Motley Fool Hidden Gems Investing - The Madden Curse for Investors

Episode Date: July 30, 2024

When you get to be a famous investor, it is harder to generate market-beating returns. (00:21) Jason Hall and Ricky Mulvey discuss - Earnings from PayPal. - Cooled expectations for Bill Ackman’s latest offering. - And if CrowdStrike is becoming a buying opportunity. Then, (15:01) Alison Southwick and Brian Feroldi finish up their Summer School series with a biology class and examine the life cycle of companies. Companies mentioned: PYPL, OTC: PSHZF, DAL, CRWD, RIVN, MNDY, AMZN, AAPL Host: Ricky Mulvey Guests: Jason Hall, Alison Southwick, Brian Feroldi Producer: Mary Long Engineers: Dan Boyd, Desiree Jones Learn more about your ad choices. Visit megaphone.fm/adchoices

You too can invest in a hedge fund. We'll see if it's a good idea. You're listening to Motley Fool Money. I'm Ricky Mulvey. We're joined today by Jason Hall. Jason, thanks for being here. Hey, Ricky. Good to be on, bud. let's uh let's get to the paypal earnings first because maybe this ocean liner is turning around here's some highlights from the quarter total payment volume is up more than 10 percent to 417 billion just on the quarter total revenue for the company is up eight percent and in the earnings call we also had ceo alex chris touting partnerships with meta doordash and the venmo

debit card getting launched on the apple and google wallets there's the menu anything really stand out to you in this quarter? Yeah, a couple, a couple of things really did. First of all, I think if you think about the part of business that PayPal, that users control, there's some positive stuff. And then there's also the things that users don't really pick or choose like the card processing stuff. It's really, really positive. We can start with just transactions and volume was up more than transactions. Transactions are up 8%. That's good. And then when total dollars was up 11% on 8% transaction growth. Some of that is going to be inflation, but not all of it at all. It says increased engagement. That's a big positive to me.

And then you look at monthly active users, monthly active accounts was up 3%. Total accounts was flat. This is all part of the Chris game plan. They've deprioritized markets and areas that aren't really profitable. And they're really focused on getting the most engaged users in the profitable markets as engaged as possible. And it looks like that's paying off. And if you look a little bit deeper, where they start breaking out the different segments of the business, Venmo is growing well. But really, card processing, which is all about relationships with merchants and big brands, is growing even faster. I think that's some real positive things that I saw. Looking back at the quarter where Alex Chris came in, this was a little less than

a year ago now, investors seemingly got a bathtub of information. He told folks that he was going to focus the company. He used the word focus a lot. Then the acting CFO at the time told investors to expect margins to continue to contract. Then in this report, we got a lift in earnings guidance in quote, the best transaction margin dollar growth since 2021, end quote. Jason, seems like maybe we got a little sandbagging or should I be less cynical and just accept that maybe the prospects have changed for this business? It can be both, Ricky. I think it probably is because I think it's important that the company really needs to set reasonable expectations and you're going through a period of transition where costs may go higher as you refocus the business

and shrink certain parts of it. There's nothing wrong with setting that expectation. But at the same time, I think maybe some things have delivered maybe faster than management expected, especially the card processing, which is a profitable business. So probably a little bit of sandbagging. And I think it might continue to a certain extent as they continue to be conservative. You look at their revenue growth rates that they're guiding for, they're lower than we've seen the past couple of quarters. So maybe it's also good execution too on a strategy that's maybe playing out a little faster than management was expecting it would. All I'm saying, there's a reason I'm not the CEO of a publicly traded company, Jason,

that's for the best. I would be horrible at it. But if I were to be the CEO of a publicly traded company, I'd think, you know what, let me give myself, let's, let's, let's book some wins in the first, in the first few months. I, I don't hate it as a PayPal shareholder. I also don't hate it. In the first earnings calls, we look back at that. And now in these sort of nine months that Chris has been here, he called PayPal quote, a great company with great prospects trying to sell it as a growth story. Are you buying that story from PayPal? So I think so. And really it just, it starts with the industry itself. E-commerce continues to expand. We know that's a big growth factor for PayPal. And then you think about person to person transactions as that

continues to be a growth business. It definitely is, right? The tides, the tailwinds, however you want to describe it, the currents are certainly growing faster than the economy. So by those measures, PayPal should be a growth company. The great prospects, we're starting to see signs that that's certainly the case. I think we can also say there's just a little bit of a turnaround here. This was a struggling, flawed, directionless company nine months ago. Even with that said, Ricky, the market's still pricing in probably more risk and weak prospects and probably some concerns about execution risk. 16 times earnings, less than 14 times free cash flows. One thing you can certainly call it, you can call it a cheap stock.

Fair enough. Let's go to an IPO from Mr. Bill Ackman, who you may have seen him on the X platform he also runs parish pershing square and he's been looking to raise funds for pershing square usa which would be a closed end fund originally looking to raise up to 25 billion dollars so all investors can get in on these hedge fund strategies jason that 25 billion became 2 billion so before we get to this not great bob bob not great bob we're calling him Bob now? No, not great, Bob. It's the line from, uh, you're killing me here. It's from a office space. Oh, okay. Not great. You know, sometimes I get hit with these like 1990s, like comedy references that I haven't seen in a minute. And it's, you know what? You're killing me, Jason.

How about that? I am. I am. I'm aging myself. I'm dating myself here. Before we get to what's killing Bob, let's get to what a closed end fund is because it's a little different from a traditional IPO. So what is a closed end fund that, that Ackman's raising here? And maybe why would he want to use it? The short version is a closed-end fund is like a bucket of money. And then that's the equity. That's when you IPO it, you raise that equity. And that's generally all the equity capital that this individual vehicle ever raises. Every once in a while, they can do secondaries, but it's really difficult. Generally, they don't. So it's kind of like a private equity that retail investors can invest in because they also take on debt.

They can do things like preferred shares, which are really more like debt than they are like stock, even though it's called preferred shares. So of course, when you do that, you can boost returns. You can also compound your losses as well. At the end of the day, a close-in fund is just a bet on the manager, like a Bill Ackman, that they're going to take that capital, they're going to invest it well, and they're going to make money for everybody. So we had this IPO where there were some lofty expectations on the part of Ackman, where a lot of folks, some of them are big hedge fund managers, but a lot of those investors are just like you and me, Jason, throwing a couple bucks into the market every week here and there.

But now the expectations for this fund have been slashed by more than 90%. Why do you think expectations have changed so much for this IPO? I think the expectations may have just been messed up from the beginning. You hear about the investment banks that are running these IPOs, that it's their job to market and really try to create the biggest pool of money as you possibly can for the IPO. But it's also on the founder, the CEOs of the companies, in this case, the fund that's going public to kind of push. And Ackman has a big public profile. He's got a big profile on social media. And when you're going public, retail investors really matter because the bottom line is that Pershing Square, they have access to all of the institutional investors, all of the

high-net-wealth folks already. They're creating this vehicle as much to leverage access to retail investors, that's us, as anything, and also to create a vehicle that's liquid, because it trades on the public market, versus investors in Pershing Square and these other funds, which your capital can be locked up for years at a time. I think $2 billion is going to be a big disappointment. There's not going to be any getting around that. But I think if they got $5 billion or $6 billion, that probably would have been very fine because setting an unreasonably high bar, um, and then seeing a much smaller number that's really bigger than any of the bigger than any of the IPOs that you've ever seen for a close in fund, much less it would be one of the biggest IPOs we've seen

this year, full stop would have been a success. Bill Cohan and Puck also reporting that maybe some investors were upset because there was like a, I think a shareholder letter where They were saying which entities were involved into what commitment, maybe before the checks had cleared. And that's not something that's going to make your potential investors super happy. Yeah. When you're Seth Klarman at Baupost, who's notoriously private, you're not happy that this information's out there. I would imagine. And Bill Ackman also, this is not the first Pershing Square offering to retail investors. There's one that's on the Amsterdam exchange. And the public shares have

been out there for about 10 years now. They've delivered, and we're going to include reinvested dividends here, they've delivered an annualized return of 8%. I'm also seeing this around X where there's the chart of Cathie Wood's ARK Innovation Fund and how it has underperformed US treasuries over the past five years. It's the hottest take right now. I mean, part of my brain goes to, is this just like the Madden curse happening in investing? What's going on here? I love that you brought that up because those, the uninitiated, uh, the Madden, uh, football game, if you're on the cover of Madden, you're probably going to have a terrible year, maybe even get injured. Um, and it feels that way with these big name, big brand, um, investors that

whenever they kind of reach the pinnacle, things are not going to go great going forward. But there are three main takes that I have. Number one, investing is really hard, right? If you look across actively managed equity funds, the majority of the fund managers underperform the index year in and year out. It's like clockwork. The majority underperform. My second take is, please refer to what I just said. Investing is hard. For the pros, it's even harder. They have a lot of additional pressures. They're not just managing their own money. They have clients with big money that are pushing on them. The quarterly spotlight. Then you have investors pulling money out. And now you have to go liquidate things that you wanted to hold because investors have taken

that ability away from you. Maybe you have a lot of capital that flows in, and now you have to figure out where to invest it in the market. That always happens when the market's hot and there's less great ideas and great places to invest your money. So that compounds the difficulty for that business. And the third one, Ricky, I think this is so important. Incentives really matter. If I'm Cathie Wood, you know what I'm making a ton of money on? Just the assets under management fees, just that 2% or half percent or whatever it may be. I make more money there than I do on performance incentives. It's the only, one of the only jobs on earth where you can consistently and regularly do a bad job for many, many years. Don't lose your job and get very, very, very wealthy.

That's, that's a little bit of a negative place. I want to move on to what may be an opportunity for our final story. And that's CrowdStrike, which will make sense in a moment. CrowdStrike having another tough day after Delta announced that it's lawyering up to seek damages from CrowdStrike and Microsoft over its thousands of flight cancellations. CNBC reporting that it cost Delta an estimated $350 million to a cool half billion dollars. Why do you think the market's reacting so strongly to Delta hiring a lawyer here? It seems like a lot. I think because it has taken as long as it has. We're over a weekend of this story and it's the kind of thing that you would have expected to see within a matter of days.

And it's easy to forget that if you're somebody like Delta, you want to have everything lined up that you can, and you want to have talked to multiple firms probably at this point to make sure you find the right law firm to partner up with. So I think that's part of the reason we're seeing the stock really kind of take this next leg down. I want to say this too, CrowdStrike, this is one of my highest conviction holdings and has been for multiple years. Think about the big tailwinds, industry leader by a mile, et cetera, et cetera, et cetera. The stock's been really, really expensive for a long time. That's kept it on my watch list. So even after this sell-off, if we think about this where we are with CrowdStrike,

I think investors should still be careful and slow play this. It still trades for 17 times sales, Ricky. For context, Microsoft trades for 11 or 12 times sales. Adobe trades for less than 11 times sales. You look at cash flows, it trades for 55 times cash flows. So it's still not cheap. Can the growth rate support that valuation? I think if you asked me two months ago, I would have said yes. But now there's another little thing there you have to think about beyond just the litigation risk with Delta, because there's a lot of us that kind of wonder if this is less about CrowdStrike's poor process of QA and sending out this product. And now it's about, well, Delta's apparent lack of ability to update their computers in a reasonable amount of

time. And of course, that's what the lawyers are going to decide about. But what we don't know, Ricky, is what other customers are we not hearing from that are seriously considering other choices out there? SentinelOne, for example. Microsoft is another one, even though their reputation may not be great right now either. But also, we don't know what is CrowdStrike going to have to do in terms of pricing actions to make sure they don't lose customers. How is it going to affect their growth rates? So, this could be an opportunity. Investors don't have a lot of exposure. Ricky, there's a clear case that maybe taking a position right now makes sense. But if you already have a lot of exposure here, I think it's still kind of wait and see.

I don't own any CrowdStrike, but it's one that is moving onto my watch list, I would say. Good idea. Jason Hall, appreciate you being here and thanks for your time and your insight. Good to be on. See you next time, Ricky. You just found out that your sales team is at risk of missing quota. Don't panic. Just ask Rippling AI. Since it's built on your real-time people and business data, Rippling AI can pull metrics from Rippling and Salesforce into a meeting-ready dashboard showing quota attainment, headcount plan, and monthly revenue to quota by region. In seconds, you'll see exactly what's behind your quota risk and fix it before it's missed. Question answered, action taken, crisis

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of companies. It just so happens that a business has the same number of stages of development as a frog. So this is how we're going to torture this metaphor. Let's go. All right. We're going to start with the egg phase by which we mean startup. Yeah, this is a really critical stage. A business is just formed. It is in the startup stage. It is very common for new companies to enter this stage. What they're trying to do in this stage is they are trying to create a product or a service that the market accepts, so-called developing product-market fit. It's very common for companies in this stage to have no resources at their disposal. They are going to outside investors, perhaps venture capitalists, perhaps even the public market, to raise capital because

these companies often have no revenue, or if they do have revenue, it's teeny tiny and nowhere close to covering their costs. Let's move on to the next stage of a business's growth, the tadpole stage, if you will, of hypergrowth. This is when a company has established product-market fit. Whatever product or service it launched to the market, the market is adopting it very, very quickly. It's very common for companies that are in this stage to have extremely fast revenue growth, often triple-digit revenue growth. However, every other number on their income statement often looks awful. For example, it's common for companies that are in a hyper growth stage to have negative or very low gross margins at the best. Their operating margins are

terrible. They're losing money, and the pace of their losses are actually increasing over time. So, financially, the only thing that looks good here is the sales growth rate. All right. And then, where is the value derived from? Is it going to be pretty similar to when it was a startup? Yeah, it's absolutely very similar to when it's in the startup phase. The management team here matters hugely because they are just trying to get this product market fit and establish a toehold, often in a growing market. But their value really comes from the sales growth that the company is having. And oftentimes, in this phase, while the company is not making money by any stretch of the imagination, their gross margin is often positive

and increasing quite rapidly. When you can see that as an investor, that should give you confidence that eventually, with time, that company could or at least have the potential to make a profit. What about the traps or pitfalls of investing in a company that is in the hyper-growth stage? All the same traps and pitfalls of the stage one really apply here. Companies in stage two are losing money. They're losing money intentionally. What they're betting is that they'll be able to grow so quickly into the opportunity that's ahead of them that they will eventually be able to cover their losses completely as the product or service takes hold. Now, that can be the right strategy to pursue, especially if it's a new and developing market

that does not have a lot of participants in it, but it is a high-risk bet because that company is dependent on outside capital from investors and debt in order to just survive. What tadpole company comes to mind for you? One that many people have heard of is Rivian, the startup electric car company trying to take on Tesla. Rivian's sales growth is very, very high right now, triple-digit, but every other number on their income statement looks awful. While they raised, I think, $12 billion from their IPO, they're going to need every penny of that to just survive. All right. The next stage of growth for a frog is tadpole with legs. I didn't know this was

one that existed. So we are also learning something about real biology. Yes, tadpole with legs. And for our business metaphor, this is the break-even stage of a business growth. Yeah. If a company survives the startup phase, survives the hyper-growth phase, the real next milestone for the hit is for them to stop losing money, to not make a profit, not make a big profit, but to just stop and stem the losses. Companies that make it all the way to stage three and hit the breakeven phase, that is a monumental achievement because they've actually proven to investors that their business model works and they can start to fund their own growth. Where's the value then derived from when I'm looking at a tadpole with legs breakeven company?

If a company is actually generating a breakeven profit on the bottom line and is no longer dependent on investors and bankers to finance themselves. Revenue growth is often very high here. It might not be triple-digit like it is in stage two, but it's often in the high double digits. Oftentimes, their gross profit is growing extremely rapidly. And it's very common for those companies to have established some type of moat at that point. Perhaps it's a network effect, perhaps it's a switching cost, and they might even have a brand name that is starting to gain cachet in the market. If a company can make it all the way to stage three, that is a major achievement. What are the traps or pitfalls of investing in a break-even company?

Well, oftentimes, if a company gets to this stage, the market that it's competing in is likely to be more established than it was just three or four years ago. If that company failed to create a moat for itself or a competitive advantage, it's very common for big companies to pay attention to that market, to launch knockoff products of their own. If that company has not built a moat for itself, those profits, which it worked so hard to achieve, could soon evaporate. What's a good example of a company like that? A company that recently crossed into the breakeven stage was Monday.com, ticker symbol MNDY. They recently started to generate an operating profit, which again,

is a major achievement. Our next stage of growth is Froglet. I also didn't know that this was the stage of growth for a frog. Froglet, or in business terms, operating leverage. So this is a company that has gotten past the point when it is consistently making an operating profit. And now the management team focuses its energy not on growing the top line, but on growing the bottom line. So it has these assets, and it's trying to maximize the profitability of these assets. So revenue continues to grow for these companies. But importantly, thanks to operating leverage, profits are growing even faster. So, what metrics would you be looking at? Well, all the standard metrics you want to be looking at, revenue growth in particular. But

this is when I start to pay particular attention to margins. If you're confused what margins were, listen to an episode we did about a week or two ago when we talked about some of the numbers. But by and large, during this stage, a key sign that a company is in the operating leverage stage is that all of its margins are ticking higher over time. So, if revenue is growing at a 10% rate, thanks to margin improvements, profits should be growing at a 15% or even 20% rate. What's a trap to avoid when investing in a company in this phase? Well, because a company is growing its profits extremely rapidly and its profits aren't fully matured, it's very common for these companies to have very low earnings. Their earnings is

artificially low given the potential of the business. Now, if a company's earnings are low, that means its price-to-earnings ratio looks artificially high. Again, the earnings has not fully shined through. So, it's very common for investors to look at companies in this stage and say, that PE ratio is 50 or 100 or 500. It's overvalued. But in reality, that means that you're just using the PE ratio too early. What's a good example of a froglet company? A company that is recently going through the operating average phase right now, and it's been through this phase before, is Amazon. Amazon, in the wake of COVID, really over-invested in the business, built way too many centers, hired way too many people.

During that phase, profitability actually tanked because it had so many more investments than it did the sales to support them. More recently, management team has focused on pulling back on the spending and matching supply and demand. So, Amazon's profitability should grow much faster than revenue over the next couple of years. All right. Congratulations, company. You have gone through many stages, and you are now a frog, by which we mean you are in the capital return stage of growth. Yep. So, this is phase five. This is the stage that every business aspires to get to. This is a phase when a company's business is fully built out, its profitability is fully shine through, and management can actually use the profits that the company is generating

to reward shareholders. So, capital allocation becomes key in this stage, where management teams actually have profits, and they're using those profits to buy back stock, or pay a dividend, or pay down debt, or make an acquisition. All right. What metrics matter when you're looking at a frog? Yeah. If you're going to be investing in a company in the capital return phase, which, by the way, is the phase exclusively that famous investors like Warren Buffett invest The things that matter here are really the valuation that you're paying upon entry, the returns on capital that a business is generating from its investments, and then the capital allocation decisions of the management team.

Those are what really create value for companies in this stage. All right. What's the trap or a common pitfall for companies at this stage? There's a lot of ways that big companies can go wrong. They can get hubris. They can make a terrible acquisition. If a company is truly very strong and very big, the way that it gets screwed up is by a terrible management team making very poor allocation decisions. If one company makes a mega acquisition of another company, that can be a very poor sign. What's an example of a company in the capital return phase? No better example that comes to my mind

would be Apple. Apple, for the last 10 years, has used its gargantuan cash flow to buy back stock and pay a rising dividend. And those capital allocation decisions have created huge value for its shareholders. All right, Frog, you did it. You became a full-fledged frog. But I'm afraid there's only one stage left, and that is death and decline. Yes, it's true for frogs, and it's true for business, too. The final stage of a business's growth is decline. And unfortunately, this phase can actually be very slow and very drawn out. The decline phase can actually last for a couple of years. And during this phase, a company's revenue is consistently lower than the year before. That's often triggered by a technological disruption or a business model

disruption. And many times, these companies can look very profitable. Their valuations can look cheap. But if that company is in a permanent state of decline, it's eventually going to go to the bankruptcy. Its stock's eventually going to be worth zero. And this is a very dangerous phase to invest in. So where's most of the value derived from when looking at these companies? Well, as Warren Buffett famously says, if you find yourself in a leaky boat, energy devoted to attaching yourself to a new boat is more productive than trying to plug the holes. So this is exactly what Warren Buffett did when he bought Berkshire Hathaway, the struggling textile manufacturer. Berkshire Hathaway, the business was actually in a permanent

state of decline. And rather than reinvest in Berkshire Hathaway, he took the cash flow from that business and bought insurance companies and built Berkshire into the company that's in today. So if you are a management team in this phase, really saving your cash, paying down your debt, and trying to go into the survive phase is absolutely key. And what are some traps or common pitfalls of investing in companies that are in a state of decline? So oftentimes when you look at a company in this stage, by any valuation metric that you can come up, it often screams at you that it's cheap. The price to earnings ratio can be in the single digits. The dividend yield can be in the high single digits or even low double digits.

The share count can often be declining. You could have said this about RadioShack or Bed Bath & Beyond. Any of these companies that are eventually heading towards zero, they can look optically cheap from the investment perspective. But again, if that company's earnings are permanently heading towards zero, there's no valuation you can pay cheap enough that will make it work in the long run. Oh, we did it. That was biology class. We did it. I hope that our listeners learned something about frogs and the growth of a business. Oh wait, but we do have one last piece of homework for our students today, because you can get more investing insights from Brian Feroldi by visiting longtermmindset.co. And you can also follow him on all the social

platforms. He's got great game on LinkedIn. Brian's created a ton of really helpful visuals and infographics designed to help you level up as an investor. Send them a friend request. I don't know. See what happens. You might become best friends. As always, people on the program may have interests in the stocks they talk about. The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow. you