I started this newsletter during the pandemic as a way to force myself to explain my thought process during a time of market panic. Explaining myself to all of you has helped me become a more clear-minded investor.
That said, I’ve never actually written down anything resembling an investment philosophy. My goal in this article is to give you – the readers – a sense of what to expect from me in my recommendations.
I expect the principles below to change, but I’m hoping a couple of these can remain constant. I’m also hoping this can be a guiding framework for future recommendations on this newsletter. Here we go:
A quick note on the use of “you” and some of the principles below. “You” in this article refers to me – this is a letter to myself. These ideas maybe could be useful to the person reading them, but I think everyone needs to find what works for them, and the below is just what has worked for me when I wrote this (March 2021).
Macroeconomics is not your job. Understanding companies and the levers that drive their returns is your job.
This principle is the most important one I think. Macro is unknowable. Talking about it (unpopular opinion alert) is a waste of time. To be clear, if you own companies sensitive to changes in interest rates or prices of raw materials, you do need to think about these things, but only to the extent that you have a good mental model of how they impact free cash flow. I don’t know what a change in the ten year bond means for the stock market and I never will. I don’t know what the Fed will do or what the administration currently in office will do. I never will and I don’t think spending time thinking about it is conducive to better investing outcomes.
I’m reminded every time I read a 10K or earnings call I learn more than when I browse a newspaper. Companies try to tell you their risk factors and on calls what they’re worried about. These things in my opinion are far more important to pay attention to than what CNBC is worried about.
Notably, I do think unexpected macro events create opportunities to buy great companies at wonderful prices, but I don’t think this really requires “understanding” macro – instead it’s just seeing the world is panicking and the markets are drawing down double digit percentages. I tried to write a little about this in Evergreen Personal Finance strategies.
Price tells you the expectations for the stock. Price therefore needs to factor into the investment thesis. However, price is largely random and checking it day to day is a waste of time.
I directly stole this idea from the book Expectations Investing.
When expectations are really high, there’s less room for error. Andreessen Horowitz has a good writeup on why SaaS companies get valued relative to sales, and the short summary is that in the future, if margin improvements and growth continue, you can value the company at a sane multiple to free cash flow.
That if necessarily means you’re making assumptions about the future. In the case of the FAANGs of the world, those ifs turned out to be correct, and teens multiples to sales were justified. That is not the case for most companies .
I’m wary of using the term “valuation” and much prefer “expectations” as it relates to evaluating the price of a stock. Again, price tells you what the market is expecting, and the price you pay should always be less than what you expect to get back in free cash flow discounted at the company’s cost of capital.
However, price is just a starting point for me, and I don’t believe in checking prices day to day because I intend to own stocks forever assuming no significant change in the investment thesis or business fundamentals relative to price.
Price fluctuations are random. We’ve all seen days where prices move across asset classes uniformly up or down, which makes no sense. We’ve all seen days when small caps double or large caps lose $200 billion in market cap for seemingly no reason. Price fluctuations I really believe need to be ignored. How much discussion time is lost over talking about why something was down 350 bps on no news?
Similarly, I occasionally get inbound on whether to buy Stock X at Price Y or to wait until it goes Y – Z, where Z is some arbitrary dollar amount. I try to tell myself if I’m thinking about increments where I’d feel comfortable buying the stock, I don’t have enough conviction and probably should look elsewhere. Great businesses don’t come cheap, and if they’re getting cheaper it’s because (1) the market is selling off, (2) something bad happened to the company or (3) a random drawdown happened. (2) would make you reconsider the investment; (1) and (3) are random. As a result, I think if you can buy below a price you believe is intrinsic value, buying on a dollar-cost averaged basis always makes sense. As an example, if I want to allocate $10,000, I may decide to buy 20 times in increments of $500 over the next quarter, with an option to continue buying depending on the next set of quarterly results (which can and should result in a re-evaluation of intrinsic value (might be the same, could be different – all depends on what future cash flows look like)).
I think this point bears repeating (I’ve been guilty of not listening to it). If you’re going to buy, buy below intrinsic value early and often and over an extended period of time. Keep buying as long as you have conviction you’re buying below intrinsic value.
Everything I own I’m committing to reading the earnings calls, important SEC documents, being on the investor email distribution list and continuing to have a beginner’s mind around the company.
If I can’t do that, I can’t commit to owning the stock. This seems like the minimum level of effort for stock ownership. On the whole, these activities take probably 10ish hours per year per stock. This principle is meant to be a guard against swing trading or accumulating lots of small tracker positions that I can’t talk to.
My experience has been when I don’t know enough about a company, I find it difficult to 1) buy more when it goes down, 2) buy more as opposed to sell when it outperforms the market and 3) not sell when it underperforms the market if I have not built up conviction through knowledge. I only expect to outperform the market by holding great stocks for decades. Therefore, I want to know so much about the stocks that I own that I can buy and sell based on business factors and not multiple expansion and contraction that is often random or groupthink based.
I want to accumulate as many amazing CEOs (or better description – allocators of capital) as possible in my portfolio.
Just like how in work settings, my goal is to hire people smarter than me, in my portfolio I want CEOs smarter than me. In my current portfolio, here are some of the managers I admire:
- Warren Buffett – I went on a huge Buffett kick this year and it was worth every second. Roger Lowenstein’s book on Buffett was life-changing for me and I can’t recommend it enough. I still am listening to Berkshire Q&As when I have free hours. My personal blog contains a quick writeup of this book if you want more here.
- Jeff Bezos – I read Invent and Wander and wow. Every AMZN shareholder letter is talking about how he is optimizing for free cash flow generation through whatever products and services AMZN is building.
- Darryl Rawlings – CEO of Trupanion and just writes amazing annual letters that really are a window into how his mind thinks about the business.
- Brian Harris – CEO of LADR – check out my post on great management groups
- Will Dannoff – I wrote about Dannoff in a previous Stock Talking
I also think it’s important I independently form what “great” means as opposed to media depictions of great. Do I enjoy reading this CEO’s letters? Why? Do I think he or she constantly says things that make sense and proves to be true in the long term? How does the CEO communicate how he or she benchmarks his or herself? Is is through free cash flow or another metric?
I highly recommend the book The Outsiders by William Thorndike for more on what a great CEO is. If your metric of success is allocating capital well, the CEO needs to be using every incremental dollar to build value for shareholders. Allocating capital is not the same as innovating or giving a rousing speech on management principles or making a splashy acquisition thought leaders approve of. It is not the same as growth (which as Buffett has pointed out can actually be bad if it’s dilutive growth). It is not the same as accolades or positive press or anything other than how dollars are spent and what the return on those dollars is.
For companies I own, I want to make it a priority to consistently be reviewing the last several years of free cash flows, how those cash flows were invested and what the outcome was. At the end of the day, capital allocation determines intrinsic value.
Easier to understand counts for a lot.
There’s a few companies where I read the earnings calls and (I think) feel able to grasp nearly 100% of the words with good understanding – AutoZone, Ladder Capital, Triton Container, ServiceNow, National CineMedia, IMAX and Corepoint Lodging to name a few. None of the analyst questions surprise me; management commentary is inline with what I expect. Reading the calls and financials feels pleasant since I don’t have to struggle to understand anything. I feel more confident in my ability to determine whether these companies are on track to continue performing well than more complex companies with more moving parts. To use programmer advice I hear over and over again, code that’s easy to understand is easy to debug. You can’t determine if a company is trading below intrinsic value if you don’t understand it.
Credit to Buffett for hammering this “Circle of Competency” concept on every single one of the Berkshire Q&As.
Free cash flow is easier to predict than multiples, so stop trying to predict the right multiple. This is why “this thing is trading way too high” and “this is way undervalued” are mental shortcuts that aren’t useful.
Multiples bounce up and down. “Cheap” and “expensive” will always be relative terms and can change in five years (what was expensive five years ago often looks cheap today if free cash flow is growing faster than price).
If you’re feeling anxiety over price declines, you may need to revisit your thesis. If you’re not buying with high conviction during price declines, you may need to revisit your thesis.
In a perfect world, your portfolio should give you zero stress. Buffett often brings up that the Dow has had decade periods where it traded below peak. During these periods, he was content to hold onto his portfolio and allocate more to stuff he had high conviction in. If that happens again, I guarantee every talking head will say equities are dead and most blogs on stocks will close down as interest wanes. I hope to be most active on Stock Talking during this time period :-).
I’m not averse to taking a small gamble if it 1) resolves FOMO, 2) I have clear entry and exit and 3) I might learn something in the process. All the bullet points above I’m glad to say only apply to 99.75% of my holdings.
A part of me really likes watching bubbles and investing in them – I know it’s junk food and a non-optimal strategy. That said, having <0.25% of my portfolio in a sector that’s taking off (without cash flow to justify it) allows me to have some skin in the game and learn more about what all the fuss is about. It also has a nice way of forcing me to have a non-biased opinion. If you have no money at stake, it’s easy to shoot down BTC, biotech or EVs as legitimate investments. Put money in though – even if it’s a token amount – and you’ll find yourself doing research. Funnily enough, if the assets appreciate, I think you’ll find you even try to make excuses as to why the bubble (or non-bubble?) has more room to run.
I recently invested in MMEDF after hearing a close friend pitch Mindmed and found myself going through this process. I was extremely tempted to reject the entire psychedelic-based medicine sector as a retail-investor led bubble. After doing thirty minutes of research, I found the following:
- Numerous companies have Phase 2 clinical trials with FDA. US and Canadian governments are giving psychedelics serious attention, as is the academic community (John Hopkins specifically)
- Big name investors and celebrities are doing a lot to market the space as a legitimate investing area (Peter Thiel, CGC’s former CEO Bruce Lipton, Shark Tank’s Kevin O’Leary, Tim Ferriss and more)
- There aren’t that many avenues to publicly invest. Compass Pathways is the only company on a major exchange that plays in this space (MMEDF will uplist to Nasdaq likely sometime in 2021)
These three facts were enough for me to try my hand at a minimal investment. I’m comfortable with losing it all, and will sell half on the first double if it happens. Worst case I learn something and lose 25 bps on my total return.
Moreover, bubble companies five years later may be the companies most discounted to intrinsic value (this arguably happened in the years after the tech bubble of 99’ popped). Getting a headstart understanding them by having a small investment is a good thing even if you have to pay a small price.
Underperforming for some time isn’t a sin; not having a strategy and forming opinions based on price action is.
Outperforming the index is hard as heck, and I don’t expect to be able to do it as I detail in Evergreen Personal Finance Strategies. I really enjoy investing and as a pastime will always trade individual stocks. I want to at least try to do it in a disciplined way where I work each day to improve. If I underperform for a year, I don’t think it makes me a bad investor. 5-10 years feels like a better period for judging performance.
Additionally, underperforming should not be the impetus for reallocating your whole portfolio. If I sell something, I want it to be on business fundamentals and not because SPY has crushed Stock X over the last six months. If Stock X trades cheaper and is going to grow faster than SPY on aggregate, why would I not continue to hold onto Stock X and even buy more?
Having a differentiated view is in part not letting the market tell you what your stocks are worth. I know I’ve quoted Buffett a million times in this post, but Buffett does say the market is here to serve you and not the other way around. I want to make it a habit to form my own views on intrinsic value by looking at business performance and not the stock price.