Classical value investors were my first investing subculture, back in the early 2000s. Like all subcultures, they have their sacred texts (The Intelligent Investor, Warren Buffett’s various epistles), their status games (Usually value investors are really impressed by obscure stocks — “My biggest position is a Hungarian haberdashery company trading at half of net working capital, and it trades 100 shares a week”), their heretics (“He calls himself a value investor, but he just bought…”), and their kids-these-days complaints.
The value investor’s usual complaint is that the market has gotten too short-term oriented. A company misses earnings estimates by a tiny margin, says its growth rate next year was going to be 20% but is now looking more like 19%, and suddenly the stock plummets. To a traditional value investor, that’s anathema: you’re buying a stake in a business, not making a bet on a number on a screen. Of course you shouldn’t exaggerate the importance of tiny, fleeting changes in near-term results. Don’t you care about the long-term?
Paradoxically, this is completely backwards. If you control for a company’s capital structure, there is a direct and positive correlation between how long-term oriented the shareholders are and how volatile the stock is as a result.
Here’s a classic Buffett line about long-term investing in consumer packaged goods:
We own a lot of Gillette and you can sleep pretty well at night if you think of a couple billion men with their hair growing on their faces. It is growing all night while you sleep. Women have two legs, it is even better. So it beats counting sheep. And those are the kinds of business…(you look for).
In one sense, that’s a very long-term outlook: over time, it’s hard to imagine anything changing the fundamental driver of demand for razors. In another sense, though, it’s a dramatically short-term outlook: the future contains no new information about the prospects of Gillette’s business!
Razors and Lasers
Suppose you’re comparing two companies: a legacy razor blade business with an established brand name, phenomenal distribution, and economics so good people use “give away the razor, sell the blades” as an analogy for other businesses. And, on the other end, let’s imagine a wild tech company that’s competing with them. Maybe somebody has designed an autonomous drone that uses tiny lasers to slice off your hair while you sleep, and continuously scrapes Tinder to determine exactly what kind of facial hair is most appealing to the people you find most appealing.
One risk to the razor company is the success of the laser company, but there are many scenarios where they can both coexist. For the laser company, though, you have all kinds of uncertainty:
- Drones start out expensive and get cheap at scale. But what if they scale too slowly and the company runs out of money? What if “cheap” isn’t cheap enough?
- Implemetation is hard. The razor industry has several millennia of experience safely swinging large blades close to important veins, but even then there are risks — Thoreau’s brother died from tetanus after he cut himself shaving. The drone company will be on the risky end of the spectrum for a long time, and its failures will make the news.
- Scraping everybody’s dating profiles to figure out their darkest desires might strike some people as a privacy violation.
For LaserCo, the future is full of important uncertainty. If it somehow went public early in its life, you’d expect wild swings in share price pretty much every time it reported earnings. Every minor glitch runs the risk of killing them, and every success pushes them measurably further away from death.
LaserCo investors spend literally all of their time thinking about the future, but the only thing they have to go on is the present. They’re making a bet on both an idea and execution, and every new financial datapoint tells them something about both. In another famous Buffett quote, Uncle Warren tells us he likes to invest in businesses any idiot can run, because sooner or later an idiot will run it. That’s not a risk you can take in tech: a business run by idiots will get stomped by a business run by reasonably smart people who work extremely hard. So the tech investor doesn’t just care about what current management is doing; they care about the talent on the bench. And that means they care all the way down: there’s a strong correlation between the companies the best people wanted to work at and the companies that ended up making their shareholders rich. (If you want to know what tech company will be huge in ten years, find out which company’s summer interns this year have the most bragging rights.)
So, every quarterly report from LaserCo is jam-packed with information about the future. Every detail of their P&L can fundamentally change a reasonable person’s assessment of how big the business will get, and how fast it’ll get there.
Compare that to RazorCo. Let’s say they miss earnings next quarter. Does this tell you something about:
a) The long-term risk that people will stop shaving, or that little metal blades will be the most efficient way to do so, or that consumers will be brand-sensitive for small purchases? b) The short-term eddies and flows of sales and costs in a complex company
It’s extremely rare for a mature, brand-focused company to have a single cataclysmic earnings miss. That comes from the flip-side of compound interest, which is that big problems start small.
Let’s say LaserCo starts taking off. In year one, they have 0.01% market share. They double it every year. It’s not until year seven that they’re at even 1% market share; if RazorCo usually grows at 5% a year, that’s a year where they grow 4%. But 5% growth, even for a really solid consumer package goods company, is usually more like 3–7%, so it’s still noise. Then, in year ten, LaserCo has 10% market share, and RazorCo is in terminal decline.
What that process looks like to the RazorCo investor is that earnings misses turn from something that happens 50% of the time to something that happens more like 60–70% of the time, and then suddenly they happen nonstop. The early misses can look like stumbles, and slowly whittle away RazorCo’s multiple. But investors have been trained: people hyped up LaserCo when it was at 0.01% market share, and 0.02%, and 0.04%, and they were always wrong. From a purely Bayesian perspective, execution missteps are more likely that terminal value destruction, unless you have a strong prior.
And that brings me back to the original claim: Buffett and other value investors do not have strong priors about the future. They have strong beliefs in the past, and those beliefs are mostly correct. Most startups fail, and even the successes usually don’t live up to peak hype.
But when they do…