Over the past several quarters we have discussed the Fed and their influence on the overall market at length. This time we would like to take a deeper look and zoom in to the company level. Last week closed out the Q3 earnings season for large industrial and tech companies. There were some major winners and losers and lots of drama along the way. Oil companies reported their strongest profits since the early days of the War on Terror and have by far been the best performing sector this year - surging over 65% year to date. Google fell below earnings expectations citing a slowdown in ad spending by businesses and headwinds internationally due to the strong dollar. The stock tanked 6% following the announcement. Amazon similarly got crushed after missing expectations and lowering their guidance for holiday shopping as inflation soars and wages stagnate. Apple, on the other hand narrowly beat expectations as demand for their products remained robust. The stock recorded its best day since 2020 by rising over 7.5%. Then there was Facebook. Meta (Facebook) reported a staggering increase in spending that sent many stockholders and analysts fleeing. The reaction was so sharp and strong it felt personal – declining over 20% in a single day. In fact, CNBC personality Jim Cramer was brought to tears feeling that he let his viewers down by leading them to a company that in his view betrayed them by burning through their free cash flow in attempts to create the new “metaverse.”
As interest rates continue to rise, earnings are once again placed in the spotlight. Over the past year it has become more difficult to obtain cash from a creditor, and businesses must find ways to create and retain more cash than previously. A simple and fundamental concept that at times seems to be forgotten when the going is good, and money is cheap. High growth companies notoriously have poor earnings relative to their conglomerate and industrial peers because instead of retaining and returning revenues to investors they use their cash flow to grow the business. But as interest rates go up, more and more cash from revenue are needed to fulfill the growth needs as credit gets more expensive or dries up completely. The overall cash flow is diminished. Let us reflect on this concept of flow. Standing in a flowing river you always have access to water, just dip in your hand. In business it’s very similar.
Take the example of a private company called Citadel. They position themselves in-between traders. In technical terms they are a market maker, in layman’s terms they buy what you want to sell and immediately sell it to another buyer. But they do so at a slightly higher price than if you were to have no middleman. It is estimated that they execute approximately 47% of all US listed stock trades. They are capturing the flow of stock and able to skim billions in profit while essentially taking no risk. Most businesses do not have such an elegant way to generate cash from the literal flow of cash running through them. Usually, a company has to convert their control of flow of some widget into cash profits. Once a company is able to do this and consistently generate cash it is prudent to protect that line of business. That’s what made Cramer weep. He felt that Facebook was uniquely positioned to capture a huge flow of the advertising market and that the cash flow generated from it should ethically be distributed back to shareholders (dividends or share buy-backs). And instead of doing that they invested in a business that is not capturing the flow of anyone or anything.
Now that dollars are more expensive to borrow and economic output is low, positioning one’s business to capture and retain flow is maximally important. Oil companies literally control the flow of oil and the more expensive it is the better they do. In times of geopolitical strife, they are a good place to hide out. Apple is worth almost $2.5 trillion because it captures the flow of smartphones, apps, media, and advertising. Google, despite the recent sell-off, captures about 1/3rd of all online advertising revenue flowing by them and are well positioned to continue to dominate digital advertising. Amazon accounts for almost 40% of online shopping and much of the internet flow runs though the pipelines of Amazon Web Services (AWS cloud). Meta (Facebook) also deserves a second look. While it is irresponsible to spend tens of billions of dollars quarter after quarter on a product with few customers, their core business is unparalleled in human history. As of last month, 3,710,000,000 unique individuals used at least one of their applications (Facebook, Instagram, WhatsApp). That is just shy of half of humanity. A tremendous flow of human communication. In general, one should not let a bad quarter or year scare you out of a strong company. Companies with large market shares have tremendous pricing flexibility and protection, or in Warren Buffet’s words, “wide moats.” They can withstand downturns and recessions much better than low revenue companies in more competitive industries. Be patient and follow the (revenue) flow.
We’ll leave you with an old Wall Street axiom, “Bear markets are when stocks are returned to their rightful owners.”