Real Long-Term Investing

In my opinion, any mentality that does not focus on the end game is not a long-term mentality.  So instead of “I will buy this stock because I think it’s cheap,” the real long-term investor thinks: “I am going to hold this stock because I think it can sustain above-market growth with low risk for the long-term.”  The first mentality is short-term focused because it presumes one can know that the market is wrong today about the price of a stock, but that it will be right in the future when one sells it for a profit, then (due to superior talent), one manages to find another mispriced stock capable of delivering an after-tax return above the market’s over the long term.  If you buy GM for $10 because it was just too cheap, and it rallies $20 in 6 months – shouldn’t you sell? But if you sell 6 months later, how is that a long-term mentality? The tax man certainly doesn’t think it is. The real long-term mentality is humbler, as it presumes the growth which has persisted will continue – and if it doesn’t – then one can admit the mistake and sell – regardless of price.  We hear of high-profile Value Investors saying that one needs a margin of safety when buying, and that one must have patience to see that their convictions that the market was wrong are correct. These famous ones got famous because they were correct.  Those who were wrong don’t usually get quoted.

Every bull market has great stock pickers that get famous.  Some of them are amazing and I follow many.  That said – the real stars are the outstanding companies that manage to grow for decades on end. Research by Mauboussim shows that It’s a really tall order to grow at above market rates for decades. The vast majority of growth companies revert to the mean after 10 or 15 years. Most companies revert after 5.  Research also shows that when growth slows unexpectedly, the stocks fall.  If one builds a quant screen (we don’t, but I have in the past), it becomes obvious that this is true in hindsight.  Likewise, the models know that if the growth accelerates and the margins expand at the same time, for a whole decade or two – dreams can come true faster than in 30 years.  Very few companies can pull that off.  If you don’t aim high you won’t catch them.  That’s my theory at least.  Others do it differently, but I believe this is what works best:  Go not just for quality – go for very high quality that is improving.

I am not attacking value investing.  As Buffett said – price is what you pay, value is what you get. What Buffett didn’t say but his quote implies, is that real value is what you get over the long-term. I consider myself a real value investor – but when I say that I am a long-term investor, that implies growth.  I know that some disagree with me here – but if there is no growth, in my opinion, then it is not long-term investing.  But if it’s not long-term investing, is it investing at all?  If it’s not investing at all, is it really a value strategy?  Will Google go down if interest rates go up?  I don’t know and it doesn’t matter to me. What matters is if Google manages to become 10 times bigger in 10 years and 100x more valuable in 30. I believe it can do better – especially if the government tries to stop it, because breaking it up is one of the more bullish scenarios. But I could be wrong, and only time will tell.

Outstanding Companies that make dreams come true need to not only have great products, but they need to have agility and adapt to changing conditions. These companies tend to be run by outstanding people who have a long record of delivering durable growth.  Durability requires not only a credible secular growth narrative (such as demographics, penetration, consolidation, and/or market share gains), but also agility to adapt (we call it swarm intelligence).  Insisting on high durability is the biggest distinction between having a long-term mentality and a short-term one – in my opinion. It’s easy to believe in super cycles and massive disruption in bull markets. It’s also easy to believe that a company’s growth should be durable and be wrong.  Think staples stocks like Kraft or Heinz, or telephone companies like Verizon and AT&T.  They were once considered high-quality durable growth businesses.  Now they are struggling.

Likewise, in a bull market when oil prices are high (say, 2011-2014), it’s always easier to believe that maybe, as an example, growth for Schlumberger, a high-quality oil services company of French origin headquartered in Houston, would be durable.  Since when has demand for oil not gone up over time?  Since at least before the mid-1850s, when the first oil well was drilled in Pennsylvania.  Back then there was already a vibrant business for whale oil. Schlumberger itself was founded in France in 1926 and came public in 1962. These days, oil struggles, and oil services stocks in particular, are making new secular lows – including Schlumberger.  The point of bringing this up is that making the call that a company is great is not enough.  One must make sure that durability gets delivered.  One must track them closely for signs that perhaps one was wrong about durability.

In his 1958 book Phil Fisher gives the example of a fictional contract that gives you the right to share in the future income stream of a school classmate. One would be well-advised to pick the classmate that gets good grades and shows leadership skills.  Let’s say one builds a portfolio of five of these contracts.  In 20 years, four of the classmates have achieved average income growth and are nearing retirement while one of them has had astronomical income growth and is said to be lined up for the top job of an extremely successful growth company. After this happens, someone offers you 50x more for this classmate’s contracts than for each of the other four.  You would be nuts to take the offer – yet value investors do that with stocks all the time.   One way to increase the hit rate of owning outstanding companies is to demand the highest quality, and only that. Why would you pick the second or third best classmate?  Well, there are the diamonds in the rough out there.  Einstein and Hitchcock and Warhol and Balzac – they were all bad students in grade school.  But then they blossomed.  Buying a share of their income stream when they were sixteen would have seemed nuts.  But selling them after they blossomed, would be even more crazy.

The notion of quality applies to management quality, product quality, and importantly, secular growth quality.  This means demanding a low cyclical component upfront. For example, it’s better to assume that what was cyclical will remain cyclical, and avoiding those cyclical narratives, than to buy into super-cycle themes (i.e. this time is different) or cycle-timing plays (buy low, sell high).  Some people do this well – but that still doesn’t make it better – if only because stock pickers don’t live forever.  Fishing for low prices in fallen angels, broken growth, and “misunderstood” stocks – is also not a great way (unless you are really good at it) to look for value over the long-term – in my opinion.  Those ponds either lack secular growth, or the company lacks credibility. Why do I say that?  For one – the market is efficient, and durability is precious.

Thinking the market is wrong about the price is an oxymoron. The market can deal whatever price it wants, and we must accept it.  Stocks do not sell for a dime more than they are worth in the market.  But if something gets 10x bigger and more profitable on a lower share base – after 10 or 15 years – the market will conform. It’s rarely a straight line (although for some companies, in log scale, it comes close), but the market acknowledges this type of value creation every time it happens – especially when the growth narrative persists or gets better.  It will obey the laws of nature and price the stock where it deserves to be priced – which is often much more than 10x the price 10 years hence.  For the outstanding company, the endgame looks more like 100x in 30 years, which annualizes to 17%.  If a company has not been at that pace for at least the last decade, one should question the secular narrative – and the market indeed questions it repeatedly over time when things begin to slow, or a quarter is missed due to a tough environment or spurious short-term challenges.

I cannot repeat this enough:  The companies most likely to sustain growth over the long term are those that have been sustaining them for decades already.  Long track records of success can breed strong cultures as much as they can breed complacency and arrogance – so it’s not a sure thing – but it’s better than betting that things will change when the longer-term record doesn’t support such an optimistic thesis. A record of mis-execution leaves scars and imprints that can compromise durability.  As GE has shown, a bad CEO or two can destroy a company. At the other extreme, great leaders and great cultures can spur new growth vectors, and greater competitive advantages for longer than people appreciate.

It’s not easy to tell along the way when you are wrong about durability.  It’s probably the hardest part of the job of investing. The key objective is to find the ones that make it, while understanding that most will not, and bailing when you can tell that you were wrong.  This becomes easier to do when the bar is high.  Betting on change is less rewarding, on average, than betting on consistency, just like betting on price is less rewarding than betting on quality and durability.  That’s an opinion that I developed long ago and has paid large dividends since.

We try to avoid trading, but five years ago our portfolio looked different than it does today.  That’s because things change.  When the world pivoted to tech – something it is still doing – we did too.  Not because that’s where the price action was, but because that’s where the best secular stories survived the test of time.  Software, internet, pet diagnostics and pet pharma, payments, transcatheter valves, simulation, connectors, and sensors – those are some of the places where durable growth hangs out.

Incidentally – Schlumberger was a good house in a bad neighborhood and a value trap.  At less than $30/shr today, it trades no higher than it did in the 1990s, and not much higher than it traded in the 1980s. Since July 28, 1980 – the first record on the Bloomberg, it has appreciated at less than 2% annually.

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