Some would argue that paying a $39 million salary to LeBron James is reasonable. He brings tremendous value to a basketball team. He will stuff the stat sheet and more importantly fill the stands. Is there risk he may have a down year? Sure there is, but at the end of the day, he is still LeBron James.

It is different paying Greg Oden $39 million in salary. My return on that $39 million could be zero. If you are asking yourself, "who the heck is Greg Oden?", well, that is the case in point.

What is a stock?

A stock, put in the simplest terms, is an equity claim on future cash flows.

Where does return come from?

Your investment return while holding a stock is driven by yield, growth, and/or valuation. Say you own stock XYZ that has a per share price of $10, it pays no dividend, has $1 of earnings, and trades at a 10x multiple of earnings (1 x 10). How could you generate return?

• Yield = 0% as it pays no dividend.
• Growth = XYZ grows earnings at 25%, so it now earns $1.25 of income. If multiples stay intact (10x), your stock price is now $12.50. This increases your investment return by 25%.
• Valuation = Multiples expand. Assume the market values XYZ at 15x earnings rather than 10x – investor sentiment and expectations of future growth has gone up. This positive expansion in multiple translates to a stock prices of 15 x 1.25 = $18.75. Rising multiples generate returns.

We want to take our capital, exchange it for claims on the future cash flows of businesses set to compound. We look through a good bit of data to get to a simple place – a combined yield + growth score of double digits. We are aware of valuation, just not dependent on multiples expanding. Reason being, we think multiples are a wash over time.

Markets ebb and flow from high valuation to low (impacting total return in a negative way) and then from low valuation to high (this is a great time to own stocks). Where do you think we are today???

Our process is consistently simple, looking for what we see as profitable, quality companies, priced reasonably (we want to avoid getting in front of crashing multiples), and hopefully positioned for growth. We will not be perfect in all environments, and that is ok. Perfection is not required when you have the right perspective on time horizon and what a stock represents.

Price Matters…So does Cash flow

A stock derives its value by taking those future cash flows and discounting them to today. This requires assumptions around what those cash flows will be, and an appropriate discount rate. There is some complexity here, but to simplify, think about it this way:

If you know you own a claim to $100 a year from now, what would that claim be worth today? If you could buy that claim at $50 vs $95, your return will obviously be better. The lower price you pay the greater potential for return. This is valuation in a nutshell. The valuation environment can be lucrative to shareholders…or not. You can substitute valuation for the word multiple like our example above.

The last obvious point is the cash flow itself. With stocks, there is absolutely no guarantee of cash flows. What happens if that $100 you expect to receive in a year turns out to be $75…or worse – ZERO?

It is most prudent to think about the price paid for future cash flows and the risk around those cash flows themselves.

An Introduction

An index is simply a basket or group of stocks whose grouping is dependent on a certain criterion. For example, the S&P 500 Index is a composite of approximately 500 stocks based on company size. It is roughly the largest 500 US based companies.

Enter… the "Goldman Sachs Non-Profitable Tech Index". This can be tracked within Bloomberg under the ticker GSCBNPTC. Here is the description of this basket of stocks:

“The GS Non-Profitable Tech basket consists of non-profitable US listed companies in innovative industries. Tech is defined quite broadly to include new economy companies across GICS industry groupings.”

You read that right – this is a basket of stocks that make ZERO dollars. In fact, they lose dollars. Their businesses are funded with outside capital (equity or debt) and the price of the future claims from this business (their stock price) is purely based on expectations and potential. Some of the companies will end up producing crazy amounts of cash flow, some of them will never produce a dollar. We never advocate for attempts at "timing" the market, and instead choose to proceed with caution, especially if valuations (multiples) are sky high.

Below is a chart from the end of 2015 through the bottom of the COVID chaos in 2020. We compare the Non-Profitable Tech basket to the S&P 500 on price return only. As you would expect, the S&P does a little better. You would have made just 17% or so by owning the S&P and you would have lost 11% or so in the Non-Profitable tech basket. This was not a great stretch for stocks as we are ending the chart with the cliff that was COVID. The point is that the performance is on par with what an average investor would expect. Companies generating sales in a profitable way performed better than those that generate sales in a negative way.