Playing Long Games, The Value Trap Fallacy, Sources of Alpha, & are we In the Midst of a Bull Market?

Market Talk, Edition 68, February 5th 2023

Feb 5

Once every second Sunday I will curate the most interesting things I have consumed during the previous two weeks. These will be bucketed into 5x must-reads (works I wish to highlight and comment on) and honourable mentions.

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I have long thought about how I can give back to the 21 folks who kindly support the newsletter. Readers will know that whilst I want to be able to write Investment Talk long into the future, I want everything posted to be free at the point of posting. As a compromise, all readers will be able to read every new post and have a one-month archive. Once a post matures past one month, it will be archived for supporters. I believe this is how Marc Rubenstein of Net Interest does things (albeit, with a considerably shorter archive than one month) and feels the least paywall-y out of the options I have entertained thus far.

Recent Publications: Memos I have shared since the last Market Talk.

• PepsiCo Paid $1 Million for This: The Absurdity of Design

• The Forgotten Lessons of 2008: Seth Klarman

• A Hike Across History: Former Rate Hiking Cycles

5x Must Reads

In every edition of Market Talk, I share a number of readings that I have consumed over the past two weeks. Here are 5 that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.

To access the suggested article, click the purple link after the source subheading.

1) Playing Long Games: Focus on Companies with Moats & Relevant Products

Length: Moderate

Source: (Ensemble Capital)

Every business will cease to exist one day. But the x-axis on the lifecycle chart below has no fixed maturity. This is a feature of the stock market perhaps best exemplified through businesses which exhibit the Lindy effect.

But this is one of investing’s hardest dilemmas. As the folks at Ensemble put it; “you want to be in [the stock] in the second inning of the ballgame, and out in the seventh”, later remarking that “our more significant mistakes have tended to come from thinking a company was in the seventh inning when it was actually in the fourth”. This article addresses this problem with potential solutions.

“In our experience as investors, our more significant mistakes have tended to come from thinking a company was in the seventh inning when it was actually in the fourth. Having cut our teeth as value investors, we are naturally inclined to ask ourselves what could go wrong rather than what could go right.
Why does this matter? As we’ve discussed in previous posts, the bulk of a company’s intrinsic value depends on its terminal value, or its theoretical steady state. Consequently, the more confidence the market has in a company’s ability to deliver a certain level of growth and ROIC in its terminal phase, the higher the multiple the market should be willing to pay for that company, all else equal. As analysts and investors, we love to follow these types of companies. And, beyond exceptional cases, these sorts of companies are regularly undervalued in the market because investors are worried that the innings are moving faster than they are.”

2) Behavioural Finance & The Sources of Alpha

Length: Moderate

Source: (Fuller & Thaler)

An old (2000) paper, but one that has some great notes on behavioural finance & biases. The paper begins by discussing the three sources of Alpha; superior information, processing ability, and behaviour. This was eerily similar to something Bill Miller said

several years later in 2015.

It then transgresses into the types of behavioural biases, optical illusions, human errors, and why we are prone to non-wealth maximising behaviours. A pretty solid recap or refresher on the biases we all let seep into our process at some time or another. I suspect the only way to routinely squash them is to remind ourselves of their existence.

“People also suffer from a lack of self-control, which can lead to non-wealth maximizing behavior. Statman (1995) shows that dollar cost averaging is sub-optimal with respect to maximizing wealth. Nevertheless, dollar cost averaging is used by many investors who apparently lack the discipline (and fortitude) to invest all of their wealth in risky assets at one point in time. However, for non-wealth maximizing behavior to result in mispriced securities, the market as a whole must engage in this type of behavior, as opposed to isolated investors.

“If today’s stock price is based on the market’s expectation regarding the future, then in order to predict tomorrow’s stock price change, one must have better expectations about the future than the market. In this sense, the mother of all alphas is the ability to form expectations that are better than the market’s expectations. Consequently, for an active investment manager to claim that he can generate above normal returns (a positive alpha) in the future, he must argue that, in some manner, his expectations regarding the future are better than the market’s expectations.”

3) The Value Trap Fallacy

Length: Light

Source: (Undervalued Japan)

A value trap is when an investor observes cheap fundamentals and believes they are getting an incredible discount with a suitable margin of safety when they are instead falling victim to the trap that never reverts to the mean. Companies trading in such cheap territories often do so for a reason, and the risk of a value trap is significant further devaluation or permanent capital impairment. It’s the worst nightmare of a value investor. The author of Undervalued Japan offers a refreshing perspective on what they call the “value trap misconception… trap”. Arguing that “permanently seeing “Value Traps” that are nonexistent is no less expensive”. They add that the “cost of missing out on outstanding opportunities will compound significantly over the long- run”. Some interesting food for thought.

If you find this interesting, you may also like this paper by Stephen Penman (2014) that covers similar ground.

“Bargain stocks do not exist in a vacuum. They are always surrounded by high doubt and great fear. It is the inflicting pain of the relentless stock price decline in combination with temporary operational issues that creates them. Seeing "Value Traps" that do not exist is a common error among value investors. In a strange habit they call out "Value Traps" in bargain stocks with temporary, albeit often prolonged, operational and stock price weakness, unable to envision that the underlying profit potentials are often largely unimpaired.”

4) Bearish or Bullish, That is the Question

Length: Light

Source: (Miller Value Partners)

Tired of reading doom porn? You might like this note from Miller Value Partners. As I write this, the S&P 500 is ~15% above the low it marked in October ‘22 after a 25% drawdown that welcomed a new bear market. The Nasdaq composite is not far behind. It appears to be that most investors are currently in one of two camps. Those who think we are in the return to normal phase, ready to fall off a cliff; and those who think we are somewhere between despair and return to the mean; ready to kick off a new bull market sometime soon.

U.S. Stock Market: Economy, Euphoria And Epidemiology | Seeking Alpha

There is still a great deal of uncertainty as far as the macro is concerned, yet this week we saw over 517,000 new jobs (vs the expected 188,000) and unemployment (3.4%) so low it’s not touched this level since late 1968. With the market being a leading indicator, I suspect it now has more faith that Powell can pull off a soft landing. I, personally, haven’t any idea about all of that.

MVP point to a range of evidence that suggests even if we do get a recession, the forward returns from now may not be so bad.

“Birinyi argues there is reason to believe that we are already in a recession based on the broad market declines of last year. Following periods where the market experienced both a bear market and a recession, forward annualized returns averaged 47%, 20% and 18% on a 1-yr, 3-yr, and 5-yr basis.”

This is definitely an article that will feed into your biases if you believe the fears of bears are looking overexaggerated, so take it with a healthy pinch of salt.

“No one can predict the future, but we know the market goes up 73% of 1-year periods, 84% of 3-year periods, 87% of 5-year periods and 93% of 10-year periods. There is always the possibility that we experience another pullback, but history tells us there’s reason for optimism and many smart observers see signs the worst is past. As Sir John Templeton says, “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

5) What I Learned From Michael Burry's Value Investor Club Write-ups

Length: Light

Source: (MacroOps Musings)

Unbeknownst to me, Michael Burry shared a series of write-ups (here) between 2000 and 2002 on Value Investor’s Club (VIC). In typical Burry style, each is short and to the point, concluding with a brief synopsis of the catalyst. The folks over at MacroOps Musings wrote a great article summarising the overlapping themes of the stock pitches. The TLDR is that Burry liked absolute valuation, downside protection, small and illiquid companies, low share counts, and no restrictions for where he hunted.

These write-ups also got me thinking. I saw this (below) exchange the other day and had actually typed out something longer for the introduction to this Market Talk but deleted it. On one hand, it boils down to a misaligned audience and a lack of nuance; I don’t imagine that professionals are the target audience of these write-ups. A retail investor with a full-time job and little time to do their own research might like a side order of storytelling with their numbers. In the same way that cooking content for beginners is of no use to a Michelin-star chef; it’s useful to someone. But I rarely see professional chefs mocking those who are less experienced as often as you’ll find on Twitter.

But taking a different perspective; if you are someone writing about stocks and this offends you, then look inwards. It’s plausible that it strikes your insecurities; the ones that tell you what you produce is not good enough. I agree that reparsing SEC filings is not unique insight. I look back at some of my older work and I think that about myself. However, I disagree with the notion that investing is purely quantitative. So there are puts and takes. I just wanted to take a moment to say that if you are someone who writes about individual stocks, ignore the part about what bucket shop capital says that feels like criticism. Instead, extract the lesson. How can you improve your writing to break away from being a storyteller and start honing in on the important insights? I say this mostly to myself by the way.

I’ve shared a few resources related to this in the past, such as the 20 second, 3 minute, 20 minute stock pitch method from Krainos Capital and how to pitch a stock in 90 seconds by Bill Miller (above). He suggests beginning with “I think it's a buy for the following 5 reasons; bam, bam, bam, bam, and bam”. A good note to come back to when you feel like Wordsworth. It’s something I still need to learn; I’ve not written about a stock since last November and have deleted several write-ups since. Largely because I feel they have too much waffle and don’t get to the point. But having the dexterity to switch between a 30 second and 5 minute pitch is something I want to work on for this newsletter.

“Burry prefers microcaps because they’re one of the least fished areas of the market. Most investors ignore them for a few reasons. First, microcaps are often illiquid. There aren’t many shares traded so it’s difficult to build a position in them without affecting the stock price and it’s even harder to quickly exit them. They are basically quasi-private market investments. Second, micro-cap stocks have a sketchy reputation. They’re like the Red Light District of public markets filled with frauds, inept management teams, and businesses that make you wonder why they’re even public. However, there’s tremendous alpha in highly illiquid and micro-cap stocks for those willing to dumpster dive.”