Focus on worthwhile businesses regardless of the current market quote
In October 2015, I wrote The Individual Investor’s Edge which argued that timeframe arbitrage is the most important advantage individual investors have over professional investors. I still think that the observations in the article hold true today. Investors who are responsible only for their own capital can afford to look at situations that might not pay off in the short run. The vast majority of professional investors do not have that luxury, and that includes professional value investors.
To be sure, there are professional value investors who carefully and clearly articulate their investment strategy and attempt to discourage clients who are not aligned with a long-term approach. However, the reality is that the world is competitive, and it is not easy to adopt a strategy that will slow down the accumulation of assets under management. The fact that so many value managers feel a need to spend considerable time writing quarterly letters to investors proves my point.
If it is true that timeframe arbitrage is the last major source of potential advantage for an individual investor with the right temperament, the question becomes how this insight should impact the research process which is a topic that I did not fully discuss in 2015. If you are more concerned with the size of your portfolio in 2030 than at the end of the third quarter of 2022, it logically follows that your research process should be different than for someone who needs to beat the S&P 500 over the next ten weeks.
In my opinion, most investors focus far too much on identifying stocks that are currently cheap based on their preferred criteria. This is why running screens is so popular. You can easily determine which stocks are trading at a bargain level compared to book value, earnings, cash flow, or whatever metric you want to target. Then, you can use that list as a starting point for research.
There is nothing wrong with this approach, but it suffers from some serious flaws. Most importantly, if you only focus on stocks that are currently cheap based on your preferred statistic, you could be ignoring the strongest companies that have excellent future prospects. A company that is currently performing well is unlikely to be statistically cheap. But it does not follow that such companies should be ignored.
I can think of two examples to demonstrate this point, one that is more than a decade old and one that is more recent:
- Microsoft was one of the high flying stocks of the 1990s and traded at multiples that few value investors would have found acceptable. During the 2000s, the business continued to perform well but the stock went through a long and agonizing period of stagnation as multiples compressed. By 2010, Microsoft was cheap as the shareholder base gradually shifted from demoralized growth investors to value investors. The value investors who had the greatest conviction to act in size in 2010 were those who had followed and studied the company for many years even though the stock was then trading at levels they would not consider attractive for immediate investment.
- Meta Platforms, formerly known as Facebook, spent most of its history as a public company trading at levels that value investors would not consider. Over the past year, investor sentiment has dramatically turned against the company, and it now trades at around eleven times trailing net income. Value investors who are already familiar with the company after following it for many years while it traded at levels far above what they would pay are now in a position to potentially act quickly and with conviction assuming they believe that the underlying business remains attractive.1
The main point I am trying to make is that individual investors have the luxury of considering themselves to be primarily business analysts. This attitude creates long-term optionality because it allows investors to act quickly and with conviction when opportunities arise. It allows investors to focus on high quality companies rather than selecting from among the wreckage of stocks that have been beaten down recently, more often than not for very good reasons.
Perhaps most importantly, taking the approach of a business analyst allows the investor to follow companies that he or she finds intellectually interesting. I firmly believe that it is almost impossible to successfully study or follow a business that one finds mind-numbingly boring. If you are an analyst working at a fund, you might be given a sector of the economy to cover. It doesn’t matter if you find that sector interesting or not — it is your job to cover it. Individual investors with a long-term mindset have no such constraints. You can look at what you find interesting and select companies that you will be motivated to follow over the long run.
One additional advantage of studying companies that might not currently be cheap enough to buy is that it can be done without feeling like some immediate opportunity is slipping through your fingers. I have looked at companies in the past that seem statistically cheap, and I was always nervous that the stock price would move away from me while I was conducting due diligence. I am sure that I prematurely purchased some stocks fearing that the quote would soon rise. That is a terrible way to research a company. It is much better to do so at a time when the stock might be too expensive to buy and there is nothing to “miss out” on in the short run.
The approach I’ve discussed in this article is the process I use to select companies to study for the Business Profiles series. In addition to being more intellectually satisfying, I purposely want to stay away from positioning this series as a “stock tip” newsletter. The purpose of the series is to discuss companies that, at some price, might be suitable investment candidates because the businesses are attractive. The reader is left to decide whether these companies deserve further study and at what price, if any, they represent attractive investment opportunities.
The market for newsletters that promise immediately actionable stock picks is far greater than what I’m describing here, but my approach is the only one that works for my personality. The companies that are profiled may represent ideas that a reader acts on today, in a month, in a year, in five years, or never. The goal is to present roughly one company per month, or twelve per year, that at least are interesting to read about and may plant a seed for future research.
There have been four business profiles published so far. The introduction and background of each company is available for all readers while the full profile is for subscribers only. A seven-day free trial is also available at the end of the introduction for each of the profiles:
Tractor Supply Company ($TSCO), July 13, 2022
Investors Title Company ($ITIC), June 30, 2022
America’s Car-Mart ($CRMT), June 8, 2022
DaVita ($DVA), May 20, 2022
One recent article that pre-dates the business profiles series but provides a sense of how I approach write-ups is What Does Buffett See in Alleghany, written on March 21 and free for everyone to read. There are also a number of business profiles written several years ago, all of which are free to read.
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- Of course, I am not suggesting that Meta Platforms is a good investment opportunity today. For one thing, nothing in Rational Reflections is investment advice. Also, I personally dislike Meta’s business practices and management and therefore would not want to own it. The point is that it is statistically cheap today but was not for much of its history before investor sentiment turned against it this year.