Take 19 - Random Investing Notes
A collection of insightful investment pieces to broaden and elevate the investing mindset. Includes: 1) Stock-Based Compensation, 2) Loyal Monopolies, and 3) Interest Rate Cuts.
A Take on Stock-Based Compensation
Stock-Based Compensation (SBC) is when companies pay employees with shares of stock or stock options instead of cash. It’s a non-cash expense but still dilutes shareholder value. Often overlooked, SBC can quietly erode investment returns.
🧠 Why Companies Use SBC
Small businesses use SBC to reward employees without draining cash.
Big Tech uses SBC to attract top talent in a competitive market.
SBC aligns employee incentives with company performance—but at a cost to shareholders.
📊 How SBC Is Recorded in Accounting
Even though no cash changes hands, SBC is treated as an expense. Here's how it flows through the financial statements:
1. Income Statement
SBC is recorded as part of Operating Expenses (usually under R&D or SG&A).
It reduces Net Income, just like any other expense.
Revenue: $1,000,000
Operating Expenses (including SBC): $700,000
Net Income: $300,0002. Cash Flow Statement
SBC is a non-cash expense, so it’s added back in the Operating Activities section.
This can make Free Cash Flow look better than it really is.
Net Income: $300,000
Add back SBC: $150,000
Operating Cash Flow: $450,0003. Balance Sheet
SBC increases Shareholders’ Equity through Additional Paid-In Capital.
It also increases Total Shares Outstanding, which dilutes existing shareholders.
🧮 Why It Matters to Investors
Dilution: More shares = smaller ownership slice for each investor.
EPS Impact: Earnings Per Share (EPS) drops because the denominator (shares) increases.
Misleading Cash Flow: Since SBC is non-cash, companies may appear more profitable than they are.
✅ Investor Takeaways
Always check if Total Shares Outstanding is rising.
SBC as a % of Net Income should be below 10% (both current and 5-year average).
Subtract SBC from FCF to get a realistic view.
The argument for including SBC as a subtraction from free cash flow (FCF) is based on the idea that SBC has an economic cost that indirectly affects cash flow, particularly for shareholders.
📘 Practical Considerations
Context Matters: The decision to subtract SBC depends on the analysis’s purpose. For example:
Valuation: If you’re valuing a company with significant SBC (e.g., tech firms like Google or Meta), subtracting SBC might better reflect the cash available to shareholders after accounting for dilution or buybacks.
Cash Flow Analysis: For assessing a company’s ability to fund operations or pay dividends, the standard FCF (without subtracting SBC) is more appropriate, as it focuses on actual cash flows.
Monopolies of Customer Loyalty
Hidden monopolies dominate niche markets not through size or visibility, but through deep customer loyalty, which acts as a powerful and durable moat against competition.
A moat refers to a company's sustainable competitive advantage that protects its market share and profitability from rivals.
Traditional moats like patents, scale, or market share can erode due to tech shifts or regulation.
Customer loyalty, however, creates predictable revenue, lower acquisition costs, and stronger margins.
🏗️ How These Companies Build Loyalty
They embed themselves into daily operations.
Create high switching costs (contracts, training, proprietary systems).
Deliver consistent quality and expand offerings.
Focus on customer satisfaction, not competitor obsession.
⚠️ Threats to Loyalty Moats
Complacency and lack of innovation.
Regulatory changes or antitrust actions.
Poor integration after mergers.
Low switching costs or poor service can erode loyalty.
Interest Rate Cuts
Central banks globally have been easing interest rates for some time, and now the U.S. Federal Reserve is signaling it may follow suit with cuts in the near future—a notable pivot from prioritizing inflation control to fostering economic growth and employment.
📉 Why Lower Rates Matter
Lower interest rates reduce borrowing costs, boost valuations, and encourage investment.
Capital-intensive sectors like real estate (REITs) and utilities benefit significantly.
Growth stocks (e.g., Microsoft, Meta, Shopify) tend to rally as future cash flows are discounted less.
📉 Short-Term vs. Long-Term Rates
Central bank rate cuts directly affect short-term interest rates (like the federal funds rate in the U.S.), which influence borrowing costs for things like credit cards, auto loans, and short-term corporate debt.
Long-dated debt (like 10-year Treasury yields or 30-year mortgages) responds more to market expectations about inflation, growth, and future monetary policy — not just the central bank’s current moves.
📈 Market Reactions & Risks
Rate cut signals often spark market optimism and rallies.
However, past cycles (2001, 2008, 2020–2021) show that unprofitable or over-leveraged companies may still fail.
Investors should avoid chasing fragile businesses that temporarily benefit from cheap debt.
🧠 Why Long-Term Rates Might Stay Elevated
Although central banks globally have been lowering short-term interest rates, yields on long-dated bonds have actually climbed. This means that even if the Federal Reserve initiates rate cuts:
Inflation expectations could remain high, keeping long-term yields elevated.
Government borrowing (e.g., rising deficits) can push long-term rates up due to increased supply of bonds.
Global demand for U.S. debt may weaken, requiring higher yields to attract buyers.
🏦 What This Means for Investors
Capital-intensive sectors like REITs and utilities may benefit from lower short-term rates, but refinancing long-term projects could still be costly.
Growth stocks might rally on lower discount rates, but if long-term yields stay high, valuations could remain under pressure.
Bond investors need to be cautious — falling short-term rates don’t guarantee gains in long-duration bonds.
I have explained this in my latest publication below.
It’s the Long End That Moves Markets
Ever notice how mortgage rates or car loans sometimes rise even when interest rates are being cut? A recent thread by @_Investinq on X reveals a major shift in how the U.S. Federal Reserve (the Fed)—America’s central bank—manages money and bonds. This shift began during the 2008 financial crisis and has left the Fed in a tough spot that affects all of u…
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