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The Science of Hitting
The Science of Hitting
Articles (451) 

The Importance of Consistency

Some thoughts on how to stay intellectually honest over time

October 11, 2017 | About:

In my last article, I briefly discussed Netflix Inc. (NASDAQ:NFLX). I think it might be useful to circle back to that discussion to address the main point I was trying to make.

Here is what I wrote:

“What I find most interesting about the FAANGs (and which seems comparable to the anointed stocks of prior eras) is the discussion rarely comes back to intrinsic value. For example, at what price is Netflix a sell? And if you owned the stock five years ago (when it was trading at $10 per share), what was your answer back then? I would love to see a write-up from an investor that answers these questions.”

Before discussing Netflix, I shoud zoom out a bit and talk about my investment philosophy. In short, I think it is important to examine decision-making over time and under different conditions (for example, if the stock was 30% higher or lower than it is today). I think it is important to remember that what is happening now should not be viewed in isolation; it is a point in time along a continuum. That way of thinking points to something I view as a fundamental truth of investing: the decisions we make today (or have made in the past or will make in the future) should be consistent over time.

The questions posed above are supposed to make the Netflix investor consider the following: What could possibly explain a nearly 20x increase in a stock over a few years? Framed another way, what fair value estimate would you have come up with for Netflix back in 2012 that could justify still owning the stock in 2017? There are a couple explanations that come to mind: (1) it was absurdly cheap a few years ago; (2) there has been a material change in the business; (3) it is absurdly expensive today.

Netflix may be the worst example I could have picked to try and make this point. I believe the company is unique in that there is a reasonable basis for the second argument: the transition to the streaming subscription business fundamentally changed the company. You could make a strong argument that the user economics and sustainability of the company’s moat have materially improved as a result of this evolution. In combination with unabated growth, maybe there is a case to be made for a significant increase in the value of the business (by significant, I mean multiples of its value from even a few years ago).

More often than not, I think you will find the case for the second argument is pretty weak: most businesses do not fundamentally change in such a short period of time (or at least not the type of businesses I am drawn to). That leaves us with the other explanations (or some combination of them): either the stock was too cheap a few years ago or it is too expensive today.

This is where consistency matters. Personally, I find value in building a model and coming to a fair value estimate because it forces you to be intellectually consistent over time. Without these tools, I fear “thesis creep” and “fair value creep,” particularly in a bull market: as stock prices continue their unimpeded march higher, you might catch yourself doing whatever’s necessary to justify holding on for just a little longer (especially if you have already sold other positions and paid capital gains – only to watch those stocks keep moving higher).

While it may be painful to miss additional gains, the alternative is abandoning a value investing framework. As Howard Marks (Trades, Portfolio) noted in his most recent memo, holding stocks as they move past your sell points is either completely illogical or a sign of investor error and lack of discipline – the type of behavior that is typical in a bull market. That does not interest me.

I think a fair value estimate keeps me honest by (very roughly) quantifying my return expectations and giving me a basis for considering my alternatives (the opportunity costs). Let’s say the return estimate of a security is roughly 10% per annum for the next decade. If we check back in a year and the stock has doubled, our return expectation for the next nine years has fallen to approximately 3% per annum (all else equal). Does it make sense to keep holding this security?

Maybe something has changed. Maybe that is why the stock doubled over the past year. How does that change compare to what I assumed in my original analysis or thesis? Do the updates to the model materially impact the fair value estimate of the business – and as importantly, if I am forced to make a significant update to my model based on financial results over the past year, do I truly have a good grasp on the underlying drivers of intrinsic value for this business?

The point, as mentioned above, is intellectual consistency over time. I think it is meaningless to think of yourself as a long-term investor if your opinions and conclusions are fleeting (especially if they are fleeting in the face of negative price action alone). The conclusions supporting your investments should rest on a foundation that does not crumble at the first sign of trouble.

If the foundation is solid, we must have the conviction to act on both ends: to buy shares even as the stock price moves against us and to sell shares as the price exceeds our estimate of fair value. Doing the latter is more difficult in the current environment. If history is any indication, we'll eventually reach a point where those that had the conviction to sell when the math no longer made sense will be rewarded for their discipline.

Disclosure: None.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.7/5 (13 votes)

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Comments

jtdaniel
Jtdaniel premium member - 1 week ago

Hi Science,

Great piece. Unfortunately, I don't own Netflix, but I did trim high-flying Waters and Microsoft in 2016 only to watch my remaining shares keep rising. I think that is just a cost of doing business.

I wonder what percentage of Netflix shares that were bought for $10 in 2012 have been held by the same owner? My guess is that traders have been flipping most of those shares back and forth to each other at ever higher prices. The true value investor who bought Netflix in 2012 has been rewarded by great business performance and the speculative behavior of others. As you note, converting paper profits into currency requires finding a prudent sell point. I don't really need to create a slide deck or consult with artificial intelligence to understand that Netflix shares are now over-priced and vulnerable to Mr. Market's unpredictable mood swings. Taking some shares off of the table, although hard to do, could prove to be a very good decision. Best, dj

asheesh
Asheesh - 6 days ago    Report SPAM

Hi,

Netflix has ben disrupting itself over the last few years and you can actually see how their product offering and user experience get better with time. It is indeed difficult to assign a value to these aspects but is clearly a sign of a company that is ready to embrace growth over a sustained period of time. However if one were to limit their exposure to NFLX, my limited sense is it should be done at a portfolio exposure level so a huge rally in a stock in your portfolio shall need you to trim a fraction to keep % exposure at a saner level.

Regards Asheesh kristal.ai

The Science of Hitting
The Science of Hitting - 5 days ago    Report SPAM

Jtdaniel,

One quick note that I think is worth remembering: there's an important distinction between being overpriced and being vulnearable to Mr. Market's unpredictable mood swings. Most people are focused on the mood swings (which is silly if they're upredictable) - and even worse, draw conclusions about the attractiveness of the security based on those mood swings. I'll stop myself from saying more because I'm currently writing an article on this topic. Thanks for the comment!

The Science of Hitting
The Science of Hitting - 5 days ago    Report SPAM

Asheesh,

No question that Netflix is a great product, that they've disrupted their own business, etc. The attractiveness of the stock at ~$200 per share is another question. Thanks for the comment!

stephenbaker
Stephenbaker - 5 days ago    Report SPAM

Hi Science,

I interpret your question to be "How rigid should your value investing principles be?"

Just like invidual stocks, value investing principles can evolve over time. When you invest in an individual company, you are investing in a framework of ideas, methods and operations, all of which are proposed and carried out by individuals in their respective corporate capacities. The "culture" as Buffett would say, is most important once a company achieves a level of success on which it can build. I'm not a shareholder (or even a follower) of Netflix, but when an investment passes the culture test, it is difficult to sell even as it exceeds what may be deemed fair value. Part and parcel of passing the culture test is management that recognizes its fiduciary duty to shareholders, and an ability to assess capital allocation in varying economic or business cycles. An ability to reinvent itself in a way that may be presently unforeseeable to passive investors is yet another factor in keeping an otherwise expensive company that has demonstrated such an ability in the past. In essence, most value principles do not take into account such "intangible" type factors, but IMO such factors should not be overlooked.

The Science of Hitting
The Science of Hitting - 5 days ago    Report SPAM

Stephenbaker,

Thanks for the thoughtful response. Here's what I would ask: with everything you've said, how do you define fair value? To me, it's the price at which I think I could conservatively generate a certain level of returns over a long period of time (with that level having some combination of absolute and relative hurdle rates).

Here's my follow up: if you don't sell stocks when they trade at a premium to fair value, when should you sell them? It sounds to me like your answer (in certain situations) is rarely, or maybe never, because of some intangibles.

To use a different example than NFLX, look at Amazon (Bezos) and what they did with AWS over the past decade; one could argue that this historic result shows that the company deserves to trade at a significant premium to your estimate of "normal" fair value to account for businesses that may not even exist until 2020 - 2025. Is that what you're saying?

My concern is that this becomes slippery; are there any prices where AMZN is a sell under that framework? How much of a premium should I apply for intangibles such as the future genius of Bezos and the culture at AMZN? I'm more skeptical than most in this regard (what I really love is when I'm able to buy a stock where little or none of the optionality we're discussing is priced in). This seems relevant here: "As value investors, our crystal ball gets fuzzier faster than it does for other people."

I look forward to your follow-up.

stephenbaker
Stephenbaker - 5 days ago    Report SPAM

Science,

Not sure I can give you a concrete (1 size fits all) answer. I owned (a lot of) AMZN in the late 1990s; sound good so far? Jump ahead 20 years and I no longer own any AMZN shares and only made a very small profit (as opposed to a very large fortune had I sat on my hands). Contrast that with shares of BRK that I have owned (and often added to) since the 1980s and MSFT shares from the 1990s (also added to but never sold) - life changing profits in both. What's the difference? As lofty as shares of AMZN have become, I could not (and still cannot) figure out how the company will ever make a profit sufficient to justify its price. The company brings to mind the old addage "Lose money on every sale but make it up in volume". When I originally bought the stock, the thinking was that AMZN could and would put other companies out of business. That notion still holds true with many folks today, but as time has passed, it looks precisely the other way to me: The WMTs,and TGTs of the world, among others are learning to cope with and compete with AMZN and beat them at their own game (not so coincidently, both companies have been good buys at times within the last year or two). Not that AMZN is going out of business any time soon - it is just not the stock that buyers today believe it to be. Contrast AMZN with Berkshire Hathawy and MSFT: Both have been extremely expensive and cheap at times during the past 30 years. Both companies (for vastly different reasons) treat their shareholders as lifetime partners. BRK, in particular is hugely underowned - it has never made sense to me why anyone with some spare cash did not invest in at least a few shares of Berkshire. Any company that has no limitations, can invest (or divest, as the case may be) in anything, and is run by two of the smartest investment minds of all time deserves far more credit that it has ever received. As for MSFT, there has arguably never been a more dominant, impenetrable monopoly that continues to this day. Sure they have made mistakes - what company doesn't - yet, they continue to innovate and remain relevant in just about every new technology that is brought to market. The culture of management of these companies breeds confidence that regardless of the ocassional blip, the future has few, if any limits. Berkshire, in particular has served multiple wonderful purposes: It is the only stock I own (or have owned for decades) that doesn't pay a dividend, yet that is precisely the appeal of owning BRK; Buffett and Munger are far better than me at allocating capital, and being self-employed, I shunned the IRA/401k option and instead invested in BRK with taxable funds without any adverse tax consequences unless I wanted or needed to sell shares, while being able to leverage the built-up value of the shares over the years as collateral for investing in my primary businesses. I am one of many people today that owe Buffett/Munger a huge debt of gratitude. My children, both teenagers, don't know it yet, but they do as well.

The Science of Hitting
The Science of Hitting - 5 days ago    Report SPAM

Stephenbaker,

I think that's a great answer.

We're getting to the heart of the matter here. What's the intrinsic / fair value of a company run by someone you view as one in a billion who is likely to be around for decades? The answer is A LOT more than whatever price is currently attributed to that security by Mr. Market (assuming anything close to "normal" valuation metrics). On top of that, you have a HUGE benefit from the tax deferral over years, decades, or even permanently (step-up in basis).

"Any company that has no limitations, can invest (or divest, as the case may be) in anything, and is run by two of the smartest investment minds of all time deserves far more credit that it has ever received." - Yes!

Now to the other side of the coin: (1) how many of those exist, (2) that you can spot in advance, and (3) that you can hold for 20+ years? Our number is getting smaller (of couse you only need 1-2 in a lifetime). Then we have the valuation issues you mentioned (and know well): in 2009, MSFT shareholders were looking at a position that was down >50% from where it had been a decade earlier. Even today, those investors are only up ~1/3 cumulatively (before dividends) from 18 years ago. And I don't think that's the whole story: I'd argue hiring Satya Nadella was very important. Said differently, it could be a lot worse than it is right now.

What does any of that mean? I know I can't predict price movements. Was there good reason to sell Microsoft in late 1999 on valuation? I'd say yes. But I also would have said that a few years earlier (1997 - 1999) and missed HUGE gains in MSFT (from ~$20 in early 1998, the result over the next two decades hasn't been too bad - roughly 7% price CAGR).

So the summary of that long answer may be that I don't have a great answer! :)

stephenbaker
Stephenbaker - 4 days ago    Report SPAM

I think the answer lies in the intangibles - anyone with some degree of intellect can compute ratios and evaluate financials. One intangible that I never read or hear about but is important to me is "How many, or few toes does a company have to step on to succeed? BRK doesn't really compete with anyone; MSFT invented (more accurately acquired) its operating system so it did not have to step on toes to establish its presence. OTOH, think about how many toes AMZN steps on to conduct its business.

Thomas Macpherson
Thomas Macpherson premium member - 4 days ago

Sometimes being inflexible in your values but very flexible in response to new data can be easily misconstrued. I think Emerson said it best.

"A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. With consistency a great soul has simply nothing to do. He may as well concern himself with his shadow on the wall. Speak what you think now in hard words, and to-morrow speak what to-morrow thinks in hard words again, though it contradict every thing you said to-day. — 'Ah, so you shall be sure to be misunderstood.' — Is it so bad, then, to be misunderstood? Pythagoras was misunderstood, and Socrates, and Jesus, and Luther, and Copernicus, and Galileo, and Newton, and every pure and wise spirit that ever took flesh. To be great is to be misunderstood."

jtdaniel
Jtdaniel premium member - 4 days ago

Hi Science,

Thank you for the thoughtful reply. My perspective is that the general stock market is over-priced and that Netflix is especially over-priced and therefore particularly vulnerable to a crash or prolonged bear market. I see it as somewhat like Dell or Cisco Systems in 1999, although not that extreme.

The Science of Hitting
The Science of Hitting - 3 days ago    Report SPAM

Tom - I have nothing to add :)

P.S. Congrats on the new book!

The Science of Hitting
The Science of Hitting - 3 days ago    Report SPAM

Jtdaniel,

I don't have any thoughts on Netflix beyond the observation that the stock has done astoundingly well. I don't think another 20x run over the next five years is in the cards :) Thanks for the comment!

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