Writtem by: Sean Peche | Ranmore Fund Management
Last month’s +5% return for the USD Investor Class was a pleasing absolute return, but disappointing when compared to the 9.6% move for the MSCI World Index.
That said, we do what we do - buy decent businesses that we consider under-valued and have attractive return potential, in the full knowledge that the market may dance to a different tune. In April, half the market’s return was from a handful of large technology companies, an area of the market where we have almost no exposure.
The price rises of some of these companies has been nothing short of staggering. One of the winners, Intel, is up 174% in 37 days on the back of its potential participation in AI and data centre capex. Intel now has a market capitalisation of over $550bn, yet the company hasn’t grown sales or generated positive free cash flow for the past three years.
We are concerned about the sustainability of the current AI capex boom and would rather sit out this dance and grow our wealth slowly than risk having no chair when the music stops.
At times like this, we think it is important for investors to focus on the underlying economics of businesses rather than simply following market enthusiasm. In recent months, the market became concerned about AI making parts of the software sector obsolete, which prompted us to research many companies looking for any “diamonds in the dust”.
However, we are no fan of the common and often egregious stock-based compensation (“SBC”) programmes used across parts of the technology sector. Convention treats SBC as an entirely non-cash expense and therefore excludes it when calculating free cash flow. To us, it makes zero difference whether companies use their cash to pay salaries or buy back from the market the equivalent number of shares they issued to employees. In either scenario, there is less cash remaining for shareholders.
As a result, we adjust our free cash flow calculations for SBC because the numbers can matter significantly. Over the past year, ServiceNow has spent $3.8bn repurchasing shares, almost twice its $2bn SBC charge and more than its entire operating income over the past two years. Yet shares in issue only fell by 0.3% year over year because the company had granted so many shares to staff that it largely offset the impact of the buyback.
In many cases, we concluded that some software companies are increasingly being run for employees rather than shareholders.
In contrast, we continue to look for businesses with strong management alignment, sensible capital allocation and genuine cash generation. One new fund holding is leading internet games company Netease. The company has grown revenue and operating income at a compound rate of 9% and 20% per annum respectively over the past five years. It also has one-third of its market capitalisation in net cash, while SBC is more modest at 11% of operating income before SBC.
That means the company’s share repurchase programme is genuinely returning cash to shareholders, with shares in issue down 1.8% over the past year. At 12x forward earnings, Netease looks far better value to us than many technology peers. The founder, Lei Ding, is also the company’s largest shareholder, owning 44% of the business, giving us confidence that management remains aligned with long-term shareholders.
As enthusiasm around AI continues to dominate markets, we believe investors should remain disciplined and continue focusing on valuation, cash generation and management alignment rather than simply chasing momentum.
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