E2224 - June 15, 2022

A framework for selecting investments + fitting Tesla into the framework

Jun 15, 2022

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A Framework for Selecting Supercompounders…

This week we discussed a relatively simple framework for selecting investments.

Find (1) high quality companies that are (2) generating 5% free cash yield and (3) increasing free cash flow by 10% or more each year. This gets you to a 15% growth rate, which, holding all else constant should double your investment in 5 years.

The definition of High Quality Company is rather amorphous. Some practitioners refer to it as competitive advantage, or moat. But at the end of the day, there is something about the business that enables it to command higher prices and higher margins than would be competitors. We could spend a month, or even a year covering business models and competitive strategy. For those interested, here are a few resources I’ve enjoyed over the years…
1. Stratechery - a blog about tech and strategy
2. Competition is for Losers - a recording of a Stanford class taught by guest lecturer and renowned investor, Peter Thiel
3. The Innovators Dilemma - and practically anything written by Clayton Christensen.
Generating a 5% free cash yield is a high bar, even in today’s market. When looking at different businesses, it is important to keep in mind how much debt a company has. Highly leveraged businesses often generate substantial free cash flow to the firm, but after debt service, not much is left for equity. Many companies will generate >5% free cash yield, but few are also able to accomplish #3…
Growing free cash flow 10% per year is no small feat. This step will require analyzing a businesses ability to scale.

Fitting Tesla into the framework…

Quality - love him or hate him, Elon has created a business that is vastly different than all other automakers. Tesla is easily 3-5 years ahead of other automakers when it comes to EVs. We’ve discussed Tesla the last few weeks so I’m not going to go into too much more detail here.
5% Free Cash Yield. Last week we established Tesla’s quarterly cash flow at $2.2b, or $8.8b on a run rate basis. $8.8b/$673.261 = 1.3% - a far cry from 5%. However, we also calculated the forward free cash flow assuming Tesla produced 2m units. This came to $25b. $25/$673.26 = 3.7%, so we are getting closer. Check out last week’s newsletter for the full breakdown.
>10% Free Cash Flow Growth. Growing cash flows generally involves scaling a business model. For Tesla, this involves scaling factories and building new factories. Elon has said that he believes Tesla will produce 20m cars per year. We don’t know the output of the Berlin and Texas factories, but they will likely be in the range of 500k to 1m cars each. If Tesla adds 1 new factory each year, they will easily increase cashflow by 10%. In fact, assuming that pace, growth wouldn’t dip below 10% until year 10. Now, these are pretty gross assumptions, but you get the point.

We will repeat this process on a bunch of companies over the next few weeks. If you have suggestions on companies to look at, feel free to send them my way.

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1 SuperCompounders

2 Macro

3 Energy

3.1 Oil & Gas

3.2 Metals Powered

4 Tech

Cloud Multiples - Check out the most recent edition of Clouded Judgement for the latest SaaS multiples.
Semiconductors
- Semiconductor Industry Association Global Billings Report
- Bureau of Economic Analysis Semiconductor Import / Export

Cryptocurrency

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