As Coastal Housing Markets Cool, 2017 IPO Redfin Is Worthy Of A Watchful Eye

For all of the business model evolutions and technology-led disruptions throughout the service economy in recent memory, the 6% realtor sales commission (a truly obscene amount for higher priced homes) for the most part has been unscathed. Tech upstarts like Redfin (RDFN) are trying to make a dent and are making progress, albeit slowly.

Public for less than 18 months after their IPO priced at $15, RDFN is using technology to save home buyers and sellers money. The company has been expanding its 1% sales commission structure rapidly, which can cut home sellers commission expense by 33% (4% vs 6%). Like Zillow (Z), RDFN also strives to offer customers ancillary services, such as mortgages.

RDFN stock had been trading pretty well, relative to the $15 issue price, up until recently:

The issue now is that RDFN was started in Seattle and focused initially on higher priced big cities for its lower sales commissions. The reason is pretty obvious; taking a 3% cut on a $200,000 home in Spokane is equivalent to taking a 1% cut on a $600,000 Seattle listing because each will take roughly the same labor hours. The idea that said Seattle seller would pay $36,000 to sell their house is a bit nutty, but that structure has largely survived in the industry.

Fortunately for RDFN, the coastal housing markets have been on fire, including double-digit annual gains in their home Seattle market for many years now. The result has been a strong revenue growth trend for the company, with 2018 revenue expected to top $475 million, versus just $125 million in 2014.

With those same markets now showing clear home price deceleration and inventory stockpiling, RDFN should see pressure on its near-term financial results, and likely similar headwinds for the publicly traded shares.

Long term, however, RDFN's future appears bright as it continues to expand its business across the country, taking aim at the traditional 6% sales commission structure. The company's market share reached 0.83% as of June 30th, up from 0.33% in 2014. While that figure is tiny, it shows you just how much business is out there for newer players to steal.

To be a long-term bull on RDFN, one needs to believe that over the next 10-15 years they can continue to grow market share and perhaps reach 5% penetration of a market worth tens of billions per year. The good news is that the company has enough money to try and get there. After a recent convertible debt offering, RDFN has about $300 million of net cash on their balance sheet, compared with an equity value of roughly $1.65 billion. That cash is crucial, as the company is purposely losing money now to grow quickly (cash burn has been in the $20-$30 million per year range).

It is hard to know what a normalized margin structure for RDFN could look like, and therefore assigning a fair value is not easy. With nearly $500 million in revenue and $300 million of cash, the stock does not appear materially overpriced today if one thinks they can earn 15%-20% EBITDA margins over time and therefore trade for 1.5x-2.0x annual revenue.

That said, if coastal markets continue to cool over the next few quarters, RDFN could dial back financial projections for Q4 and 2019, which would likely put pressure on the stock short-term, despite it being a long-term story for most investors. Accordingly, I think RDFN is an interesting stock to watch, especially for folks looking for growth without having to pay a huge premium for it.

Rising Interest Rate Shock: 2019 Edition

Back in February I published the table below to show investors where the S&P 500 index would likely trade if interest rates normalized (10-year bond between 3% and 5% is how I defined it):

Published 2/27/18

The point of that post was to show what the typical equity valuation multiple was during such conditions (the answer is 16x-17x and we don't have to go back too far to find such conditions). Now that 2018 is coming to an end and earnings are likely to come in at the high end of the range shown in that table ($157 is the current consensus forecast), let's look ahead to 2019.

I have added a gray section to the chart (see below) to include a range of profit outcomes for 2019. The current forecast is $176 but I believe there is more downside risk to that than upside, so I did not add any outcome in the $180+ area.

As you can see, the equity market today is adjusting rationally to higher rates, with a current 16.1x multiple on consensus 2019 profit projections. The big question for 2019, therefore, is not huge valuation contraction. Rather, it comes down to whether earnings can grow impressively again after a tax cut-powered 26% increase in 2018. If the current consensus forecast for earnings comes to fruition, the market does not appear to be headed for a material fall from today's levels.

Given that the long-run historical average for annual earnings growth is just 6%, assuming that in the face of rising rates the S&P 500 can post a 12% jump in 2019 seems quite optimistic to me. Frankly, even getting that 6% long-term mean next year - resulting in  $166 of earnings - would be solid.

For perspective, at that profit level, a 16x-17x P/E would translate into 2,650-2,825 on the S&P 500, or 3% lower than current quotes at the midpoint. Add in about 2% in dividends and a flattish equity market overall seems possible over coming quarters if earnings fall to post double-digit gains next year and valuations retreat to more normal levels.

Many Gaming Related Companies Are On Sale

I have written enough about Wynn Resorts (WYNN) in recent years that much more in the way of commentary is likely unnecessary. Investors are once again getting a unique buying opportunity with the shares down a stunning 30 percent on very little news:

Even if they wind up selling their under-construction Boston property prior to opening, the haircut for shareholders would likely be less than $5 per share (a 20% gain on the $2.5B cost is just $500M). Although Macau revenue growth is slowing, the August figures are still well into the double digits.

Other leading gaming related stocks are also selling off and warrant special attention. Two notable ones are lottery and slot machine giant International Game Technology (IGT) and video game behemoth Electronic Arts (EA). 

IGT is a global leader and despite low single digit revenue growth (most markets are mature), the business is minimally cyclical and the company's valuation seems extremely reasonable at 10 times 2019 earnings estimates and a dividend yield north of 4 percent.

EA has been riding the coattails of a transition from packaged software sales to cloud-based digital sales, and the higher gross margins such a distribution model affords. A recent profit warning, due in large part to a delay in the upcoming release Battlefield 5, has helped the stock fall about 25% from its highs. While not dirt cheap (low 20's multiple to earnings), continued revenue growth, margin expansion (digital sales still represent less than 70% of the total, which could reach 90% over time), and a stellar balance sheet should be accretive to shareholder value over the intermediate term.

No matter your investing style, and despite the market near all-time highs, there are plenty of gaming investments worthy of consideration right now.

Would Moving To Six Month Financial Reporting Solve Anything?

News that President Trump has asked the SEC to study the potential benefits of moving from quarterly to biannual financial reporting for public companies has stoked a debate as to the merits of such a proposal.

While it is certainly true that short-term thinking, often motivated by the desire to please Wall Street, should not be a focus of management teams of public companies (I can’t stand it when I see quarterly financial press releases tout how actual results beat the average analyst forecast), I am not sure that six-month reporting would materially help solve the problem. From my perch, there are several reasons why I would not expect much to change if such a proposal was enacted:

• Many companies already do not spend time predicting or caring about short-term financial results, and those firms adopted such a strategy on their own. They did so because the boards and management teams of those firms decided it was the best way to run their business. Those calls fall under their job descriptions, and they take them seriously regardless of what guidance they receive from regulatory bodies.

• For companies that choose to give forward-looking financial guidance today, they would likely continue to do so on a six-month basis. If they tried hard to hit their quarterly numbers, sometimes doing so at the expense of longer term thinking, the same would be true when dealing with six-month financial targets. Behavior would not change, just the outward frequency of such behavior would.

• Reducing the frequency of financial reporting would only serve to make companies less transparent with their own shareholders. Since we are talking about public companies that are serving their shareholder base first and foremost, it should be up to the investors to voice concerns about what metrics are being prioritized at the management and board level. There is a reason activist investing has found a place in the marketplace (and the goals are not always short-term in nature, despite media claims to the contrary).

• Just because companies are required to file quarterly financials does not mean they need to spend much time on them, or communicating them. Jeff Bezos likes to brag to his shareholders at Amazon's annual meetings that the company has no investor relations department and does not travel around the country to tell their story to the investment community. He does not think it is a good use of his time. Plenty of smaller firms simply file their 10-Q report every 90 days and hold no conference call to discuss their results. In essence, they spend minimal time on financial reporting (10-Q reports are not super time consuming when the same template is used every quarter and the company has to close their books every period regardless of external reporting requirements).

• There is an argument that less frequent financial reporting will result in more volatile stock prices when companies do publish their financials. Essentially, if things are going unexpectedly, the surprise could be twice as large if the gap between reporting periods is twice as long. For many companies, this might be true. But I am not sure of the net impact, given that it can work the opposite way too. If a company has a poor Q1 but makes it up with a strong Q2, it could be a wash when it comes time to report mid-year results, whereas quarterly reports would have resulted in surprising investors twice, in opposite directions.

  It seems the core problem people are trying to solve here is the focus on windows of just 90 days from a management and investor perspective. I firmly believe that whether a company takes a long term view, at the possible expense of short-term results, or not, that decision is a reflection of top management and the board, with input from shareholders hopefully playing a role. If that is true, then reporting frequency itself is not the core determinant of the behaviors we see. As such, we should expect companies to continue their chosen management styles and strategies, whether they have to publish financial reports every 3, 6, or even 12 months.

  From an investor standpoint, if I am going to be given information less frequently, I would want to at least believe that performance will be superior, in exchange. In this case, I do not see how six-month reporting would benefit shareholders by changing behavior at the corporate level, leading to improved revenue and earnings growth over the long term.

  If a simple financial reporting rule change would dramatically change decision making inside public companies, then the same managers who are pushing for six-month reporting should take responsibility for how they are running their companies and simply de-emphasize short term results.

  They can do so without rule changes at the SEC, and they can go further if they want. For instance, there is no rule that says you need to host quarterly conference calls after reporting earnings. Companies could easily host one or two calls per year if they chose to (or none for that matter), which would send a clear message to their investors and free up time (albeit not that much) to focus on the long term.

Canada Goose: Brings Back Memories Of Other Fashion Stock Heydays

In the spirit of fashion, let me begin this article off with a runway of sorts, even if it is a lineup of stock charts rather than models.

Here is a chart of Michael Kors (KORS)  stock since its late 2011 IPO. Notice the move from $20 to $100 by early 2014:

Here is Coach stock -- now called Tapestry (TPR)-- since its IPO in 2000. In this case there were two separate astronomical run-ups, neither of which could be maintained.

Abercrombie and Fitch (ANF) was scorching hot when I was in high school in the late 1990s:

And one more: UnderArmour (UAA):

There are many things these companies have in common, and not all bad actually. For instance, notice how all of these brands have survived and built sustainable multi billion dollar businesses?

But on the flip side, the stocks have been duds over long periods of time. While they have been volatile (making for plenty of trading opportunities in both directions), the reason why none of them have been good long-term buy and hold candidates is because fairly early on in their stints as public companies the brands were so popular that the stocks became massively overvalued. So even though the businesses continued to grow, the stocks turned out to be poor investments.

It has been a little while since we have seen a surging fashion brand on Wall Street (UnderArmour likely the most recent), but recent IPO Canada Goose fits the mold. Here is the chart since the 2017 IPO:

GOOS currently is valued at $6 billion USD, versus expected 2018 revenue of $420 million, for an enterprise to sales ratio of ~15x. Even with 20% growth in 2019, to $500 million (the current Wall Street analyst consensus estimate), the multiple is ~12x.

Consider what types of enterprise value-to-revenue multiples the large fashion brands currently trade for:

Tapestry 2.5x

Michael Kors 2.3x

Ralph Lauren 1.5x

Tiffany 3.9x

Nike 3.5x

UnderArmour 1.8x

There is simply no way to justify such a sky high revenue multiple for GOOS. The median revenue multiple from the group of 5 comparables above is 2.5x. So how much does GOOS need to grow over the next decade to simply justify the current stock price? The numbers come out to an 18% compounded annual growth rate from 2018 through 2028, which gets the company to roughly $2.2 billion of annual revenue:

$420M * 1.18^10 = ~$2.2 billion

Put another way, if the business grows from $420 million this year to $2.2 billion in 10 years, and the shares trade at 2.5x EV/revenue at that point in time, the stock price will go nowhere even though sales would have grown by 424%!

The only way these numbers don't work is if GOOS has somehow figured out  a way to sell clothes for far higher profit margins than the leading fashion companies in the world, which have already amassed multi-billion dollar businesses. Betting on that outcome seems ridiculous to me.

As a result, although it can be tempting to jump on highflying recent IPOs like GOOS, thinking it could be the next big thing in fashion, it is important to realize how lofty the valuations can be. And if stock prices reflect plenty of growth already in future years, the share price will not have to follow suit.

One last example, outside of the fashion space -- remember how bonkers investors went for the Shake Shack IPO back in January 2015? Take a look at how the shares have done since hitting $96 in May 2015:

And that is despite SHAK's revenue surging 137% from $190 million in 2015 to an expected $450 million in 2018.

GOOS buyers beware.

With Aetna Buyout Set to Close Soon, CVS Health's Flat-lined Stock Still Looks Cheap

Last October I wrote about the just-leaked CVS Health (CVS) bid for health insurance giant Aetna (AET) and tried to convey the notion that the move was about far more than just diversifying away from retail pharmacies for fear Amazon might compress margins in that industry. Interestingly, CVS's stock price was $69.05 when I published that note, and today it closed at $69.05. So almost 10 months later and all investors have earned from the shares is the not-too-shabby 3% annual dividend.

CVS reported a solid second quarter this week and is on pace to book nearly $7 of free cash flow per share in 2018 ($6.88 in my internal model), which puts the stock at 10 times free cash flow, a price normally reserved for melting ice cube businesses. And there are plenty of people who see CVS (incorrectly) as just a bricks and mortar pharmacy company destined to be disrupted by some trillion dollar market value tech darling. Others acknowledge their huge pharmacy benefits management business (Caremark), but believe the thesis that those firms are actually robbing their commercial clients blind and helping boost drug prices, when the opposite is actually true (and hence why their clients don't fire them). If both of those notions turn out to be correct, CVS will not be a good investment over the next 5 or 10 years, but I am taking the opposite view.

In fact, the story will get even better when the Aetna deal closes (CVS management indicated on their quarterly conference call this week that September or October is the most likely timeframe for closure). Essentially, CVS is building a healthcare services juggernaut, it seems to me anyway, and will be able to use a vertically integrated business model to offer consumers numerous options and generate efficiencies in an otherwise complex healthcare system. Bears on the company seem to fail to realize that a network of drugstores and in-store clinics, coupled with pharmacy plan management, assisting living and nursing home drug distribution, and insurance plans is an all-encompassing system that can be designed and integrated in such a way as to drive convenient usage from customers of all shapes and sizes, which in turn should bring down costs as scale is leveraged.

Now, there is no guarantee that the company will figure out the best way to harness this potential, but the goods news is that the stock is pricing in failure already at 10x free cash flow. Nothing positive is being considered by most investors and many of them figure the 3% dividend will be immaterial once Amazon announces 2-hour prescription fills delivered by drone starting in 2022 (that is merely speculation on my part -- no announcements have been made). However, when you look at the breadth of CVS's offerings it seems to me that this company is more than just a bricks and mortar retailer selling a commodity at a higher margin than Jeff Bezos would. It does not seem like something the tech giants could duplicate successfully.

As for the PBM side of the business, a lot has been made about pharmaceutical rebates and how they may be encouraging drug prices to remain high on a gross basis. The anti-Caremark thinking assumes that drug markers are giving the PBM rebates on drugs and those payments are juicing the profits of the PBM while patients pay huge out of pocket costs. CVS told investors this week, however, that they keep just $300 million of rebates annually, and pass the rest (roughly 97-98% of the total collected) back to their clients in one form or another (different clients choose different structures). That $300 million figure represents just 4% of the company's annual free cash flow.

Put another way, in a world where PBM plans are restructured so that no rebates are kept by the plan manager, CVS's free cash flow would drop from $6.88 to $6.59 per share. Not only is that hardly enough reason for the stock to be trading where it has been for the last year, but it is unlikely that Caremark would have to give up that $300 million at all. Rather, the PBM contracts would likely be changed to move away from rebates at all, and be underwritten in other ways such that certain folks would no longer insist rebates were the problem. Given that PBM clients are renewing their contracts in the high 90 percents every year, providers like Caremark would likely have no trouble keeping their existing business relationships, at the same underlying profit margins, even if they changed how the reimbursement of negotiated drug savings were handled.

As an investor in CVS Health, I am intrigued to see what the company can do with Aetna added to the mix. Since I don't expect their business to begin a slow decay over the next few years, I am sticking with the shares, despite them merely treading water lately, as I firmly believe the business is far more resilient and value-providing than the bears are giving it credit for. Even at 15x annual free cash flow, still a material discount to the S&P 500 index (remember when consumer staples used to trade at a premium?), CVS stock would trade north of $100 per share. Call me crazy, but I think we will get there sometime within the next 2-3 years. Add in a 3% dividend while we wait and the upside potential is impressive, especially given how negative sentiment is today (which limits further downside to some extent). 

The Price of "FAAAM" - 5 Tech Stocks Now Worth Over $4 Trillion

We hear a lot about the "FAANG" stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet) leading the S&P 500 higher in recent years, which is undeniably true, so I decided to take a look at a slightly modified version to see where valuations are within the group.

Below you will find data on "FAAAM" which I have coined to represent the top 5 most valuable companies in the S&P 500 today. By adding Microsoft in place of Netflix, we have a fivesome worth more than $4.1 trillion, or about 16.5% of the entire S&P 500 index ($25 trillion total value).

There are many conclusions investors can gleam from this group of tech stocks, and not everyone will agree. I will share a few of my views and feel free to chime in.

• While not unprecedented, having such concentration within the dominant U.S. equity index means that near to intermediate returns for the market are largely correlated with large cap tech leaders. Given that none of the valuations are inexpensive, and Apple is probably the only one that looks to be no worse than fairly valued, investors relying on this group for future returns will need growth rates (in revenue and earnings) to continue at high rates for quite a while. It is hard to know whether this expectation is reasonable. For instance, will the size of these firms lead to slower growth by default, or are they dominant enough to continue to garner the lion share of the sector's growth overall?

• At 18x EV/EBITDA, are the valuation of this group reasonable enough to expect that the stocks, on average, can generate double-digit annualized returns over, say, the next 5-10 years? If 20% annual growth rates in the underlying businesses persist, then the valuations are not likely too high, but that is a big open question. For instance, Amazon's revenue in 2018 is projected to reach $235 billion (current analyst consensus estimate). To keep growing at 20% per year, the company needs to find an incremental $50 billion of revenue every year, which equates to $1 billion every week! The stock is priced as though such an outcome is likely. What happens if revenue growth slows to 10%?

• Of the five companies in "FAAAM" the only ones I would consider putting fresh money into, based on growth and valuation, would be Apple and Facebook. Apple's run to $1 trillion this week on the heels of a strong earnings report could signal the stock is topped out in the near-term. Facebook, however, trading down lately after ratcheting down growth expectations on their latest conference call, is really the only FAAAM stock that is down materially at all. While I am not exciting to buy any names in the group at current prices, they could very well have the best mix of untapped growth opportunities and less-than-exuberant investor sentiment.

Facebook Growth and Margin Warning Should Not Have Surprised Anyone

Shares of Facebook fell hard on Thursday after guiding investors to slower growth and falling operating margins going forward. Many FB bulls acted as this was a total shock (and obviously the stock was not reflecting the news either), but really this was bound to happen. In fact, FB had already warned that expenses would rise faster than revenue in 2018, to deal with all of the issues the company has been battling in the news lately. As a result, margin compression should not be surprising.

Evidently investors also believed that even with 2 billion active users, the company could continue to grow revenue at 40%-plus. How that is possible when 2018 revenue will top $50 billion and user growth has slowed dramatically (there are only so many connected humans on the planet) is hard to understand. Perhaps investors see Amazon growing revenue 39% this past quarter and just assume that every high flying tech company can do the same. Amazon, however, is the exception, not the rule.

Below is a summary of Facebook's financial results, including some estimates I came up with for what 2018-2020 might look like. These are not all that different from the numbers I had been working off of for my last FB post earlier this year, but now that the company has publicly guided investors in that direction, it should be less of a speculation on my part.

As you can see, GAAP free cash flow is unlikely to get much above $7 per share, even assuming the company can grow revenue by more than 100% over the next three years. Using my preferred measure, which includes stock-based compensation as though it was being paid out in cash to employees, free cash flow might struggle to get materially past $5 per share.

The big question for investors, then, is what multiple to put on such growth. The large cap tech leaders have been getting 30-40x multiples in recent years, but it is hard to know whether slowing growth rates (as these firms get so large) will crimp those valuations.

Facebook bulls would probably argue 30x that $7 figure is more than reasonable, and therefore would suggest a rebound to $210 per share (versus the current low 170's) is on the horizon over the next 6-12 months. Add back the company's cash hoard and maybe $225 is doable (the stock was already at $217 two days ago!).

More cautious investors might use 25x and prefer the $5 free cash flow figure, which would mean $125 per share, or $140 including FB's ~$40B of cash in the bank.

That leaves us with perhaps 20% downside and 30% upside depending on which camp you are in. Such a risk/reward does not exactly get me excited to build a position in the stock, but at least the shares are coming back to reality.

FB bulls are getting a good entry point and the bears have more reasons to watch from the sidelines. If I had to guess, I would give the bulls a slight edge and would not consider betting against the stock at current levels. In more specific terms, I think FB shares are more likely to see $200 again before breaking below $150 (the Cambridge Analytica bottom).

Are Stock Buybacks Really A Big Problem?

I read a recent article in the Wall Street Journal entitled The Real Problem with Stock Buybacks (WSJ paywall)  which spent a lot of time discussing multiple pitfalls of stock buybacks and touched on some lawmakers in Washington who would like to limit, or completely outlaw, the practice. To say I was dumbstruck by the piece would almost be an understatement.

Let me go through some of the article's points.

First, the idea that the SEC should have the ability to limit corporate buybacks, if in its judgment, carrying them out would hurt workers or is not in the long-term best interest of the company.

To be fair, the authors disagreed with this idea. They were simply bringing to readers' attention that it was out there. Public companies are owned by shareholders, and those shareholders are represented by the board of directors (whom they vote for). The CEO serves the board on behalf of those shareholders, though admittedly this is a problem when the CEO is also Chairman. As such, the government really has no place to tell boards how to allocate profits from the business that belong to the shareholders. This should be obvious, but evidently it is not to some. The entire activist investor concept is based on the idea that too few times investors pressure boards to act more strongly on their behalf. The system works, and should stay as-is.

The authors, however, do make an assertion of their own that I fail to understand. They claim that the real problem with stock buybacks is that they transfer wealth from shareholders to executives. More specifically, they state:

"Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate."

This paragraph makes no sense, and of course, the authors (a couple of Harvard professors unlikely to have much real world financial market experience) offer up zero data or evidence to support their claims.

So let's address their claims one sentence at a time:

"Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses."

This statement implies that a shrinking share count and earnings per share growth are bad, or at least suboptimal. Why? The reason executive bonuses are based, in many cases, on earnings per share, is because company boards are working for the shareholders, and those shareholders want to see their stock prices rise over time. Since earnings per share are the single most important factor in establishing market prices for public stock, it is entirely rational to reward executives when they grow earnings.

"Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity."

Insiders are notorious for owning very little of their own company's stock. Aside from founder/CEO situations, most CEOs own less than 1% of their company's stock. In fact, many boards are now requiring executives to own more company stock, in order to align their interests with the other shareholders even more. As such, the idea that executives unload stock at alarming rates, and that such actions form the bulk of their compensation, is not close to the truth in aggregate.

In addition, if the stock price is being supported, in part, by stock buybacks, does that not help all investors equally? Just as insiders can sell shares at these supposed elevated prices, can't every other shareholder do the same? At that case, how are the executives benefiting more than other shareholders?

"Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity."

This one makes no sense. Insiders buyback stock when it's cheap?! Oh no, what a calamity! In reality, company's have a poor record of buying back stock when it is cheap and often overpay for shares. Every investor in the world would be ecstatic if managers bought back stock only when it was cheap.

And how are buybacks a secret? Boards disclose buyback authorizations in advance and every quarter the company will announce how many shares they bought and at what price. It is true that such data is between 2 and 14 weeks delayed before it is published, but that hardly matters.

Again, the authors imply that increasing the value of stock is bad for investors, unless those investors are company insiders. In those cases they are getting away with something nefarious. In reality, each shareholder benefits from stock buybacks in proportion to their ownership level (i.e. equally).

"Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate."

Huh? Buying back cheap stock reduces investor returns and hurts public shareholders? I can only assume that the authors simply do not understand as well as they should what exactly buybacks accomplish and what good capital allocation looks like. It is a shame that the Wall Street Journal would publish an opinion so clearly misguided.

As Large Cap Tech Continues to Lead, Valuations Begin to Stretch

There is no doubt that the tech sector is where investors will find earnings growth in today's market, and many money managers are willing to pay full valuations to stack their portfolios with most, if not all, of the big name innovators.

Even though it means sometimes missing out on huge share price run-ups, I tend to buy these companies when they miss a quarter, during a market drop, or any other time when the valuations look "reasonable" (knowing full well they rarely will be cheap on an absolute basis). There was a great opportunity in Amazon (AMZN) in 2014, for instance. Last year, Alphabet (GOOG) in the low 900's looked like a good bet. Facebook (FB) briefly dipped below $150 earlier this year during a string of negative press, though I regrettably didn't pull the trigger on that one.

In fact, massive buying of these leading tech companies has resulted in the sector comprising 26% of the S&P 500 index, a level not seen since the peak of the dot-com bubble in March 2000 when tech accounted for a stunning 34% of its value. For comparison, financial stocks peaked at 20% of the S&P in 2007, before the housing collapse and no other sector has ever reached the 20% level. Amazingly, the five most valuable stocks in the index today are tech names:

I have previously written about Amazon's recent share price ascent and how its price to revenue multiple is getting quite rich -- which has not stopped the stock from jumping 20% since -- and today I want to dig into Alphabet as well. While that stock around $900 last year looked like a solid GARP ("growth at a reasonable price") play last year, as it approaches $1,200 today I am a seller.

A big issue with these tech companies is their tendency to dole more and more stock, instead of cash, to employees as part of compensation packages. This allows them to produce inflated cash flow numbers, which investors/analysts then use to justify their investments/recommendations. When I value them, conversely, I use an adjusted free cash flow metric that subtracts from reported free cash flow all stock-based compensation. To me, this adjusted number more fully reflects how much cash the business is actually generating.

Below are some data points for Alphabet, from 2015 through 2018:

As you can see, stock-based compensation at Alphabet equates to roughly one-third of free cash flow. Therefore, when the investing community cites strong operating cash flow, or impressive free cash flow, they are ignoring billions in stock comp. To give you a feel for the magnitude of these numbers, my internal estimates indicate Alphabet's stock comp will come within striking distance of $10 billion in 2018. It is more than just rounding error.

Despite strong sales growth (the consensus view calls for 20% per year, on average, for 2018 and 2019), investors are paying quite a big price for the stock at current prices. At $1,180 each, GOOG fetches just shy of 50x times my 2018 free cash flow estimate, less stock-based comp, of $25 per share.

As an alternative, using EV/EBITDA, which includes stock comp and gives the company full credit for their large net cash position, the multiple is an unattractive 18x (using my 2018 EBITDA estimate of $41 billion).

While there will always be investors willing to pay up for growth, the main thesis in recent years ("the stocks are not expensive") might be harder to justify now. As a result, I think it is more important than ever to be opportunistic and focus on taking advantage of near-term pullbacks, rather than buying the biggest U.S. companies indiscriminately just because they have performed so well in recent years.

Full Disclosure: I have been selling shares of GOOG this week