Focus on the business

First Principles Reasoning Series

Mar 12, 2021

Fellow Partners,

A warm welcome to three new partners this month!

Several of you have asked how the partnership is growing. In a word, “steadily”, which is just the way we like it. We are growing the partnership based on alignment to our principles. If we didn’t get the occasional “no” or found ourselves accepting every offered check we would be violating this approach.

We are resuming our First Principles Reasoning series this week after our brief pause to discuss Bitcoin.

On to the update.

Distractions

It has been an interesting few weeks in capital markets. At the start of February I remarked to my wife that “returns aren’t supposed to be this easy”. Growth in some areas of the market was getting out of hand.

The recent pullbacks we’ve seen in those areas are, on balance, healthy. Businesses are beneath every stock price. A connection between market context, secular tailwinds, and business performance is vital to good long-term results. Risk goes up when prices move too far from underlying realities.

Our friends at Ensemble Capital nicely contextualized some of what we’re seeing for those that want to read more: Don’t Learn the Wrong Lessons from the Dot Com Crash (8 minute read).

Focus on the business

At all times — and especially in times of strong volatility — we must anchor ourselves in the realities of the businesses we invest in. Many portfolios had strong rallies from the start of the year through mid-February, only to give up those gains by the close of last week.

What happened? At the business level: not much. In our case, most of our businesses have reported their year-end 2020 financials over the past few weeks. Most of what really matters — revenue growth, healthy margins, strong returns on incrementally invested capital, and chunky moats around the business — is just fine.

In fact, recent market volatility has given us the opportunity to increase our ownership in several wonderful businesses, which we have done.

Understanding what drives long-term returns

What about underlying business value? For those with a long-term mindset, revenue growth is the primary necessary condition, along with the many factors that support the quality of that revenue (more on that in a future series).

Though by no means a sufficient condition for success, revenue and revenue growth are required for a business to have the opportunity to generate cash flow, invest in business opportunities, refine their business model and improve their products and services. Revenue is a necessary enabler; revenue growth is evidence of effectiveness.

Putting growth in context

Some have commented that multiples — that is, the amount investors are willing to pay for a given level of business performance — are at risk of contracting. This is true, and it will happen at some point. But this risk should be rightly understood.

First, one can miss an incredible amount of growth while waiting for lower valuations. This can be as damaging to long-term returns as over-paying.

Second, sufficient persistent growth can overcome headwinds from multiple contraction, and should be factored into one’s return and risk calculus. See the chart below1.

Finally, for long-term investors, periods of multiple contraction create buying opportunities just like the one we discussed above. If the intrinsic value of a business has not changed much and we liked it at, say, $10 per share, we should love it at $5 per share.

This is not advocating buying at any price, but rather suggesting that elevated multiples should be factored into one’s risk equation — not simply become a reason not to buy.

A more balanced perspective: paying relatively high prices in the short-term requires relatively higher confidence in the ability of the business to grow at elevated rates over the longer-term.

Closing thoughts

It is immensely helpful to zoom out — sometimes way out — to recognize the broader context of our investments.

We are emotionally wired to think this way2: