Motley Fool Hidden Gems Investing - Why IPO?

Episode Date: September 12, 2023

Investors are lining up to buy shares of British chip designer, Arm. (00:21) Ricky Mulvey and Bill Barker discuss: - Why Arm is going public. - Disney and Charter Communications making peace. - How investors can break down a company’s prospectus. (15:07) Plus, Robert Brokamp and Alison Southwick open the mailbag and answer your questions about 401(k)s, bonds, and asset allocation. Companies discussed: CHTR, DIS, ARM Host: Ricky Mulvey Guests: Bill Barker, Alison Southwick, Robert Brokamp Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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I'm Ricky Mulvey. Joining us now is Bill Barker. Bill, good to see you. Good to be here. So, last week on the show, we talked a lot about the Disney and Charter negotiations. And as Monday Night Football happened yesterday, Spectrum cable TV subscribers got their football back. Charter has decided to move forward instead of moving on. ESPN and the communications company struck a deal to set the table, Bill. Disney got more cord cutters during the blackout. Hulu live TV experienced more signups than expected by 60%, whatever that means. presumably billions of dollars in carriage rights fees disney got 2.2 billion dollars for that last

year and on the other side charter got disney plus for some subscribers at what was called a wholesale rate charter wanted it for free but alas these are businesses doing business they also got espn plus in a sports bundle and some version of a direct to consumer espn product when it goes public. There's the table. Who do you think was the winner in this negotiation? I don't think it's necessary to pick a winner in the negotiation. But if I had to, I guess Charter. I just think Disney is operating from such a weak position right now in terms of what it can afford to have go wrong. This was not something that it could really afford to let go for a long period of time. I think that was part of the reason that it settled quicker than you

may have expected it to. The other reason is football. But it's not a big win for Chargers It's a good negotiation, a good arbitration compromise when nobody's happy with the end of the deal. We don't have to pick winners and losers, then. What were your big takeaways from this negotiation process between the cable company and Disney? Well, Disney's not got that much negotiating power, as much as it had in the past, I would say, because it gave up a fair amount in terms of the Disney+, and ESPN+, versions that are going to be on charter right away, and the other versions that will come at a later date. I think it just narrows the situation for both of them, raises the floor, lowers

the ceiling. We see that as things stand in time, we haven't reached that moment where Disney can afford to let the charters of the world go and operate without them. They really can't afford the hit to cash flow that that would bring on. But that's going to happen in the future, just not yet. We'll have to figure out some version. I have to say, I've got a little bit of humble pie to eat, Bill Barker, because last week on the show, I said that I expected this dispute to go on longer than past ones. I was thinking of the writers' strike, where you have essentially this existential debate in the center, in that case, between a company and writers and actors, in this case, an existential

debate about what the future of cable is with regard to streaming and how those products are added in. I was looking at the details, but what I forgot was how angry people are when you take away their football, myself included. I think that is probably one of the most powerful forces in speeding up a negotiation in any type of business. Well, you're right. The numbers on the football drove some of this. I know that in the weeks before, there were some angry people. I follow tennis Twitter a little bit who were outraged at some of the tennis matches not being available, that they had wanted

to because they didn't have ESPN on charter, and this was speeding up their picking up ESPN+. But the number of angry tennis people, and even if they all got angry at the same time, how frightening would that be? Is that like John McEnroe and two other people? What's a group of angry tennis people doing? I think a bunch of angry tennis people are writing strongly worded letters. that's what they're doing. I say that as an occasionally angry tennis player myself. But I think that football, you're looking at the end of society if everybody gets on the same page about anything who's a football fan and a really passionate football fan.

This did drive things a lot faster. You look at the writer's strike and how many people are saying, I just don't have enough recorded things to watch. When am I going to ever turn my TV on again to watch something that's worth seeing? But football comes and goes, it's over at the end of the game. You're not going to watch it later. You're not going to catch up on football if you are deprived of it at the beginning of the season. So, that was an important thing. ESPN with Monday Night Football still has a major card, and Charter realized that. Yeah. Netflix can just show suits again, but that's a little bit tougher with live sporting events. Charter stock took a little bit of a bump on this deal getting ironed out. You have to imagine that they're going to have

a similar discussion with other content companies like Warner Brothers, Discovery, Paramount. Does this change the appeal of any of the streamers or cable to see them working together? They're getting the synergies going, Bill. I think if everybody can work and play well together, then that's the best thing for the customers and possibly a way to let the customers miss how much they are paying if they continue to have the charter subscription, plus all the other deals that they likely have by now. They can't afford to live without each other yet. Disney is going to, at some point, have a really compelling package of Disney+, and Hulu, and ESPN, and that's going to be something that gives it a lot more leverage, and plenty

have leveraged now, just not as much as it used to have. I'll also be curious to see how a company like YouTube or Alphabet responds to this. You would have to imagine that that company would like to allow people to pick and choose their own free paid ad-supported packages on the YouTube TV stuff. Interesting to see how that continues to play out. I want to turn our attention to the ARM IPO, one of the most highly anticipated initial public offerings of the year, Bill. The British chip and software design company is going public. This company makes most of its money from licensing blueprints for its chips and central processing units. Its designs earn about 99% of smartphones. Right now, the IPO is oversubscribed by at least 10 times. Take a step

back for those unfamiliar with the IPO process, what does it mean to be oversubscribed by that amount? There are a lot more people to 10X the number that want that IPO price than the shares that are being made available. Now, SoftBank is not making many available, less than 10% of its holdings. It's also making a sizable chunk of that available to the anchor investors in the IPO, likely including Nvidia and Amazon is reported to be in the mix as well. So, the actual number of shares that are going to be floated to the smaller investors through the Wall Street houses that are going to get the access to some and then pass it on to their better clients is a very small number.

a lot more people think, oh, this is some sort of mini-NVIDIA or something like that. And therefore, if you invest in an IPO, if you actually get in on that price before it goes trading at all, you always make money on something hot. So, there will be a lot of people that make that calculation, flip their shares quickly. Many others, like the anchor investors who are going to hang onto their shares. I think that you and I are standing behind a long line of willing purchasers at the moment. By the time we get a chance, it's going to be higher than it is at the IPO price and higher than it should be, and higher than it's going to be at certain days in the future. Is this also a case where you think

the investment bankers might be doing a poor job? I mean, on the surface, if the share is oversubscribed by 10X, that would seem to me that these investment bankers who are putting these shares public couldn't find an appropriate price for them. I think that it is a fair question to say, if there's more money, look, the money isn't going to the company itself, it's going to the owner, SoftBank. It's not as if the company is being deprived of a large pile of cash by being priced too low, what is happening is SoftBank is getting a fair price for this small percentage of its holdings and is going to have the opportunity, if this is continued, to have more people wanting to buy the shares

than are available to buy the shares, they're going to be able to sell some additional shares to a willing pool of the market later on, and that's part of the game that's going on here. Looking at the prospectus in this case, because it's a British company selling shares on an American exchange, it's an F-1, not an S-1. Under the use of proceeds section, what they're going to do with the money, it seemed awfully short to me in a document that's otherwise more than 200 pages long, basically saying, quote, all net proceeds from the sale of these shares in this offering will go to the selling shareholder. Is that normal? I thought companies went public to raise money to do other things. Well, I mean, Arm has been public in the

past and was taken private, and then SoftBank tried to sell it to NVIDIA. So, it's not a small growing company that's on the cutting edge of a huge growth trajectory that it needs money to realize everything that it thinks it can do, it's perfectly fine being private. It's just the owners want some money. They want to monetize their investment. They wanted to monetize it by selling to Nvidia, which was not permitted by the regulators. They're to monetize it with Nvidia possibly participating as an anchor investor and others getting a chance to buy the limited quantity that's being made available. They will be able to divest themselves of as much as they want over time. Right now is a good time to put it on the market.

If you got an AI story, absolutely. This is where it's a little weird to me. The The prospectus claims that Arm will be, quote, central to the transition of AI and machine learning-enabled computing. Its revenue is also flat year over year. This is at the time where AI, machine learning spending, has absolutely been on a heater. Right. Arm is just everywhere else. The biggest chunk is the 99% share of the smartphone market that it's got. That's not growing fast. That's a mature market. There are people constantly upgrading and replacement cycles, and a few more people who don't have a smartphone yet are buying them. But that's their bread and butter. That and other things like that.

AI is an incremental ad. You had the chip shortage over the past year or two, three years. And chips, as a general market, have once again saturated the market. So, to hold flat isn't too surprising, even given the growing percentage of AI that they're going to participate in. That's balanced against a very, very mature chip design business that isn't exploding today because it exploded two and three years ago. In this prospectus, it's almost 230 pages long. When companies release these, investors like to go through them, but it can be a little intimidating. What's your advice, let's say, to a newer investor about what they should look for,

maybe some general things that they should be looking for in these documents before a company goes public? Yeah, 229 pages is a big ask. You might want to just cut and paste it and throw it into your favorite AI learning tool and ask them what they see there. You wanted to look at the risks section, which in this case is going to include China. Pretty big risk for the company because China is known to interfere with a good market when they see an opportunity to help out their own companies. That is in the risk section. Also, I would look at the management compensation section, what the incentives are for management, how they are getting bonus pay. If you read all of those two parts, you'll have done more than most, I would

say. Bill Barker, appreciate your time and your insight. Thanks. Thanks for having me. 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 averted. When you have critical business questions that need answers, don't just file a ticket and wait weeks for an outdated report. Describe what you need and have Rippling AI build it instantly

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the impact of these payments?" Well, Douglas, indeed, I think you can think of the income that you're going to get from Social Security, a pension, maybe another reliable source such as annuity as something like a big holding in bonds. Technically, if you have a lot of Social Security and pension income, you could invest more in stocks in your portfolio. But of course, you might be like, well, what's the value of that holding? Well, if you're good with a spreadsheet, you can calculate a present value of that income. However, most people don't know how to do that. I'm not even sure I know how to do that. Fortunately, one person who has already done the work for you is Dr. Benjamin Bailey,

who is a professor of communication at the University of Massachusetts Amherst. He was actually curious how to put a dollar value on his defined benefit pension. He couldn't find a good online present value calculator, so he built one himself, which you can find by visiting valueyourpension.com. And even though it says pension, you could also use it to calculate the value of your social security. Now, as you click around the site, you'll see that some tools are free, some you have to pay for. So just know that ahead of time. But once you've calculated sort of that number for the value of your pension, social security, whatever, you can consider that value as a big bond holding, and then you allocate the rest of your assets accordingly.

However, there's another way to factor your guaranteed income into your portfolio decisions that I think makes more sense, especially if you're near or in retirement. Let's illustrate this with an example. Let's say you need $70,000 a year in retirement and you'll get $30,000 a year from Social Security. You're going to need $40,000 a year from your portfolio. You build your asset allocation around that, starting with your income cushion, which is at least five years worth of portfolio provided income out of the stock market into safe stuff like cash, treasuries, short-term bonds. In this example, if someone needs $40,000 a year from their portfolio, the income cushion would be at least $200,000 because you multiply it by five. It's actually a little bit more

because you should project what you'll need in years two through five factoring in inflation, but we're going to just use $200,000 as an easy example. Now, let's say it's the exact same situation, except besides the $30,000 from Social Security, this person's also going to get $20,000 a year from a pension. Thus, they only need $20,000 a year from the portfolio. You multiply that by five, you get an income cushion of just $100,000. Their income cushion is only half of the previous example. They only need to put $100,000 in that super safe stuff like cash and bonds and things like that, which means, theoretically, they could invest more in the stock market. But I say theoretically, because that's important, because you have to have the

risk tolerance for it, and only if it's appropriate for your situation. Next question comes from Barry. I have been a subscriber to Stock Advisor for the last 11 years and I'm super happy that I was able to find it to begin with. Oh, that's great. I think I'm going to be editorializing a bit in reading this one. Okay. I have put all of my savings into stocks following the advice of the service and have done very well over the years. Oh, that's good. I am now 49 years old and single. All right. That's cool. In October of 2021, I realized that my portfolio was over the amount that I felt comfortable to retire on. Well, that's awesome. Okay. I sold my house, my car, et cetera. I then moved to Mexico and was

very excited. Wow. That is exciting. Of course, after the market crashed, my portfolio was cut in half. Oh, okay. Now, now, now I'm less excited. Yeah. I was able to stay the course returning to work in Canada for the summer of 2022. I then left for Southeast Asia and returned for work this summer, and I'm now getting ready for South America this winter. What a whirlwind adventure, Barry, you're taking us on. All right. Let's keep going. The majority of my portfolio is in tech. I am fine with the volatility. I can always return home to work in the summer again if I need it. But I'm now thinking about the future and would like to know what you would suggest for a plan when I decide that I no longer wish to work again. How should

I do that? Well, Barry, it starts again with the income cushion. I know it's kind of boring, but regardless, I said it should be at least five years. Barry's got enough excitement going on in his life. Income cushion sounds great. That's right. I keep saying five years because the typical Motley Fool reader and listener tends to be more aggressive. That's probably true for Barry, too. But this past weekend, we aired my interview with Bill Bernstein, the author of The Four Pillars of Investing, an outstanding book. He recommends setting aside enough to pay for 10, 20, maybe even 25 years retirement needs. Again, that's probably too much for Barry. But for others, it might be the right move and want more predictability and peace

of mind in retirement. Once you're within 10 or 5 years from retirement, you want to start gradually building up that income cushion. But the other thing for Barry is to think about diversifying away from tech stocks with some of his money. While you're saving for retirement, volatility may not matter if you have the risk tolerance for it. In fact, it could be a benefit because every time the market drops 50%, you can buy more stocks at lower prices. But once you're retired, volatility matters a great deal. When your stocks drop, you ideally can live off your income cushion for a year or a few while waiting for your stocks to recover. But at some point, you may be forced to sell stocks when they're down, and this will greatly

increase the chances that you will run out of money. The Nasdaq, which is a good proxy for growth-oriented tech stocks, has been on a tear the last 14 or so years, even including last year's 33% decline. It may be easy to forget that we saw something similar during the dot-com boom of the 1990s. Unfortunately, the Nasdaq began to crash in 2000, eventually dropping more than 70%. It wasn't until 2016 that it fully recovered. Any retiree who is relying exclusively on Nasdaq-type stocks likely would have had to return to work. Meanwhile, over that 16-year period, value stocks, small cap stocks, REITs, even international stocks held up better at times

and would have provided a life raft to retirees while they waited for their tech stocks to recover. Barry, it might make sense to gradually begin diversifying your portfolio now so that your entire retirement isn't relying on just one sector. Man, I wish we still asked people to send postcards. I think Barry could help us out with checking a bunch of countries off the list. I totally agree. All right. Next question comes from Jeff. I have traditional IRAs and a Roth IRA, as well as a taxable investment account. I'd like some help sorting out the best location for the various types of equities in my portfolio. For these purposes, I divide my portfolio into

the following groups, growth stocks, dividend-producing stocks that give me qualified dividends, dividend-producing stocks like REITs, real estate investment trusts, that give me non-qualified dividends. I'd like to put my growth stocks in my Roth IRA because their growth in value won't be taxed. However, I'd also like to put my REITs and other producers of non-qualified dividends in my Roth IRA because they don't qualify for any favorable income tax treatment, but there's only so much room in there. I expect my growth stocks to generate annual returns between 10% to 15% per year over the long term. That makes me think that if I'm expecting a REIT to generate more than 10% return per year, it can go into the Roth IRA. But otherwise, I might be

better off reserving that space for my growth stocks, particularly the ones I have the most conviction about? Well, the question of which investments should go in which type of accounts is known as asset location. It's part science, part art. One way to do it is to rank your investments in a couple of ways. The first is by tax consequences, starting with the most tax inefficient investments, and then on down to the investments with built-in tax advantages. Of the investments you mentioned, Jeff, you're right. REITs are the most tax inefficient. Every year, they throw off a lot of income, and those are not considered qualified dividends, which means they're taxed at ordinary income rates. Other investments that pay dividends,

and if they're qualified, those dividends are taxed as long-term capital gains rates. It's a lower tax rate, so they're in the middle range in terms of tax efficiency. Then you go down to stocks that don't pay dividends at all. These are actually very tax-efficient, even if it's in a taxable brokerage account, because you own the stock, You don't pay taxes on it until you sell, ideally years, if not decades later. At that point, you pay long-term capital gains rates, which are lower. Also, along the way, you can do some tax-loss harvesting, if that's your thing. I will put out that Jeff didn't mention cash or bonds.

Up until this year, people didn't really care about the tax consequences of cash or bonds, because we didn't get any interest, so there was no interest to be taxed. I think this year, when people do their taxes next April, they're going to be very surprised because they're actually now getting interest from their cash and bonds. That usually taxes ordinary income, and it's going to surprise them because taxes aren't withheld. Their bill is going to be a little higher than they expect. So, for cash and bonds that you're saving for retirement, probably keep them in an IRA

or something like that because they're very tax inefficient. The other ranking to consider, and Jeff touches on this, is expected returns. What you do is, if you think, what are the investments that I think are going to be worth the most when I retire and throughout retirement? As he suggests, you should put the investments that you expect to have the highest returns in your Roth, because the Roth is the tax-free account, and you want your tax-free account to grow the most. You use your other accounts for investments that you expect to have middling or lower returns. If Jeff expects his REITs to be among his highest returning investments, then the Roth makes sense.

Otherwise, he should keep those in a traditional IRA because they're so tax inefficient, you definitely keep them in a tax advantage account of some kind. As you can see, there are a lot of moving parts here. Do an online search for the terms asset location and learn more about where to hold your investments before making any big changes to your portfolio. Our last question today comes from Brad. Throughout the 20 plus years that I've been saving for retirement, I have gone on the assumption that if I can get an average 5% to 6% annualized return in my retirement portfolio over the 30 to 40-year arc of my career, I would be set to comfortably ride off into the sunset. Up until recently, I have kept minimal

funds in bonds, generally less than 10%, mostly because bond yields have been so low during the last decade as to drag down my rate of return. After taking my licks in 2022 with the bond market, it's time that I start increasing my exposure to bonds as my horizon to retirement is starting to shorten. I have been considering investing a good portion of my IRA bond allocation in individual U.S. treasuries with a junk bond or two intermingled for the higher yields, but recently stumbled across some government-sponsored enterprise, GSE, 10 to 20-year bonds with a credit rating of AAA or AA+, that have a yield of 6.33% and 6.40% respectively. I see the potential upsides to investing in these would be that they beat my annualized goal of 6%

return. Is there something there that I'm missing? Because these bonds seem to have yields approaching some junk bonds, but with a governmental credit rating. Yeah, GSEs are generally private banks with implicit, implicit is the important term there, government backing that are intended to provide credit to certain segments of the economy. And the ones most people are familiar with are like Fannie Mae and Freddie Mac. But there's a few others, such as the Federal Agricultural Mortgage Corporation, known as FarmerMac. And they are highly rated by agencies such as Moody's and S&P because they have the implicit

backing of the United States, based on the belief that they are so important to the credit system, Uncle Sam wouldn't let them fail. And that's exactly what happened during the housing crisis of 15 years ago, when folks like Fannie and Freddie got bailed out. But during that process, there was a good bit of uncertainty and a little bit of volatility there. And if you look at the fine print for any of these issuers, it'll say something like, quote, these bonds are not guaranteed by the United States and do not constitute a debt or obligation of the United States, end quote. So they're not technically as safe as treasuries, which have an explicit backing from Uncle Sam. Still, they're considered very safe. So, it's likely fine to buy some of

these bonds. I just wouldn't make them the only type of bond that I buy. You do mention that you were going to buy one or two junk bonds. I'm actually not a big fan of junk bonds because the reason you own bonds is that generally, usually, but not all the time, as we saw last year, they hold up when the stock market goes down. But that's not what happens with junk bonds. When the stock market goes down due to some sort of economic slowdown or recession, junk bonds go down 20% to 30% as well. If you're going to buy them, I wouldn't do it as just one or two different bonds. Do it in a diversified, low-cost ETF because you're going to need the diversification. And then finally, I'm just going to point out that you want to buy these 6% bonds because it

exceeds the amount that you need to retire. The way bonds work, though, it's important to know that let's say you buy a bond, you put $10,000 in a bond that matures in 10 years. You're going to interest of 6%, but 10 years later, your principal is still $10,000. The principal is not going to grow. The important thing that you need to do is that you make sure that every time you get interest from your bonds, you reinvest them in something else that also earns at least 6%. That's the only way you're going to have the total amount of your money growing 6% compounded over that period until you retire. Thanks for listening. On tomorrow's show, I chat with Bill Mann about one of Warren

Buffett's favorite businesses. 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 stocks based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.