Understanding Short Selling with ORTEX’s Evan Niu
ORTEX analyst Evan Niu describes what it means to short a stock and how several related metrics could be interesting for investors. He and 7investing CEO Simon Erickson also...
January 4, 2022– By Simon Erickson
2021 was an interesting year for investors.
Overall, the S&P 500 composite index increased 26.89% during the year. But digging in deeper, those top-line return numbers are perhaps a bit deceiving.
More than 20% of the S&P 50’s market-cap weighted index is consolidated in its five largest constituents. Those would be Apple (Nasdaq: AAPL), Amazon (Nasdaq: AMZN), Alphabet (Nasdaq: GOOGL), Amazon (Nasdaq: AMZN), and Tesla (Nasdaq: TSLA), in that respective order.
Several of those stocks had an incredible year, which caused the overall performance of the overall index to similarly look incredible. But if you take out just a few of those high-flying names — such as Alphabet’s 65% gain or Tesla’s 50% gain — the total return suddenly becomes significantly less impressive.
As such, the recent volatility of the broader market leaves investors in a conundrum. With the looming threats of rising interest rates or inflation, should we continue to flock to the relative safety of the market’s largest companies? Or conversely, is the recent market selloff actually presenting an opportunity to buy into several smaller companies at a relative bargain?
To help us answer those questions, we’ve brought in two of our favorite investors. Ryan Henderson and Brett Schafer together host the investing podcast Chit Chat Money and are also the general partners of Arch Capital. We thought the recent volatility presented an excellent opportunity to hear their perspectives on the status quo of the stock market.
In this exclusive interview, Ryan and Brett spoke with 7investing CEO Simon Erickson and 7investing lead advisor Steve Symington about a variety of topics. They first discussed how investors should think about volatility and the process they follow for their investing methodology. They also describe three of Arch Capital’s largest holdings — Sprout’s Farmers Market, Spotify, and Nelnet — and provide a thorough recap of why they like each of these positions.
And to have a little fun in the outro, Ryan, Brett, Simon, and Steve each share one stock that was on their Christmas List for 2021.
Publicly-traded companies mentioned in this interview include Boston Omaha, Callaway, Costco, Latch, MongoDB, Nelnet, Rocket Lab, Spotify, Sprout’s Farmers Market, and Walmart. 7investing’s advisors or its guests may have positions in the companies mentioned.
Simon Erickson 00:00
Hello everyone and welcome to today’s edition of our 7Investing Podcast. I’m 7Investing founder and CEO Simon Erickson. I’m joined by my fellow lead advisor Steve Symington. And I’m also very excited to welcome our guest to the show today, Ryan Henderson and Brett Schafer are the general partners of Arch Capital, but also the host of their own podcast, Chit Chat Money. We always like keeping in touch with him a couple of times throughout the year to hear about what’s going on out there. Hey, Brett and Ryan, thanks for being part of our podcast here today.
Ryan Henderson 00:27
Yeah, thanks, Simon. Happy to be here.
Brett Schafer 00:29
Glad to be here.
Simon Erickson 00:30
We’re coming up on the holiday season. So we’re going to be talking about a few stocks that are on our Christmas list this year, we’re also going to be talking about some of the larger positions that Arch Capital is holding right now. But first and foremost, gentlemen, there’s been a lot of market volatility right now. A lot of investors are scared, a lot of investors don’t know what to do. A lot of investors are questioning their existing strategies. What’s your take on what’s going on in the market out there right now?
Ryan Henderson 00:58
So we sent over wanting to talk about this topic. And so I looked into it a little bit. And to the average index investor, you might not notice, I guess a lot of the carnage that’s gone on, or a lot of the pain. And I think a lot of that is because it’s quite often has all the factors broken out and it’s primarily in small cap growth. That’s where a lot of the underperformance has been. And that tends to be at least where Brett and I and I think a lot of the people we talked to kind of fish for companies. And so it’s underperformed by I want to say around 20%. And then a lot of the a lot of the the ARK innovation type companies have also kind of tracked the ARK innovation ETF from what we’ve seen. And so we have some exposure to companies that overlap with their portfolio. And so those are kind of where the majority of the pain has been for us. But I think philosophy wise it hasn’t changed much for us. Would you say?
Brett Schafer 01:58
No, Yeah. This is something you kind of got to expect going in. I think if you’re an investor in something that maybe you got surprised with this year of this happening, just know that I mean, this is part of the process, especially if you’re investing in the small cap growth names. The volatility is going to be part of that process. And it’s really, if you’re going to hold on to a multi bagger, you have to look at the history of what most multi baggers do. And they’ll probably have at least a few 50% drawdowns. Maybe not as much as 50%, but at least something like that. And at least in the current time, if you don’t hold on, let me see if I get the five names right. Apple, Google, Microsoft, Tesla and Nvidia. If you don’t own those, you’re probably underperforming right now. And that’s a bit weird. Like, I think it’s hasn’t happened much where it’s such a waiting on the top few names for performance of the year, but go ahead Ryan.
Ryan Henderson 02:51
It’s, so I went and kind of just looked at the numbers yesterday and Apple, Microsoft, Amazon, Google and Facebook account for 22% of the S&P 500. And when I think about those companies individually, I have a hard time saying they look wildly overvalued because they’re such high quality businesses, and they they’re kind of able to grow at the rate they want.
Brett Schafer 03:13
Yeah, so I guess it’s it’s a, I don’t know, what do you guys think on it? I guess, on that?
Simon Erickson 03:19
Steve let me hand it to you, but just to kind of spot that up? You know, Brett, you did mention that before the show that there was a dispersion between large cap growth and everything else. Like you said, there’s a lot of uncertainty on the table right now, what’s the Fed going to do? What’s inflation going to look like? What’s the discount rate gonna look like for a lot of those smaller companies? Steve, it looks like they’re spot on, everybody’s been going for the high large cap growth names. What’s your take on what’s going on out there?
Steve Symington 03:40
Yeah you know that’s part of the challenge, right, is that the broader indexes are masking, really wide reaching underperformance by much of the rest of the market. You have those five companies comprising such an outsized portion of those indexes, and the majority of the indexes recent gains, right? And that’s, that’s the tricky part is you look at that, and a lot of people will look at their own portfolios and be like, Wow, I’m the worst investor ever. Like, why am I so bad at this? When really you see a little bit of compression, in multiples for a lot of these small cap and growth names.
Steve Symington 04:17
And it’s painful for sure, but really, in many cases, the underlying businesses for a lot of these underperforming names remains healthy. And for someone who is is a net buyer of companies like this, like we are in for people who think long term, these are the times where we kind of should be celebrating. And it’s it’s counterintuitive, but the chance to buy businesses at lower prices over time – I’m consistently adding to my own portfolio, for example, in buying shares of my favorite stocks. That that helps kind of negate the risk of of putting a ton of have money to work at some crazy high valuation and then having multiples contract and then temporarily underperforming. But if you’re thinking years and years out, that’s when the the returns become much more predictable. And like I said, a lot of these smaller companies that have been underperforming are still healthy and they’re still growing it pretty impressive clips. So I’m just keeping my head down doing what we’ve always done and analyzing and buying shares of good businesses.
Ryan Henderson 04:29
Yeah, I was kind of thinking the same thing when I was just looking at the portfolio recently. And part of the problem for us it’s, it’s this weird balance of a little bit of disappointment, but also optimism. Because we benchmark Arch Capital against the S&P 500 so it’s been particularly frustrating to look at it every quarter, especially when when we write to investors. But as we’re kind of writing our quarterly letters, it’s like, we know what our performance looks like right now. But at the same time, this is for the majority of our businesses, the forward looking returns haven’t looked better at any point in our history. So that that part gets us kind of excited, I think.
Brett Schafer 06:09
Yeah for anyone that looks at that, it can be easy to look at the S&P 500 benchmark, or NASDAQ, 100, or whatever and get nervous about oh, I’m not doing too well. I think one of you guys mentioned like, oh, wow, I think I look at that I’m like, I’m the worst investor ever. But you have to just detach from that when analyzing the company and to say, is this business doing well? Is it doing what I thought it would do? And if it is, well, this is just what you got to go along with, when you’re, when you’re buying something like this, you have to expect that to happen. And you can’t really control what the stock price is going to do in the short term. And I guess you can’t control what the business is going to do. But if they keep putting up the business results you can. It’s the classic cliche, in the long run, it’ll be a weighing machine.
Brett Schafer 06:51
And just for some context for anyone. On Koyfin, which is a nice little tool. Most of it’s free that people can use. They have a performance thing where it compares all the different factors versus the S&P 500 this year and year to date there’s only two well ones about breakeven, there’s only two factors that are outperforming the S&P 500. And it’s the buyback one and large cap growth. And every single other one is below, trailing the S&P 500 performance year to date and small cap growth is down 20%. So, I mean, sometimes you just kind of get caught up in factor exposure. And that’s something you can’t really control in the short run. It’s just the price you gotta pay.
Simon Erickson 07:38
It’s really interesting. The whole conversation about is the S&P 500 the right benchmark for investors? Like you said, there’s only five companies that are a quarter of the index now. You’ve got something like Alphabet up, I don’t remember the number 67% year to date or something like that. Yes, you could put all of your money into the large cap growth names. The buyback is an interesting one that you mentioned too Brett because of course, those companies have got deep pockets. And if their stock price falls, what do they do they just have a repurchase plan and say, Okay, put a couple thousand, a couple billion dollars to work on buying back shares.
Simon Erickson 08:10
It is interesting, though, to kind of see how this is impacting investors out there. It’s kind of the Warren Buffett quote, right? If when the tide goes out, you can see who’s been swimming naked. Which companies are gonna have it separated out. You’re gonna see a lot fewer people on fin twit bragging about the year to date returns, whereas there was so much enthusiasm in 2020. But Steve, let me bring it back to you because I know that you’ve written on 7Investing an advisor update the kind of has been watching this for several months with fascination. You see that there is going to be at some point, kind of a small and mid cap rally that you kind of predicted here.
Steve Symington 08:43
Simon Erickson 08:44
Is this impacting your investing style at all? Are you going more defensive now? Are you still going after kind of the growth knowing that’s going to turn out eventually?
Steve Symington 08:50
No, I mean, that’s the the danger of watching investors chase returns and part of what I’ve been writing about for the better part of the last year. Because this this underperformance is stretched since what last February is kind of when it started happening, and you saw that the disparity between the returns of that broader index and some of the small cap growth names and they tried to come back sneakily, and just in the last month and a half or so kind of diverted again. The part of the temptation is to say, oh, I should have just bought an index, but you know, would have saved myself all this stress and why didn’t I just buy, you know, the like a low cost S&P 500 index funds insurer, you know, that’s a decent option for a lot of people, but that’s also assuming that the S&P 500 is going to outperform individual stock picking indefinitely. |
Steve Symington 09:43
And you know, in my experience for the better part of the last 15 years or so here. There’s been a few times where I’ve kind of felt like this. Where you’re like, oh, it’s painful to watch your approach underperform even temporarily. And I think it’s it’s mostly a matter of just sticking to your guns and continuing to just pick great stocks month after month like what we choose to do at 7Investing, and trusting that those names will ultimately outperform and time. It’s always worked for good stock pickers. And and I think it’ll continue to work when you focus your focus your capital on the highest quality names. I do think that we see, eventually kind of a reversion to the mean because right now, it feels a little extreme when it comes to that small cap growth underperformance relative to the S&P 500. And I do think that we we do see an eventual rally, however painful it might be in the near term. That kind of brings things back more in line to the the actual performance of these businesses, which is strong.
Simon Erickson 10:58
Let’s talk about the focusing on those highest quality names. You know, Ryan, and Brett, we’ve been fans of yours for a long time now. We actually are partners of yours with 7Investing with your own show. I want to chat a little bit about your investing approach and some of the highest quality opportunities that you see because you actually are partners of a fund now.
Simon Erickson 11:16
Before we get into that, I do want to let everybody know that we have a an ongoing holiday promotion right now for 7Investing. If you use Brett and Ryan’s promo code of “money”, when you’re signing up at 7investing.com/subscribe, you get $100 off your annual order. Steve, that’s not just a one time discount, that is a recurring $100 off the annual subscription for as long as you stay active. So it’s kind of a really sweet deal that we’ve got going right now if you use “money” right now that $100 off at 7investing.com/subscribe.
Simon Erickson 11:48
Brett and Ryan, let me bring it back to you. Steve was talking about high quality names. We know that you are very thorough analysts and really good investors. How are you approaching this market? Are there certain types of companies that you’re looking for right now? Or what’s kind of the process that you go through when you’re picking out companies for your fund?
Brett Schafer 12:09
Yeah, I can start on this one. We, our strategy hasn’t necessarily changed. But one thing we try to do is just constantly prepare, a list of companies say, on our watch list, I guess is just the easiest term to use. Where throughout the year, we’ll come across companies, a stock might seem very overvalued to us or something like that, or Oh, hey, this just IPO’d , it’s kind of at a crazy multiple, we’re gonna have to wait till see the lockup is over. But if we think the business is good, or it has some promise, we’ll do some analysis go through a pitch together, and then it kind of goes on our on the bench on the watch list. And then right now, say when there’s some market volatility or something like that, we’ll look at that and we kind of have this queue that’s hopefully growing and growing over time. And if the business checks out, and it can, you know, it’s continuing to grow, do well, and maybe the price is coming down to something more reasonable, then that’s kind of how we’re looking at it. So no matter what the market is doing, we still have that same philosophy of trying to build up a catalog, say, in our heads, or just in the, you know, the notes that we’ve made of quality companies, and then waiting for, say, the price to price to pay or when the price, you know, comes down to something we’re willing to pay. Ryan does that make sense? Is there anything else we do?
Ryan Henderson 13:32
That’s sort of that’s sort of the back end of our process, which is like if either one of us finds a company that we really, really like, we pitch it to one another. And then usually, what the case has been most of the times that we love the business, we don’t love the price. And so we kind of set once it gets into this range, let’s reconsider. Let’s look at it. Now unfortunately,
Brett Schafer 13:45
Most of the time, it won’t get into that range.
Ryan Henderson 13:57
Or most of the time, it gets into that range, but so has everything else in our portfolio. So then we have to re rank it against what is the best opportunity for the cash that we have at our disposal?
Brett Schafer 14:07
Well, actually, one thing we do that I think a lot of people and we do it mainly to discuss with each other to see what we’re each of us is thinking. And I think this is a great thing to do. Probably not you don’t have to do the exact way we do it. But every two weeks, we force rank all of our positions on a one through 25 scale one being the best. If it was one, it’s like, okay, we want this the highest weighting is the best risk reward were super confident this. And 25 is alright, we’re considering to sell.
Ryan Henderson 14:36
And we don’t have, we don’t have 25 companies so it can be anywhere in there. You know, there could be like three at the top and there could be one way at the bottom. Its just basically a scale from where we like it compared to our other holdings. And it isn’t, sometimes it’s more just to discuss maybe events that have happened in the last few weeks.
Brett Schafer 14:56
Exactly. So yeah, we do that to say okay, we both write this a lot higher this week, maybe we should think about adding it. This could probably be because I don’t know, maybe the stock sold off 30%, something like that. I think that doing something where you almost journal, whatever it is. Ours is journaling in an Excel sheet. It can really help you lay out your ideas of what you’re thinking at the moment. Because when stocks go crazy, and say, something’s down 30% in a month, it’s hard to just detach yourself and say, Okay, what’s the business looking like? You know, I don’t want to panic. And I want to let all these psychological factors go into that. So that’s, that’s kind of how we try to look at it and prepare ourselves for any sort of market volatility in any companies we own.
Simon Erickson 15:40
Makes sense. Now, how are you evaluating the companies with the force rankings? Are there – is it just fundamental growth that you’re looking at? Are you looking for competitive moats? How are you determining your favorite company on that list?
Brett Schafer 15:52
That’s a tough one.
Ryan Henderson 15:53
So on the list specifically its during the pitch, we look at all the qualitative factors and then we do some financial modeling. It’s pretty simple financial modeling, just basically, what do we think it can generate in cash over the coming years. Some businesses, it’s a lot harder to predict, some it’s really easy. And so that pitch is more thorough, but these are more kind of gut check slash continuing updates, where we rewrite the valuation just to see what it’s at. We see if there’s been any more developments, maybe what has changed. And then if the time comes where we want to add to something, we’re going to revisit that pitch, we’re going to revisit a lot, a lot of the more comprehensive work we did on it. Am I getting most of that, right?
Brett Schafer 16:40
Yeah, and the most important thing for us there is that it has a timestamp of what we were thinking at that time, because your brain can trick yourself, say six months later and say, Oh, no, I was thinking that then, okay, this business looks fine now I should buy. But no – or some a stock could be down like 40%, you can trick yourself into saying, Oh, no, it could fall farther. It looks scary right now, I don’t want to buy right now. But when you look back and say, Oh, no, that was the price we’re willing to pay, the business hasn’t changed. Okay, I want to listen to my past self. And there we go. But the rankings is a bit. It’s difficult, because there’s some companies that we own, that are maybe on the higher risk end with lower weightings. So we think the risk reward might be better, but you don’t want to wait something that’s maybe a smaller micro cap growth, stock with less durable moat out there at lower waiting. So I don’t know the it’s kind of hard to describe the weightings. But it’s more of a, an update that we do every every week. Or every two weeks, not an exact science.
Simon Erickson 17:42
Makes a lot of sense. You know, and I’ve always appreciated you guys aren’t just running with the rest of the herd. You’re not afraid to go out there and find some ideas that other people are not looking at. I want to talk about a couple of the larger positions that you have. You were mentioning before we started recording this show that you met with some of these executives, and you thought of them as celebrities. And they were saying, Hey, we aren’t getting a whole lot of attention out there. Which is even better. For investors when you’re not just doing the same thing that everyone else is. Largest position right now you have at Arch is Sprouts Farmers Market. Ticker on that is SFM (NASDAQ: SFM). What is interesting to you about this business and what makes it your top position.
Brett Schafer 18:15
I can start out with saying if anyone wants any more detailed research or anything like that we didn’t make a research report on them public on our website, which began. It’s easy. Just look up Arch Capital Funder or ping us on Twitter, and we’ll be able to send it over to you. But Sprouts Farmers Market, it’s a small grocery slash specialty food supermarket that’s based in most of the states in the US, but it’s in California, Arizona, Texas, and Florida mostly. So you know, the West Coast, Southwest, Texas, and then the southeast is where they’re building it out. And one thing that attracted us to them is one, the valuation is super cheap. It’s not as cheap as it is right now. I don’t have the exact numbers in front of me. But I think if we look at his current market cap of about, let me get it for anyone’s reference here. It is three points, say $3.1 billion. We saw it and we thought okay, they’re going to do about $300 million in cash flow this year, something like that. Okay, that looked attractive.
Ryan Henderson 19:21
Probably a little more.
Brett Schafer 19:21
Probably a little more. Okay, let’s investigate it. Why is why is this at such a cheap price? And it was really because coming out of the pandemic, or actually during the pandemic, and before the pandemic, they had some comp sales issues. So in 2019, they got this new CEO in. I guess I just want to give the context to kind of show why we got to where we are today. So they brought this new CEO and because comp sales, excuse me margins were doing really poorly and they brought up this guy from Walmart named Jack Sinclaire who is a big part of our thesis because he was running – he was the VP of grocery at Walmart for North America. So he was in charge of a huge grocery supply chain, all that sort of stuff. He has a great track record with that. They brought him in, right before the pandemic, I think it was in the summer of 2019. He said, we’re gonna cut out all of the coupon clippers because Sprouts had, they had struggled to get, you know, profitable customers in the door. So they started doing insane, not insane, but a lot of marketing discounts. Their margins were deteriorating, and they went down from say, like 7%, operating margins back to 3%. They said, We’re gonna cut that, and then we hit the pandemic. And then okay, grocery stores got supercharged growth, everyone was doing fine. And they had these comp sales going like crazy. But then we turn around to this year, and he had the double whammy of comp sales are going to look tough, because
Ryan Henderson 20:53
Everyone stockpiled groceries.
Brett Schafer 20:55
The grocery stores, all the comp stuff look bad except for your Costco, you don’t want the best businesses of all time. And then they also had gotten rid of the coupon clippers. So right now comp sales are looking really, really tough. And that kind of scared out a lot of people. And I say that context, because that is why we think it is so cheap. Going forward, they have a huge, not a huge runway, but a considerable runway to grow their store count, by a decent amount. They have pretty standard, I mean, they’re not crazy returns on invested capital. About 10% to 12%, returns on invested capital. And we think they can invest a ton and growing their store count across the country. They’re only at about 370 stores. And the model is probably pretty replicable across the country. I don’t know Ryan, am I missing anything? It’s a very simple thesis in that regard where it’s a store chain, it’s supposed to be kind of a whole foods, but at a cheaper price. They’re not your number one stop, but they’re kind of hopefully going to be the Trader Joe’s stuff for a lot of people.
Ryan Henderson 21:53
I’d say the biggest thing is the buyback program that they put in place. They pledged to buy, I’m not sure on the duration of the buyback but it’s $300 million, I think it was maybe over a year or so. But they’ve bought back, I want to say six to 8% of their shares this year. And so you’re getting a really high return just purely on that buyback. And so now you’re having the problem of what’s a better return, buying back their own stock, or opening a new store. And so they’re gonna have to balance that moving forward. And I guess that’s a good problem to have. Since it’s grocery, since its sort of specialty retail, it isn’t necessarily the highest quality business we own. But it is really, really cheap. And that they’re they’re trying to return capital to shareholders, and they’re doing a good job at it. So that’s what attracted us.
Brett Schafer 22:42
Yeah, I guess I’ll sum it up. Because we can kind of be all over the place there. Why we really own a stock. There’s five points that we send up in a research report. There’s 10% annual store growth with a long runway of reinvestment, which is kind of the big key for us. Some of that was kind of stagnating and maturing. They have a recovered margin profile, which is what we’re seeing their operating income per store, and their operating margin is staying high, and then a return to comp sales growth eventually, after this year. They’re redoing their formats, and they’re introducing a better supply chain that would really hamstrung them before because they brought in Sinclair and he was like, well we need to really step up our game. It’s not – we’re not doing stuff that just logically makes sense. For one that didn’t even have self checkout, which as grocery store. I mean, you got to have self checkout on the 21st century.
Brett Schafer 23:30
For example, with the supply chain thing. They they have stores in Colorado, but they don’t have a supply center, a fulfillment center distribution center, excuse me, in Colorado. So before they had to drive everything from Arizona, up through the Rocky Mountains, and over into Colorado, which is ruining that region for them. They introduced this fulfillment store in Colorado, they introduced one in Florida, and they want to have a fulfillment store within I believe it’s either 250 miles, or excuse me a store within I think it’s either 250 miles or 500 miles within every store. We think that’ll help with margins, it’ll help with the quality of produce there. Then the other things that we like is the consistently dropping share count and the current high free cash flow yield. I know that was a lot of numbers thrown at you if you guys have any questions. Hopefully that was good summary.
Steve Symington 24:20
Yeah. I mean, it seems like kind of a compelling confluence of events. That could happen. I was reminded of a conversation I had with 100 baggers author, Chris Mayer last year. He talked about this kind of these twin engines of growth, where it’s like earnings and sales growth, and that eventually that leads to a higher multiple, which is what happens when you end up with a business with healthier margins that rebounds. And then the following chapter, I believe he actually dedicates an entire chapter, surprised me, to how stock buybacks accelerate returns. And if they’ve reduced their share count by 6, 8% this year, those those repurchases could look like a quite an astute move by management. So really, really interesting business. And maybe that might be a good opportunity for us to kind of shift gears a little bit. I understand you also like another business that’s consumer facing, but in a much different way. Maybe isn’t your second largest position Spotify?
Ryan Henderson 25:24
Yeah, everyone knows that.
Steve Symington 25:27
And it’s been beaten down hard, what it’s down 50% over the last year or so. What’s the current state of Spotify? I’d love to hear more.
Brett Schafer 25:35
Yeah, I’ll let Ryan talk about this one. But that that’s a good point on how that one’s been beaten down. That’s a big holding in the ARK invest portfolio, their ETF. So it’s kind of one if you’re investing in a company, and it’s a high growth name, maybe check if it’s in the ARK portfolio and say, Okay, if they’re going to have a lot of volatility that you have to expect that with your companies do. But yeah, Ryan, do you want to talk about Spotify (NASDAQ: SPOT)?
Ryan Henderson 25:56
Yeah, it is a weird one, too, because it’s, I know, everyone probably says this about their companies. But we felt like this was a really good year in terms of performance for Spotify. It kind of hit everything we wanted them to hit. And the stock performance hasn’t followed. So I guess what we like about it is, we really get a lot of experience from the creator side with the podcasting. And so they, they really do drive a lot of value for creators. And alternatively, we think it unlocks a lot of potentially higher margins. So the big knock on Spotify has always been that the content on their platform doesn’t belong to them so they have to pay out whatever it is, I think it’s 66, maybe 65 cents on the dollar to the labels and the music content owners. And so podcast is very different. And there are some ways to grow within music as well, which Brett can probably touch on. But within podcasting, they own, I guess you could call it the podcast supply chain. So if you distribute your podcast on Anchor, or you distribute it on Megaphone, which I think I want to say 70 to 80% of podcasts are on either of those.
Brett Schafer 27:10
70% of new podcasts on Spotify were built on Anchor or launched on Anchor, which is what they own. That’s kind of something they highlight. So I think if you backfill the number of podcasts that are on Spotify have about 3.2 million, versus what they had, like a year ago, I believe a million new podcasts have been started around the world on Anchor. Wich is big, which Ryan I’ll introduce for the ad supply.
Ryan Henderson 27:31
Yeah then the big part of that is there’s basically a two pronged approach to Spotify’s revenue, which is the premium business. You subscribe, and you get all your content for free, or not for free, ad free. And then there’s the ad supported side. And for a long time, people kind of counted the ad supported side as zero. But now advertising is kind of becoming this big part of Spotify business. And they call it the Spotify Audience Network. And so if you’re an advertiser, and we’ve tried to do this with our with the Chit Chat Money podcast, actually. You can go in, and you can pick, now a guest from a range of audio bases to try to target different customers. And so you could pick – we’ve had, we’ve had, I guess, a whole bunch of different advertisers advertise on our show our podcast through and it’s all done through the Spotify Audience Network. And so we you can just basically plug in advertising inventory, a little ad slot on your podcast, it automatically gets bid on in real time, based on the listener preferences. And we think it’s a much more targeted approach than what you get with linear radio. And so we think we can really attract a lot of the ad dollars from there.
Ryan Henderson 28:44
And then you’re, you’re also beginning to see that in the growth I think. They crossed a billion dollars in ad revenue for the first time this year, or maybe a billion euros. And Daniel Ek himself said, he thinks that advertising can become up to 40% of revenue within five to 10 years. And right now, it was at 13%. And the other part is, there’s more than, you know, you could potentially have I know, they have podcast. They bought an audio book distribution service called FindAWay, which is sort of the leading distribution for audiobooks. So possibly, you could have advertising in there as well. You’ve got advertising on the music side, there’s a lot of different forms of audio that I don’t think get accounted for in Spotify’s price. That’s sort of what we like about it, I guess, generally, am I missing anything?
Brett Schafer 29:34
Yeah, and I’ll go back to the music part, people discount that a lot because that it is low margins. I believe the premium gross margin is at about 29%. Ticked up from about 25%. So still really low, you know, when you’re looking at them, definitely do a gross profit multiple. And you should not expect you know, very high cash flow margins or a profit margins or anything like that. They guide for about 10% on that one, but I still think that’s a really good business. You have a long runway for growth. I think there’s barely over 500 million total music premium streaming service subscribers globally, and that’s not from Spotify. That’s for all the different competitors, including China. And it seems to us that that business can still grow a lot. It’s hard to quantify, it’s hard to tell how many people around the world are going to pay for a music streaming service, but we think it’s gonna be more than 500 million out of the 8 billion people around the world.
Brett Schafer 30:30
Again, it has low margins. But we still believe that’s a really high quality business, because churn is super low. It’s continuing to drop. And they’ve actually started raising prices. So that’s an interesting thing where we kind of he, we looked at it, and you’re like, okay, is this a good subscription service, it may not be the same as Netflix. But recently, what’s been a big indicator for us about how good of a business this is, is they actually raised prices and a lot of places across the world. Not crazy amount, but say in the US, they raised the price in the family one for about maybe $15 a month to $16 a month. In that same time period, churn actually went down. So that indicates to us that they have a lot more pricing power than people maybe giving them credit for. And again, we we like to write about him publicly. So if and it’s actually kind of a coincidence, we wrote about Spotify, on our website. So if anyone wants any more details, I know it’s kind of a confusing story. We have a write up if anyone wants to read it. So.
Simon Erickson 31:28
It’s a clever business. Right. You know, it’s an underappreciated opportunity when you think about the advertising side of it. I think most people think of advertising support subscriptions. This is the advertising that’s writing that podcasting wave, like you mentioned in the market. Let’s go with one more real quick. This is one that’s a little bit less known out there. Nelnet (NYSE: NNI). Ticker on that is NNI. Student loans, a financial services company that’s got a lot of exposure to student loans. That’s a hot topic these days. What can you guys tell us about Nelnet.
Ryan Henderson 31:54
It’s like the most anti promotional business we’ve ever seen. Sometimes their investor relations page doesn’t even work for us sometimes. But we so this is the one where we actually ran into the chairman at another shareholder meeting. And he was like, like, how do you know about us? Like he almost like didn’t want to get noticed. We kind of like that.
Steve Symington 32:13
You didn’t see anything.
Ryan Henderson 32:14
Yeah, exactly. Yeah, so there’s sort of a another Nebraska conglomerate, I guess, if you will. They’re from Lincoln. And it’s kind of a hodgepodge of different businesses. So previously, it had been a loan underwriter. And so they have this giant loan book that was kind of generating cash flow. But in 2008, I want to say the federal government took that in house. And so they just have this basically, giant ice cube of giant melting ice cube of cash flow coming in from that.
Brett Schafer 32:48
Because they weren’t allowed to start new loans, so they have this existing one. And then they’re like, Okay, we got to do something else with it with this cash.
Ryan Henderson 32:54
Yeah. And I guess, taking that cash, and they’ve redistributed into a bunch of different businesses. And so there’s one segment that’s got, I want to say 10 different software businesses that are software and payments related businesses, mostly for education technology. So administrative software for like the principal’s office. And then there’s like tuition processing for either private schools or colleges. Those actually have more market share than I think a lot of people maybe realize. It’s very niche, and there is doesn’t seem to be a whole lot of churn from that. Those are higher margin businesses. Then there’s just like, it’s almost a black box of good investments, it looks like from the outside where they own, I think it’s I want to say 20% stake in Huddle. And Huddle is a private company. But if you have played high school football, or college football or anything like that, you know that that, I want to say, a monopoly in the film. The athletic film industry, which is kind of a really important business.
Brett Schafer 34:01
Most important software a coach will have. You’re in that for four or five hours a day. You have to subscribe to this. The switching costs on that are going to be really, really high. And it provides so much value, we think there’s gonna be a ton of pricing power with that business. But that they don’t like a 20% stake and part of our thesis is that when that that company eventually IPOs within the next – it looks like their timeline, looking at their venture investments that kind of done some late stage seed rounds, or certain seed round, late stage venture capital investments. The those VCs are probably expecting them to go public within the next two to three years. And we think versus now that’s market cap. Again, I should give listeners some reference here, three and a half, three and a half billion market cap 3.7 billion market cap. We think the huddle investment could be worth a good chunk of that. It’s a bit of an unknown. There’s a lot of variance there.
Brett Schafer 34:54
But what else we like about them is how much cash they’ve deployed and be able to redeploy into new investments. They have this table in their annual letter that the chairman writes, who was the person that we met. And in 2020, they actually reinvested $1 billion into new stuff. They have a whole timeline which outlines what it is. And part of it was in Huddle. They did part of the upfront in Huddle, which is $26 million. But what’s interesting is they invested $396 million, in quote, other, which, again, you’re like, all right, why don’t you tell us what you did there. But that includes venture capital, real estate, and solar. So what gets us excited about that is they have a strong track record of having a high return on their invested capital, I think it’s about 17% if you look at their book value per share, which we think is a good metric for a financial company like this. Or a company that has a lot of outside investments, like you know, the Huddle stakes. Book value can be a decent measure, it’s not perfect, but it’s a good measure. And if they’re able to invest a billion dollars this year, $396 million into these other bets, we think the upside is strong. With the loan book, which is almost guaranteed, because everything is backed by the federal government, it’s not a no way they would never get paid and there is some interest rate risk with some of this stuff. But, if you have that existing loan book, it has a floor of say, put your own discount rate on what it’ll generate probably in between $1.5 billion and $2 billion over to the company over the next decade. So that’s almost like their insurance ish float that’s going to be coming in for them. Basically giving them a free income of, you know, cash coming in, that they can reinvest further. So I know you guys have any questions on that, or is that it’s a bit confusing.
Simon Erickson 36:48
It sounds like another solid compounder. I know that you guys are fans of companies that can just steadily grow that book value per share year after year after year. Another one of those of course in the Midwest is Boston Omaha. I know that you actually met up with Steve a couple of months ago. And Steve out but you bought the drinks when he went on that trip. Is that how that went down?
Steve Symington 37:06
Can’t remember. It was good that. Yeah, that’s actually where we were they ran into the Nelnet chairman. We got to talk to Boston Omaha’s chief executives and I ended up inadvertently sitting in the family section during that shareholder meeting. I was I think I was next to Alex Rose’s wife. Am I supposed to be here? Yeah. That’s funny.
Simon Erickson 37:32
Well, real quick, as we kind of wrap this up, I do want to go around the horn, just a real quick, maybe 30 seconds or a minute from each you know, it’s getting to be the holiday season. Let’s put one stock that’s on your Christmas list this year. Ryan, let me start with you. What’s one stock in your Christmas list you’re interested in with all the market volatility.
Ryan Henderson 37:49
I like Callaway (NYSE: ELY). Most people probably know it as the golf equipment producer or manufacturer. They have clubs, and golf balls. But then they also have an apparel line. Travis Matthew is probably the name that most people would recognize. But then they last year, they closed on a deal to acquire Top Golf which is the part that really excites me. It seems like a very unique business model and kind of hard to replicate. And they tend to generate good returns on their venues. And so that’s quickly become the biggest part of their business. Top Golf just generally, like I said, it’s a business we like. And there’s also, I don’t know if you’re familiar with the top tracer technology, but they install these at driving ranges, and I can kind of track your golf ball. And so that’s Top Golf technology and driving ranges will pay to have it installed. So there’s just a lot of different revenue streams within Top Golf’s little umbrella. And it trades at like, I want to say 15 times operating cash flow, but they’re also investing heavily to grow their new venues. They’re putting a lot of new Top Golf venues all over the country.
Brett Schafer 39:04
Top Golf is Yeah, it’s pretty capital intensive.
Ryan Henderson 39:06
So yeah, and so that’s kind of that’s the business. I’m kind of keeping an eye on. Hopefully, we get a Christmas sale here or something. But yeah, it’s a business I’m watching.
Brett Schafer 39:16
Yeah want me to hit mine?
Simon Erickson 39:19
Yeah, I was gonna say probably some pretty high margins too from the beverages that they’ve got out there on the driving range too Ryan. Is it ELY the ticker on Callaway?
Ryan Henderson 39:28
Yes, I think it’s kind of a strange ticker. I think it was the last name of the founder or something. I believe that’s what it was. But anyway.
Simon Erickson 39:36
Love it. Love it. And how about Brett, bring us home? What’s it what’s your what’s your stock on your Christmas list this year?
Brett Schafer 39:40
Yeah. So this is another one that well, I guess it’s different than Callaway, but it’s a SPAC and it’s pretty early on in his business. So this is one were definitely on my watch list and hopefully over the next few years, the business proves itself out because I think it’s pretty promising. It’s called Latch (NASDAQ: LTCH). They do a software hardware bundle to apartment buildings. So how it works is they sell the smart doorknobs, which might not sound that exciting, but it goes on all the units. And it goes on all the outside doors. And it provides security and easy access for all the tenants. So as a tenant, you get value because you just use your phone, and a replaces your key and stuff like that. And then the property managers, it really increases the efficiency and the security of the building. And there’s a lot of other stuff to it. But how it works is they basically sell the hardware at cost, and then the software gets charged at about $10 a month per unit. So pretty decent recurring revenue per apartment building. Say you have 100 units. That’s it, that’s a sizable amount.
Brett Schafer 40:41
But they’re willing to pay that because you can increase your rents while you do that. And it also decreases your costs. So you’re saving on the money that you’re paying Latch. And what’s interesting. And what I like about it is that once it gets locked into the building, they’ve had zero churn so far, and they usually sign these five to 10 year deals, because apartment buildings pretty steady. It’s not going to go away, most likely, unless the area that you’re in fully goes into a downturn. They’re willing to pay, a lot of these companies, willing to pay the Latch five years or six years upfront. So I really like that part of the business model. However, they’re very early stage. They’re only doing $11 million in revenue last quarter. And most of that was from hardware. So the software business is just starting up. I do think the unit economics on that can be very, very attractive because the software margins are at 90% right now. Gross margins. In the very early stage. Definitely one I’m going to watch for you know, this quarter the next few quarters. I think the business could be promising. But it’s a SPAC. So I’d like to see the annual report and kind of see how they do the first few quarters as a public company.
Simon Erickson 41:42
Love it Brett switching costs from avoiding switching locks. Right. And the ticker LTCH I believe is ticker that one right?
Brett Schafer 41:50
That is correct. That’s correct.
Simon Erickson 41:51
Okay, how about one more? Steve, what is your Christmas list stock this year?
Steve Symington 41:56
With a caveat that we have, you know, recommendations coming out on January 1, as per usual, and we just named our best buys yesterday from our existing recommendations. But another stock that’s not one of those I can say that I really like is MongoDB (NASDAQ: MDB) at this point. They’re they’re outperforming – they haven’t been hit as hard as some of the other kind of growth names. They’re a relatively big business, but you know, looking at their growth for their Atlas, fully managed cloud database product accelerated at 84% year over year, last quarter. This business is firing on all cylinders. I’ve always loved them as a database nerd, you know, you can even see a couple of my textbooks right behind me for database systems and, and they’re no SQL database. So rather than like, you know, structured query language, relational databases, they focus on unstructured data and really, really nicely scalable software that allows enterprises to horizontally scale their database structures. I think it’s still very early in their long term story so MDB is the ticker on that one. Business I love and own.
Simon Erickson 43:06
That is definitely a very Steve stock for sure. And then I’ll put for my for my Christmas wish list is I’m gonna go with Rocket Lab (NASDAQ: RKLB). That’s another Steve stock too I think. That’s RKLB. This is one that’s participating in the space economy. Was really focused on launch and kind of disrupting the commercial launch industry but I was really appealed or really intrigued rather by that now almost 30% of revenue is coming from space applications. This is outside of just launches actually building the satellite components that customers that necessarily couldn’t do that themselves are now hiring Rocket Lab to do. In the space company a lot of opportunity, huge market. So the ticker on that is RKLB. Steve’s was MongoDB, MDB. And our guests, Ryan Henderson and Brett shaper. Ryan went with Callaway, ELY. And Brett went with Latch LTCH. Ryan and Brett I really appreciate you being on the 7Investing podcast. Thanks for joining us here today.
Brett Schafer 43:58
No problem. Glad to be here.
Ryan Henderson 43:59
Appreciate it. Thank you, Simon, Steve,
Simon Erickson 44:01
And reminder to everyone else that wants to learn more about their investing process or the actual companies that they have in their funds. They are the general partners of Arch capital. You can learn more about them. There are also their own podcast Chit Chat Money. And if anybody wants to sign up with 7investing.com/subscribe and use their code “money”, you get $100 off of our annual subscription option today. So that’s it for today’s edition of our 7Investing podcast. We thank you for tuning in. We hope you have a wonderful holiday break. We’ll see on the flip side of it and until then, we’re here to empower you to invest in your future. We are 7Investing.
ORTEX analyst Evan Niu describes what it means to short a stock and how several related metrics could be interesting for investors. He and 7investing CEO Simon Erickson also...
GigaOm CEO Ben Book describes how larger companies are embracing the digital transformation and deploying new technologies within their enterprise, as well as several...
The commercial space economy is continuing its successful launch! Businesses are finding innovative new ways to set up shop in orbit, and Andrew Chanin and Micah Walter-Range...