Alignment Quality

金融风暴不可怕,可怕的是心灵风暴; 景气不好不必惊慌,怕的是人心不安。

Translated in English, it reads: “The vicissitudes of the capital markets are insignificant compared to the disturbance of one’s soul; there is no need to panic amidst a lacklustre economy but of great concern if one’s mind and heart is not tranquil.”

It may take many years of practice to achieve a state of equanimity as a human. And as an investor, I’ve learned that one of the ways to help attain peace of mind in investing is by zooming on two factors, after the usual stuff that we look out for, namely Valuation and the Quality of Management.

Valuation

Valuation is the only factor that an investor has full ownership of and can choose to align herself as an investor with the management

To illustrate, consider the case of Microsoft back in the late 1990’s during the infamous dotcom bubble’s bull run.

At the height of that gold rush, investors were literally queuing up to buy Microsoft’s shares either directly or indirectly through their mutual funds and Exchange Traded Funds (ETFs) etc, at a price range of USD30 to USD59.97 per share which translate to EV/EBIT valuations between 26.8x and 55.4x, respectively.

Now get this right – Microsoft is (and continue to be) a profitable and sustainable business run by honest management and has the largest PC/ laptop market share in the world as well as being the de facto leader in their Office Suite of applications. More than 90% of the developed nations’ student population use their products.

They were the Netflix, the Amazon and the Google of their time, we shall call this trio NAG – Microsoft utterly dominated their industry and were the largest of their kind.

Yet an investor who invested in Microsoft at 55.4x EV/EBIT (USD59.97) would need to wait more than 16 years to breakeven on their purchase price (Chart 1)

Chart 1. Historical price chart of Microsoft (NASDAQ:MSFT). Source: Google Finance

Granted they started paying dividends from 2003 so the actual breakeven time would be shorter, but you get the point. 16 years to breakeven means the investor got a return on investment of 0% after waiting for 16 years. Even if said investor bought at the lower range of 26.8x EV/EBIT (USD30), after 13 years the ROI would have been around 0% (Chart 2).

Ouch.

Chart 2. Historical price chart of Microsoft (NASDAQ:MSFT). Source: Google Finance

Now consider the same company in 2014. If an investor bought into Microsoft on 7 February 2014 and held on to the shares through the vicissitudes of the capital markets, today the investor’s gain will be about 175% excluding dividends (Chart 3). That work out to be around 28% Compound Annual Growth Rate (CAGR) i.e. 1 x 1.28775 x 1.28775 x 1.28775 x 1.28775 = 2.75.

Chart 3. Historical price chart of Microsoft (NASDAQ:MSFT). Source: Google Finance

Scooping up Microsoft shares on 7 February 2014 valued the company at about 9.3x EV/EBIT which is a fair value by most measures, especially by today’s bullish sentiments as well as in late 1999. Microsoft’s valuation continued to march up from 9.3x to 12x in 2015, to 18x in 2016, to 23x in 2017 and to today’s 28x.

Simply put, an investor who invested in Microsoft in 1999 at 26x EV/EBIT to 55x EV/EBIT is not aligning her interest to the management’s, because management most likely “got in” earlier and at a (much) cheaper valuation. Investor lost and management win less (only lose their paper gains).

By contrast, an investor who invested in Microsoft on 7 February 2018 at 9.3x EV/EBIT is more likely to have aligned her interest to the management’s because if the price and valuation got any lower it will have a tangible and real impact on management’s net assets based on the price they got in. Investor win and management win (If it got any worse then Investor lose and management lose).

Quality of Management

On 4 February 2014, one trading day before our chosen comparison date, Satya Nadella was appointed as the CEO of Microsoft, he is of Indian descent and was the 2nd CEO of Microsoft after Founder Bill Gates passed the baton to Steve Ballmer in 2000. He had been with Microsoft for 22 years then and was their executive vice president of Cloud and Enterprise Group before leading the team as CEO to focus on developing their cloud systems which transformed Microsoft’s products radically to keep up with the times of cloud and distributed computing.

In some rare interviews, Nadella shared that his success of leading the Microsoft team to their new heights (fundamentally, not the share price) was attributable to ONE FACTOR – Empathy, or the ability to feel for someone else.

He also shared how he, as a young man, had a humbling experience when he was turned down definitively in an interview after the interviewer asked him “what will you do if you see a child crying after having fallen down?”, to which he worked his brain to their limits and came up with an almost robotic, algorithmic answer “Call 911.” Funny how us software engineers think.

Nadella’s expanded ability to feel for someone else comes from his first child, Zain, who was born with severe brain damage and had developed cerebral palsy. Nadella was devastated at first but eventually came to realise nothing had happened to him.

“Really something has happened to my son,” Nadella said he told himself. “It’s time for me to step up and see life through his eyes and do what I should do as a parent and as a father.”

Adding on, “Most people think empathy is just something that you reserve for your life and your family and your friends, but the reality is that it’s an existential priority of a business,” Nadella told Bloomberg in 2017. “I think empathy is core to innovation and life’s experience.”

Nadella proved to be highly intelligent, hardworking, honest, and having perhaps the rarest trait of CEOs, Heartful.

The question is what could we as investors learn from Microsoft’s twenty year journey? Would it help us if we can identify the next Satya Nadella or Tadashi Yanai (of Fast Retailing) on other companies? Could we learn what are “fair” and “ridiculously low” valuations as opposed to what is “high” or “stratospheric” valuations?