Finding a Place in the Market Ecosystem

In my market ecosystem post I described different types of investors and the roles they might play throughout an idealized company’s life cycle. Writing that post caused me think more deeply about my own investing philosophy and the role I play in the market ecosystem (this is one of the reasons I write).

I used to think of myself primarily as a value investor: someone who is out there looking to pick up dollars for fifty cents. There is a still a part of me that is deeply attracted to these types of investments due to the margin of safety they afford.

However, another part of me is attracted to compounding machines. In order for an investment to compound over time it needs to generate high returns on capital and also offer ample opportunity to reinvest that capital for similarly high returns. This is identical to the reinvestment assumption underpinning the IRR and YTM calculations.

Traditional value investments may not compound very well. Many are maybe single digit revenue growers but with strong free cash generation. What keeps them from compounding at high rates is that the cash cannot be reinvested in growth initiatives (maybe the market is mature). Even worse, a management flush with cash may start doing stupid things to “buy” growth (such as play venture capitalist).

However, compounding machines tend to be more expensive than traditional value investments. It can be tough to find them with a fat margin of safety, particularly these days when valuations across the quality spectrum are stretched. This is mitigated somewhat by the fact that it is easier psychologically to hold a compounding machine for a very long time. A compounding machine by definition merits a richer valuation.

Therefore, what are more and more interesting to me are businesses that have reached inflection points. Ideally these are businesses that have been dumped by growth investors and are at increasing risk of being dumped by value investors but where the business nonetheless has a reasonable probability of inflecting positively. Low debt levels are important here as leverage can be catastrophic for a business in transition.

Here are some reasons I like this approach:

  • These businesses tend not to screen well on backward-looking quantitative measures. This makes them more likely to be overlooked and less likely to be owned by sophisticated investors facing pressure to deliver strong relative performance versus benchmarks (active mutual fund managers, pension funds, endowments). Taking a position in a stock at an inflection point introduces significant career risk into the equation for these players.
  • These businesses usually face significant uncertainty, which causes their market valuation to overshoot and undershoot significantly relative to intrinsic value.
  • If you fish for these businesses in the smaller cap segment of the market (under $1 billion and preferably $250 million or less) that is an additional constraint on large institutional investors that contributes to a structurally inefficient market niche.
  • If you are able to fish in the niche described above, the trading volumes for these stocks can be thin which means the price gets bounced around whenever someone buys or sells. This may present attractive buying opportunities as you build a position (but it can hurt if you need to exit the position in a hurry–another example of the advantages conferred by a permanent capital base).

The biggest risk to this investment approach is buying into a value trap. Thus, that ought to be the central focus of a risk management discipline. I am pondering how best to codify this but I think it starts with the decision to average down.

To summarize some valuable insights from John Hempton (whose portfolio management discipline I admire), one should never average down any of the following:

  • High leverage (financial or operational)
  • Technological obsolescence
  • Potential fraud

Related concepts I have been examining are use of the Kelly Criterion in position sizing and implementing some kind of explicit Bayesian updating process. Details to  be determined and perhaps discussed in a future post.

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