Motley Fool Hidden Gems Investing - How SEC's Proposed Rule Changes Could Affect Investors

Episode Date: June 9, 2022

SEC chairman Gary Gensler outlined rule changes to require trading firms to directly compete to execute trades from individual investors (0:25) Andy Cross discusses: - Why payment-for-order-flow (PFOF) is going to be a big topic this summer - Potential threats to Robinhood's business model - Five Below's recent (and uncharacteristic) struggles - Takeaways from Spotify's investor day event, including a push into audiobooks (15:45) Deidre Woollard continues her conversation with Jason Hall about homebuilders, including key metrics to watch and a few stock ideas.  Stocks discussed: HOOD, FIVE, DLTR, DG, WMT, SPOT, AMZN, AAPL, MTH, LGIH, NVR Host: Chris Hill Guests: Andy Cross, Deidre Woollard, Jason Hall Producer: Ricky Mulvey Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Chris Hill. Spotify is going after part of Amazon's business and the SEC is going after a certain type of stock trading. Motley Fool Money starts now. I'm Chris Hill and I'm joined today by the Chief Investment Officer, Andy Cross. Thanks for being here. Andy Cross. Yeah, of course, Chris. Thanks for having me. We got some companies to get to, but we got to start with the SEC, which is a place we rarely start on this show. But on Wednesday, Gary Gensler, the Chairman of the SEC, proposed

rule changes that could affect individual investors like you and me and the dozens of listeners. The plan would require trading firms to directly compete to execute trades from individual investors in an effort to increase competition. This is all about an issue that we've heard about and talked about from time to time over the past couple of years, payment for order flow. This is where brokers like Robinhood and E-Trade and others are paid by wholesale market makers for orders. Gensler put this out there and it really starts this process that, if I have the timing right, Andy, this is going to go through the summer, eventually official rule changes are going to be proposed, will be available for public comment for institutions and individuals to weigh

in on. But based on what you've heard so far, what is your reaction to this? Well, Chris, this has been going on for about a year now, really since in the middle of the COVID pandemic when so many individual investors got involved in the markets, and we love that, that's great. We love to see more and more market participants, especially individual investors who are investing the right way that we've been talking about for 25-plus years here at The Motley Fool, especially around a lot of the meme stocks, AMC and the likes, where there were just concerns raised about, is this in the best interest of the individual investor? The SEC started talking about this payment for order flow, especially as more

and more users started using the likes of Robinhood, which makes a bulk of their revenues through payment of order flow. Chris, the role of the SEC really has a couple of purposes. It is to protect investors, maintain efficient markets, and help with capital formation. This is an area that I fully expect the SEC to continue to push into, and Gary Gensler came out at a conference today, the chairman of the SEC this week, and talked about that, and talked about having better disclosures, and do we get the best execution? Where is the transparency, the order-by-order comparisons among the wholesalers, as you mentioned, the high-frequency traders like Virtu and Citadel, and then the exchanges? And how is this all playing out? Because roughly

about half of the trading now goes through traditional exchanges and the other half goes through these wholesalers who provide liquidity to the market. That's their argument. We provide liquidity and this pricing that allows the likes of individual investors to receive zero commission trades here in the U.S. There has been a benefit if you like that, as long as you take it responsibly as we talked about in the past. Just because I get free food at the buffet, I can't go there and just gorged to death. You have to be very careful about that. So, this is a very nuanced issue, Chris. I think you're right. This will go on well through the summer. It is an important issue. It is something that we want to make sure is done in an open

environment, that Gary Gensler and the SEC is open and communicative with all of the stakeholders and players in here. They have their – Virtue has a lot on the line, Virtue and Citadel and these wholesalers, UBS, they have a lot of revenue at stake with this, Chris, so they obviously have a voice in here. They believe they are opening up the ability for individual investors to get the best pricing. There are some questions about that. Obviously, the SEC has some questions there too. It's an area that you want the SEC to focus. We just want to make sure it's done in a transparent, open environment so individual investors who are participants in the marketplace can understand the pros and cons to have a voice.

If these rule changes go through, if there are a version of these changes that forces a company like Robinhood to change their business model, because as you said, right now, it's an attractive business model proposition for new, particularly younger investors, like, hey, you can trade for free. And there's a version of the future whereby Robinhood, Ameritrade, which is the online broker I've been using for more than 20 years, E-Trade and others may have to essentially change course and say, all right, if we're not going to get paid by the market makers, we got to get paid by someone. And guess what? We're going away from free trading to you're going to have to pay us a couple of bucks every time you execute a trade.

Yeah, 100%, Chris, for the likes of Robin especially, and you start to see as they start to think about different ways to monetize their Unibase. Charles Schwab, which had made the acquisition of Ameritrade, Ameritrade, I think it is, and Charles Schwab gets paid for payment of order flow, but Charles Schwab has a very robust, large business that provides lots of of other different services. That marketplace platform of a Charles Schwab is far more attractive to me than the likes of Robinhood, which you just really do have these big risk factors that their business model, same thing with Vertu and Citadel, can really be disrupted by some regulatory changes with the SEC. Even if it is in the best interest of individual

investors, that can really affect these businesses. Now, the key thing, Chris, is because there's so much activity goes on with electronic trading nowadays, with the dark pools, with the wholesalers, the high-frequency traders, individual investors, global traders, that kind of thing. We just want to make sure that the SEC is thoughtful about this, like you said, has the opportunity to make sure they take in all the opinions, because we want that competitive marketplace when we are buying and selling our orders for all different securities, by the way, because what Virtu and the others will say is that they provide a lot of liquidity for small liquidity stocks and other asset classes that if there was an open market, there wouldn't be liquidity for that. Who

takes that on? They have a very clear understanding of where they provide the values. We want to make sure that's known and make sure that individual investors are truly going to be benefiting from this. That might mean that we end up paying a little bit more. We actually pay something for our trades. That would have to be factored into the calculus because certainly the zero commission trading that has been implemented in the last couple of years has been a very attractive component to the U.S. markets. You want to make sure the U.S. markets remain as competitive and open as possible with any regulatory change that may come down from the SEC. All right. We'll keep our eyes on this throughout the summer and into the fall.

let's get to a couple of companies making headlines. Five Below had mixed results in the first quarter, the discount retailers' profits were a little higher than expected, revenue was a little lower. Tipping the balance in terms of what the stock is doing today is the fact that Five Below cut their full-year guidance. This is historically a good operator that really seems to have struggled over the past year relative to competitors like Dollar Tree, Dollar General and even Walmart. Chris, I'd actually say it's probably put it in the great operator. Revenues have grown on an average basis of more than 23% of the last five years. Earnings per share almost 30%, about 29%. A very high operating

margin of 12% to 13% range. For a retailer, that's very good. It's always traded at a premium price, the stock is, and it still does, especially just thinking about its marketplace today. But as you mentioned, it was a little bit mixed. With all the other retailers, Chris, we're looking at inventory levels and their inventory per store was up 37% this quarter. It was up 20% just on a unit basis. That gets into, even for Five Below, gets into the inflationary changes there. Their SG&A sales general administration costs were up by 2.8% this quarter, and that was really, Chris, relative to sales, and that was that margin difference, and that was on higher wages, increased marketing, fixed costs, and there's a lot of focus on

the cost for these retailers, because when you do have relatively thin margins, all those costs really add up. But I think, Chris, as you mentioned, the concern on the stock side what investors are seeing is some of the concern on the comp store growth, the comparable store growth. For the quarter coming up, you mentioned the comp growth now expected to be somewhere in the minus 2% to minus 5%. And for the year, flat to minus 2%. And I think most of the marketplace was expecting positive on those movements. So the fact that Joel Anderson and his team at Five Below, which have been really great executors, as you mentioned, said this environment is going to be a challenge for us. Consumers, we think we're on the right side with their inventories,

they talked about that, but it is a challenging environment for consumers. I think especially at that discount level side, when those who make less than $50,000 in household income, $75,000, the inflation numbers and what that does to the cost structure of a household really adds up. It's interesting when you think about what Target did earlier this week in terms of dealing with their own inventory changes. It really looks like they are trying to clear the decks over the next, call it six weeks or so, so they are as ready as possible for the back-to-school shopping season. You think Five Below is in that same situation? Not that they've had the inventory issues

that Target has had, and certainly the stock didn't take the hit that Target stock took. it's one of those moves by Cornell and his team that made me wonder, is everybody going to be doing this in the retail space? Chris, I think that's exactly why Joel Anderson mentioned in the press release, said, we are well-positioned from an inventory standpoint with improved in-stocks and accelerated receipts for summer and back to school. So, I think that was Joel trying to get ahead of what's lined up with- Hey, look, we're not Target, for whatever you think of us. In so many words, I think that was. I think that was there to get that out front. I mean,

the stock's down 34% this year, Chris. So, it has been a real struggle for Five Below. I think that's mostly because of concerns around the changing consumer behavior. But I think you're right. I think inventory is such a big issue with all retailers nowadays that they were very up front and wanted to get that out right away. Before I let you go, Spotify had an Investor Day event yesterday, CEO Daniel Ek outlined Spotify's plans for the future, including goals of a billion listeners by 2030, $100 billion in annual revenue, gross margins of 40%. What stood out to you? Because this is for a business that, if you look at the stock has really struggled over the past year or so. These are some pretty audacious goals.

Well, Chris, and that just puts some context. They did $10 billion in revenue last year, so you're talking about a 10 times growth in revenue by 2030, and that's about an annualized percentage in the high 20s, almost 30%. You are talking about some very healthy, robust growth numbers. For a company that's very well-known, they have more than 180 million users on the Spotify platform. So, there needs to be continued growth and innovation for Spotify. And I think this is what has frustrated investors. We're maybe not seeing it. And I think they wanted to have this meeting. Dan Eck, who owns 7% of the company, is worth more than $1.5 billion and built this company from the ground up, really wanted to talk a lot about that. Especially with

all of just, it has been such in the news, I mean, how much money they have spent on podcasts, over a billion dollars since 2019. They think podcasts can be a very large business going forward. The real interesting push toward audiobooks, Chris, which Amazon and audible.com dominate that market. By some estimates, they have almost 50% of the market. It's not a huge market, but it's growing maybe 20% per year. Some are probably in the $10 billion range from the market size. That was one part, Chris. A lot of talk around profitability. You mentioned the gross margins getting up to that 40% level. They're in the high 20% level now, Chris. Danak and his team really laid out an expectation. Now, it is very long-term, but an expectation

of what Spotify can be, but the proof is really in the pudding. Obviously, investors over the last year haven't been buying into it and have really been concerned about both the cost side and whether they can really truly compete and be a lasting business, lasting thriving business. Dan Eck, in this meeting with investors, wanted to get that out and be very clear that he said we can be and we are not, quote, a bad business. You got to feel a little bad for any CEO who has to stand up in front of investors and say those words out loud. The audio book thing, I think that's going to be worth watching Because, you know, one of their executives made the comment, like, look, there's one

major player, as you said, Andy, you know, it's Audible, which is owned by Amazon. And it'll be interesting to see what route Spotify decides to go down in terms of making that as accessible as possible, because Audible wants people to subscribe, that's really what they've pushed, that's how their business model has shifted over time, as opposed to, In the early days of Audible, it was like getting people just buying one audio book at a time, they really want the subscription. And Spotify is a business built on subscriptions. So it'll be interesting to see if they enable people to essentially just buy a single audio book on their platform, or if the only option people have is a monthly subscription and

the annual subscription, and maybe they try and undercut Audible on price. I mean, Chris, if you think about just the listening habits that we have, other than video where you might be not watching, but listening to it, you really have. It's audiobooks, it's music, it's podcasts. Those are probably the three big giant areas, just that I can kind of think off top of my head. Maybe there's some other ones, but those are the big ones. What Ek and his team are laying out is like, we're going to be players in all of this space. There's one big player in audiobooks to boost competition and a marketplace, we want to go into that, we can be very aggressive in that, we can be very profitable, we think we can be very

profitable in that, as well as with music, which they're expecting the profitability picture to increase, and podcasts too, as I mentioned earlier, they've made a lot of investment in, but they think over the next couple of years, that can flip to gross margin profitable for them and contribute to the improving bottom line for Spotify. But clearly, there's a lot to prove with Spotify, looking at the stock price, looking at the valuation, the size of the business, and the competitive landscape out there. They are not the only ones doing that. You just see what Apple continues to do with their innovations, Chris, and what they did just this week with Buy Now, Pay Later, and the effect that it has had on some of those other Buy Now, Pay Later

competitors out there. That is always sitting out there, them and Amazon for the likes of Spotify, that is going to be a very tough competitive space for them to succeed in. Andy Cross, really appreciate your time. Awesome, Chris. Thank you for having me. Up next, Dieter Willard and Jason Hall continue their conversation from yesterday's episode about homebuilders, including key metrics to watch and a few stock ideas. All right, Jason, so we've looked a little bit at some of the overarching trends in our last conversation. So now let's talk about some of the things that we look for as investors when we're talking about homebuilding. You and I have talked before about the three L's, which is land,

labor and lumber, sort of lumber and other materials costs. Land, definitely we've seen more home builders getting more land, having land both that they own and on option. Labor, you mentioned it earlier. We've got that labor issue that continues. We've had a construction worker shortage long before COVID. And lumber, lumber was really high last year, moderated this year, but now we've got things like gypsum and steel and concrete going up. Right. So as an investor, you're looking at these three factors and kind of seeing how home builders can respond to these, right? Yeah. And persistent low interest rates and double digit price increases, um, have certainly been great to cure, um, those, those rising costs. You know, we're taught, we've talked

about margins for these, um, home builders are some of the highest levels we've, we've seen, um, in a very, very long time. Um, and honestly, I think we're going to start seeing those margins get squeezed. And as an investor, how can you kind of see the cadence? And it's different from every builder, right? Because home building is housing is very local, right? We talk about it on a national or regional basis a lot, but it is very local. And for these home builders, it's the markets that they're in where you have to understand it. And I think looking at their quarterly reports and their gross margins, if you see gross margins start to decline, the first thing you need to look at is average selling price. Okay. So what's going on with the price they're

realizing for the house, right? And if margins are coming down and selling prices quarter over quarter, particularly are starting to come down, well, there's part of your answer, right? You also need to start thinking about those earnings calls and what is management talking about. They love to talk about their labor situations, their land inventory situations, prices for materials. They will share that information. They will share that information to some degree of depth, depending on the company and the

management team. So read what they, don't just read what they said this quarter, go back and read last quarter. What did they say last quarter? and are, are they moving the goalposts a little bit, or is there some consistency in the story that they're talking about the challenges they faced last quarter? And here's what we're trying to do to work on it. And did they say, okay, here's, here's how we're moving forward on that. Or is like, well, this is the other thing that's happening. Right. So I think that's a really useful way to look at it. Um, but I think the big thing here is that these are going to continue to

be pressures, even on material costs, right? The producer price index for wood, this is indexed to back to the 80s. It's in the 300s, right? And 100 would be the same price against that index. And your supply is starting to get better, but what's happened? Oil is $115 a barrel and you got to put this stuff on trucks and you got to put it on trains and all of those in the energy costs for the mill to make this stuff has gone up. So there are persistent pressures, I think, on costs that builders are going to continue to be dealing with. And now with higher interest rates, buyers are going to be much more price conscious of the house because they're shopping a payment in a lot of cases. And guess what? If their interest rate's gone up, they can't afford as

much house as they could six months ago. Yeah, absolutely. And as we wrap up, I want to take a look at some home builders. But the other thing I want to say that I look for now, and I think this makes this particular cycle different than the last one, is we've got another thing happening, which is optionality in home builders. And that is that there's a single family rental market that didn't exist during the great financial crisis. We've got massive companies like Invitation Homes. There are tons of private companies with portfolios with thousands of single family rentals. That I think is something that is a positive thing for home builders. So with that kind of in mind and thinking about optionality, which of the home builders do you like best?

So I, I'm, I'm a growth focused investor and my favorites tend to be the smaller builders and the ones that have kind of positioned themselves where there is the most demand that I think it's going to be the most persistent demand. And I think the biggest area where there's the most persistent demand is going to be entry-level housing. So that first house or move up, like the first move up. And I think the two that are probably best positions that are relatively large are Meritage Homes, ticker MTH, and LGI Homes, ticker LGIH. And they really focus a lot on that entry-level property. The vast majority of what they build is in that area. And they tend to be fixed designs, right? So you don't have a lot of customization here. They tend to be smaller.

As a result, you get to build more units per acre. Less custom work means lower costs and faster builds. And that results in higher margins. This is one of those rare areas where the lower cost thing actually can result in higher gross margins, right? So they're both really good at that. The downside, you build more homes on spec, meaning speculation. You don't have a buyer already lined up, who's paid a deposit and is committed to buying it. And the risk there is if the cycle turns. They also tend to own more of their land and don't use options as much as some of the other larger builders. I'll talk about one in a minute. And again, that's a cycle risk because you've got more of your balance sheet tied up in an asset that if the cycle turns,

it's going to be harder for you to sell. The worst thing is being a home builder with a bunch of half completed homes and no buyer. And then a couple of months, the cycle turns and you've got to finish these houses. You've got to try to find a buyer. You've got a bunch of land on your balance sheet and there's risk there, right? There's risk. The thing I like about Meritage and LGI is they both are pretty well capitalized, especially Meritage. It has an incredibly strong balance sheet, and the valuations you're looking at, single-digit earnings multiples, like five times earnings or less, I think the market is giving us a good risk-adjusted reward opportunity with these companies. What I would see would be a temporary thing, if we do see a turn

in the cycle, for durable businesses that would be able to get through that cycle and come out the other side in good position. Now, if you're a little more risk-averse as an investor. You're looking for a little more stability. NVR, I think, is really interesting. And NVR, that's the ticker. Ryan Holmes is its biggest retail brand. But it's more integrated, right? So they have a finance business that they do. They make pretty good money through that. It's not a lot of risk with it. They do a lot of originations. And they pioneered the use of options for land, right? Meaning its balance sheet tends to be less leveraged. It's probably the strongest in the industry. You won't get anything as close to a cheap valuation here,

but you're paying up for a more stable business that I think can still be a wonderful investment. Again, I don't think these are trade opportunities. I think these are investments that you're looking at a multi-year horizon because there is uncertainty. The market's valuing them where they are because of the uncertainty. With the economy, rates going up, costs still very high and the potential for the housing market to turn. I think if you have a multi-year time horizon and this willingness to kind of go through some of this potential turmoil, these valuations are going to prove to be wonderful, wonderful entry points. Yeah, definitely. I think people get a little scared off because NVR has a very high per share

price and they don't think they're going to split, but it's a great business. And if you look at it over time, it has really done well for investors. Well, Jason, that was awesome. I love talking HomeBuilders with you. Thank you so much. Me too. This was great. Thanks, Deidre. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow. Thank you.