil down to one of two sides (instead of running along a gamut of possible outcomes) but it does happen often enough that you can find the market giving an early verdict with still enough time to make handsome returns.  

A relatively recent example probably helps crystallize the point best. In late 2022 and early 2023, Salesforce started coming under pressure from several activist investors. It’s hard for me to remember a time when so many high-profile activist investors all targeted the same company in such a short period of time, starting with Jeff Smith’s Starboard Value in the fourth quarter of 2022.

We’ve written about Salesforce briefly in the past, and for as wonderful of a product it was, its grotesque capital allocation policies meant investors, even those exclusively interested in software, were better served looking elsewhere. Namely, the company suffered from poor capital allocation, wasteful spending, horrid M&A, and a growing amount of technological debt.

Starboard highlighted some of these issues in a presentation in 2022, believing that substantial discipline on costs and a more mature philosophy on growth could unlock substantial Free Cash Flow; instead of trading for over 23x FCF, Starboard argued the stock would be closer to 12x, implying a significant opportunity in the shares if management complied.

Salesforce had always been a bit of a battleground stock even before activists got involved because of some of these wasteful trends paired off with a product that most customers love and is vital to their day-to-day operations. For the better part of a year across 2022 and 2023, the stock had been stuck in a range between its pre-Covid high of around $200 (where it had found support/buyers willing to step in multiple times) and a Covid-induced trough around $125. The bull and bear case in the first quarter of 2023 was quite clear, at least as clear as it could get in financial markets.

Bulls touted the wasteful spending, indispensability of the product, and valuation support, along with the pressure from noted successful activists. Bears cited that there was no way management would go along with a plan to pivot from growth and acquisitions when it had treated them so well for so long; the habits were calcified, they argued. Add in a concerning macro environment and the coming Covid hangover effect and the stock deserved to move down further.

Figure 1: Salesforce was Rangebound

From a technical perspective a robust move out of that range in either direction could signify a verdict in the debate. The real value in that verdict comes not just in knowing what side “wins” but how much upside is left.

The chart in Figure 1 runs through March 1, 2023, right before Salesforce’s earnings report. Here’s the same chart but three months later:

The stock has clearly moved outside of the range and to the upside. Coupling the chart to the fundamentals in this case would show not only was their credence to the bull case and that management was pivoting, but also that despite a 25% move since that earnings report, there was substantial upside left. Here’s the chart as of today:

The stock moved an additional 40% after that first earnings report. Despite the initial pop, a buyer would not have been “too late” or have “missed it.”

The opportunity was so large because the fundamentals had that much low-hanging fruit. And the market was telling you to take that probability seriously, more seriously than the bear base.

As for those fundamentals, Salesforce will grow free cash flow by approximately $5.5B (from 6.3B to 11.8B) since the presentation by Starboard while only increasing revenues by about $7B in that time, meaning that for every $1 of incremental sales, 70 cents resulted in free cash flow to shareholders. Operating margin will go from ~5% to over 30% in two years. For context, it took $23B of incremental sales for Salesforce to increase FCF by $5.5B (from $1.7B to $6.3B in their 2017-2023 fiscal years); a sign of just how much low-hanging fruit existed for so long.

2. How Not to Do Valuation

“2 years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

–       Scott McNealy

The quote from Scott McNealy above comes from an interview in 2002. McNealy, then the CEO of Sun Microsystems, is not being literal in his analysis (at least as far as I could tell) but rather more speaking off the cuff on the absurdity of valuations in the run-up to the dotcom bust (at one point Sun’s stock traded at ~500x earnings). Sun Microsystems was one of the poster children of the bubble in technology stocks and while history often doesn’t look too kindly upon the company, it deserves enormous credit for not only some pivotal technological innovations but also for planting the roots of key ideas within computing and networking that others built upon, and that live with us today and will carry on into future.

McNealy’s quote gets brought up a lot within (some) investing circles, usually around the time of some explosive move in a tech stock (usually Nvidia). The first time I read the quote I remember my immediate reaction being “That’s not how valuation works,” but for those who think all investing gets boiled down to a metric, the quote is gospel.

For one, the proposition completely ignores terminal value. I don’t know of many, if any, equity investors who seriously look at any large-cap company and walk away thinking it’s too expensive and thus must be going to zero. Ignoring terminal value then is a non-starter. Taking the quote literally requires one to approach equity valuation with the mindset and methodology of a bond investor. 

Second, and related, if one were to believe that they are entitled to access equities at multiples that suggest a discount to the bond market (as many, many people do) then what exactly is the right multiple for a diversified basket of equities when interest rates were zero or even negative? More negative? Are equities supposed to pay shareholders to hold stocks? Assuming a discount to the bond market is not inherently a wrong approach as a default case or maybe even the market, but it certainly is not an inherently correct one either.

Finally, since this quote, there have been probably hundreds and hundreds of companies to prove the threshold false and farcical. So many companies today are able to grow their margins and bottom line faster than their top line once a certain velocity has been met. Does valuation matter? Of course! But a 10x P/S ratio is a meaningless metric in a vacuum.

3. It’s a Dovish Fed

Let’s paint a picture just for fun:

> Economic growth in the preceding quarters bottomed at levels consistent with the estimated long-run equilibrium growth rate of 2% after inflation

  • After that growth accelerated above 3%
  • And all that occurred with the housing sector in contraction

> The unemployment rate is below 4%

> Risk markets are healthy with High-yield spreads below 4%, far below their long-term average, and stocks having turned up after a painful year are up over 10% YTD

> Oil is up over 20% YTD

Why would the Fed cut in such a scenario, as Powell is clearly wanting to do?

It’s a bit of a trick question. That scenario is not the present day. It is from 2019 when the Federal Reserve did cut rates in the midst of an economic expansion that was being held back by the critical housing sector. The Fed cut rates three times in the span of six months.

Investors made the mistake throughout 2022 in not believing the trajectory of Fed Funds was upwards in the midst of the worst inflation in 40+ years. We wrote about it here, stating that investors’ confident prognostications in the Fed’s dovish nature were misguided; they were basing their projections on a sample size of zero and a history that had no relevance to present conditions (see the reference to Aristotle from a couple months ago as well).

Today, extrapolations are being made in the opposite direction, under the flawed belief that because things are good, the Fed has no need to and thus will not cut. Again, investors are ignoring whether or not the context is relevant to the analysis and to the conclusion. At the end of the day, if the data does not get worse, from an inflation perspective, the Fed will cut because the Fed wants to cut.

It’s a dovish Fed after all.

4. Recommended Reads and Listens

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