[WEEK 44/52]: It’s our job to find the baby in the bathwater, and save it.
[TOPIC]: Marvell, CoreWeave, and ~90% of the other hyped-up AI stocks are overvalued. But there some small % of AI companies that are undervalued, still. Today we hunt for the baby in the bathwater.
What is a business?
First, visualize the concept of a business being a ‘bottleneck’ around a pipeline.
Each business collects a ‘toll’ on all the cashflow that moves through their pipeline.
Companies with high gross margins + operating margins are able to use a high % of the cash that moves through their pipeline.
Companies with high profitability are able to use a large % of the cash that flows through their pipeline for improvements.
So if $1 goes through the pipeline, and the company has 60% gross margins, then 40% of that cash stays moving through the pipeline in the form of COGS.
And 60% is sent up for the business to use, and retain what it can.
So that 60% goes into the business, and it’s spend on operations, maintain, obligations, and then the rest is retained as Owner Earnings.
Those owner earnings can then be used for good, or for bad.
It can generate a high yield (leading to compounding).
Or it can generate a low yield (leading to value destruction).
It is the job of every great investor to mathematically figure out what the company could actually take out safely in earnings without disrupting future company ops, and then weigh that against what are they actually doing with the cash.
Specifically, owners earnings can be used for a number of activities:
They could decide to shrink the companies outstanding shares, therefore making the current stock more valuable to holders.
They could decide to re-invest in growth capex, which would be another way of tightening their grip on that pipeline so they can extract a larger toll.
They could acquire companies which gives them new pipelines of cashflow, or enhances their own.
And so fourth.
But, there’s a catch…
The fact that you’re earning a ton of money, and growing your stranglehold on the pipeline, does NOT mean it’s a good investment for a stock picker.
It could be a great business at a bad price.
As Buffett says, “PRICE IS WHAT YOU PAY, VALUE IS WHAT YOU GET.”
Let’s take Marvel for example…
It evidently has a strangle hold on the bottle neck, and you can argue demand is remaining strong for years on AI.
They are generating more cash than ever before, however, this fact has already been priced into the stock.
In fact, MRVL is generating $1.6 Billion of Operating Income…. yet already valued at $150 Billion.
So you’re only earning a roughly 1% yield on your cash.
That sucks.
Especially when you can get 4x that from risk-free treasury.
Find the Baby in the bath water
90%+ of AI stocks are overvalued.
All the net-benefits of demand have been priced in by investors. And even after their 30% pullback I surmise there’s plenty of room for a further drop from AI.
HOWEVER….
There are also some AI companies out there who did not rise over the last year on a stock price basis.
Yet they grew revenue and profitability 50%+.
And those companies are earning you 10% yield on your cash… wayyyy higher than treasury rate.
In other words, those are the companies you want to own, those are paying you for the risk.
So when investors throw out all of the AI pure plays and stocks tank…. your job is to find the baby in that bathwater, buy the baby, and hold on for dear life as it’s going to be a volatile ride as the rest of the water gets drained out.
Good luck!
~Don Stein
SUBSTACK.MEETDONSTEIN.COM
https://x.com/donversationz