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Freezing Order

We recently read Bill Browder’s Freezing Order which is a continuation of his pursuit for justice from the bestselling book Red Notice1. We were fortunate enough to have Bill speak at one of our conferences in London (pre-Covid) and he is an exceptional human being. His patient dedication to righting injustice is a life lesson for us all. He has achieved some remarkable results due to unwavering persistency and immense personal reserves of resilience – the same skill that a successful long-term investor needs – which, as it happens, he is also! This got us thinking about the nature of patience as an investor, and more specifically about ‘duration’.

The great freeze on free money has arrived with a jolt as inflation cleaves through the global economy. Central banks globally are raising interest rates and this is having a chilling effect on equities and bonds alike. Long duration assets are losing favour given higher rates act like gravity on the price of securities whose intrinsic value is based on cash flows generated further into the future. So, what is our equity duration and how much patience and resilience might we need?

Duration is typically described in one of two ways: the weighted average time to receive the cash flows or the sensitivity to change in interest rates. Clearly, they are intertwined. Delving into the academic literature on equity duration reveals a surprising lack of consensus on how to calculate it when cashflows received are not fixed coupons but change every year. There’s also the gnarly issues of variable – hopefully growing – payments into perpetuity and embedded real options when most bonds have fixed terms and flat coupons. It’s tempting to reconcile these issues by resorting to shortcuts. The most common shortcuts make all sorts of unrealistic simplifying assumptions to end up using either inverse dividend yield or inverse earnings yield (a.k.a. the price-to-earnings or P/E multiple). We remain highly dubious of price-to-earnings ratios as a proxy for value given earnings can be distorted by “creative” accounting and the measure embeds a range of factors into a single number. We inherently prefer actual cash flow. Intuitively, it seems obvious that higher growth equities have cash flow further out and therefore longer duration. Implicitly this means they will have a higher sensitivity to rising interest rates too. But how do we calibrate this within Global Leaders?

Fortunately, we do 10-year forecasts for each investment and we can use our base case ranges to estimate probable future annual cash flows. We discount each year at our 10% minimum weighted average cost of capital (WACC) and some infinite series maths gives us the basis for some rough approximations2. Today the Global Leaders portfolio cash flow duration in real terms is in the 15 to 17-year range using this calculation. Hence, in aggregate we are more sensitive to rising interest rates than any 10-year bond but less than a 30-year 3% coupon government bond at par. This feels about right for our high return on invested capital (RoIC) and highly cash generative companies, although we would concede our cash flows estimates are less secure than either bond’s coupons. Nonetheless, we suspect our equity duration is shorter than many quality managers (and probably the vast majority of growth managers) due to our conservative double-digit discount rate.

One way to deal with regime changes in markets is to switch styles from quality equities over to “value” as they often have a shorter duration (we would argue harsher fade back to average too). In theory this is obvious. It’s the practical application where market timing fails. If one misses the top 50 days over 10 years one loses all the performance over that entire 10-year period – good luck getting those 50 decisions right! We are low turnover investors with an average 7-8 year holding period – nearly half the investments in Global Leaders have been with us since day one. We believe that giving our high RoIC compounders the opportunity to reinvest into their business will deliver value handsomely for our co-investors in Global Leaders over the long run.

What is the half-life of our WACC?

Another interesting book that we came across recently is the Half-life of Facts by Samuel Arbesman3. In it he proposes that facts’ usefulness deteriorates with time. Specifically, economics has a half-life of 9.4 years after which knowledge becomes out-of-date. In other words, half of what we knew a decade ago as true is now obsolete, wrong or has been superseded. Longtime investors know that we have used a 10% WACC as our minimum discount rate since inception over seven years ago. It is the same for all sectors and all developed market countries globally (we use a minimum of 13% in emerging markets). This standardization is not any sort of claim on accuracy but it enables comparability across geographies and industries with an in-built safety buffer, especially when global interest rates were next to zero. The question becomes is 10% still appropriate? Or is its half-life over?

We often joke that we can make a discounted cash flow (DCF) say whatever you want to hear and subscribe to the view that “more fiction is written in Excel than in Word”4. DCFs are very dangerous if not used thoughtfully. Our standard valuation framework looks out over a 10-year cash flow forecast ending with zero % real growth in the terminal cashflow (technically we use 3% nominal terminal growth). If we take the starting base year cashflow and grow for 10% per annum across the 10-year forecast then we end up with 40% of the DCF value within our explicit forecast period and 60% in the terminal term. We expect some of our companies can grow cashflow faster than this, most will not. Yet even with our conservative assumptions, 60% of the value still lies outside the next 10 years. By this valuation method, the portfolio cashflow duration is in the 16 to 17-years range. A lower WACC, say 7 or 8% typically used in sell-side models, results in a longer cashflow duration with 70-75% of the value pushed beyond 10 years and consequently a lower margin of safety and higher sensitivity to changes in discount rate.

Arbesman reminds us that we can never be too sure about our cherished beliefs, we need to question and recheck every assumption. One good piece of news is that big concepts and central theories are only overturned infrequently, it is little ideas and “mesofacts” that churn more regularly. Anyone with children in school has probably witnessed this in action in the classroom! We have been asked many times recently about lifting our 10% discount rate as central banks globally embark on interest rate rises. How different to when we wrote the 2Q 2020 letter (link) and we were being asked about taking our WACC down! The last time U.S. rates were going up in 2018 we did debate raising our WACC hurdle when the Federal Reserve (FED) funds rate was at 2.5% and appeared to be going higher. We are nowhere near 2.5% base rates at the time of writing, but this could change quickly. Back then rising rates from 2.5% would have started to narrow our margin of safety but the FED paused and we ended up without any change. We have never considered lowering the WACC as it is our cost of capital – we want a double-digit return per annum so our implied discount rate is 10% minimum. We view our discount rate as the return we want as investors, it needs to be above the market return.

One astute investor pointed out that 3% terminal growth sounded low with inflation running at approx. 8% in the U.S. and U.K. We have not changed this either (yet). When we started Global Leaders, zero % real terminal growth in a low inflation world meant 3% nominal growth was conservative. We should always think in real terms, not nominal, but most especially during high inflation. A higher long-term inflation assumption will ceteris paribus increase duration, not shorten it. One could argue for increasing the WACC and a higher terminal growth rate given today’s inflation but these are offsetting and we don’t know how long inflation will persist. For now, we remain very careful before making any changes, just as we were when rates were falling, but we are cognizant that there is a half-life to our DCF assumptions and we remain open minded to updating them given changing economic circumstances.

Our conservative valuation framework – be it the 10% WACC or the zero % real terminal cashflow growth after 10 years – means Global Leaders has a relatively low equity duration compared to other quality portfolios and so we believe it will be comparatively less sensitive to rising interest rates too. Nonetheless, equities and bonds struggle when rates rise and with our duration around 15 years we will still be more impacted than many “value” funds. Bond proxies – which worked well in a low rate environment – won’t suffer as badly as fixed-coupon bonds but, unless they can pass on all inflationary costs without a consequent fall-off in volume, then their inflation hedging is questionable. We have always been absolute cashflow value focused, our DCF’s guardrails are rooted in the slow-changing traits of mathematics. Maths has a long half-life and a DCF correctly done accounts for inflation. Relative valuation – be it short-cut multiples or free-cash flow yield relative to government 10-year bond yields – is like a mesofact. It is changing all the time and gives little protection in a rising rate environment.

But equities are an inflation hedge! Aren’t they?

The impact of inflation and rising interest rates is not univariate into discount rates. Warren Buffett – the man with a near monopoly on folksy investing quotes – wrote about the pernicious effects in his 1977 Fortune article: “How inflation swindles the equity investor”5. There are a couple of impacts worth noting, all of which impact RoIC: financial leverage and higher debt servicing cost, working capital and capital expenditure (capex) costs. The obvious higher cost of debt means our lower leveraged companies – half the portfolio has net cash – should benefit comparatively based on their equity financing. Less financial leverage means our cashflow doesn’t get diverted to debt holders when refinanced at higher interest rates. The inflation impact into working capital is already being seen in a higher cost for inventory at a couple of portfolio investments and subsequently lower inventory turns which are a drag on invested capital and RoIC. Industry-wide moves to “just-in-case” from “just-in-time” inventory management only adds to the working capital drag. Another hidden impact comes as maintaining the current asset base becomes more expensive when the replacement cost of maintenance capex rises with inflation. Depreciation rises over time too. In short, overall capital intensity rises under inflation and asset turnover falls. High and sustained inflation distorts RoIC in another way too: the current nominal profits are boosted yet the historical capital invested stays at old book cost. For Global Leaders we are relatively well positioned as our investments on average have no financial leverage and low capital intensity, but all companies – ours included – will see higher capital costs on top of operating expense (opex) and labour wage hikes.

Conventional wisdom believes that equities are an inflation hedge. We wrote about inflation and the different types of pricing power our companies have in our recent letter (link) but lifting price without adding any new customer value risks an offsetting decline in volume as customers budgets’ are not infinite. Recurring, non-discretionary revenues become paramount. Higher inflation leads to false growth. Yes, we all see topline revenues grow faster but equities are not an inflation hedge simply because nominal earnings go up when inflation rises. In the 1970s, accounting earnings kept up with inflation but underlying free cash flow did not! Protection of equity investor cashflow in real-terms is not guaranteed, it depends upon what type of pricing power you have (if any), price elasticity of demand and cost inflation in both opex and capex (look out for that delayed depreciation). There are many moving parts, not the least is expected vs unexpected inflation. Management can plan and price for expected inflation but unexpected inflation injects uncertainty and volatile inflation makes long-term planning and investment difficult. Ask any investor in emerging markets over the past 20 years – it is only real cashflow growth per share that creates value for shareholders. We expect that many of our investee companies will provide good inflation hedges, however capital intensive and highly levered companies will probably not. Inflation is a malevolent force for investors that can reap a whirlwind of destruction into equity fundamentals and valuation. In the long run we believe quality is one of the only defences.

Is stock-based compensation really a “non-cash” expense?

We appreciate many companies exclude stock-based compensation (SBC) as a non-cash expense in their definition of non-GAAP EPS6 , yet as cash flow focused investors, we include all prior claims above us including SBC so any debate had largely passed us by. Well, not entirely. Having invested during the last tech boom 20 years ago, we vividly remember the uproar as the U.S. Financial Accountings Standard Board brought stock-based compensation into the definition of U.S. GAAP in 20027. We thought this discussion had been settled, SBC is a real economic expense which dilutes existing shareholders.

However, recent discussion amongst technology companies on repricing prior SBC grants due to falling share prices has reignited some debate about this as an expense. The argument is that as the war for talent in tech companies rages on, if prior employee SBC grants are underwater then staff attrition may go up because the cost of poaching rival’s staff goes down. To us, logic would suggest that if it is now easier to hire talent, then costs should be going down, not up. It’s all a little bit circular and most certainly self-serving (who doesn’t want to double-dip on prior comp?). It reminds us of the furor surrounding Steve Jobs allowing back-dated option grants at Apple in 2006, it might have been (questionably) legal at the time and make employees happy but it doesn’t look good ethically, and it is still a cost to other shareholders. Any repricing down or issuance of additional awards ultimately further dilutes external shareholders for work historically performed and previously paid for.

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it?”8

SBC is an expense to shareholders – the real question is how to account for it. Firstly, we need to differentiate between past awards which show up in diluted share count and further dilution from future grants yet to be given out. It turns out errors show up in both regularly. Many data providers use basic share count to calculate market cap or enterprise value, not fully diluted. Next to zero sell-side analysts include a cost for future grants in their EPS estimates. But wouldn’t it be double counting to use diluted shares and include a cash cost for SBC? No, not if you are thoughtful. SBC expensing for past awards and using diluted share count would be double counting. We need to differentiate between past and future awards; forthcoming dilution will diminish any future cash per share that we receive.

Additionally, as SBC is treated as a non-cash expense it is often added back to operating cash flow. This means a common management definition of free cash flow excludes SBC (free cash flow = operating cash flow less capex). The actual cash to shareholders will be lower. The inescapable lie of SBC as a non-cash expense is found in share buybacks. Is that buyback actually returning money to shareholders or just offsetting past SBC dilution? Often buybacks are set “at a minimum to offset SBC dilution”. That cash is all going to employees. It is a chimera to the external shareholder and should be accounted for correctly as a cost before it disappears. An alternate method occurs when companies target an annual rate of dilution. Again, we should not double count with a future SBC cost and a future dilution rate. At least management here are open and honest about the future impact and that calculation is easy albeit often ugly in a DCF (a 2% per annum dilution doesn’t sound like much…).

There is a reckoning underway for a lot of option-based technology and biotech companies – both in equity duration addressed in the first part of this letter and the actual cash per share dilution to shareholders in the latter (Snowflake at 100x revenues anyone?). It reminds us of Scott McNealy, then CEO of Sun Microsystems, venting his frustrations at an investor conference post-internet bubble bursting in early 2002 (see below). We have endeavoured to be thoughtful (more likely just boring and old fashioned) yet we have still taken the opportunity to invest in some exciting long-term technology companies too. Time will tell how well these work out. In the end we are fundamental, bottom-up, long-term investors and so long as we can find investments with double digit cashflow IRRs passing our 10% WACC hurdle then over time, our co-investors should do just fine.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes which is very hard. And that assumes you pay no taxes on your dividends which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” -- Scott McNealy9

London Value Investors Conference & the Global Equity Forum

We were fortunate to be invited to speak at the London Value Investors Conference (LVIC) and the Global Equity Forum recently alongside numerous well-informed investors. At LVIC we had Mick present our long-term thinking on what constitutes value (great customer outcome, high RoIC and high reinvestment rate, not cheap multiples nor mean reversion) and how we believe this is on show today at Taiwan Semiconductor but not at Intel. It was great fun, there were many good debates and we recommend attending. We had a good discussion with Simon Brewer from The Money Maze podcast (check out this episode with AKO founder and current Norwegian Sovereign Wealth Fund CEO Nicolai Tangen10) who was there to interview investing legend Joel Greenblatt. The Global Equity Forum at the Royal Institute was incredibly interesting and we presented our experience in incorporating behavioural economics in a practical way into fund management. They are two very different parts to investing but both necessary and certainly good opportunities for us to learn from other professionals. We hope to see you at both events – in person – in the future.

Thanks for reading,

Mick, Bertie and the Global Leaders Team

1 Freezing Order: A True Story of Money Laundering, Murder, and Surviving Vladimir Putin's Wrath by Bill Browder Red Notice: A True Story of High Finance, Murder, and One Man's Fight for Justice by Bill Browder
2 https://ssrn.com/abstract=3742725
3 The Half-Life of Facts: Why Everything We Know Has an Expiration Date by Samuel Arbesman
4 https://memex.naughtons.org/quote-of-the-day-307/26023/
5 https://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equit… 6 Non-GAAP earnings are an alternative accounting method used to measure the earnings of a company. Many companies report non-GAAP earnings in addition to their earnings based on Generally Accepted Accounting Principles (GAAP).
7 FASB Statement #148, Accounting for Stock-Based Compensation—Transition and Disclosure, 15 December 2002
8 Warren Buffet in the Berkshire Hathaway 1992 Annual Report
9 https://www.bloomberg.com/news/articles/2002-03-31/a-talk-with-scott-mc…
10 https://www.moneymazepodcast.com/podcast/nicolai-tangen-ceo-of-the-norw…

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The Global Leaders Strategy invests in a concentrated portfolio of market-leading companies from across the globe. We believe that companies that combine exceptional outcomes for their customers with strong leadership can generate high and sustainable returns on invested capital (ROIC) which can lead to outstanding shareholder returns.


Past performance is not a guarantee of future performance and you may not get back the amount invested.
If you are a private investor you should not act or rely on this document and should consult with your financial adviser.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.