Non-Consensus and Right – An Essay on Investing

A. Introduction – Investing is not easy. You have to be Non-Consensus and Right
Charlie Munger once said:

“Investing’s not supposed to be easy. Anyone who finds it easy is stupid”

John Kenneth Galbraith made an equally profound statement:

There is nothing reliable to be learned (about making money). If there were, study would be intense and everyone with a positive IQ would be rich.

Making money on the market is hard. If I think something is underpriced, so does the chance that everyone else on the market does and the price is bid up. My opportunity to earn a profit greatly reduces in an efficient market. In fact, the market can be seen as a system that brings down excess profits to zero!
Like the legendary investor Howard Marks (someone I follow keenly) says, it is not enough to be right. You have to be contrarian and right.
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You have to be right, and the your opinion should be non-consensus relative to the market. If you think Apple is going to sell more iPhones this quarter and everyone else thinks too, then the price is already factored in and it doesn’t make any sense to buy the stock (assuming you want to make money in the short term).
Similarly, Goldman Sachs reported its first quarter earnings on April 19 2016. By every objective measure, it was a completely bad quarter, but the stock was up by 2%! That was because the bad news was already factored in and the stock had already taken a beating over the past 3 months. Consensus and Right would have again made no money here.
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Recently, there was an interesting money making opportunity on May 18 2016. Exit polls on May 16 predicted a DMK win in the Tamil Nadu Elections. The stock shot up on May 17 opening. On May 19, the market opened to the news that ADMK has taken an early lead. The stock price tanked. Shorting the stock on May 18 would have brought handsome profits. What if DMK had won? There would have been limited downside to shorting the stock because the good news that DMK won had already been factored in! So it was good odds to take the bet.
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B. Where to find Non-Consensus
But markets are not perfect. Markets offer opportunities to make money when ‘it’ miscalculates and the pricing is incorrect. Some common areas markets tend to miscalculate (and hence where you can find non-consensus and be right):
1. Total Available Market – Markets sometimes underestimate the market size that a company is going after. For example, when Apple announced the launch of the iPhone in the now famous keynote on June 29 2007, what would be the total market size that smartphones would capture? Would it capture the entire luxury Blackberry market? Or would it be disruptive to the computer itself? Betting on the latter would mean stockpiling Apple stock yielding enormous profits.
2. Innovation Premium – Markets miscalculate the ability of some companies (especially tech companies) to come up with new blockbuster products. Let us call Innovation premium is the amount of premium in the market cap that is not explained by the NPV of their cash flows. Tesla for example, currently holds a high innovation premium as does Facebook. But Apple currently has a low innovation premium. Its price/sales ratio is 2.28. Is the market wrong in assuming that Apple wouldn’t innovate much in the future?
Similarly, in my opinion Google is uniquely positioned because of its unique assets of datasets (derived from their Search and other products), they can attack sometime in the future a large market in health and medicine. A lot might happen in the intersection between Biotech and AI. But my sense is that market is highly underestimating Google’s play in these areas (and hence probably undervaluing them).
3. Rate of Adoption – This happens more on the venture capital side. Analysts look at the current adoption numbers of a new innovation or product and vastly underestimate at the rate of adoption. For example, Automated Investment Advisors (or called in the press as Robo Advisors) collectively held only $19 billion AUM by end of 2014 – a drop in the bucket compared to total assets under management. But the growth might be tremendous.
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4. Extreme Market Movements – Howard Marks says in one of his thought provoking memos –
“…the market does not have above average insight but it is often above average in emotionality. Thus we shouldn’t follow its dictates”.
Extreme market movements have always proven to be one driven by psychology, herd behaviour and extreme irrationality and have been happy hunting periods for really savvy investors.
Cornwall Capital (whose founders were featured in the book the Big Short) made a killing on Capital One at the beginning of the 21st century when it was under investigation for accounting fraud. A simple due diligence meant Capital One would not be convicted and Cornwall bought a bunch of stock at rock bottom prices.
More recently, after Brexit, the stock market in UK (and around the world) tanked. Was it an overreaction? Will it greatly affect the prospect of UK companies whether or not it was in the EU (other than say financial services)? Interestingly, the stock market regained all its losses in a few days (see the FTSE 100 below for example), suggesting it would have been a good bet to buy in that scenario.
ftse 100
5. Incentives – Markets often tend to ignore incentives and especially bad ones. One example of bad incentives is the fee that banks got paid for originating loans. Another related example is the incentive for credit rating agencies to generally give high ratings for bonds. Government policies can create bad incentives which the markets might underestimate (and even willfully ignore!).
IBM spent at least four times more money on share buybacks vs. CapEx. What is the incentive of the management to do so? Will the short term focus hurt IBM in the long term? When Marissa Mayer was brought in as Yahoo CEO, her compensation was tied to Yahoo stock (including that of Alibaba by virtue of Yahoo’s stake in it). Does this incentivize the manager to maximize the value of Alibaba’s stake which was an easier thing to do rather than doing the hard work of turning around Yahoo.
6. Non-Market Forces – Markets underestimate or overestimate the Non-Market Forces involved. For example, there have been some honest attempts to create Education related startups but the success rate of these startups has been phenomenally low in India. Unless the Government and politicians loosen the grip on Education, very little value is going to be created by the hungry and passionate entrepreneur.
Solarcity, a company founded by Elon Musk could be selling at a premium precisely because of him – Elon Musk. But the non-market forces might be a far bigger factor in the success of the company than Elon Musk himself.
A company like Reliance can be expected to have a stable cash flow based on its Non-Market activities in India.
7. Unique Assets – Some companies have unique assets that maybe highly underestimated by the market. These unique assets maybe used to launch future blockbuster products/services or might be highly valuable to other companies and may be an acquisition target.
Unique datasets can be an example of a unique asset. Google with its enormous data will reap blockbuster rewards if AI quickly advances. Uber’s datasets might be far more valuable than is currently imputed. Facebook has a lockdown on the ‘Social Graph’ of a person. Nextdoor has the ‘Local Graph’ of the person. A startup Orbital insight converts Satellite images into actionable information to be used by entities from the Government to Hedge Funds to Retailers.
This is Twitter’s stock price over the past year.
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Twitter might be the most ‘mentioned’ company in history. Every day the news media mentions tweets. All the most famous people are present there to connect directly with the audience from Heads of State to sports and movie stars. Yet it doesn’t make enough money ‘yet’. Seems like a pretty good bet that the company or future activist shareholders will eventually figure out how to kickstart growth and a good case can be made that it is undervalued.
8. Shifts and Trigger Events – Shifts are trends that are going to last for the foreseeable future and may cause consumers to make decisions far different from the status quo. For example, American retailers are suspecting that there has been a big change in consumer behaviour from baby boomers to millennials. It has also been documented that millennials are far less keen on ownership – be it cars or homes. What would that mean for certain stocks? Have we reached peak car ownership in the west?
Another shift would be the trend towards the Gig Economy or the rise of Freelance work. Will open new opportunities for new products in Insurance, Financial Services etc. Backing companies that capitalize on these shifts would be a great opportunity.
Trigger events are those which will quickly lead to widespread adoption of a business model. For example, the quick adoption of AirBnB (both from the supply and demand side) was helped in no small part by the 2008 recession. Similarly there will likely be some trigger events that will unleash new business models in areas like Healthcare and Education.
In my opinion, the trigger event for education would be the increased automation of entry level jobs that students get post-college. Once the cost-benefit of college (and college is often seen as an insurance policy) looks bad, there will be huge pressure to allow other business models. Student Loan debt will no more be sustainable and changes will be forced.
Similarly, healthcare costs are on track to becoming a huge burden which will naturally cause massive deregulation to spur innovation and reduce costs.
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There are some other examples of Trigger Events like Privacy. For example, traffic to the privacy oriented search engine Duck-Duck Go increased tremendously post the Snowden revelations.
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Another example would be the low level of confidence of people they place on News Media. Which would mean new business models like Crowdfunded News is ripe for take off.
C. Great Companies
The above points can be used to find out opportunities where there can arise non-consensus and the market might miscalculate. Then you can use financial theories and formulae to get a ball park on what might be the right valuation/price for a company.
However, companies with certain characteristics tend to outperform the market and can be considered for investment if they are undervalued:
1. High Defensibility – Companies with one or more of the following – IP, Scale, Network Effects, Brand etc.
2. Zero Marginal Costs – The marginal cost to acquire the nth customer is zero (Windows OS, Microsoft Office etc.). In such cases, when Revenue increases, profit margins also tends to increase.
3. Customer Lock-in/High Switching Costs
4. High Gross Margin Levels – The same revenue but with higher gross margins would trade at a much higher multiple
5. Low Bargaining Power of Customers and Partners – The lower the bargaining power of the customers, the better will be the price. SpaceX and Palantir (if it goes public) would have high unpredictability since the US Government will be their biggest customer. On the other hand, Google Ad words has much lower customer concentration. Similarly some Partners may have a huge bargaining power that may be outside of company management. The high dependency of Zynga on Facebook for example.
6. Organic Demand – Low Customer Acquisition Costs and Marketing Spend are also good indicators of a terrific business
7. Unique Assets – Have covered in the previous section. Such companies are increasing in number and are highly valuable
8. High Optionality companies – Some companies are very good at new product development and/or in acquisitions. These initiatives are examples of the ‘optionality’ thinking of the company. For example, Facebook’s acquisition of Instagram seems to paid off handsomely. Google’s acquisition of Android, YouTube and DoubleClick have turned out to be tremendous successes. Amazon seems to do very well in their in-house development – Kindle, AWS, Amazon Echo etc.
9. Monopolies – Do companies control a huge share of a (even a small) market? Much better than businesses that control a small share of a big market.
10. Greater Cash Flow than Earnings
11. Growth!
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