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The Science of Hitting
The Science of Hitting
Articles (708) 

Investment Note - October 2020

Some thoughts on where we stand

October 27, 2020 | About:

Seven months ago, in mid-March, I published an article in which I shared my thoughts on the state of financial markets. On the day I wrote it (March 18), markets had fallen by nearly 5% in the days session, and were down more roughly 30% from their highs a month earlier. While it was a chaotic time in the markets and in the world around us, I thought the appropriate course of action for an investor was to stay calm and remain focused on the long-term:

"Personally, despite "losing" more money – by far – than I ever have in my life over the past month, I'm honestly not that worried about what's going on in my portfolio. In fact, I'm generally excited and optimistic on the markets. The big reason why I'm excited is because stocks are much cheaper than they were a month ago. While the current issues facing the world are likely to have significant short-term consequences, I ultimately believe that this will prove temporary."

With the benefit of hindsight, it's quite stunning to see just how quickly equity markets have rebounded (an outcome I certainty would not have predicted). On March 18, the S&P 500 closed just below 2,400. On Monday, the index closed at 3,400 – up by more than 40% from mid-March. For the year, the S&P 500 is now in positive territory (up mid-single digits).

But what I find even more interesting than the market's performance over the past seven months has been the divergence between certain types of businesses and industries. I'd sum it up simply: that which appeared somewhat (or egregiously) expensive at the start of the year has done very well, and that which appeared somewhat inexpensive or downright cheap has done poorly. In the case of some of the names I own, most notably Wells Fargo (NYSE:WFC), "poorly" is putting it nicely.

Here's where I'm struggling as an investor. I fully appreciate the importance of business quality and would love to only own the best companies, the ones with the brightest futures ahead (organic growth with attractive returns on incremental invested capital). The problem, as I see it, is that Mr. Market is asking me to pay a lot in my cases for the opportunity to do so - particularly in comparison to what he's asking me to pay for businesses of slightly lower quality.

Consider Chipotle (NYSE:CMG), which I wrote about last week. The company earned $14 per share in 2019, comparable to what they earned in 2014 and 2015 (for what it's worth, I think the company's earnings will likely decline by more than 10% in 2020). The difference is that the stock traded at roughly $650 per share, on average, in 2014 and 2015, compared to a current stock price of more than $1,300 per share. Is there any way for Chipotle to ultimately justify today's stock price? Yes, I think that's a real possibility over the long run. But that assumes plenty of things continue to move in the company's favor, with few stumbles along the way (and as we saw a few years ago with the E.coli outbreak, this company is not immune to setbacks). And even then, if much goes well for the copmany over the next few years, I'm still not sure investors buying at current levels can bank on great returns as an outcome. Generally speaking, that's how I feel about many of the companies with attractive long-term growth opportunities: Mr. Market sees it.

On the other hand, I see companies with some hair on them that Mr. Market is completely uninterested in (or worse). Based on the historic financials, many of them are objectively good businesses – and maybe even better investments given their current prices. But for many of these stocks, that has been the case for a few years now – and recent price action has not been kind. Despite this, or more correctly because of it, I've found myself increasingly attracted to this area.

In summary, I'm struggling to balance my desire to own great businesses with my desire to find attractive investments that are likely to deliver outsized returns. As I see it, I'm left with three options on a business like Microsoft (NASDAQ:MSFT). As it crosses my estimate of intrinsic value, I can:

(1) Do nothing, effectively becoming indifferent to the price / valuation equation.

(2) Sell and hold dry powder until "great businesses" become cheap again.

(3) Invest in less than great businesses that I believe are priced for attractive returns.

In the past few years, I've done a bit of number three, and the results have been quite discouraging. But when I step back and think many of these ideas that have not worked (so far), I walk away with the belief that I should buy more - or at the very least not sell. At the same time, I think there's some validity in guarding against too much style drift. Said differently, while I can live with some of the "good business at a great price" type investments, particularly in the context of a portfolio (as opposed to judging each security in isolation), I simultaneously want to ensure that I move forward with clear eyes (some or all of these companies may ultimately be value traps).

The answer, for me, has been a variation of something once discussed by John Hempton of Bronte Capital (bold added for emphasis):

"We have a default at Bronte - and the default at Bronte is that we have a maximum percentage for a stock (typically say 9 percent but often as low as 3 percent depending on how we assess the risk of the stock) and as the fund manager I am allowed to spend that whenever I want but I am not allowed to overspend it. If we have a 6 percent position with a 9 percent loss limit and it halves, I am allowed to add 3 percentage points more to the exposure. But that is it. Simon, being the risk manager, isn't particularly fussed if I add the extra when the stock is down 30 percent of 50 percent, but I can't add it twice. If it is a position on which we agree we are allowed to risk 9 percent then I am allowed to risk 9 percent.

We will not fall for the value investor trap of losing 18 percent on a 7 percent position.

We have made a modification of this over time. And that is every six to nine months I get another percentage point to add. That is at Simon's discretion - but the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more."

Over the past three to six months, I've copied Hempton's approach. While my rules are not as formalized, I've also put a governor on additional purchases of laggards. It's one way to try and avoid permanent loss of capital (if I'm ultimately wrong on a company like Wells Fargo), as well as a roundabout way of keeping up my allocation to "great" businesses like Microsoft.

In summary, I feel a bit out of touch right now. The companies that I own that I believed had somewhat worrisome valuations at the start of the year have become more expensive, while the companies that I own and have been buying that I thought were cheap have become cheaper.

I've concluded that the best way for me to operate in this environment is with a balanced approach. While some people see themselves as a memeber of the growth camp or the value camp, I live squarely in the middle. I'm perfectly willing to participate in either arena if the combination of business quality and valuation is attractive. For that reason, I currently own some FAMNG and I own some financials. I can see the merits - and potential downside - in both at today's prices.

Whether it's a question of business quality or valuation, I'm still of the belief that owning an overvalued stock results in the same outcome either way: underwhelming long-term returns. No matter what comes next, I think I'm positioned to survive and see another day.

Disclosure: Long Microsoft and Wells Fargo

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (9 votes)



Nicola Guida
Nicola Guida premium member - 1 month ago
Hi Science,

thanks for sharing your thoughts.

I feel exactly the same and my reaction was, apart from continuing to search for undervalued companies (which, as you say, have been laggards for quite some time), start to consider companies with good ROIC and small or no debts.

Most of all, Thomas Macpherson's approach has convinced me to move from my position. I am starting to see the force of growth within a strong moat as superior (or at least, equivalent) to the attraction that a stock has towards its intrinsic value: the only difference is that in the former case the intrinsic value continues to grow, as there's a sort of compounding effect, while in the latter the margin of safety is (apparently) bigger but you don't have this "pull up" effect.

That's anyway difficult for me because, like Mohnish Pabrai (Trades, Portfolio) once said of himself, I'm a cheapskate, but I'm trying. :)

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Nicola - It sounds like, yet again, we view the world similarly.

I want those great businesses, but guess I'm a cheapskate as well :)

Moaty7 - 2 weeks ago    Report SPAM

I find Chuck Akre (Trades, Portfolio)'s model the best.

Buy companies with above average profit margins. Usually they are fairly-priced or overly-priced.

Buy some when fairly priced. Buy more when their valuation is the same as the market, and every once in a while they sell at a discount to maket multiples at which time you load up.

He describes this very well in his talk at google.

This is similar to charlie's comment on buying 'business at a fair price' is better than a 'fair business at a good price'. It is tempting to buy cheap business, but we will get some right and some wrong (obviously our ego says we will be right) which ends up being a wash or equal to market performance at best.

The Science of Hitting
The Science of Hitting - 2 weeks ago    Report SPAM

Moat7 - Sounds good to me! Thanks for the comment.

Arafen - 2 weeks ago    Report SPAM

Thank you for the extensive description and examples. I'll keep it on mind. I am still promoting investment attraction also through presentations. I found some good guys from slidepeak, they just specialize in representing firms and businesses. They pointed me to the poi errors and redrawn my site. So now I can safely recommend them to everyone.

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