Investors should focus on what’s important and knowable. Yet the future, which determines everything that investors do now, is unknowable.
If the future is far from certain, how can any investor make a decision today?
I reconcile the contradiction using “endgames”. The path to the future may be unpredictable, but certain parts of the destination are clear when backed by overwhelming logic.
There are two endgames that I think would happen (these should address the most common questions from readers of my annual letter).
Don’t fight the Fed and the world
The first endgame is low to acceptable inflation. The current narrative of lasting high inflation is very likely unsustainable.
Because every central bank is formed to fight high inflation. Traders quip don’t fight the Fed, or any central bank for that matter (Soros may disagree).
Another reason is the commoditized nature of most products and services. They have trouble raising prices because of competition and lack of differentiation. Cutting prices to get more customers is also not sustainable. Competitors would respond in kind, resulting in an end state where everyone makes just enough (usually meager) profits to survive. This is the brutal reality for most businesses.
For inflation to be high, most businesses have to raise prices in concert with competitors. This means that most businesses have to risk dealing with detrimental competitive responses.
Why would any business want to take the risk? My guess is they have no other choice. Costs have increased so much that they are certain every competitor has the same issue. Hence they are certain that no competitor would cut prices when they raise prices.
The reader should find the aforementioned extraordinary. How can costs increase for every business, given diverse inputs/niches/geographies/customers, all at the same time?
History has shown that would only happen when the most fundamental inputs become expensive. One example is energy. The formation of the OPEC cartel in the 1970s increased energy prices so much that no business is spared.
Other examples are labor and transportation. Covid has reduced the supply of aggregate labor so much that, again, no business is spared. So wages have to rise in aggregate. Policies to reduce the spread of Covid have slowed supply chains to a point that transportation costs have increased in aggregate.
The whole world is united to eradicate Covid. Just as no one should fight the Fed, no one should bet against the will of the entire world to end Covid. When Covid eventually passes, costs of common inputs would stop increasing, and inflation would moderate.
Bet on value-creating machines
The second endgame is companies creating the most value would prevail. This seems redundant to say, but it is a timely and timeless reminder
My investments are lagging market indices by the widest margin since the inception of FRC. But price may not be an accurate indicator of value.
A rising stock price does not mean that the underlying business is doing better, and a declining stock price does not mean that the underlying is doing worse. This is because stock prices are nothing more than the collective behavior of many buyers and sellers, many of whom transact without any concern for underlying businesses.
Ben Graham once said that the stock market is a voting machine in the short run, and a weighing machine in the long run. While price and value may disconnect in the short run, price eventually catches up to value, for better or worse.
That is why I am invested in value-creating machines. They continuously create value, and their best years of exponential growth are still ahead. Their consistent value creation would eventually be recognized by their stock prices.
The stock prices of these companies are lagging because of expectations of rising interest rates. Fears of persistent inflation (which I hope are dispelled at this point) have led to expectations for rising interest rates. Rising rates depresses the value of future cash flows. The further out the cash flows are in the future, the less valuable they are (given standard yield curves). So companies with cash flows now seem more valuable than those with future cash flows.
This phenomenon is so pronounced now that the valuation for the S&P 500 (proxy for the former) exceeds that for the S&P 600 (proxy for the latter) by the most in 20 years.
Neither Covid nor high inflation would be persistent in my opinion. Rising interest rates, by extension, would also not persist.
Over the long-term, what truly matters is the sum of all cash flows, both current and future. Near-term volatility may make a convincing but mistaken case in valuing one over the other.
When interest rates stabilize at a level higher than they are today, there would be little impact to value-creating machines with high returns on capital and long growth runways. It won’t be the same for weak companies. The higher costs of funding means they have less capital to burn to gain traction, and would be insolvent sooner rather than later.
Rates cannot differentiate between good and bad capital investments. The market is selling every company making large capital investments, even those making good capital investments that would yield high returns
Both Sea Limited and Roku, discussed in my letter, make high returning capital investments (see table below)
|5Y incremental revenue ROIC||5Y incremental gross profit ROIC|
These are incredible returns. Compare them to other best-in-class companies for context:
|5Y incremental revenue ROIC||5Y incremental gross profit ROIC|
Great returns in the past may not last. That is why value-creating machines must also have long growth runways sustained by positive feedback cycles (mentioned in my letter) and grounded and inventive leaders (also mentioned in my letter).
If these companies create so much value, why are their stocks prices so volatile, and when would the market realize their potential?
Human nature, and the market by extension, prefers the certain and the now. A bird in the hand can be worth two in the bush, but most would prefer the former than the latter.
It’s uncertain that value-creating machines would continue to grow and eventually show profits. Investors can only guess at the future, and guesses can fluctuate wildly and make stocks volatile.
But value-creating machines actually have futures that are clearer than what most investors think. Their attributes underlie my confidence in their endgames.
When would the market agree with me? My best answer is to allow time for it to happen. Invest in companies that are likely to deliver growing top-notch fundamentals, monitor to make sure they’re delivering, and …
There is really no better answer.
Human nature is impatient, because waiting introduces uncertainty. That’s why quality detailed research is prized. Good research reduces uncertainty.
But the analysis for truly big gains in stocks fits poorly in a spreadsheet. No analyst would dare to model 50% growth in revenue for 5 years. A regression to mean growth rates seems more certain and likely to be accepted by peers, regardless of the company in question.
To seek certainty is to wait as little as possible. To gain acceptance is to differ as little as possible. Combine the two and you get short-term group-think, the concoction for low returns.
To get truly big returns is to do the opposite – long-term independent thinking. The truly big gains requires living with the uncertainty of waiting, independence from peers, and above all the courage to do both.
In my letter, I discussed why deep understanding is important. The point is not to simply know more, but to know what matters. And what matters, after you find a value-creating machine, is to be a true owner.
True owners know what matters in their assets. They stick to fundamentals, and are not easily shaken by non-fundamental reasons. They see their assets through temporary difficulties, as long as the key drivers are intact. They are able to manage the emotional discomfort of uncertainty and independence.
While true owners may not be right on every bet, their mentality allows a fighting chance at truly big gains.
I knew a financial advisor who always said to stick to what’s comfortable in stocks. I suspect his clients would had done better if he were a realtor or car salesman.
Behave well. It offers the best chance in dealing with the unknowable future.