Episode 45: Revenge of the Nerds | Deep Diving Pt 2

It's Part 2 of Revenge of the Nerds where our guys delve into the depths of some of the more technical aspects of what we do for our clients. You've been warned.

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You're about to get lucky with the Barenaked Money podcast. The show that gives you the naked truth about personal finance. With your hosts, Josh Sheluk and Colin White portfolio managers with WLWP Wealth Planners/iA Private Wealth. This week, we're picking up where we left off last time with another deeply technical episode of Barenaked Money, welcome.

I have enough uncertainty about what the future looks like to make sure that I maintain a degree of safety in the client portfolios that need it and maintain a certain level of bond exposure, because, hey, if we're wrong and interest rates go the other way, what's going to perform best in your portfolio? Surprise, it's going to be your bonds. So unique, so I guess... I don't know what the word is I'm-

Deconstructing.

Deconstructing this a little bit. Thanks Colin. What I'm trying to say is, one, you need to have a view on interest rates. So what do you think interest rates are going to do to determine where you want to invest sort of the bond money in your portfolio? Or how much you want to allocate to bonds? But the other view, you can't lose sight of the risks that are out there in the market and the risks that are there to your view. So it's always a balance between these two things, when you're making decisions on the bonds.

The best knowledge I've found to explain this is, again, looking at the Farmer's Almanac. If it's going to be a dry season, as a farmer, they say, "I'm going to abandon my crop plant altogether and plant only things that do well in a dry season." That's dumb. If you go out and say, "Gee, maybe I should secure the rights to some more water or improve my irrigation just in case that's right. That's prudent. And that's the kind of stuff that we've done. So there's the trade-off on the yield curve, where do you invest on the yield curve? There's a trade-off on credit as to what kind of credit risk you're willing to take in the portfolio. And you can even start to get into things like private debt, a little bit, because private debt is probably the next closest step.

Where you lose me, and this is the example that I used going into 2020, and a lot of people did this was, "Hey, real estate's just like bonds. It always goes up. It's reliable. Let's invest in commercial real estate at a six point four percent yield. There's your bond. You're fine." Then a global pandemic hits and maybe your commercial real estate didn't deliver six point four percent, maybe you're underwater. You unintentionally accept risk into your portfolio, because you had such a strongly held belief that something was just a secure.

And we've done podcasts on being confident. And we've given many examples about what the danger of being confident is. And this is another time that people are really confident. Interest rates are going higher, therefore, we should abandon fixed income. No, there's our quick answer, because as Josh has described, interest rates has had, was it a 40 year, 38 year cycle in basically one direction?

Yeah.

Call the bottom. Tell me when it's going to move. Is it going to go the other way for 40 years? What's your call here? How smart are you? And if you give a real quick answer, that means you're dumb.

Basically, as long as I've been in this industry, which admittedly is not that long, but people have been calling for interest rates to go higher. "Interest rates can only go higher," is what I've heard for at least a decade now. And they've gone lower pretty much for that entire period of time up until the last 12 months. So, again, and these are professionals, very well read, and very thought of people. So we just don't know, the future is very hard to predict, news flash. And don't bet the farm on any one thing that you think is going to happen.

The other thing that we look at just to complete the circle here on evaluating bonds is there's more than just interest rates. There's also the relative risk or rate of return that you're getting from the different areas of the bond market. And we talked about before government bonds versus corporate bonds. There's something that you've mentioned the term a couple times, Colin, called the credit spread. The credit spread is essentially an average of the higher rate of return that you get relative to government bonds on corporate bonds.

Again, for example, if your corporate bond pays four and a half percent and a government bond pays two percent, then your credit spread is two and a half percent. It's the difference between the interest rate on your corporate bond and the interest rate on your government bond. And these spreads, these credit spreads, they fluctuate over time. So when people generally are more optimistic about the economy, those credit spreads get smaller. So there's less of a premium that you would get on a corporate bond relative to a government bond, because people are pretty optimistic about those corporate bond that they'll get repaid their money, so they're willing to put more money into them.

On the other hand, if things are not looking so rosy for a specific company or the economy as a whole, those credit spreads may widen and they may widen a lot to a point where you could get paid substantially more for a corporate bond than you would for a government bond. And, again, it doesn't just mean that you say, "Oh, when I'm getting five percent or more, I go into a corporate bond and anything less than that, I'm in a government bond," because obviously there's a million factors involved with trying to evaluate each individual corporate bond, the government bond, where the market's going as a whole, where the economy's going, all of these things.

Yeah. And, again, at the end of the day, we're responsible for making decisions and using this information to do an asset allocation. So we'll take a look and say, "What's our expected rate of return and the volatility in the equity space? What's our expected rate of return and the volatility in the fixed income space?" And then allocate the portfolio accordingly and to talk. A little bit more about how we allocate in fixed income, because we think interest rates are going higher, one of the choices we've made is to reduce our duration risk. We're not holding a lot of 30 year government of Canada bonds, because if interest rates go up, that's where it's going to get massacred. So we don't have what the industry would consider it index exposure to the government bond space in fixed income, because we don't think that's prudent at this moment.

We haven't gone off reservation and put it all into commercial real estate. What we did was we went shorter duration. We bought bonds that mature sooner, and we did a little bit in the private space, in the corporate space to get slightly higher yields. And, again, not the same sensitivity on the interest rate side. So there are ways to nudge your boat out of the way of the storm without completely running in one direction and abandoning the boat. It's just a matter of, we lean into it. We lean away from it. Those are prudent steps you can take, because Vladimir Putin turns up dead tomorrow or launches a nuke tomorrow or North Korea launches a missile tomorrow, I'm pretty sure there's going to be some random activity in the markets. And who knows where the right place is going to be in that shorter timeframe. So, again, going all one thing or all something else is never a good idea in our opinion.

And for more on reviews on asset allocation and what that means, you'll have to tune in to another one of these segments. We didn't want to put you completely to sleep, so we have broken this up into a bit of a three part series looking at bonds, stocks, and asset allocation as a whole.

What I said to Josh was, "Hey, we should do a podcast on some of the technical aspects and actually get into the weeds." And he came back with three, so I guess this is what we're stuck with. So I'm not sure we're going to release them in a row. They may get released over a period of time so that our listenership doesn't completely dry up.

Thanks for lobbing me all these meatballs today, Colin. I appreciate it.

Josh, thank you for being you. And thank you for being up to the challenge of our unnamed client who wanted to hear some of this done. So I'll make sure I send him the unedited copy so that he gets absolutely all of the tidbits that we talked about here today. And thanks everybody for tuning in. Hey, listen, if you like, what you're hearing, pass it on to your friends, give us some feedback. Like I said, we're taking requests, and if you give us a request, that's more interesting than technical analysis, then that's going to get closer to the top of the list.

Welcome to the next edition of Barenaked Money featuring Josh and Colin. We are continuing to respond to feedback that we've received regarding wanting more technical stuff. And, yes, that's how it was requested, more technical stuff. And when I told Josh, he lit up like a Christmas tree. So this episode, we're going to talk about equities, more colloquially, referred to as stocks. So Josh, are you ready?

I am. I just keep thinking back to when you told me this, and it's funny, because we go out over our way to intentionally be not industry jargony or not too technical. And then here are people asking us, "No, we want the technical stuff." Hey, you got to give the people what they want Colin."

Only every once in a while. Only every once in a while, because some people don't know what they really need. But anyway.

This could be one of those times where the guy who asked for it is, "Oh, my God, what did I do?"

All right, so we're going to start slow and easy. We're going to start with, Josh, what is a stock?

A stock, a stock is essentially an ownership stake in a business. That's the way that I want everybody to think of it. When you purchase shares of a company, you're purchasing an ownership stake in that business. And that means that you get an ownership stake of all of the profits and all of the losses that business makes for all of eternity, until you sell your portion of that business.

So I guess we could remind people at this point is under most conditions, trading in the market, your risk is no more than what you've put into the stock. So they can't come back to you asking for more money. So just to Josh's, you get to participate in the losses, only up to the amount that you actually invested in the particular stock. And just because you're an owner of the company, doesn't mean they're going to call you up and ask your opinion on what the next Apple iPhone should have on it. You can't buy five shares in Apple and make it on the board. Just because we use the word ownership, doesn't mean you really get to control jack squat. So just to make sure everybody's staying in their corner.

Yes, those are the differences between owning your own personal proprietorship, where you get to make the decisions. And by the way, if you lose money, the bank's going to come knocking on our door and take your house with you. These stocks, when you buy a share in a publicly traded corporation, you're buying with something called limited liability. So, again, you can lose the amount of money that you've invested in that company by nothing more.

So what factors are there to consider when investing in a stock?

There's lots of factors to consider, and different people-

I'm going to the washroom for a little bit, and I'll be back in 15, 20, 40 hours.

Yeah. We literally could be here all day. They teach courses on this type of thing, but I think we want to simplify it a little bit today. We want to focus more so on what we look at when we're evaluating stocks. So you can look at all kinds of things. You can look at the industry, you can look at the economy as a whole, and make decisions at more of a macro level. You can make decisions based off of, is a company a dividend paying company? Or a growth company? Or does it trade below a certain valuation in terms of its price to earnings multiple, et cetera, et cetera?

But ultimately the way that we approach investing in stocks is we want to evaluate a stock like we would evaluate a business. And when you evaluate a business, what you're essentially trying to understand is how much for profit or how much cash flow, more important than profit, can this business kick off to me as a holder? The only thing that matters is cash flow when you're a business owner. And really the only thing that matters is the cash flow in the future. And, Colin, you're an accountant. So I will, as I said on the notes prior to this meeting, I said, accounting is bullshit, and I will let you explain to our listeners why accounting is bullshit.

There's something in the accounting world referred to as GAAP, generally accepted accounting principle. Now inside we say the gap in GAAP, because there's a range of things that you can assume in putting together a legitimate set of financial statements. And we accountants love nothing more than to hear, nice, good looking guys like Josh say, "All that matters is cash flow." You want cash, I'll give you cash flow. There are 18,000 different ways I can give you cash flow, and I can do all kinds of trickery to hide where it came from.

So the accounting profession is very good at hitting one or two things, which is why, when you're evaluating a company, it's really important to take a broader approach, to make sure that you look underneath the rugs, and they're not actually sandbagging you, because that's where the art form is, and it's an active fight. So just every time you figure something out, we figure something out too. So when you truly analyze a stock, that's where experience and all the rest of it comes into it. And all you're doing at that moment is weighting the fight in your favor, because at the end of the day, there's a lot of uncertainty, and buying a stock is about the future and having an informed opinion.

But I want to add a really important distinction here, Josh, which I think is going to color the rest of this conversation, the difference between investing and speculating. Because you can invest in a publicly traded company or you can speculate on a publicly traded company, and speculation would be, "Hey, marijuana is legal.' If that's your investment thesis, you are now speculating, because you there's no profit to look at. There is no track record to look at. There's no balance sheet to look at. Therefore, you're speculating.

We prefer to invest, which means we take a look at the actual underlying facts behind a business before we will take a position. And we'll work later into indexes and all that other kind of stuff. But right now we're still at the stock level. And yes, Josh actually wrote down, and I've cut this out, and put it into my diary, accounting is bullshit. And I'm not going to argue with him, because it's just so nice to hear that he's actually caught onto to what I've been putting down.

The point we're trying to make here is these companies, any company that has a publicly traded stock on something like the Toronto Stock Exchange, for example, a major stock exchange, they have to release their results every quarter. So every quarter they're putting the results out there. They're telling you how much they made in profits. They're showing you their balance sheet. They're showing you their assets. They're showing you their liabilities. But our point is here, you need to take all of this with a grain of salt. Even if you are truly doing a little bit of due diligence on these companies, when you're you're making investment decisions, it can be very misleading. It can be very temporary. It can be very manipulated.

So having a view, not on the profit necessarily that is reported by the company, but having a view on your interpretation or estimation of future cash flows for a business, can be very helpful. Because there are a number of things that are expensed, but you don't actually pay out of pocket for them. There are other things that you pay out of pocket, but are not expense. So it becomes a pretty convoluted thing when you're looking at the actual bottom line on just a quarter by quarter basis for a company.

All right. Josh, let's take this in a new direction. We have established, I think, there's no way to challenge what we've established here, that buying an individual stock is fraught. It has nuance to it. It has difficulties in knowing the truth. And there is a risk in buying a share in a business. What would a really smart portfolio manager do if they were struggling with, "Gee, I don't know if buying this stock is good for me." What's a way to manage that risk? Can you think of a way that we would manage that risk, Josh?

Are you talking about diversification, Colin?

Wow. Look, that's not even in Josh's notes, and he got all the way there.

Yeah. So look, as we said, we're looking to invest. We're looking to make informed decisions when we make any investment. It doesn't mean it's just a stock, with any investment that we're making, we're looking to make informed decisions about it. And here's a news flash for you. A lot of our decisions are not going to turn out to be right. On average if we're-

Some.

Some.

Some. Some.

Some. We're going to make a lot of decisions, some are going to turn out to be wrong, but the way that we approach things, and having a disciplined process, having a consistent and repeatable process to evaluate and make informed and intelligent decisions is going to lead us, Colin, to more right decisions than wrong decisions and good results over the longer term. So to prevent sort of a catastrophe or chance of failure or anything like that along the way you diversify. You make a lot of these decisions. The more decisions that you make, the greater the odds are in your favor that most often they're going to be profitable for you.

Yeah. And as we go through our process, it tends to start at a much more macro level as to what we think the relative potential rates to return are in fixed income versus the equity market. We tend to start at that level. And part to that is we look at the equity markets as a whole, and then we work our way down to the company level. But the equity markets as a whole is a little bit more challenging and there's metrics that could apply out there. Like price earnings is something that gets thrown around, Josh. Do you have a comment on where the current price earnings multiples of various markets are? And how attractive or unattractive or how unimportant that statistic happens to be?

We could get, again, really into the minutia of accounting. But if I tell you that accounting's bullshit, then by default price to earnings has to be bullshit, because it's based off of an accounting measure. So price to earnings is just a simple ratio of the price of a stock or a market relative to the earnings of that stock or that market. And the earnings are based off of what's reported by accountants, the net income. Again, it can be a somewhat of a useful indicator at a very high level, in a very naive way, but also you don't want to take it as gospel because there's a lot of ways that even market wide, these factors can be manipulated.

So there are some investors that are out there that simply look at price to earnings multiples to decide when something is right to buy, and when something is right to sell. They'll say, "I'll buy it below a price to earnings multiple of X," which implies that it's cheap, "and I'll sell it above a price to earnings multiple of X," or something simplistic like that.

That's very, again, it's a very naive way to look at things, because maybe I have a company that's trading at a very low price to earnings multiple, which would imply that the profits have been high this year, but it's not expected to be profitable for the next 10 years. As I said, the only thing that really matters is your future cash flow. So great business right now, or for the last 12 months might not be a great business to own for the next 10 years.

Let's stop calling accounting bullshit and say, is subject to manipulation.

Or interpretation, one of the two.

Because, again, in the accounting world, and again, I is one, and I watch people do this, you've got your target to hit. And so you will burn the building down to hit a target, but when it becomes apparent you're not going to hit a target, you throw in the kitchen sink. If we're going to miss, let's miss big. So you really make every decision you can to have a really bad period of time, because the next period's going to look really good.

Those kinds of fluctuations and motivations for companies and industries to behave this way, make the price earnings a little less reliable or a lot less reliable. The reason I love this conversation is that we did not start with, the S&P 500 is apparently trading two standard deviations... The people who take that one measure and build a whole thesis on that one measure are using words, that are putting together in sentences that are turning into paragraphs, but they're not really giving a whole lot that's investible, because it's a trail indicator.

So you go through a period like we've gone through with the shock we've gone through and you start relying on that information, what's it really telling you? It's telling you we had a global pandemic. It's telling you the global supply chains have been interrupted. And there's all kinds of nuance and minutia in there. Just to take the final number and say, "We are going to make a decision based on this," is fraught, would be the word I would choose. And this is what I love about Josh, and I love about our approach is we're not going to get sucked into a conversation about the last five years price earnings or the last 50 years price earnings, or we're trading...

However people want to talk about it, because when you start taking something that is so valuable and putting that much weight on it, you can put yourself in a bad way unnecessarily, because you just need to open your eyes up and consider a few things around that one metric. Are there any other metrics that you want to talk about? Small cap versus large cap versus midcap, and all of the assumptions that get drawn in that space?

Again, what we're talking about now is different factors, and we call them factors in the industry. All the factor is when you're talking about a stock, is a different way to categorize a stock, and different way to categorize them based off of shared characteristics. So when you're talking about large caps, small cap, midcap, what you're talking about is companies that large cap sort of the largest companies on average, based off of their market value, small cap, smaller companies, based off of their market value, on average.

So some people will tell you have to invest in large cap at this time, small cap at this time, again, very difficult game to play. The fact that a company is more valuable than another one, doesn't tell you anything about the future prospects of that business necessarily. So just, again, using a naive metric like that to make a decision based off of is fraught with all kinds of risks, and I think over simplification.

Yeah, it's a little bit of the Texas sharp shooter fallacy. You take two guys, you put them in a blind looking at the side of a barn, and the empty case of shotgun ammunition into the side of the barn. At the end of the night, they walk over and they draw a circle around the biggest clump. They're going say, "Yep, that's where I was aiming." When we look at all the data in the market, there are people who will go look for those patterns, and they will define companies based in small cap, large cap, price to book, price earnings, looking backwards and draw a conclusion. So absolute correlation of, this is what the data has said. Now the predictive value of that is where it gets a little bit fuzzy. What is the predictive value of grouping things in this way?

Because again, I've been in the industry long enough to watch.... There are providers of data in our industry and you know who they are, Josh, when they have a category like Canadian equity, if they one category Canadian equity, there can only be one number one Canadian equity fund. If they have 18 different categories, 18 different companies can have a number one fund in the Canadian equity space. They create these patterns, they create these groupings strictly for marketing reasons. There's no predictive value in what they've done, but it starts a conversation.

And, again, this is what I love about us, we're not going to get caught up in auspicious conversation about things that are not really investible. And Josh, actually, you can't see him, but he smiled at me when I threw the small cap, mid cab, large cap thing at him. Because, again, it's one of those things that gets thrown around. I've interviewed money managers and walked in and said, "Hey, how is the midcap investing going?" He goes, "The what?" "Yeah. According to your brochure, your a midcap." He goes, "I didn't know that." The guy running the money didn't know what was on the brochure, because the marketing guys had to fit it on their shelf and had to put it in a spot.

So I'm not saying that all of this has no value. I'm just saying it doesn't necessarily have the value that some people would ascribe to it. And my other favorite one, and I'm going to throw one more at, Josh, because again, I'm starting to get wound up, when the dotcom thing hit, all the tech companies, who didn't have any earnings, they needed to come up with a number that they could talk about. So the PEG ratio was born, the price earnings growth ratio, right?

Yeah.

They had to make one up. Literally, it didn't exist. If you go back to 1985, there was no such thing as a PEG ratio. Mid '90s, "Hey, we have a PEG ratio." "Oh, let's do a correlation on that. What's the right PEG ratio to invest in order to..." It's similar to some of the other single layer measurements that happen that people rely on. Back me up on this or argue with me, Josh, there's no one single measure that you can invest on reliably through all periods of time.

Oh, of course not. But if you merge them all together and make a super measure, then do you have it?

There's the genius idea. Stop recording, we're going to come up with the genius option. No, these conversations are muddled for a reason. It's not simple. But when you start talking about investing in equities versus investing in fixed income, it's not simple, and you cannot simplify it. Yes, you can... Dividends is another favor one of my, Josh, or distributions, yields, these things get thrown around interchangeably all the time. And you see this to, Josh, which one gets you most wound up? I know which one gets me wound up.

For me, anything that references priced to book value these days is just, I think, it's archaic. So just for our listeners, the book value is, again, an accounting measure, and these days has a lot of issues with it. And I say these days, because if you go back to, I don't know exactly what time, I'm going to say 30 years ago, when companies had a lot of physical assets, they had a lot machinery, they had a lot of factories, they had a lot of goods, like physical goods, things that you buy and sell that you can touch, and ascribe a value to. They carried all of these assets on their balance sheet. And it came out to something called the book value.

These days, there's a lot of companies that don't have physical assets. They have something called intellectual property, and that could be a software program. It could be a brand value. It could be some type of algorithm. It could be just their workforce. And these things don't go on their balance sheet anywhere, but we're still using this price to book value ratio, to make decisions based off of. And now that we have such a huge chunk of our market in software and intellectual property focused companies, technology companies, it seems to have become pretty much completely irrelevant for me.

No, because cost basis means the cost you paid for it, less depreciation, which is a completely useless measure in virtually everybody's mind, because no idea what it's worth today. But it's something that's reliable. There's a lot of history on it. We can plot it on a graph. We can calculate a correlation. Therefore, we can predict the future. That's why the accounting profession kind of loves it. Mine, and I'm going to go back to what I started with, because this is the one I want to attack, is the whole distribution, dividend, yield thing. So there's lots of people who hold it as, "Hey, I'm only going to invest in dividend paying companies." Do you understand what a pay ratio is? How much of their actual net income are they paying out? How much of their cash flow are they paying out? Are they paying out more than what they're bringing in to attract investments from people like you?

I watch presentations given by major firms that talk about, "We're going to issue this product with a yield of six and a half percent." "Wow, where you getting six and a half percent? What's what's the underlying investment yielding?" "Underlying investments yielding three and a half percent." "So three percent of it you're giving me my money back." "Yes." "All right. So this is really a three and a half percent yield." "No. It's six and a half percent." "No it isn't." That's out there. So, again, when people say, "As long as I buy dividend paying stocks, I'm okay." No, you're not. If you buy a company or a group of companies where they start to pay out and they could be motivated for good market reasons to pay out more than they're bringing in, that's not sustainable. And that dividend rate's going to fall.

Therefore, anybody who bought it because of the dividend, is going to be disillusioned, and potentially sell, and then you've got a problem. So it's one of those ones that a price earnings ratio, we should absolutely trade on that. No, not so much. Dividend yield, no, definitely not. Because anything you give me a one dimension, I can gain as an accountant, I'm certified in. But you start to have multiple dimensions you look at something, then it gets really tough to put together a real functioning scam that works across multiple measures for sure. And that's why money management and making these kind of decisions is difficult, not easy. And there's no shortcut, because if enough people believe in a shortcut, somebody's going to gain that shortcut.

Have we hit on anything else, Josh, that you really find galling, when it comes to making decisions about investing? Let me change the question. Is there any current metric in the marketplace right now that you want to comment on with regards to equity, valuations, and where we are historically and where we may be going forward? Is there anything spring to mind with the... I'm going to keep talking, because you're going through the thousands of hours worth of stuff that you read, trying to pick the one thing that you want to say at this moment. Is there any comment that you want to make with everything that you've read in the last two or three months?

Not specifically, actually. I think really where you're seeing valuations, if you look at some of those basic measurements were sort of average right now. But as the saying goes, "If my head's in the freezer and my feet are in the oven, on average, I'm the perfect temperature." But that's-

But not comfortable.

... not really helping you. Not comfortable-

But not comfortable.

... not doing well, so that has its own issues. But I want to bring this kind of back around full circle to what we were talking about before and cash flows and how we can actually evaluate a business. And so really what we're looking to do when we buy stock is we're looking to make an estimate of the future cash flows of that business. And there's one concept here that is super interesting. Again, super interesting, maybe not... It's super important. It's super important. It might not be interesting. It's super important though. It's really important to understand.

And that's this idea of present value and discounting, because a dollar of profits today is not worth the same as a dollar of profits a year from now or 10 years down the road. A dollar of profits today is worth a lot more than a dollar of profits a year from now or 10 years down the road. And the reason is, because I'd much rather have this dollar in profit, because then I can take this dollar and go invest it somewhere and go earn a rate of return on my money. So all else equal, if I tell you I'm going to give you a $1,000 today or a $1,000 a year from now, you're going to take that $1,000 today every time.

And so when we're projecting these future cash flows for these businesses, and this is where it becomes so hard, it's not just looking at our current profit for the business or next year's profit.

We you're trying to project this for many years down the road and then trying to figure out, maybe even more difficultly, how much is this going to be worth today? How much do I discount this? How much opportunity cost am I giving up by taking that profit five or 10 years down the road than I am with getting it today? And we've seen this become pretty precarious with some of these very high growth businesses over the last year. We've just projected future cash flows, future profits for these businesses, when today there are none.

And if they start to materialize, that's good, that's worth something, but maybe it's not worth the hundreds of billions of dollars that some people are paying for today. So this concept of discounting those future cash flows back to a value today, which is a process called trying to come up with the present value, the value today, that's a super important concept to understand, when trying to put a price on the stock.

This is, also, it comes back to again, that's based on investing, not speculating. Because you got companies like GameStop is still at their trading, some people are still speculating on that. And there are those would argue. And again, I read a piece a while back that I was talking about the valuation that's been put on Amazon compared to Walmart, and the fact that in order for Amazon's current share price to make sense, now this was a little while ago now, but it's still relevant, in order for that current share price to make sense and have ratios similar to what Walmart has, they would have to have a 100% market share on two earth size planets, in order for their numbers to make sense. And the person who was talking about it was making the point that nobody should pay that for Amazon.

Now, if you follow the track record, Amazon's not a Walmart. They're doing other things, they're getting into different things, and they're making shit up, and they're making new shit that we didn't know we need, and they're going into industries, they're going to be a huge disruptor now in the delivery space, because they've got this fleet of delivery vans around, and we could deliver other stuff too. These things that seemingly are completely valued irrationally, just have assumptions on future growth built into them or expectations, more than assumptions. Expectations that they're going to continue to be marvelous. And some people are going to get paid off on that.

That's, you could argue, speculating, maybe not, but it's not based on the same type of fundamental analysis that Josh is referring to, which is something that you can see, touch, and feel. And we're more comfortable in that space, because we can calculate a floor and protection. And, again, your financial success is based on not picking the one thing that's going to win. It's not blowing all your shit up, and that's how the game gets won. So the one thing you miss or the two things you miss, is not going to cripple you. If you get it materially wrong on a huge level, then that is going to hurt. And that's a better way to approach this.

I'm just going to run through some of the things that go into actually determining or estimating a cash flow in the future. Just so people have an understanding of what's involved with this. Because again, it's not a simple process just to estimate a cash flow for one year is extremely difficult. So when we're projecting future cash flows, we're projecting revenue growth, not only for one year, but for a number of years, and not only for a number of years, but we're trying to figure out for how long can this company grow its revenues at an above average rate? So you sort of need to determine, one, a growth rate, and two, for how long it's going to grow at that level. Beyond that, you're going to look at profit margins. So this influences or factors in all of the costs for this business, how much cost does the company need to incur to generate that revenue?

And, again, you're looking at a long run expectation and how long does it take to get to that profit margin? You got to look at tax. You have to look importantly at capital expenditures. So companies don't just generate new revenues by just going out there and being good people. They actually have to take some of their harder money and reinvest it back into their business. If you're going to produce more cars, you got to build a new factory. You got to staff that new factory. You got to put more equipment in that factory. That's what you call a capital expenditure.

And then, importantly, once you have all of these things, yes, it spits out a cash flow number, but you have to figure out what's the right rate to discount that cash flow number at back to today, so you can try to estimate the value for that company today. And just the coming up with a discount rate alone is very complex, because, again, a number of different ways to do this. The way that we do it is we use something called BETA, which sort of estimates the volatility of that company or the risk of that company relative to the market as a whole.

And that risk is influenced by the countries that that company does business in, and how risky those countries are relative to other countries. So coming up with this discount rate is just one step of the process. And that's extremely challenging, coming up with all of these numbers, equally as challenging. But again, if you have a consistent and repeatable framework and some smart people looking at it, we think that you can come up with a reasonably high chance of success over the long term with a properly diversified portfolio.

Yep. Josh is right. Absolutely. And I'm sorry, I fell asleep part way through that, because we're pushing deeper into the worm hole, but, no, these are tremendously difficult things to do, and we don't do it with a whole lot of competence. So that's why we diversify, because again, it's not that we're stupid, it's just that we're smart. And we understand what you can be confident about, what you should be confident about. And just trying to dispel the whole idea is, "Marijuana's legal, therefore, it's a good investment." "No." Or, "This company is dominant, Amazon's a great company." "Yep." "We should buy some." Well, wait. What's the current share price compared to what we think the cash flows are going to look like out of it?" As one measure.

So it's got to do with, what do we have to pay for it to get? Is also important. And there's some really great businesses out there, and there's what was it a TikTok or something? Where somebody said, "The secret to success was, take a look at your credit card and buy shares and everything you spend money at."

Yeah. Well, that's one of the places that I've heard that, for sure.

Yeah. It's like, "Oh my God, no." Seriously. But anyway, people have different ideas on this, and then hopefully we've been able to share some of the nuance with some of the stuff that goes into making an equity allocation decision and the valuation of stocks and/or equities in general. And you've seen a conspicuous absence of some of the topics that are commented on in a lot of other media, because, honestly, at the end of the day, it's not that simple. It doesn't lend itself to a 45 second segment on the news at night.

Yep. And for anybody that wants to go through some of the spreadsheets that we have on a discounted cash flow analysis, just give me a call.

Please don't. Please don't.

I don't think I'm going to have people lying up at the door calling, don't worry.

To Heather, who's probably the only one still listening to this episode. I'm pretty sure she's got access to the Excel spreadsheets on her own without having to ask for them.

That's right. Thanks, Colin.

This information has been prepared by White LeBlanc Wealth Planners, who is a portfolio manager for iA Private Wealth. Opinions expressed in this podcast are those of the portfolio manager only, and do not necessarily reflect those of iA Private Wealth, Inc. iA Private Wealth Inc is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc operates.

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