Optionality; 8 stocks with hidden value
Weekly KnowHow
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In this Week’s KnowHow:
What is optionality?
How do you measure optionality?
Underpriced R&D Investment
Underpriced capital investment
8 Stocks with hidden value
In a world where your average investor seems to be delivering generational returns by chasing momentum stocks on minimal analysis, you might wonder why the KnowHow team have decided to write a note on underpriced potential. Well, we like to be different and we also like to dig deep in data. From an investing perspective identifying optionality is hard beyond the traditional… “I have a feeling this could be huge”. But, if you can build an understanding of how to think about optionality, we think it’s invaluable as a long term investor.
What is optionality?
In our view, optionality in an investing context is underlying trends or investments within a business that are hard for investors to value but could deliver significant future returns. In some cases, if you have an OnlyFans or Stripe-esque mousetrap, Facebook et al of previous years, you can achieve those supernormal returns with minimal incremental investment as platform effects take over. But, in the vast majority of cases, building optionality in your business requires investment.
There is probably no greater example of optionality than Amazon’s success with AWS. If you had followed the AWS story and bought Amazon stock when they started investing in 2006 you would have found yourself a 10 bagger. This was a time when most of Wall Street would have told you Amazon was just an online book retailer. Stellar Fusion chart below.
How do you measure optionality?
Let’s walk through the Amazon example above. Jeff Bezos would have told you in 2007/08 that they had been investing in APIs that were starting to get customer traction and could become a significant business within Amazon. The stock was volatile during this time but as success picked up, they accelerated R&D spending even further in 2010.
If we start from the basis that optionality is investment and companies tell you, for the most part, how they are investing, you can build a fairly simple framework. Investment can be technology, sales, marketing or manufacturing/development capabilities. Of course, these can be acquired organically or through M&A. But simplistically, if you invest well and have a lot of money to invest, you will generate the most returns. No surprise then that the top r&d spenders in the US are also some of the best performing stocks of the past 10yrs.
On a company level, we like to look at this through continued R&D and Capital Investment. Continued/growing because typically, that should be a good gauge for management thinking their plan is taking shape, as discussed in the Amazon example above.
Of course, as this chart from Strategy + Business shows, spending big doesn’t always lead to returns. Without embracing an innovative culture, it can just be money down the drain. Hence, make sure you bring your own qualitative overlay to the analysis we are about to run you through.
We’ve broken our analysis down in two ways: i) R&D spending, and ii) Investment spending in which we incorporate capital investment and some level of sales related headcount costs where the data is available.
Underpriced R&D Investment
The scattergraph below shows all US companies with a market cap of more than $10bn with their 3yr growth in R&D spending on the y-axis against their EV/R&D spend on the x-axis. Companies on the bottom right are expensive relative to their R&D spend and companies on the top left are relative cheap and a good place to hunt for optionality in our view.
The below chart zooms in on the 20 or so stocks that are investing more in R&D than the market is potentially giving them credit for in our view.
Underpriced capital investment
Almost identical analysis below looking at capital investment. We have also incorporated acquisitions in here, ex-goodwill, and some level of staffing spend also where the data is available. We have not included marketing as it tends to be more cyclical but clearly it will have an impact on short-term revenue trends.
Again, 20 or so stocks that look under-priced based on this analysis relative to their spending.
8 Stocks with hidden value
Our aim in this analysis is to provide you with the framework to assess optionality in stocks and a couple of screens that you can take away and dig further into. You may have noticed an element of artistic license above around some of the stocks we blanked out. Largely because they were biotechs, defence or industrial businesses.
If we were to pick out a few that we think you should focus on, we would suggest below:
Facebook and Amazon standout amongst big tech
Align and Chegg are two KnowHow Capital stocks where we have done a fair amount of work. We believe both are investing heavily in scale and platform.
Redfin has probably built the top mousetrap in the real estate business but is now investing heavily to accelerate development further but also scale offices and realtors. We own Zillow but the optionality in the above analysis is immense
Salesforce is another KnowHow Capital company. We like the Slack acquisition and whilst Microsoft has stolen a march, we think the market underprices the potential in Salesforce
Our Twitter views are reasonably well known. A consistent ability to grab defeat from the jaws of victory. But, the company has been investing heavily in product and is priced more like a sleepy big tech
What to say about Uber? The stock trades on little over 3x it’s asset base. We own Uber and have written extensively on it. There are a number of short term issues to navigate but it remains a company full of future optionality in logistics, food delivery and autonomous driving.