Saber Capital Management: A Stock Picker’s MarketJohn Huber
There is a strange dichotomy in the stock market right now. The market is painting large portions of industries with the same broad brush, and I think it’s creating investment opportunities. Anything related to software-as-a-service (SaaS) is deemed a future winner, while anything related to the physical world is toast. In aggregate, this trend is directionally correct, but the market doesn’t do a great job at parsing out who the winners and losers might be from within those two broad groups. And there will be winners (and losers) in both groups. Some cloud software companies are incredible bargains relative to their future earning power (if you know which ones, please let me know), while others will never earn a dollar of free cash flow. But it seems like the market has gotten lazy about parking out winners and losers.
The excitement currently surrounding portions of the tech world has played out in the same general way throughout many past cycles. Exciting innovative solutions to society’s biggest problems will never have a hard time attracting capital. Nikola is an electric truck company that recently saw its market value rise larger than the market cap of Ford and Fiat Chrysler combined (the second and third largest US auto maker by sales). But Nikola has never sold a single truck and has yet to even build production facilities to make those trucks. The company’s own timeline still has them years away from their first dollar of revenue. Bono said “America is an idea”, and currently that is all Nikola is. This is an extreme example, but it shows how discernment often loses out to narratives (“the next Tesla”) when the cycle reaches a certain point.
However, investors are usually right about future prospects for companies these new industries. There certainly will be far more EV’s on the road in a decade or two. Software really is eating the world. These are long-term fundamental trends that every investor should be paying attention to, looking for possible opportunities. I certainly am.
But the big risk is not being right or wrong about the trend but rather picking which businesses will extract most of the profits out of that trend, and most profits almost always accrue to a chosen few.
There have been over 3,000 auto companies that have come and gone in the United States, but all of the economic value was taken by a select few that could be counted on one hand. There was so much optimism in the 1920’s that auto executives estimated that 6 million cars would be sold annually by the end of the decade, which turned out to be a level that wasn’t reached until 1955. Those predictions were very much correct in direction, just not in magnitude.
There were hundreds of computer companies in 1985, mostly small startups in garages all chasing the leaders. Commodore sold 34% of the 8 million PC’s sold that year. Less than ten years later that company was bankrupt and liquidated. 1985 was also the year Apple laid off a fifth of its staff, Steve Wozniak left, and Steve Jobs was ousted. I read the 1986 annual report recently to see what the company looked like then, and it wasn’t pretty. If I knew one of the two wouldn’t survive the decade, I would have put terrible odds on Commodore going bust before Apple. Picking winners is tough, but it’s what makes this game interesting. And luckily, you don’t need to bet each hand, or very often at all.
I read an article by a tech blogger who said 140 software companies have a market value of over $1 billion, and an industry peer review site called G2 tracks over 57,000 smaller ones looking to get there. Not all will be winners. The majority of these firms will never earn their cost of capital, even though (or maybe because) they operate in such a large and fast growing market.
It is true that there will be enormous value created in cloud software generally. Around $4 trillion gets spent around the world by IT departments, much of which will transition to services that these new software companies provide. Both the size of the software economic pie and the number of winners will vastly exceed the winners of the two industries I referenced above, partly because the economics of software are much better than making cars and building computers and partly because the market really is massive (again, software is eating the world). But those 80% gross margins, recurring revenue streams, big markets and low barriers to entry strongly encourage new competition. This is a great thing because super smart people will continue to solve more and more problems, both big and small, and our economy and our society will benefit in a big way.
So investors need to answer two questions: Who are the winners? And assuming the winners can be predicted, are their stock prices currently reflecting their bright future?
A central part of the thesis when we invested in Google and Facebook a few years ago was that the market had correctly determined those two companies had “won” the digital advertising game, but it was too conservative in its estimate of the size of the pie. These big tech companies were not just taking share of a static market, but helping to grow the markets they were in.
Facebook and Google created new advertisers. The ceiling for Facebook wasn’t the size of the existing advertising market, it was the size of the advertising market that Facebook and Google would help create. The market wasn’t a zero sum game of shifting ad spend from TV and print to digital, it was a positive sum game whereby new businesses were formed solely because of an ability to reach new customers via Facebook and Google. A video game mobile app could get all its users from Facebook, shirts could be sold without a storefront, razor blades without shelf space.
Small businesses spent money on ads that would have previously been devoted to rent at a physical location. Digital ads weren’t taking share from just TV and print, but also landlords. But in many cases, the share wasn’t being taken from anyone, it was newly created. The companies spending on ads wouldn’t have previously existed.
So the market was right about being optimistic on Facebook and Google (and the rest of the FANG’s), but just underestimated how successful they’d become. In some cases, I still very much have the same general thesis.
But I fear the opposite situation could be true in mid-2020 for some other companies. Many companies will become big winners in software, but the stocks might not be great investments simply because they already reflect that future. So the risk is just paying too much for a great business.
But the great thing about a market where everything gets painted with the same brush is that mispricings occur. My watchlist of current focus ideas seems to be strangely as long as it was in March, and I’m finding a lot of interesting opportunities to research.
I think there are real opportunities to capitalize on what seems to be indiscriminate pricing. And that doesn’t mean one group is all cheap and one is all expensive. There are both undervalued and overvalued stocks in both camps. In some cases, the market will be directionally correct but wrong on magnitude, meaning some winners will come from the popular sectors even as their stocks are hitting new all-time highs. In other cases the babies are getting thrown out with the bathwater and perfectly good businesses with bright futures are mispriced, simply because they sell something that doesn’t involve bits.
I’ve never really understood the term “stock picker’s market”, but maybe this is just that.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at [email protected]