where undervaluation is today

I’ve been meaning to write this for a week or so but haven’t been able to figure out a coherent way to begin. Here’s what I’ve got:

–this started with Robinhood (HOOD). I’m not a fan of company management. What I get from them is that they want to grab me, turn me upside down, shake all my money out of my pockets and then toss me aside. It’s never a good thing, in my experience, if the other side believes this is the necessary condition for its prosperity, rather than thinking we should all get rich together. On the other hand, I’m not the target customer.

The company went public last year at $38 and quickly rose to an intraday high of about $85. It’s been all downhill from there.

It hit an intraday low about a week ago at just under $10. At about the same time, I hear the chairman of Interactive Brokers (IBKR) comment admiringly that HOOD has a unique hold on younger investors and that it makes 50% more on customer assets than IBKR does.

And I looked at the company financials. At last report, HOOD had net working capital of about $8 a share. This means if it simply stopped doing any business and would itself down, in short order there would be a shell with $8 a share in cash in it. Although the corporate history is very short, my guess is that HOOD is adding $1+ to that each quarter.

So I could buy for $2 a share the same business and brand name that (admittedly, only for a nanosecond) went for $70+, ex net working capital, a year ago! So I bought some at about $11 and have continued to add. The business is going for $6.50 as I’m writing this.

In my view, this is a classic value stock. Lots of warts, but loads of potential.

–I think HOOD isn’t an isolated story. To my mind there’s been relentless, not particularly well-informed, selling of a whole class of relatively early-stage tech-ish stocks for months. The general conceptual idea, if there is one other than maybe that the ARK funds own them, seems to be that the companies in question aren’t showing GAAP profits. It isn’t just SPACs, which would be my simple screen if I were being forced to do across-the-board shorting. The argument is presumably that if you can fog a mirror, you can show GAAP profits, therefore..

–if you flip past the income statement, though, and look at the flow of funds statement, you may notice three things that to my mind make a loss-making company worth a second look: positive cash flow from operations; non-cash employee expense (non-cash = stock options/grants, which may be unusually large in the first year public); and large spending on software infrastructure. Arguably, at least some–maybe most, depending on the company–of this spending is more akin to factories and the machinery in them than to office supplies. But, because of abuses a generation ago, GAAP rules say this spending must be expensed as incurred rather than put on the balance sheet and written off little by little as sales occur.

Of course, there’s also the balance sheet itself, where there may substantial value in cash or cash-like holdings.

–Barton Biggs of Morgan Stanley popularized the term “dead cat bounce” a long time ago, writing that if you toss even a dead cat off the top of an office building, it will bounce when it hits the ground (my guess is this isn’t true). This was his way of saying that it’s dangerous to read anything into the kind of upward move we’ve had in tech-ish stocks since January 24th. This second is right, I think. But odd as it sounds, I think there’s much more value in “dead cat” tech than the consensus realizes.

2 responses

  1. Hi,

    Very interesting and love reading you and happy to see that you are publishing now more often.

    Could you give some more color on what is it that you are looking at and analyzing with respect to the none cash employee expenses and the large spending on software infrastructure?

    Mary thanks

    • Sorry for the late reply. There are two different issues, I think. A key employee of a firm, say, a software engineer, may be paid $250,000 in cash and another $500,000 in restricted stock units in a given year–maybe $1 million+ in the year the company goes public. The numbers may be much higher. The RSUs may be expensed over a few years. But one way or another, the financials show them as an expense, even though no cash leaves the company. So the firm can look like it’s losing money even though cash is steadily coming in the door. The cash flow statement is where you can see this happening.
      The other thing is that, because of past accounting scandals, the expense of creating software isn’t treated like constructing a factory, even though both may have useful lives of decades. In the factory case, the cost is put on the balance sheet and subtracted from income little by little over the plant’s expected life. Software–meaning mostly engineers’ salaries–is expensed right away, even though it has an enduring value. I think of this a little like what advertising expense was a generation ago, before Warren Buffett began to highlight its importance. If Coca Cola has spent $50 billion over the years (I have no idea what the actual number is, but it’s a huge amount) building a brand name, that’s an immense competitive advantage over any potential rival, even though the advertising expense is accounted for purely as a loss of income. I think that at some point investors will begin to regard software as an intangible asset, too, just as they began to regard brand names as a plus a long time ago.

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