Rational Price
Fellow Partners,
Imagine you were going to buy a business today that you were required to sell next month, next quarter, or next year. How much would you pay? Given the substantial uncertainty currently dominating capital markets, your answer would be much less than you thought the business was actually worth. This thought experiment describes much of what we are currently seeing in the stock market.
I would love to find a dataset that splits publicly traded capital by its duration — that is, the period over which performance is assessed and rewarded or punished. I expect it would look something like this:
This level of precision is not available (though please send any proxies my way!). However, there is good evidence to suggest that the majority of capital now trades on very short time horizons — well less than a year. This includes strategies that trade securities for their volatility regardless of their business attributes.
Rational Price
Over the past few weeks our partnership has been building a position in a business whose long-term intrinsic value we estimate at around $70 billion. It is currently offered for sale around $7 billion.
We could be wrong in our estimates, but $7 billion vs. $70 billion is such a large gap that, unless the business is permanently damaged, it is starting to drift into territory some may call "irrationally cheap".
Or is it?
We are currently in a season of substantial short-term uncertainty: inflation is high, interest rates are rising, growth is slowing, supply chains are still a mess, Covid-19 is still present, and the war in Ukraine rages on.
Our $70 billion estimate is based on evidence of past business performance, analysis of business incentives, estimates of business performance we expect in the coming five to ten years, and a reasonable valuation of that performance. On a five to ten year time horizon a move from a $7 billion valuation to a $20 billion or $40 billion valuation would be a healthy return, and one we would be pleased to endure, even if it meant our $70 billion estimate was far too rosy.
But what if we were required to sell this business next month, next quarter, or next year? I doubt we'd buy it. While we are confident in the five to ten year prospects of the business, we have no idea when the market will reward its performance.
It may be a while. We're fine with that. But any short-term capital — which is the majority of capital currently traded — can't be. For capital trading with a time horizon under, say, one year, the substantial uncertainty of our present reality means that the rational price may be $7 billion.
Anatomy of the Disconnect
How does this happen? Let's work it through:
Price is set by the most recent share transaction, which itself is the aggregation of buyers and sellers of the stock.
If the majority of capital is trading the stock for its prospective performance in the coming days, weeks, or months, substantial sell pressure is created by any news or analysis that suggests the company’s prospects are unknown or negative.
Furthermore, a substantial amount of capital trades based on variables entirely unrelated to business performance e.g. momentum and volatility. This can become reflexive, i.e., the stock goes down and volatility goes up, attracting strategies that trade momentum and volatility which can further reduce price.
These effects are present even if the business’s long-term prospects are highly favorable.
The only forces to counteract sell pressure is capital like ours that has a longer-term business perspective and investment time horizon.
If long-term capital is a minority of capital active in the position, over the coming days, weeks, or months, it will be insufficient to counteract the sell pressure from more voluminous shorter-term capital.
This dynamic is exacerbated by long-term capital already invested in the stock and committed to riding out the volatility in pursuit of long-term business and stock performance. This capital is not selling, but nor is it buying.
Due to these dynamics, the short-term rational price for the business may well be $7 billion or lower, even if we are correct that the longer-term value of the business proves to be much closer to $70 billion.
Options
This creates two basic options.
Option 1: Become short-term capital. This places one in an enormously competitive arena that has a very mixed track record of success, is a de-facto attempt to time the market, and with a strategy that elevates fees and taxes.
Option 2: Be grateful for the opportunity and take advantage of it. This places one in a far less competitive arena with a good track record of success that does not require one to time the market, and with a strategy that generally has lower fees and taxes.
Option 2 is the most rational for this partnership's disposition and capital duration. We are doing something psychologically hard — acting against our human nature to fight volatility or flee from it. However, this also allows us to build the position while the discount exists and exposes us to long-term rewards if we are correct about the long-term intrinsic value of the business.
Perspective
In the long run, staying our course through substantial volatility will make the market our servant, not our master.
Jeff Bezos shared similar thoughts when reflecting on the dot com crash:
The stock is not the company, and the company is not the stock. So, as I watched [Amazon] stock fall from $113 to $6 I was also watching all of our internal business metrics: number of customers, profit per unit, defects, everything you can imagine. Every single thing about the business was getting better, and fast. So as the stock price was going the wrong way, everything inside the company was going the right way. We didn’t need to go back to the capital markets because we didn’t need more money. The only reason a financial bust makes it really hard is to raise money. So, we just needed to progress.
The current market is creating opportunities to purchase businesses that have made substantial progress vs. the last time they were available at their current prices. We have recently been buying at 2016, 2017, and 2018 prices, purchasing businesses that are multiples larger than their 2016, 2017, and 2018 selves, with improved business models and traction, and much lower valuations vs. prior years.
While we’re not deploying our capital all at once, we are thoughtfully taking advantage of our ability to be patient and have the longest perspective in the market.
We are watching our businesses’ progress, confident that we will be pleased by the long-term rational business prices.
All the best,
John
Founder and Managing Partner