[The Weekend Bulletin] #67: Two Different Approaches to Valuations, Ten Traits of Good Investors,...
...John Huber of Saber Capital, 23 mental models towards financial freedom and more.
A digest of some interesting reading material from around the world-wide-web. Your weekly dose of multi-disciplinary reading.
Today marks nearly a year since most of us (here in India at least) have been working from home. Who would have thought that we could have stayed away from office and conference rooms for this long? It's amazing how much our lives can change in a year, isn't it?
Beyond the initial bursts of online family games, binge watching, and cooking experiments, one of the things that held me sane through this tumultuous year was ‘reading’. It provided a good escape from the present - from the gloom of the abandoned outsides to the doom of the see-sawing markets.
Here is a good tribute to reading that I came across recently:
Section 1: Investing Wisdom
There are a few components that go into making an investing - the underlying business, the purchase valuation, and the investment horizon. While a lot has been written about the business and time horizon, valuations have not received as much attention. The subject of valuations has gained increasing prominence over the last two decades or so, especially in the light of changing business models (lower balance sheet investments) as well as investing styles (focus on earnings and cash flow over book value). Further, the last decade's monetary and fiscal stimuli, resulting in near zero interest rates, have exposed the shortfalls of valuation shorthands like the p/e and peg ratios. Investors are increasingly realising the importance of nuances like cost of capital assumptions, reinvestment rates, competitive advantage period, and other such measures that go into more detailed valuation exercises like the DCF. In that vein, below are two interesting approaches to valuing a business that can help investors overcome some of the shortfalls of the more traditional methods:
The first is a quantitative rumination on Warren Buffett's quip that its far better to buy a wonderful business at a fair price, rather than a fair business at a wonderful price. While we all have some idea of what a wonderful business is like, there is no readily available deduction of a 'fair price' - a subjective assessment hitherto. This thread provides a way to mathematically deduce the fair price of a business. If you've always worried about what the right multiple to value a business is, you'll find a simple way to arrive at that multiple in it.
If you are someone who does not like to assign a multiple to a business but rather likes to identify the information embedded in the current price, then this thread should be your go to resource. It will teach you to break a business's value in to two: steady state and growth. Determining the steady state value will help you infer the growth implied by the current price. A good tool for those that like working backwards.
Combining the two methods above can help you arrive at a your own estimate of the business's fair value as well as assess the market's current estimate of the business' future trajectory. Some of the best investment ideas will lie at the point where these two methods contradict each other.
Having looked at what constitutes a good business (Issues 46 and 63 amongst others), what defines your investment horizon (Issue 64), as well as how to value such businesses (current issue), there is one more component that deserves attention. That component requires looking in to the mirror - understanding ourselves. No matter how good a business, how cheap we buy it, and how long we intend to hold it - all this wont mean anything if we do not have what it takes to be a good investor. Here is a list of 10 values observed in a number of good investors. Treat this list as an aspiration to work towards (only a handful of investors will possess all 10; for the rest of us mere mortals, developing as many of these traits as possible would be good enough).
From short threads, lets shift focus to a long-form read. This interview (page 29 onwards) spotlights the journey, investment philosophy, and ideas of John Huber of Saber Capital. For those of you not familiar, John is a not only a good investor (he brings interesting perspectives to well known businesses) but also a great writer (his prices on ROIC and moats make for great reads). This interview makes for a good peak into the mind of great investment thinker. Below are some snippets:
"There are two main categories of investments that I think my portfolio has had over time. One is what I call dominant moats. These are really durable, high-quality, strong businesses with great balance sheets and very entrenched business models. They also tend to be mature...Then the second category are what I call emerging moats, and these are the compounders. These are the companies that have really high returns on capital, long growth runways, and are developing a strong lead."
"When I first invested in Apple in 2016, it had a valuation of around $500 billion. In two years, it went to a trillion. Then inside of three months, in late 2018, it went down 40%, shedding about $400 billion in value in just one quarter. Then from there, it went back to $1.5 trillion in just a year, up 150% from $600 billion. All of this was before COVID. It just goes to show you how the largest, most well-followed stock in the world can fluctuate far more significantly than the underlying value of the business. Why is that the case? Why is there an opportunity with Apple? I think one reason is time horizon –some people didn't want to own Apple because they were worried about the next quarter."
"I think there was also an analytical edge with Apple; this refers to looking at things through a different lens than others. In this case, I think some people were looking at Apple like a computer hardware company. A computer hardware company sells a commoditized product, margins will revert to the mean over time, and any excess returns on capital will be fleeting. They'll revert to the mean, and you'll never produce any excess profitability.
The other way to look at Apple was to view it as a consumer brand, along the lines of a Starbucks or a Nike. Nike makes a product from commodity inputs, manufactured overseas. Most of their products are essentially replicable commodities, but they get a 75% markup over their costs to make those products, and those gross margins exist because of the brand that Nike has.
...I think the combination of short term time horizons and thinking about Apple in a different way created an environment that resulted in a stock that was significantly undervalued, even though it was the most widely followed company in the market."
"Opportunity cost is a big factor in investing. Sometimes you make a mistake when you buy a stock, but the most costly mistakes can be when you sell something that you should have kept, because the opportunity cost of forgone profits can grow to become many times the size of a loss incurred by making a bad investment."
"I'm a conservative investor by nature, but there are drawbacks to being too conservative. I just read a note by my friend, Rob Vinall who runs a firm called RV Capital. He made a great point – banks that are aggressive when underwriting loans end up going bust, but so do banks that are too conservative over time, because they’ll miss writing the loans that are most profitable, which is needed to pay for the inevitable mistakes. As investors, our goal should be accuracy when evaluating a business."
Talking about banks, here is a nice list of 10 laws that govern banking. Think of this as a crash course into understanding the banking industry and as pointers to look for in the next bank that you identify for investments.
Section 2: Mental Models & Behavioral Biases
This is a good to follow list of 23 mental models for finding your way to financial independence. Whether you find it in 8 years or 40 will depend also on factors outside of your control, however, this list will definitely help you hasten the process. It'll be helpful to have yourself reminded of this list at regular intervals - stick it on your desk or create Anki reminders out of it. Also, remember to check some of the comments below the thread, as a few important details are covered in them as well.
Section 3: Personal Development
One of the articles above talks about the necessity of holding opposing ideas. Here is one such idea: reading slow, but fast. This article argues that slowly reading a book - taking breaks to ruminate, to question, to connect ideas, and to refer - is the best way to read a book. However, it also argues that you need to speed read a book. Confused? Read the article to find how you can read slow but fast. It'll also provide some speed reading techniques towards the end.
This is a hilariously honest read. It addresses one of the biggest decisions of our lives, one of the real long term choices that we make - marriage. It posits that we are all going to marry the wrong person. No matter how much diligence we conduct, choosing whom to commit ourselves to is merely a case of identifying which particular variety of suffering we would most like to sacrifice ourselves for. Hidden behind this matrimonial column is the secret elixir to a happy life (married or otherwise): "We should learn to accommodate ourselves to “wrongness,” striving always to adopt a more forgiving, humorous and kindly perspective".
Link this to last week’s read on the Common Denominator of Success.
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That's it for this weekend folks.
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Have a wonderful week ahead!!
- Tejas Gutka
[Mar 20, 2021]