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Equitable Investors

May 2023

May Edition

Funds operated by this manager:

Equitable Investors Dragonfly Fund

Disclaimer

Nothing in this blog constitutes investment advice - or advice in any other field. Neither the information, commentary or any opinion contained in this blog constitutes a solicitation or offer by Equitable Investors Pty Ltd (Equitable Investors) or its affiliates to buy or sell any securities or other financial instruments. Nor shall any such security be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.

The content of this blog should not be relied upon in making investment decisions. Any decisions based on information contained on this blog are the sole responsibility of the visitor. In exchange for using this blog, the visitor agree to indemnify Equitable Investors and hold Equitable Investors, its officers, directors, employees, affiliates, agents, licensors and suppliers harmless against any and all claims, losses, liability, costs and expenses (including but not limited to legal fees) arising from your use of this blog, from your violation of these Terms or from any decisions that the visitor makes based on such information.

This blog is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The information on this blog does not constitute a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Although this material is based upon information that Equitable Investors considers reliable and endeavours to keep current, Equitable Investors does not assure that this material is accurate, current or complete, and it should not be relied upon as such. Any opinions expressed on this blog may change as subsequent conditions vary.

Equitable Investors does not warrant, either expressly or implied, the accuracy or completeness of the information, text, graphics, links or other items contained on this blog and does not warrant that the functions contained in this blog will be uninterrupted or error-free, that defects will be corrected, or that the blog will be free of viruses or other harmful components. Equitable Investors expressly disclaims all liability for errors and omissions in the materials on this blog and for the use or interpretation by others of information contained on the blog

Airlie Quarterly Update

Airlie Funds Management

April 2023

Emma Fisher, Portfolio Manager, provides her views on the current market environment and discusses her recent trip to Europe where she visited CSL and QBE Insurance, which are two holdings in the Airlie Australian Share Fund.

Author: Emma Fisher, Portfolio Manager

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: Units in the fund(s) referred to herein are issued by Magellan Asset Management Limited (ABN 31 120 593 946, AFS Licence No. 304 301) trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks. Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.

Why investors shouldn't desert quality banks

Pendal

April 2023

Here, Pendal's head of global equities ASHLEY PITTARD makes the case for quality banks ahead of a likely US recession

• UBS, JP Morgan, Wells Fargo top picks

• US recession likely; should trigger a steepening of the yield curve

THE turmoil among global banks over the past six weeks has created opportunities for investors, with Swiss based UBS and Wall Street giants JP Morgan and Wells Fargo the top picks, says Ashley Pittard, our head of global equities.

"I think UBS is a standout for the next ten years as an investment," he says.

"You want to invest in a bank that's one or two in its market, and has high quality management.

"Bank stocks can go down in a crisis environment, but the quality banks don't go broke and that's a key point."

Banks should do well in coming quarters as they reprice credit and achieve higher margins.

"Near term, interest rates have stopped rising and the yield curve is flattish or even inverted.

"But if we fast-forward through the year, we believe there's going to be a recession in the US. That would likely mean the Federal Reserve will have to cut rates into next year.

"The yield curve will steepen and that's good for banks because they borrow short and lend long and they are going to get a wider spread. That will feed back in a couple of years' time into higher earnings."

The current turmoil could push out weaker lenders who aren't pricing loans rationally - which would help the top banks.

Short-term risks

Pittard warns there are risks in the short term.

"What are the write-downs going to be, particularly if the recession is hard? That's the big near-term risk.

"That's why you want to be with the highest quality banks - number one or two in their market."

On UBS, Pittard says its metrics are strong. It has just absorbed its second largest competitor, has a 30 per cent plus share in retail banking in Switzerland, and is the number one global bank for ultra-high net worth individuals.

Importantly, UBS has strong management, he says.

"The new CEO, Sergio Ermotti, is the Tom Brady of European banking," Pittard says, referring to most successful quarterback in US football.

Ermotti left the bank in 2020 after a successful stint, and then took the top job again on April 5.

"He first came to UBS after the global financial crisis and got them out of high-risk investment banking, increased market share in their ultra net worth business, and boosted dividends and the stock price. 

"He just grinds away. He gets costs out of the business, right sizes the riskier parts and gives money back to shareholders."

Pittard says two US bank stocks worth looking at are JP Morgan, run by the very experienced Jamie Dimon, and Wells Fargo, run by Charles Scharf.

"Dimon is the last remaining US bank CEO who actually went through the GFC," Pittard says. "Scharf got the CEO job at Wells Fargo in late 2019 and has cleaned it up and ticked all the boxes."

In terms of why the global banking sector found itself in its current situation, there are several factors, Pittard says.

"There were poor management practices. There's also been mishandling of the repricing of the rapid interest rate changes over the last year. You've also had volatility around what the US Federal Reserve is going to do."

Pittard says there's also a regulatory overlay.

"When Donald Trump was in power, he rolled back some of the banking regulations that were put in place directly after the global financial crisis which meant the regulation of smaller banks, like Silicon Valley Bank, was lighter than regulation of the big banks," Pittard says.

"Also stress testing of the bank last year didn't consider large jumps in interest rates, which is what actually happened."

Author: Ashley Pittard, Pendal's Global Equities

Funds operated by this manager:

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 8, 2021. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

What to do about Stock Based Compensation?

Eiger Capital

April 2023

The tech sector sell-off that began in early 2022 has seen a renewed investor focus on 'disciplined growth'. We think this is investor code for a shift to positive operating free cashflows and the end of equity market funding of operating losses. Lossmaking tech is now on the nose.

The equity market sell-off has also led to greater scepticism at the increasing use of alternative corporate earnings measures such as 'underlying' profits. These are often presented by companies that want to adjust (i.e. increase) statutory reported earnings for 'one-offs' and 'non-cash' items.

A common adjustment of concern for investors, especially popular with companies in the tech sector is the issue of SBC. Companies are able to report higher underlying earnings (or more to the point reducing underlying losses) by using the justification that SBC is a 'non-cash' item and thus should be added back to statutory earnings.

We are unconvinced with this argument as we reason below. SBC is a real cost of employment and thus should be accounted for in reported statutory earnings.

Let's start with a "101" on SBC - what is it?

SBC is quite simply an alternate form of compensation paid to company employees, often as a substitute for a cash salary.

There are two main types. SBC is equity in the business that employees work for and is most typically issued either in the form of employee stock options or otherwise as restricted stock units (RSUs). It is common for both types of SBC to vest over a specified time period and often subject to some conditions (most commonly just tenure at the company). SBC is not a new innovation. It has been around in the US for more than 70 years. Although employee stock options did exist in the US pre-WW2 their unfavourable tax treatment meant they were little used. Very few executives had executive stock options prior to 1950¹.

Then shortly after the war their issuance started to rise quickly with the introduction of the 1950 Revenue Act. This new law allowed for lower capital gains tax treatment on the sale of executive options. As a consequence, executive stock option issuance jumped to around 18% of top US executives remuneration, just one year later.

Nevertheless, stock options remained mostly restricted to top company executives until the early 1960's. Late that decade Robert Noyce and Gordon Moore (of "Moore's law fame), two of the original founders of Fairchild Semiconductor (the inventor of the silicon chip) established a new company called Integrated Electronics. This company was later renamed Intel and was one of the first companies to use employee stock options more broadly as a tool to incentivise the staff of their new company. 

Once again, their use rapidly increased during the dot-com boom of the late 1990's. This popularity was again sunk by dotcom bust of 2001. Many recipients of SBC found themselves on the hook for large tax bills despite the value of their options now being mostly worthless.

More recently, SBC has again blossomed with the FANG led tech bull market of the late 2010's / early 2020's. High inflation and the end of zero interest rates globally from mid 2022 has led to a tech industry selloff that has again put SBC back onto investors' radars.

Why do companies issue SBC?

SBC is most commonly issued to staff by early stage 'startup' tech businesses for a number of reasons.

1. It better aligns employees with the performance of an early-stage business. Such businesses, usually in the tech sector, often have the promise of significant 'blue sky' potential and SBC is a way of sharing this with the small highly motivated teams typical of these businesses. They want to incentivise their staff to work harder for greater upside reward than salary alone.
   The SBC dynamic is more difficult to create in larger more established businesses where it has less of an enterprise based motivational impact on staff. In these businesses, individual employees are merely small cogs in a big machine with little realistic impact on the prospects of the entire enterprise. For these larger businesses especially in the tech industry SBC has become just a cost of doing business (see discussion below).
2. Early-stage businesses are generally cash constrained. SBC allows them to pay for staff using less of their scarce cash reserves that can be directed to other critical areas. Larger businesses generally have less need to manage their cash reserves as intensely so there is less of a reason to use SBC.
3. SBC helps smaller tech companies attract and retain the best staff they can. It offers employees an equity kicker to compensate for lower cash salary versus what larger tech companies can offer them. The vesting schedules often attached to SBC help companies retain staff as equity typically only vests to the employee after a period of time.
4. The upside potential of SBC is usually inversely proportional to the size and maturity of the tech business. Large tech enterprises can pay higher salaries than early stage tech start-ups but their SBC will rarely have equivalent 'blue sky' upside. Accordingly, larger companies suffer an SBC competitive disadvantage to smaller early-stage tech companies.

What are the problems with SBC?

There are a number of concerns for investors arising out of the payment of SBC and not just the issue of the cost of SBC not being appropriately reflected in earnings.

1. The biggest issue of SBC for equity investors is one of shareholder dilution. SBC dilutes the equity participation of the company's shareholders on a per share basis. The issuance of SBC over time erodes earnings per share for other shareholders, regardless of the company's expense recognition policy.
   If the company is self-funding then this is a lazy capital issuance practice that surreptitiously reduces per-share value over time. It might be a case of 'out-of-sight, out-of-mind' but only whilst share prices are going up. Investors are more willing to 'look the other way' during these good times and ignore or dismiss the gradual creep in the share count that robs them of their previous level of participation in the profits of the enterprise. Those times appear to be over.
2. Adjusting for SBC (by adding it back to profits) will cloud and misrepresent a company's earnings. The pretence that SBC is not a real cost (due to it's 'non-cash' nature) ignores the reality of the impact of SBC on other shareholders. We strongly disagree with the notion that SBC is not cash.
   SBC is intrinsically just the netting-off of two separate transactions, an expense transaction and a financing transaction. Firstly we have a salary cash payment to an employee. It needs to be treated as an expense. This is concurrently implemented with an equivalent micro equity issue to the same employee in exchange for the cash salary already paid. This needs to be treated as a financing event.
   Whilst the net cash impact is zero, the impact on enterprise value is not. The unbundling of SBC into its two distinct sub-components makes it impossible to argue that SBC is a non-cash expense that should be excluded from underlying earnings.
   
   Warren Buffet² said it best in his 1992 letter to shareholders when opining on this issue:
3. SBC adds complexity for investors. SBC is often poorly understood by equity market investors (and often undervalued by staff who receive it - see below). Few investors fully understand how the expense of SBC is calculated (compounded by the restrictions often attached to SBC) and how to calculate the equity dilution resulting from it.
4. SBC doesn't always properly align employees. Whilst SBC seeks to align staff incentives with the operating performance of companies they work for, in reality this only happens in a rising share price / equity value environment. In environments of falling valuations it will more often than not have the opposite effect of de-motivating staff (or worst still imprisoning staff if SBC is matched with a recourse loan that is in negative equity).
   Staff may feel cheated for not being fairly compensated for their work when the value of their SBC is declining. The aftermath of the dot-com bust saw much of the stock options that had been issued suffer material value destruction. In the end those staff had in fact been working for salary alone with the value of much of their SBC rendered worthless post crash.
5. Not always fully valued by recipients. As a consequence of point 4, staff may not always fully value the SBC they receive at its true accounting / expensed value. They may see it more as an equity 'kicker', akin to a jackpot payout for them if the business is very successful. In these situations a cash salary may have proven more of a motivator than SBC.
6. SBC is now overused and abused. SBC has long-ago moved beyond the realm of early-stage businesses and is now broadly used by many well established tech industry companies as a standard component of staff remuneration. Clearly, executive management see SBC as a useful mechanism that allows them to report higher 'underlying' earnings whilst the cost of dilution goes unspoken.

A recent Barrons³ article highlighted the now more common practice of many large companies in the tech industry. More of them are using SBC for a greater proportion of their total employee compensation. As revenue growth rates have slowed and correspondingly tech valuations have dived, this practice is increasing the anxiety of many investors who consternate at the growing ownership dilution of their business.

The article points out that average stock-based compensation for the US tech industry rose from just 4.2% of revenue in 2012 to 10.5% in 2020, and then more than doubling a year later to 22.5% in 2021.

At these levels SBC has moved well away from its tech industry origins as a tool to align and motivate small teams in early-stage businesses. Instead it is now "part of the culture and the expectation from software company employees"… with the consequence being that… "an increasing amount of shareholder value (is) being transferred to employees and away from investors, as companies dole out more stock at lower prices".

Perhaps the most egregious recent example of the above practice has been pandemic beneficiary Zoom. SBC became very entrenched as part of employee expectations during the good times when the share price ran up from US$70 in Dec 2019 to a peak of almost US$600 (+760%) less than a year later in Oct 2020. However rolling forward to late 2022 with the share price back at US$70 (-88%), employees who unlike shareholders need to be compensated for the lower share price, requiring the company to issue significantly more SBC than when its share price was US$600.

According to Kelly Steckelberg, Zoom's CFO, this was done to ensure workers were not "feeling that they're being undervalued"⁴. Unfortunately this resulted in very large levels of dilution for suffering shareholders, who's feelings were apparently less important to the CFO.

The one possible fly in the ointment for employee SBC is that the rising level of tech industry layoffs is eroding the current culture of expectation. If tough times continue then tech sector remuneration will undoubtedly come under more pressure. The consequences will not only be lower levels of SBC but also possibly lower levels of total absolute compensation, although evidence of the latter is yet to be seen.

Not all of the tech industry has been exploiting SBC-adjusted underlying earnings. Some of the larger profitable tech companies such as Alphabet (Google)⁵ and Meta (Facebook)⁶ have long since moved away from an 'underlying' earnings measure that excludes SBC. They recognise that it is indeed a true cost of attracting and retaining staff and account for it as a proper expense.

Unfortunately many other large but still unprofitable tech companies continue to rely on SBC as an 'underlying' earnings adjustment to help hide the fact that their margins are miserable on a fully costed basis. The tables and charts below show some well-known names such as Adobe and DocuSign as the biggest serial users of SBC.

Final thoughts

We may in the not-too-distant future see SBC returning to its origins of tech start-up land. It is here where the cost of equity dilution to investors is more than offset by the 'blue sky' value creation potential that a highly motivated and well-aligned small tech team can deliver.

Author: Victor Gomes, Principal and Portfolio Manager

Funds operated by this manager:

Eiger Capital Australian Small Companies Fund

¹ https://secfi.com/learn/history-of-employee-stock-options
² https://www.berkshirehathaway.com/letters/1992.html
³ https://www.barrons.com/articles/okta-confluence-snowflake-tech-stock-based-comp33588231
⁴ https://www.businessinsider.com/stock-based-compensation-wrecking-tech-shares-stock-slump2022-12
⁵ Google, 2017 "SBC has always been an important part of how we reward our employees in a way that aligns their interests with those of all shareholders. Although it's not a cash expense, we consider it to be a real cost of running our business because SBC is critical to our ability to attract and retain the best talent in the world. Starting with our first quarter results for 2017, we will no longer regularly exclude stock-based compensation expense from Non-GAAP results"
⁶ Facebook, 2017 "we are no longer reporting Non-GAAP expenses, income, tax rate or EPS. Given that stock is an important part of our compensation structure, we believe that investors should focus on our financial performance with stock-based compensation included"
⁷ https://tanay.substack.com/p/lies-damned-lies-and-stock-based

This material has been prepared by Eiger Capital Pty Ltd ABN 72 631 838 607 AFSL 516 751 (Eiger). It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Any projections are based on assumptions which we believe are reasonable, but are subject to change and should not be relied upon. Past performance is not a reliable indicator of future performance. Neither any particular rate of return nor capital invested are guaranteed.