Price Always Matters

When a subset of equities enters a time of prolonged euphoria, market participants start engaging in all manner of dangerous behavior. This includes developing theories that business rules have fundamentally changed, new businesses can always outpace any lofty expectations (despite many of them often competing against each other) and that the current period is a historically unique period of disruption (I’m 45 and this is my second major period of historically unprecedented disruption… and I’ve read about many others in the 20th century alone). Like other 1000 year events, historical technical disruption seems to occur every few decades.

These ideas are both compelling and, generally, incorrect. Compelling because they feed into the emotional pull that sweeps investors away during times of euphoria. Incorrect because they can be disproved with some basic analysis and, more painfully, with the passage of time and experience.

Nor is this a statement of “value” is better than “growth.” Indeed, this taxonomy, often based on a set of quantitative values, is somewhat arbitrary and, worse, a backward looking evaluation applied to a forward occurring process. It doesn’t matter if you consider yourself a “growth” or “value” or “whatever else” investor…

Price. Always. Matters. And sometimes it matters A LOT.

Investors’ concern should grow as both relative and absolute prices increase and should border on terror when an ever louder cacophony of voices claim otherwise. This is especially true when those voices are armed with unimaginable short term returns driven by unsustainable manias.

FACEBOOK AND TWITTER

Let’s take a look at two companies: Facebook and Twitter, one that IPOed in mid 2012, the other in late 2013.

Facebook’s revenue growth looks like this:

While Twitter’s looks like this:

In the year ending 2013, Facebook had $7.8b in revenue and a $139b market cap while Twitter had $665m in revenue and a $36b market cap. Despite both companies having healthy revenue growth in the future, the starting point was very different. Investors in Twitter were paying 51x Enterprise Value/Sales while Facebook investors had a comparative bargain at 16x EV/S.

By the end of 2020, Facebook had grown it’s revenues to $86b, roughly 11 times; and Twitter revenues had grown to 3.7b… a much smaller, but still respectable, 5 times. Investors results were somewhat lumpier. Facebook shareholders were sitting on a 400% gain while Twitter shareholders had to deal with a 15% loss.

You may think that comparing two businesses like this is a bit silly and contrived because there are so many variables at play. It’s a fair point. Maybe Twitter’s growth wasn’t as good as it should have been. Maybe they weren’t as thoughtful with how they allocated their resources. Maybe they didn’t innovate fast enough. Maybe they didn’t have great acquisitions. Maybe Twitter is just a fundamentally worse kind of business. And so on.

Nevertheless, if we simply reverse the relative price and keep everything else the same; the picture changes dramatically. Had Twitter investors paid 16x EV/S they would have paid $10.6b instead of the $36b for the business, and enjoyed a 300% return. Similarly had Facebook investors coughed up 51x EV/S, their return would be reduced to 93%. Not terrible but substantially less.

Whether they knew it or not, Twitter investors were paying substantially more than Facebook investors for their respective future expectations.

And that’s what price primarily is. An underwriting of expected future performance. The less you charge for your underwriting premium (i.e. the more you pay for a company), the greater your risk when things turn out worse than expected.

Let’s expand on the insurance comparison a bit. The insurance industry also goes through periods of mania and periods of depression; and it also has auction characteristics. Customers tend to favor lower rates (higher prices from the insurance company’s perspective). During a mania, it is difficult for insurance companies to be prudent because doing so means “missing out” on new business and you must face your shareholders when they ask you why you aren’t growing as fast as your competitors. It takes a strong mind and stomach to tell investors that the growth your competitors are enjoying is built on foolish risks which will only manifest in the future, while your subdued growth is based on prudence that is sure to pay off in the goodness of time. Nor is this a certainty. Only in the future can we discover if the price paid was reasonable given the potential risks. Insurance companies that do this badly get wiped out in the long run; insurance companies that do this well have to deal with angry shareholders in the short run. There is no “easy” path.

So does that mean investors should have avoided Twitter and focused on Facebook, because Facebook proved to be a “better” business? Not at all. It simply means that price mattered and Twitter investors overpaid.

Let’s consider the picture just a few years later.

By the end of 2016 Twitter’s revenue had growth to $2.5b while it’s Enterprise Value had dropped to $9.6b. Investors at this point were paying a mere 3.8x EV/S. Facebook on the other hand had growth its revenues to $27.6B and seen it’s Enterprise Value rise to $303b for an EV/S of 11x.

Between the end of 2016 and the end of 2020 Facebook investors received a handsome 130% return; while their Tweeting counterparts enjoyed a far superior 230% return. From this point if the timeline, it appears that Twitter investors chose the “better” business while Facebook had languished. But this is primarily a function of them paying a better price.

This brings into question the maxim that High growth businesses grow into their high valuations thus multiples are justified. This lacks nuance. SOME high growth businesses SOMETIMES grow into their high valuation and thus SOME multiples are SOMETIMES justified. It’s only in hindsight that we can be sure which ones and when.

My belief is that if you see a great, high growth business today trading at excessively high multiples, just wait a while. Companies always encounter challenges, go out of favor, make stupid mistakes, and are subsequently punished; often disproportionately. The higher their valuations going in, the greater the punishment. There is no good reason to pay a huge price today for what you will likely be able to buy at a more reasonable price tomorrow; especially when it's possible to find the unjustly punished today by looking elsewhere.

The challenge here is an emotional one. If FEELS good to buy things when they are expensive, because we react to the volume of bidding happening in the market. Conversely, it FEELS bad (stupid, in fact) to hold up your bidding card in an auction when everyone else “knows” that what is being offered is a stinker. Twitter investors at the IPO were able to spot the high potential and great future of an incredible business while investors a few years later were suckers leashing themselves to a lame duck.

SOLOMON ASCH AND THE POWER OF CONFORMITY

Consider the experiment on conformity by Solomon Asch (a great video here: Asch Conformity Experiment - YouTube). Asch presented people with a picture of 3 lines on one side and one line on the other.

The people are then asked, in order, which line on the right, the line on the left matches. The trick is that all but one of the people are confederates placed to influence the response of the lone test subject. Asch found that in 37% of cases people will agree with the group when they identify the (obviously) incorrect line; despite knowing that this is the wrong answer.

Importantly, Asch discovered that if just ONE of the confederates went against the crowd and proclaimed the correct answer, conformity drops to 5%. This second point demonstrates the value of looking for disconfirming evidence when formulating an opinion about something. By exposing yourself to the possibility of the veracity of a view you do not hold, you protect yourself from being overly influenced by the unanimous voices you may otherwise be exposed to.

In financial markets we are not looking at simple line length. There is an endless amount of information that we can draw on in order to justify why line 2 is in fact the match regardless of how much our sense of rationality tells us it’s 1. This is why it’s important for investors to try and have some simple rules they can lean on, especially in times of high conformity (negative and positive manias). If you can limit your decisions as to which line is “correct” to a few simple tests, I believe you will do better as an investor… caveat being that you have superior psychological self control and you don’t choose the wrong line despite clearly seeing that it is wrong - the harder part.

AMAZON, A COUNTEREXAMPLE

Now let’s take a look at a counter-example.

Here is the revenue chart for Amazon:

and here is the corresponding EV/S chart:

Between 2003 and 2008 EV/S dropped by nearly 75%. Yet the total return to the 2003 investor comes in at 5700% while the Dec 2008 investor does only marginally (relatively speaking) better at 6200%. We must factor in the impact of the worst financial crisis in a century which made it unlikely (both economically and psychologically) for the 2008 investor to be comparable to the 2003 vintage. In the case of Amazon, it was almost always incorrect to wait for a “lower” valuation because the underlying business was growing so fast that the seemingly high price turned out to be too low. Amazon in particular acts as a scourge to so-called “traditional” or “value” investors. Of special note here is the influence of Nick Sleep who correctly identified Amazon early and had a remarkable ride. You can read his complete fund letters here, I highly suggest doing so more than once.

Ironically, Nick Sleep’s approach to valuing businesses like Amazon is now frequently used to justify the valuation of some of the most high growth (and high priced) businesses available today. While much of this analysis is correct it often misses one vital point… when Nick Sleep bought Amazon it was comparatively cheap and out of favor. An investor reading his letters will come away with the impression that Sleep is an investor who loathes paying a high price. He bought Amazon not because it’s future growth was so great that even a high price didn’t matter; he bought Amazon because he believed many other great investors misunderstood the way to price it.

The argument of “no, you’re wrong, this company is not expensive because you are valuing it incorrectly” is fundamentally different than “no, you’re wrong, it doesn’t matter how expensive it is because of how much it will grow and dominate the market.”

Back to Amazon.

The major exception to this “it’s better to buy now” approach was the peak of the .com bubble. Investors who purchased Amazon in Jan of 2000 were rewarded with a 4,600% return through Dec of 2020. Investors who picked up the remains in the rubble at the end of 2002 had an incredible 22,800% return. More than a marginal difference.

It’s important to note that Amazon’s underlying growth continued undeterred by the .com collapse. The growth engine remained perfectly in tact, the willingness for investors to pay for it did not.

1998-2000 mania aside, it was almost ALWAYS true that buying sooner rather than later was the correct choice - valuation multiples be damned. Even if you had bought in the beginning of 2000 and held till today, you benefitted from an incredible 19% CAGR. Held from its IPO in 1997, Amazon has delivered an extraordinary 32% CAGR.

This provides healthy ammunition for those in the “great growth at nearly any price” camp. Indeed the longer a great company can compound, the less the price we pay today matters. A company that compounds its revenue at double digits for 20, 30, 50 or 100 years will overcome nearly any high multiple today. However, the risk we take in this case is not one of price, but whether or not we can determine which businesses today are the Amazons of 2040. Additionally, it is very likely that between today and 2040 the new Amazon will fluctuate considerably in price and future investor returns accordingly, as we see in the table below.

Clearly the BEST time to buy Amazon was at the IPO. However the second best time was NOT during the period of growing or maximum euphoria, but rather in the time at maximum depression. Aside from those extreme periods, it was generally better to buy Amazon sooner rather than later.

Thus, if you happen to currently hold an Amazon of the future and you bought it at a reasonable price; it’s probably good advice not to sell during a time of euphoria; but if you missed the initial period, it’s probably good advice to wait until the euphoria turns to depression.

WHAT ARE THE NEXT AMAZONS, TWITTERS AND FACEBOOKS?

We now boldly step into the world of speculation. Investing requires us to have opinions about the future; and as such they are going to be imprecise, questionable and, hopefully not too often, incorrect. I write the following with some trepidation as making public proclamations can distort future decision making, but I find it important to not just rest on the past, but also look at the present and the future.

There are businesses today which appear to me as “inevitables” - companies that are entrenched enough in our behaviors that they are likely to grow considerably into the future. How that growth manifests, how long it lasts and how profitable it is remain to be seen.

Two examples I consider compelling are Spotify and Shopify. Both received considerable attention from investors but as with Facebook and Twitter, surface level multiples are vastly different.

Shopify has an Enterprise Value of $130b while Spotify is about a third of that at $50b. Shopify’s EV/S is around 46x while Spotify’s is around 4.5x. Like Facebook and Twitter, I understand that these are completely different businesses with different profitability potential, potential market sizes, expected operating margins, length of growth and so on. Nevertheless, at a basic level, Shopify investors are much more optimistic about future growth and profitability than Spotify investors are - and arguably more so than Amazon investors were in the heady days of 1998. IF Shopify turns out to be like Amazon, that will be well rewarded, if, however, the trajectory is closer to Twitter (or if there is a multiple contraction the likes of which we saw happen to Amazon in 2000-2002)… the short term may prove quite painful. Spotify investors, on the other hand, could survive a much more modest future growth and profitability picture; and still have a decent chance of a reasonable return (or moderated losses).

This was not always the case, as we can see by gazing at Shopify’s recent past.

At the end of 2018, Shopify investors were only willing to pay 12x EV/S; and this was after 4 years of 60%-80% annual revenue growth and two years of profitability. Are Shopify’s prospects today three times better than they were two years ago? Did the business fundamentally change in 2019-2020? Perhaps.

But perhaps what has changed is the level of excitement in the bidding environment. If I had to guess, I would expect that at some point in the next 3-5 years, Shopify will be available at much more reasonable prices while its core growth engine remains well in tact; and at that point, if its future resembles Amazon, returns could be quite compelling. In my view it is more likely that Shopify today looks more like the Amazon of 1998-2000 vs the Amazon of 2002 onward; but that remains to be seen.

I am unable to predict the future of the market. I have no idea if or when the market will “crash” nor would I attempt to time it. This is not a question of market timing but rather a question of risk management. High growth, high quality businesses are almost always better investments than low growth, low quality businesses - but as we have seen price matters… and some times it matters a lot.

In times of euphoria, human behavior and psychology causes investors to systematically overestimate the future prospect of high quality businesses and underestimate how much the valuation of those prospects will can drop. Conversely, in times of depression that same behavior causes those same investors to underestimate the potential resilience of quality businesses and how much their prospects (and investor willingness to pay for them) to increase.

It would not be unusual or unexpected for a great business like Shopify to increase revenues year after year… for decades… and yet at some point endure a massive reduction in it’s valuation not because of a decay in business fundamentals; but simply because of investor sentiment. Given these prospects, I believe it is better to wait until prices come down.

HOW DO WE KNOW WHAT A “GOOD” OR “LOW” PRICE IS?

But how can we know if prices will EVER come down?
And how can we even know what a low price is?

These are not simple questions nor do they have precise answers. My own view is to look at this through two lenses. The first is a historic and comparative lens and the second is through a market psychology (or rather market participant psychology) lens.

We did some of this above and continue a bit below.

Shopify; when compared to similar businesses in the past and compared to businesses today, is RELATIVELY expensive. However, how can we be sure that Shopify’s 45x EV/S multiple IS the new normal and in the future we will see multiples of 100x with 30-40x being the new floor (for Shopify in particular)? We can’t and this is possible. But investing is a game of probable outcomes. I personally prefer to be defensive and bet that its valuation is more likely to come down substantially and if it does; I am able to acquire the business at a safer price. If it never comes down, I miss out on a great opportunity; but the market will produce an infinite supply. If Shopify’s 45x multiple is the new normal, then why do businesses like Spotify trade for so much less? Is it explained away by complex fundamental analysis or is it also a function of investor psychology? We must each make our own determination, but when differences are so extreme I favor the latter.

At the most extreme we could postulate that this approach will result in never buying anything because great businesses ALWAYS appear overvalued. While this may be true in the future, it has not been a problem in the past. Personal experience in the past 20 years has provided me with three substantial market wide drawdowns where beautiful babies were thrown into the gutter along with the oceans of bathwater; and countless other opportunities at the individual equity level. I am very confident this trend will continue.

The second lens is perhaps more challenging.

Experience helps us calibrate the relative level of mania present in a market environment.

The most critical element here is self-calibration. By example I will state that I “skew” negative and overly skeptical. I am “early” and overly sensitive to perceived euphoria and thus run the risk of believing things are more expensive than they are and more at risk then the future proves. Similarly, I tend to believe that periods of extreme negativity will last longer and go deeper than they do. Knowing this allows me to calibrate my actions such that during periods of extreme negativity (i.e. March 2020) I don’t pull the rip cord and sell everything and, in fact, buy if possible precisely because I know my “gut” is not to be trusted. It also allows me to stay more fully invested in times of my own perceived euphoria (such as now - Mar 2021) and remind myself that things are probably not as irrationally exuberant as they seem.

If you are a more optimistic person you likely have the opposite risks. Whatever the case may be it is critical for investors who engage in individual stock picking to “know thyself” and “to thine own self be true.”

Without this, I suspect pain awaits in the future.

With that knowledge in hand, I believe that in most times there is a “normal” level of mania. The news is constantly full of information and analysis as to why the market looks really good or really bad - and it can fluctuate wildly. Usually there is a reasonable pushing and pulling between “bulls and bears” as they argue whether Tesla is a fraud or the best business ever created; if Microsoft will successfully pivot or die; if Netflix can recover from its disastrous decision to separate DVD rentals from online streaming. Intelligent people armed with technological wizardry have no problem in finding copious objective data that proves their own position correct and the position of their opponents nonsense. Less frequent is that these intelligent agents understand that the picture looks the same from the other side.

During this time buying good businesses at reasonable prices will usually provide adequate returns. A good investor may then be able to pick out a few exceptional cases and profit at some level above those reasonable levels. This proves to be VERY difficult and the statistics demonstrate that most active managers underperform a simple index - especially in “normal” times.

Occasionally an individual sector, company, group of sectors or group of companies will enter a much more rabid frenzy. In the past these things get names like the “Nifty 50” “New Economy” and so on. These buzz words offer us a clue as to how frenzied the environment is.

The classic example for 2020 is Tesla. For Tesla bulls the massive run up is evidence that their thesis going forward is correct. The run up itself provides new investors with the confidence and evidence required to take part in the, now, even more elevated prices. Investors (especially visible, professional investors) who were short get crushed and this feeds a narrative that the old way of thinking no longer works and the new breed of unstoppable visionaries have taken over. Independent of your view on the future potential of Tesla investor returns there is no doubt that they are substantially lower than they were just 18 months ago. It is hard to argue that fundamental changes to Tesla (or the economy as a whole) alone justify the substantial valuation change.

My personal advice (and behavior) is to avoid manias. If I see “memes” or hear my non-investor neighbors making recommendations or a business or series of businesses being associated with things well beyond what they actually do… I stay away. I don’t go short, I don’t go long. I have no ability to predict how the psychological behavior of individuals or crowds will manifest over a period of time. For disclosure I like Tesla cars. I own one and it’s the best car I’ve ever driven. I hope they continue to improve their products and I look forward to potentially buying another. I also like that Tesla has pushed the auto industry into the future by putting substantial pressure to innovate. These are great things.

However, I also believe that Elon Musk is 50% genius, 50% showman and he does and says crazy and unpredictable things. The mania around Tesla stock has been around for a number of years and it has reached heights I could not have imagined - and could still reach much higher heights. I can imagine a world where Tesla is the biggest company that has ever existed, and I can imagine a world where it goes bankrupt. Given those scenarios, I will elect to take the defensive posture and not take a position one way or the other. Should Tesla drop in value considerably while its basic business fundamentals remain healthy (if indeed they are healthy), I would probably take a second look, but generally I find businesses like Tesla very hard to value and I usually just say… no thank you.

SaaS stocks have entered a similar environment; though I believe that the comparison to the .com bubble is not warranted. During the late 90s there was very little skepticism about the “New Economy.” Today I see much more pushback against the high flying, high growth SaaS stocks. I also don’t see uniform overvaluation. There are pockets of companies that have seen substantial increases in their valuation (not explained away by their underlying changes in future potential) and there are ones that have not. I must also caution that how much of this is a difference between now and the late 90s and how much of it is a change in my observation and analysis is impossible to say. I highly recommend looking at different times in history yourself and reaching your own conclusion.

What this means about the future is hard to say. It seems entirely possible that valuations could go MUCH higher and that a “bull market” could go on for much longer that some people believe. It’s also possible a major crash is just around the corner. I don’t know.

What I can do is try and remain calm and patient in proportion to the mania and impatience around me.

My suggestion here is for investors to try and act in proportionate inverse to the level and direction of mania they perceive around them - adjusted by their own calibration.

Thus as I perceive increases in activity and enthusiasm I act with greater skepticism and inaction (i.e. create limits around buying and selling things, treat optimistic forecasts more brutally, etc). As the perceived level of negative activity and pessimism grows, I act with great action and increase skepticism regarding how BAD things will become in the future. This is not a precise number nor can it be. Investors must practice and take time to develop a personal calibration. A great tool for doing this is to keep an investment journal that both records specific actions (I bought/sold x,y on this date) as well as a narrative (I felt this way, this is what I thought, this is why I did what I did). I have done this for some time and it causes both great pain and enlightenment to go back and read it, especially during times of mania (March/April of 2020 are a good example).

I believe now (March 2021) is a great time to do a lot of reading, thinking and planning and very little buying and selling. When an individual company that I may like endures some major temporary correction (either individually or as part of a larger event) that becomes the time to take action. The general level of enthusiasm and mania tends to predict the frequency of those opportunities in inverse fashion. My “gut” tells me that today this is generally elevated, and in some cases specifically insane; but I do not see an environment of generalized insanity - though that may very well lie ahead.

CONCLUSION

The ideas presented here are embarrassingly simple and the analysis very surface level and basic. My goal was not to create a precise way to measure the value or price of companies or to do a deep dive on what Amazon, Shopify or Facebook are “worth.” Instead my hope is that it represents a framework and disposition from which to do such activities. Investing is very simple but also very hard. I believe that often the amount of information and level of detail becomes a tool of our own self delusion - allowing us to convert basic psychological errors into complex numerical analyses. I believe that time is better spent improving and recognizing our psychological limitations than on improving our detailed analytical skills. An investor with very basic analytical skills and superior psychological self knowledge and control will do vastly better than one with superior analytical skills but pool psychological control. Indeed, the worse the psychological control, the more damage the superior analytical skill can inflict.

All the best,

Hermann