Long-term front-running
An introduction to value investing. Estimated reading time: 21 minutes
I’ve received comments that Asian Century Stocks is difficult to grasp for those outside the finance industry. So let me try to address that issue once and for all.
In this post, I’ll provide an introduction to value investing. For example, why do people bother doing fundamental analysis? How do investors choose to invest in a particular stock? I’ll try to explain those issues and many others in simple terms.
Here’s an 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 calm water
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - Benjamin Graham
Viral stories spread exponentially. This is true not only of memes but also of exciting stories about stocks.
We get bombarded with narratives daily. Open up CNBC.com, and you’ll see the stories I’m talking about. About elections, interest rate cuts, new products, etc.
How do you respond to these stories? You’ll typically form a view of whether you agree with it or not.
We tend to “adopt” narratives that already correspond to our existing set of beliefs. Especially those that spark greed or fear, a feeling of community or a sense of community.
For example, when COVID-19 hit in early 2020, stories began spreading on social media about sickness and death. Some discarded the event, as perhaps they were of the opinion that epidemics tend not to be a big deal. However, others interpreted the data differently and masked up for years as a consequence.
When faced with convincing narratives and emotions that bubble up, we’ll be tempted to act, perhaps by buying shares in a company benefiting from the supposed trend. During COVID-19, for example, many were compelled to buy shares in vaccine maker Moderna.
Compelling stories tend to spread in an exponential fashion, from one journalist or one investor to the next. Social media “retweet” buttons have only amplified this virality.
I like to think of this virality as the movement of ripples in calm water as narratives spread from one person to another in ever-greater numbers.
What does exponential spread mean for investors? Well, if one individual spreads the story to two people each, you end up with the following pattern across Stage 1, Stage 2 and Stage 3:
If that story is an exciting stock tip, and each person is acting on that tip, then the share price will increase exponentially from Stage 1 to Stage 3.
My point is this: most individuals will hear about the stock tip in Stage 3 (60% likelihood), not Stage 1 (only 14% likelihood). That’s the nature of how compelling stories can spread, in an almost exponential fashion.
So, if you hear a convincing story and buy a stock based on that story, you’ll be among the last to invest — perhaps close to the peak.
That’s why trying to assess narratives in mainstream media is a stupid idea. You’ll be among the last to read and act on those stories, chasing narratives that have already been priced in.
2. Momentum investing
“Successful investing is about having people agree with you ... later.” - Jim Grant
So how do you make money, then?
In theory, you’ll want to invest in Stage 1 before others catch on to the story 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’s an example of a typical “hype cycle”. As a positive narrative about a stock spreads from one person to another, the share price will exhibit the following pattern:
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 the stock mentioned, you’re unlikely to have much of an emotional reaction to it. In fact, you probably don’t even know about the company’s existence. Then, suddenly, a new trend emerges: some government regulation, a new product, or enthusiasm about a specific category of products.
In Stage 2, the new trend starts showing up in the company’s financials. The media comes up with a narrative that explains what’s showing up in the data. Investors start putting on exposure. Sell-side analysts pick up coverage and raise their estimates. New buzzwords such as “BRICs”, “The Internet of Things”, or “AI” become known by the general public. And finally, institutional investors buy into the stock as the liquidity becomes high enough for them to accumulate shares. Throughout Stage 2, skepticism remains.
In Stage 3, momentum leads to the stock overshooting to the upside. The valuation multiple becomes hard to justify. And suddenly, only trend-followers remain. Then, a flaw is exposed: for example, perhaps growth is slowing down, or accounting irregularities are exposed. This is typically where volumes peak as the shareholder register churns. The initial drop is typically bought and explained away. But over time, investors stop checking their brokerage accounts. It takes a while for them to change their minds. After six months to 2 years, investors start to come to terms with the fact that the stock might not recover. They’ll adopt new narratives about the stock, that “the growth story is finally over” or that “the stock has lost momentum”. The decision to get rid of the stock is finally related to fatigue, growing tired of getting disappointed repeatedly.
Companies that have experienced hype cycles include Nvidia (ChatGPT), Tesla (electric vehicles), Meituan (delivery services) and DraftKings (US online gaming). Somehow, these types of stocks have been able to capture the public’s imagination.
The “hype cycle” described above illustrates a set of realities. One is that investors tend to extrapolate the recent past far into the future. When growth accelerates, the P/E ratio tends to rise commensurately on top of the actual earnings growth. And when growth decelerates, we’ll instead see the P/E compress.
Another fact of life is that almost every company hits a speed bump sooner or later. Never assume that the future will be smooth sailing. It never is.
And finally, the more popular a stock has been, the faster trend-following speculators must sell to avoid disastrous drawdowns. Escalator up, elevator down. That’s how stock prices tend to move.
3. Value investing
“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. That’s precisely what value investors try to achieve.
They buy stocks cheaply, hoping the market will eventually recognize the intrinsic value of their portfolio holdings.
Most also try to minimize downside risks by sticking to high-quality companies that sell products that are either needed or desired. For example, if a company sells a product that customers need and can’t get anywhere else, that company is probably not going out of business. It should be able to raise prices, at least in line with inflation. And if the management team is strong, it might even be able to expand the business over time.
Warren Buffett popularized the concept of “economic moats”. These are company characteristics that protect the company’s profits from competition. And the lack of competition helps them maintain high margins and a high return on capital.
Examples of such business characteristics include:
Brand recognition: Customers are willing to pay up for great brands. These brands can help customers minimize the risk of purchase. They can also serve as a status symbol － a costly signal that you have the resources to buy them.
Network effects: Services with network effects are those whose value to each user goes up as more users join the platform. Companies with network effects are typically hard to dislodge. Instagram is a perfect example.
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. SAP’s enterprise resource planning system is famously hard to switch away from.
Barriers to entry: Regulatory hurdles or high capital requirements.
These are quantitative factors that are difficult to assess. But if a company truly enjoys a competitive advantage, you should also see it in the numbers, for example, in the return on equity (net profit/equity). If a company can achieve a 20% return on equity across the cycle with clean accounting and treating its stakeholders fairly, 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. In commodity industries, a company might be better served with a CEO with a relentless focus on costs and capital allocation.
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. Problems need to be dealt with head-on.
That said, high-quality companies rarely trade at low prices. The only time such stocks trade down is when a company experiences short-term challenges. The market is frequently too myopic to see beyond the current downturn. Having a longer-term time horizon than the market is known as “time arbitrage” － making money by being more patient than others.
Over a hundred years ago, John Maynard Keynes made the point that few investors are patient enough to buy value and wait for years until that value is realized for the benefit of shareholders:
“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 certainly be boring, and it can take years to recognize the underlying value of an asset. Patience is needed.
4. Catalysts
”What are the catalysts for the company's proper valuation to be realized?” - Julian Robertson
We know that stock prices tend to exhibit short-term momentum. We also know they tend to overshoot to the upside as investors pile on and bid up the price. And finally, we know that paying attention to value can minimize losses over the long run. So what should we make of these facts, then?
My suggestion is to combine both strategies. Buy stocks that are undervalued compared to their long-term earnings power. Also, ensure the stocks have catalysts that could cause investors to bid up their prices.
Such “catalysts” can include anything that causes investors to buy them soon. Typically, they’ll be events that cause shifts in investor expectations. I like it when sell-side analysts upgrade their earnings estimates and call their clients, suggesting they buy the stock. If institutional investors like a story, they’ll often be willing to pay up for it.
So, you’ll want to identify future events that markets may have overlooked. Focus on significant change. And ignore events that only affect earnings for a quarter or two.
Events that will happen in the next six months are usually priced in. Events further out in the future might be in the process of being priced-in, but haven’t been incorporated into sell-side estimates yet.
I think the sweet spot is events 6-24 months from today, as those will start to be priced in by market in the upcoming year. By looking further ahead, you’ll be able to front-run the buying of other investors as they, too, catch on to the story.
How do you know what earnings expectations are? You can start by looking at sell-side analyst estimates. You can also look at P/E multiples. But don’t assume that just because the P/E ratio is low, investor expectations are likely to shift higher. It requires earnings growth to surprise on the upside, too.
I prefer to make my own earnings forecast. Then, compare that forecast with sell-side estimates. It’s challenging to make predictions, but try to look at the granularity of an estimate across volumes, selling prices, margins, etc. If you have access to company management, they might be able to help you.
Identifying catalysts is about understanding people’s psychology. Your job is not just to predict earnings but also to predict how other investors are likely to react to those earnings. So you’ll need to put yourself in their shoes and observe how they behave. Only then can you understand whether a particular catalyst is likely to move the needle or not.
5. Implementation
“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. Put together 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.
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 multipleI’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.
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.
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.
6. Fertile grounds for ideas
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.
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.
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.
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.
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.
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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Great article mate. Really good stuff. Felt as though you really had some distilled wisdom
Great summary, thanks. You should turn it into an e-book. On a different note, I’m in the middle of plowing through some academic papers as part of my research for a book. It’s pretty shocking how poor the writing is of some of the top academics is compared to writers on substack