Martin Shkreli Finance Lessons: Notes & Takeaways

Lesson 1

Source

• Most people (99%) become successful by managing Other People’s Money
• e.g. pension funds, banks, hedge funds (Sculptor Capital fka. Och-Ziff Capital, Citadel), Carlyle, Fortress, Berkshire (only half owned by Buffett)
• Tiny percentage (1%) of people become successful by managing their own money (Family Office)
  • e.g. George Soros, Carl Icahn, Michael Bloomberg, Michael Dell, Steve Cohen, Bill Gates (Cascade Investment LLC), Joe Lewis (currency trader)
• Better route is to gain some skill that someone will pay you a lot for.
  • Someone should be willing to pay you for your advice if you are actually “good” at this.
  • Fee income may be better than income based on own capital (higher risk)…
• If you can make 20% per annum with Other People’s Money, generally that is sus.
  • Buffett’s LT return p.a. is only 15%
• Better to listen/take advice from “Legends” who have made $100M to $1B vs. people who have made $1M on accident.
  • Rather wait for the right mentor since its hard to shake bad habits.
• Myth: Unable to access really rich people
  • Build your network: You can’t access Buffett, but you can know friend of Buffett, or friend of friends
  • Examples: Einstein in-person meeting with famous physicist, Palmer (founder of Oculus) – be brilliant at one thing)
• Will not be successful if you only focus on 1 asset class

Teach Yourself by Learning from the Best

• Top Priority: Read everything by Warren Buffett & Charlie Munger, books, annual letters, old hedge fund letters from Buffett
• Read everything you can from the famous investors (e.g. Carl Icahn)
• “Corporate Finance Textbook – Brealey & Myers” (Cheaper version here)
  • Shkreli got this textbook for 14th bday
  • Not technical, much more philisophical
  • Whole Major in 1 PV formula
• “Phil Fisher – Common Stocks and Uncommon Profits”
  • Practical book
  • “Scuttlebutt” originates from here. Means talks, rumors about the company.
  • A manual on due diligence – e.g. channel checking
• “Seth Klarman – Margin of Safety”
  • Practical book
• Thinks the two books above replaces the Graham-Dodd books; does not recommend Graham-Dodd books

Basics

• Price = The price of one share. Does not mean much. Just the last price.
  • Has no correlation to total value of company
• Mkt Cap = Total pie. =Total outstanding shares * Last price.
• Cash = Cash + ST investments + Marketable Securities + Equity Method Investments + Other investments
  • Cut it off at accounts receivable (takes 45-60 days) and inventory
• Debt = ST debt + Loans and notes payable + Current maturities of LT debt + LT debt

Lesson 2: Financial Statements, Apple Model

Source

• 8K: Any material/disposable event
• 13G/D: Ownership statement (“big ballers”)
• Spend a lot of time on IS/BS, then graduate to CF statement.
• Important metric to look at: Net Cash / Market Cap
  • Eg. Apple had $150B in net cash (excl. debt), and with a $500B market cap, 30% of the market cap is in cash.

Balance Sheet

Assets

• Goes in the order of most liquid to illiquid
  • Cash
  • Marketable securities (bonds, equities)
    • Martin adds in Long Term marketable securities (likely 2050 US govt bonds) to cash
  • Acc Receivables
    • Usually paid in 30-60 days
    • Figure is inclusive (net) of bad debt
  • Inventory
    • Includes raw materials, work in progress (WIP aka half finished products), and finished products
  • PP&E
    • Hard asset (buildings) with a useful life of 1+ year (required!)
  • Goodwill & Intangible Assets
  • Other Current Assets (Prepaid expenses)
    • Eg. Money earned by MSFT when you pay on Jan 1 for a subscription
• Look up unfamiliar line items in the financial statements such as:
  • “Vendor non trade receivables” in Apple’s BS

Liabilities

• Accounts Payable: Expenses that you have to pay on a paycheck-to-paycheck basis (more ST oriented)
  • e.g. you have to pay $2K to an employee in the upcoming 2 weeks in exchange for work
• Accrued Expenses: Total expenses that you have to pay sometime in the future (more LT oriented)
  • e.g. you have to pay a senior partner $10M bonus for targets achieved by the end of the year
• Deferred Revenue (aka Unearned Revenue): Received $ for undelivered product.
  • e.g. Tesla Cybertruck, gift cards
• Commercial Paper: Loans from banks

Shareholders Equity (SE)

• Shareholders Equity (SE) = Book Value
• Shareholders Equity (SE) = A – L
• Tangible Book Value = SE excluding intangibles/goodwill

Income Statement

• Revenue
  • Definition: When the title of the product is passed to the customer
  • “Revenue Recognition” rules are the most important thing to look at.
  • Remove inter-company revenue
  • Rules for returns
• Example: I get paid $10M cash to promote product over 4 years
  • IS: Each quarter revenue: $625K
  • BS: Cash: +10M, Deferred Revenue +9.375M
• COGS vs. SG&A
  • COGS: Costs to make the product.
    • Labor to create iPhone and factory managers’ pay are included in COGS per Martin
  • SG&A: Costs to run the company.
    • Tim Cook’s salary, rent for office buildings, legal expenses, marketing
• Tax Rate = Taxes paid / Pretax income
  • Denominator is not revenue

Time Value of Money

• Discount rate (r) = risk free rate (aka interest rate and usually equal to inflation rate) + risk premium (aka risk of default)
  • Risk free rate: The % return you expect to earn on CF now vs. CF later.
    • Can earn 1.5% from US risk free bonds.
  • Risk premium: The riskiness of the cash flows.
    • US govt is risk free so rp = 0%, Brazil is risky af so rp = 6%.
  • High interest rate (7.5%)
    • –Martin’s perpetuity is worth less cuz u can reinvest for high interest rate now vs. later.
  • Low interest rate (1.5%)
    • ++Martin’s perpetuity is worth more cuz you don’t earn much more by reinvesting now.
• $1 today > $1 tomorrow
• Opportunity cost = risk
• Most fortunes are made because someone correctly predicts that a black swan event happens or doesn’t happen.
• PV Perpetuity = 1/r
• Dividend Discount Model = 1/(r-g)
• Excel =NPV(r, Series of CFs)

Lesson 3: Guide to Fundamental Research

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Summary of How to Value a Company

• “A company is worth the discounted sum of its cash flows from today until eternity.”

Guide for how to do Fundamental Research

• Use Common Stocks and Uncommon Profits as a guide
• Reach out to IR team for any questions, its their job to talk to you

1. Read 10-K to learn about (in detail) what each Business Segment does

• Each business segment has its own tab in the Model
• In each revenue segment: who are Clients/Customers? who are Competitors?

2. Listen to the earnings conference calls on the website, while reading the earnings decks

• Tip: Go to Press Releases instead of 10-K for quarterly earnings data, and 10-Q’s for the rest

3. Read a minimum of 1 year of press releases and take notes/update model with them.

4. Grill management

• Trust determines how high (bad) or low (good) the discount rate is – do you trust the CEO to be able to generate sustained/grow CF for the next x amount of years?
• Red Flag if CEO cant be bothered to join earnings conference call

5. Rinse and Repeat on peers, customers, suppliers in order to understand the entire supply chain.

• Who to Ignore:
  • Other investors, Wall St. Research, TV/CNBC
• Bonds
  • Debt where lender gives borrower funds and expects to be paid back with interest.
  • Senior to equity
• For NPV: Equity discount rate must be higher than debt’s discount rate since debt is senior to equity.
• Discount the cash flows (NI)
• Don’t forget to get Terminal Value as well, discounted to today

Lesson 4: IBM Model (Value Co)

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1. Project out rev/NI
2. Terminal Value = Apply a -3% NI decline for the rest of infinity
3. =NPV( discount rate, the NI stream in step 2)
4. Project out Net Cash + NI for the rest of infinity
   • ROIC = The rate of return IBM can earn on their Net Cash balance. Martin used =Interest Income (in “Other income” in IS) / Net Cash balance

• Example: if 12x P/E or EV/Earnings multiple: it will take 12 years to get your money back.
• Flipped around is the Earnings Yield (E/P or Earnings/EV)
  • Compare this % yield to what a 10-year bond yields.
• Remember to adjust for currency swings:
  • Look up USD/EUR historical prices over quarters. If USD/EUR has dropped, this means the Euro has dropped significantly.
• No arbitrage concept: Stock prices and news have nothing to do with each other
  • Everyone knows good news is coming, so there is no upside left.
  • Has to be a surprise vs. expectations to generate alpha.
• Red Flag: When companies say that this 1 segment of their business is doing very well, that means the rest of their business is falling apart.
• On average, 8 out 10 stocks will be fairly valued, 1 will be cheap, and 1 will be overvalued

Lesson 5: Alarm.com (ALRM) Model (Growth Co) and AT&T Model

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• Narrow your universe to the area you want to focus on, are most interested in, and you think can generate the most alpha.
  • This is your Main Database page that you come to and will link off towards external models
• Number of employees is important
• This concept I still don’t really get: Apparently a lower P/E is bad since the earnings yield is higher.
  • E.g. AAPL 8x EV/E vs. IBM 13x EV/E
  • 12% AAPL E/EV vs. 8% IBM E/EV, so investors are assigning a higher discount rate (riskier) to AAPL vs. IBM…
• D&A
  • Do not include D&A in EBIT/NI for SaaS Co’s since it is a non cash expense
  • Include D&A in highly asset intensive industries such as telecom, energy
• Operating Leverage definition: NI Y/Y growth should grow faster than Revenue Y/Y growth since your costs will only grow equal or less than revenue growth
  • If rev +10% Y/Y, costs should only grow equal or less than 10%, so resulting NI Y/Y growth should be >10% Y/Y
• Depreciation (to expense tangibles) and Amortization (to expense intangibles)
  • Depreciation Expense for any PPE (useful life >1 year) is not included in IS
  • Capex expenses for PPE is expensed as Depreciation expense/n years of life

Cash Flow Statement

• CFO
  • Swung by Acc Receivables and payables. Not as stable as NI per Martin.
  • Add back D&A, usually the biggest swing factor
• CFI
  • Capex will show up here, any purchase of PP&E

Lesson 6

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• Almost all corporate activity on planet is done in aim of creating equity value through increased stock value or dividends.
• For every seller there is a buyer.
• What is the ideal number of stocks in your portfolio?
  • The more the better, but both have winners
  • Diversified: Renaissance and Steinhardt (2 famous outperforming hedge funds with 100-1000 stocks in port)
  • Concentrated: Buffett’s early portfolios, Sequoia
• Excel IRR formula: =RATE(5 years, 0, -10, 20)
• “Securities Lending Payable”: Means the company is short stocks
• NI is a smoothed out CF statement. CF is more granular & volatile – shows how a business moves it about on a quarterly basis.
• To Value Growth Stocks Like FB:
  • Use ARPU*DAU as a better estimate from straight-line revenue growth
  • Check Y/Y growth rate of users (volume growth)
  • Check Y/Y growth rate of ARPU (price increases)
  • …and compare against Y/Y revenue growth rate
  • Comp prices against peers per month, and if you would pay that amount per month

Lesson 7

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• Read No Bull by Michael Steinhardt
• Watch out for tail risk (5 sigma moves)
• Prefer steady upward trend with minimal drawdowns
• Martin likes 10-20% of stop loss as max
• Position sizing: no position greater than 10% of port
• Comparables in main database can tell you alot of interesting things:

• Google competitor analysis:
  • Total TAM ($600B ad spend) – what is its growth and Google’s market share?
  • Google’s market share vs. Facebook, WPP, Omnicom (traditional media, radio, TV)?
• 1. Growth of the CFs vs. 2) Risk to the CFs
  • Look at both to calculate value
• Common Shares: Shares that are not subject to an event
• Diluted Shares: Includes shares that are convertible upon certain events (employee stock options)

Lesson 8

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• Left off at: 1:10:00
• Short: Borrowing shares
• Buy side (investors): mutual funds, hedge funds, pensions, individuals,
• Sell side (investment banks): Service the investors. securities research, securities trading, ibanking (lending – if IBM wants to issue debt, you have to go to a bank and they will coordinate with the buy side folks, M&A advice, underwriting)
• Stock recs
  • Ignore everyone else’s opinions
  • Time is better spent researching your own independent opinion
• Level 1 ADR: Sponsored by the company, company makes US filings
• Level 3 ADR: Not sponsored by the company, company does not file in the US (e.g. TCEHY)
• Make sure 1 ADR = 1 Overseas share, could be different
  • 1 ADYEY share = 0.02 ordinary
• Hard to find Asian and European companies’ total shares outstanding on their materials
• Excel: =TRIMMEAN(A1:A10,80%)
  • Only data points that are within 80% of the median are included
• Intel Model
  • No revenue growth stocks trade at similar multiples. Expected.