We are indeed living in a Leptokurtic world of unpredictable and inestimable fat tails and extreme oscillation of outcomes, where neither policy makers nor investors can find a comfortable middle of a normal distribution. Instead, financialization, tech disruption, extreme inequalities and more frequent exogenous events accelerate the pace of change while making it more erratic. And as disoriented public sectors respond to conflicting and violent changes, investors and policy makers will likely swing from shortage to abundance, from inflation to deflation, from growth to recession, from calm to extreme volatilities, and from predictability to unpredictability. Market turbulence is inevitable. Ironically, it is precisely at times like these that we need to go back to basics and try valuing businesses, uncertainty notwithstanding. Uncertainty is not a shield against investment decision. If we wait until we feel “certain” about our valuation, we will never act!
Risk is in the future, not the past. Yet being an investor is to live at the intersection of story and uncertainty. And we have learned that if we worry about what has happened already and/or constantly worry about macro events, it does more damage to our investments and the portfolio than getting it right. To the degree that worrying about things we do not control is going to hurt us as investors. So, the only rational answer is to control what one can control and avoid wasting limited intellectual bandwidth on things that one has neither control over nor has the ability to estimate. Investing is all about maximizing the areas we have control over and know about while minimizing the areas we have no control or know little about. We also understand that it is easy for some people to get carried away and try to predict the immediate future. What will oil do? Where will inflation stop? When will the recession begin? What will it look like? And some people do this, probabilistically, and often they are right and sometimes they are not. But even if we somehow manage to get an economic forecast correct, that is only half the battle. We still need to anticipate how that economic activity will translate into a market outcome. This requires an entirely different forecast, also involving innumerable variables, many of which pertain to psychology and thus are practically unknowable.
Former U.S. Secretary of Defense Donald Rumsfeld famously said: “There are unknown unknowns, things we don’t know we don’t know, and there are also known unknowns - things we know but don’t fully understand”. Right now, what is driving markets is not what is happening to individual companies but what people see in the macro environment. Too much has happened too soon for investors to try to make sense of what is coming. Last year started with the onset of many unknown unknowns - omicron outbreak, war, unprecedented inflation. After such challenging times, this year will still be uncertain, with the continuation of unknowns such as high inflation, slowing growth and geopolitical tensions. The silver lining for this year is that many of the unknown unknowns - pandemic, war, high inflation - have become somewhat known unknowns. I also understand that investing is really hard when central banks are tightening, and companies are dealing with a toxic combination of surging inflation, higher interest rates, and economic stagnation that could jeopardize their growth trajectory. So, preparedness is key. And the best preparation for tomorrow is focusing on what is actually happening to the companies in which we have invested.
Citing now one of my favourite memos from Howard Marks, where he recalls a lunch he had with Charlie Munger: As it ended and I got up to go, he said something about investing that I keep going back to: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” One of the learnings from past mistake is to act promptly when we discover new information about an investment that is inconsistent with our original thesis. For example, we are always looking for incremental changes in things companies say from quarter to quarter in their SEC filings, and conference calls. Last year we stumbled on one from NVIDIA, the semiconductor titan, that could have hampered its business in China. During Q2, the U.S. government announced new restrictions impacting exports of their A100 and H-100 based products to China. These restrictions impacted the quarterly revenue, largely offset by sales of alternative products into China. Even though NVIDIA has been dealing with some geopolitical challenges, the good thing is that the company’ fundamentals for the quarter itself were terrific, and its long-term future remains extremely bright.
Artificial intelligence (AI) is the world’s most important computational problem, and NVIDIA has already an incredibly strong position within AI, and it is the only company in the world that produces and ships semi-custom supercomputers in high volume. And if investors hold on to this stock, then historically the probability of an outperformance is not a fringe one. Why? Because NVIDIA has no intention of ceding its AI dominance - which began when the hardware and software company helped power the deep learning “revolution” of a decade ago. In fact, the foundation and infrastructure for the digital economy is the NVIDIA software and hardware stacks, which give modern data centers the power to accelerate generative AI and high-performance computing workloads. And NVIDIA shows few signs of losing its lead as generative AI explodes with tools like ChatGPT. The company is significantly ahead in customizing higher level libraries for specific verticals and industries. With the company having more software engineers than hardware and significantly greater R&D budgets than its peers, this AI software advantage is likely to persist for a long time. I warmly recommend reading our NVIDIA Valuation Presentation FY2017-2023 that sheds insight into our thinking, investment philosophy, conviction, and more.
After more than two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from those that dominated the 20th century. While much is made of the fact that some of the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, we think the bigger difference is that these tech companies are also less capital intensive and more flexible. Put simple, value investing has to adapt to the new economy, with less of a balance sheet focus and more flexibility in how investors assess value. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside.
Value investors are facing one of the most challenging investing landscapes in history. The shift in economic power to more globalized companies, built on technology and immense user platforms, has made many old-time value investing nostrums useless. Now value investors have to leave their preferred habitat (mostly mature companies with physical assets bases) in the corporate life cycle to find value. One of the biggest issues with old-time value investing is that it viewed and continues to view uncertainty as something to be avoided as much as possible, and takes the view that they cannot value businesses, where there is too much uncertainty. That view has led investors to focus on mostly mature companies and kept them out of investing in tech companies. Unfortunately, value investors are born pessimists, and they believe that making bets on the future and/or paying for growth is a sign of weakness. This is, of course, the mirror image of the investor’s lament that a tech company cannot be valued.
The debate about tech valuation is interesting on many dimensions, but one that is worth focusing on is how much growth is worth, and what we are paying for it. As Bill Gross recently wrote “stocks may decline based on disappointing earnings growth, not higher interest rates”. But there are some investors who argue that growth is speculative and that it is worth very little or nothing. At the other extreme are those who argue that growth is priceless and that we should therefore be willing to pay for it. Even though both groups seem to be in agreement that valuing growth is pointless (mainly because it requires estimates that will be wrong in hindsight), I personally believe that it is not growth that we should be paying a premium for but quality growth, with quality defined as the excess return generated over and above the cost of capital.
While the approach to value investing of a hundred years ago has obviously needed to evolve, the underlying principle has remained constant. Buy companies capable of generating returns over and above the cost of capital at discounted valuations when the market has over extrapolated short-term information. Essentially, I have two questions when investing in any business. First and foremost, where is the company in the capital structure? It is true that some managers and investors like me, in the name of prudence, think that less debt is always better than more debt, and no debt is optimal. And second, what do we think about the company’s excess return on invested capital? Scaling profits to invested capital yields accounting returns, and comparing those returns to costs of funding, we get excess returns, shorthand for the value created or destroyed by growth.
Picking stocks with high ROIC and avoiding those without earnings was a simple, yet extremely effective, way of outperforming in 2022. Luckily for us, we have an equity portfolio of value-creators and price-setters, with set investment objectives and risk limits, rebalancing regularly, making tactical shifts when the risk premium changes, and exploring the entire investment universe for top quality companies with solid cash flows. Within selected countries and sectors we only own companies that can (i) invest capital at significantly higher returns than their cost of capital (value creation), and (ii) raise prices without impacting demand (price setting). Returns on capital must be high, consistent and unleveraged, with competitive advantages, ideally switching costs and network effects, preventing returns and margins from being competed away.
According to Buffett, the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. Pricing power, always a positive for companies that can sustain it, may be a crucial competitive advantage in the year ahead. Inflation has surfaced across many global economies, and there are signs that it could linger in the coming months. Rising costs can erode a company’s profit margins and, ultimately, investor returns. But companies with clear, sustainable pricing power can protect their profit margins by passing those costs along to customers. As a friend once told me: “compounding is just returns to the power of time. Time is the exponent that does the heavy lifting, and the common denominator of almost all big fortunes is not returns, it is endurance and longevity.”
The trickiest part of finding a great business to own is striking a balance amongst growth, profitability, and reinvestment, while arriving at a plausible story that holds these strings together, to derive value. After all, there should be no disagreement that the value of a business comes from the letter to the shareholders, the balance sheet, the income statement, the cash flow statement and the uncertainty we feel about future cash flows, and as we see it, all that discounted cash flow valuation does is bring these into the fold. Yes, valuing each business across time is very labor intensive but there is no real shortcut to compounding investing knowledge.
It is also worth remembering that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term. Markets regularly fall prey to ‘narrative fallacy’, and have a strong predilection to shoot and think later. In other words, in the short run, the market is not a particularly smart investor. Some investors prefer to focus on the short term - next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the long term that determines the value of a company, rather than the near-term results. One reason that it is hard for many people to manage money is that they are influenced by what other people do. Ben Graham would say you’re not right or wrong because 1,000 people agree with you and you’re not right or wrong because 1,000 people disagree with you. You’re right because your facts and reasoning are right.
The secret to great investing is a happy marriage between plausible investment stories and numbers, with the recognition that no matter what the story or potential is for a stock, the narratives eventually have to show up as numbers (revenues and earnings). It is worth emphasizing that there are lots of possible stories, a smaller subset of plausible stories, and an even smaller set of probable stories. As investors we focus exclusively on really understanding what we are looking to buy.
A narrow list of exceptional companies that have demonstrated commitment to capital returns and solid balance sheet;
Valuing each business as an owner while mapping out possibility, plausibility and probability; not everything that is possible is plausible, and not all plausible opportunities make the transition to the probable;
Spend thousands of hours curating and learning about this list. When we buy a stock we do become part owner of a living organism. The business is a team of people, with certain leadership, values, energy and personality;
Systematically, repeat.
In this process, we try to understand what makes it tick rather than the numbers alone. The underlying business, the industry landscape, its strategy and competitive moats. We also need to look at the strength of the company's main value-drivers (sales growth, operating margin, and capital intensity) and how they are trending. Using a reverse-cash flow model (starts with the current share price), understand what level of performance (value-drivers and FCF) the company must achieve to justify the current price. We then use our information edge and knowledge of the company's value-drivers to develop our own expectations. Are our long-term performance expectations greater or less than what the market is pricing in? Greater = a potential stock to own. As Warren Buffet famously said, “we do not have to be smarter than the rest, we just have to be more disciplined than the rest”.
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