Fundamental analysts spend an inordinate amount of time with Microsoft Excel software trying to gauge the magnitude and direction of the future cash flow evolution of a company with detailed projections around revenue, margin and earnings trajectory. Yet over time, the lesson one learns is that, more often than not, it is what is not in the excel spreadsheet that counts.
Our belief has always been that companies exist in an ecosystem, and understanding and analysing the ecosystem gives us the best chance of making accurate judgements around its future earnings trajectory.
However, with the fast pace of technological disruption changing the landscape and ecosystem in every industry, the work of a long-term investor has become more difficult. The moat for most companies seems a lot leakier than it once did!
In fact, one must step back and ask whether it is even possible to imagine what an industry or company will look like 10 years from now, let alone try and predict their cash flow and earnings for that time period?
We would posit that analysts buried in excel spreadsheets would have scarcely had the imagination to predict how Netflix, Amazon, Apple, Facebook & Google would change the world as we see it or equally would have been hard pressed to forecast that in one of the best bull markets in history (2009-2018), GE, the largest industrial company in the world, original uninterrupted member of the Dow Jones (for over 120 years) would be a shadow of its former self in just under 10 yrs.
So: just how can an active investor capitalise on these changing times? Here are 6 suggestions:
1: Extend time horizons
Paradoxically while disruption and uncertainty have increased, the importance of investing with a medium to long-term horizon has never been greater.
Albert Einstein called compounding the eighth wonder of the world, once saying: "he who understands, it earns it…. he who doesn’t, pays it".
Long-term investing gives our money more time to stay invested. This gives greater opportunity for compounding and growth, and reduces dependence on the vagaries of the stock market.
Further, from an active investor’s perspective, one must also recognize that the game and its rules have changed; the battle for short-term investing is already lost to algorithms and high-frequency traders.
However, these depend on the quality of data inputs and once you extend time horizons less frequent data means less ability to make probabilistic judgments and decisions.
Hence: patience and compounding are your friends over time, and it is only over time that artificial intelligence yields to natural intelligence.
2: Play to our human strengths
Creativity and empathy make us human and differentiate us from machines which are generally products of strict rules and instructions. To differentiate ourselves we need to focus more on what makes us unique.
Consequently, in our process, we find the importance of personal interactions be they company meetings, site visits and regular interactions with management teams has only grown in importance.
I have yet to see an AI join us at the table with senior corporate management or at a mine visit - when that happens I will keep you posted!
3: Importance of Management
Indeed when moats are falling away at a fast pace, the importance of great managements only increases. Investing is all about searching for those leaders and once you find them, sticking with them as they evolve their strategy to fight against growth and economic headwinds with constant innovation. If your choice is right, again compounding will be your friend.
The constituents of what makes a great management team are constantly changing and evolving, and are probably too exhaustive to list. Even though our horizons are long, we need to constantly observe and evaluate these changes.
The Peter Drucker quote ‘culture eats strategy’ captured it all and has proved timeless. Great management teams understand that ‘constant change’ (a necessity in the age of disruption) is not possible without having the right culture in place.
However, some leaders have modified this quote to ‘culture breeds strategy’ To give an example, Satya Nadella’s vision for Microsoft was well articulated in his first few ‘emails to employees’ (and well elaborated in his book ‘Hit Refresh’, which we highly recommend). He wanted to re-energize the organization and make the organization a tool for employees to achieve their ‘purpose’.
In 2015 the organization changed its mission statement from ‘a computer on every desk and home’ to ‘empower every person and every organization on the planet to achieve more’.
Through meetings with various senior employees & leaders in Microsoft, it became clear to us that these were not just high-sounding statements but that every level in the organization was energized and using them as a North Star to execute towards. As a result, under Nadella’s tenure as CEO (which mirrors our ownership of the stock) Microsoft has seen its share price grow from $35 to 93$ vs. the previous ten years where it essentially stayed flat.
This mission statement demonstrated that to be successful in the new age, it is essential to have:
- a sense of shared purpose for the entire organization
- recognition that companies must strive (through their products and services) to consciously improve the lives of everyone they impact
- a culture which will re-energize and constantly breed new ways to win
4: Capital allocation & Incentives
The "holy grail" in investing is to find an excellent business, trading at a discount to fair value with a management team that allocates capital well.
Capital allocation (reinvest in the business vs buy a competitor v/s return capital to shareholders) is by far the most important decision that managers take. How they make those decisions is in no small part driven by the incentives that drive them.
We consequently like to see incentive structures that promote long-term thinking (in sync with our investment horizon). We also prefer to see more returns-based incentives with metrics tailored to the company/industry. rather than blunt ‘EPS growth or TSR based metrics’ which many a time incentivize poor M&A activity or are so out of management control so as not to matter.
We are therefore fans of high management ownership and avid followers of how insiders treat their stock. A good anecdote to illustrate this is from February 2016, when investors were worried about a global recession and markets were in turmoil. Jamie Dimon of JPMorgan Chase (another portfolio holding) backed-up his message of calm by buying $26mn dollars of stock with his own money at £53$ a share. As of end of March 2018, with the stock trading at £110, he and all those who followed him had pretty much doubled their investment in two years.
5: Confidence and paranoia
We have observed that strong management teams exhibit a high degree of duality. Nothing captures this better than being confident about your strategy and execution yet consistently paranoid about everything that could impact that equilibrium and throw you off that high horse of success.
Most management teams we meet display a high degree of confidence. Paranoia is not often on display and therefore we seek more of it. Put simply, if the management team is ‘always paranoid’, as investors we sleep easier.
A good example of this was our meetings with Facebook in 2017 (which we covered in our wire ’What Peter Lynch taught me about Facebook') which suggested that the company and the market was not ‘paranoid enough’ about privacy issues as well as the risk of government regulation. Recent events have suggested that even for a fantastic management team like Facebook, a degree of paranoia would have helped.
6: Positive difference to the world
In our view, strong management teams try to not lose sight of their ‘raison d’etre’, - to try and leave their company, customers, employees and the world in a better place than they found them.
This trait, however, is one of the most difficult to evaluate (or count) given it has only shades of grey rather than being black and white. I must clarify that this strategy is not an ESG approach and neither does it aim to become one.
Yet we find that thinking about the long-term necessitates that we evaluate company strategy and execution through the lens of their impact on the world and is an area where we think, as active managers, we can make a positive contribution to the discussion.
Given the shades of grey, this remains an evolutionary concept where one must try and constantly keep pace with society and investor demands. We will explore this fascinating area further in our next wire.