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Negative free cash flow is (often) a good thing

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I tweeted the following half-jokingly

This is in response to comments from investors and analysts where they raise a red flag on a company with negative free cash flow, without further analysis.

What’s free cash flow

Let’s define free cash flow for a business

Free cash flow = Operating cash flow (including depreciation) – Maintenance capex

Maintenance capex is defined as capital required by a business to maintain its unit volume and competitive position. This capex would be in the form of working capital and fixed assets.

Let’s take a simplified example to illustrate it. Let’s say you own a house on your own piece of land (a rarity but go with me on this one). After a few years, you decide to get the house repainted as the old paint is peeling off and there are cracks in the wall. Let’s say you spend 5 lacs on the whole thing.

After the house is painted and repaired, you feel good about it. Keep in mind that the value of the house hasn’t gone up. If you were to list the house it would not sell for more (though it could have sold for less if the repairs had not been done).

Let’s fast forward a few years. You decide to extend your house and build a new room. The square footage of the house goes up by 15%. If you decide to sell the house now, you will be able to get a higher price for the house as the area of the house has increased.

The first scenario is that of maintenance capex – money spent to maintain value of the asset. The second is the case of growth capex – money spent to increase the value of the asset.

No published numbers

The same point holds true for a business/ company. The only difference is that a company will rarely break out the annual investment into maintenance and growth capex. This is something an investor has to figure out based on a study of the business.

Investors look at the cash flow statement with the following math

Operating cash flow + depreciation – working capital investment – fixed asset investment

If the above number is negative, they flag it as an issue. The problem here is that the investor is not distinguishing between growth and maintenance capex.

Any money spent on maintenance capex does not increase the value of the business. If all the investment in the above equation is maintenance capex and the resulting number is negative, then it is a red flag.

A lot of businesses, especially in the commodity space, have to keep investing just to stay in the same place from a competitive position. That’s the main reason why these businesses do not create value for their investors over a business cycle.

A company in growth phase and investing into growth capex, will also have negative free cash flow which could create value down the road.

How to evaluate growth capex

This requires a detailed understanding of the business and competence of the management.

There are businesses which requires very little maintenance capex (almost equal to depreciation) and re-invest all their free cash flow for growth and at high rates of return. Such businesses create a lot of wealth for their shareholders in the long run.

The key point to evaluate is whether the investment is being above the cost of capital (including debt). If yes, then you want the management to invest as much as it can (within reasonable limits) as these incremental investments will create value for us down the road.

The main job of the analyst is to figure out whether the management is truly investing above the cost of capital. That unfortunately cannot be accurately estimated to a decimal point, though there are indicators which can help you make an educated guess. You need to ask questions on the attractiveness of the industry, the opportunity size and capability of the management (based on past performance) and come up with a rough guess.

The next time you hear someone talk of negative free cash flow without an analysis of growth v/s maintenance capex – you can recall my tweet above. Such a person is implying that spending on education is a red flag as there no free cash flow being generated in the present.

Survival is the ultimate prize

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It seems ages since I wrote the following comment three months back

How does one invest under such extreme uncertainty? One option is to assume that there will be a quick recovery and go all in. The other extreme is to wait till it is all clear and then deploy the capital. In the first approach one is making a bet on a specific scenario which may not occur, leading to sub-par results. In the second case, we may end up with sub-par returns too but only because prices will adjust once all the uncertainty goes away.

At that point of time the future was uncertain and anyone making a specific bet was ‘assuming’ a specific scenario. If we assume that 50% of the investors bet on rapid recovery and the other 50% bet on the whole thing dragging on, the first group turned out to be right.

You are now hearing from such investors who went all-in, in the month of March/April.

It could have easily gone the other way and in that scenario, the second group would be highlighting the merits of being cautious, whereas the first group would have been silent.

I personally avoid taking a specific view of how the future will unfold. The risk of doing so is high, if you get it wrong. If you are managing money for others (like me), then the risk is asymmetrical. If you get it right, you can tout your performance. If not, then your investors bear the brunt.

I will not tar all managers with the same brush. A lot of them, including us, are invested the same as their investors. In such cases, the behavior of the manager changes quite a bit. In such cases, your focus shifts to survival, than shooting the lights out. It does not mean that you will not make mistakes, but are very focused on managing the risk.

If the goal of investing for an individual is to achieve his/her financial goals, then the first priority is to ensure that you don’t incur a massive loss from which you cannot recover. The older you are, the higher the risk. I would recommend an individual investor to NOT look at the performance (especially near term) of professional investors. You should never do what this class of investors is doing, not because they are smarter (they are not), but because of the asymmetry of risk faced by them.

I took the following approach in the middle of the crisis

Under the circumstances, my approach is that of ‘regret minimization’. That’s a fancy way of saying that I will do something in middle, so that I can avoid FOMO (fear of missing out) if the first scenario occurs, but at the same time have enough dry powder available incase the economic recovery takes longer.

Instead of going all in, we have slowly added (and even sold) positions as shape of the crisis has become clear at the company level (and not at a macro level). It has allowed me to sleep well and live to fight for another day.

In investing, there is no finish line and gold medal at the end of it. The end goal is survival and meeting your financial goals.

Basket Bet

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I wrote the following note to my subscribers on a recent position we have initiated. Specialty chemicals and Pharma is currently among the few sectors which have caught the fancy of the markets. I think these sectors do have the potential for above returns in the long term, though not every company will benefit equally from the tailwind.

The success or failure of each company will come down to the unique advantages/ competencies built by the management and their execution going forward. In addition to that, each company faces idiosyncratic (fancy word for unique) risks with FDA audits being one of them.

As a result, a single company bet can lead to losses even if rest of the sector does well

In order to mitigate this risk, I have taken a basket bet approach for the portfolio. This is also due to the fact, that one cannot estimate such risks ex-ante (before the fact). Diversification across the sector reduces, though does not eliminate the risk.

Pharma Sector bet

This is different from our usual transactions. This transaction is part of a sector bet. I am betting on the pharma sector for the following reasons

  • Several companies in the sector have been investing in R&D across a wide range of products such as Finished generics, API, Biosimilars and new dosage forms. As these investments have a long gestation period, the result is not fully visible in the P&L statement yet. We are now at the cusp of seeing the result of these investments, which have been made over the last 5+ years
  • Several companies have been investing on the front end (marketing) for the US and other markets. This allows the company to have a better control on the supply chain (with better margins) and work directly with customers. However, building the front end takes time and we are seeing early results of that.
  • The industry went through a growth phase till 2015, when it was hit by a mix of issues. The industry was hit by FDA audit failures which resulted in a loss of revenue for companies which failed the audit. At the same time, there was a consolidation of buyers (companies which buy pharmaceuticals for hospitals and pharmacies) which resulted in higher pricing pressure. This caused a drop in the growth and margins for the industry resulting in re-rating of the sector.
  • The industry has since then improved its processes and has a much better record of passing FDA audits. In addition to that, companies continue to invest in these processes to improve their compliance rate.
  • Several companies in the sector are now expanding beyond the US (and India) into other countries such as the EU, Japan and Africa. This should provide further growth opportunities for the sector.

We have an option to bet on a single company to play the above theme, but the risk of FDA audit and higher pricing pressures in some product segments continues to be high. I want to take advantage of this long-term tailwind and growth opportunity, but at the same time reduce the risk of failing an FDA audit.  Hence my plan is to go ahead with a sector bet where we will spread out our capital across a few attractive ideas.

I have not decided the number of companies or the size of the bet yet.

The ideas in this bucket – which I will call the pharma bet (PB) could be rotated in and out with a much higher frequency compared to other positions in our portfolio. I have been studying the sector for some time now and like a few other companies in this space. My plan is to add companies some of which could be long term plays whereas others could be more tactical in nature.

Throwing in the towel

T

-2%

-28%

-48%

This is what you have lost in the last three years if you invested in nifty 50 (large cap), Nifty Midcap 100 and Nifty Small cap 100. Even these numbers understate the actual losses. Large caps appear to be a safe haven, but even that is driven by a handful of companies.

One can find comments on media, comparing equities with other asset classes such as fixed deposit, gold etc. and implying that equities are doomed to perform poorly in the future.

I think such people are too lazy to look at the data. Equities over a 3, 5 and 10 year periods outperform all other asset classes. What is not stated that equities DO NOT outperform in ALL 3,5 and 10 year periods. This difference may appear to be subtle, but the effect of it is not.

The probability of equity underperforming other asset classes is as follows

3 Year rolling buckets     :             25%

5 Year rolling buckets     :             18%

10 Year rolling buckets   :             10%

What the above stats mean is that for every 3-year rolling period, equities can underperform other asset classes such as fixed income, one out of three times. The recent 3- and 5-year period has been one of those times. This is another representation of risk, namely that a particular asset class will underperform from time to time.

If you are losing patience with equities as an asset class, there are two questions you need to answer for yourself

Do I believe equities as an asset class will deliver high returns in the future?

The way to look at this question is to look at the last 100+ year of data across countries. This data supports the view that equities do outperform all other asset classes over the long run. However, there are periods of underperformance which test the patience of almost all investors.

Do I believe the fund manager can deliver above returns?

The way to look at this question is to look at the performance of this individual/fund house over the long run (across market cycles). Different styles are in favor at different points of time. 2014-2017 saw small and midcaps do well. Large caps, especially quality has done well in the last two years. In order to eliminate the chance of luck, look at the performance of the manager over a 5 to 10-year period and check if the investment approach makes sense to you (and suits your temperament).

There is no magic pill which will convince you to invest in equities. Data can help you make a rational decision, but at different points of time in your investment journey, you will need some blind faith to keep going.

I have been through such periods in the past (in different aspects of life including investing) and often faith supported by data has worked for me.

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