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Description:
After covering the building of a bull case in the previous week’s show, we moved on to the other side of the coin: the bear case. This requires you to think creatively and dig deeper, as management won’t dish out these nuggets and make it easy for you. After all, they are incentivised to drive the bull case.
This episode will help you learn where to look for some of the really important points in a bear case.
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
Full transcript:
The Finance Ghost: Welcome to episode 193 of Magic Markets. Last week we spoke to you about how to build a bull case. This week we are going to do the other side of that coin as promised and we are going to talk about how to build a bear case. Moe, I think you are the quintessential bear among the two of us, actually, although we debate this point fairly often. You are more commonly the bear case, and so we always make you present the bull case when we do Magic Markets Premium, much like you make me do the bear case. The truth of it is that we both work on the bull case and bear case in every single show, and it’s really great to be able to think through this stuff, isn’t it?
Mohammed Nalla: Indeed, Ghost, I think that’s really what we highlighted in the show last week when we discussed the bull case. It’s so important to challenge your conventional thinking. And if you are predisposed to being bullish, well, then challenge yourself and actually go and build a bear case. If you’re predisposed to being bearish – and that’s kind of easy for me, I have historically been the more bearish one as I go and look at the bear case, but I force you to actually go and build the bear case. But today we’re going to discuss just the kind of thinking, the mental models, what approach you should take when considering a bear case. There may be some similarities to when you’re building a bull case. Obviously you are looking at the same subset of data, but applying a differential lens to that. So, Ghost, because we always challenge you to look at the bear case, I want you to jump in first and tell us what is your approach when starting off contextualising what the bear thesis is on a stock.
The Finance Ghost: I try hard not to go in with a predisposed set of ideas as far as possible, because otherwise you just turn yourself into a little echo chamber, which kind of defeats the purpose. Look, obviously when we research something that we’re familiar with, I guess you have an idea of what worries you. But you know, you’ve also got to be very open to looking at this thing and being informed by the numbers, by the management narrative, but also by what they aren’t saying. Maybe that’s an important point about the bear case versus the bull case.
The bull case is going to be influenced by management because that’s what they want you to believe. They are way more likely to give you nuggets for your bull case than for your bear case. For the bear case, you’re going to have to be a little bit more creative and you need to read between the lines.
You need to look at what they are not saying rather than what they are saying. And often, you need to go and do your own calculations on their numbers because that’s the thing with the key highlights section: they’re going to give you the good news story. If revenue was great this year but margins sucked, rest assured they’re going to focus on revenue. They might make mention of margins and it depends how financially mature the management team is and frankly, just how good they are at giving a balanced view.
A lot of companies are not good at that on purpose. They will only give you the good news story. They are hoping that the media will pick up on those nuggets and turn them into headlines. I know this from my own Ghost Mail writing. That’s what they are relying on. They don’t like it so much when you go and do the digging and you actually think, hey, there are some problems here that weren’t anywhere in the highlights section. That’s how you start to build out a Bear Box.
Mohammed Nalla: I think that’s so important – reading between the lines. It’s why we always go and look at the earnings transcripts. Go and listen to the call. Sometimes it’s so important to not just read the transcript, but if you have the ability and the time, go and listen to the call because you pick up the slight tonal differences in how they’re addressing questions.
It’s not about the prepared comments. Quite often some of the bear points come out from the analyst questions because the analysts try and challenge management. You want to actually look at how management addresses some of those questions.
I want to just take a step back, because when we look at stocks in Magic Markets Premium, we don’t go in with a preconceived notion of, hey, this is a bullish stock, we want to buy this, or this is a bearish stock, we want to sell this. We actually look at it with a very cold, unemotional lens. And the first thing that I go and look at in the financial statements is the revenue trends. Quite often, like you say, management’s going to try and point you towards the metrics they want you to focus on. Go and have a look at the long-term history on the stock. Go and see what’s happened over the course of not just the last quarter, but what’s actually happened over the course of the last several years.
Is this a company that is actually building momentum? Is it growing revenue, or are there some question marks around that? That, for me, really goes at the top of framing whether we should be looking at some of the trends. I started out the Bull Box saying: is this a mega trend or a mega sector that I want to be involved in? And I do the same thing in the Bear Box. What is the macro picture doing for me? If we’re going into an interest rate cutting environment, what does that mean for the macro picture? And does that mean I want to be in the sector or I don’t want to be in a particular sector? And that starts to frame some of the bullish, or bearish narrative in this case in the Bear Box. Maybe you want to start avoiding some of the sectors? If there’s a lot of cyclicality, if consumers are under pressure, those kind of themes.
And then to your point, in terms of what is management trying to point you towards, I tie that into our assessment of management in general. You look at management and you say, do we have good leadership? Do we have good succession? And a prime example here again, I think we used an example of Disney in the Bull Box talking about their content library. But if we look at management, you can actually use the same example. You can look at Disney and how they bungled the succession planning from Bob Iger to Bob Chapek and back to Bob Iger.
I read a fascinating story in the New York Times recently, just looking into some of the underlying details of that. Very often, if you see a company that lacks a talent pool and management depth, or that lacks a good, strong succession plan, those all start to frame some of the softer issues that you’re not going to pick up in the numbers. They could be a very important flashpoint to pay attention to when looking at the Bear Box.
The Finance Ghost: People say you need to turn the optimist off when you look at this kind of stuff, but you can still be really optimistic about a company and then use that to actually help you build the Bear Box. The one point that people miss all the time is the impact of competition. So for me, Tesla is the best example of this. And yes, you can be bearish for a long time and be wrong in terms of what the share price does. Certainly I missed out on a lot of money that could have been made in Tesla. But my principle is to buy things that I believe are reasonably priced and are going up, so you’re always going to miss some, you’re always going to get some wrong. That’s life.
But Tesla, that’s such a great example of how competition has really hurt their story, because success attracts competition. There is such a thing as first mover disadvantage, even if there’s no evidence of it yet in what you might be looking at, be very, very careful of a company trading at a crazy multiple where they’ve gone and basically said: You know what? We’re going to grow like this for the rest of time, and no one’s going to come along and eat our lunch.
That is not real life. People are going to come along and go after that tasty lunch. And even if they don’t necessarily take a lot of market share from you, they might be strong enough to just stop the growth story. They can hurt you. They can suddenly turn that amazing 25% a year growth into 12% a year growth. Now, 12% a year growth in hard currency is still good, but it doesn’t justify crazy multiples that companies that were growing at 20% and 30% would typically be trading at.
The other thing you need to think about is stuff like threat of substitutes. Get your Porter’s Five Forces out here. Stuff like changing consumer preferences, and you can see this coming through in the financials as well, because again, management’s probably not going to stand up and say, hey, guys, you know, our product isn’t as cool as it used to be. With the exception perhaps of Michael Kors, who, you know, of Michael Kors handbags and everything else, who in their FTC trial this week for the merger of that group and Tapestry, he basically said to the authorities that Michael Kors might not be in vogue anymore. We’ve kind of run our course people are a little bit tired of our brand. That’s a very rare example of someone being honest, although heaven knows if he’s really being honest or just trying to get an outcome there, get the competition authorities to say, yes, go for it.
You won’t see management coming out with stuff like that very often. So you have to look at it logically and say, is this the case out there? Is this what’s happening with consumer preferences? And one of the ways you can see it is a diminishing gross margin. I think that’s really important. The reason being, if a company can increase prices, they will. Don’t believe the garbage of, hey, we chose not to increase prices because we’re nice. If they can increase prices, they will. And if they can’t, in all likelihood, it’s because there’s too much competition.
Mohammed Nalla: That competition point is absolutely vital because at the end of the day, it comprises a very important part of the work that we do at Magic Markets Premium. We often do a competitive analysis. We look at who are the competitors in a particular market. We look at some of the disruptors. And talking of competition, another very important point that I want to raise here is looking at a company’s moat. Quite often we discuss the moat when we’re looking at the Bull Box, whether a company has a moat and what the trend on that moat actually is. Is it a moat that they can sustain that is actually building up? Are there more barriers to entry or is this a market or an industry where the barriers to entry are low and we actually see an eroding moat? I think that talks to some of the points that you were discussing under the competitive section. And like I said, this features very prominently in the work we do at Magic Markets Premium, where we do a full competitive landscape. We look at who’s actually coming through.
Now, why I raise this Ghost, is that it is actually very important. Sometimes when you’re fleshing out your Bull Box, your Bear Box, and you’re looking at the competitive landscape, you might not land on: hey, this company we’re covering this week is a great investment or a bad investment, but you might actually pick up another interesting company that warrants further research. So that is a very important part of our process.
Now actually taking that through into the risk of competitors, not just in terms of how they’re operating in the current environment, but also the risk of disruption. And this is very important because disruptors often come from left field and can completely erode a company’s competitive standing. That ties in very nicely to the point that I just made around whether a company has a moat, whether they’re high or low barriers to entry in a market.
And then the last point I want to touch on, just leveraging on the point that you had made, are valuation concerns. Because quite often you might have a great Bull Box, or a great Bear Box, but you also have to dovetail that against the work that you do on the underlying numbers because a great company at an insane price is still not going to give you a strong investment case. You’ve got to pay attention to that. You’ve got to say: what’s actually priced into the market? How much growth is actually priced into this thing? Can it actually sustain or deliver on the market’s expectations of that growth over the time period? And if the answer is a no, well, guess what? That could actually also feature in your Bear Box.
The Finance Ghost: Yeah, there are so many linked points. You speak about the macro a lot, Moe, and it’s really important. One of the ways you can see that coming through is in deteriorating unit economics. If a sector sucks, the businesses that are in that sector are going to struggle. It’s just that simple.
I always use the telcos industry as a great example. What did you pay ten years ago for your monthly cell phone contract? Personally, I paid more ten years ago than I pay today. Never mind adjusting for inflation. I literally paid more. Thank you WhatsApp, for bringing that cost way, way down, as well as the fact that I don’t really care anymore what phone I have. All these smartphones pretty much do the same thing. I saw some interesting headlines that Apple has not necessarily achieved the pre-orders it wanted for this new iPhone, so it’s not just me who thinks this way. There’s a good example of a company we’ve covered before on Magic Markets Premium and that is actually a threat that we raised. In that Bear Box for Apple, we talked about what their next big product is.
Mohammed Nalla: I want to jump in there on the Apple point because I watch Apple quite closely, as I think most investors do. It’s just a company of that kind of scale and significance. But if you cast your mind way back when, and some of our listeners might be too young for this, there was a company called Research In Motion, then rebranded to BlackBerry and they were the leader in the smartphone market. This is post-Nokia. We know Nokia was the leader, then Samsung, but then there was BlackBerry and BlackBerry was all the rage. Think of the iPhone today. That is BlackBerry of yesteryear. And what really unravelled for BlackBerry was management buying its own hubris, believing they could deliver the kind of growth that they’d always delivered in the market. And when Apple transitioned into actually having a seamless touchscreen approach, BlackBerry’s approach was very much, well, actually, we think this is a fad, and the market actually wants a keyboard on the device that they can press and that they can feel. And that really points to what we’ve discussed there. One is management buying its own hubris, their own hot air that they put out there. The other is the risk of disruptors coming through. And the third would really be valuation.
I think at that time, Research In Motion, or BlackBerry was really priced for all of that growth in the long term and got disrupted very strongly. And the question on Apple specifically is, are they reaching a similar inflection point? We know consumers are migrating to different types of devices. Very interestingly, Huawei, just several days after Apple’s launch of the iPhone 16, came out with its triple fold phone. So keep an eye out. It is very important in framing the bearish thinking on a stock.
The Finance Ghost: Berkshire Hathaway sold a chunk of their Apple shares this year, which was interesting because I think we raised some of that bearishness before that even happened when we first covered Apple. And again, it was what is going to be the next iPhone? Is it really these virtual reality goggles? I don’t think so.
Mohammed Nalla: I’m jumping up and down because you’ve almost pre-empted the next point I wanted to raise. You said Berkshire Hathaway sold a whole chunk of its Apple stock. We also look at insiders and what they are doing – and it’s not just insiders being management. We look at the big institutional shareholders. Are they buying? Are they selling a stock?
Two great examples. One you’ve mentioned, being Berkshire on Apple, but also Berkshire buying into Ulta Beauty, a company that we covered fairly recently here at Magic Markets Premium. Now, it’s not to say you should blindly follow what the big investors are doing or what the insiders are doing, but it does give you a very interesting lens. Specifically, if you’re seeing sales from interesting insiders, sometimes the management team, that could also contribute to either a bull point, but quite often to a bear point when framing an investment thesis.
The Finance Ghost: I’ll give you a couple of other examples of deteriorating unit economics. How about platinum miners? The PGM price, platinum itself, roughly the same now that it was ten years ago. Imagine ten years of inflation in your mining costs to just get the stuff out of the ground. That is scary stuff. Obviously mining is tough to forecast, but the other one Moe before I hand back to you is just online advertising-type businesses. These are businesses where they need to keep buying ads on Google to stay relevant. We covered Tripadvisor at some point in Magic Markets Premium and that was one of the issues they faced: Google just has the keys to the front door and everyone else sits behind it and fights to be at the front of the queue. If the business you’re looking at is like that or they’re in an industry that is growing in popularity, just understand that over time their marketing is going to become more and more and more expensive because that is how Google’s business works. They create an auction that creates scarcity for eyeballs and people pay. Simple as that.
Mohammed Nalla: Yeah Ghost, I’m loving this particular show because we’re dovetailing quite nicely, we don’t prepare our comments beforehand. The important point I wanted to land on here is just paying attention to how companies operate in their respective value chains.
Are you the company selling shovels in the gold rush? You mentioned platinum miners. Well guess what? Some of the disruption that’s come through in that industry comes from further upstream in their value chain. If you look at the rise of EVs and hence less of a need for PGMs in catalytic converters, then disruptors don’t necessarily come from your competitors alone. They can come from your positioning or your relative positioning in your own value chain. And the same point can be made for Google. For example, if you look at mega themes, we’ve got Microsoft with OpenAI. A lot of negativity I’ve seen recently coming through on Microsoft, which has sold off a little bit, has been around the fact that they seem to be losing some ground on the OpenAI hype that has come through. Competitors in the rest of the value chain have actually started to make an impact in that space and Google again popping up time and time again.
So, pay attention to disruptors, not just from your direct competitors, but within your own value chain. I think that is an absolutely vital point that I’m glad we brought up because it’s easy to actually overlook.
The Finance Ghost: We can probably do three shows on the Bear Box alone and probably the same on the Bull Box, but another example that I want to raise quickly is looking for a blind spot in the company. This would typically be some kind of segment or division that is just causing a lot of trouble. Is there part of the business that is letting the team down? And then you need to think about, you know, how dark is that hole? How deep is that hole? Are they going to keep throwing good money after bad? Is it just a slow grower, or is this something that can actually turn into a serious problem? And we’ve seen this before, and that’s where you’ll often see a share price gap down tremendously, is when the market ignored the fact that there’s a specific division that is just sucking up cash and causing tons of problems. We look out for that. We always go into the segmental report. I mean, that’s one of the most important reports in any set of financials. And it’s really, really, really useful to go and see what the underlying segments are actually doing.
Mohammed Nalla: The last point I want to land on can also tie into blind spots to a degree. We have to look at a company’s balance sheet. Quite often, people look at the growth numbers, they look at the sales, they look at the operating margins, and they say, okay, well, this is a great company. But remember, these companies are only as vulnerable as their balance sheet allows them to be. Given my bearish predisposition, I tend to focus on how much leverage does a company actually have on the balance sheet.
Again, I want to reiterate, it’s not to say that leverage is a bad thing. Some companies have actually proven that they can use that leverage very effectively in order to supercharge returns to equity holders. But when you have a lot of leverage on the balance sheet, it just does one thing Ghost – it constrains your ability in terms of flexibility should you reach a downturn. If you’re a company with very low leverage on the balance sheet, if you reach a downturn, you can actually gear up the balance sheet and survive that kind of cyclical move. Alternately, if you flip that on its head and if we’re in a bullish market, for example, and you’re a company with low leverage, you have the ability to gear up your balance sheet in order to pursue growth or acquisitive growth opportunities.
I always pay attention to the balance sheet. How much flexibility does management actually have? And that ties nicely into your cash flow point here. What are the capital allocation decisions that are being made by management? Do they have the flexibility to pay a dividend? Are they just paying a dividend so that they can actually stay in those dividend indices where people track the dividend the company pays? We often see that.
You’ve got to tie the balance sheet point up with the dividend payout ratio as well for companies that do pay a dividend. You’ve got to see: is that sustainable or is the company actually doing some tissue damage just in order to maintain that dividend status over the long term?
Pay attention to the balance sheet. More often than not, you will find that that will inform either the bull case or the bear case. And in some instances where it’s the bear case, it tends to be a lot more severe.
The Finance Ghost: The bear case is probably a bit more technical to build at times than the bull case. And the good news is that if you want to see this playing out in practice, this is exactly what we do in Magic Markets Premium, even if you are not actively investing in the US market at the moment, but you want to learn and you want to see how to apply that to what you are investing in, Magic Markets Premium will do that for you. Every week, we take you through a bear case on a listed company, along with a bull case, and an overview of the strategy and a summary of the numbers and a technical analysis and the fundamentals and all the good work we do. So go and check it out. If you haven’t given it a try before, it’s only R99 a month and there’s no minimum number of months to sign up for. So literally zero commitment beyond R99, which these days barely buys you a decent meal at McDonald’s, sadly. And Moe, that’s another company we’ll have to cover at some point soon, actually, because they’ve just come out with earnings.
I think we’ll have to leave it there this week. It’s been really fun to do the Bull Box and Bear Box in the past couple of weeks. To our listeners, thank you for joining us and we look forward to having you on the next one.
Mohammed Nalla: Thanks and cheers.
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.