(Note: This was adapted from the Q3 2020 letter to limited partners of Silver Ring Value Partners.)
[activistinvesting]
Q3 2020 hedge fund letters, conferences and more
“What is going to cause this stock to get re-valued by the stock market?” This is a question that I hear a lot from my frustrated value investor friends. It is asked with equal exasperation about stocks that are incredibly cheap relative to their profit levels and ones that are astronomically expensive relative to any fundamental measure.
I do not know. Nobody knows. In some cases, that valuation might even be appropriate, at both extremes. After all, value investing is not about statistical metrics at a point in time, but rather about weighing the full future cash flow stream of the company.
We humans are social animals. It is ingrained in our brains that prolonged disapproval of our peers is something to be avoided. In the old days that might have meant expulsion from the tribe and likely lonely death. While that is no longer the case for most of our society, our brains still, to some degree, respond to the disapproval of the group with the same trepidation.
The longer the stock market withholds its validation from our investments, the more natural it is for our brains to begin to doubt our conclusions, no matter how rigorously derived. There is a healthy aspect to this self-doubt and an unhealthy one.
It is healthy to use the negative feedback from the market to reassess our thesis. To re-focus on the business and whether or not we are approximately right on our estimated cash flow stream that underlies our investing decision. Just like when driving on a highway in a fog you can keep track of the road by the bright white line on the side, so we can use the company’s free cash flow to help us decide if our thesis is on track.
It is unhealthy to re-focus on the stock price. Gradually accepting the market’s current stock price as the right answer the longer it persists regardless of fundamentals is just mental capitulation to pain. When I have spoken in the past of temperament being the most important differentiating characteristic of a good investor, this is what I meant.
“Are value investors just missing growth stocks?” That is the question almost everybody is asking, including value investors themselves. Especially as that dwindling group of value investors observes sometimes smug growth investors describe how they had owned yet another stock that went from 5x sales to 20x sales due to the company’s amazing fundamentals. Which, of course, these growth investors foresaw in advance.
Why have growth stocks done so well in the last couple of years? There are three reasons:
- Falling interest rates mathematically increase the net present value of higher-growth cash flow streams by a greater percentage than that of slow-growing or declining ones
- Real value creation by new companies doing things better than their predecessors
- In a time of great uncertainty, investors are looking for a combination of a business model and current results that implies a great degree of certainty about the future
To expand on the third point, think about which business models have gone up in price the most in this stock market. It is companies that are subscription-based (“as a Service”), or have similar economic characteristics, are showing above-average current growth in sales and which have convinced investors that they can sustain that above average growth for a long time. In an uncertain world where not only the economy but also the very structure of our society seems less certain than it has been in a while, those three characteristics have imbued this group of companies with a comforting glow which makes investors not worry too much about price.
Is this time different? Over the last 100+ years we have seen waves of innovation and innovative companies. To list just a few, think about radio companies in the 1920s, Nifty Fifty companies in the 1960s and the internet companies in the 1990s. Technology has changed drastically: from horse buggies to cars to commercial air travel; from telegraph to telephone to smartphone. What would someone 100 years ago think about color TV, which we all take for granted?
Here is the point. New technology is… not new. There have been many waves of companies with powerful demand trends driving their sales growth and seemingly unstoppable business models. A few have done marvelously well both as companies and as investments. However, the experience of investors investing in all of these companies as a group has been terrible. Why? Because in their mad rush to catch the wave, capital was deployed with little regard to the price of the investments.
If you possess the skills to find the few long-term technology winners in advance of the market price becoming so high that future investment returns are likely to be unattractive – then more power to you. I know myself, and I know that I do not have that skill. I suspect that of the investors who are currently patting themselves on the back and enjoying the temporary stock market validation, many also do not possess that skill. Only they do not know that yet.
Benjamin Graham, when he wrote Security Analysis in 1934, addressed this well. He had just witnessed the mad rush towards new market darlings of the 1920s followed by the bust of the Great Depression. Having observed human nature up close during this boom and bust cycle, he had this to say about growth investing irrespective of price:
“Considering the 1927–1929 period we observe that since the trend-of-earnings theory was at bottom only a pretext to excuse rank speculation under the guise of “investment,” the profit-mad public was quite willing to accept the flimsiest evidence of the existence of a favorable trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward.” – Security Analysis, 6th Edition, page 364
“We incline strongly to the belief that this last criterion—a price far less than value to a private owner—will constitute a sound touchstone for the discovery of true investment opportunities in common stocks. This view runs counter to the convictions and practice of most people seeking to invest in equities, including practically all the investment trusts. Their emphasis is mainly on long-term growth, prospects for the next year, or the indicated trend of the stock market itself.” – Security Analysis, 6th Edition, page 375
Does any of this sound familiar? How little things change in investing.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
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Article by Behavioral Value Investing
