How to Catch A Monster

Over the past 22 years, the shares of Monster Beverage (NASDAQ:MNST) — best known for its large cans of Monster brand energy drinks — increased in value by a mind-numbing 2,300-fold. That is almost too big of a number to wrap our heads around, so let’s put it like this: for every $10,000 invested in 1997, a shareholder that held on would be sitting on $23,200,000 today.

In 1997 that $10,000 could have bought a decent second-hand car. Today, after investing in Monster Beverage it would buy them a helicopter to go with their cliff-top mansion.

Monster Beverage is one of my favourite investment stories of the last few decades. It’s not just because of the spectacular returns. It’s because it was an easily understood business, and at several points in its journey, clearly undervalued. Monster Beverage demonstrates a particular path to massive wealth creation for shareholders. A path that doesn’t require lucky flukes, or taking huge risks. 

Monsters

While most of the market is mired in mediocrity, there is a small group of companies that generate insane returns for shareholders. I call these companies Monsters for the way they dominate their industries and transform portfolios. A few years ago I set out to study these huge monster winners, reading books like ‘100 to 1 in the Stock Market‘ and trawling through Standard & Poors data to see if I could identify any common traits. Most importantly, I wanted to see if it was possible to identify these winners early, before they started their huge run, and the rest of the market caught on. 

It is still early days, but the results of Monster hunting, both as a professional investor, and privately, have been pleasing so far:

[Note: These are ordered based on starting date for each position e.g. Altium dates to 2014, Nearmap is the most recent addition, from 2017. Big thanks goes to our former Pro team particularly Ryan Newman, and previous PM Joe Magyer in helping to find/research several of these companies. I have excluded any companies with less than a 5X return, such as Xero etc.]

The Four Steps

As I see it, there are four steps to catching a Monster:

  1. Choose your hunting ground – avoid pretenders to the Monster throne.
  2. Catch your monster – identify key traits.
  3. Watch closely – continuously monitor and sell quickly if your thesis is broken.
  4. Hold on – be able to stomach the volatility without selling too early.

I’ll talk through each step in turn.


Watch this Space:

In the next few weeks I will be announcing an exciting new project. I will also be sharing more detailed breakdowns on the investment lessons behind these companies. If you know someone that would be interested to follow along, invite them to subscribe for updates. And if you haven’t subscribed yourself yet, get cracking!


Choose your Hunting Ground

Investing is an art of negative space. What you don’t buy is at least as important as what you do. The best investors say no to potential ideas early and often.

The vast majority of companies have no shot at generating monstrous returns. These businesses should be avoided entirely. They are either struggling to keep the lights on, or they have already begun their long descent into obscurity. If you buy mediocre businesses you’re not going to be able to capture the kind of returns we are seeking.

But there are also four other types of companies that can generate big returns, that I don’t count as Monsters. These are companies that rely on luck or high risk. And for that reason, even though they can deliver high returns, I still avoid them:

Lucky speculations

If these companies had a motto, it would be: ‘it’s better to be lucky than good’. There is nothing wrong with being lucky, but it’s not a repeatable strategy. Winning the lottery 5 times in row is pretty rare.

Speculative mining companies are the archetypal example. Every now and then some bonfire for shareholder capital actually manages to strike oil/gold/lithium and hits the big time. There’s a reason Australia is called the Lucky Country, and there are plenty of these stories around. The problem is that there are several hundred speculative miners on the ASX. The vast majority of these businesses are cash-infernos. Accurately forecasting winners in that space is almost impossible. 

Speculative biotech and pharmaceutical research companies are a similar breed. At least they are attempting to do something more useful than put holes in the ground. But good intentions don’t equal a good investment. 

I avoid these speculative ‘lotto tickets’ entirely. Good luck to all players. Not my game. 

Commodity price swings

These are companies that soar due to a sharp change in the supply-demand ratio for a basic commodity. The commodity price rockets, taking the company’s shares with it. 

This tempts many otherwise smart investors: use your big brain to identify some commodity that will be in high demand, and buy the producers of that commodity before the price rises. In practice, it is extremely difficult to forecast these commodity price swings, and even harder to profit from them. Increased demand typically brings in legions of new suppliers, which ultimately send prices crashing back to earth faster than a lump of unwanted coal. 

If you think you can forecast commodity prices well enough to pull this off reliably, you should probably be day-trading commodity futures. Good luck with that. 

Highly-leveraged businesses

Companies which have a huge amount of debt can have some interesting properties. If the debt is large enough, and the business manages to avoid being crushed under its own weight, it acts as a big amplifier of returns, good or bad.

The math of leverage explains why. If a business has total debt of $90m, and a market cap of $10m, we would say it has an enterprise value of $100m. If the business doubles in value to $200m, this extra $100m of value would all go to the equity i.e. to shareholders. So a 100% increase in business value results in the company’s market cap increasing ten fold to $100m, and the shares soaring 1,000%. 

On the other hand, if the business’ value falls by even 10%…

These highly leveraged companies can be very profitable for shareholders, but the leverage is a double-edged sword. If things don’t work out these companies’ share prices face a large ‘crash risk’, and the sword stabs its owner in the leg. The debt can even overwhelm the company and push them in to bankruptcy.  

I like my thai food spicy, but not my shares. Pass.

Back from the brink of bankruptcy

These are zombie companies that were once on death’s door and have now re-entered the land of the living. Buying companies that are going through a panic, or financial distress, can be a winning strategy if the business makes it out the other side.

In times of significant market panic even great companies can be priced like they are going out of business. That would get my attention. But generally speaking, I will leave the zombie wars to others. 

That’s four categories I avoid, now let’s talk about true Monsters.

Catch Your Monster

Monsters are businesses that deliver huge shareholder returns by compounding high returns on invested capital. These businesses generate strong free cash flows, and most importantly, the business is able to reinvest those cash flows at high rates, and for a very long time. That reinvestment has a compounding effect over time, with the company’s value building up faster than a snowball rolling downhill. 

Altium, Appen, a2 Milk etc. all fall into this camp. I have found there are four key traits these monsters tend to have at the start of their journeys: 

#1: They start out small

This might be an obvious one, but it’s important. It is much easier for a company to increase in value 100-fold or more, if it is starting from a low base. Today Amazon is valued at $900 billion. The shares are up 1,200x because the company started off small. For Amazon to increase another 1,200x from here would give it a market cap of over 1 quadrillion dollars. That’s a sum so large it is greater than the value of every financial asset on earth. Jeff Bezos has some ambitions for Space exploration so perhaps we shouldn’t write it off. But it is safe to say that growing gets tougher the bigger you are. 

This is why I focus on fast-growing small companies with long growth-runways ahead. 

#2: Unique edge

The company must have some kind of durable competitive advantage that forms a barrier to competition. This barrier allows the company to earn those high returns on invested capital, and to ensure that those returns are not eroded over time by new competitors. 

These advantages can come in many forms. They include consumer brands, patents, intellectual property, switching costs, economies of scale etc. The most powerful edge usually comes when a company combines both demand advantages and supply advantages. The very best businesses are then able to link these two edges together in a positive feedback loop or ‘flywheel effect’. 

My goal is to identify companies with these competitive advantages, and where the advantages are increasing over time. 

#3: Superior Management

The importance of high quality management is magnified in a small fast-growing company. If the captain of a large ocean liner steers the boat off course, it takes a long time for the effects to be felt. But if a small speed-boat captain turns the wrong way, they can quickly find themselves on the rocks. 

We need a management team that thinks long-term, and has the vision to understand their competitive playing field. This is why we focus on identifying high-quality and aligned management teams. Ideally the founders are still in charge, or management at least hold a large number of shares and behave like owners. 

Assessing management is so important to my process that it is very rare that I haven’t met with a management team before buying shares, and often I meet with them several times before becoming comfortable enough to initiate a position. 

#4: Misunderstood

I left this for last because it is the most important. There is no business so beautiful that it can’t become an ugly investment at the wrong price. 

To achieve truly spectacular returns, a company has to start off with a valuation that does not fully reflect its market-thumping future. Ideally it will begin its journey with a valuation that is downright cheap, and then the market’s rising expectations will add a multiplier effect to its growth. 

Ultimately the most important step in determining whether to add a potential Monster to the portfolio is to assess its intrinsic value and then to buy at a significant discount to that valuation. And to be undervalued is to be misunderstood. 

Whenever we are deciding to buy a business we are asking ourselves what our variant perception is compared to the market. What do we believe that the market disagrees with us on? Perhaps the market doesn’t think that growth will stick around for as long as we do. Maybe it’s not giving credit for new products or geographies. Whatever the reason, their mistake is our potential to profit. 

Buying companies at a discount to their intrinsic value is at the core of all sensible long-term investing, Monster-hunting is no different. 

Watch closely

The price of catching monsters is eternal vigilance.

Once you have caught your monster, the next step is to clearly articulate your thesis at the time of purchase and then regularly review that thesis as new information comes to hand. Actually writing out your thesis is important. If you don’t use it already I recommend checking out strawman.com as a platform for research.

Not every company that I thought had Monster potential actually delivered. So a core part of my strategy has been to sell quickly when my investment thesis has been invalidated. Class Software is the clearest example of being willing to cut bait quickly when a thesis is broken, as I covered in detail in The Selling Blindspot

Hold on tight

Catching Monsters takes patience. But even more than that, it requires conviction. 

Holding on to a company is much tougher than just passively waiting for the cheques to come in. It means enduring the pain of seeing your company’s share price fall and fall, and maintaining the conviction that it will come out the other side stronger. There is a critical tension here between holding on and selling quickly. The deciding factor is your investment thesis. If it is intact, hold on and ignore the market’s price swings. If the business’s quality is eroding, be prepared to sell quickly.

This is what I like to call a ‘pain chart’, inspired by a Morgan Housel article, for a2 Milk. This chart shows when, and by how much, a2 Milk shares were below their all-time high. (Periods at 0% show when shares hit a new all-time high). Remember, this was during a period when shares increased more than 1,600%:

There have been five times when a2 Milk’s share price fell 20% or more. And on two occasions the shares fell by 30% or more. To enjoy the monstrous gains to date shareholders needed to avoid giving in to fear and selling during those troughs of despair. Those shareholders also needed to avoid the temptation to lock in a profit when the shares were up 30%, 100%, 500%, or even 1,000%. 

To hold for that wild ride, investors need to develop, and maintain, a high level of conviction that their investment thesis is correct. Then, ultimately, they need to be proven right.

Most of the market is incredibly short-term oriented. This applies to individual traders as well as large fund managers. These investors are always trying to own the hottest-stock-this-quarter while missing the 100x Monster that is growing beneath their feet. 

If you can tune out the market’s noise you will separate yourself from the others. 

Vision, Courage, Patience

Catching Monsters is hard. Our view of the future is cloudy at best. The power of compounding means that the biggest winners will create most of their value many years, or even decades, from today. Forecasting that far in to the future is not easy.

Investors need the imagination to be able to think big. To visualise how the company could be performing in the distant future. But then they also need the discipline to bring that big vision back to the reality of the present day, and value it appropriately. That marriage between lofty big picture thinking, and the cold hard facts of present day valuation, is tougher than it sounds. 

“To make money in stocks you must have ‘the vision to see them, the courage to buy them and the patience to hold them’. Patience is the rarest of the three.”

100 to 1 in the Stock Market author Thomas Phelps expanding on a quote from financier George F. Baker.

If you can demonstrate those three qualities: vision, courage, and patience, you have a shot at aligning your portfolio with these unstoppable engines of wealth creation. The ride can be bumpy, but it’s also a heck of a lot of fun.

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Disclosure: No part of this report, or disclosure, should be considered to be a recommendation or financial advice. At the time of publishing, Matt holds shares in Altium, Appen, a2 Milk, Nearmap, Pro Medicus, Strawman, and Wisetech. Holdings are subject to change at any time. 

The Selling Blind Spot

Selling is a big blind spot for investors. For every thousand articles about when to buy a company, we’re lucky to find one about when to sell. Yet selling has a huge impact on our long-term performance. And the evidence is clear: most people are no good at it. But this weakness also provides the opportunity for a massive competitive advantage.  

The Problem

It’s well known that a lot of individual investors suffer from selling biases like loss aversion. Recent research shows that the professionals struggle too. An impressive study found that professional fund managers, although pretty good at buying, are terrible at selling. It was a landmark study, so let’s unpack the findings.

“We document a striking pattern: while the investors display clear skill in buying, their selling decisions under-perform substantially…selling decisions not only fail to beat a no-skill strategy of selling another randomly chosen asset from the portfolio, they consistently under-perform it by substantial amounts.”

The sell decisions of professional investors are so bad that they performed worse than chance. That’s rough. But the buy decisions did add value, so it’s not that fund managers have no idea about investing. Instead the authors found a flawed process where selling doesn’t receive adequate attention:

“We present evidence consistent with the discrepancy in performance between buy and sell decisions being driven by an asymmetric allocation of cognitive resources, particularly attention…We conjecture that PMs [Portfolio Managers] in our sample focus primarily on finding the next great idea to add to their portfolio and view selling largely as a way to raise cash for purchases”

“PMs in our sample have substantially greater propensities to sell positions with extreme returns: both the worst and best performing assets in the portfolio are sold at rates more than 50% percent higher than assets that just under or over performed. Importantly, no such pattern is found on the buying side – unlike with selling, buying behavior correlates little with past returns and other observables”

Most professionals have no good process for selling. They focus on buying, and only think about selling when they are fumbling around to free up cash. When they do sell, it is with little research. So they sell whatever sticks out the most: the biggest gainer or the biggest loser. It’s not logical, and they don’t think about the future prospects. The result is decisions that are so bad, they would have been better off throwing darts at a board to pick a position to sell.

This focus on past returns is also mirrored in much of the folk wisdom that floats around about selling:

  • ‘Sell when a stock doubles (or is up 20%, or 30%, or whatever arbitrary number)’
  • ‘Never sell at a loss’
  • ‘Nobody ever went broke taking a profit’
  • ‘Sell anything that falls by 10%’
  • ‘Water your flowers and trim your weeds (sell companies whose share price has fallen)

Intelligent investing is supposed to be forward-looking. It’s the future that counts. Yet all these rules of thumb, and the trading of the average fund manager, is based on past price movements.

The core problem is that most people’s sell process abandons all that is good about their buy process:

buysellprocess1

It’s a big problem. But there is a better way. My style of fundamental growth investing, led me to adopt two core selling principles:

Principle #1: Sell quickly when a thesis is broken

This principle has been a core driver of investment performance for me. Selling quickly when a thesis is broken allows you to ‘lose small’ when you have made a mistake. More importantly, it allows you to quickly re-deploy your precious capital in to a new high-conviction idea.

Like running a marathon, it is simple, but not easy.

There are five steps:

  1. Identify your thesis (actually write it out)
  2. In that initial thesis, identify what would cause you to sell
  3. Continuously monitor the company, its competitors, customers etc.
  4. Update your valuation estimate and avoid thesis creep
  5. Sell quickly if the thesis is broken

Let’s work through those steps with a real-world example: Class (ASX:CL1). Class provides a SaaS software product that helps Self-Managed Super Funds (SMSFs) manage their accounts. It’s a sizable industry in Australia, with over 500,000 SMSFs. It’s a growing market: each year more people’s retirement balances hit a size where it becomes worthwhile to consider managing it themselves.

Step 1: Identify your thesis (actually write it out)

Few investors clarify their thinking on why precisely they are buying a company. Even fewer take the time to actually write down that investment thesis. If you do, you will be ahead of the pack.

We must have a clear idea of what our logic is in the first place, so that we can know when that thesis is broken.

We first bought Class shares shortly after the IPO in early 2016. It was a simple thesis. Class was disrupting traditional desktop software – an inevitable shift to the cloud was underway. At the time of purchase, Class was dominating the new cloud-based market, and winning over two thirds of new cloud customers.

Even better, Class’ major competitor, the incumbent BGL Super, had stumbled with their first launch of a cloud product. We initiated a position and over the next two years Class’ share price rose over 80%.

It looked like the ideal investment, a scalable software business that was dominating a sticky niche, while a sluggish incumbent failed to adapt.

But that would change.

Step 2: Identify what new evidence would cause you to sell

The moment before you buy a stock is the last time you will be thinking objectively. It is crucial that you use this moment to write down precisely what new evidence would cause you to sell in future.

We identified multiple risks that could have befallen Class. The government could have changed the rules around SMSFs. A major security breach could have broken client’s trust in Class’ cloud service. Neither of those came to pass.

Another risk was that a competitor could somehow crack the market and start stealing share. Class would not be so lucky on this count.

Step 3: Continuous monitoring

Eternal vigilance is the price of superior returns.

We must continuously monitor for thesis-breaking evidence. That means keeping tabs on the company, its staff morale, its new products, customers, competitors, regulators, suppliers, etc. There are many tools that can help this along: Glassdoor, Google Trends, product forums, Google Alerts, investing forums. But that should be just the beginning. Superior returns require superior portfolio monitoring.

In the example of Class there was one obvious source of intelligence that most of the market somehow missed. Remember that big incumbent BGL? Well BGL would regularly release announcements about how their new cloud based product was progressing.

For a long time these press releases were mostly hot air. Every company claims that their products are market-leading, next-generation, cutting-edge. But in early 2017 it became apparent that BGL’s new cloud products were gaining traction. Talking to BGL’s customers, it seemed that the incumbent may have started to get its act together.

No company goes without serious competition forever though. So we were careful to avoid a knee-jerk response.

That all changed in October 2017.

Step 4: Re-evaluate and avoid thesis creep

Thesis creep is one of the great traps that ensnare investors, particularly value investors. The company reports some bad news, and rather than recognise the mistake and sell, the investor holds on.

The share price has usually fallen by this stage, which can allow the original thesis to sneakily creep its way to something new: “Sure, we originally thought the company would do XYZ, and it clearly hasn’t, but it’s just so darn cheap now, we couldn’t sell at this price”.

There were two new pieces of information that were released on the 5th of October. First, Class’ reported its latest quarterly update. It showed that the company’s net new account additions had fallen, dramatically.

In the comparable quarter a year earlier Class had added 11,880 new SMSF accounts. The same number in 2017 showed just 6,232 new accounts. A fall of 47%. And this was after a soft June quarter, which the company had guided would quickly rebound. To make matters worse, the chart the company usually reported which would have shown this fall clearly was no longer included.

Something had changed.

Later that day it was confirmed. BGL announced that it had now surpassed 100,000 accounts on its own cloud-based product. Worse still (for Class), their biggest competitor had added 23,402 accounts during the latest quarter.

When we first purchased shares, Class was winning approximately 66% of new cloud accounts. Now it appeared to be winning just 20%. That’s a huge swing in competitive position. We updated our intrinsic value estimate with the new information. Lower growth and higher acquisition costs meant the shares were significantly overvalued.

It was time to face a tough truth.

Step 5: Sell quickly when the thesis is broken.  

Class had been a star of our portfolio. I had even interviewed the CEO in a fireside chat at a client event. It wasn’t easy to reverse course and admit that we were wrong. But when a thesis is broken, we must be decisive.

We reached our sell decision on the same day the news broke. Although the shares were already down slightly, it would take many months for the market to fully absorb the new competitive paradigm. We were able to exit our position for a 67% gain.

It worked out well. Today, almost 18 months later, the shares are now over -50% below where we sold.

Sell quickly when a thesis is broken.

Principle #2: Sell if you would not be buying today

Holding is an active decision, not a passive one. It just doesn’t feel like it.

Each day the market offers us the opportunity to buy or sell our shares. Every day that we hold a position we are effectively choosing to ‘re-purchase’ it at today’s prices, and in today’s position size. If we don’t think that the current position size is the best possible allocation of our precious capital, we should sell.

This principle – to sell if you would not be buying today – includes those situations mentioned in the first principle. But it also adds the hard edge of a valuation-based sell. If the share price has risen so much that you would not be buying the shares today, it is time to sell. No business is so great that its share price can’t rise high enough to render it an unattractive investment.

It sounds simple, but again the execution takes work. It requires maintaining an accurate estimate of the company’s intrinsic value, and being willing to trim the position, or even sell out entirely, when share prices rises too far above intrinsic value.

My personal approach to investing in high growth businesses is to sell slowly when the motivation is purely based on valuation. This is to reflect the ability of truly superior businesses to consistently outperform even the most optimistic estimates. It is both an art and a science, but ultimately we must be disciplined: sell if you would not be buying today.

Conclusion

Selling is a big blind spot for most investors. But that weakness means we have a huge opportunity to improve. If you adopt a sound selling process, based on the future and not the past, you will gain a massive competitive advantage over other investors. 

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The Hidden Power of Inflection Points

My investing was never the same again after I discovered this. Realising the simple power of fundamental inflection points started me on a journey toward a new (and thus far, fairly successful) investment approach.

Some lingo

But first, let’s get clear on what we mean by a fundamental inflection point. The Investopedia definition will suit us fine:

An inflection point is an event that results in a significant change in the progress of a company, industry, sector, economy or geopolitical situation and can be considered a turning point after which a dramatic change, with either positive or negative results, is expected to result.

To be super clear, we are talking about changes in the fundamental cash flows of the business, not ‘charting’ share price changes.

There are many types of fundamental inflection points. Here are just a few of the types I like to look out for:

  • Turnarounds (with a major catalyst sparking the revival)
  • A new fast growing product/segment, ideally whose early growth has been hidden by a larger flat or declining segment
  • A major demand side break-through such as a new distribution agreement
  • Growth company tipping in to profitability (with strong operating leverage)
  • Hyper growth company that has has just ‘crossed the chasm’ (a topic for another update)
  • Corporate spin-offs

All of these have one thing in common, which is a very rapid rapid acceleration in the rate of improvement in fundamental performance.

Today I’ll talk through just the corporate turnaround example, as it is where I first got started as a value investor.

Turnarounds

Imagine a company that has been generating steady revenue and profit when it suffers a setback and its performance takes a dive:

TheTurnaround

There can be a thousand causes. It could have been: a failed product launch; a botched acquisition; or a newly assertive competitor. Revenues slump, and profits plummet.

But whatever the cause, in this example, the declining business finally gets its act together and makes a rapid recovery. Note that this only occurs when there is a specific cause of the slump that can be quickly rectified.

The share price response to both the slump and the recovery is normally exaggerated. Here’s the typical share price moves we’d see in this situation:

TheTurnaround1

This simple chart sums up a lot of ‘classic’ value investing.

Value investors look for businesses that have had some fundamental setbacks (the dip in revenue and profit). But more importantly, they are looking for situations where the market has over-reacted to the bad news (the share price plunge) and the shares are undervalued. They purchase shares during the troughs of the market’s despair and hope to sell later, when the market’s mood has improved.

TheTurnaround2For many years this was my investing modus operandi: buy something cheap, usually watch it continue to get cheaper, finally (hopefully) a rebound arrives, sell.

It can be painful. Value investors are cursed with being early. That means suffering through significant further price falls before the company’s performance improves. Classic value investing doesn’t really have an answer to this painful process, aside from developing the stomach to hold your nerve (always good advice).

And that is actually the best-case scenario.

“Turnarounds seldom turn” — Warren Buffett

In plenty of cases the turnaround never comes. The traditional value investor is left holding the bag on to a company that looks cheap, but where performance continues to decline. The ‘cheap’ often just keeps getting ‘cheaper’. This slow-motion train wreck is known in the industry as a value trap.

But what if we could cut out most of the pain of suffering through falling prices, and almost all of the value trap blow-ups?

A better approach

Instead of purchasing purely based on an estimated discount to intrinsic value, we can also wait for indications that a fundamental improvement is already well under way. We can wait for the fundamental inflection point:

TheTurnaround3

By waiting until the inflection point has already started we avoid the worst of the losses that long-term holders have suffered. In turn we also miss out on some of the gains, since we are unlikely to be buying at the absolute bottom. But that also means we join in just when the fun is really getting started.

Most value investors arrive for the party two hours early and make awkward chit-chat with the hosts over a bowl of dip. We arrive a half-hour late, a couple of other guests have already arrived and the conversation is flowing. Soon the party will be in full-swing. Later on, when Mr Market has gotten drunk and starts making a scene, we’ll make a polite exit.

Here is a zoomed-in version:

Outcome

My preferred spot is to wait until *after* there is already some compelling evidence that the company has hit an inflection point (the black line). This has the added benefit that we rely more on observation of the world as it currently is, than solely on forecasts of how it could be in future.

When executed well, this focus on inflection points can radically enhance our expected returns:

  • Reduce the number of severe ‘value trap’ blow ups. This helps us win big, lose small.
  • Reduce behavioural biases: less pain from holding falling shares means less temptation to sell at the worst possible time.
  • Shorten the average holding period. This is a key part of generating high annualised returns i.e. it is better to make 50% in six months than to wait two years.
  • Higher ‘hit-rate’ which allows greater concentration i.e. the number of profitable trades as a percentage of all trades increases.

So why isn’t everybody already doing it?

Why it works (a.k.a. why it’s hard)

Thankfully, there are several challenges to successful inflection point investing.

First: anchoring. “I’ve missed it” are three of the most dangerous words in investing.

By the time the inflection point is already underway, the share price has likely rebounded off its lows. Investors that have been watching the stock often anchor to the lows, instead of reassessing the current value. They avoid buying, thinking that they have missed the gains.

Second: cognitive biases. The changes that happen at inflection points tend to be extremely rapid. We humans are not great at exponential thinking.

Our brains evolved to be very good at linear forecasting. That lion is running towards me. I predict that if this continues I will be his lunch. I better do something. That is very helpful linear forecasting. But it is less helpful in the modern world of finance.

When it comes to forecasting rapid change, our brains are slow to adapt. The market tends to forecast based on a linear extrapolation of recent results:

estimates

The market repeatedly under-estimates how quickly the company will improve. Then finally, the market actually overshoots to the upside. The stock then becomes overvalued. Smart investors sell, and the whole glorious cycle of expectations can start again.

Third: the search is hard work. No one rings a bell to tell you an inflection point is underway.

Small-cap and micro-cap companies are often a good place to look for these opportunities. Often nobody else is watching closely. Or more precisely, nobody else that is managing enough funds to move the price.

In these ‘under-followed’ cases it is often possible to identify the inflection point simply by following the company’s latest financial reports. But it is not always that easy. Often by the time the inflection point is readily apparent in the published financials, it is already too late. Smart investors need to be doing the hard work of equity research to identify a fundamental inflection point before it is obvious in the reported results. That means digging through every piece of information about the company, it’s competitors, suppliers, customers etc. Investors also need to ensure they aren’t being fooled with a false positive. Or as Buffett calls it, a ‘turnaround that keeps on turning’. It can be an incredibly rewarding process, but it’s hard work.

Fourth: patience. Or rather, being extremely selective. It is hard enough to find a company that is undervalued. Inflection point investing means holding off, and only investing when you have found undervaluation and a positive fundamental inflection point.

Thankfully none of that is easy, or everybody would be doing it, and the magic would disappear.

Conclusion

Understanding the power of inflection points can significantly enhance a ‘classic’ value investing approach.

We’ve only scratched the surface of inflection point investing. We talked through just one example, the corporate turnaround. But there are dozens of others. In fact, we didn’t get a chance to talk about about my favourite type of inflection point (a hyper-growth company that has has just ‘crossed the chasm’). That will have to be the topic of another update!

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While the World Worries

For the past couple of weeks the financial world has been worrying about falling share prices, and interest rates, and sanctions, and things that go bump in the night.

At times like this it helps to take a step back and look at what has been going on in the real world, outside the share market echo chamber. When we take the blinkers off we find a world marching relentlessly upwards.

It is always fun to start with space. It’s hard to raise our gaze higher than humanity’s ambitions to launch ourselves out in to the universe.

SpaceX last month announced an upcoming Moon tourism mission. Over the past week the company launched another rocket in to space to escort an Argentinian satellite into orbit. Even more epic, the booster returned to the air base eight minutes later, and landed back on its launching pad, undamaged and ready to be reused.

That last astounding fact about the rocket-booster being re-usable barely made the news. What better testament to our progress is there than that? This was an incredible technological achievement that only became possible in February. Now, just eight months later, it is barely worth mentioning.

There were some spectacular scenes:

Closer to home, scientists have for the first time used gene-editing to prevent a lethal disease before birth. This technology is just in its very early stages but holds the promise of one day allowing diseases to be removed from children before they are even born. Meanwhile, scientists in China have used CRISPR technology to create mice which have two female parents. A potential win for same-sex parents. But more broadly, successfully editing genes at this level opens the door to major improvements in fighting thousands of diseases.

There was a major breakthrough in the battle with Alzheimer’s: “Scientists believe they have isolated and may even be able to alter the gene responsible for the devastating disease.” It is another example of how humanity may be just at the dawn of a new golden age in health and longevity.

Machines are pitching in to do their part too. A new algorithm can predict which patients are at risk of a heart attack, years before any attack occurs.

While in China, a newly developed AI system saved the lives of coma patients by predicting that they would wake from their coma, despite neurologists giving them a very low chance of ever waking up:

“After reviewing the varying conditions of seven patients in Beijing, the doctors rated the patients on a coma recovery scale. The patients were given very low scores, meaning that it was unlikely they would ever wake up and their families were legally allowed to take them off of life support.

The system which was developed over the course of five years by the Chinese Academy of Sciences and PLA General Hospital, disagreed with the scientists and gave the patients close to full scores with a prediction that they would wake up within 12 months of the scan.

As it turns out, the AI was right – all seven patients woke up from their vegetative states within the year.

The system, which reportedly has an 88% success rate of diagnosis, achieves its efficiency based on its ability to see “invisible” details in hundreds of human brain images. In contrast, the current method of assessing a patient’s chances of recovery are based on subjective reactionary tests and judging certain factors, such as age and the condition of the brain.”

Meanwhile in an impressive technological breakthrough, the world’s longest ever non-stop passenger flight landed safely in New York after 17 hours in the air. The huge 16,700km journey was possible thanks to lightweight composite materials and extremely fuel-efficient engines. Welcome news for those of us that have ever feared falling asleep at the airport during a long-haul stopover.

And finally in a piece of welcome geopolitical news, North and South Korea have finally begun clearing mines from the demilitarized zone.

Conclusion

Those are just a few of the headlines. There are literally millions more stories like them. Stories from people that found some way to make all our lives better. Beneath all the fear and noise there are billions of ordinary people all around the world that cooperate every day to bring forth a better tomorrow.

If you done any work over the past few weeks, paid or not, you too have contributed your part to the incredible international cooperation network that is the modern world. You created something valued by others, and by doing so, you added to humanity’s collective stock of wealth.

Our businesses do this on an even larger scale, by serving customers needs in return for cash. The best businesses then reinvest that capital to expand, developing new innovative products, and serving the needs of even more people, and thereby accelerating our collective upward spiral. When we invest our precious capital into these businesses we are aligning our portfolios with this unstoppable engine of human progress.

Whenever the news cycle gets too negative, take a moment to pause, and look around at the wondrous would we live in. The torch of human progress has never been extinguished. And if we keep our heads about us, it never will.

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3 Lessons from a 31% Annual Return

One week ago, after four and a half years working on a special portfolio called Pro, and leading an extremely special community of clients, I left The Motley Fool.

We generated some exceptional returns over that time, so to kick things off, let’s explore three of the biggest reasons why.

Outcome

First, for those just tuning in, here are Pro’s returns on an annual basis since inception in April 2014, through to October 2018. We were just six months in to Year 5 when I stepped down last week.

Pro returns by year 2

[Note: from inception in April 2014 to August 2016 I was the Research Analyst for the portfolio, (with Joe Magyer as PM), before taking on the Portfolio Manager role myself part way through Year 3. Huge credit over the last 2+ years also goes to our outstanding Research Analyst, Ryan Newman.]

Those returns might not seem so unique to friends in the U.S. where markets have been on a tear for several years, but it is the portfolio’s out-performance vs. our local benchmark (the ASX All Ordinaries Accumulation Index) that we were most proud of:

Pro returns inception1

Pro outperformed the All Ordinaries Accumulation index by 192% over those four and a half years (April 2014 to October 2018).

We generated annualised returns of 31% per year, vs. an 8% return from our benchmark, for an annual out-performance of 23% per year.

Process

There were three core parts of our portfolio management process that set us apart.

#1: Asymmetric bets

We sought out unique investment opportunities which had relatively little downside, combined with very high potential payoffs. In other words we looked for positions that had the potential to either win big, or lose small.

The chart below shows the returns that we generated, on a position by position basis, over the 4.5 years (some positions were only added towards the end of the period, so had less chance to thrive than others). ReturnsByPosition3

Over 4.5 years, our worst position only fell by a total of -34%. That is in a portfolio that delivered total returns of 232%, and had eight positions that saw a total return greater than 100%, with five over 200%.

Win big, lose small.

#2: Sell quickly

To deliver on ‘losing small’ requires constant vigilance. And to be willing to sell quickly if a thesis is broken.

So as part of our intrinsic valuation process, we made a downside assessment which sought to answer three questions:

  • What could go wrong with our investment thesis?
  • How much would that would impact the company’s intrinsic value?
  • How could we check if things were going wrong?

The third point is crucial. If we could identify a failed thesis early enough, we could sell before the worst of the downside hit.

For each company we watched certain criteria that would represent a broken thesis if they eventuated. It could be a core operating metric from the company itself, or some intelligence from a supplier, or often from a competitor. We were able to sell very quickly, when those negative outcomes did eventuate, because we had prepared for them ahead of time. It wasn’t flawless, and we got some things wrong, but we avoided the worst falls and kept our losses as minimal as we could.

One of the investment decisions I was most proud to be involved with didn’t make us any money, but it demonstrates this well.

Step back in time with me to early 2014… we had just purchased shares in a local satellite television network which had an enviable monopoly position.

You can probably guess where this is going.

Our thesis at the time was simple: an extremely dominant competitive position, with strong barriers to entry. The company had dealt with disruptive innovation before and had been able to co-opt the new technologies (TiVo devices, DVD-by-mail). Management had a plan to deal with the disruption of Netflix and other online streaming providers while also adding their own internet-based streaming platform.

It was a little over a year in to holding the position, when Netflix launched in the local market. There was a lot of hype, but it was hard to separate the noise from the underlying traction. Was the incumbent going to see off the new challenger once again, as it had done so successfully in the past?

We scoured for new data points that would validate, or invalidate, our thesis. Finally we found one. One of the country’s leading internet service providers made a press release that mentioned that they were seeing huge increases in traffic from video streaming, and most importantly, from the gorilla in the room: Netflix.

We corroborated this new information with other industry sources, and revised our valuation. The shares were now trading below our original purchase price. But despite the fall, the share price was actually above our new valuation once we baked in the new growth rates.

We sold quickly, taking the pain, and realising a total loss of -8%.

As of today the shares have fallen a further -65%. Bullet dodged.

When a thesis is broken, sell quickly.

#3: Buy Low, then Buy Higher

This is a core part of my personal investing strategy, adopted from an excellent private investor, Ian Cassel. “Buy low, sell high” might be the  four most famous words in investing, but they cause most investors to sell themselves short.

The market’s long-run average return is not evenly distributed. The big winners dominate the rest of the market, in much the same way that a few actors in Los Angeles star in all the Hollywood blockbusters, while the rest make ends meet waiting tables. A few multi-bagger companies generate the lions share of the market’s overall returns, while the rest do their best to stay in business.

When you find one of these massive multi-baggers early, the trick is to hold on. Or even better, buy more, even at higher prices. As with all investments, what matters is not what the share price has done in the past, but what the business will do in the future.

We often bought more of our biggest winners, even as their share prices increased, because the thesis was improving along with prices. Here is the returns by position chart once again:

ReturnsByPosition3

To take one example, we purchased shares in ‘Position 3’ on four separate occasions. For our last purchase we paid more than 100% above our initial purchase price.

Most investors do the opposite: they sell a great long term investment simply because it has gone up 30% or 40%, without considering how much the underlying value has increased. Or worse still, they double-down on their biggest losers.

Of course there are times where it makes sense to rebalance. We trimmed ‘Postion 1’ on two occasions to keep the portfolio in balance. And if you are given the chance to buy an outstanding business at an even cheaper price, you should take it.

But most of the time people are really selling because of fear. Fear that their modest gains will disappear. Or fear that if they don’t buy more of a failing position, they will have to face up to their original mistake. Neither are good decision drivers.

Buy low, then buy higher.

Conclusion

There is a lot of great traditional thinking on portfolio management. But to achieve excellent results you need to master all of those basics and then also do a few important things differently. For us there were three crucial differences that set us apart from the rest: win big, lose small; sell quickly when a thesis is broken; and buy low, then buy higher.

And if you are one of those previous special clients reading this, thank you once again for your trust, and continuing to be interested in my thoughts on investing and business.

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