Don't compete with robots
First Principles Reasoning Series
Fellow Partners,
Thank you for your continued referrals. We are growing and look forward to welcoming several new partners in March. More on that in the annual report, due out this April or May.
On to the update, which is the third entry in our First Principles Reasoning series. Prior entries covered history can’t tell you what to do and priorities.
Knowing vs. understanding
Any fool can know. The point is to understand.
Albert Einstein
The first book I ever read on investing was David Dreman’s classic Contrarian Investment Strategies: Beat the Market by Going Against the Crowd. His insight was that investors overreact, consistently overvaluing the best stocks and undervaluing the worst stocks. His conclusion was to use this insight to bet against the crowd.
Dreman and a host of others produced research concluding that statistically cheap stocks are likely to go up and statistically expensive stocks are likely to go down. The conclusion drawn by many investors has been to buy statistically cheap stocks and wait for them to go back up.
These sorts of contrarian actions sometimes produces outstanding results. But while contrarian action may be a common ingredient in successful investments, it alone is not sufficient.
Look, all I want is to invest in some high-quality assets at low multiples. Is that so wrong?
Common complaint of value investors
Statistically cheap businesses can be wonderful businesses, or businesses on their way to bankruptcy. And it is not uncommon for wonderful businesses to never be statistically cheap (for example: Costco’s P/E and other ratios have been high for decades, but it is such an effective business that is has been a wonderful investment).
The key is to buy businesses for less than their intrinsic value, which requires combining historical measures of value (e.g., statistical cheapness) with a reasonable quantitative perspective on future growth and evolution (e.g., product and margin changes) and qualitative factors (e.g., competitive advantages, optionality).
This is all to say: successful contrarian actions are the result of good analysis. Contrarianism is not the process itself. (Surprisingly, this statement will be controversial to many.)
Deep reality
Nick Sleep put this well a few decades ago. Nick is best known as a value investor in the mold of Buffett, and known for understanding Amazon’s potential early on and holding as well as growing the position to enormous gains (when Nick closed his fund in 2014, his Amazon position was 66% of the portfolio).1
One of the things we have learnt over the last few years is that our most profitable insights have come from recognizing the deep reality of some businesses, not from being more contrarian than everyone else.
Nick Sleep
The “deep reality” of a business is a powerful concept.
The value of a business is simply the discounted value of the cash that can be taken out of it during its remaining life. The key questions are, “how much cash?”, “when will we get it?”, and “how much certainty do we have that we’ll get it?”
A surface treatment might reference historic earnings, company multiples, peer multiples, and estimates from management and analysts. These are all useful. But businesses with certain futures will be priced to match. Greater opportunity exists in thinking differently.
Amazon has never had a reasonable P/E multiple because it has always (very publicly) invested its free cash flow back into improving its business and building new businesses.
Costco typically has a high P/E multiple because it excels at growing same-store sales and developing new warehouses. Price grows with earnings; growth fuels returns.
Netflix had negative cash flow and growing debt for years as it invested in building an enormous subscriber base; now it generates more cash than it needs, and no longer anticipates having to borrow money to fuel its growth.
What these examples have in common is that the businesses are playing a different game — a longer game — than that of many who wish to understand them. Their deep reality is that they are shifting money over time: spending now to earn more later. When this clicks it becomes possible to answer valuation questions from the perspective of the deep reality that each business has created — not from the perspective of shortcuts such as P/E ratios.
Not everything that counts can be counted, and not everything that can be counted counts.
Albert Einstein
Don’t compete with robots
The tough part about understanding the deep reality of businesses is that it requires curiosity, work, an open mind, and an open investment mandate.
The great part about understanding the deep reality of businesses is that one is far less likely to be competing with robots which, as a rule, is wise to avoid.
Think back to valuation ratios: any investment strategy (contrarian or otherwise) that relies solely on historical measures of, say, statistical cheapness, can be — and has been — programmed into robots, which execute these strategies with far more consistency and discipline than any human could hope to match.
This creates two problems. First, robots are infinitely scalable, such that any successful robo-strategies with eventually attract enough capital to minimize their profitability. Second, even while the strategy is profitable, the robots will always out-execute the humans.
So how do we compete? First and foremost, we aim to play the longest game of any market participant. Uncommon patience is a unique advantage. It enables us to let our winners run. It lets us focus 100% of our efforts in allocating capital to the right places and businesses and lose no time worrying about when markets reward wise capital allocation. Most importantly, it lets us time-shift seeking profits in businesses, focusing instead on cash flow and capital allocation within the businesses we hold — to the benefit of long-term returns.
The intelligent investor is a realist who sells to optimists and buys from pessimists.
Benjamin Graham
For the purposes of this partnership, we will never have more information, process information faster, or get information sooner than other market participants we compete with. If our edge were in these factors, we should be worried. Good news: we’re not trying to compete with robots.
Until next week —
All the best,
John
Founder and Managing Partner
Nick’s partnership letters are an excellent read.