Decision Making > Research
And the merits and consequences of doing nothing
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The Build: Decision Making
The job of a fund manager is to make intelligent decisions. It is not to do research.
Elevating decision making over research is a seemingly contrarian idea. Participants external to the money management game, and even participants in the game, often get hung up on the glory of research.
An otherwise great article from Bryne Hobart at The Diff about research allocation led with this:
“The job of a professional investor is mostly reading, listening, and talking, followed by a bit of Excel. And the more senior someone gets, the less time they spend making sure next quarter's cash flow estimate includes reasonable assumptions about accounts receivable buildup, and the more time they spend on the qualitative work that informs this. And even outside of investing, there seems to be a positive correlation between seniority and doing something that looks a lot like research. (Someone who isn't a professional investor, but who is managing a company or a team, is still making investment decisions—they're allocating time and their own attention more than dollars, but still aiming for the best risk-adjusted return.)”
I love the second part of Bryne’s quote — highlighting that non-investor management has a similar capital-allocating responsibility that depends on intelligent decision making. It’s the first part that spurred this Deload.
Research is what money managers spend time on, but the job is to make intelligent decisions.
As partner at an investment firm that touts research as a differentiator, demoting research to decision making is uncomfortable. It’s also not flippant. I’ve been living the idea of research vs decision making since we founded Loup five years ago. As former sell-side analysts, the research was the easy part. Translating research into intelligent investment decisions has been the hard part.
Decisions are not intelligent because they are right. Decisions are intelligent because they are guided by a coherent investment philosophy or process.
Over those five years, I’ve embraced three important learnings about decision making as a fund manager:
1. Define the game you’re playing
2. Respect the efficient frontier of knowledge
3. Be disciplined
Define Your Game
You can’t make intelligent decisions if you don’t know the point of your decisions in the first place.
All investment firms are judged relative to the market. As such, most firms vaguely adopt beating some benchmark as the game they play, but I think that’s the first failure point of creating a solid foundation for making good decisions.
If all you care about is beating a benchmark, you’re necessarily inviting an unstable judge of decisions. The market does wild things that don’t always make sense, sometimes for long periods of time. If your decisions are judged against the market — even if just implicitly via a mandate to beat it — you’re eventually going to have to do things that don’t make sense to keep up.
A firmer decision-making foundation excludes market influence.
We invest in where the world is going. Where the world is going necessitates a focus on innovation and growth. It’s broad enough for us to focus on growth-oriented companies but narrow enough that we’re not chasing every company with a pulse and an attractive free cash flow yield.
We also have a strong discipline about valuation. We think about getting paid back through free cash flow generation, not higher multiples and market sentiment.
These two philosophies mean we’re playing the “own growth assets that will pay you back in free cash flow over time” game. If we play this game well, we should beat the market over time.
When you know your game, you can judge your decisions against that game. Our discipline on valuation has forced us to allocate capital slowly. So slowly it’s painful. It led to underperformance last year, but we haven’t had our heads ripped off this year. There are always things we wish we did differently, but we’ve stuck to our game, and I can live with that decision.
Efficient Frontier of Knowledge
Not only do we often glorify research in the investing world, but we also glorify research to the point of knowing more than anyone else.
You don’t need to know more than anyone else. You need to know enough to make an intelligent decision based on the game you’re playing.
Knowledge about an investment opportunity lives on an efficient frontier. You want to take your knowledge out to the point where returns to incremental knowledge diminish. Often this point will mean you know more than most other investors, but that shouldn’t be the point of research.
The value of incremental knowledge diminishes for several reasons. The biggest is that at some point, the incremental data point is irrelevant to the bigger picture of the business. Knowing the fourth sales rep in Utah had a bad month probably won’t be the difference between a 10-bagger and a zero.
Not only is excess information useless, it can be harmful by making you overweight unimportant things. Also, the deeper you go into a research process, the deeper your commitment. If you’re predisposed to liking a company, the more work you do on that company will only serve to reinforce that view.
Outside of irrelevance and bias, research beyond the efficient frontier comes with opportunity cost. When you go deeper in one company, you can’t learn about another. If some company is too expensive and not a great investment, no amount of knowledge will change that. Only the market can readjust expectations. You’re better off looking for other companies in the meantime.
There’s no science to knowing when you know enough about a company. It’s an art that comes with repetition.
The point of this piece isn’t to diminish research. Research is critical. Everyone knows it. Everyone is also doing it, and a lot of other investors are good at research too.
Discipline is in shorter supply than research. We don’t talk about discipline as much because it’s abstract and hard to sell. It’s a matter of willpower, a belief in your processes, and it will always be challenged when the market works against you.
No amount of research can save an investor from undisciplined mistakes.
Sometimes investments don’t work because of bad luck or bad timing. That’s unavoidable. Investments that don’t work because of lack of discipline are inexcusable. If you can limit those mistakes, play the game you set out to play, and keep your knowledge on the efficient frontier, you’ll find success in the long run.
Notes and Quotes
On Doing Nothing
Another great challenge for fund managers is to deal with the pressure for action. Doing something, anything, is often more comfortable than doing nothing because of the implicit demands of being paid to manage money. It’s easy to fool yourself into believing that investors are paying you to act, especially in chaotic times.
A fund manager’s job is not to act, it’s to make intelligent decisions.
Sometimes the most intelligent decision is to do nothing. It may be the most intelligent decision far more often than most investors admit.
At the Sohn conference, Stan Druckenmiller said of the current bear market:
The most uncomfortable thing is often the most intelligent, and doing nothing feels pretty uncomfortable right now.
The Fed, on the other hand, has done nothing for too long. They need to do something fast. We could debate how much the Fed can really do in the face of inflation, how we got here, how CPI masks true inflation, but all of that is besides the point.
“Rather than debate how we got here, we need to be focused on what can we do moving forward. The average American family is getting decimated financially right now. The cost of eating food at home has increased 11.9% over the last 12 months. Gasoline is up nearly 50% in the same time frame. That is almost impossible for a family to withstand, especially when wages aren’t growing at the same rate.”
Fed’s gotta do something.
I talked last week about how playing the Fed guessing game is dumb. I’m not going to guess what they’ll do next week, but a few things seem important in trying to set probabilities for both Fed and economic outcomes:
The May number came in hot, up 8.6% y/y vs 8.3% expected.
Inflation is essentially tied for the most important problem facing the U.S. according to a Gallup poll. Slightly ahead is…poor leadership.
Political pressure is increasing on the Fed to do something meaningful. President Biden made it clear just over a week ago that controlling inflation is on the Fed.
Inflation is bad. Everyone knows it’s bad. Everyone’s talking about how bad it is, and that reflexive spiral makes it worse.
The idea of a continued gradualism in Fed tightening seems less and less tenable by the day. A few weeks ago, it seemed there was growing belief that the Fed would back off of tightening after July with growing signals of recession. Now there’s talk of 75 basis points next week.
To ask the obvious: Can we really imagine the Fed backing off in September with rates sub 2% if inflation is still in, say, the 5-6% range? Is that politically viable?
Perhaps we’ll find out.
Monopoly Builders and Destroyers
Legendary growth investments depend on gaining relative monopoly power, then broad monopoly power. As Peter Thiel says, competition is for losers. His startup playbook is to dominate a niche, then expand that domination.
Meanwhile, competition has been a core topic for the government, particularly as it relates to Big Tech that have been those legendary investments. FTC chief Lina Khan and DOJ chief Jonathan Kanter are engaging in significant revisions to merger guidelines aimed to reduce monopoly power.
From Matt Stoller at BIG:
“Kanter and Khan are trying to use the merger guideline process to restructure this environment, and bring back the legal tools to address the agglomeration of capital. Both of them withdrew existing merger guidelines, which are descended from the Reagan era, and have started a process to rewrite them to attack corporation concentration. That process has been going on for more than six months, and it is very different from how such guidelines were crafted in the past. The last time the guidelines were updated was in 2010, and during the entire time they were being rewritten, the FTC received just 32 total comments from the public.
This time, however, Khan and Kanter have done listening sessions with workers and business leaders, and collected over 5800 comments from the public - including from many of you. The merger guideline rewrite is also an ideological fight; Kanter has been more aggressive than Khan on this point, explicitly dismissing the old consumer welfare standard as largely incoherent and irrelevant in speeches before corporate antitrust lawyers. Mergers aren’t the only area of legal revival. Kanter, for instance, is revitalizing criminal law, upsetting the antitrust bar by suggesting a revival of criminal enforcement of laws against monopolization.”
As I explain in what feels like every Deload, equity values depend on the sum of all future cash flows discounted back to the present. Good investing requires ultimately getting more cash flow than you pay for. Monopolies have long duration cash flow streams that are often underestimated by market prices, making them persistently attractive investments.
The machinations at the FTC and DOJ may make it harder to achieve and sustain true monopoly status, and investors should pay attention.
In the near term, we should expect rockier paths to big mergers. Markets are demonstrating that given the ~20% discount for Activision given Microsoft’s takeout price. In the longer term, we’ll see how the regulatory framework shapes up.
If the new frameworks are so onerous that any level of monopoly is attacked by the government, we should adjust long-term expectation for future cash generation at monopolistic companies accordingly.
Thanks for reading, and see you next week.
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