Welcome back everyone. We have another exciting episode of the Joseph Carlson show and this time it's centered around an investor named Terry Smith. If your listener of the Joseph Carlson show you've heard of Terry Smith before, but if you're new, Terry Smith is a great investor. Not only is it great investor, but I think he's overall just a cool guy. He's someone that's outspoken. He really speaks his mind on any topic.
He's beat the market. Since the Inception of his Fund in 2010, he has an investing strategy. That's both rational focal. This is strongly on risk-adjusted. Returns, doesn't try to time the market and overall, I just think he's a very sensible well-adjusted investor. That will likely beat the market for a long period of time. He categorises his strategy into three parts, buying good companies, not overpaying and
then doing nothing. Now, the strategy is a little bit more complex when you dive into it. But that's the three basic pillars. One thing that you may not know about Carrie Smith unless you've read about him, is that he's incredibly competitive. This guy is competitive. He Likes to win. He likes to come in first place and you can see that with how he conducts himself, and he's also very outspoken.
And I would say even a ruthless when he finds incompetence in companies that he's investing in companies in the market or incompetent management teams in his latest investor letter, he is ruthless. He calls out companies directly he calls out management teams directly he calls him out for poor management. He calls him out for deceptive accounting practices and he even calls him out for virtuous
signaling. When the letter is an outright tongue-lashing for these companies, I think there's a good chance that some Executives will be fired, as a result of this shareholder letter. And that would not be the first time that Terry Smith has gotten Executives fired. He also dives into a topic that I spent some time thinking about that I've made episode after episode about the topic of stock-based compensation. Now, there's nothing wrong with stock-based compensation in and of itself.
But the problem is how these companies account for stock-based compensation. In many cases is highly deceptive and now after making multiple videos on the subject, we have Carrie, Smith weighing in and he does. So in his manner of being, extremely detailed and straightforward. So Terry Smith has a lot to say in this letter and he says a lot, this is going to be an exciting episode. It's jam-packed with information, we have a lot to get to. So let's go ahead and Jump Right In.
Now, part of the reason I like Carrie Smith is because he views investing very similar to the way I do not the same, but Terry Smith is one of those investors. That I do, give some inspiration and I get some thoughts from him on investing in different potential companies. When I'm looking at my portfolio, I'm always concerned with buying companies that have high returns companies that can reinvest back into their business and get very high returns.
As a result, these are high-quality companies and this is specifically what Terry Smith looks at companies that you can buy in to hit your wagon to and year after year. After year, they will produce a tremendous economics for the investor. They'll be able to pay dividends, they'll be able to do by packs. They'll be able to reinvest at high rates of return and they also have incredibly low downside risk.
These are the type of companies I'm looking for, I call them Compounders Terry Smith calls, them, good companies. So even though I don't marry his portfolio and I don't invest in all the companies he does, I will look at his 13f filings and see what he's doing. Try to keep track of it because when Terry Smith buys a company, it's already gone through an extensive screening process. So I know that he's already looked at some things with a company and that can spark some
ideas for future research. Now, we have his portfolio hair and he has made changes to it. And that's what he talks about in his latest letter. Dear fellow investor, this is the 13th annual letter from fun Smith, equities fund, our funds performance in 2022 will give Credence to those who suffer from tricycle, Deca phobia. Now, I don't know what this word was. I didn't know what it meant. I looked it up and it means a fear of the number 13, which
makes sense sir. But to start off, he goes over the performance of the fund. The table below shows, the performance figures for the last calendar year and the cumulative and annualized performance since Inception on November 1st, 2010 and various comparators, we have the total percent return of funds, Miss Equity, Fund, it underperformed, its Benchmark index last year, the Benchmark, which he compares to, as down 7.8%. He was down 13.8. He did go through a period of under performance.
Now, the annualized performance and cumulative performance is much better. Better. He's made about double the gains of his Benchmark index. So, overall, since the start, he's doing well, but last year was not a great year and he addresses underperforming last year whilst a period of under performance against the index is never, welcome. It is nonetheless, inevitable. We have consistently warned that no investment strategy will outperform in every reporting and every type of Market
condition. So, he says, as much as we may not like it, we can expect some periods of under performance, which is entirely reasonable. To performing the msci. World index is one issue. Registering a fallen value is another in 2022, unless you restricted your Equity Investments to the energy sector you were almost certainly to have experienced a drop in value. If we look at this performance chart of the different sectors in 2022, energy is the only sector that in aggregate went
up, and it went up a lot 59%. So Berkshire with their huge, massive energy Holdings did well in 2022. But everyone else to as exposure to all these other Industries, probably lost money for most investors, I would say 99% of investors, they lost money in 2022. Utilities was down Consumer Staples is down Healthcare Industrials. Materials Bank software and services. Real estate was down except for Vici. Shout out to Vici. There was up, 12%, consumer, discretionary, communication
Services, all of that was down. So basically, don't feel too bad if you lost money in 2022. That's the way the market works now. Next part of this letter, he gives a history lesson and it's like five pages long.
I'm not going to go over all of this but you can read the letter if you're interested in the long history lesson on interest rates because it does explain his funds performance I would summarize this history lesson in this one paragraph he says it is inevitable that when interest rates rise as they have now to combat inflation, longer-dated bonds fall more than shorter
dated bonds. And so it is with equities with more highly rated shares, meaning higher Multiple companies, which are discounting earnings or cash, flows, further into the future. Highly rated companies, suffer more in a downturn than lowly rated ones are so-called value stocks. Now, he doesn't entirely blame interest rates. He also notes that meta had some big problems with competition with the Apple changes and with them going all in on the metaverse that spooked
investors. So he brings up other things. He's not making excuses, but he does note that longer duration assets, which are highly rated companies, they do get a Acted more in downturns than value stocks which have their cash flows coming to you almost immediately and then right off the bat, Carrie Smith starts to dig in to individual companies. He first starts off with PayPal saying that PayPal seems intent on snatching defeat from the jaws of Victory.
It is taken a leading position in online payments and parlayed that until lamentable share price performance. The elements of this would appear to be a disregard for engagement with customers, newly acquired during the pandemic and no obvious attention to or control of costs. So he's pointing out two things there for PayPal, but he doesn't end there. He continues on an even intensifies, his criticisms towards PayPal.
This is hardly surprising given the attention devoted to pursuing some clearly overpriced Acquisitions. That is what happens when management starts to conclude that Investments do not need to earn an adequate return in this line, I think is spot-on. This is a huge problem right now. Companies doing merger and acquisition after merger and acquisition and Hit at horrible prices, horrible rates of return.
I just did an entire episode on my other channel going over, Disney's acquisition a fox and how overpriced that was. So, this is something that's a problem with more than just PayPal. If one word could be used to describe last year's winners, it would be defensive out of his biggest winners last year to or fast-moving consumer goods companies and one is a drug company. So interest rates did play a part in the valuation, collapse
of a lot of companies. The higher valued one's, Got further discounted as interest rates went up, but he notes that that's not the only thing going on. There's a lot of Shifting economics here, the cyclic ality of tech spending an online advertising is probably about to become evident as the economy slows and maybe falls into recession. It may be greater than in the past, simply because Tech spending has become a much larger portion of the overall corporate and personal spending.
However, there may be a silver lining In This Cloud as this pressure on Revenue growth may cause Some companies, some of their tech companies that they invest in to behave as though money is not free and the halt, some of the less promising projects outside of their core businesses, so he's finding some upside and what's going on right now as interest rates go up, companies can no longer make as many stupid decisions without
consequence. So it's actually forcing companies to become more prudent and well managed by them, having a cost attached to Capital and this is something that I really do enjoy. Enjoy.
I like the investing environment today more than I did two years ago, two years ago, bad companies were going up in stock price for no apparent reason other than Dreams by investors companies were not being accurately priced and now we're getting to an environment where companies are actually being priced based on their current cash flows.
And realistic assumptions about the future gains from companies is going to be much harder earned in today's environment, and that is something that I think is better for the economy. He names three companies that are actually. Adapting to this new environment, alphabet, which I've noted many times, has a bloated corporate structure, a lot of overpaid employees, a lot of bloat, they also have a huge
money-losing, other bets. He notes that lightning does not strike twice alphabet struck, lightning with their search business and that's unlikely to be replicated. No matter how much money they throw at it Amazon, they're also cost-cutting. It's already withdrawn from its food, delivery and Technical education, and India, and it has highly successful e-commerce and cloud computing.
Shooting business on which to focus and then we have Meta Meta stock price would have been fine if it didn't torpedo Itself by focusing. So intently on the metaverse, they say, without the spend on the metaverse, they would own a leading communication and digital advertising business on
a single figure PE ratio. So you get the best of both worlds, a high quality company at a low valuation, this brings back to their strategy of buying, good companies, not overpaying and doing nothing in. This is where they go through each leg of the Strategy. One of my favorite things in Terry Smith's updates is this look through portfolio. And what they basically do, is they take all of these metrics, like, the Returns on Capital employed, gross margins and they
combine it into one company. So you can see their entire portfolio mush together into one company and then you get an overall idea of how powerful a company it is. If it was a single company and then he Compares that against the S&P 500. As if the S&P 500 was one big company and he ill The streets by this comparison that his company is a better company than the aggregate of the S&P 500. So we look at the Returns on Capital employed, which is
always number one. The first thing Terry Smith looks for 32% for his portfolio in 2022, 18% for the S&P, 500, gross, margins 64 percent for his portfolio. 45% for the S&P 500 operating margins 28 percent against 18, cash conversion. That's the only one that's identical between In the two and then interest coverage, this is the amount of Leverage, the higher, the number, the better. That means that you cover your interest payments by a higher degree, which just means he has
less levered companies. They have roughly half the amount of Leverage then the companies in the S&P 500. So he beat them on returns. He beat the company's on Gross margins operating margins. He had a tie with cash conversion and then he beat them by double on Leverage overall. Terry, Smith's portfolio is much stronger, much stronger than the S&P 500. Oh, oh, and Terry Smith has consistently worked to try to highlight the differences.
This makes in the total returns and the long-term returns of companies. Consistently High Returns on capital r, one sign we look for when seeking companies to invest in another is a source of growth High returns are not much of a use. If the business is not able to grow and deploy more Capital at these high rates. So the perfect business is one that has high Returns on Capital employed and a lot of opportunities to employ Capital. Now, he shows how Companies did economically in 2022.
They grew their Cash Flow by 1% so barely any growth. He didn't have much growth in cash flow. They barely edged up 1%, but if we compare that against the index, the index had the cash flows Fall by four percent last year. So the S&P 500.
Cash flows went down his cash flows, went up and this is especially impressive because Terry Smith's portfolio, grew cash flows by 20% in 2021. So basically they grew cash flows, a ton two years ago and then they still were able to grow cash, flows ever, so slightly the following gear. There's no huge regression. The S&P 500 is not growing cash flows. As fast as Carrie Smith portfolio, and the growth of cash. Flows is an incredibly important ingredient in valuation.
In this is where we get to the second part of the strategy valuation. Not overpaying for companies. This is probably the most common criticism I receive as an investor. I, by good companies. I'm just over paying for all of them. Any company that I'm buying because they're in the high 20s PE ratio. I'm overpaying for those companies in this is something that Terry Smith is also aware of and he's fought against throughout the entirety of
running his fund. People wondering why he's overpaying for these high multiple companies even though he's outperform the market for 13 years, the weighted average free cash flow yield of his portfolio is 3.2%. The year-end medium free cash flow yield of the S&P 500 was 3.4%. And roughly in line with his portfolio. And this is important because basically right now they have similar free cash flow yields in
terms of free cash flow. His portfolio selling for around the same price as the S&P 500. So the big determining Factor here of which one will do better. Terry Smith's portfolio or the S&P 500, it will be determined by their free cash flow, growth rate, whatever one can grow free, cash flow, the quickest over the next five years because they have roughly the same Point. And if I had a bet between the two, I think there's much better
odds. That Terry Smith's portfolio will grow free cash flows faster than the totality of the S&P 500. Because his portfolio consists of companies that are fundamentally a lot better than the average of those, either in the index or valued fractionally higher than the average of the S&P 500. He buys better companies that are simply better at consistently growing cash flows. So I'm looking at valuation on any company, I'm looking at this starting point.
Of the valuation. The starting point is the yield of the company. Texas Roadhouse has a free cash flow yield of four point one six percent. And like we just saw the S&P 500's, current free cash flow yield in aggregate, is 3.4 percent.
So we have a better valuation starting off with Texas Roadhouse but not only is the starting valuation cheaper for Texas Roadhouse but I also believe it will outgrow the S&P 500. I think the free cash flows will grow quicker, so that Of way of trying to outperform. Yes and P. 500, finding companies have starting yields as high around the same as the S&P 500 but which can grow their future cash flows at a faster rate than the S&P 500.
Now, the third part of this strategy is one that I think I struggle with the most, which is to do nothing. I think this is just mentally the most difficult part and investing in individual companies, which is to truly have a long-term mindset. I think doing analysis is fun. Doing analysis is Viv and I could do that for hours on end and really dissect and learn everything there is to learn about a company. I can find out the valuation, I can look at the future cash flow.
I can look at the downside risk of the company, I can assess the moat and I enjoy doing that. But doing nothing is something. I struggle with have a very difficult time, just sitting back and watching my portfolio from afar and doing nothing. So this is an area that I'm really trying to get better at this year. A real Focus trying to hold my companies for longer periods of time and only Then if things have really materially gotten worse for the company.
Now, Terry Smith tries to do this as well, minimizing portfolio, turnover remains one of their objectives and he says that they had a turnover of 7.4% that was around the same. As me around eight percent turnover last year. Now Terry Smith did sell and buy a number of names and this is where we get in to some of the juicy details of his criticisms about different companies. He says that we sold our steaks and Johnson & Johnson. Chuck's cone into it and PayPal.
The only company that I own is Starbucks and I've recently trimmed around half of this position because the price has surged up past $100 very close to its fair value. So, I've made some gains in Starbucks, but I still hold this company. Now, he purchased mettler Toledo, Adobe, Otis and apple. He sold a number of companies and he purchased a basket of new companies. And this is where the spicy criticisms start. Terry Smith starts to dig into these companies and he gives A
tongue-lashing. He really does not hold back and this is something that I appreciate he says last year I wrote about Unilever and attracted a virtual tsunami of comments and remarks about the company events soon. Overtook this commentary insofar as Nelson Peltz tree, and partners announced that it had bought a stake in Unilever and he was invited to join the board.
Now, this is interesting, Nelson Peltz is the one that just purchased a steak and Disney and he's trying to get a board seat on Disney because the company's doing so poorly, I want Nelson Peltz. To get on the board of Disney. I want somebody to get in there and to try to hold this executive team and these directors that have underperformed for a decade accountable. So I'm actually in favor of Nelson Peltz.
I think Terry Smith is too but he's frustrated with how these companies are conducting themselves. He says, once contact had been established with Unilever, we then tried to make some points about what we saw as problems with the performance of the business, and the focus of the management, which were duly ignored. This is a business making A non-capital in the mid to low teens below, the market average, where you could measure annual
growth. If you could only count to three and which missed every Target, it set out when summarily rejected the Kraft Heinz B approach. So it's not like there weren't some questions to be answered now. He says, I don't know how long tree and held its take before mr. Pelts was invited to join the board or how big of that steak was, but I would guess that they held it for far fewer months than we held it in terms of years. He says, we have no objection to mr.
Pelts involvement. But here is where Terry Smith gets to his biggest. Complaint, what I find questionable is that companies mouth platitudes about wanting to attract a long-term shareholders yet based on our experience, we tend to get ignored whereas an activist who has held the shares for far fewer months and we've held years gets invited to board meetings. That is the big problem here, they're not paying attention to
their long-term shareholders. They only pay attention to activists because activists muscle their way into companies. They do fights and Roxy fights, they force companies to pay attention to them. And meanwhile these companies are ignoring their long-term shareholders. One example, may just represent an outlier but what about PayPal? We had held PayPal shares since it was spun off from eBay. In 2015, we tried to engage with
PayPal as we identified. Seemingly long before the management that their lack of Engagement. With new customers was a problem as was cost control and that their Acquisitions were value destroying. In particular, we pointed out that the value Value destroying Acquisitions, might be avoided if management are enumerated.
Incentives, included, some measure of Returns on Capital, a representative of the board kindly told us, they would think about it and again, it requires muscle, it requires fair, and it requires power for them to actually pay attention. Whilst they were allegedly thinking about it. Elliott management who, by the way, it's ran by Paul singer. Who's one of the scariest guys in the capital markets. He's not like Nelson Peltz. He's not a friend. Work with Management in the same type of way.
He's one of the most feared investors in the entire Market. May be the most feared we have Carl Icahn and Elliott management right there. Kind of neck and neck is the most feared investors. He bought a stake in which led to them being given a board seat and information sharing agreement. Please don't misunderstand the criticism. I'm leveling here, I'm not
envious. I do not want a seat on the board of Unilever, PayPal, or any other listed company, nor do I want an information sharing agreement, I think our research has been able to identify the problems of PayPal and Unilever, better than the management. And without the need for access to any unpublished information, even without their inside information. They're saying that they can better identify problems with these companies.
And then Terry Smith put together this table, that shows the reporting of Unilever and their different Acquisitions, and what they're showing and what they're not showing, for example, off to the right here. We have all these different products that they've purchased Time. And the check mark means that there including the performance of these new companies. They've purchased the X means that they've decided to not leave that in the earnings
reports over time. This companies leaving out more and more products that Terry Smith is saying basically, the only reason a company would do this and not give investors insight to what's going on is because the Acquisitions they're doing are not giving good returns. So over time this company is becoming less and less
transparent. Now, Terry Smith has been calling out these companies for a number of Years, their business practices Acquisitions. And of course, he's getting a lot of people that agree with them, but also a lot of pushback e, says amongst the outpouring of comets last year where a number of apologists for Unilever, who are at the pains to point out that the elands brand has been growing revenues. Well, and that this was proof, that quote purpose works.
Of course, there is no control for that experiment. We do not know how well it has grown, without the quote purpose. And then he literally Strikes Out virtue signaling. He's calling this Signaling to further illustrate. This this year. We're moving onto soap when I last checked, it was for
washing. However, Apparently that is not the purpose of Lux, the Unilever brand, which apparently is all about inspiring women to rise above everyday sexist, judgments and express, their beauty and femininity unapologetically. I'm not making this up, you can read it. Here we go to the Lux Brand's website and that is the the top statement there. This brand of soap, inspires women above of sexist judgments and to express their beauty and
femininity unapologetically. Keep in mind, this is soap. I will leave you to draw your own conclusions about the utility of this. Now, moving on, we have, what I think is the most important topic in this entire presentation is share based compensation, and especially its removal from the non-gaap generally, accepted accounting principles profit figures. So share base. Compensation is stock-based compensation. This is something that I've talked about routinely on my
channel. To help investors understand this and how it works with companies, and how in many cases, it misrepresents the earnings potential and the true profitability and the true cash flows of a company share based compensation has become an increasingly prominent part of some companies expenses in recent years, especially among companies in the technology sector share based compensation expense expressed as a percentage of the revenue has gone from 2.2 percent in 2011. To 4.1% in 2021.
So, over that 10-year, period, the percentage of stock-based compensation doubled in these companies, this may not seem like much of an increase, but keep in mind that during this period, revenue for the set of companies had almost quintuple Don average. So, not only is the percentage of stock-based Compton Revenue doubling, but also the company's revenues are going up four times and these companies make up a much bigger and bigger percentage of the index.
So this is Literally a growing issue and he agrees with me that there's nothing wrong with stock-based compensation. If you get paid that way, I'm not saying you shouldn't get paid that way. What's wrong here? Is how investors are being misled about their Investments. I want to focus on how share based compensation is accounted for and more accurately, how it is not accounted for.
In these companies in this is where we get to some alarming statistics among the 75 companies in the technology sector, 45 of them, remove their stock, Base compensation from non-gaap versions of their earnings per share operating income or both in plain English. They remove the amount of their debit for share based compensation which boost their profits that is about 26 billion of expenses that have been adjusted out in reporting, the 2021 profits in their, non-gaap
results of these 45 companies this amounts to an average of 600 million dollars in share based compensation for Company, which is excluded or added back and reaching their non Gap. Earnings, that is massive. These companies aren't only moving this out of the free cash flow statement. But they're literally reporting their non-gaap earnings, and they're not including their stock based compensation. This makes some companies look dramatically cheaper than they
actually are. Now not only that, but the companies that are participating in this accounting, trickery are the ones that have the most stock-based compensation. So, the ones that have this as a big problem, Um, in their companies, a big expense. They're the ones removing it as an expense, making it look like it's just nothing. It doesn't exist in their profitability.
Now he actually goes on to give an example of specific companies that are participating, and I think, I think it's accounting trickery, I really think the intentions and purposes of companies doing this is to trick investors into believing. Their companies are more profitable than they really are and that is where I offer a solution and call trim with this. You And see the real effects of stock-based compensation. We have the example of Salesforce has free cash flow hair.
This is what it looks like when not factoring in stock-based compensation. It looks like they're making 5.3 billion dollars in free cash flow. But then you add in the financing expense of paying their employees and you have two point seven, eight billion dollars in stock based compost so I can clearly and easily see how much free cash flow in excess of stock-based
compensation. Up this company is making without a tool like this without something that clearly illustrates that you have no way of knowing how profitable your company. Is it looks like it's twice as profitable and even in the free cash flow yield of the company sales force, really, doesn't have a true 3.74 percent free cash flow yield because again, stock-based campese out roughly half of what their free cash. Flows are.
So the real free cash flow yield is instead around 1.8%, but unless you have a specific tool like cual trim specific charts, Lay this out, side by side, most people are being tricked by this and Terry Smith gives a very specific example of it. He says take the example of Microsoft and into it into it is a company that's tricking. Investors, Microsoft is a company that's not tricking investors.
Microsoft shares are currently being valued at a PE ratio of 25 times the consensus CPS estimates for the fiscal year looking forward into 2023. So, basically a 25 for PE ratio, meanwhile, into it is being valued at twenty eight times. It's forward earnings. So we have Microsoft at 25 and into it at 28 and a lot of investors would simply just compare these two PE ratios and that's the relative valuation. You can either buy Microsoft at a 25 or into it at a 28.
That's where most investors would stop with their valuation. But if you dig into the numbers here this is highly inaccurate. For example, if you include stock-based compensation, which would make it more of an apple, To Apples comparison. Then you can actually see how Microsoft's valuation Stacks up with into its this would mean that the shares of into it would be trading around 43 times. So by including stock-based, compensation to show the true profitability of the company it
went from 28 times forward. P/E 243 times forward. Earnings. He says, I think investors and analysts may find a premium of 14% for into it over Microsoft to be reasonable. I'm not sure they're fully aware. Are that into its Shares are actually trading at a premium of 73%. If share based compensation is treated the same manner between the two companies. This is a massive problem and
how investors are valuing. These companies that have a lot of stock-based compensation and I've seen investors get burned by this over and over again. It's something that I've been trying to warn about four months. Many investors and analysts including us look at the cash flow metrics more than the accrual profits. That's the same way that I'm looking at. Most of these companies, not through the lens of PE, but mostly Their free cash flow yield and their expected cash
flow growth. He says, unfortunately, share based compensation may cause distortions in cash flow metrics as well. Even when they follow gaap under gaap share based compensation is added back in the cash flow from operating activities which in turn is used in the computation of the free cash flow. Some researchers and commentators argue that share base compensation should be reclassified from the operating activities section to the
financing activities section. All of the cash flow statement for analytical purposes. We agree after all the decision to fund, compensation to employees with shares, rather than cash is a financing decision rather than one pertaining to the operations of a company. This is something that I 100% agree with. I think these companies should not be adding this back to the
free cash flow. Now, one thing that I can do in the meantime is even though we see the big free cash flow numbers of these companies, we can look at it with these stock-based compensation. Lined up right next to it and I'm going to even add in a new chart that does exactly what Terry Smith is saying that Gap accounting should do it. Nets out the difference. We take out the stock-based compensation from the free cash flow.
So you see the raw numbers of how much they're actually generating and cash counting, the stock based compensation as a financing activity and again, just to illustrate how much of a problem this is and how it creates apples to oranges comparisons, Salesforce has half of their free cash flow. Eaten up by stock-based compensation. Other companies, like SP Global that also generate a large amount of free cash flow. They have barely any stock-based
compensation. So when you're looking at these numbers depending on the stock based compensation, you can draw very different conclusions when this company actually generates 3.5 billion dollars of cash flow. That's really about 3.4 billion dollars of real cash flows, it's much more meaningful. And I've been highlighting the example of Salesforce here, Terry Smith is highlighting the example of into it. We look at their free cash flow statement. We can see the same thing.
Looks beautiful growing free, cash flows. I think into it's actually a great company but then we flip over to the stock based compensation. Stock-based compensation has accounted for 1.3 billion dollars of the free cash flow. So if you net that out you get a very different valuation which is exactly what Terry Smith does. If we apply this concept to the case of into it, it would imply that the company is not, in fact, trading at a trailing 12-month, free cash flow yield.
Of 3.5%. So right now, it looks like the company has a free cash flow yield of 3.5 and he saying that simply not the case. If you net out the stock-based compensation, the free cash flow yield goes from three point five to two point two. So different companies are using this to trick investors and make their companies look more profitable than they actually are. And I don't think this is going to change until the Gap
accounting. Rules are updated and then finally after Terry Smith highlights these numerous abuses of stock-based compensation accounting, he signs off for the year. That's his letter for the year. And in summary, like I said, from the very start, I viewed this letter overall is just angry. I think he's just upset at a lot of things. These companies are doing not communicating, what the long-term shareholders hiding their performance with Acquisitions. Having bloated cost, structures
bloated performance. Investing in things with low Returns on Capital employed and then doing accounting trickery to make companies appear cheaper than they actually are. There's a lot of abuse has a lot of frustration a lot.
A lot of things highlighted in a single letter and I agree with basically all of it. One of the things I've done with my portfolio, over the past year, is better understood how the accounting Works, how these companies report their profits so that I can actually get the true numbers. So, that's my thoughts for this episode. I hope it was informative and helpful, but that's all for now. And I'll see you in the next one.