Renting vs Buying Businesses
Speculating on fundamental improvements
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The Fundamentalist Investor
Is Stan Druckenmiller, one of the greatest traders of all time, a speculator or an investor?
Most “investors” are speculators by the strictest interpretation of Buffett, who said:
“When I buy a stock, I don't care if they close the stock market tomorrow for a couple of years because I'm looking to the business — Coca-Cola, or whatever it may be — to produce returns for me in the future from the business.
Now, if I care if whether the stock market is soap tomorrow, then to some extent I'm speculating because I'm thinking about whether the price is going to go up tomorrow or not. I don't know whether the price is going to go up.
Speculation, I would define as much more focused on the price action of the stock, particularly that you, or the index future, or something of the sort.
Because you are not really — you are counting on — for whatever factors, because you think quarterly earnings are going to be up or it's going to split, or whatever it may be, or increase the dividend — but you are not looking to the asset itself."
To Buffett, Druck must be a speculator, but that doesn’t feel a fair estimation.
Druck didn’t build a legendary career on full tilt buying meme stocks and crypto. I’m not aware of any hidden TikTok accounts where he says he just looks for stocks that are going up, buys them, and sells them when they start going down.
The “is Druck a speculator” question has me rethinking the nature of speculator vs investor.
The Money Spectrum
The speculator vs investor debate seems binary. A better framework might be more of a spectrum with three zones:
The speculator focuses on where the price might go. He trades based on momentum, rumors, hype, or other non-business factors with hopes of selling higher.
The fundamentalist buys the business that he believes will generate improving earnings over some foreseeable period. The market usually marks up assets with improving prospects 6-18 months before the improvements happen. After his thesis plays out, the fundamentalist looks for the next area where businesses will show fundamental improvement.
This is the game Druck plays. He doesn’t lock himself into owning businesses the way Buffett does — the business buyer.
The business buyer looks for assets that can compound capital by generating strong ROIC and long-term cash flows as if he owned the whole business. He doesn’t care if he can sell the assets because he doesn’t plan to.
Visually, the spectrum and focus metrics look like this:
The speculator trades tickers, the fundamentalist rents businesses, and the business buyer owns them.
Buffett disciples argue that owning businesses is the holy grail of investing, true investing. You want to own assets for the cash flows they generate to you as owner. A true business owner — imagine a landscaper — doesn’t trade in and out of his business when fortunes wane.
Fundamentalists — which includes most hedge fund managers — would counter that the long term is inherently unpredictable. Few investors can build the understanding of a business like Buffett, and no business is truly predictable beyond a few years. Things change. The near-to-mid term performance of a business dictates more predictable price action that builds into the less predictable long term. Since the structure of public markets allows for the easy renting of businesses, ignoring these near-term changes leaks alpha.
Choosing a game is a matter of personal preference, but it’s clear neither the fundamentalist nor the business buyer shares much in common with the speculator.
Despite their differences, the business buyer might do well to borrow from the fundamentalist’s playbook.
P/E Sweet Spot
One of the biggest mistakes business buyers make is paying too little heed to the near-term earnings picture. Business buyers believe too strongly in their ability to see the distant future through the lens of a business’ current strengths.
To compensate, the business buyer can think like the fundamentalist by considering how much a company is going to earn in the foreseeable future and the multiple those earnings deserve.
Predicting one-to-three-year earnings is the crux of most investment analysis. It’s the core focus of the fundamentalist investor who looks for areas where earnings expectations are too low for cyclical, sector, or idiosyncratic reasons.
But it’s hard to find positive earnings revisions heading into a likely recession.
Anecdotally, fundamentalists generally seem more bearish than business buyers today, and that makes sense. The fundamentalist sees downward earnings pressure that may not be fully reflected in current prices. The business buyer looks past the potential of recession and may see what he thinks a great bargain.
They both may be. Stocks may need to come down more in the near-term per the fundamentalist, and there may be some great bargains for the business buyer looking longer term.
This is where I think the business buyer can learn most from the fundamentalist.
Buffett adherents may say that predicting macro outcomes is impossible, but factoring in a deteriorating economic picture is the sane middle ground between fundamentalist and business buyer. The business buyer should be careful not to underestimate the potential for near-term pain beyond his ability to bear it despite a commitment to long-term ownership.
Persistent issues in near-term earnings are where the business buyer risks missing a signal that a business franchise may not be as strong as he thinks. Most great companies demonstrate consistently strong earnings quarter after quarter. In some cases, expectations may get ahead of a stock, and even a great business may disappoint for a few quarters; however, sustained disappointing earnings and downward revisions are usually a sign that a business may not be as great as the buyer may have thought.
When the near-term results defeat your thesis as a business owner, there’s no glory in continuing to own for the sake of being an “owner.” It’s time to move on.
Multiples A & B
Multiples are on the spectrum twice because there are two ways multiples affect the near-to-medium-term value of an asset: macro and idiosyncratic.
Multiple A on the left side represents the impact of rates and macro on market valuations. Generally, when rates go up multiples come down and vice versa because rates affect the risk-free opportunity cost of an investment. If rates go higher, the opportunity cost of an investment is higher, thus the yield of the investment should go up. Multiples are yields inverted, so multiples must come down for investment yields to go up.
Buying stocks purely on the hope of macro-driven multiple expansion is closer to speculation. Business buyers should specifically avoid getting overly excited by businesses when rates are very low and multiples are very high because there’s only one way for multiples to revert (see 2021).
Multiple B is the idiosyncratic component of an asset’s valuation. This lives closer to the side of business buying than speculation because it relates to the sustainability of the business.
Setting aside macro factors, markets assess lower multiples to businesses with shorter assumed life spans. This is perhaps overly simplistic, but the reason Apple and Coke trade over 20x earnings and oil companies were trading in the single digits until recently is because investors assume the former will be around for a long time. The latter not.
Fundamentalists consider whether evolving business performance over the next several months may change how investors think about terminal value, yielding a higher multiple. The fundamentalist may see a new product or business line ramp not just as a tailwind to earnings, but a reason to rerate the multiple upward. The business buyer sees the same success as a reason to assume greater duration in the asset, meaning a richer terminal value.
Viewing the nearer-term market outlook as a fundamentalist via multiples and earnings, Michael Burry said the current correction may only be half over:
Multiples have compressed, as they should have given a ~200 bps increase in the 10-year Treasury. Maybe we escape recessionary calamity and earnings don’t need to come down too much. Or maybe we’re destined for a sharp recession, and earnings need to come down a lot.
Only time will tell. Either way, the business owner will be well served to heed near-term business signals as a fundamentalist.
Notes and Quotes
Happy Birthday America
As I write this on July 4th, I can’t help recognize the growing predictions for the end of American greatness.
Some cite China’s growing threat, others the extreme polarization that’s gripped the nation. The latter gives me the greatest pause.
Noah Smith prefaced a quote from Abraham Lincoln’s Lyceum Address:
The fundamental danger to the U.S. right now is internecine conflict. Our external enemies and rivals are formidable, but in recent months they have shown themselves to be less competent than we believed — Russia military, and China economically. The U.S. has managed to stymie Russia’s entire army without a shot fired, simply by supplying a bit of arms and intelligence to Ukraine. And China’s period of rapid catch-up growth appears to be over, thanks to a real estate crash, ill-advised Covid lockdowns, and a rapidly aging population. Abraham Lincoln’s famous words from his Lyceum Address still ring true:
“Shall we expect some transatlantic military giant, to step the Ocean, and crush us at a blow? Never!--All the armies of Europe, Asia and Africa combined, with all the treasure of the earth (our own excepted) in their military chest; with a Buonaparte for a commander, could not by force, take a drink from the Ohio, or make a track on the Blue Ridge, in a trial of a thousand years.
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.”
A democracy naturally lives through all time or dies by suicide. That is her destiny. Truly free men can only lose freedom through surrender. None can take it. That’s why internal conflict poses such danger to America.
Christopher Hitchens — the patron saint of contrarianism (yes, that’s ironic Hitchens fans) — once said that politics are meant to be divisive. I’m not sure if he meant to this extent — the extent of ideological denial of basic truths.
I think often of the parallels of markets and politics.
Markets are driven in large part by extremes just like politics — rabid bulls followed by vicious bears. But markets don’t permanently lose the fundamental underpinnings of what makes them work. Participants might deny the fundamental truths of valuation in a raging bubble, or they might act like the world is ending in the depths of a bear market, but markets don’t die. They’re resilient, as are the truths that govern long-term market function. Markets always come back, buoyed by the persistent growth of American progress.
I hope the same is true for our democracy.
Happy Birthday America. May we enjoy many more.
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