You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.Warren Buffett
One of the most frustrating aspects of investing is the long and loose feedback loop between decisions and outcomes. Humans are inherently impatient and need direct feedback. We want to be proven right or wrong immediately, so we can move on to the next decision. Hopefully right, but often wrong despite our aversion to admitting it. As a consequence of our psychological hard-wiring, investors become speculators – time horizons shrink, price guides behavior, and action replaces inaction. Brandon Beylo wrote a great piece referencing studies that showed how people would rather hurt themselves than wait patiently doing nothing, and how detrimental that can be when investing.
Further, since investment decisions require a transaction price, price movements are closely followed as a proxy for the outcome. Bought a stock and the price went up? You were right! Down? Wrong. For speculators, this may hold true. But for investors, is it really that straightforward?
In this piece, I want to touch on why an investor is right or wrong, and judging mistakes with some examples of my own.
As Buffett’s above quote suggests, you are right because your facts and reasoning are right, regardless of whether other people agree with you. In other words, independent and superior analysis is an edge, and price is not a reliable indicator of correctness. An increase (decrease) in price may signify you’re right (wrong), but it depends on the rationale for the increase (decrease). Unfortunately, or fortunately, depending on your temperament, price and value are often loosely correlated. It’s worth reiterating that price and value are independent.1 Value is driven by business fundamentals (cash flows, growth, and risk) while price is driven by public opinion (Mr. Market’s mood and momentum). Essentially, “facts” translate into value and “whether other people agree” translates into price.
The reason why “you don’t have to worry about anybody else,” is because a company’s stock price will eventually converge to its value. Back in the day, this notion seemed speculative and mystical. When testifying before Congress, Benjamin Graham responded to the question of “What caused a cheap stock to find its value?” with “That is one of the mysteries of our business, and it’s a mystery to me as well as to everybody else. [But] we know from experience that eventually the market catches up with value.”2 Although markets “can remain irrational longer than you can remain solvent,” eventually they must succumb to reality.
Since investors estimate value, their thesis is based on expectations for the fundamentals of the business. Because forecasting with any sort of precision is impossible, a thesis should be general in direction but specific enough to gauge progress. Whether the company’s future fundamentals align with an investor’s thesis determines if an investor is right or wrong, regardless of its future price. In other words, if the facts broadly align with your thesis, you’re right. If they diverge, you’re wrong. This point may be counterintuitive to some. But then again, shouldn’t all decisions be judged by their logic? Suppose you’re playing a game of billiards. On the final stroke if you pocket the 8-ball in a non-designated pocket, you lose. Imagine the stock market were closed. You’re right if the business generates the cash flows you expect. Whether another buyer comes along to take the shares off your hands at an exorbitant price is out of the business’ control.
This line of thinking is uncommon for two reasons: price is easily observable, while fundamental value is not, and price is often thought to be equivalent to value. But Benjamin Graham’s wisdom that, “In the short run, the stock market is a voting machine. In the long run, it’s a weighing machine” is especially pertinent. If value is weighed over time, then price fluctuations over any short-term basis are insufficient to judge an investment decision. This thought was also succinctly summarized by Joe Frankenfield, Portfolio Manager at Saga Partners. Moreover, it seems consistent that the time period over which to measure an outcome should match the time period for the decision. A long-term decision should be judged… over the long-term.
It becomes even trickier, though, since information changes and theses can evolve. Incorporating Bayesian thinking leads to a constant updating of your beliefs and expectations based on new information. So it’s possible to be right and wrong with the same investment. Howard Marks has written that, “Being too far ahead of your time is indistinguishable from being wrong.” Possibly, in the P&L. But in the end, decision quality should be judged on the eventual facts. Michael Burry was right, eventually.
Take the recent Gamestop (GME) saga; yet another classic extreme price mania that has almost completely retraced. Where GME trades over the short term is clearly anybody’s guess, but it’s unlikely Gamestop’s value appreciated in sync with its price. Could it have been undervalued? Some thought so, and continue to think so, but a spike in price driven purely by speculation is not evidence that investors were right. Whether the business can turn itself around will determine the fate of an investment. Speculators can indeed celebrate, however. That is, if they got out before the inevitable decline. (Before publishing, GME has again spiked off its recent lows, but the same general theme applies).
Similarly, and ironically more controversial, the dramatic rise in Tesla’s stock price in 2020 does not signify that investors are correct. With the probability of bankruptcy off the table, it’s certainly true that Tesla’s value has increased. But, once again, facts and reasoning determine correctness. Let’s take Ark Invest’s 2019 thesis. They projected Electric vehicle sales of $150 billion in 2023, and gave Tesla an Enterprise Value target of $270 billion. That’s a stock price of $1,400 ($280 post-split). Updating their thesis in Jan 2020, and incorporating expectations of a fully autonomous taxi network, they assigned an expected value target price of $7,000 ($1,400 post-split) based on 10 scenarios. The highest 2024(!) target price without a taxi network is $3,400 ($680 post-split), which is below the current price. In 2020, Tesla generated $31.5 billion in sales. So, Telsa has a long way to go to meet Ark’s fundamental expectations. But that’s what Ark needs to project for them to justify being bullish at the current price! Whether or not Tesla hits Ark’s targets will determine if Cathie and team are right or wrong, not the immediate-term stock price.
Clearly, investors can be wrong and still make money! Luck always plays a factor, but mustn’t be confused with skill. Which leads to how to think about mistakes.
Too often, investors flag “mistakes” as either not buying a stock that subsequently goes up or buying one that then goes down. Possibly. But more times than not that statement is rife with hindsight bias. In my view, a real mistake is made when you err in your process or do something that you know you shouldn’t. In my view, it’s not a mistake if the known risks to the investment thesis come to fruition, nor if an unknowable event occurs that negatively impacts the business. In the former, you were incorrect in your judgment and in the latter you were unlucky.
To state the obvious, the biggest mistakes are errors of omission rather than commission because stocks can go up more than they can go down. The former happens when finding a business within your circle of competence to be a good value and not buying it. In his year-end investor letter, Elliot Turner of RGA Investment Advisors highlighted such an example when he was considering buying SHOP and ended up not (it turned out to be a a not-so-bad mistake since it lead to an early investment in ROKU). The latter happens when you transact without doing adequate due diligence or acting when you know you ought not. For example, buying a stock based solely on someone else’s recommendation or trading options when you don’t understand the respective influences of implied volatility and the Greeks. Guilty on both counts.
Let’s take Buffett’s airline investments. Although he said buying the airlines was a “mistake,” I disagree. An exogenous, unpredictable shock three years post the initial investments completely changed the picture. That’s unfortunate. If instead, competition reduced their collective return on capital to a point of eliminating economic returns, then Buffett’s analysis would’ve proven to be wrong. If he bought the airlines predicting oil prices would decline further, he would’ve made a mistake by making a commodity call, something outside of his investment process. Furthermore, it would’ve also been a mistake if he panic sold, something he knows he shouldn’t do. Going forward, whether Buffett will be right or wrong in selling his positions will be determined by the airlines’ fundamentals over the next 10 years, since that is his investment time horizon. People exclaiming he’s an idiot for selling “at the lows” simply misunderstand his thought process. Taking the opposite side of the greatest of all time has historically been the mistake.
In his investor letter, Joe Frankenfield says, “When I realize that a mistake has been made, all that really happened was that my long-term outlook for that specific company was different than I previously believed. The future was unfolding differently than anticipated.” It takes intellectual humility to admit mistakes – and everybody makes plenty – but it’s also important to distinguish between what’s within your control and what’s not. Joe realized his thesis was wrong, but, in my view, it’s a bit harsh to say it was a mistake given his decision process was not compromised. Being wrong is not a mistake; staying wrong is.
As I was reviewing my past year’s thoughts and portfolio turnover, I realized some mistakes I committed. (Note: this was written in mid-February so some %’s may be off, though still generally accurate.)
I sold my BKNG position a week before the Pfizer vaccine news hit the wire. The stock subsequently jumped 20%, and is 50% higher now. I sold my DISCA position in early December after it rose 50%. It has since climbed 75% more. I sold my ROKU position late November after it had risen 33% in a month, and 5% in a day. It is now 80% higher. Ouch. Gains were certainly left on the table. That said, the subsequent price increases are not indicative of mistakes. The mistakes were elsewhere.
My mistake in BKNG was not selling sooner, after I concluded travel companies would be negatively impacted for much longer than I initially expected. Changing your mind is difficult, especially if it means realizing a loss. My mindset was to wait it out; travel will inevitably recover and BKNG was undervalued going into the pandemic. But when the CEO says in June, “It’s not a quarters thing; it’s a years thing. It’s going to take some time to get back to the place where we were in 2019” your projections should take note. In my view, I got lucky that the price rebounded to February levels despite the devastation to their financials and industry. Can the business prudently manage costs while facilitating a rebound in sales and defending their moat? Probably, but they ran pretty lean to begin with. I still believe travel demand will return, potentially with a vengeance, but the industry will see lasting changes. In 2019 the stock traded around 5x NTM EV/Sales, 13x NTM EV/EBITDA. It now trades at 6.6x and 17x on 2019 numbers. On a forward basis, it trades at 11x and 40x, respectively, and is at an all time high.
My mistake with DISCA was not doing enough due diligence on the business and buying purely based on prior financials, prevailing multiple, and the backing of a legendary media operator. A P/E of 9x seemed cheap for a business with returns on capital near 10%, returns on equity around 15%, and free cash flow margins around 50%. I expected multiple expansion. Then the pandemic hit, and it became even “cheaper,” so I bought some more. The P/E multiple did expand in July, yet the P didn’t budge. Useful reminder that the E also matters. While the market continued to climb, the stock was stagnant. Then, on the market’s rotation into “value,” the stock ripped and the multiple jumped to 16x. Realizing that I didn’t understand the story as well as I should’ve, I decided to get out after I broke even. Plus, said legendary media shareholder also reduced his stake. Could Discovery withstand the accelerating cord-cutting and successfully transition into streaming? I thought so, but I didn’t have conviction let alone a good grasp of their hit content and competitive positioning. After I sold, they announced their discovery+ streaming service. The stock shot to an all time high and is now trading at 28x P/E.
My mistake in ROKU was trying to time the market. Everybody sins sometimes! I bought ROKU in March believing that the pandemic in combination with the increase in SVOD/AVOD services and channels would provide a boost in the number of eyeballs on their platform. Unlike in 2000, eyeballs actually do translate into value nowadays! An EV/Sales multiple of around 7x LTM, 5x NTM, seemed justifiable for a emergent leader in a rapidly growing industry predictably taking share from legacy providers. However, by December the multiple reached 27x and 19x, respectively, far above the historical range. I became skeptical of the multiple expansion on top of the rapid growth in revenue. It had been a stellar performer and expectations climbed, so I decided to take my gains and wait for a pullback to potentially get back in. I knew I shouldn’t have, but the price rise seemed too much. Can ROKU deliver the cash flows to justify its lofty sales multiple? The market seemed to think so, and I wasn’t so sure. The EV/S multiple has since climbed to 35x, and it’s at an all time high.
One of the biggest mistakes to date was selling my position in AAPL sometime in 2016, based on a naïve lack of conviction, belief in market efficiency, and recent price appreciation. Despite fully buying in to the “Apple ecosystem” thesis – Apple isn’t just a hardware company, has highly sought after and sticky products, has a stranglehold on demand, and has a toll-road in the form of an app store – the narrative that “Apple is a low-growth hardware business reliant on iPhone sales, and smartphone sales have matured” was so prominent that I doubted myself. And the price reflected the narrative, trading at an earnings multiple of 9x and 7x ex-cash. The market is smart and efficient, right? After it appreciated 30% heading into an earnings report, I sold thinking it would trade lower and I could buy it back. I’m still waiting.
My mistakes are clear: dismissing new negative information, fixating too much on prior price or multiples, trying to time the market, and doubting my conviction based on the crowd’s narrative. And these aren’t a complete list; I’ve made tons of mistakes and will make plenty more. Luckily, mistakes are learning opportunities. This year I recognized I was making similar mistakes and acted to correct them. I sold out of my LMT and NOC positions, which I entered into solely due to their depressed multiples, and bought FB for the first time since selling in 2018 (mistake) because I disagree with the crowd’s narrative that users shift off of it’s platform to other social media/entertainment apps like Tik-tok. Now, FB is a highly controversial company, but in my view, the value it derives from it’s targeted advertising, new e-commerce offering, and soon-to-be-released AR/VR products, far outweighs the crowd’s dour narrative. Similar to AAPL in 2015, it’s available at a good price when taking into account the expected growth over the next few years. I have no idea where the stock price will go in the short run, but whether I’m right or wrong will be decided in 2023 and beyond.
Avoiding mistakes is not possible; avoiding the same mistakes is. As Stan Druckenmiller explained after being asked what he learned from capitulating and piling into the dot-com bubble near the top, “I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So, maybe I learned not to do it again, but I already knew that.” A refresher course on “what you already know you’re not supposed to do” can be very rewarding.
1. Price can influence value through reflexivity, momentum, and the ability to raise capital
2. “Buffett: The Making of an American Capitalist” pg 57-58