The anatomy of an investor
John, an avid value investor, reads the latest issue of “Value Investor Insight” with great interest.
The monthly publication outlines the thoughts and investment ideas of famous value investors. In a world of immense complexity, it is wonderful to have someone like Titney Wilson help us find investment ideas.
On page 9, Titney offers his view on United Bananas (ticker: UBAN)
“The company has a 15% market share in the booming organic banana segment”
“The recent tuck-in acquisition of Costa Rican banana farms will lead to economies of scale”
“If you assume the melon business will break even, you are paying just 10x EBITDA for their market leading banana business”
The different data points are confusing and the information is a bit too much to process. John takes comfort in the fact that the multiple is low and everything looks rosy for the company. Plus, Titney Wilson is a famous hedge fund manager on par with Will Eckman and Dave Steinhorn. If something goes wrong, at least it won’t feel like it’s my fault. They must have done their research.
After reading Value Investor Insight, John goes to bed worried about what to do with the cash in his brokerage account currently earning 0%. Seeing his next door neighbour triple his money in Netflix makes it all the more humiliating. He actually lost money last year despite the S&P rallying to new highs. His wife’s comments about how the stock market is a fool’s game doesn’t help either. It’s not supposed to be like this – the market is supposed to be fair.
John’s wife Lynda puts her money into low-cost ETFs. She always thought fund managers earned too much money. They lost her a lot of money in the great financial crisis, and even now they underperform the S&P. She feels clever saving so much money on management fees, and feels empowered by the liquidity and choice the ETF world has to offer. She recently heard that India’s new prime minister will reform the country and that it will become the next Asian growth miracle. She doesn’t know anything about India but what is the alternative? Emerging markets is where the growth is. And China is facing a financial crisis. High growth stocks is a good complement to her otherwise conservative and high yielding bond portfolio.
John falls asleep and wakes up the next morning thinking about UBAN. He opens his Twitter feed and finds several of his follows discussing the stock. They all like it. The stock is a true undiscovered gem. Markets can be so irrational sometimes. They need the help of us believers to truly understand value.
A week goes by and John doesn’t think too much about United Bananas. While mowing the lawn, he notices his Netflix neighbour coming by to say hello. They chat about gardening and the weather and finally also about stocks. John can hardly contain his contempt for stocks such as Netflix. How can a company with a PE ratio of 100x have any value? It’s just speculation! Suddenly, his Netflix neighbour mentions that his broker had mentioned a new hot stock to him: United Bananas. Everyone eats organic bananas these days. If the penetration rate goes from current 5% to 25% United Bananas stock could go up 5x times.
John gets excited and hurries home. Everyone (including his dumb neighbour) is catching on to the United Bananas story. He better get in fast. The stock was up 5% yesterday but is said to trade at a PE ratio of 10x. He remembers what Peter Lynch said about diversification (or “diworsification”, rather). You should put all your eggs in one basket and watch it. John has never had a higher conviction on a stock. It has a low PE ratio and growth at the same time. Just what Warren Buffett told him to do. And he never heard anyone say a bad thing about the company. So he puts 40% of his portfolio in the stock without telling his wife. He can tell her afterwards once he has made 5x his money.
He checks his stock every morning as a ritual. It keeps going up so he feels like a genius. For all extents and purposes, John has already discounted his planned 5x gain. He is planning to buy a new Subaru SUV with the gains from his UBAN purchase.
Months later the stock suddenly drops 20%. No-one knows what happens. A fellow value investors tells him: “Mr Market is like a manic-depressive. Investors get emotional for no reason. Nothing has changed in the underlying business”
His Twitter follows seem to be taking advantage of the opportunity and buy more UBAN stock. It seems like a good move. It is trading at a PE of 8x. How much lower can it go? The market doesn’t understand value. United Bananas is a market leading company, growing 10% per year. People are not going to stop eating bananas. So he buys another 5%, expecting the stock to rebound.
The stock keeps on sliding. For some reason, the PE ratio on his bookmarked Yahoo Finance page doesn’t decrease as fast. A broker downgrades the stock, commenting on the company’s heavy debt load and lack of free cash flow. A research analyst from Goldman Sechs calms buyers saying that the debt load is a way to optimize the capital structure. Debt has become cheap and it’s stupid not to leverage up. They expect net debt/EBITDA can increase to 6x given the low interest rate climate of 4%. Free cash flow is low because they are reinvesting cash into the business for growth. John thinks the analysis makes sense and doubles down on the stock. The upside has grown to 10x now so it would be stupid not to buy. He feels angry that sell side analysts can have such influence on a stock. It doesn’t feel fair.
More trouble at UBAN emerges. A rogue short seller claims that their non-GAAP “cash EPS” has been boosted by the omission of certain recurring expenses. John thinks to himself that short sellers should be regulated. It’s the little guy like him who suffers from the rumour-mongering of vicious short sellers. The stock falls down another 20%. Titney Wilson sells his stock due to investor redemptions but doesn’t offer much guidance to his fellow value investors. He considers himself lucky that he doesn’t need to sell due to redemptions. Stocks always come back in the long run.
The judgment day comes on a windy autumn day, when the CEO of United Bananas shows up on the front-page of Wall Street Journal. He is accused of falsifying invoices of banana shipments to the Chinese distributor JV. The stock falls a further 30% and down 80% from where he began buying it. John thought he bought a solid company but it turns out it was a dud. It was a misunderstanding.
He feels angry and wronged and wants to forget the whole thing. So months later when he reads the new Value Investor Insight he finds a stock with a more compelling story than UBAN. The stock has stabilised but is going nowhere. There are no catalysts. The acquisition-led growth has stopped now that access to financing has become more difficult. It is better to invest in a high yielding utility instead of chasing growth from these fancy platform companies.
I’m using the story of John to illustrate the thought process of a typical investor. Key points of the story:
- Choosing among thousands of stocks is impossible to do rationally and investors must rely on heuristics such as “trading at PE ratio of”, “growth rate of x% vs a PE ratio of Y”
- Investors seek help from experts in an effort to avoid taking responsibility and do the actual work themselves
- Stories such as “stocks are better as cash is earning nothing” always seem logical. But the average uninformed investor tends to make the wrong decision
- We seek out confirming evidence to feel good about ourselves. That is the cause of speculative epidemics.
- A falling stock price and negative reinforcement is enough for us to lose confidence in the story
Value investing or fundamental analysis is not the only “philosophy” used to pick stocks but popular among mutual funds and less informed professional investors. Trend-following momentum investors tend to exacerbate trends rather than create them.
So, stock prices go up because of buying pressure exceeding selling pressure at any given point in time. The reasons why stocks may go up include:
- Liquidity factors: if the money supply expands quickly while capex/inventory spending stays at a reasonable level, some of this money will find its way into the stock market
- Technical factors: short-term traders go in and out of the market on a short-term and long-term basis depending on cycles of greed and fear
- Reasons to do with investment philosophy
If we are to make money in stocks, we need to buy them before other investors decide to press the buy button and then sell them before other investors do. For lack of a better word, long-term front-running of other investors.
Investment philosophies come and go. In the 1840s railway investment boom, book value and dividend yields were most popular among investors. In the UK until the 1960s, dividend yield was also preferred to low PE ratios. In China today, there are practically no value investors among the major fund management. In China, momentum traders rule the day and you would not perform in the short-term just using discounted cash flow analysis.
Opportunity cost makes sense and value investing also makes sense. Discount at the right discount rate and forecast cash flows accurately 20 years out and you’ll most likely make a rational decision. But no-one knows what will happen in 20 years, and for us facing short-term performance pressures it is not exactly helpful that a stock will go up in 10 years’ time. It may ruin your performance the first 9 years.
Front-running other investors may be just as rational. In much of the Western World, that means front-running the typical “Moat-plus-growth-at-a-low-PE” fundamental investor, or front-running investors using discounted cash flow models. Stocks don’t necessarily have easily identifiable intrinsic values, people just think they do.
Front-running someone like John requires you to find leading indicators of what he considers to be a perfect buying set-up. To summarise the thought process that he goes through before buying, he appears to make sure:
- It is a market leader or has a moat of some sort
- Growing fast with a seemingly high potential
- Is trading at a low valuation multiple
- Catches the attention of sell side analysts or individual investors
The first point is something particular to the company that won’t change much over time. A moat is a fuzzy concept and really, any company can be argued to have a moat as long as it has a major market share.
Something must change that causes the growth to accelerate. Secular tailwinds are great, but long-term in nature so hardly something that would cause an acceleration in revenue growth. A highly competitive new product compared to its substitutes can cause a growth spurt, if you are able to identify its merits ahead of competition. A new management with a new strategy might help improve margins and/or the revenue growth potential. New government regulations can also help improve the economics of the business. Changes in industry supply/demand can also change the growth rate of companies in commoditised industries. Stocks in such industries hardly have moats, but then again it hasn’t stopped value investors from buying General Motors and Standard Chartered.
Once the growth rate accelerates, you would want the multiple to fall to a low-enough level to push up the stock price. So all else equal a low EV/S multiple and margin improvement potential should definitely be helpful.
What makes a story captivating? I think there are four main building blocks:
- It provides hope and endless potential
- Easy to relate to, ie something that we see in everyday life
- Conveys meaning to a trend that we have identified
- Vivid, tellable story
Examples of stocks that catch people’s attention are Tesla, Netflix and Apple. New industries that have the potential to transform the world. We use cars, watch Netflix and use iPhones every day so get constant reminders of their potential. A rising stock price feels well justified given how great Tesla’s cars are said to be. Elon Musk and Steve Jobs are geniuses that we all admire and aspire to become. Investing in their stocks feels like being part of something greater, something that can provide hope and upside in an otherwise perhaps dreary life.
The stock also needs to have a large number of potential buyers left. So catching the trend early is the safest. When mainstream media outlets start touting the story, or when third tier mutual funds or uninformed retail buyers start buying, it is probably time to step out. When volatility spikes and price action resembles a tug-of-war between uninformed buyers and intelligent sellers, the speculative epidemic may have reached its logical conclusion.
Front-running professional investors is easier in that they tend to use discounted cash flow models. Understand where they’ve gone wrong in their assumptions about future growth, and you will be able to front-run upgrades of analyst estimates in the future. Institutional investors, including hedge funds, still like brand name stocks though. It will make it easier to sell their funds to less-informed clients.
A fool-proof method of catching boom-bust processes is by observing irrational behaviour. Most likely such buyers and sellers won’t stay irrational forever. People tend to make financial decisions for the wrong reasons, as reality is hard to make sense of. It is unclear whether there is any rational way of valuing EM corporate bonds, for example. We should probably assume that their popularity is due to a speculative contagion.
That is, at least, the way I look at investing.