Rube Ex Machina

A way to think about a portfolio is like a Rube Goldberg machine. You put some money in. The money passes through a lot of seemingly random stocks, bonds, other financial things and, at the end, you get your money back, plus a return. Almost magic.

If we peek inside the LCM/Rube Goldberg machine, one of the ways LCM scores the portfolio is by bucketing investments into "Profit Now" and "Profit Later." Profit Now companies are determined by, well, they make money today. Pretty straightforward.

Profit Later companies include ones that do not make money today. Also, pretty obvious.

But why are “Profit Later” companies worth anything?

One of the topics you'd cover in An Afternoon of Investing Knowledge is that it mostly requires some cash up front with the understanding that you'll start getting your money back plus a return sometime in the future. Not immediately. Profit Later companies are still in the phase where they’re spending more money than they make. LCM’s Profit Later investments mostly have contracts, customer agreements and other structural things that ensure that they'll make money at some point. They're not quite there yet.

I'll table the "Later" companies for a moment and focus on the Profit Now ones.

The good folks at Stanford University have been preaching the idea of replicating a pension as the right goal for a long-term investment portfolio. The idea here is that an investor shouldn’t care so much about the price of an investment today as long as it generates sufficient income in the future.

Pensioners don't think too much about the lump sum of their asset; they think in terms of “I’ll get $3,000 a month, forever,” or whatever their pension check is. An ideal investment would be one that produces future income at a price of zero! We’d buy all of that. But until we find that one, we’ll settle for maximizing the amount of income an investment throws off for a given price.

This is the stuff that I get excited about and why I’m the one sitting at my desk writing about it while you’re hopefully spending your summer kicking up dust in Mojave, hiking in Steamboat or sailing into a slip in Monaco. Different strokes.

From these two very broad questions – “does it make money?” and “how much?” – LCM looks at the portfolio as if it were just one company or just one bond. LCM didn’t come up with this framework. A guy named Warren in Omaha uses a similar schtick to “look through” to all his holdings and evaluate them as a single investment.

So, grab a cherry coke, a handful of See's candies and we'll take Uncle Warren's look-through analysis for a spin.

As of June 30, LCM's overall portfolio conjured about $7.60 in cash in the past year for every $100 invested. For the S&P 500, a similar investment would produce just $2.40 in cash. So that's $5.20 (or 3x!) more generated by the LCM portfolio than the broader market.

This cash all came from LCM's Profit Now portfolio, which made up just 52% of the pie. For the S&P 500, about 75% of the companies are profitable. For just LCM’s Profit Now portfolio, investments drummed up cash of $15.00 for every $100 invested versus $3.24 for profitable S&P 500 companies (4.5x here!).

But are they just junk (you ask raising your eyebrow)? Is the LCM Profit Now portfolio made up of cigar butts ‑ companies that are profitable today, but will blink out of existence because of obsolescence, competition or changing tastes?

Like the Profit Later portfolio, most of the Profit Now companies operate under high-quality, long-term contracts ensuring they'll be around for a while, ensuring they'll continue churning out cash. Many of them were recently Profit Later companies that turned the corner and still have room to run. From the end of 2021 through June 2023, cash earned by LCM's Profit Now portfolio grew 171%.

Maybe they’re just tiny, weird companies that no one can trade into or out of?

The average market cap for a company in the S&P 500 is $74 billion. The average value for a company in LCM’s Profit Now portfolio is $67 billion, so a bit less, but not by much. The Profit Now Cos are largely outside the S&P 500 for various reasons, but those reasons aren’t profitability, growth and mostly not due to size.

What do they do with all that cash piling up?

LCM loves cash coming back from its holdings. The companies generating the most cash all have programs returning it to shareholders. They’re paying dividends. They’re buying back shares. Only where appropriate – where they can earn a sufficient return – are they reinvesting back in the businesses.

This last piece ‑ shareholder returns ‑ closes the loop for the Profit Now portfolio. LCM makes an investment. Cash goes into the Rube Goldberg machine. Profit Now companies do their thing. Voila: invested capital comes back home, plus a return.