We Study Billionaires - The Investor’s Podcast Network - TIP508: Berkshire's Purchase of TSM & Meta "Doomsday" Analysis

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the Investors podcast. I'm your host, Clay Fink. On today's episode, I'll be covering some research I did on Berkshire Hathaway's most recent large purchase in Taiwan semiconductor manufacturing, ticker TSM. During this episode, I'll also be covering TSM's business model and competitive advantages, the critical role semiconductors play in our overall economy, potential risks investing in TSM, as well as the geopolitical tensions between the U.S. and China with the U.S. restricting China

Starting point is 00:00:35 from benefiting from the global semiconductor market. Then later in the episode, I talk about the key drivers in the stock's performance, some highlights from Todd Combe's speech at the Gramandotte annual breakfast, and be sure to stick around until the end to hear meta-stocks doomsday analysis and why the company might be undervalued today. With that, let's dive right into today's episode. The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Starting point is 00:01:15 Now, Buffett recently made a purchase in Taiwan Semiconductor, ticker TSM. In their 13F quarterly filing that was released in mid-November, they announced the purchase of 60 million shares for $4.1 billion, making the average price per share roughly 68, $0.50. This made TSM Berkshire's 10th largest holding in their equity portfolio, comprising of 1.4% of the $296 billion total. Apple tops the lists at 42% of the portfolio, Bank of America's 10%, then Chevron 8%, and then going down the line, they have Coca-Cola Still, American Express, Occidental, Coftines, Moody's, and Activision. The only other noteworthy change in Berkshire's portfolio for Q3 at 2022 was upping their position

Starting point is 00:02:11 in Occidental. They added 36 million shares and that now makes 4% of the overall portfolio with 194 million shares. Now for TSM, it isn't really clear who exactly at Berkshire decided to make this purchase for the portfolio. It may have been Buffett himself or it may have been Todd Combs or Ted Weshler, who are also allowed to make some smaller purchases for Berkshire without running it by Buffett. If we see that Berkshire continues to add to this position, then it's pretty likely that Buffett was pretty involved in this decision. Now, Taiwan Semiconductor is a huge company. They have a $400 billion market cap at the time of this recording, and it's largely known as one of the behemists in the semiconductor space. This is not the type

Starting point is 00:02:57 of purchase one might expect from Buffett, but for those of us who have studied him, we know that he's always willing to change as the facts and environment change. In Buffett's 2008 shareholder letter, he stated that if a company has lots of technology involved, then he won't understand it. So one would think that he wouldn't get into the semiconductor industry. But let's remember that Buffett made a huge bet on Apple that paid off tremendously for him, and that was also a technology investment, which historically he avoids outside of his purchase of IBM. When Buffett was asked about his Apple purchase, he said, I didn't go into Apple because it was a tech stock in the least. I went into Apple because I came to certain conclusions about

Starting point is 00:03:39 the value of its ecosystem and how permanent that ecosystem could be. Buffett almost always puts a tremendous amount of emphasis on the competitive advantage of a business as well and how durable he foresees that advantage being in the future, as he stated, the key to investing is not assessing how much an industry is going to affect society or how much it will grow, but rather determining the competitive advantage of any given company and above all the durability of that advantage. Now, the chip manufacturer industry saw a surge in demand after COVID. TSM, for example, was $53 in February of 2020, and then it ranged in the $110 range for most of 2021, and then it pulled back to over $60 in October of this year, and the stock got a boost

Starting point is 00:04:30 from the announcement that Buffett purchased, and it now sits around $80 per share. The company reported revenue in the most recent quarter at $20.2 billion, which is a really impressive year-over-year increase of 35%. Their operating margin was around. 50% that quarter, which is also really profitable for them. Plus, the company is trading at a Ford PE of only 13. And the general bear case for why this may be pretty low is that the semiconductor industry is somewhat cyclical, meaning that if we see a pullback in the demand, then these earnings could really pull back as well. They're projected to do roughly $76 billion in revenue for 2022. Just in 2019, they did $34 billion in revenue. So from $34 billion in 2019, all the way up to

Starting point is 00:05:20 $76 billion in 2022. Revenue growth so far seems to be pretty resilient despite the macro headwinds as of late. Zooming out a little bit, they grew their revenue by $9 billion total from 2014 to 2019. And they increased their revenue by over $41 billion from 2019 through 2022. I always like to check and see the return on invested capital or return on equity as well to see how effectively the management team is able to redeploy those profits back into the business. Incredibly, the ROIC and ROE for TSM has been in the 25 to 30% range for the past 10 years. Meanwhile, the stock is up 16.6% annualized over the past 10 years as well. I think one of the biggest concerns for investors in TSM is the possibility of China invading

Starting point is 00:06:14 Taiwan. This would likely really hurt TSM's business, but maybe this is a risk that gave Buffett a chance to really purchase a good business at a fair price. When I was looking at the company's reports, I found the breakdown of their revenue quite interesting. In their most recent quarterly report, they list 10 different types of technologies they sell. The largest one comprises of 28% of revenue, which is the 5 nanometer chip. Their revenue by platform was led by smartphones at 41%. In North America was the largest market for sales, which accounted for 71% of overall sales. Now, semiconductors are not something I was ultimately too familiar with prior to doing research on TSM. I was familiar with companies like Samsung and Intel who are in the

Starting point is 00:07:03 semiconductor space. And I know that the semiconductor chips, we're having supply chain issues after COVID, and these chips are used in just so many items today from our smartphones, our computers, laptops, cars, and so on. As far as the industry overall, semiconductors are really the foundation of the digital economy. Taiwan Semiconductor is the sole manufacturer of the chips for Apple's iPhone. Tesla is another company that creates a lot of demand for semiconductor chips. They get theirs from Samsung. And TSM alone, produces over 50% of the world's chips, which is just incredible given how critical they really are to our global economy. In learning about the overall industry, I really gained an appreciation

Starting point is 00:07:49 for just how complex these chips are. What gives this company a competitive advantage is the amount of capital that's required to build out these sort of manufacturing facilities, as well as the R&D spend required to continue to innovate and improve on these chips. In 2021, alone, TSM's depreciation and amortization expense totaled $15 billion, and their R&D expenses were $4.5 billion. On top of the capital expenditures that are required in the industry, the expertise is super, super important as well. Much of the talent in the industry is over in Asia, so it would be really difficult for a company to get going in the U.S. because much of that talent is just overseas. So the expertise, I believe, is really a key piece to the moat that TSM has.

Starting point is 00:08:38 The semiconductor industry overall has really been a big beneficiary of Moore's Law, which states that the number of transistors on a microchip doubles every two years, so these improvements in the chips lead to the continued exponential improvement of computers in terms of speed and capability. Gordon Moore, who was the co-founder of Intel, in 1965, he hypothesized that every two years, the number of transistors that can be packed into a given space will double. This is the foundation of how Moore's Law came to be. His insight eventually came to be the golden rule of the industry.

Starting point is 00:09:14 So with Moore's Law every two years, we essentially pay the same price for a product that ends up being twice as good. This continued exponential improvement, of course, can't go forever because eventually it hits some sort of physical limitation. Moore himself acknowledged this, and engineers believe that some of the Sometime this decade, we will hit that limit where it's just simply impossible to create smaller circuits. Now, why did Buffett choose TSM over all these other chip manufacturers?

Starting point is 00:09:43 TSM is a major provider to Apple, which we all know, Buffett is well aware of. Buffett, of course, is bullish on Apple. He put tens of billions of dollars into the company since 2016, and it's appreciated in value quite well, and he's continued to purchase shares in Apple. And we know that Buffett really likes to own these companies with really strong brands for a long time. So if Buffett expects Apple to do well over the next 10 to 20 plus years, then it makes sense from that perspective that he would choose the semiconductor company that is the primary supplier of the iPhone, which is the most important piece of technology to Apple.

Starting point is 00:10:18 If Apple does well, then it's likely TSM will do well because their businesses are interconnected to some degree. So instead of Apple getting vertically integrated and producing their own, chips, Buffett has vertically integrated his portfolio, so to speak, and now owns an extension of the Apple ecosystem. Now, given that Taiwan plays such a critical role in the global economy, I found it interesting to go back and dive into the story of how it came to be this way. TSM was founded by Morris Chang back in 1987, and up to that point, the companies that

Starting point is 00:10:52 would create these technologies would just do it in-house. and Chang had essentially started what would come to be known as the Foundry Model, which essentially meant that different companies started developing and innovating in the semiconductor industry, and then they would sell these chips to the companies that use these actual products themselves, whether it be cell phone manufacturers, the automakers, etc. Chang had attended Harvard and MIT and earned his master's degree in mechanical engineering, followed by his PhD in electrical engineering from Stanford. In 1958, he worked for Texas Instruments, which is currently a player in the semiconductor industry,

Starting point is 00:11:32 and he worked at Texas Instruments for 25 years and became the head of the semiconductor business. In 1987, Cheng could have retired, but instead, the government of Taiwan recruited him to create TSM, and this helps boost the country's technology sector. At the time, most semiconductor companies were in the U.S. in Japan. Most companies would design and manufacture their own chips, and this model really created problems for the industry. Chang made a really key breakthrough because he focused solely on the manufacturing, and TSM didn't do any of the designing.

Starting point is 00:12:09 So to use Apple as an example, it's my understanding that Apple does all the designing of the chips for their iPhone, and then TSM will just handle the manufacturing for them. Since TSM would handle the manufacturing of the chips, this led to a surge in the chip. startups that would solely focus on the design, as companies that designed the chips didn't have to put up all this capital to build out the facilities, to manufacture it, and they could just simply outsource this to a company like TSM. From 1999 to 2015, sales from the fabulous chip companies that designed chips quadrupled and went from 7% of total semiconductor sales to 29%. Most of this growth ended up flowing to TSM as they are by far the world's largest semiconductor

Starting point is 00:12:55 foundry, and they've captured 60% of the foundry market. Morris Chang actually retired in June of 2018 after leading the company for 31 years, and he passed the torch to C.C. Wei, who is now the CEO, and Mark Liu, who is the chairman today. As a lot of people are probably aware, there has been a really big push overall for manufacturing to move to the U.S. rather than being reliant on countries overseas. The U.S. has recognized the importance of the semiconductor industry for the future, as this summer they passed the Chips and Sciences Act, which provides $52 billion in subsidies for chipmakers based in the U.S. Financial Times are an article here in early December

Starting point is 00:13:41 that TSM will be investing $40 billion into production facilities into the state of Arizona. They stated the reasons for this was the rising geopolitical tensions and pressures from customers, which my guess would mainly be Apple. Here's the short clip I wanted to play of Tim Cook discussing this important issue. As many of you know, we work with TSMC to manufacture the chips that help power our products all over the world. And we look forward to expanding this work in the years to come as TSM forms new and deeper roots than America. When you stop and think about it, it's extraordinary what chip technology

Starting point is 00:14:24 can achieve. And now, thanks to the hard work of so many people, these chips can be proudly stamped made in America. So the U.S. is taking these steps towards moving the chip manufacturing within its borders. However, even with this investment in the U.S., many believe that the U.S. is still largely dependent on foreign manufacturers of chips. And if China were to happen to invade Taiwan, then this could just totally wreck havoc for all countries globally. And this would really be more detrimental than the Russian invasion of Ukraine is what many believe. The production of these chips are pretty concentrated in Taiwan, as they alone produce roughly one-third of the world's chips and 90% of the most advanced chips available. Let's take a quick break and hear from today's

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Starting point is 00:19:14 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Another issue is that the U.S. manufacturing would be one technology generation behind most advanced production that is in Taiwan. The Financial Times article titled TSM Triples Arizona Chip Investment to $40 billion. This article states that industry executives and analysts said that trying to build the most advanced capacity outside Taiwan with throw TSM's operations model into disarray.

Starting point is 00:19:53 Economically, it just wouldn't work for TSM to build out the latest technology manufacturing facilities in the U.S. because their research and development is based in Taiwan, and replicating that in the U.S. would be extremely costly for them. So it seems like being based in Taiwan really gives them a solid cost advantage. One Morningstar analyst stated that the U.S. plants will allow TSM to provide the chips for legacy model iPads, but certainly not the iPhones from the latest product cycle. Apple's next generation iPhone will start production in the second half of 2023, but TSA M's nanochip 3 chips, which those products need, will become available in the U.S. only in

Starting point is 00:20:36 2026, by which time the chipmaker is expected to move to the N2 in Taiwan. The good news about TSM playing a huge role in the semiconductor industry is that although they're geographically located close to China, they don't necessarily favor working with China over the U.S. The founder of TSM is an American citizen, and they have American-Tencompassing. ties in working with Apple, who is one of the largest companies in the world. They seem to have played a more neutral role in the global economy in that most of the production is in Taiwan, and they will sell to really wherever the demand is, not necessarily favoring one particular country over another. But I didn't mention earlier that over 70% of sales go to North America,

Starting point is 00:21:22 so they do have a really strong incentive to play fair with the U.S. Tim Colpin, who was a columnist from Bloomberg Opin, touched on his big, potential risks he foresees in TSM. He did so in an interview on the Odd Lots podcast. Tim mentioned that the first risk he sees is the potential for the technology to become so good in the industry that the better products they provide don't really move the needle, and they aren't really able to differentiate themselves from the other players in the industry, so they could spend billions of dollars developing this new technology to potentially not have

Starting point is 00:21:56 as much demand as they might have hoped in the future. Another risk, Colpin mentions, is their variable costs of their manufacturing facilities, as the process of making these chips is very energy-intensive. Recently, another company called UMC, which is also in Taiwan recently had a power outage because of the energy issues the country is having as a whole, as Taiwan is currently in a looming energy crisis. Another risk I think is worth mentioning is that many tech companies are reducing spend and doing layoffs, and with the tightening market conditions, this could, of course,

Starting point is 00:22:30 affects TSM as well in the short term. Next, I wanted to discuss the geopolitical tensions that are currently happening. On October 7th of 2022, the Biden administration announced a new export controls policy on artificial intelligence and semiconductor technologies to China. These restrictions prevent AI chip designer companies like Nvidia and AMD from selling their high-end chips for AI and supercomputing to China. This is really a huge deal, and it's almost hard to believe the steps the U.S. is taking to try and prevent China from getting ahead technology-wise. Jordan Snyder from China Talk wrote a wonderful article explaining this

Starting point is 00:23:12 in detail. He explained what he calls the Biden administration's four semiconductor policy chokeholds. The first chokehold he goes into is cutting off access to U.S. made high-end chips. The highest levels of leadership in both the United States and China believe that leading in AI is critical to the future of global military and economic power competition. And China is a global leader in AI research, AI commercialization, and AI-enabled military tech. In the past, the US made efforts to prevent the chips from getting to the Chinese military by targeted sanctions and not allowing sales to commercial businesses, but these efforts proved to be ineffective in actually preventing the chips from eventually

Starting point is 00:23:58 flowing to the Chinese military, which are extremely reliant on U.S. chips. So instead of trying to allow some sales and not allow others, high-end AI chips can no longer be sold to any entity operating in China, whether that be the Chinese military, a Chinese tech company, or even a U.S. company operating a data center in China. Of course, if China is cut off from US chip makers, they will want to try and develop these chips for themselves, which brings Jordan to the second and third chokehold, which is to cut off access to the U.S. made chip design software and U.S. built semiconductor manufacturing equipment. To take that another step further, the U.S. is even prohibiting any semiconductor manufacturer

Starting point is 00:24:42 worldwide from providing services to any Chinese chip design company that is seeking to make high-end chips for AI or supercomputing. Jordan states that any chip manufacturing operation, whether Chinese or otherwise, that seeks to build Chinese chip designs, will risk losing its own access to U.S. semiconductor manufacturers. This puts China at a significant disadvantage because their domestic manufacturing just isn't near as advanced as their U.S. counterparts. The fourth chokehold the U.S. is putting in place is blocking access to U.S. components that are used to build semiconductor manufacturing equipment.

Starting point is 00:25:21 Jordan states that designing and building the equipment for manufacturing semiconductors is among the most technologically complex, expensive, and difficult undertaking that could occur anywhere in the global economy. So with all these choke points the U.S. is put in place, it's going to be extremely difficult for China to get up to speed in manufacturing these chips domestically due to all the reasons I just went through and just how complex this whole thing is. You can just imagine how globalize our overall economy is. And if you just force one country to produce something as complex as these semiconductor chips, it can really complicate things for them because someone like the U.S. really relies on these other countries to produce things for them. And the U.S. itself doesn't even

Starting point is 00:26:07 have much of the capabilities that others have. Jordan Snyder's article goes into incredible detail if you'd like to learn more about this piece specifically. But I thought it was definitely worth touching on. CC Way, who is TSM's president and co-CEO, commented on the U.S.'s actions stating, the new regulation set the control threshold at very high-end specification, which is primarily used for AI or supercomputing applications. Therefore, our initial assessment is the impact to TSMC is limited and manageable. Regarding to what's to come for the semiconductor industry, Way stated, we expect probably in 2020. In in the semiconductor industry will likely decline, but TSM also is not immune.

Starting point is 00:26:53 But we believe our technology position, strong portfolio, and longer-term strategic relationship with customers will enable our business to be more resilient than the overall semiconductor industry. And that's why we say in 2023 will still be a year for growth for TSM and the overall industry will probably decline, end quote. Related to TSM, I thought it would be interesting to touch on N-Sept. as well. Intel is an American semiconductor chip manufacturer, and despite the company having grown at a good clip in recent years, the stock has just been in a free fall as of late. The start of the year, it was around $50 a share, and now it trades at around $28 per share. Intel's PE ratio is just under

Starting point is 00:27:36 9, while TSM is 14, so Intel's PE multiple is almost 40% cheaper. For those listeners who prefer To buy something that's really cheap, Intel may be worth considering. I follow this Twitter accountant blog named Value Stock Geek, and he writes a blog and does deep dives on companies. He did a write-up on Intel that was released at the beginning of 2021. In that report, he highlights that the EPS had grown by nearly 20% annualized over the past decade, fueled by the growth in their business, as well as the share of repurchases, boosting their EPS number. The company's return on equity has averaged over 20% for the past 10 years. And one reason that Intel is trading so cheap today is because they have fallen behind technologically.

Starting point is 00:28:24 As of late, competitors like Samsung and TSM have gotten ahead of them keeping up with the newest chips, and Apple announced they're going to be ending their reliance on Intel chips and going to use their own chips and some of their products. With them falling behind technologically, it's interesting to see that Intel's R&D spend is 17 billion over the trailing 12 months, while TSM only spent $5 billion during that same period. So with the company's high R&D spend for Intel, they are somewhat playing catch up with the market. The market this year seems to be pricing as if they won't catch up to their competitors and the demand for their products will decline. And with a very low multiple on Intel, you can see

Starting point is 00:29:04 that the market much prefers companies that design the chips rather than manufacturing them. Intel does both, and they have a PE of 9, whereas you look at Nvidia, they just design the chips and they have a PE of 78. It's just a complete night and day difference between the two in terms of valuation multiples. I personally tend to take the Buffett approach of believing that turnaround stories often don't end up panning out, but if Intel is able to turn the ship around and get caught up from a technology perspective, we could see plenty of upside for the stock going forward. Intel is still a really big company, so coming up with the money to develop this technology shouldn't be a big issue for them, but we'll see how that one plays out.

Starting point is 00:29:48 During this episode, I also wanted to touch on a stock's return and where the return actually comes from. I think if you ask to your typical person what causes a stock to go up, they would tell you that a stock's increase in value comes from the underlying growth. Growth is the reason why companies like Tesla, Nvidia, Zoom, they all get so much attention and got so much attention over the past couple of years. They had a growth story attached to them, and these stocks were doing so well. Well, if you studied Buffett's work, you know that a company's increase in long-term shareholder

Starting point is 00:30:23 value does not come from the growth of the top line revenue. What really matters is the earnings that the company produces, or what Buffett calls owners' earnings. What's also just as important is how those earnings are being deployed, whether that be reinvesting back into the business, share repurchases, or issuing a dividend. Todd Combs, who is the CEO of GEICO and a portfolio manager for Berkshire, recently spoke at the Graham and Dodd annual breakfast, and he stated that at Berkshire, they focused on owner's earnings. Owners' earnings can be calculated as the reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges, minus the capital expenditures that the business requires to fully

Starting point is 00:31:09 maintain its competitive position and its unit volume. How many times on CNBC do you see the reporters talking about owners' earnings of a business? I would guess it's likely very little. CNBC wants a lot of viewers on their show, so they aren't going to point out that maybe Zoom isn't allocating capital effectively, or that 100% annualized growth isn't sustainable over the next decade. They want to attract as much attention as possible so they can collect more revenue off their ads and their business model.

Starting point is 00:31:39 So oftentimes, the best companies to own are the companies that aren't shown on CNBC. Odds are, most of the companies that the mainstream media likes to talk about probably won't be great stocks to hold for the long run. Many companies that retail investors are attracted to because of the market, of their high growth potential end up being much more speculative bets because the price you need to pay for these companies relative to the earnings power is really high. So they need to continue their high growth for many, many years and then grow into their valuation and then start to pay eventually a reasonable level of their earnings relative to the price. So many of the high growth

Starting point is 00:32:19 companies are more like venture bets in my mind where many of them won't provide that grade of return, while a select few will end up paying off really big. A venture portfolio might buy 50 startup companies and hope that two or three of them go up 100-fold. Now, a much more reliable approach to investing in individual stocks is to do it in a way like Warren Buffett does it. He looks for something that's stable and predictable. There's not a lot of hype around it pushing the multiple up. He sees that management is rational and ethical, and they invest money back into the business at a return that is greater than 10% consistently. This way to build wealth is regarded as get rich slow. It's touted as boring, you won't get rich overnight, but you can earn a

Starting point is 00:33:04 reasonable rate of return over a long period of time, and it's much more reliable. When you're investing in a bunch of growth companies, you're swinging for that grand slam, and with value investing, you're hitting the consistent singles over and over again. To help further illustrate this, let's take a look at a stock like Home Depot. Home Depot from 2011 through 2021 grew their revenue by only 8% per year. To your average retail investor or to maybe CNBC or mainstream media, this is a really boring stock. You walk into their stores and it's honestly pretty boring, unless you're a plumber or in-home improvement and enjoy purchasing those types of items, but for the most part, it's a pretty boring business. Let's take that a step further.

Starting point is 00:33:48 Home Depot's store counts have increased by just 65 stores since 2011. 65 stores in 10 years. Their store count at the end of 2021 was just over 2,300. So how about Home Depot stock performance? Despite their revenues having only grown by 8% per year, the stock had a 10-year annualized rate of return of 18% versus the S&P 500's 11%. So what does this mean? What it really means is that management has done an effective job at returning capital back to the

Starting point is 00:34:24 shareholders through dividends and sherry purchases, and then they also have reinvested back into the company where they can earn a high rate of return. Home Depot's return on invested capital has averaged over 30% over the past five years, so management has done an exceptional job at allocating capital on behalf of shareholders, and that has now been reflected in the sheer outperformance. You look at their operating margins, and those have increased by 50% over the past decade, their revenue, free cash flow per share, and dividends just march upward year after year, and the share counts are declining as they do share repurchases. These are the types of things you want to see from the companies you own, and these stocks will give you sustainable,

Starting point is 00:35:06 longer-term growth when they're purchased at a reasonable price. Now, I'm not saying that all investors should avoid companies with high revenue growth, but just remember that, what is really going to drive long-term shareholder value is the growth of the company's earnings in the moat that the company has to ensure that those earnings are sustainable moving along into the future. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance,

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Starting point is 00:39:02 of high growth companies will see their growth slow within 10 years. And when that growth does all of a sudden stabilize, then the stock tends to get crushed because the market then reprises its expectations going forward. Zoom is a perfect example of this, as their growth has almost come to a grinding halt, and their stock is down 60%. Since I mentioned Todd Combs, I'd like to touch more on the Graham and Dodd annual breakfast he spoke at recently. A substack called Investment Management Insights wrote about the event if you're interested in learning more about this, but I'll provide some of the highlights here. During his talk, Combs recalled that the very first question Charlie Munger asked him, was what percentage of S&P 500 businesses would be better businesses in five years?

Starting point is 00:39:49 Combe said it was less than 5%. In Munger believed that this number was less than 2%, noting that you can have a great business, but it doesn't mean that the business will be great in five years. And this statistic is quite surprising to me, at least, and it's a good reminder that capitalism is brutal. The rate of change of businesses is as fast as ever, and there's always another business out there working hard to steal your market share. Todd Combs and Warren Buffett, as many know, get together and talk about businesses on their

Starting point is 00:40:19 Saturday afternoons. He said that 98% of what they talk about is the qualitative aspects of a business. If a business has a 30 times earnings multiple, then you can run the numbers on what it will have to do to achieve run rate earnings and how the worst businesses are those that need high levels of capital in order to grow and have declining returns, whereas the best businesses grow exponentially with very little capital investment. Combs also touched on incentives and look to see if a company and its management team are more focused on internal or external growth. Charlie famously says that you get what you incentivize, and if management is incentivized to

Starting point is 00:41:00 appeal to Wall Street rather than to shareholders, then they may make longer-term sacrifices for shorter-term gains. For example, for say Home Depot, when they announced in the mid-2000s, that they were going to shift away from building new stores, the stock got severely punished, but management knew that they reached their market potential for store counts and that building new stores wouldn't be the best use of shareholder capital. They were making decisions based on shareholder interests rather than appealing to Wall Street and investing in growth just for the sake of growth. A big signal Combs looks out for is when management changes the KPI for which they will be compensated by, presumably because management won't get

Starting point is 00:41:42 compensated if the original KPIs are left as is. Combs estimates that 20% of companies in the Fortune 500 are changing the incentive metrics for management, and that's no accident. Every time Combs meets with a company, there are two questions he always asked the managers. First is, how much time do you spend talking with investors? The median response he gets is 25%. Second is, what would you be doing if you were not publicly traded? To this question, Combs typically received a list of things management would do that makes sense. Combs then follows up and asks them why they aren't doing those things, to which the managers would state that they feel handcuffed. So you can see that when Combs is assessing the quality of management, he wants to

Starting point is 00:42:27 avoid the ones that are focused on the quarterly performance rather than focusing on the long-term growth and shareholder value. To add to this, he also mentioned that founder-led businesses tend to outperform because the founders are better fiduciaries and tend to have a longer time horizon. Combs also talked a bit about EBITDA, or what he and Charlie calls BS earnings. EBITA is a metric I see many investors mention when assessing the performance of a company. For those who aren't aware, EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The big problem with EBITDA is that it can make an unprofitable,

Starting point is 00:43:08 business look profitable. So in effect, it can make a business appear on the surface to be much better than it actually is. When Warren and Charlie are talking to managers and they want to highlight the EBITDA numbers, then red flags really go off in their head. Interest, taxes, depreciation, and amortization are real expenses, so they should be considered when calculating the owner's earnings for a company. Buffett has said that the reason it has become so prominent and widely used on Wall Street is really to try and fool investors into thinking they are buying profitable businesses. Now, that's not to say there aren't some uses of EBITDA, such as comparing different types of businesses or industries, but this is just another item to be mindful of when you're

Starting point is 00:43:52 analyzing a company. Now, Bill Ackman asked a question, I've always wondered, and I really appreciate him bringing it up. He asked Combs about the moral grounds of investing in a company that makes sugary beverages like Coca-Cola, which... You know, Coca-Cola does a really great job at showing skinny people playing volleyball on the beach while drinking their product, while many cities around the world are really having a lot of issues related to diabetes, obesity, fatty liver disease, etc. And he noted that the company is effectively

Starting point is 00:44:25 the Philip Morris or a tobacco company of this generation, and it's causing a lot of harm to society while doing a really good job of marketing it. So, Ackman asked Holmes about the moral grounds of owning a company that really isn't that great for society. Unfortunately, we didn't get much of a response from Combs, as he said that Coca-Cola wasn't a name he had chosen on behalf of Berkshire. When Munger was asked a similar question of Wells Fargo in the past, he stated something to the effect of, we have to invest in the world we live in, and not the world we want to live in. This is something I've pondered a bit in particular with a company like Meta. The Facebook Blue Platform and Instagram are both obviously large parts of their business, and there are studies

Starting point is 00:45:11 that show that Instagram is harming teens in terms of mental health and depression, and that these platforms hire programmers to get their users literally addicted to it. Now, I don't judge anyone for buying a company like Meta or Coca-Cola. It just somewhat irks me personally and tends to lead me to try and look elsewhere for investment opportunities if I can. While we're talking about meta, I think this is an important stock to touch on as well, and I think there's a lot we can learn from it. I mentioned earlier that just because a company has spectacular revenue growth doesn't mean the company will have superior stock performance. Meta, since their IPO in 2012, has increased their revenues by 23 times, yet their stock has essentially matched the performance

Starting point is 00:45:57 of the S&P 500 over that same time period. This company's IPO was in 2012 at a market cap of around $104 billion, and it reached a trillion-dollar market cap in July of 2021, before pivoting to focus on the Metaverse, and then the market cap, you know, just plummeted, and now it's below $300 billion. For Q3 of 2022, meta's quarterly revenues were down 4% year-over-year, and to add fuel to the fire, their operating margin, which was 36% last year, is now 22%, So we've seen a really drastic drop in their operating margins. Facebook's financial statement shows a net income of nearly $29 billion in a PE ratio of only 11, and we're all aware that they are betting big on the Metaverse.

Starting point is 00:46:46 Essentially, the market is pricing in that the pivot to the Metaverse is going to be a total failure until proven otherwise. Investors really don't believe that Zuckerberg is making a wise bet into the Metaverse, And as far as I can tell, why should investors believe them that it's going to pan out? They haven't communicated any sort of business model on how they're going to capitalize on this bet or when they expected the bet to actually pay off. Is it going to be a subscription model to access their platform? Is it going to be based on transactions that happen in the Metaverse or is it based on ads?

Starting point is 00:47:19 I mean, nobody really knows from what I'm aware at least. But let's not forget what Facebook has achieved to date. They have over 3 billion people who spend their time in the ecosystems they own, plus they own an incredible amount of data on these users, and they get most of their revenue from digital advertising, which is a market that has grown substantially during the rise of this company since its IPO. Digital advertising increased from less than 10% of advertising in 2005 to over 70% now in 2022. And there's a simple reason for that. Advertisers tend to get more for their money or they get a better return on investment when they advertise digitally rather than through

Starting point is 00:48:00 the traditional methods of advertising. This business model is running into headwinds, though, as users are starting to become more conscious of their privacy, and Facebook's ad business depends on collecting data from you. The more data they collect, the more personalized ads they can deliver, the more money they can make. Invasion of privacy is a feature of this business model and not a buck. Additionally, the growth of the digital advertising space is beginning to slow, so it doesn't take much imagination to believe that Facebook and Google's advertising revenue growth will slow

Starting point is 00:48:34 over the coming years. I'm sure Zuckerberg saw this coming eventually, and rather than just accepting the reality of a mature business and lower growth, he decided he wanted to be the leader in this new industry of the Metaverse and essentially reinvent the company. Now, since 2019, they've lost well over $20 billion. in their Reality Lab segment and still only have $2 billion in revenue in the previous 12 months to show for it. Over the next decade, they plan to invest close to $100 billion in the Metaverse, and Facebook isn't the first big tech company to invest in new business segments. Microsoft, Google,

Starting point is 00:49:13 and Amazon have successfully invested in the cloud business. Google has their other best division, But the size of Facebook's investment that they're doing and doing it in the light of an anticipated recession, it's a big difference between Facebook's bet and these other big tech players' bets in the past. And we could also argue that the investment in the cloud business by, say, Microsoft made a lot more sense in 2015, and Facebook's investment now is much more questionable. Aswath Demodran, who has been on William Green's Rich or Wiser-Hapier podcast, put together what he calls a doomsday scenario for meta.

Starting point is 00:49:48 He was on Williams Show back on R.W.H.005 back in April of 2022. In his doomsday scenario for meta, he made four assumptions about the business to come up with a valuation. And I'll be linking the video to this in the show notes as well. Now, the first assumption for his doomsday scenario for meta, he took what the company made for its operating income over the past 12 months, and he extended that out for the next 20 years. One could argue that this operating income is conservative because of the maximum. macro headwinds, the strong dollar, and the slowing economy. So he's using a conservative income amount to project forward for the next 20 years. Then after that, it goes to zero. The free cash flow figure he came up with for this analysis was $26.6 billion. The second assumption is that he took

Starting point is 00:50:36 what they did for R&D over the past 12 months, which was $32 billion, and ran that R&D spend for the next 20 years. This is really what makes it what he calls a doomsday scenario. There investing like crazy in this Metaverse, making these crazy bets, but these investments really turn into nothing in terms of additional operating income in the future. The third assumption is that the $10 billion that Facebook lost on the Metaverse will continue for the next 20 years, so the Metaverse will net them nothing in positive earnings. And then the fourth assumption is that the cost of capital is 9%, which puts them in the 75th percentile of all companies in terms of risk. Under that scenario, he calculated the intrinsic value of the company at $258 billion,

Starting point is 00:51:23 and if he were to take out the $10 billion annual loss from Reality Labs, then this would lift the intrinsic value to $330 billion. Interestingly, at the end of October, Meadow was trading at a market value of $247 billion, which is well below Aswat's calculation of what it's worth in the doomsday scenario. So essentially, he came to the conclusion that the market is being extremely pessimistic on where the company is heading going forward. Based on the stock price, the market expects the metaverse to just be an utter failure and will return essentially nothing to shareholders.

Starting point is 00:52:01 And the market is pricing in no additional income from their core business. They just don't trust Zuckerberg at all and just think management is totally blowing it in terms of just based on what the stock is priced at today. He closes out the analysis by saying that Facebook has failed to communicate to shareholders how these massive investments in the Metaverse are going to pan out. They seem happy to communicate how much they will be investing in the Metaverse, but they haven't done a good job of telling their shareholders what their business plan actually is, where the money is going, and then how these investments are actually going to pay

Starting point is 00:52:36 off in the future. I'm not saying that meta is a buy or a sell here, but I think after watching that video by Aswath that the argument is quite compelling to take a long position, especially if we see it pull back again to the 90 range. Right now, the stock is trading at around $114. So it's rebounded a bit lately. If you're interested in learning more about meta, you can check out Aswath's work, which will be linked in the show notes. All right, that wraps up today's episode. I really hope you enjoyed it and found value in it. I learned a lot about the chip war specifically. from TIP's daily newsletter, We Study Markets.

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