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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Introducing… The Three Wise Monkeys Podcast!

I am very pleased to announce a brand new Australian investing podcast: Three Wise Monkeys!

Hosted by myself, and my good friends Claude Walker from Ethical Equities and Andrew Page from Strawman.com, we’ll be diving in to the most interesting parts of the ASX in a weekly panel discussion.

For our first show, released earlier this week, we discussed the Corporate Travel Management (ASX:CTD) short battle, as well as Kogan’s (ASX:KGN) recent fall from grace.

Be sure to subscribe to stay up to date. Now available on:

And if you like it, leave us a review, or even better, share it with someone you think would dig it!

 

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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Welcome!

This website is the new home of my latest thoughts on investing, technology, and business. I’ll be covering everything from the mindset of investing, to the traits I look for in big winners, as well as digging in to specific examples from interesting companies I have come across.

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