Sunday Finds + 3 Thoughts From Last Week
Amazon and the Trade Desk
3 Thoughts From Last Week:
Where is the optimal hunting ground during a bear market? We all know the quotes about buying the dip during market declines. “Buy when there’s blood in the streets”, “Be greedy when others are fearful”, all that good stuff. But I think a better question to ask is: What should you buy during a bear market? A lot of investors would say the value factor, given its historical outperformance during downturns. I think that strategy makes sense if you’re looking to optimize returns over the next 12 to 36 months. But if you’re time horizon is longer and you want to minimize the stress of dealing with a portfolio of low-quality businesses, I actually think the smart thing to do is avoid the value factor and focus on researching high-quality “growth” stocks. What this means is that, if we go into an extended bear market over the next year or so, I’m going to be focused on finding and researching companies that:
Are growing the top-line 10%+ a year, preferably with durable industry tailwinds
Have proven they can generate free cash flow and/or have good returns on invested capital (ROIC)
These types of companies have much more palatable valuations compared to just a few months ago, or really anytime in the last five years excluding March 2020. These stocks will likely underperform the value factor over the next 24 months if we go into an extended bear market. However, if I’m thinking about how to achieve the best risk/reward in my portfolio from now until 2030, I’d much rather buy a top-notch compounder at 20x free cash flow than a low-quality business at 5x free cash flow.
How do you know when something is in your circle of competence? Every investor learns — usually the hard way — that you should stay within your circle of competence. This is a fancy way of saying “buy what you understand.” But how do you know when something is in your circle of competence? That question may seem simple, but I’ve found it very hard to answer. One thing that can help is to have a bias towards putting a stock in the “too hard pile” even if you think the opportunity might be promising. Right now, semiconductor, SaaS, and cannabis companies fall into my “too hard pile,” which is unfortunate because I think each industry has promising prospects over the next decade. I just don’t understand them well enough yet. Another thing that can help is to make a checklist to decide whether an industry/business falls within your circle of competence. Here are some questions I like to ask myself on the subject:
Do I know all the major companies in the industry?
Do I understand all the relevant companies in the supply chain and why each has the margins it does?
Do I understand the customer value proposition?
Do I understand what competitive advantages (if any) some companies have in the industry and why they have these advantages while others don’t?
When a piece of news comes out within the industry, do I understand how it will effect the company I own?
I’m sure there are some others I’m not thinking of, but if you can answer yes to all of these questions, you’re well on your way to having a stock become investable.
Straw hats in the winter. Related to the first topic, a tweet that was thought-provoking for me this week (linked below) was Pythia Capital’s question: What are today’s straw hats? It is referencing Leon Cooperman, the famous investor who has said “I want to buy straw hats in the winter.” People do not want to wear straw hats in the winter, so there is low demand, so they are typically on sale (it is just an analogy, I’m not sure if it is actually correct). Cooperman is using the straw hats as a metaphor for assets that nobody wants to buy right now. The most popular responses to the tweet were Meta Platforms (Facebook) and cannabis. Both could be correct looking at the current earnings multiples and historical top-line growth rates. Personally, I think companies within the ARK Invest universe are straw hats right now. Most of the firm’s holdings are down 50% or more in the past year, and nobody wants to touch any of it. The negative feelings a lot of investors have about the fund could provide investors with great buying opportunities by finding the baby that was thrown out with the bathwater.
See you next week,
Brett
***Our fund, Arch Capital, may own securities discussed in this newsletter. Check our holdings page and read our full disclosure to learn more.***
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Catch-up on Our Shows From Last Week:
3 Good Reads:
1 Good Listen:
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