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 imprecise feedback loop between decisions and outcomes. Humans are inherently impatient and want 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 that people would rather hurt themselves than wait patiently doing nothing, and how that is detrimental when investing.
Additionally, since investment decisions require a transaction price, price movements are closely followed as a proxy for 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 fundamental expectations for the business. Because precisely forecasting the future is impossible, a thesis should be general in direction, but specific enough to gauge progress. Whether the company’s fundamentals align with an investor’s thesis determines if an investor is right or wrong, regardless of price. If the facts broadly correspond to your thesis, you’re right. If they fall short, you’re wrong. This point may be counterintuitive, but shouldn’t all decisions be judged by their logic? In billiards, on the final stroke if you pocket the 8-ball in a pocket other than the one designated, you lose. Or, imagine the stock market were closed. You’re right if the business generates the cash flow you expect, and you get your fair share.
This line of thinking is uncommon for two reasons: price is easily observable while fundamental value is not, and price is 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 in judging 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.
It becomes even trickier because 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.” In the end, though, decision quality should be judged on how the eventual facts correspond to the thesis. 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. While value increases with the probability of bankruptcy off the table, the facts and reasoning determine correctness. Ark Invest’s 2019 bullish investment case based on Electric Vehicles sales of $150 billion gave Tesla an Enterprise Value target of $270 billion, in 2023. 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 of $7,000 ($1,400 post-split) based on 10 scenarios, subjectively weighted. The highest 2024 target price without a taxi network is $3,400 ($680 post-split), which is below the current price. Not to mention, the extreme expectations for deliveries and margins. They need to to justify the increase in price. But seriously, I would love to jump to 2024 to see which scenario actually played out. I’ll take the under, by a lot. Thus far, Ark’s thesis has been wrong, consistently being way too bullish. It’s possible they’ll be proven correct, but that’ll be determined by the Tesla’s fundamentals, not it’s current 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 not buying a stock that went up in price or buying one that went down in price. It’s possible, but often 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. It’s not a mistake if the known risks to the investment thesis come to fruition, nor if an unknowable event occurs. In the former, you were wrong, and in the latter, you were lucky or unlucky.
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. Elliott Turner highlighted such an example (SHOP) in his fantastic year-end investor letter. 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 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.
Although Buffett said buying airlines was a “mistake,” I disagree. An exogenous, unpredictable shock three years after making the investments completely changed the outlook. That’s unlucky. 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. Whether Buffett will be right or wrong in selling his positions will be determined by their fundamentals over 10 years, since that is his investment time horizon, and not the current stock prices. It would’ve been a mistake if he emotionally panic sold, something he knows he shouldn’t do.
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.” Precisely. Joe realized his thesis was wrong, but that doesn’t mean he made a mistake given his decision process was not compromised. 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. Being wrong is not a mistake; staying wrong is.
As I was reviewing the past year’s thoughts and my portfolio transactions, 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 news story about 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. It’s difficult to change your mind with a held position, 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 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 other prominent shareholders. 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. Oh yeah, 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, breaking even. Plus, said prominent shareholders also sold. 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 the announcement of discovery+, the stock shot to an all time high, now trading at 28x.
My mistake in ROKU was trying to time the market. Everybody sins sometimes! I bought ROKU in March believing that the pandemic combined with the increase in SVOD/AVOD services and channels on their platform would provide a boost in the number of eyeballs on their platform. Unlike 2000, nowadays eyeballs actually do translate into value! An EV/Sales multiple of around 7x LTM, 5x NTM, seemed justifiable for the leader in a rapidly growing industry predictably taking share from a legacy industry. 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. Could ROKU deliver the cash flows to justify its lofty sales multiple? I wasn’t convinced. The multiple has since climbed to 35x, and it’s at an all time high.
One of my biggest mistakes was selling my position in AAPL, sometime around 2016, based on a naïve lack of conviction and belief in market efficiency. 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 again. 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 are just the ones I’m highlighting; I’ve made tons of mistakes and will make plenty more. Luckily, mistakes are learning opportunities. Already this year I recognized I was making similar mistakes and acted to correct them. 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 helpful.
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