Buffett's 50% per year on small sums

[Vish_ram]

Yes, it depends on how you look at it.

 

If current revenue is a small fraction of TAM, and if the company is a leader, then it is undervalued on average.

If a company’s entire functionality is just a feature in a competitors integrated suite, then it is trouble.

 

I stay clear of no moat that doesn’t have stickiness. I avoid of Semis even thought many have done well. I’m perfectly ok not owning many of them.

 

When Tesla traded at 180, I ran several excel models and thought that the present price is justified if they get 30% of world market share in 20 years. I thought it was so far fetched, but boy I was wrong. The way things are going they might end up with 50% share. As Chamath says , IC autos will eventually go bankrupt due to diseconomies of scale. Think of SHLD in action.

[LC]

2) Value investors don't lack the ability or knowledge, but lack the imagination to invest in growth. They want to see everything upfront (earnings, cash flow etc) before committing up front. The market is too smart for that. Market prices in potential upside.

 

My main gripe with "textbook" value investing is the lack of understanding of the above, and also the poor ability to differentiate between expected vs. realized return.

[valueinvestor]

 

In general MOST growth stocks are way undervalued (how else do you explain the subsequent superior returns).

 

Yes, when growth falters or margins shrink, it'll take a plunge. This was the case of MSFT during 18 years that it under performed.

 

 

Can I quibble here?  Most growth stocks are overvalued since growth will not materialize to level the stock price is implying; however, for the growth stocks that do grow over the long term they are undervalued because they not only meet expectations but likely surpass them. 

 

Subsequent returns in the short term are often due to changes in expectations not improvements in long term prospects. 

 

+1

[Vish_ram]

Let me restate my comment differently

 

99% of growth stocks are either extremely undervalued or overvalued; only time reveals the truth.

 

The general perception is that most growth stocks are overvalued, which is incorrect.

 

 

In general MOST growth stocks are way undervalued (how else do you explain the subsequent superior returns).

 

Yes, when growth falters or margins shrink, it'll take a plunge. This was the case of MSFT during 18 years that it under performed.

 

 

Can I quibble here?  Most growth stocks are overvalued since growth will not materialize to level the stock price is implying; however, for the growth stocks that do grow over the long term they are undervalued because they not only meet expectations but likely surpass them. 

 

Subsequent returns in the short term are often due to changes in expectations not improvements in long term prospects. 

[Tim Eriksen]

 

The general perception is that most growth stocks are overvalued, which is incorrect.

 

 

What is the evidence for this?  Historical studies have shown the opposite to be true.  Has that changed recently? 

[writser]

2) Value investors don't lack the ability or knowledge, but lack the imagination to invest in growth. They want to see everything upfront (earnings, cash flow etc) before committing up front. The market is too smart for that. Market prices in potential upside.

 

I think such generalities are nonsensical. Value investing is simply paying less than you get. That does NOT mean buying a terrible business at an 6x multiple automatically leads to outperformance. It also does NOT mean that buying a great business at a 200x multiple automatically leads to outperformance. Either one could be too cheap, too expensive or about fairly valued. Unfortunately you simply have to think about what you are buying, do due diligence, model the company in question, think about the actors involved, make assumptions, try to falsify those assumptions and think about why the market valuation could be wrong. That's called: work. Nobody likes it. If "imagination" was a substitute for that I'd be a billionaire but I don't think it is.

 

If you presume in advance that buying a balance sheet play, or a low multiple play, does not work because 'the market is too smart for that' yet you assume that you can outperform by buying growth stocks because 'the market does not have my imagination' I think you are giving the market not enough credit and you are also limiting your own options.

[Gregmal]

2) Value investors don't lack the ability or knowledge, but lack the imagination to invest in growth. They want to see everything upfront (earnings, cash flow etc) before committing up front. The market is too smart for that. Market prices in potential upside.

 

I think such generalities are nonsensical. Value investing is simply paying less than you get. That does NOT mean buying a terrible business at an 6x multiple automatically leads to outperformance. It also does NOT mean that buying a great business at a 200x multiple automatically leads to outperformance. Either one could be too cheap, too expensive or about fairly valued. Unfortunately you simply have to think about what you are buying, do due diligence, model the company in question, think about the actors involved, make assumptions, try to falsify those assumptions and think about why the market valuation could be wrong. That's called: work. Nobody likes it. If "imagination" was a substitute for that I'd be a billionaire but I don't think it is.

 

If you presume in advance that buying a balance sheet play, or a low multiple play, does not work because 'the market is too smart for that' yet you assume that you can outperform by buying growth stocks because 'the market does not have my imagination' I think you are giving the market not enough credit and you are also limiting your own options.

 

+10

 

Flexibility with respect to ones mindset and ever changing data is the all important attribute. Imagination by itself can be both awfully good and awfully bad. I see plenty of people on social media "imagining" the next EV powerhouse or COVID vaccine candidate and "imagining" their calls going up 100x by Friday. Imagine that?

[KJP]

If your first rule is to not lose capital, then you look for things in which you have high confidence in your ability to predict or project into the future.  The ability to predict is correlated with the pace of change.  So, if your first rule is not to lose capital, then you would tend to seek out very stable industries.  Stable industries, in turn, don't lend themselves to high growth, because high growth is often a byproduct of newness and can itself attract competition and unpredictability.  So if your first principles are steering you to slow growth industries, then you better have a sharp focus on current valuation according to traditional metrics.  This approach produces bad results if either you pay to much or you're wrong about the rate of change and rather than buying into a stable industry/business, you're buying into a decaying one (thus the potential danger of blindly buying anything with a single-digit multiple).  The traditional ways to address these risks are skilled qualitative assessment (Buffett) or high diversification across apparently attractive quantitative characteristics (Schloss).

 

So, I don't think the traditional value approach stems from a lack of imagination.  Rather, it's a predictable outcome of focusing on downside rather than upside. 

[Munger_Disciple]

If your first rule is to not lose capital, then you look for things in which you have high confidence in your ability to predict or project into the future.  The ability to predict is correlated with the pace of change.  So, if your first rule is not to lose capital, then you would tend to seek out very stable industries.  Stable industries, in turn, don't lend themselves to high growth, because high growth is often a byproduct of newness and can itself attract competition and unpredictability.  So if your first principles are steering you to slow growth industries, then you better have a sharp focus on current valuation according to traditional metrics.  This approach produces bad results if either you pay to much or you're wrong about the rate of change and rather than buying into a stable industry/business, you're buying into a decaying one (thus the potential danger of blindly buying anything with a single-digit multiple).  The traditional ways to address these risks are skilled qualitative assessment (Buffett) or high diversification across apparently attractive quantitative characteristics (Schloss).

 

So, I don't think the traditional value approach stems from a lack of imagination.  Rather, it's a predictable outcome of focusing on downside rather than upside. 

 

+1

 

Excellent post KJP. Bill Ruane who founded Sequoia Fund once said (when asked about the secret to their success) they were really closet bears. That says it all!

[Guest cherzeca]

you are not going to get 50% PA returns as a value investor unless you can "imagine" a catalyst. that is not to say that value investing's focusing on the downside doesn't make sense, but you have to be able to not only understand value but also understand how that value can accelerate...hence some focus must be made on the upside catalyst probabilities.  I actually think value investing with a special situation/catalyst focus lets you buy cheaper opportunities for value acceleration (since not everyone will see the catalyst) than growth investing where paying up for the upside is built into the buy price

[wabuffo]

I continue to maintain that anyone with a proven 50% CAGR track record over 5+ years can only get there with the use of leverage/margin.  If its real estate, then there are mortgages/borrowed money involved.  If its equities, then there is option usage (which is also another form of leverage). 

 

Even Buffett during his BPL days would often use borrowed funds up to 25% of portfolio assets (usually on the workout portion of the portfolio).  Greenblatt talks about using WFC LEAPS during his salad days of the early 90s.

 

I think "god-mode" on a long-only equity portfolio with no margin/leverage probably maxes out in the high 25-29% range over 5 years in average markets (ie, +15-20% better than the equity benchmarks). 

 

wabuffo

[Gregmal]

I continue to maintain that anyone with a proven 50% CAGR track record over 5+ years can only get there with the use of leverage/margin.  If its real estate, then there are mortgages/borrowed money involved.  If its equities, then there is option usage (which is also another form of leverage). 

 

Even Buffett during his BPL days would often use borrowed funds up to 25% of portfolio assets (usually on the workout portion of the portfolio).  Greenblatt talks about using WFC LEAPS during his salad days of the early 90s.

 

I think "god-mode" on a long-only equity portfolio with no margin/leverage probably maxes out in the high 25-29% range over 5 years in average markets.

 

wabuffo

 

And usually follows some sort of major "reset" type event.

[scorpioncapital]

Not sure I understand. If a stock you own (or a REIT) uses 2x leverage, then do you mean that if I buy it without leverage I might get 50% due to the look-thru leverage of the stock/reit? By this standard virtually every stock out there except some cash rich tech stocks are using at least 2:1 leverage. Anyway these days every stock seems to be using alot of look-thru leverage.

[wabuffo]

If a stock you own (or a REIT) uses 2x leverage, then do you mean that if I buy it without leverage I might get 50% due to the look-thru leverage of the stock/reit?

 

SC - I think you might be misinterpreting what I said.  I'm not talking about the underlying capital structure of a business whose stock you buy.  I'm talking about using borrowed money to buy the stock. 

 

WFC might be levered 10-to-1 on its balance sheet but buying WFC common stock is not employing borrowed money, IMO.  Buying a WFC 2022 LEAP call is employing borrowed money because that is what a call option is.  Its buying the underlying WFC common on margin plus a put option.

 

Hope that helps,

 

wabuffo

[scorpioncapital]

I think I understand. I agree that for very large or even medium cap stocks you need some leverage for outrageous returns. Although very small stocks can very easily do 50% without any leverage, but it may be one time and require multiple 'punchcard moves'.

 

 

 

[samwise]

 

I think "god-mode" on a long-only equity portfolio with no margin/leverage probably maxes out in the high 25-29% range over 5 years in average markets (ie, +15-20% better than the equity benchmarks). 

 

wabuffo

 

This study supports your conclusion about "God-mode". (But notice the -75% drawdown!)

https://alphaarchitect.com/2016/02/02/even-god-would-get-fired-as-an-active-investor/

 

It is large caps though (top 500), and weighted to large caps even within that. So scorpion is probably right that smaller caps might allow more than 30%.

[LanceSanity]

Lance, do you have any letters or writings about their thoughts on market, portfolio selection etc?

 

They don't have public writings, so not much to go on. From their website:

What Abdiel does

Abdiel generally invests in publicly traded companies that are likely to gain market share over long time periods. We prefer businesses that have recurring revenue and that are managed by people with a large share of their net worth in the stock. Our ten largest investments frequently comprise more than 75% of invested capital. We started in 2006.

 

What we want for our investors

Returns that are good on an absolute basis and that outperform the market, measured over 3-5 years.

 

How we value companies

We estimate the return a company’s cash flows would deliver to someone who bought the entire business at the available stock price and held it permanently.

 

What we look for “under the hood” of companies

The same thing we look for in our own. Leaders who care viscerally about the quality of the products they sell. A corporate culture in which people thrive. Coincidence or not, in our experience we make more money with companies we admire than with those we don’t.

 

What we want Abdiel to add to the world

Work done well and with pleasure. The craftsman is a better person for his efforts, and so is anyone who notices. Moreover, good investment analysis helps companies raise the world’s standard of living. Enterprises work best when they have access to capital priced to reflect the value they can create. Index funds, by the way, do not price capital; they only mimic the actions of those who do.

 

whalewisdom estimates Abdiel's performance to be 53%/yr for the past 5 years. It's definitely gone up since they added more FSLY, and their stocks appreciated a lot since q1.

[netnet]

For successful companies like Google, Apple, Microsoft the ultimate TAM is way bigger than what you expected when you invested. E.g. if you bought Apple for iPod TAM, it was overpriced (likely), but then came iPhone TAM. Same with Microsoft (DOS -> Office -> Windows, etc.)

 

Imagine Microsoft O/S that is growing well (30 years ago). If you value MSFT purely on O/S you will see that it is very expensive.

 

No and No!

I have to disagree here.

 

Although it was(somewhat) hard to see at the time, and perfectly obvious in hindsight, Microsoft was not expensive on just the O/S in 87.  It was order of magnitude 200 million and it was a 'tax' on a rapidly growing market--OS sales on the PC. 2 billion market cap was relatively easy to see, as these things go.  (It would of course help if you were in the industry.)

[coc]

This thread is an amazing document to show the dominant ideologies of the moment. Some of the posts remind me quite strongly of the "New Era" in the late 60s and the Internet Mania of the 90s.  I have seen one investor after another "convert" to the New Era style (buy companies with "disruptive" nature almost regardless of price as long as a theoretical DCF justifies it).

 

"TAM is all that matters"

"Earnings are for LOSERS"

"Value investors have to learn to pay for growth"

etc. etc.

 

This time really always does seem different. We shall see!