“I’ve never been able to predict accurately. I don’t make money predicting accurately. We just tend to get into good businesses and stay there.” - Charlie Munger
“I have never professed to have a crystal ball that forecasts market direction.” - Daniel Loeb
“My financial success stands in stark contrast with my ability to forecast events.” - George Soros
"I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections, but we care very much about, and look very deeply at, track records. If a company has a lousy track record, but a very bright future, we will miss the opportunity..." - Warren Buffett
"Accepting that we cannot predict the future - ie there will always be unexpected and highly consequential events - is the first step to becoming less fragile and more adaptable. People should be highly skeptical of anyone's, including their own, ability to predict the future and instead pursue strategies that can survive whatever may occur." - Seth Klarman
Margin of safety investing: the best way to invest
In the highest ranks of investing, there is a certain kind of Omaha bro that will enthusiastically tell you how much the investor despises predictions. In such circles, it’s all about a margin of safety. The idea is that your investment strategy is to wait for some idiot to sell you some security at a significant discount to fair value. There are many reasons why people would sell you a stock (or the entire company!) at a discount to fair value:
Maybe people are uninformed. When Buffett bought shares in the chocolate manufacturer Rockwood & Company, the company was paying a cocoa dividend and anyone could make a significant profit just from the arbitrage. Buffett was paying attention so he bought cocoa at a discount to fair value.
Maybe people think we’re on the verge of an apocalypse. When the world is on the verge of an apocalypse, like in 2008, investors have the trait of selling literally centenary companies like Burlington Northern Santa Fe for 10x NOPAT. And Warren Buffett was the trait of buying these companies.
Maybe people give too much credit to some bearish narrative. When Buffett bought Apple for the first time in 2016, it traded for 10x earnings, despite the incredible franchise. Of course, growth was decelerating, but it was clear to anyone noticing the present that people weren’t stopping buying iPhones to buy Samsungs.
This way of investing is likely the best one. You don’t need to make forecasts, just analyze the present. Also, the significant margin of safety means quite a room for error.
But if you work managing other people’s money, you’ll find some problems deploying such strategy.
You need to hold significant amounts of cash for when such opportunities occur, you’re able to benefit from them. But customers usually don’t like to give you money to be on the sidelines for many years waiting for such opportunities to appear.
Customers don’t like to give you money when an apocalypse is happening. Actually, they usually want their money back. This creates pro-cyclical dynamics that prevents people managing other people’s money to completely benefit from Black Monday kind of environment.
Facing a bearish narrative is the easiest one to deploy. The problem is that the market is always on its never-ending journey to become more efficient, so even though you as a compounder bro love the brilliance of the Costco model, it’s fully reflected in the stock price. The ideas where you find securities where there’s a misplaced narrative around them are few and when you find them, you usually need to bet big on them. You should be thankful if you find a stock like that per year. The problem is that customers get anxious with concentrated bets and there’s also the risk that you make wrong assumptions and you end up destroying your investment franchise with that.
Another reason why it’s hard to adopt the “no forecasts way” is because it can take significant periods of time to be vindicated, even with significant margins of safety. If you’re managing other people’s money, they can get anxious with the prolonged period of underperformance and get their money back before prices go to intrinsic value.
Why do investors try to predict the future?
“The idea of a margin of safety, a Graham precept, will never be obsolete.” - Charlie Munger
What is clear is that to adopt such strategy, you need a level of trust from your customers that most people don’t have it. Usually, this means perpetual capital. And this is unavailable to most people.
If waiting to buy securities with a margin of safety is such a winner strategy, why isn’t it more widely adopted?
It is widely adopted. In fact, it is so widely adopted that there are way fewer cocoa arbing opportunities in the market today.
People can’t afford to wait for opportunities to surge and for margins of safety to close. When many investors say that their edge is to have a longer time horizon, there is some truth in that.
The seduction of predicting the future can be understood through many lenses. Here are some non-exhaustive reasons for how people try to predict the future in financial markets.
If you are a pod investor trying to predict the companies’ quarter, you are ahead because literally all the companies in the market report every quarter. So there are always companies reporting all the time. Also, because you get to play the game every 3 months, you get more feedback and can iterate more.
If you are a macro investor trying to predict the short-term future of the economy, you are ahead because there are always things happening in the economy. There’s always a draught somewhere that will affect soybeans’ prices. There are always things happening that affect the global economy in unexpected ways. Many financial indicators that move markets like PMIs, inflation, and unemployment data are released monthly, so your game can be even more iterative than the company quarter predictor counterpart.
There are many technical reasons why securities move. Maybe if you hire a couple dozen of Mathematics and Computer Science PhDs you can discover some of them and profit ahead of these technical reasons. Maybe people tend to sell securities when the Manhattan weather is ugly and if you discover that, you can trade ahead of the ugly day and turn a buck.
If you are in the business of venture capital or growth stock investing, you can try to predict the far future. Even if your game isn’t as iterative as the two above and can take as long to if not longer than the margin of safety game, here you have Power Law-like returns that are hard not to feel greedy about them. Although buying below the margin of safety can also get you into Power Law returns, more likely than not, the securities that make 20-50-100x aren’t the ones where you get a likely 2-3x.
One subset of the growth stock investing is the compounder stock, the one that doesn’t exhibit very high levels of growth, but which by growing high single digits, mid-teens per year for very long periods of time, can offer you a decent above-average return.
I don’t have much to add about the first three ways of predicting the future, because they aren’t my game. But I understand the appeal of growth stock investing.
This method works during the good times, and good times are most of the times. Good times also align with when customers are willing to hand funds to you. In fact, if you’re betting that things are getting better and let’s say, people are getting richer and will travel to ski resorts more often, there’s no better time than good times to do that bet. If you’re a growth stock investor, instead of talking to your customer and saying “things are too good, we’re piling on cash” you can say “things are good and we think because of that, people aren’t appreciating how many people are going to start skiing due to the great economy of ours”.
Another interesting bit of growth stock investing is that you outperform during the upmarket part of the cycle, while value stock investing usually outperforms during the downmarket part of the cycle. Because you need to pile on cash to be able to buy Burlington Northern Santa Fe during the apocalypse, your book didn’t go high as much as those who were betting that Research in Motion and Motorolla were on the verge of dominating the smartphone industry. But from a business standpoint, outperforming during the downmarket is a worse proposition because people are scared and they won’t give their money to anyone, including you.
Most securities in the market trade near market multiple and market multiples usually don’t suppose much growth. So if you can find a stock that trades at market multiple, grows profits by some amount, and return cash to shareholders near market multiple yields, you’ll likely get some outperformance.
Another tidbit of growth stock investing is that it’s usually coupled with tailwinds. Teams are more excited to work, better executives choose the industry/company, and competition is less fierce because you’re not in a zero-sum world.
Here’s an example. Microsoft currently trades at 24x earnings. I think that given the quality of the business if has at least a 3% growth into perpetuity (GDP + Inflation). Given the 3.3% 10y U.S. Government bond yield and a 4.5% equity risk premium, it lands at 22x earnings. Therefore, except for some new changes in the world, like the entirety of the financial system leaving Excel to Spreadsheets, 22x earnings is somewhat near the fair price for a Microsoft that grows in tandem with the economy. But I have some other views on Microsoft: I think that they charge a low price for the completeness of their Microsoft 365 bundle, I think that their cloud offerings still have a long runway for growth given how much CIOs say they still plan to move lots of workloads to the cloud, I think that Microsoft will be able to use their enormous cash generation to make great M&A like Linkedin, Mojang, GitHub or Activision Blizzard. Therefore, I think they can grow their profits at a high single digits low teens pace to the level that if in 5 years people still recognize the Microsoft franchise like they do today, I’ll be able to sell my Microsoft stake to another investor near market multiple + carry + growth.
Boy, I am predicting the future big time here!
This form of future forecasting is what I call compounder bro. The security seems fairly priced or slightly above fairly priced, but it doesn’t recognize the growth potential. Therefore I’ll own it for some years, things will grow, and I’ll exit the investment at a similar multiple, but getting the earnings growth and cash generation.
Of course, another way of growth investing is to buy stocks that are priced to grow, but you think the growth will be even bigger! A16z famously paid 100x revenues in Databricks, but today it’s obvious that it was underpricing the growth that actually occurred in the company.
This form of investing is particularly good because people like to listen to the many ways the future will be different and how ready you are for the transformation that will soon come. It is more exciting to say “We and our limited partners will soon get rich because electric vehicles are soon to surprise everyone with their quick adoption” than “We and our limited partners will soon get rich because Mr. Market decided to sell us a stake on this ancient reinsurer for less than it was worth.”
Of course, if you’re buying a company that can grow that fast, it’s reasonable that sometimes things will not go as well as expected. Zoom investors who paid a $152B valuation in October 2020 (a larger capitalization than century-old ExxonMobil), a nose-bleeding 48x NTM sales, discovered that even though Zoom was about to grow by a lot in the coming quarters, it didn’t grow as much as they expected. When you’re paying 48x sales for a stock, unless the future is incredibly bright, there’s no margin of safety below you, and these investors soon lost 86% of their capital.
On the other hand, in that same October 2020, the investors who paid 15x revenues (or $27B market cap) for the vaccine maker Moderna, enjoyed until today a 96% profit (it achieved 600%).
In the business of predicting long-term trends for companies on the verge of massive growth, sometimes there are incredible home runs like Databricks and Moderna, but sometimes you lose almost everything, like in the case of Zoom.
But sometimes predicting the future isn’t enough
One tweet that I think more than I should is Mostly Borrowed Ideas about Meta:
It’s quite annoying. Theoretically, a Meta investor in 2017 did all the right things: paid a near market multiple, correctly forecasted that the company profits were about to double, and bought a cash-generating machine that generated $152B in operating profit in the period. But it wasn’t enough. When you’re buying securities for twenties multiples of profit, even a gene can have a hard time being vindicated, because the only way to get your money back (or get a significant profit) is to wait for years, sometimes decades, it takes for that cash to be generated.
One alternative way then to describe the job description would be then “You should forecast the financial performance of the business but more importantly, you must forecast the exit narrative, doesn’t matter if it’s right or wrong, of the stock.”
Let’s say that my friend @FbBagholder is right. TikTok is a fad, Instagram and Facebook franchises are going strong and Meta is on the verge of monetizing WhatsApp and soon to monetize the trillion-dollar economy of the metaverse. But unless the narrative changes, the only option for him is to wait. People don’t seem trilled to discount the far-out profits of the metaverse economy.
Meta is a cash-generating machine, so the downside is somewhat limited, but what actually happens is that in the growth stock land, the companies are investing hard and the only way to exit (sometimes for decades! RingCentral was founded in 1999, and today, in 2022, still isn’t expected to turn a profit anytime soon) is finding another investor willing to buy your stake and the grandiose vision of the future.
It’s easy to spot the problem with such an investment strategy. You’re predicting the future, the time passes and you’re right about the short-term path of these predictions, you’re also right about the long-term future predictions, but it doesn’t matter because if other people aren’t convinced, there’s no way to be vindicated
A small summary until here
If you’re actively investing in the stock market, what you’ll discover:
The best way of investing is buying securities with a significant margin of safety without the need to predict the future. The problem is that most of the time, the market is very good at predicting the present and there are fewer patsies in the market.
If you accept you’re going to predict the future, this broadens the universe of investment opportunities considerably and better fits the pro-cyclicality of when customers are handling funds to you. This also addresses the fact that as the market gets more efficient, there are fewer plain obvious opportunities available.
The problem with predicting the future is that the stocks generally price decades of cash flows. Even if in the future shows that it was a complete bargain to pay $37B for RingCentral, it can take a very long time to be proven true without the help of the market.
But if you’re in the business of predicting the future, but want to be completely vindicated in a 3-5 year time horizon that is the most you can afford running a public stock investment shop, what would fit you is:
A company with the potential to pay its market cap in cash during a reasonable investment horizon, making you independent of the sentiment of other market participants.
A company that is expected to go down and lose significant amounts of its earnings powers for whatever reasons
But the company isn’t about to lose its earning power or even if it’s true, it will lose significantly slower than expected.
Melting ice cube investing
In many ways, melting ice cubes have similarities with high-growth stocks. If you’re wrong, you lose a significant amount of your capital (potentially all of it). If you’re right, you get an attractive return.
Many times, melting ice cubes occur in parallel with growth stock stories. If electric vehicle adoption is slower than currently expected, Garret Motion will benefit. If it’s faster, Tesla will benefit. But Garret Motion benefits differently than Tesla. Because Garret Motion trades at 2.5x EV / EBITDA and Tesla trades at 37x EV / EBITDA, even if Tesla is making double the forecasted EBITDA next year, the stock can potentially go sideways or even down, because 37x is a lot of times EBITDA.
So in a sense, if you’re in the business of predicting the future and the future you’re predicting is one where current melting ice cubes will melt slower than expected, you’re more guaranteed to turn a profit than when you’re forecasting that a high flying stock is underestimating the stock future potential because melting ice cubes can potentially pay their entire market cap in cash in just a few years.
One can ask, isn’t this just traditional value investing? No. In traditional value investing you’re buying stuff that doesn’t change much for less than it’s worth. A value investor wouldn’t buy stuff on the verge of disruption. Buying a melting ice cube can possibly be a value trap and there are too many outcomes for the no-forecasts bro.
This is the first essay in my publication. Here I’ll try to offer some thoughts that are value added to other people. The formats will vary until I find something that I think will fit my interests and my capabilities.
Dumb q. How'd you get 22x for MSFT in above example? I'm coming out at 20.8x.
FV PE = 1 / (.033 + .045 -.03)