• X-Bonds are some of my favorite investments today
  • Should we be buying this dip?
  • Next-generation electric vehicle (EV) batteries may be closer than we think

Dear Reader,

Welcome to our weekly mailbag edition of The Bleeding Edge. All week, you submitted your questions about the biggest trends in technology. Today, I’ll do my best to answer them.

If you have a question you’d like answered next week, be sure you submit it right here.

Investing in “X-Bonds”

Excellent presentation this morning. I just have a few questions:

Is any part of the income from an x-bond considered a “Qualified Dividend” by the IRS?

Do the X-bonds have maturity dates (like corporate bonds) and are they issued with various dates like 5 years, 10 years, etc.?

Can an X-bond be held in a Schwab IRA? Schwab brokerage account?

Thanks,

– Chris B.

Quick questions on the X-bond opportunity: How long is the investor committed for with an X-bond purchase? 1yr, 2yrs, 5yrs?

What happens if the investor of the bond has to get out early?

– John C.

Hi, Chris, John. Thanks for watching my recent presentation on “X-Bonds.” And thanks for your questions.

For readers who missed the presentation, “X-Bonds” are the name I use to describe a special type of convertible bond. Specifically, X-bonds are convertible bonds in high growth companies that have little to no downside risk, and still have the upside potential associated with exponential growth companies.

These are investments that very few people know about. But they are some of the best opportunities for us in this volatile market.

At a high level, a convertible bond is a type of corporate debt. It‘s a hybrid security valued for both its interest payments, as well as the potential convertibility into equity. Just like most debt, these bonds are issued by growth companies looking to raise capital. Holders of the bond will receive regular payments (referred to as a coupon) and will reclaim the par value of the bond at the time of maturity.

And because these assets are bonds in high quality companies, they are a very conservative investment. The issuing company is obligated to pay its bondholders.

The only real risk – assuming we hold to maturity – is if the issuing company goes bankrupt before maturity. But I don’t see that happening with our bonds. As I share in my research, the only companies I consider for X-bond investments are in businesses with strong – and growing – free cash flow. These companies are leaders in their space and have attractive product portfolios ensuring future growth.

This ensures that they will have the capital to make their coupon payments, as well as return the par value of the bond upon maturity. 

So far, this should sound relatively familiar for a bond investment. But here’s what makes convertible bonds different.

As the name suggests, these bonds can be “converted” into shares of stock in the underlying company. This is an important feature of these assets that give us the potential for significant upside.

As I shared last Saturday, a convertible bond issued by Advanced Micro Devices (AMD) in 2016 is now showing a return of more than 10x.

This is only possible because of the convertible feature built into the bond. When these AMD bonds were issued, the price of AMD’s shares was $5.90. And the conversion price for the bonds was $8. That means that holders of those AMD bonds were able to convert their bonds at just $8 a share. And with AMD trading close to $80 a share, it’s easy to see how investors made a 10x return.

And what I love about these assets is the built-in downside protection. If AMD’s stock had not performed over this period – even if it fell – bond investors would simply sit back, collect their coupon payments, and receive the par value of the bond at maturity.

At a time when markets are incredibly volatile, that sort of downside protection is incredibly valuable. And it keeps us open to future upside when equity markets return to “growth mode.”

As for your questions…

These bonds issue regular coupon payments. This is money that will be deposited into our brokerage accounts. We can think of the coupon as an interest payment and is therefore taxed at an investor’s marginal tax rate.

When we reclaim the par value of the bond, this will be treated as capital gains and taxed accordingly. Example: If we buy a bond at $700 with a par value of $1,000, we’ll reclaim the full $1,000 at the maturity date. This is a 43% return and will be taxed as if it were capital gains (long term or short term, depending on the duration of the investment).

And in the event the bond goes well above the par value – which will happen when the underlying stock climbs higher above the conversion price – this will also be taxed as a capital gain.

Yes, these bonds have varying dates of maturity. Some bonds have maturity dates that are just a few years in the future. Others have maturity dates that are a decade away.

The X-bonds that I recommend will have a specific maturity date. Some companies have different issuances at different maturities, conversion prices, and coupon payments. Investors can choose which bonds work best for their individual circumstances, but for the model portfolio purposes, I make specific recommendations.

It’s worth mentioning that X-bonds differ from a typical municipal bond offering. A primary offering for a municipal bond will raise a total amount, but that amount is broken up into a range of maturities across 10 or 20 years. This provides a lot of flexibility for investors as they can choose the maturities most suitable to when they would like to receive the par value of the bonds in the future.

Convertible bonds can be purchased in an IRA. That might be preferable for investors looking to use the tax advantages for these retirement accounts.

As for the last question. What if an investor needs to “get out early?” This is where some nuance comes into the equation.

We will reclaim the par value of the bond at the time of maturity. But it’s possible for the value of these bonds to fluctuate between now and the maturity date. That means it’s possible to see paper losses for these bonds between now and maturity.

But we should keep in mind that this is temporary. The company is obligated to repay the par value of the bond – typically $1,000 per bond – at the maturity date. As we approach that date, the value of the bonds will rise to par value.

For that reason, my official guidance is to only invest in bonds that we are comfortable holding through to maturity. That’s how we’ll manage our risk.

If we follow this strategy, I see three possible scenarios:

  1. Worst case scenario, we’ll hold to the maturity date, and investors will receive the par value of the bond upon maturity (that is usually $1,000 per bond). We will also collect our coupon payments along the way.

  1. The share price of the underlying stock rises, and with it, the price of the bond increases as well, as the AMD example above shows. This gives investors the option to sell the bond at a profit in addition to having received the coupon (interest payments).

  1. If the share price rises well above the conversion price, investors have the option to convert their bonds into shares of the company at the conversion price.

My prediction is that we will have option two or three available to us well before the maturity date. The next six months or so will certainly be volatile. But healthier markets will return. And when they do, our bonds will benefit from the rebound in equity prices, and we’ll be able to close out our X-bonds at a large profit.

And in the (unlikely, I believe) event that this volatility persists longer, we’ll have option one available. We’ll collect our regular payments and make a great return when we reclaim the par value at maturity with basically no downside risk.

In my view, this is the best of both worlds. X-bonds combine the conservative, income-producing nature of bonds with the upside potential of tech stocks.

For readers that would like to learn more, please go right here.

Should we add to our positions?

Good afternoon, Jeff, I understand your fundamental stance on size positioning for investments we have made, and your thesis remains the same so adding shares at the current, much more favorable costs makes common sense to me. Why is this not an effective strategy? I have only been a subscriber since early 2020 and I thank you so very much for sharing your wisdom, knowledge, expertise, and guidance!

Enjoy the weekend,

– Charles M.

Hi, Charles. Thanks for being a subscriber. And thanks for your question. I’m sure many readers are wondering as well. The answer will depend entirely on the individual circumstances of each investor. Most importantly, it will depend on:

  1. Our time horizons as investors

  2. The amount of capital we are willing to deploy

  3. Our tolerance for risk

Also relevant to this question is the actual asset class that we’re investing in. Is it a higher risk, higher return asset class? Or are the investments in blue chips like Amazon or Apple?

Having an outsized position in such high-quality companies like Apple or Amazon is reasonable. And increasing position size in a market downturn is usually smart.

But doing the same in a higher risk asset class will depend more on the three factors I listed above.

Experienced investors, with additional capital to deploy and the right time horizon and risk tolerance, are well suited to take advantage of artificially depressed valuations. This is typically the very best time to buy, and/or add to an existing position.

However, for a more risk averse investor who prefers to build their cash position and avoid volatility, the better decision is to sit on the sidelines and wait for market conditions to improve.

As a publisher of investment research, I do not and cannot know the individual circumstances of my subscribers. This is why I can’t provide individualized investment advice. My goal is to provide high quality, interesting, and actionable investment research that can help my subscribers make informed decisions about their own investments.

To use a current example, Block (formerly Square) now trades at an EV/Sales of 2.28. We’d have to go all the way back to 2016 to see similar levels. Even during the crash of 2020, Block traded at an EV/S of 4.

I could understand the valuation markdown if Block had suddenly stopped growing, but that’s not the case. The company took a small hit on free cash flow this year. But Block estimates its free cash flow will be $1.12 billion by fiscal year 2024, up from $0.5 billion for FY 2022.

Advanced Micro Devices (AMD) is another great example. On August 3, the company reported some fantastic earnings. The company revenue grew 70% year-over-year. Data center revenue grew 83%. Gaming revenue was up 32%. The company improved its gross margins. And they even set a new record high for EBITDA (earnings before interest, taxes, depreciation, and amortization).

And the company’s products will be a workhorse in the data center space for years to come. Basically, AMD is doing everything we could ask of it and more.

So, there are plenty of growth stocks out there that are doing everything right. But they’re simply getting caught up in the market-wide volatility. As a result, valuations are compressed, but once healthy market conditions return – and they will – valuations will quickly expand, and so will the share prices.

If investors are interested and comfortable with adding to positions, I could suggest a few places to start. These are all large-capitalization technology companies I’m confident will come back strong once we get past this current volatility.

  • Advanced Micro Devices (AMD)

  • Corning (GLW)

  • Taiwan Semiconductors (TSMC)

  • Block (SQ)

Thanks for your question, Charles.

The landscape for next-gen battery makers

I read about the company highlighted today by Mr. Brown called Factorial Energy. Jeff, I was just wondering if you could touch on how Factorial compares to another EV solid state battery-maker called QuantumScape?

Thanks.

 – Efren T.

Hi, Efren. Thanks for your question and for being a reader.

For subscribers that missed it, we profiled a next generation EV battery company called Factorial Energy on Thursday. Factorial is one of a few companies working on solid-state batteries for EVs.

At a high level, solid-state batteries have a number of advantages over current EV batteries. Solid-state batteries have the potential for longer range (400+ miles on a single charge) and shorter charge time (less than 20 minutes).

QuantumScape is one of the more prominent companies working on solid-state battery technology. It was the first of its kind to come out of gates and access the public markets via a reverse merger with a SPAC (special purpose acquisition company).

As a result, there was a lot of irrational hype in late 2020 and early 2021 around the company. None of it was justified for a company that was, and still is, in the developmental stages of solid-state battery tech development. 

I never recommended QuantumScape because the valuation simply didn’t make sense. I knew it would crash. And it did. QuantumScape is down more than 90% from its all-time high.

Today, QuantumScape is valued at almost $4 billion. It’s still too much. The company’s expected revenues by 2025 are a mere $20 million. That puts today’s valuation for QuantumScape at 197 times 2025 annual sales! Complete insanity.

And the other thing to understand is that it will run out of cash within the next 24 months, which means it will have to raise additional capital, which will almost certainly dilute existing shareholders.

Factorial is still a private company, and as such, we know less about how their technological progress compares to QuantumScape.

Factorial’s latest announcement to build a $45 million production facility in Massachusetts suggests that they might have “something” worth taking to production and ultimately commercialization. I’m excited to learn more and see if they have something concrete.

Sometimes, an announcement like this is meant to generate further interest from venture capital firms. It doesn’t necessarily mean that the company has had a breakthrough. So we can watch progress with cautious optimism as it targets its goal of having its plant operational by early next year.

If Factorial can hit their ambitious goals, they could be the first company to begin mass production of solid-state EV batteries. And that means that solid-state EV batteries could be much closer than we originally thought.

One final and critical thought about investing in general: valuation matters. The share price of a stock does not. Whether it’s a public company or a private company, it is so critical for us to understand the valuation of a company and whether or not we are getting in at an attractive price, or investing in something that is overvalued. This is one of the biggest mistakes that most investors make, which is why I spend as much time as I do working on and writing about valuations. If we get that right, we’ll all be far better investors in the end.

That’s all the time we have this week. Remember, if you’d like me to answer one of your questions, send me a note by writing to [email protected]. I’ll do my best to get to it in a future mailbag.

Regards,

Jeff Brown
Editor, The Bleeding Edge