As 2019 comes to an end, I am wrapping up my fourth year of doing this and was reflecting on how much I've learned since I started. You see a lot of job-posts for funds usually looking for 5 years of experience, and I can see why now, I truly didn't know shit when I started. I wanted to focus this post on a few key lessons that I've learned that are less specific to my individual situation so that others may get some value out of them. Before I get into it I'll start with a disclaimer: On one of my other posts where I discussed asset pricing theory, one of the comments was that it wasn't original. Yes, no shit, how often do you ever truly come up with an original idea or theory in finance? I'm not Eugene Fucking Fama here, I'm just a guy from a non-target, with no mentor, trying to figure this shit out on my own, and who reads a lot to accomplish that goal. There are a lot of ways to make money in markets and I am continuously looking for the most optimal path, which is far from straight and narrow. As I have traveled down this path, this forum has been a useful resource, especially early on. So my objective with these more educational posts is to share what I have learned and to try and write from the perspective of "what would have been most helpful to myself when I was starting out?" Some of these lessons overlap but all were turning points for me once I realized them.
Know whether you're generatingor putting on beta
This is one that it took me a while to understand, and my work to create a risk-factor model for us and the research that went into it really helped drive this home for me. You only generate alpha if you have identified a genuine mispricing, a reasonable catalyst, and timeline for the mispricing to correct. In reality, this is very difficult to do. For it to be a real alpha generating opportunity, you have to first be correct in your estimates, be different than the consensus, then understand what the market is missing, figure out how the market will realize your estimates are more correct than what is priced, and figure out how long this will take to occur. This does not mean that you cannot outperform without assessing these factors, but you will/should not outperform on a risk-adjusted basis. You can outperform by timing a cycle or getting a directional risk factor call correct, but that is beta and not alpha. You can get paid big for correctly timing betas, but it is even more difficult than finding genuine alpha in my opinion, and much less likely to be repeatable. Understand this and get comfortable with it, because being right for the wrong reasons is one of the worst things that can happen to you early in your career. By the way, if your group does not track some kind of risk-adjusted return measures, that should be a red flag.
At some point is not an investment strategy
Getting the timing of your calls correct is essential. This is less important if your thesis is built upon some kind of big secular driver over say a 5 + year period, but timing will still have an effect on every call to some degree. Fuck moral victories, no one is going to pay you 100 bps or 2 and 20 for a career of moral victories. If you identify a mispricing and a catalyst but it takes 3 years longer than you expected to play out, it dilutes the alpha of your call if it does not eliminate it almost entirely. Additionally, the longer a call takes to play out past your expectation, the more you expose your thesis to exogenous factors and the greater the likelihood you will be subject to thesis drift, which is a cardinal sin for an analyst. It is ok to be wrong, but know what has to occur for you to be correct and know when it has to occur. Do not get married to any idea and always be ready to admit that you were wrong and bail. If at any point during the construction of your pitch you find yourself thinking or writing "at some point" with regards to any part of it, either cut that piece out or rework that angle. Timing is essential.
Investing isn't about evaluating businesses
It is, but that is only half of the game. The other half of it is figuring out what expectations are priced into the valuation. You can get the trajectory of the business and your fundamental estimates 100% correct and still be wrong. That is because you are judged off of your returns, not your ability to predict fundamentals. Your returns are generally an output of your ability to predict fundamentals, but at the end of the day you will be judged off of your returns. If you forecast a business to grow 5% but the stock is priced to grow 8%, and you end up being correct without realizing what is priced, you will be wrong. Valuation is about forecasting what you think will happen, and then sensitizing your numbers and talking to others to figure out what they think will happen. If there is enough of a difference, and assuming that you are more correct than others for whatever reason or edge you have, can you capitalize on it and be confident in the timing that others will see it your way? A good business does not necessarily make a good stock.
Know what you don't know
Be aware of the limitations of your research as a public markets investor, and be aware of the opportunity cost of the time you may need to invest into an idea to close certain holes in your thesis. For example, if you are looking at a multinational serial acquirer, know that you are going to be fighting an uphill battle trying to gauge the attractiveness of the portfolio as a collective and the attractiveness of the individual pieces on a standalone basis. Is this idea worth it? What is the opportunity cost of taking the time to formulate depth on the idea? Would your time better be spend on something easier to understand? The key here is to know what you don't know. If a company has guided 100 bps of margin expansion annually, do you have enough information to reconcile that claim? Has management delivered on its targets in the past? In most cases you will be making some kind of call on management's honestly and track record rather than being able to pinpoint exactly where the dollars will come from. The same goes for a new product launch or something along those lines. Will it work? Will you have some way to gauge early success? Or are you making a bet based more on faith in management's ability to deliver and their track record in doing so? If you know where you could be wrong, or where there are simply holes in what you can know through public disclosures and information, you will have a much better handle on the business over time and you will have a better idea if volatility presents opportunity or risk. Always acknowledge and address these limitations.
Forget using multiples
Value investing is not simply buying "cheap stocks". Buying cheap stocks is an implicit directional bet on interest rates and the economy, and it can work, but know that is what you are betting on rather than individual fundamentals. True value investing, and I would reason all investing, is about navigating mispriced assets. This could mean a stock priced at 30x should be priced at 33x, the same as it could be buying aat 10x that should be trading at 11x. To have any hope at accurately valuing an asset, you simply have to build out a full model and value its cash flows. A multiple is the bi-product of the interrelationship between returns on capital, forward growth outlook, and the discount rate, it is not a market anomaly or natural phenomenon. Without addressing differences in those factors you just can't accurately compare peers based on multiples, and without addressing how those factors have changed over time, you can't even compare a company's multiple to its own historical range. The first book I ever read was Graham's II, and I said ok all I have to do is buy cheap stocks, maybe trading below their cash balances or net asset values and sit back and outperform. That just isn't possible anymore when any idiot can log into their etrade account and screen through 2,000 stocks in one click and there are billions of dollars flowing into quant strategies and quasi-passive etfs. Where guys get it wrong as 's go is that it isn't about precision, it is about forecasting a range of outcomes and sensitizing the numbers to different variables. In reality, multiples are just short-hand for valuing cash flows, and rarely in investing do you get compensated for taking short cuts. I have been fully converted to doing full 3-stage DCF valuations from my more multiple-based mean reversion beginnings. If investing was as easy as looking at multiples, which only requires the ability to be able to do elementary school division, everyone would outperform. "But everyone just uses multiples" Yes. And if you want differentiated performance you have to do something different. Don't be afraid to be different.
Valuation should come last
You really should never start with valuation in your research process. If you really think about it, it doesn't make any rational sense to do so. You don't go to the store with $100 and say I'm going to spend this on the cheapest items I can find. You go to the store with specific products in mind that you need, and once you have compared what is on the shelf and the differences in quality, you choose best priced item relative to that quality and your need. In investing the products you need are securities that will allow you to compound your capital at attractive risk-adjusted rates of return, so that is what you should shop for. When you screen for valuation, which will be multiple based, you begin from a biased starting point. We all do it, you see the 10x stock and say why is it so cheap or the 30x stock and say why is it so expensive? If this is a fresh look at a stock, you are just in no position to make a claim like that because you don't know a single thing about the business or its trajectory. Break this habit and focus your earlier searches on what the business actually does and whether you find that attractive or not, the fundamental function of the business should be your starting point. Yes, you cannot quickly screen this way, but as with multiples, you don't want to take short cuts when it comes to investing.
Don't let an investment ideology or strategy define you as an investor
Even if you are working at a fund that is marketed to outside investors as value or growth or some other type of segmentation, don't allow this to seep into your identity as an investor. You have one goal as an investor: to compound capital. I have found that people who identify as a value investor or small cap or large cap or growth or QARP or GARP or momentum or whatever the fuck you want to call yourself take some sort of strange pride in the titles. There is no nobility in shitty returns. Never lose sight of the fact that your one job is to compound capital, nothing else matters. Even if you are at a fund pursuing a specific style or strategy, investors will leave if you do not compound their capital, which is the only fundamental truth in this business.
Bad incentives can ruin good businesses
Always know what management is comped on and how that affects their decisions. Bad incentive structures can ruin good businesses. The most common case I come across is incentive structure that allows value destructive M&A to clear performance comp hurdles. Any kind of absolute sales orare not based on organic growth or adjusted for M&A are deadly. The ideal compensation structure should be setup based on organic growth and returns on capital. Even TSR can lead to performance bonuses being earned for factors outside management's control or direct influence. I don't like margin targets either, as they often will incentivize margin expansion over value additive investment. If I was a CEO and the board said ok your bonus is based on an absolute revenue hurdle. I am going to lever this bitch up to the max and acquire all the revenue I can find, I don't give a fuck about the long-term, you're paying me too much in the short-term to care about the long-term, and I'll be retired long before anyone finds out if these deals added value or not. Do the deal and slap some 5-year synergy target on it, retire after 5-years of max payouts. Life is too short and I'm going to get mine while I'm here. Always be aware of management's incentives.
Your PM has to earn your respect
It is easy to look at someone's track record and instantly give them credibility if it has been good, and if they are running any kind of sizable AUM they are probably well-polished when they speak about markets and the portfolio. Do not do this. There are a lot of idiots out there running money who were in the right place at the right time or were right for the wrong reasons on some big call. All it takes in this business is one home run to make a career as a PM. Give your PM the benefit of the doubt to start, but as time goes on make an honest assessment of the historical returns and how you are positioned going forward, and what that means for a long-term career with the fund. Don't assume that longevity in this business implies skill, there is often a TON of luck involved with a lot of different guys. Make sure your PM has a repeatable process and isn't riding a massive luck streak before drinking their Kool-Aid. You'd be shocked at how many guys out there are just complete idiots that were in the right place at the right time.
Tailor your pitch to your PM's biases
If your PM happens to be on the idiot side of the spectrum, it is likely that they are highly biased with regards to their views. This is a major function of being right for the wrong reasons early in one's career. Once you learn which biases have the most influence, you will have a better idea of what will work and what will not work. When pitching a name, highlight what you know will be received positively and keep the negatives more around the margin, if you talk about them at all. In a perfect environment, you should be able to acknowledge all the factors that go into and affect your thesis, positive and negative, and be able to have a rational, fact-based, emotion-free discussion around it. That is not the environment that I am in, and as such I am telling you how to get things done for the good of the portfolio. Remember the one fundamental truth, your job is to compound capital. Most investors don't want to know how the sausage is made, and this is how someone can make a career out of being right for the wrong reasons (and how people get wrapped up in Ponzi schemes), but this is not sustainable over the long-term. Therefore you need to bring in ideas for the good of the portfolio, which is in your best interest to do so if you want a long-term career. At the same time, you must balance this with what will score you points with your PM. Do what you have to do to achieve this balance, even if you have to tailor your pitch to conform to irrational biases or leave out facts that would be relevant in a normal environment. I'm not telling you to make shit up, but be selective with what goes into your pitch for the good of the portfolio.
I think that is enough for now. Again, this is all my personal opinion from what I've learned over my first few years as an analyst. Hopefully someone finds it useful.