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Majoring in the Majors
Pumping Iron and Income-generating Assets
“The Iron never lies to you…It never freaks out on me, never runs. Friends may come and go. But two hundred pounds is always two hundred pounds.”
I started strength training about two decades ago because I was skinny and weak. I got bullied a little, and I didn’t like it, so I decided to do something about it. That chip on my shoulder served me well. I got strong and started competing in strength competitions. I even qualified to compete in my weight class at a national level in strongman a couple of years ago.
More than anything, the chip fueled a persistent curiosity about how to get stronger, and the best way to learn is always to do. I’ve learned many lessons from The Iron, but not just lessons about physical strength. I learned lessons that apply to life and even investing.
The most profound lesson, the one I finally accepted after 20 years under the bar, is to just focus on getting the big things right. If you do that, not much else matters.
It’s a lesson worth remembering in volatile markets.
Don’t Major in the Minors
When you’re new at something, all you think about are the major things. There’s nothing but major things when you’re learning the basics. When you have a little knowledge, all you think about are the small things. Then, when you have a lot of knowledge, you realize how much of it doesn’t matter, so you go back to thinking about the major things.
I first heard, “Don’t major in the minors,” from an elite powerlifter named Jim Wendler. He used it to describe how so many people in fitness worry too much about the minor things and spend too little time on the major things. Those who major in the minors worry about how many sets and reps they should do of triceps and leg extensions instead of just squatting and pressing. If you put solid effort into the latter, all the tricep work in the world isn’t going to make much of a difference.
Majoring in the minors is just as common in investing as it is in fitness.
The minors consume most investors. Endless news about stocks, pro-forma non-GAAP adjusted sales multiples, 100-page analyst reports justifying why some business is a quality business, and on and on.
The reason the minors consume us is because the minors make us feel busy, and if we feel busy, we feel like we’re accomplishing. The minors make fund managers feel like they deserve their fees and analysts feel like they deserve their salaries. Most of the things that investors think they should spend their time on have little to no relevance on the outcome of an investment. Worse, much of it distracts us from the major things that do matter to that outcome.
The Majors, Bulleted
There are five really major ideas with some corollaries that keep coming back to me as a fund manager. I’m reminded of them every time the market crushes me like a heavy weight:
1. Fair value for any income-generating asset is the present value of all discounted future cash flows.
1.1 Cash flow determines the long-term value of a business, not revenue, not earnings, not customers, and not innovative technology. It doesn’t matter if we’re talking about a mega cap public stock, early-stage startup equity, a building, intellectual property, or an NFT that yields more digital goods of some value. It doesn’t matter if we’re talking about deploying capital as an institutional money manager, an individual investor, or the CEO of a company. Over the long run, income-generating assets will reflect fair value. This is the most fundamental idea in investing. It’s worth revisiting often because the market will often make it seem that it’s not true in the short term.
1.2 To be a great investor, you need to pay for less cash flow than you’re ultimately going to get. The same “it doesn’t matter” string from above applies. It also doesn’t matter if you’re a growth or value investor. Great growth investors pay seemingly expensive prices for assets that are actually cheap relative to the future cash flow they will generate. Great value investors pay truly cheap prices for assets relative to the future cash flow they will generate. Bad growth and value investors pay truly expensive prices for assets that will never justify the price.
2. The price of an asset is a demand for some minimum level of future performance. That level of necessary future performance is roughly calculable given some basic assumptions.
2.1 Good investors frame their bets based on the probability that an asset will generate more cash flow than the price demands. Whereas point 1.1 is the most fundamental idea in investing, I think this idea is the most important and the least appreciated.
2.2 If you fail to build an intuition for the future cash flow demanded by an asset’s price, you can’t assign reasonable probabilities to that outcome happening. Your outcome on these bets is based on luck, not skill, and should be considered speculation rather than investing. There’s nothing wrong with speculating if you know you’re speculating and play by the rules of that game. Problems come quickly when you think you’re investing and act like an investor, but you’re really a speculator.
2.3 Anyone can look like a genius from luck for a long time, but eventually luck runs out.
3. Every major mistake I’ve made as an investor has been built on a misunderstanding of the future demands built into the price of a stock. This happens in two ways: either I fail to calculate what’s priced in at all, or I fail to appreciate the magnitude of what’s priced in. Failing to calculate is inexcusable and usually happens when I rely on shorthand like earnings or sales multiples. The magnitude error usually relates to not appreciating base rates and how hard it is for companies to sustainably grow at strong double-digit rates.
3.1 Errors of omission hurt just as bad as commission, if not more. Just recently I passed on an investment where the price felt expensive because of basic multiples, so I didn’t take the time to fully understand what the price demanded of future cash flows. Turns out it wasn’t that expensive, and the stock is up 100% since and may still have some more, but muted, upside.
3.2 The other major mistake I’ve made as an investor is not betting heavily enough even when probabilities seemed strongly on my side. It’s not enough to be right. You have to make enough money for being right to really be right. The more you trust your ability to build reasonable probabilities around necessary investment outcomes, the more comfortable you get with bigger bets.
4. Contrarian ideas are the only path to extraordinary returns.
4.1 The rationale for contrarianism as the only path to extraordinary returns is logically infallible. If you do the same thing as everyone else, you’re bound to get the same result, and the market represents the actions of everyone else. Therefore, if you do the consensus thing you get the market result. The only way to get results different from the herd is to do something the herd doesn’t. If that thing is right, you get extraordinary results. If that thing is wrong, you get terrible results.
4.2 The hardest thing for a contrarian is picking the right battles. Unconventional wisdom is often wrong. The contrarian equity investor should always test the uncomfortable and unlikely variant view, ignore it often, and bet big when the probabilities are favorable.
5. Buy quality businesses that have a good probability of returning more cash than the price demands and hold that business for a long time. It feels stupid to even write something that obvious, but most investors think they want to play that game. Few do it.
5.1 My contrarian view on quality: Most investors spend too much time trying to prove a business to be of good quality. If it isn’t quickly obvious, it’s probably not a quality business.
5.2 It’s better to start by trying to prove a business isn’t quality. Bad business traits are easier to prove than good ones: Products customers don’t care about or can easily replace, high price sensitivity to the product, lack of repeat business, bad balance sheet, average management, etc. The greater challenge for the investor is to embrace the discipline of saying no rather than knowing what should be a no.
5.3 One of the best pieces of advice we ever got starting our investment firm was “don’t flinch.” The advice was about venture investing, but it applies across all spectrums of investing. Don’t flinch means don’t overlook some little thing that bothers you. A flinch is your instinct saying something is a bad bet. Never flinch on management. Never flinch on the quality of a product. Never flinch on customer addiction to the service. Never flinch on what the price demands for future performance.
5.4 As to what makes a great business, I look for four major qualities:
A virtuous cycle of value sharing between company and customer. This means the company can provide more value to the customer while simultaneously improving the business prospects, i.e. cash flow.
A product or service that the customer can’t live without and can’t easily substitute or get anywhere else.
An addictive or cult-like element to the business.
Management you’d describe as an animal (h/t Paul Graham). A trustworthy animal.
5.5 When you find it at the right price, swing.
What You Come to Resemble
The Henry Rollins quote that started this piece is well known among lifters, but it’s another quote from the very same piece that I think is even more striking for investors:
“It took me years to fully appreciate the value of the lessons I have learned from the Iron. I used to think that it was my adversary, that I was trying to lift that which does not want to be lifted. I was wrong. When the Iron doesn’t want to come off the mat, it’s the kindest thing it can do for you. If it flew up and went through the ceiling, it wouldn’t teach you anything. That’s the way the Iron talks to you. It tells you that the material you work with is that which you will come to resemble. That which you work against will always work against you.”
Now, replace The Iron with The Market:
It took me years to fully appreciate the value of the lessons I have learned from the Market. I used to think that it was my adversary, that I was trying to beat that which does not want to be beaten. I was wrong. When the Market outperforms you, it’s the kindest thing it can do for you. If it laid down and let you beat it every year, it wouldn’t teach you anything. That’s the way the Market talks to you. It tells you that the material you work with is that which you will come to resemble. That which you work against will always work against you.
When you work with the majors, you prepare yourself for major outcomes. If you work against the majors, you set yourself up for major failures. The Market wants you to win, but you must accept the lessons it teaches you. The lessons I keep learning bring me back to the majors, and that’s the kindest thing the Market has done for me.