Frankly, My Dear…

By: Yale Bock

“Frankly, my dear, I don’t give a damn.” In case you did not know, maybe the most famous line in the history of motion pictures is uttered by Rhett Butler in Gone With the Wind. Clark Gable plays the swashbuckling blockade runner who falls for the protagonist, Scarlett O’Hara. Scarlett spends the whole film chasing after a man whom she thinks she loves but does not love her, and after three marriages, the last one to Mr. Butler, she finally realizes it is Rhett whom she adores. Why does this apply to investors?

If you have not been paying attention, the capital markets are a bit, shall we say, flighty. Over the last few months, and especially in February, the largest software entities have seen their market values plummet. In many cases, the losses have been dramatic, in some instances over thirty, forty, or fifty percent. The term being bandied about is Sassalypse, or software-as-a-service apocalypse. Consider the mental state of a CEO who heads one of these enterprises (lucky you). For the last decade or more, your company has consistently grown profits and wealth for its investors. Conservatively speaking, let’s call it, say, twenty to one hundred billion dollars of value has been created. A few years ago, large language models came along, with the underlying technology being some form of artificial intelligence. You see it as an excellent opportunity to help your business grow stronger. Initially, the largest institutional investors agree, and things are fabulous. Suddenly, in the blink of an eye, these intelligent and loyal investors decided their initial belief about large language models was incorrect! The creators of these models are releasing new versions that are viewed as mortal threats to your business. The institutions that own large blocks of your securities begin selling and do not stop. Your stock is now down big, members of your board of directors are shocked and upset, and you face the task of proving the merit of your business once again.

This is what has transpired for the few winners over the last decade. What is more likely for most companies is that institutions and investors of all kinds are not interested in your stock. For CEOs who have the financial ability to do so, they adopt the Rhett Butler approach and decide, “Let’s end this nonsense.” They raise capital and take the company private or offer it up for sale through the public markets. This is atypical. A more practical and often successful approach is to use company profits to both grow earnings power and opportunistically buy back stock. It requires good business judgement and comparing uses of capital based on each business segment and the current price of the equity. When the stock is unwanted, many CEO’s face the predicament of not being able to use it as a currency. Some resort to alternatives, like issuing preferred stock (which is really a form of debt), conventional loans, convertible debt, or, in a highly creative approach, rights offerings, in the event they want to do a deal. Whatever tactic is chosen, growing earnings power is the primary objective. Buying back a cheap stock works over a lengthy time horizon when the strategy is consistently executed, and the number of shares retired is substantial. When a company retires 30% or more of the outstanding shares over a three- or five-year period, shareholders usually see a nice benefit, but not always.

For investors, learning from Rhett Butler is instructive. What you do not want to do is what the CEO of a large REIT has done. He was resigned to his stock being stuck in the basement, as it had been for a long, long time. Remember the basic premise: buy low and sell high. You are looking for leaders who recognize the stock is undervalued and are committed to making the situation temporary. You also need to look at the underlying assets and businesses to make sure they have strong and enduring competitive advantages. The reason the capital markets are freaking out about artificial intelligence is that investors believe the long-term earnings power of many companies is under serious attack. It is our job as investors to evaluate each company to consider the investment merit. In the case of many software entities, the multiples are still elevated and certainly not cheap. I continue to maintain that the biggest value resides among the unloved and ignored. Sometimes the investment world has periods where everything suddenly seems rotten. Rhett Butler is one of the great characters in movie history, but from an investment point of view, you do have to care.

Originally posted on March 1 on Y H & C blog and newsletter

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DISCLOSURES:

Y H & C Investments may have positions in companies mentioned in this newsletter. Nothing in the newsletter should be taken as an offer to buy or sell individual securities. It is the responsibility of each investor to research the investments mentioned so they can decide on the appropriateness and suitability of the investments consistent with their risk tolerance, risk constraints, and return objectives.