Long-term front-running

An introduction to value investing. Estimated reading time: 21 minutes

I’ve received comments that my newsletter is hard to grasp for those outside the finance industry. So let me try to address that issue.

In this post, I will give an introduction to value investing.

Why do people bother doing fundamental analysis? And how do they decide on whether to invest in particular stocks? I will try to explain those questions in simple terms.

Here is the outline of today’s discussion:

Table of contents
1. Stories spread like ripples in calm water
2. Momentum investing
3. Value investing
4. Catalysts
5. Implementation
6. Fertile grounds for ideas
   6.1. Variant view with a catalyst
   6.2. Baby out with the bathwater
   6.3. Scepticism about a great growth stock
   6.4. Special situations
   6.5. Booms and busts
7. Conclusion

1. Narratives spread like ripples in water

Ripples in calm water. Source: Getty Images

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - Benjamin Graham

Each day, we get bombarded with narratives. About a coming global recession, accelerating revenue growth, and so on.

The person reading or hearing the narrative is faced with a choice. He can discard the narrative as biased or untrue. Or he can adopt the narrative and perhaps even spread it to others.

Typically, we adopt narratives that already correspond to our existing set of beliefs. Especially those with emotional impacts sparking greed or fear, a feeling of community or a sense of superiority.

Just as an example, when COVID-19 hit in early 2020, stories began spreading on across social media about sickness and death. Analysts, journalists and social media commentators interpreted the data differently, providing narratives that spread like wildfire － much like the epidemic itself.

When we face a convincing narrative and emotions bubble up, we’ll be tempted to act, perhaps by buying shares in a company benefitting from the supposed trend. During COVID-19, for example, many were compelled to buy shares in vaccine makers such as Moderna.

Narratives tend to spread from one person to another in an exponential fashion. This exponential spread can best be described as the movement of ripples in calm water, as narratives exhibit a ripple effect to larger and larger audiences.

If one person spreads a narrative to two individuals, and those two individuals spread the idea to another two individuals, you end up with the following pattern:

Let’s say that the original narrative is about an exciting stock. If each person acts on the stock tip, the share price will increase exponentially from Stage 1 to Stage 3.

My point is that most individuals will hear the story later in Stage 3 (60% likelihood), not Stage 1 (only 14% likelihood). So if you hear a convincing narrative and buy a stock based on it, you’ll be among the last to invest. At the peak, presumably.

This is exactly how speculative bubbles form. By continuously trying to assess narratives in mainstream news reports, you’ll usually be among the last to read and act on them. You end up chasing narratives that have already been priced in.

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2. Momentum investing

Jim Cramer. Source: CNBC

“Successful investing is about having people agree with you ... later.” - Jim Grant

So how do you make money, then?

Theoretically, you’ll want to invest in Stage 1 before others catch on and bid up the price. You might call this strategy “long-term front-running”. Not front-running in the illegal sense, but rather buying before others do － sometimes years in advance.

Here is an example of a typical “hype cycle”. As investors catch on to a narrative, a stock goes from being unknown to an investor favourite, and then eventually back again:

More information on each of those stages for a hypothetical stock:

• In Stage 1, the stock tends to be illiquid and does not receive much attention from either journalists or sell-side analysts. If you hear about it, you’re unlikely to have much of an emotional reaction to the stock. Then, a new trend begins: perhaps new government regulation, some innovation, or a consumer fad emerging out of nowhere.

• In Stage 2, the new trend starts showing up in the company’s financials. A narrative starts spreading about why the company is performing well. Investors look at the increase in the share price as evidence that the story has legs. And then they pile on with greater exposure as the story continues. New buzzwords such as “BRICs”, “The Internet of Things”, or “AI” have become increasingly known by the general public. Sell-side analysts pick up coverage and raise their estimates. And institutional investors buy into the stock as the liquidity becomes high enough for them to accumulate shares. Throughout Stage 2, some scepticism remains.

• In Stage 3, momentum leads to the stock overshooting. Only trend-followers remain. Suddenly, a flaw is exposed. Perhaps growth is slowing down, or accounting irregularities are exposed. Volumes reach incredible levels. The initial weakness is ignored, as investors stop checking their brokerage accounts. Just like a skater on ice, it takes a while for investors to change their minds. But ultimately, investors concede that “the growth story is finally over” and that “the stock doesn’t have momentum anymore”. Or that “they don’t need this kind of volatility” in their lives.

Companies that have experienced hype cycles due to new narratives include Nvidia (ChatGPT), Tesla (electric vehicles), Meituan (delivery services) and DraftKings (US online gaming).

The “hype cycle” described above illustrates a set of realities. One reality is that investors tend to extrapolate the recent past far into the future. That’s why prices eventually reach unsustainable levels.

Another reality is that almost every company hits a speed bump sooner or later. So never assume that the future will be perfect.

And finally, the more popular a stock is, the faster trend-following speculators must sell to avoid disastrous drawdowns.

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3. Value investing

Warren Buffett. Source: Getty Images

“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” - Warren Buffett

One way to deal with the speculative nature of financial markets is to avoid hype cycles altogether. You might do so by ensuring you buy stocks at attractive levels － no matter what.

This is what value investing is all about. Value investors try to buy stocks cheaply, hoping the market will eventually recognise their intrinsic value. Most also try to minimise downside risks by sticking to high-quality companies.

For example, if a company sells a product that customers desire and can’t get anywhere else, the company is probably not going out of business. And it should be able to raise prices, at least with inflation. And perhaps even expand the business over time.

Warren Buffett has popularised the concept of “economic moats” that protect the company’s profits from competition. Attributes that help the company maintain high profit margins and returns on capital, for example:

• Brand recognition: We know that customers are willing to pay up for great brands. A brand can help minimise the risk of purchase and serve as a status symbol － a costly signal that you have the resources to buy it.

• Network effects: It’s also hard to compete with a network with a significant scale. Services enjoying network effects are those whose value to each user goes up as more users join. That makes Instagram a far better platform to join than some no-name start-up where none of your friends are active.

• Cost advantages: Some companies have major fixed costs, such as R&D spread across large unit volumes, enabling them to charge lower prices. Samsung Electronics memory chip unit comes to mind.

• Switching costs: When it’s expensive or inconvenient for customers to switch to a competitor’s product or service.

• Barriers to entry: Regulatory hurdles or high capital requirements.

These are obviously quantitative factors that are difficult to judge. Another way to determine whether a company enjoys a competitive advantage is to look at the return on equity (net profit/equity) over time. If the return on equity is consistently above 20% across the cycle, with a simple corporate structure and clean accounting, it’s probably doing something right.

When judging management teams, ensure the CEO is well-equipped to deal with the particular environment he or she is operating in. For some innovative companies, it might be important to have a CEO with a background in product development. It might be more important for companies in commodity industries to have a person with a relentless focus on cutting costs.

In any case, you’ll want the CEO to focus on the business rather than golf or anything else. And you’ll want somebody who skates to where the puck is going rather than focusing on the past.

The problem is that high-quality companies rarely trade at low prices. They only trade down when the company is experiencing short-term difficulties and the market is too myopic to see through the downturn. This is known in the industry as “time arbitrage” － making money by being more patient than other investors.

Few people have enough patience to engage in time arbitrage. John Maynard Keynes made a similar case almost a hundred years ago that few people are patient enough to buy value and wait for years for value to be realised:

“The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

So while value investing works, it can be boring, and stories can take many years to play out.

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4. Catalysts

”What are the catalysts for the company's proper valuation to be realized?” - Julian Robertson

We know that stock prices exhibit short-term momentum and tend to overshoot to the upside as investors pile on and bid up the price. We also know that paying attention to value can minimise losses over the long run. So what’s the best strategy, then?

I want to make a case for combining both strategies by sticking to stocks that enjoy 1) low valuation multiples and 2) short-term catalysts in the years ahead.

“Catalysts” can be anything that causes investors to buy the stock in the future. Typically, those refer to shifts in investor expectations. An excellent catalyst is when some positive event occurs, causing sell-side analysts to upgrade their earnings estimates and their clients to buy the stock.

Identify future events markets may have overlooked. Focus on significant change and ignore temporary events that only affect earnings for a quarter or two.

Focus on events in the next 6-24 months out. If you have to wait for ten years for something to happen, you might lose patience, and the annualised rate of return won’t be attractive compared to the alternatives. Conversely, events in the next six months are probably already priced in, at least in speculative markets.

In other words, by focusing on events 6-24 months from today, you’ll find the data points likely to come on the radar of other investors in the next year. You’ll be able to front-run the buying of those investors as they, too, catch on to the story.

How do you know what earnings expectations are? You can look at sell-side analyst estimates. You can also look at P/E multiples. But don’t assume that just because the P/E is low, investor expectations are more likely to shift higher.

It’s better to make your forecast of earnings and then compare that forecast with sell-side estimates. Such a forecast is difficult to make but typically includes volumes, selling prices, margins, etc.

Identifying catalysts is about psychology. Your job is not only to predict earnings but also to predict how other investors are likely to react to those earnings. That job requires empathy and understanding of how investors actually behave.

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5. Implementation

Steinhardt & Partners. Source: New Breed on Wall Street

“What will change?” - Michael Steinhardt

I believe every investment decision should be based on your opportunity cost. If you can invest in 10% risk-free government bonds, you better find stocks that offer a total return much higher than that.

The same is true for comparisons between individual stocks. You’ll want to weigh the potential upside vs the potential risks for each stock. And develop a portfolio where each stock will likely provide a return based on its calculated upside higher than the other, risk-adjusted alternatives.

5.1. Assessing the potential upside

Start by opening the company’s annual report and looking at the segment breakdown of revenues and expenses. Then look at the management discussion and analysis to determine the key drivers of revenues and margins.

A good starting point is to extrapolate long-term trends and then ask yourself: what might change?

Here is the checklist that I use when trying to think about what might change when it comes to an individual company:

• Business model viability: is the business model fundamentally profitable?

• Secular demand trends: affects the long-term likely steady-state growth rate

• Product competitiveness: strong engagement suggests market share gains

• New products: creating entirely new revenue streams

• Runway of growth: how much longer the company can continue growing

• Barriers to entry: whether the market share or margins are sustainable

• Industry supply: greater supply can put pressure on industry selling prices

• New regulation: affects the viability and competitiveness of products

• Management: influences the development of new products and strategic bets

• Restructuring: can help unlock value by, e.g. shutting down unprofitable segment

• Capital allocation: shifts in how money is allocated can benefit shareholders

• Macro variables: interest rates, currency exchange rates, business cycles, etc.

• Accounting quality: earnings manipulation games cannot last forever

• Insider transactions: suggests management knows something you might not

• Reflexive processes: e.g. use of high-priced stock to buy cheap assets

Of course, some of these factors matter more in the short run and others more in the long run. So it will truly be an art to think about how each of the fundamental factors of the company might shift in the years ahead and then model earnings properly.

I pay great attention to long-term secular trends affecting the company, such as the rise of e-commerce, Western dietary habits or the containerisation of trade.

I also pay attention to customer delight compared to what competitors can offer. Because if customers are happy, then the company will be able to raise prices, expand －or even both. You can judge customer delight by speaking to them or looking at engagement metrics or product reviews.

For commodity industries, I pay the greatest attention to shifts in industry supply. A large increase in the industry supply of any commodity will cause its price to drop. I like to look at total industry capital expenditure from the annual reports of each company in the industry, their expansion plans, industry inventory, and commodity prices.

In your estimate of future earnings, don’t forget to consider where margins might end up, given competitive pressures, industry supply & demand, etc. And think about the impact of interest expense and corporate income taxes.

My earnings estimate for NagaCorp, which many criticised for being too cautious. Source: Asian Century Stocks

After forecasting earnings, apply a P/E (price/earnings) multiple you think is reasonable. You might base it on the company’s trading history, the peer group or the perceived quality of the business.

Intrinsic value = future EPS x P/E multiple

I’d be willing to use a 20x P/E multiple on a high-quality slow-growing business. But perhaps not more than 10x P/E for a low-quality business selling a commodity product.

Finally, look at the quality of upcoming catalysts and how soon they are likely to occur. The closer they are to the future, the greater your annualised return on investment.

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5.2. Assessing risks

I think you’re best off thinking about downside risks qualitatively. And then come up with a subjective feeling of risk based on those qualitative factors.

Many things could happen that we can’t even imagine. For example, practically nobody had predicted COVID-19? Yet it happened.

So instead of trying to predict future negative events, think of the attributes that cause companies to become more fragile. For example:

• Whether it has economic moats or not

• Whether revenues are recurring or reliant on discretionary spending

• Excessive leverage

• A track record of fraud and misrepresentation

• A product at risk of technological obsolescence

• A variety of legal or regulatory risks

• Excessive customer or supplier concentration

Going through this list for each company will give you a feeling of the risk of the assets. With experience, you’ll understand what factors matter the most in what situations.

Your familiarity with the company and industry in question should also affect your perception of the potential downside risks. As you become more comfortable with a particular situation, you should be willing to allocate more to that investment.

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5.3. The risk-reward skew

To reiterate, I suggest calculating the upside in percentage terms and then weighing that upside against a subjective feeling of the risk of a particular stock. You might call this the risk-reward skew － whether the reward justifies the risk.

For a risky stock with high leverage, customer concentration and a commodity product, I’d want more than 100% upside － especially if the story will take years to play out.

Conversely, for a moaty company selling an industry-leading or differentiated product, perhaps I’ll be happy with as little as a 50% upside.

And also, take into account whether are any near-term catalysts in your timeline of future events. If you have to wait many years for something to play out, then the annualised rate of return on your investment will likely prove poor. If all you get from a risky stock is a sub-10% yearly return, then why bother?

Finally, in the event that the company has a near-term problem, wait for it to pass. It’s hard to guess how bad things can get. And how long it will take for the company to recover.

Life is short. You’re better off looking forward to positive surprises.

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6. Fertile grounds for ideas

Source: Getty Images

So far, I’ve argued that you should find stocks that enjoy significant upside to their intrinsic values, have positive catalysts in the near-term future and don’t carry too many downside risks.

But where do you find such stocks? Here are five suggestions on situations that I consider fertile grounds for ideas:

6.1. Variant view with a catalyst

“Investing is about discounting the obvious and betting on the unexpected” - George Soros

In this category, I’m referring to situations where you know something that the rest of the market doesn’t － some events in the future that will cause earnings expectations to shift in the next 24 months. Perhaps a future product, a future regulation, or a shift in industry supply & demand.

There’s no easy way to identify these situations other than interacting with people in the industry. You can also try to use Google Alerts, filtered RSS feeds and more with keywords that signal a coming event.

Or dig into the individual companies from A-Z and ask yourself, “What might change”? And then invest if you think earnings expectations will shift materially in the next few years.

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6.2. Baby out with the bathwater

“Usually, when an entire industry is in a crisis, with one or two companies bankrupt or on the verge of it, the whole industry is due for a bounce, as long as there is something in the situation that should change fundamentals” - Jim Rogers

Investors are quick to put stocks in categories and judge them based on their affiliation with these categories.

For example, whenever an asset class or a sector becomes “uninvestable”, individual stocks will become unfairly punished just by virtue of being part of that category. The high-quality company (the “baby”) gets thrown out with the bathwater, so to speak.

The trigger for such crashes tends to be outflows from a particular category of funds, perhaps country or sector funds. And then trend-followers sell with no regard for price. Illiquid stocks are usually punished the most - especially those that fall below the market cap or trading volume thresholds that institutional investors require to invest.

Whenever uninformed peers tell you that a region “sounds risky”, there are probably bargains. They might concede that stocks look cheap but will typically tell you that “there are no signs of a turnaround yet” and that the “picture is still dark”.

You’ll need to question these popular narratives and start buying shares of high-quality companies that have been unfairly punished － companies that will survive the crisis no matter what. I like companies with strong balance sheets, differentiated products, high returns on capital, clean corporate structures, and actively buying back shares.

Remember, crises are typically the only time when high-quality companies become even remotely cheap. So make sure you pounce once opportunities present themselves.

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6.3. Scepticism about a great growth stock

“Unless there is fear in a stock, it probably doesn’t have a great capital gains potential” - Bob Wilson

Great growth companies are rare. As Michael Mauboussin demonstrated in The Base Rate Book, betting on continued 20%+ growth usually leads to disappointment.

But, once in a blue moon, you might come across a product you think is so far above the competition that you think it will grow fast for years or even decades. With a management team well-equipped to take advantage of the opportunity. Monster Beverage comes to mind, as does Tencent.

In that case, consider buying shares in the company and hold until the growth opportunity has been exploited.

For great growth stocks, I pay attention to customer engagement, whether the products dominate their niche or are differentiated in some way, whether their market share is increasing, whether margins or return on capital are higher than peers and whether operating cash flow per share is rising.

You might wonder why such stocks could ever be undervalued. You’d be right to be sceptical. But in some cases, investors in non-speculative markets might be myopic. Despite extraordinary growth prospects, they might be unwilling to pay more than 20x or 30x P/E.

Also, be on the lookout for sceptical comments about the company’s growth prospects. Investor scepticism can be seen as fuel for further gain. Scepticism may persist for years but eventually dissipate as the stock goes higher in the hype cycle, at which point it will be time to sell.

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6.4. Special situations

“I'm looking for these special situations, these unique ideas” - Michael Burry

What Joel Greenblatt calls “special situations” are those where a stock price has dropped due to factors that have nothing to do with company fundamentals.

What makes special situations investing so compelling is that you don’t need to be a great financial- or business analyst. Just buy a stable-enough business at a ridiculously low valuation. And hopefully, the business will be humming along until other investors realise what a bargain the stock really is.

Events that might have triggered the forced selling of shares below intrinsic values include:

• Spin-offs

• Post-reorganisation equities

• Broken IPOs or merger arb

• Dilutive rights issues

• Dividend omissions

To identify special situations, run screens through Bloomberg or some other paid service. In some of the above cases, you may need to search manually through filings or news reports.

I’d suggest reading Greenblatt’s 1999 book since he covered special situations far better than I ever could. I think it’s a must-read for any event-driven investor.

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6.5. Booms and busts

“Just about the time you learn to play the game, they change the rules” - Alan Abelson

As I alluded to above, people invest based on narratives, and price movements can reinforce the perception of the narrative itself. Whenever a particular method of investing becomes popular, fund flows into that strategy start to pick up. The flows can help the strategy perform and attract further inflows.

In finance, reflexive processes refer to situations where an increase in the price of a security can lead to further price gains. Perhaps as higher-priced stocks can attract better-quality employees through dilutive stock options. Perhaps through accretive acquisitions financed through high-priced equities. Or just as trend-following investors pile on as a story continues to deliver.

But eventually, at Stage 3, the valuation gap becomes too big to ignore, and momentum traders become jittery. Something sparks a shift in investors' minds and they start selling. The stock will fall much faster than it rose, not forming a bottom until true value investors feel compelled to step in.

Let’s say you’re impressed by ChatGPT and want to play the “AI” boom by buying Nvidia. What are some of the signals that might tell you where we are in the hype cycle?

• If a new buzzword has just been created (such as FANG, BRIC or ETFs) but not yet used by the general public, we might still be in an early inning.

• Smart investors step in ahead of the general public.

• Fund flows tend to be positive throughout the build-up of the boom and tend to accelerate just before the peak.

• The mass media starts paying attention to the theme midway through the cycle.

• Long-term log-periodic oscillations in the share price tend to increase in frequency, indicating overcrowding until a breaking point, which can be identified through quantitative models.

• In the euphoric stage, margin debt as a proportion of market value shoots ups.

• In the end, only trend-followers survive as participants - i.e., it is hard to find any value investors left as shareholders.

• Volatility tends to rise at around the peak as retail investors step in and smart money sells.

• An element of fear is introduced - doubts start to emerge among shareholders, and their “continuity of thought” against higher prices is somehow broken.

• The exponential price trend breaks, and the price fails to make a new high despite positive commentary.

The stocks most affected by boom and bust patterns are those whose intrinsic values are difficult to determine: growth stocks, gold, collectables and cryptocurrencies.

While some investors baulk at paying high multiples for stocks, it’s usually not possible to entirely disprove why a growth stock should not trade at a certain multiple. It just depends on how many years of growth you are willing to discount.

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7. Conclusion

Investors who adopt the “value-with-a-catalyst” strategy tend to focus on stocks that are undervalued compared to their future earnings. They then identify catalysts that might cause other investors to reassess their earnings expectations.

I suggest weighing the calculated upside of investing in a particular stock with a subjective view of the risks involved. Call it the risk-reward skew.

• The upside is best measured by projecting earnings by analysing consumption trends, new products, regional expansion etc., and then applying a multiple against those earnings.

• The downside is best measured in qualitative terms by ticking off a checklist of potential risks: leverage, the company’s economic moat, customer concentration, risk of fraud, risk of technological obsolescence, the valuation multiple and whether you have expertise in a particular country or industry.

Getting to a well-balanced portfolio requires turning over many stones and discarding ideas that didn’t work out. And when you find ideas that score particularly well, be prepared to bet big.

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