Steve Bleiberg
Hello, and welcome to actively speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Welcome back to, another episode of actively speaking. This is kind of a midyear episode. And so given that it is the middle of the year, this is we've just seen the annual rebalancing in the Russell value and growth indices.
And this year, there were some particularly interesting changes, specifically Amazon, Meta, and Alphabet have all been added to the Russell value indices, at least partially. You know, Russell will sometimes take a stock and assign it partially to one index, partially to the other. So they may say one company sixty percent growth, forty percent value, and so it gets included in both indices. So it's not that these stocks are being called pure value stocks, but they are being partially added to the value indices.
It's not the first time for some of these stocks to have been included in the value index. If you go back, a few years ago, Alphabet and Meta at one point were added. But in the past, that was, usually driven by poor performance by the stocks, which caused the price to book ratios to drop. And price to book is really how Russell defines value.
But this time around, the price to book ratios have fallen not because of the poor stock price performance, but really because of growth in the book value of the companies. In other words, it's not that the numerator in the price to book ratio was declining so much as it was that the denominator has been increasing. And that tells us something very interesting about what's going on at some of these mega cap tech companies. So it seems like a particularly good time to talk about what value investing means in a market that has become so dominated by AI related businesses.
And to do that, I'm joined by Justin Howell, lead portfolio manager of TD Epoch's US value team, he's making actually his first appearance on this podcast. Justin, thanks for joining me.
Justin Howell
Thank you, Steve. Happy to be here.
Steve Bleiberg
So, we'll get to the changes in the value index and what they mean in a moment. But I want to start by actually looking back a bit over the last few years first. Now for several years, I know you've been drawing attention to an important issue, which is the increasing importance of companies whose success is driven by intangible assets and the way that those companies can seem to be kind of penalized in a sense by GAAP accounting compared to companies whose assets are, you know, more tangible, like factories. So tell us what the key issue is here and give us an example.
Justin Howell
Yeah. Sure. Thank you, Steve. The key issue is that GAAP accounting is very much stuck in the economy of fifty years ago and hasn't evolved with the times. We have a chart in every one of our client books that basically shows tangible and intangible investment in the United States economy going back over the last fifty years. Tangible investments are things that you can see and you can touch, like factories, trucks, retail stores. And then intangible investments are things that you can't see, can't touch, think things like brands, software, biotech, and pharmaceutical patents, etcetera. In 1977, which is as far back as we have the data, tangible investment was thirteen percent of the United States GDP, and intangible investment was only nine percent of GDP.
Fast forward to today, and those metrics have completely flipped. So now tangible investments are only nine percent of GDP, and intangible investments are sixteen percent of GDP. So to drill down a little bit further on how the GAAP accounting is not accurately reflecting economic reality for all companies these days, we use two stock examples. Walmart, which everybody knows would be an example of a tangible investment company, and then Microsoft is an example of an intangible investment company.
Now if Walmart builds a new store with a twenty year average useful life, Walmart's management is required by GAAP accounting to capitalize that store and expense it over twenty years. And so that has the effect of basically, you know, overstating Walmart's earnings and book value, relative to an intangible asset based company. And so the intangible based asset company that we use as an example is Microsoft. And if Microsoft signs up a new software customer with a twenty year average useful life, they are actually required under GAAP accounting to expense all the research and development, with creating that software code and all the marketing, with acquiring that customer immediately upfront rather than over twenty years. And so that has the effect of penalizing or understating Microsoft's earnings and book value. And so, you know, I think you can see from that example, that when you are comparing intangible based asset companies and tangible based asset companies. On GAAP accounting, you're really comparing apples and oranges. And I think that's part of the reason that people have struggled with value investing for the past several years is a lot of the intangible, investment companies like a Microsoft or Facebook or Google have seen their earning earnings heavily penalized, by the fact that GAAP accounting is still very much stuck in the world of fifty years ago, where intangible companies are required to expense everything immediately even if it has a twenty year average useful life.
Steve Bleiberg
Well, and that highlights the importance of, you know, something we all talk about here at Epoch, across all the strategies, the importance of focusing on free cash flow and, and not earnings necessarily because of these distortions built in by accounting, which leads me to another question, which is so do the metrics that worked well in the past in that world that was dominated by tangible asset companies do they, you know, the metrics for valuation, do they, in terms of identifying attractive stocks, do they still work as well in a world that's dominated by intangible assets, or should we be looking at, you know, different metrics?
Justin Howell
Yeah. I would say in a GAAP accounting world of fifty years ago, price to book and price to earnings worked very well, and most value investors just bought the cheapest, companies on those metrics and then hoped for mean reversion. And that was a pretty good strategy until we really saw the rise of these intangible asset based companies that we mentioned earlier.
We have another valuation chart in all of our client books, and it looks at twenty different valuation factors. This is an independent study from Bloomberg. And the interesting thing is that free cash flow, to enterprise value and free cash flow yield are the two best performing metrics in this particular study over ten and fifteen years. Price to earnings, still yields a positive signal, but it's much weaker than free cash flow, and it's in the middle of those metrics in terms of its efficacy. But I think the issue that's most important, especially for value investors, is that price to book has actually turned into pretty much a meaningless metric. And if you followed a low price to book strategy over the past ten and fifteen years, you would've had negative alpha, and price to book was the worst performing valuation factor out of all twenty over that time frame. And so we would argue, and this is something we've been arguing for several years, is that, free cash flow based metrics are much better than GAAP accounting metrics, and that's basically because, cash flow can't be manipulated. It's not subject to some of the inaccuracies, that we just described with GAAP accounting. And when you are looking at companies on their ability to generate free cash flow, as opposed to GAAP earnings or book value, you're doing a more apples to apples comparison of tangible and intangible asset based companies. The other metric that we like to look closely at is return on invested capital. We believe it's the best measure of the quality of the business and also their competitive advantages. And then lastly, how management is allocating capital for the benefit of shareholders.
We also don't believe, and Steve, you've discussed this in some of your Cap Re white papers, that investors do a good job of distinguishing that higher ROIC companies should trade at a much higher earnings multiple or valuation multiple, all else being equal. And so if you have a twenty percent ROIC business and a ten percent ROIC business and both of them are growing five percent and everything else is held constant, then the twenty percent ROIC business should trade at a much higher multiple because they only have to reinvest twenty five percent of their cash flows to grow five percent, and the other seventy five percent can be returned to shareholders in the form of dividends, share repurchases, or debt pay down. On the other hand, if you have a ten percent ROIC business growing five percent, they have to retain fifty percent of their cash flows just to hit that growth target, and then only fifty percent rather than seventy five percent of their cash flows are available to returns for shareholders. And so we think people are actually, you know, excluding or forgetting about some of these dynamics with return on invested capital when they're statically looking at PE multiples rather than doing discounted cash flow models.
Steve Bleiberg
Certainly. Music to my ears and to the rest of the Cap Re team. Okay. So we have that context now about the importance of intangible assets. So let's talk about something that I mentioned at the top of the podcast, changes in the value index and what they tell us about how some of these companies that we've thought of as, you know, being totally reliant on intangibles like Alphabet or Meta, you know, are they changing, since AI came on the scene in a big way with, you know, the release of chat GPT, which is now almost three years ago. Tell us about that.
Justin Howell
So I would say the interesting thing is because of our free cash flow and ROIC focus as opposed to low PE, low price to book, we have owned and been arguing for some time that some of the Mag seven names are value stocks. Warren Buffett actually had an interesting quote, back in his shareholder meeting from 2017 that he thinks the five largest companies in America by market cap, which were all the Mag seven at that time, essentially required no equity capital at all to run these businesses, which is pretty remarkable. If you would have gone back to the 1977 I referenced in that particular study on intangible versus tangible investment, the largest market cap companies back then were companies like AT&T, ExxonMobil, and General Motors, and they were all extremely capital intensive. Whereas the five largest companies in 2017 were all very capital light, generating tremendous free cash flows and acting in a much different manner than the top five companies, you know, forty or fifty years ago.
The interesting thing though, and the reason that we're having this conversation today is with the dawn of AI and ChatGPT launched in November of 2022, we've actually seen a dramatic shift in the capital expenditure plans for these Mag seven intangible asset based companies. They are now spending billions and billions of dollars on data centers, Nvidia chips, power generation in order to, basically have AI streamline their businesses. And so, an interesting stat here is that in 2020, the year before, you know, COVID or right around COVID, the capital expenditures for Microsoft, Amazon, Meta, and Google combined were ninety three billion dollars. But in 2024, they had exploded to two hundred and twenty four billion, and they are expected to grow an additional thirty four percent to over three hundred billion in 2025. So, essentially, in three short years, we've seen these companies going from capital light to very capital intensive. They basically tripled their capital expenditures. But here's the interesting thing too about despite these companies increasing their CapEx requirements so much in the past five years, The returns on invested capital are actually going up. The companies are actually using capital expenditures to substitute compute or artificial intelligence for labor. And so they're actually getting more efficient over time and their margins and ROICs are going up. And so a good example would be, Meta Platforms.
The owner of Facebook in 2020, Meta had revenues of eighty six billion dollars, a margin of thirty eight percent, and CapEx of fifteen billion, and an ROIC of twenty two percent. But over the past several years, Meta has actually been able to grow their revenues sixty percent while their employee base is down fifteen percent, but their capital expenditures are up a hundred percent, and they are producing all time high margins in ROICs.
And so, actually, what we've seen is that these companies, even though they're investing more and more capital every year, traditional economic theory would probably be the more capital you invest, your returns on invested capital should be going down, where we're actually seeing the opposite with the MAG seven. And then we've also received quite a bit of anecdotal data points just in the past couple of weeks from these companies that AI is gonna be able to make them even more efficient. So Mark Zuckerberg has basically said, that Meta is going to have artificial intelligence that's going to be equivalent to a mid level, software engineer. So they expect they're going to have a lot less software engineers going forward. And so they're going to be able to continue to grow their revenues without adding headcount.
And then, interestingly, there was an article in The Wall Street Journal yesterday, and Andy Jassy, the CEO of Amazon, confirmed this last night in the interview that they now have more robots than they do humans in their retail warehouses and that they're going to be able to continue to substitute robots for human labor over time. And they're gonna continue to get more efficient, and their margins and ROIC should go even higher.
Steve Bleiberg
Now when we were, planning this podcast, we were talking, and, you had the copy of, Fortune magazine, the annual, issue devoted to, you know, the Fortune five hundred rankings. And you were noting how so many of the stocks that have produced the best returns over the last ten years would have been really hard for a value investor, to justify owning at the start of those ten years, you know, back in 2014.
So Netflix and Amazon, say two examples, they've both generated annualized returns of over thirty percent a year over the last ten years through the end of last year, 2024. But ten years ago, you know, they were trading at very high multiples of their earnings at that time, which you know, so how could a value investor have benefited from those returns? Although, a quick aside, you know, earlier in my career, I worked at Legg Mason and, you know, at a time when Bill Miller ran the Legg Mason Value Trust. He was famous for, you know, outperforming the S&P 500for fifteen years in a row. And he was a very early investor in Amazon, I mean, literally over twenty years ago. And when people would say, how can you own, you know, a stock like that in in something called the, Legg Mason Value Trust was the name of the fund, he would say, well, it's trading below where I think it should be. So that makes it a value stock, which, I thought always amused me because I'm I'm not aware of too many managers who go around saying I buy stocks that are trading at a price higher than what I think they're worth. So by by that definition, everybody's a value manager.
But, you know, you get what I'm saying here that, you know, when you see stocks that are trading at very, very high multiples of earnings or book value, it's hard to think of them as, quote, value stocks. But, again, they've ended up doing phenomenally well. And today, even those two stocks, Netflix and Amazon, even though they're up so much, as I say, over thirty percent of your annualized returns over the last ten years. Today, they trade at much lower multiples of their current earnings than they did ten years ago.
So as a value investor, what lessons do you draw from the experiences of those stocks, and how do they inform what you look for in a stock today?
Justin Howell
So just a little bit of background. The Fortune five hundred is an annual list, produced by Fortune magazine, and it's almost like a baseball prospectus or compendium of every statistic you could look at, for the five hundred largest companies in the US. And so I actually started looking at this Fortune five hundred study probably a decade ago, and I followed it every year since because I think it gives you a great sense of the trends, going on in the business and the economy. And you're right. Netflix and Amazon both compounded at over thirty percent a year, in the past decade, and that is a pretty astonishing number. So I always like to convert, annualized, returns into cumulative returns because I believe humans have a lot of trouble thinking exponentially. But if you invested in, say, Amazon ten years ago and compounded at thirty percent a year, that means you would have roughly fourteen times your money over after a ten year period. Over the same time frame, the S&P 500 compounded at nine point nine percent a year. And if you generated that nine point nine percent for ten years and compounded out, it's only two and a half times your money. So Amazon at fourteen times versus the S&P 500 at two and a half times shows you really the power of that compounding.
And so, look, you're right. In 2015, if you went back and looked at Amazon, it traded at nine hundred times earnings. And I'm sure everybody was, especially in the value investing community, immediately passed on Amazon, you know, when they saw that PE multiple. But the thing that they would have missed is that Amazon was actually only trading at five times the earnings they were going to earn ten years forward or in 2025. And the reason for that is, one, Amazon grew revenues close to twenty five, thirty percent a year for all those ten years. But the other thing is they also dramatically expanded or exponentially expanded their margins. And so, Amazon was earning about a two percent margin ten years ago. Today, they're doing close to eleven percent, so the margins also went up five times. And the interesting thing again, we actually feel that investors are making the same mistake with Amazon today. So Amazon today actually only trades at thirty three times earnings, which still sounds like a high multiple for a value stock. But, again, you know, we think Amazon, conservatively can grow their revenues at a double digit pace over the next, decade, and we think Amazon can double their margins again. And the reason for that is Amazon's fastest growing businesses, which are its AWS cloud compute, its advertising, and its subscriptions businesses are all forty percent or greater margins in our estimation, while their core retail business is really the one that's lower margin and slower growing. But just as you get the mix shift of those AI and advertising and subscription businesses growing twenty percent a year at much higher margins, you're going to get quite a bit of, margin expansion organically from that. Then at the same time, again, we mentioned Amazon's getting much more efficient on the retail side with robots. Their international business after losing money for twenty years just flipped positive for the first time. And so when you add it all up and you say Amazon can grow revenues kind of ten percent, maybe hit a twenty to thirty percent margin in ten years, and the stock again is trading at five times earnings. And so Amazon is one of our biggest and best ideas.
The other thing coming back to Netflix, it was trading at three hundred times earnings.
So, again, a value investor would have never invested, but Netflix ended up growing its revenues pretty dramatically over that time frame. But, again, you know, Netflix was only earning, like, a two or three percent operating margin ten years ago. Today, they're earning twenty seven percent. And so, if even though you were paying three hundred times earnings, 2015 earnings, you were paying a single digit multiple of 2025 earnings. And the thing that we're not even, highlighting in those earnings numbers, by the way, again, is the aggressive intangible investment that both Netflix and Amazon were making in research and development and in customer acquisition that were penalizing their earnings very much in the short term, even though it was arguable that they if you made accounting adjustments where you maybe capitalize that R&D, capitalize that, subscriber acquisition or customer acquisition cost, the metrics would have looked much better. But still, that's that in a nutshell is kind of the, you know, the lesson in looking at this is a lot of the best performing stocks didn't appear cheap ten years ago. They don't particularly appear cheap again today, and that's because through a combination of double digit revenue growth and exponential margin expansion, they're looking at much cheaper forward multiples.
Steve Bleiberg
Okay. Well, that's all really, interesting stuff. Was there anything else in that Fortune magazine issue that we've been talking about? Anything else that jumped out at you that's, of interest?
Justin Howell
Yeah. I would just say that it's pretty incredible, how much AI has really dominated the market and the economy already. And here's a couple of quick stats that I think will highlight things is actually eight out of the ten largest market cap companies in the United States now are all AI related, with Broadcom joining in the Mag seven. The only two that aren't AI related are Berkshire Hathaway and Eli Lilly to the point we were discussing earlier about, Amazon, Google, and Meta coming into the value indexes. The interesting thing was three, four years ago, these companies virtually had no book value, because they were returning all the cash to shareholders and dividend share repurchases, etc. But since the dawn of AI or the launch of Chat GPT, they've really started investing aggressively, retaining a hundred percent of their earnings for CapEx, and now their book values are growing very significantly. And so when I look at that list at the largest companies by shareholders equity or book value, the largest is Berkshire Hathaway at six hundred and forty six billion. Second largest is JPMorgan at three hundred and forty four billion. I don't think either of those are surprises. They're two of the biggest financial companies in the United States, very strong financially. But then pretty quickly after that, you start getting into some of the Mag seven names. And so Alphabet now has a shareholder's equity of three hundred and twenty five billion dollars. Amazon's at two hundred and eighty five billion. Microsoft's at two hundred and sixty eight billion, and Meta is at a hundred and eighty two billion. And all of these companies now are top ten companies in the market by shareholders equity as they transition from, these capital light business models into these capital intensive compute AI models.
The MAG seven too, even though they have very large market caps, very large capital bases, they are not employee intensive at all. And so of the top twenty employers in that study, the number one is Walmart with two point two million employees. The number two is Amazon, one and a half million, that's all mainly in the retail business. There is not a single company in the top 20 that is AI related or Mag seven related. And so these companies are very efficient at, generating revenue, generating profits, generating market cap per employee.
Couple other stats is, you know, margins are always a good, thing to focus on in terms of pricing power and competitive advantages of the businesses. The overall operating margin for the S&P 500 hundred is eight percent. Amazon, as we mentioned previously, has an eleven percent margin, but all of the other MAG seven names are thirty percent or above, and so they have much higher margins. And then, again, something that probably comes back to this tangible versus intangible investment world and how the economy has shifted over the years, the, Mag seven, even though they're already the largest companies in the world, are still the fastest growing. So over the past ten years, the S&P 500 on average has grown revenues five percent a year, but the MAG seven has been growing seventeen to thirty percent year over year in terms of revenues. And, again, if you go back to 1977 when the largest holdings were AT&T, General Motors, ExxonMobil, Those companies all seem to hit a limit in terms of their scale, and they really had a hard time growing faster than nominal GDP. While it seems like the Mag seven in an intangible based world, there's increasing returns to scale. And even though they're already the largest market cap companies, they're not seeming to hit any limits on their growth. And so they still are the fastest growing companies in the market even though they are the biggest, which is not something we would have seen in the past.
Steve Bleiberg
Okay. Yeah. Well, that's it it reminds me of, of white another white paper, that's that I wrote a a number of years ago called what do we mean when we talk about value. And one of the points I made in that paper was, you know, the word value implies you're getting something for less than it's really worth. And I think you are with all the stuff you've been talking about with highlights that it's tricky to define to measure how do you know that a company is trading for a quote less than it's worth or less than it's going to be worth in the future. And, yeah, we've tended to rely in our business on these metrics like price to book and price to earnings ratios. But, again, they don't necessarily reveal much about what's going on behind the scenes in terms of returns on capital or changes in margins. And, ultimately, that's really what drives prices higher is the ability to expand margins or in higher returns on capital. So, yeah, defining what is value can be tricky.
I think we're going to leave it there. So, Justin, thanks for joining me.
Justin Howell
Thank you.
Steve Bleiberg
And, thanks for listening.
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