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The Discerning Investor
Expectations Matter More Than Quality
I published this a week ago, but didn’t send it out to the email list. If you’ve already read about calculating expectations to make smarter investments, ignore. If you haven’t, enjoy. Either way Happy Holidays.
What if 2022 is the year of the discerning investor?
2021 certainly wasn’t. This past year, we enjoyed the boom of meme stocks, SPACs, and high-growth tech. We witnessed the extension of “high-growth tech” to everything from restaurants to alternative milk companies. It’s the future of salad! It’s the future of milk! They may be great companies, but they probably won’t escape being subject to the same valuation parameters and market opportunities as traditional salad and milk companies.
If 2022 is the year of the discerning investor, it would be a throwback to the past. One of the 11 contrarian tools I use to generate non-consensus ideas is to remix what’s old because the old often works again after it goes out of favor. It may sound crazy given the past year, but valuations used to matter, and they will matter again.
The question that best describes the return to the discerning investor is what’s more important, quality or value?
Quality vs Reality
For the past several years, and most acutely the past 18 months, investors have grappled with how to value high-quality, high-growth businesses. We’ve regularly seen public market revenue multiples of 30x, 40x, 50x, and even higher. The SPAC boom has brought venture-stage companies into the public markets with minimal to no revenue.
The quality investor argues there’s almost no price too expensive for a quality company that can generate strong returns on invested capital over long periods of time. The value investor says it’s a mathematical fact that price determines the magnitude of returns. The more you pay, the tougher it is to generate acceptable return and the lower your margin of safety.
The discerning investor embrace both disciplines. They patiently wait to buy quality at a good to great price. A simple rule that isn’t simple to implement. Patience is particularly tough in a market where it seems like stocks keep going up.
I think that the investment community has gone too far in idolizing quality vs appreciating the reality of what’s priced into stocks. In the case of tech stocks, where I spend almost all my time, this manifests into unreasonable expectations for future growth relative to historical norms. Over reliance on near term multiples, even when they seem crazy, abstract away what a company will eventually need to generate in terms of future cash flows to justify its current price. What’s more, creative and intelligent analysts conduct deep research that can convince anyone — including themselves — that a certain company is the next coming of Facebook or Google.
Good thing the discerning investor has simple tools to avoid the mistake of blindly investing in quality.
Reverse DCFs and Base Rates
To make a sound investment, the discerning investor must understand what’s priced into a stock and how realistic those expectations are. The way to figure out what’s priced into a stock is to use a reverse discounted cash flow analysis. The way to compare that to reality is to use base rates. My colleague Will has written about both on his blog.
A quick 101 from me.
The reverse DCF determines what future cash flows, discounted back to the present, would be necessary to justify a stock’s current price. This stands in contrast to a traditional DCF that attempts to estimate fair value based on an analysis of future prospects. The reverse DCF technique was popularized by Michael Mauboussin, although popularized may be too strong a word given how rarely it seems to be used.
Base rates are typically historical outcomes related to the event in question. In terms of assessing what a stock prices in via a reverse DCF, base rates would primarily be the levels of revenue growth and margin that comparable companies achieved in the past. Mauboussin, perhaps unsurprisingly, is also an evangelist for base rates.
When you’re dealing with high growth, high multiple stocks, the most useful base rates are those of hall of fame tech companies like Salesforce, Google, Facebook, Tesla, Paypal, Netflix, MercadoLibre, etc.
Hall of fame growth and margin looks like this:
The hall of fame is the hall of fame for a reason. It’s hard to approach anything like the financial performance they’ve demonstrated at almost every stage in their lifecycle. That doesn’t mean any given company can’t do the same, but it does mean that the base expectation should be that they don’t do it.
Generally, when a company has a few hundred million in revenue, stock prices that demand a 30%+ 10-year growth should raise caution flags. When a company has a billion in revenue, a 20%+ 10-year growth should raise caution. To put each scenario in context, compounding a starting revenue base of $250 million at 30% a year for a decade means increasing revenue by almost 14x to $3.5 billion. Compounding a starting base of $1 billion a year by 20% for a decade means increasing revenue by 6x to $6.2 billion.
Can that high-growth, high-multiple company you’re analyzing really do that? Will it reach the hall of fame one day?
The quality purist may persist that you can still make money paying for quality at a fair price, even a price that reflects the opportunity. True, but you’ll probably be disappointed by the results.
Facebook 2012 Case Study
To build a perspective on investing in a company that meets high expectations priced into its stock, I retrospectively looked at what investors should have paid for FB in 2012 if we knew the future perfectly. In other words, if we had built a DCF with the actual results Facebook has reported from 2012 through 2021 of about 40% compound annual revenue growth (plus forward assumptions through 2029), what should the discounted cash flows have been worth in 2012?
Today, FB trades at around $330 per share. If investors paid close to what FB was really worth in 2012 given how the business would perform, the return would have only been about 9% annualized. At that rate, you would have been better off investing in the QQQ which returned 21% annualized. (It would have still surpassed the 9% FB return even altering history for a lower contribution to the QQQ from FB).
In reality, Facebook IPO’ed at $38 per share in 2012 and languished into the mid-teens before the year was over. The $38 price per share implied around 17% compound annual revenue growth, while an $18 price implied something closer to 10%. At $38, the annualized return was 27%. If you had the guts to buy FB when it was cratering to $18, the annualized return to today was 38%.
Price obviously matters.
The Uncomfortable, Discerning Investor
The discerning investor lives by a single rule: Find companies that could generate hall of fame business results, but the market doesn’t expect it. This means investing in companies that, for some reason, the market has either lost faith in or never cared about. If you only invest in obviously great companies, you’ll be comfortable, but a lot of the return will already be priced in. Facebook traded down to the mid-teens because it wasn’t obvious the company would be able to make the transition from desktop to mobile. Buying Facebook at $18 was uncomfortable in 2012, even though it seems painfully obvious today.
Whether 2022 is the year of the discerning investor or not doesn’t matter. Discerning investment is the surest way to superior returns for any financial investment in any market. Quality at a great price generates great returns. Invest discerningly. Profit uncomfortably.