The Virtue of Patience

And the Shift from Seller's Market to Buyer's

Jul 19, 2022

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Painful Patience

To beat the market, buy great companies at cheap prices then hold them for a long time.

That's the fundamental axiom of investing. If you buy high-quality companies at cheap prices, there’s almost no scenario where you don’t beat the market over time.

Many investors want to play this Buffett-inspired game but don’t. We give into the excitement of the markets, buy a handful of stocks, watch them closely go up and down, and never think much about the underlying business beyond a year out. We’re too impatient.

Patience is painful. If it wasn’t painful, patience would be easy. If patience were easy, then it wouldn’t be patience.

Our impatience as investors encourages us to violate obvious extensions to the core axiom:

Extension 1: Most businesses are not great. We trick ourselves into buying mediocre businesses.
Extension 2: Most great businesses are not “cheap.” We trick ourselves into paying too much.
Extension 3: Most of the time, we shouldn’t do anything. We trick ourselves that activity correlates to returns. Inactivity is more likely to correlate to returns, particularly if you avoid the prior two traps.

To be patient, we have to start with knowing what kinds of businesses we want to own.

Great Businesses

Quantitatively, all great businesses can reinvest cash flow at strong rates of return for long periods of time. Finding that outcome is the objective of the great business buyer.

Qualitatively, the components that create the right environment for long-duration reinvestment are obvious:

The customer loves the product with high referral rate.
The product has a high rate of reuse.
The customer can’t get a comparable experience anywhere else.
The customer uses the product basically forever.
“Everyone” needs or wants it, even if indirectly or unknowingly.

This framework describes Apple, Amazon, Google, and Microsoft. It describes Costco, Nike, Lululemon, and Coke. It describes Adobe, S&P Global, TSMC, and American Tower.

If a company makes a product that customers really love, they can’t it get anywhere else, they use it forever, and everyone needs or wants it, that must create a lasting environment for reinvestment back into the business at strong rates of return.

But most businesses are not great.

Most products are average, commonplace, and transitory in need or want. Most customer bases are limited well below “everyone.” Usually, these realities are obvious. We fool ourselves into ignoring the signals more frequently than misunderstanding them.

And even when we don’t ignore the necessities of the great business, we often ignore the price.

Great Businesses at Cheap Prices

Usually, great businesses present great prices for one of three reasons:

Broad market headwinds.
A temporary fundamental challenge to the long-term prospects of the business.
The great business is only emerging now, and the market hasn’t fully appreciated it.

We’re living through a macro regime change where equity multiples everywhere are being re-evaluated. In hindsight, one day we might look back and say the 2022 bear market created many great values for great companies, but things aren’t cheap just because it’s a bear market. If you can underwrite a great return from a great business, that’s cheap.

Temporary fundamental changes are like when Apple had issues with China and disappointing product cycles in 2016, which is when Buffett started buying. Even great companies sometimes stumble. The challenge is identifying whether the impairment is permanent or temporary.

Meta (Facebook) is the most acute megacap example today. Time will tell whether the headwinds of the past few quarters are a change in their business or more reflective of broader market adjustments in ad consumption. (Disclosure, we own some at Loup).

The emerging great business is where many tech and growth investors spend so much time. Everyone wants the next Apple or the next Facebook. The result is a swath of midcap hopefuls with high valuations, many of which will never pan out. Your favorite, SAAS, ecomm, EV, etc company fits here, but back to the prior section: Most businesses are not great. If we make 10 bets on emerging companies that we think might be great, a 20-30% hit rate would be impressive.

Cheap is cheap when it comes to great businesses. Market pullbacks are no more virtuous a cause of cheapness than temporary fundamental challenges or emerging growth. Great companies are rarely cheap, so we shouldn’t be critical of the reason why so long as they are truly great.

The Virtue of Doing Nothing

Patience is the defining virtue of great investors.

The greatest struggle in managing money is the demand to act. When you get paid to make investment decisions, it’s easy to forget that quality of decisions matters far more than quantity. Quality is hard to come by, so quantity makes us feel like we earn our management fees.

Patience is easier when you know what you’re looking for in an investment, but you also have to trust that you know how to find it. That comes with experience. It comes from mistakes, which are often more frequent than successes. That’s ok so long as the successes are big enough.

Most of the time, the smart investor shouldn’t do anything. But when it is time to act, when the pitch is right, you have to make sure you swing hard enough so that it matters. Patience.

Source: Ted Williams The Science of Hitting

Notes and Quotes

VC Bid/Ask Spread

Last week I wrote about the insanity priced into Klarna’s 2021 $46 billion valuation as it was confirmed by the 2022 85% markdown to $6.5 billion.

This week, Tomasz Tunguz, a successful VC at Redpoint, spoke about the vast divergence between bid/ask spread in venture — “VC (the bidder) & a company (seller).”

He went on to say:

“In the past few years, the spread has been tight. The market is liquid. Many founders sell shares to buyers at mutually attractive prices. Like the old stock trading floors with brokers yelling at each other, but in our era, we negotiate over Zoom coffees instead.
Today, the bid/ask spread measures in the tens or hundreds of millions of dollars depending on the company’s stage.”

Now venture markets are quite illiquid, which is the outcome of widening bid/ask in any market. Illiquidity in this context represents the painful transition between a seller’s market and a buyer’s market. Many sellers (founders) still have 2021 prices anchored in their minds regarding the value of their companies. Buyers now have -60-80% public comps anchored in mind.

There’s only one sane solution to the standoff: Founders eventually need to accept lower prices.

Klarna set the stage. More will follow.

I have one serious bone to pick regarding “mutually attractive prices.”

How was Klarna’s 2021 valuation, now marked down 85%, “mutually attractive?” It’s been a seller’s (founder’s) market in VC for a while now. There was a lot of dry powder, and VCs needed to deploy. Prices, particularly for later stage venture, were only mutually attractive to the extent that they cleared the market given tremendous competition. They almost certainly weren’t attractive in an absolute and fundamental sense of value.

Retrospective VC returns will show us this in time.

For the record, we at Loup paid stupid prices for some tech assets we bought over the past year, but we avoided most of the 2021 insanity by holding cash. No excuse. We didn’t lose money because “investors suddenly voted in the opposite manner” (Sequoia’s Moritz on Klarna) or because prices were no longer “mutually attractive.” We lost money because we paid too much for the assets. Other VCs and investors should admit the same lest we repeat similar mistakes.