The most critical exercise in a rapidly accelerating world is working out which changes are transient and which are enduring.
With the considerable advantage of 30 years of experience in the stock market, this piece has been written in collaboration with The Knall/Cohen/Pence Group’s own Tom Pence.
[7 minute read]
“The four most dangerous words in investing are: this time it’s different.”
- Sir John Templeton
“The twelve most dangerous words in investing are, ‘The four most dangerous words in investing are: this time it’s different.’”
With the mania in meme stocks showing no signs of slowing, observing that “this is crazy and will probably end badly” is so obvious as to be utterly useless. Unless you can tell when it will end, which it appears nobody can. Common knowledge often has negative value. It mostly consumes your time and attention to tell you something you already knew.
What is worth observing is that, while the human behaviors being exhibited are common to previous bubbles, the technological landscape is radically different. For one thing, the internet had 24x fewer users in 1999 and was dramatically slower in every imaginable way. If the size of the addressable market for narratives is exponentially greater, then like most bubbles, this can go on for longer and be more extreme than many people expect. It’s like comparing a rat loose in a bodega with a rhino rampaging through a Wal-Mart.
Amidst the information deluge, this means one change that’s likely to be permanent is that short-term returns will accrue to the people who can dominate salience. It’s a persuasive argument that some people have become the richest people in the world in part because of their ability to attract and retain attention online.
The meme mania is about the decentralization of power and information. But one has to consider that just because previously-inaccessible information is suddenly made available to everyone, there is really no assurance that it will be utilized in the most sensible way. Tom likens it to cyanide pills suddenly being made freely available over the counter at CVS. “While some may find a productive use for such a purchase, it clearly could lead to some unintended consequences.”
The stock market is exhibiting one of the most interesting characteristics of today’s massively networked world. The systems we now inhabit have been inexorably driven by efficiency and profitability. They have consequently become terrifyingly fragile when faced with spikes in energy and information. We’re seeing the results almost weekly. Much of the internet was taken offline for a couple of hours on June 8 due to a reliance on a single company. A ship turned sideways in the Suez Canal and brought global trade to a halt. Multiple cyberattacks have brutally exposed network bottlenecks. The retail trading horde, however it originates, is exploiting market structure dynamics like short squeezes, low liquidity and options hedging to dramatically spike stock prices. They’ve learned how to run a lot of capital through very small doors.
The new global network is defined by flows and bottlenecks. So you want companies with the strongest and most flexible cash flow. Since the massive expansion of the global network when China joined the World Trade Organization in 2001, free cash flow has been a key driver of stock prices.
Source: Empirical Research
Tom has long maintained the belief that a predominant driver of long term stock market returns is the ability of a company to (ultimately) be able to generate free cash flow and to preferably compound that FCF into the future.
Moreover, it seems obvious stocks that can flexibly span the digital network have reaped historically unprecedented gains. For example, intangibles have substantially increased as a driver of stock prices over the past decade. Brands and digital technology are radically more important in an online world. Intellectual property (IP) now comprises significantly more of the market’s enterprise value.
©2020 Aon plc/Ponemon Institute LLC 2020 Intangible Assets Financial Statement Impact Comparison Report.
If so much of the world is now “intangible,” how should we think of the role of deep change in laying down the new investing bedrock? Both Tom and I were rather taken by growth investor James Anderson of Baillie Gifford’s recent retirement letter after two decades and 1,700% in returns.
“The common factors that are most likely to recur in the narratives of great investments are that the company should have open-ended growth opportunities that they should work hard never to define or time, that it has initial leadership that thinks like a founder (and almost always is one) and that has a distinctive philosophy of business - almost always from independently thought through first principles.”
These are all fundamental drivers, but also somewhat qualitative, hence the need for human judgement to assess them. Similarly, the greater importance of IP requires an intrinsically much more subjective assessment than the harder asset value of a factory building. It’s very much in line with Tom’s own approach to investing. These intangibles still generated enormous free cash flow. Who wouldn’t want that?
As we move forward in a world that’s changing daily, the real trick will be working out what beliefs are no longer true. Tom and his team believes that the things that seemingly don’t matter to meme stock investors today (the expectation of eventual profitable revenue growth and FCF generation) will return to the fore in future. “Stay in your seats, it’s a long ballgame.”
- Read. Stay on the road less travelled by James Anderson (17 minute read).
- Why read. As quoted above, a relatively short retirement letter from Anderson that’s a strong examination of successful growth investing principles.
- Read. The Games People Play with Cash Flow by Cedric Chin (39 minute read).
- Why read. I’ve been lucky enough to discover Cedric and his work recently. Whenever I find a pithy business insight I think sounds smart, I Google it and find out he’s meticulously debunked it using case studies. He has the keen research skills I wish I had. He sent me this piece, his favourite, which just happens to be a deep dive on today’s topic of cash flow.
- “People with limited understanding of business think that business is all about making profits. But those who actually run businesses know that running a business is all about managing cash flows.”
- Listen. Invest Like The Best with Dennis Lynch at Counterpoint (1 hour 10 minute listen)
- Why listen. As I tried to explain in The Attention Span. “Ship of Theseus”, people who see the massively networked world in siloed ways (e.g. looking at the Fed/U.S. in isolation without looking at capital flows from Taiwan/Germany into the U.S., or looking at rates or inflation in one country in isolation) are going to be continuously caught out by the way an interconnected network flows. Lynch makes the point about Global Industry Classification Standard (GICS) sectors creating misclassification opportunities, as well as experts getting stuck in their buckets.
- “But I think one of the key things there too is that often the biggest mistakes probably get made in this regard by poor classification or misclassification. And what I mean by that is look, human beings have to make decisions every day. And we put things in the buckets and classify things in order to get there. When it comes to analyzing a company, same thing. …..And often when you can't quite put a company into a bucket that easily, it tells you that there might be something unique happening. And probably our greatest successes over time have been cases like that, where it wasn't so obvious.”
- “But when you're dealing with markets, which are more dependent on human behavior, it's important to have experts, but also recognize that most industries built around them, a lot of the expertise is compartmentalized and there can be advantages to either having non-experts on the team that their role is just literally to float from area to area.”
- “Michael Mauboussin has the whole idea of the markets being a complex adaptive system. I definitely see it that way as well. And it's been a great contribution for me just learning that from him way back then. And what that means is that market's really a learning machine and it's constantly updating its aggregated process from all the individual participants. And I think what that means is actually plus the opposite, to answer your question, which is it's always getting harder not easier in some ways or feels that way because certain strategy or certain area of the market was under appreciated or a certain company or type of company. Often, the market a few years down the road suddenly has incorporated that into the equation. And as I think I mentioned earlier, when I look at the perspective returns today of companies we like, we also have a pretty wide purview. We don't have to own certain types of companies generally and we have the ability to look from small cap U.S. all the way to large cap international. So we really can look at just about anything, but it's hard to find things that appear right now to us as really compelling. And again, that's probably has something to do with where the opportunity cost is today, the risk-free rate and the fact that real opportunity cost continues to be negative. But if we do our jobs right, we will continue to try to figure out what comes next. And if there was a transition at least from our vantage point of Return on Invested Capital (ROIC) free cash flow yield into companies not as currently profitable with the kind of long end game growth potential, it's up to us to find that next interesting area.”
Have a great day!