Investing PatternsGary Mishuris, CFA
At the heart of investing is understanding why something is mis-priced. Contrary to the belief casually held by many, “it’s cheap” or “it’s a good company” or “it’s growing rapidly” is not a sufficient reason to believe that a mis-pricing exists. Cheap stocks can be overvalued because their businesses are deteriorating rapidly. Good companies or those experiencing rapid growth may be priced at a level that implies they are even better companies or faster growers than they are.
So what constitutes an investing pattern of reoccurring mis-pricing? For such a pattern to exist, investors need to be repeating a mistake, under similar circumstances, where they are improperly estimating the present value of the company’s cash flow stream. Furthermore, we need to be able to identify that mistake in real-time and act to take advantage of the resultant disconnect between price and value.
Investing patterns can be divided into analytical patterns and behavioral patterns. Analytical patterns are those where investors systematically under-appreciate the future cash flow stream in a way that is predictable at the time. Behavioral patterns occur when events trigger investors to react viscerally rather than analytically, and as a result create an investment opportunity where rational analysis would clearly indicate a higher value than the market price.
There are a number of investing patterns that I know of, and likely many more that I don’t know of. The important thing is not the number of patterns that an investor knows, but which ones are within his or her circle of competence and behavioral comfort zone to execute successfully in a repeatable manner.
The first class of patterns that I find fits my process and temperament is that of a temporary problem facing the business which is currently depressing profitability. The financial profile of such a company should show recent profits at reduced levels from those achieved in the past. There are two distinct patterns within this class: cyclical problems and company-specific problems, and they have somewhat different ways in which we can take advantage of them.
With cyclical problems, there is usually an industry-wide or an economy-wide recession in corporate profitability. Assuming we have correctly diagnosed the problems to be cyclical, which isn’t always easy to do, the restoration of past profitability is a matter of when, not if. Typical cycles last anywhere from 12 to 36 months, but there is no way that I know of to predict the length of any specific cycle.
However, that is exactly what most market participants try to do. They sit there, and pointlessly try to guess when the cycle is about to turn. Why? Because they don’t want to buy the stock too far in advance of the turn in profits, for fear of having it not appreciate, or worse, go down further for some period of time. So there they are, using methods not too far removed from reading chicken guts, guessing which quarter or in which half of which year the cycle will turn, so that they can be smart and buy the stock 3-6 months ahead of such a turn and have it appreciate soon thereafter.
There is a better alternative. Rather than using the timing of the cycle as the trigger for investment, it is much better to use the relationship between price and value. The whole point is that if we correctly diagnosed the problems as cyclical, the cycle will turn, usually within a couple of years, and the price/value gap should close when it does. So the way to prevent yourself from “being too early” is to demand a low enough price in relationship to value so that even if the time for the gap to close is on the outer end of the typical range our annualized rate of return is still very attractive.
For example, imagine that there is a cyclical company that your thorough analysis suggests should earn $1 per share in free cash flow per year on average. You do not believe there is any long-term growth in this business cycle-to-cycle and therefore conclude that the stock should be worth approximately $10. Of course you should be thinking in ranges rather than specific point estimates, but for brevity let’s just assume that the $1 in free cash flow and the $10 value represent the mid-point of our range. However, the company is currently earning only 50c per share because of a cyclical problem in the industry, and so the market, believing that profitability is permanently reduced, prices the stock at $5.
Assuming your analysis is correct, if you buy the stock at $5 and the market revalues it to $10 when you are proven right, you can afford to wait quite a while and still earn a high annual rate of return. So whether this cycle takes a year or 3 years, your returns will be very attractive. Even if the cycle takes 5 years to turn, you will still early approximately 15% per year. You might be thinking: isn’t the business worth less if the cycle turns later rather than sooner because the present value of the cash flows is reduced? That’s correct, but the magnitude of this effect is quite small, in the 5%-10% range in most cases, and if you allow for sufficient margin of safety in your purchase price you will still do very well.
The second investing pattern is the turnaround, or a temporary company-specific problem. The difference from a cyclical is that the problem will not go away on its own with mere passage of time as the supply/demand dynamics of the industry normalize. Management needs to correctly diagnose the problem, create a plan of action to fix it, and then execute.
The key insight with respect to turnarounds is that historically most of them do not turn! This is notwithstanding confident statements and plans from well-dressed and well-credentialed executives to the contrary. So the base rate probability of turnarounds is that approximately 1 in 3 “turn” as defined by their profits being restored to prior levels.
With cyclicals, being early to invest is perfectly fine as long as the price is right. Not so with most turnarounds. Early in a turnaround the probability of success is low. So barring some mitigating circumstances such as asset-based downside protection or a price so low that even a scenario where the business does not turn around would translate into an attractive investment, investing early in a turnaround can often be a mistake.
So when is a good time to invest in turnarounds? When the key operating metrics have started to turn, but prior to them being fully reflected in restored profitability of the company. At this point the odds of success will be dramatically higher, which should more than compensate for the potentially higher stock price. Mathematically, an 80% probability of getting $10 in a year purchased at $6 is much better than a 33% chance of $10 in 3 years purchased at $5.
I have observed that successful turnarounds, especially those in which new management has come in to fix the problem, usually follow a similar timeline:
- Year 1: Understand the problem and plan the solution
- Year 2: Implement the solution and begin executing on the plan
- Year 3: Accelerate execution of the plan
Evidence that the solution is working is usually visible sometime between the second half of Year 2 and the first half of Year 3. Furthermore, once a turnaround shows signs that it is on track, it is relatively rare for the progress to reverse. It is also frequent that there are company-specific metrics that will show improvement if the turnaround is successfully happening before profits begin to recover. Actually, in some cases profits get worse at the exact moment as the key operating metrics are flashing green. That’s the opportunity. The market participants mostly wait for evidence of a profit recovery, and if you know your target well and management publicly discloses the key operating metrics, you can reach a high-probability conclusion that a turnaround is very likely before the market reflects it in the stock price.
A third investing pattern is companies with long duration of moderately above-average growth that is underappreciated by the market. Investors get very excited about high growth rates. However, there is a range of growth, usually in the 6% to 12% range, which mostly meets with a yawn and a slightly above-average valuation. However, there is a huge difference in value between a company growing at 10% for 5 years and one that is growing at 10% for 20 years. That difference is not always fully appreciated by the market. So if you study the business carefully and reach a conclusion that it is capable of sustaining moderately above-average growth for a long time, you might be able to purchase the stock at a price that does not reflect that.
The fourth investing pattern is action by the market that is driven by behavioral mistakes rather than by an incorrect analysis of the situation. This might take the form of a whole industry being perceived as undesirable for investment purposes and therefore not worth further analysis. Or it might be forced selling for noneconomic reasons, such as in the case of some spin-offs. Complexity is another barrier to rational analysis, so complex situations usually get a disproportionate share of quick “passes” from investors, thereby sometimes depressing the price unduly. Finally, a version of this is simple neglect, as might be the case with a company emerging from bankruptcy or one that is small and is not well followed by market participants.
What all of these have in common is that other thoughtful investors would probably reach the same conclusion as you based on a rational analysis of readily available facts. However, that’s the whole point: in these situations they are not engaging in rational analysis, but rather either avoiding the analysis or substituting an emotional response for a logical one. Remaining rational and having the temperament to act calmly on your analysis is all that is required – but for many market participants that is too much to ask for in certain circumstances.
There are a number of other patterns that I am aware of. For example, high-growth “compounders” that have attractive reinvestment economics for a long period of time, resulting in decades of high growth not fully appreciated by the market. Or companies that are early in an adoption “S-curve” for their product and which are about to experience staggering, in percentage terms, growth that is not reflected in market prices.
So if I am aware of these, then why not try to add them to my repertoire and take advantage of them as well? They are outside of my mental comfort zone, in large part because the starting valuation is usually quite high, which would result in a material loss in case I am wrong on the fundamentals. I have also realized that I am uncomfortable betting against base rate probabilities, as would be the case of a statistically very expensive stock that you think should be even more statistically expensive based on your analysis.
Taking advantage of investing patterns only works if you are able to remain calm and act rationally, usually when others aren’t. If you are yourself uncomfortable, there is a decent chance that it will be you rather than other market participants making the mistake at some point in the investment journey. Knowing yourself and knowing the boundary beyond which you are not able to maintain your temperament is crucial to investing success.
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Article by Gary Mishuris, Behavioral Value Investor