Sleep Well At Night

SWAN – That’s our rather unimaginative acronym for our style of investing: Sleep Well At Night. Our investing style is long-term, focused, and calm. We don’t trade a lot. When we invest, we intend to hold on to the position for 2-3 years, if not more. And we pick carefully – we aim to hold only 20-25 stocks in our portfolio. This strikes the right balance between depth of research and diversification of risks. More on Risk in the sections below.

Now, you may think that this is sleepy investing, which probably means low returns. It doesn’t. Our goal is to achieve 10-15% Annualized Returns over the long-term. So far, so good. But is this possible? High Return with Low Risk?

It’s not only possible, but it’s the only way we’d have it. We’re not adrenaline junkies. We’re not looking to make a quick buck. We will never play the musical chairs game of betting on what other people may think tomorrow. We like comfort. We invest in comfortable businesses at comfortable prices. So, we sleep well.

How do we do it?

Black Swans are everywhere…

…we just can’t see them. The concept of Black Swans was conceived by the philosopher David Hume, but it was popularized by famous author Nassim Nicholas Taleb – he wrote a whole book on it after the Great Financial Crisis of 2008/09. But even before he did that, he quickly explained the concept in his outstanding first book, Fooled by Randomness:

“In his 'Treatise on Human Nature', the Scot philosopher David Hume posed the issue [of induction] in the following way: ‘No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute than conclusion’.”

The fact that we’ve named our process SWAN Investing recently (after consistently describing our flavor of investing as sleep-well-at-night) is not inspired by Hume’s concept of The Black Swan. Hume (and Taleb) used the analogy to bring our attention to unknown risks – the ones that we don’t know about because we’ve never seen them. The analogy, as interpreted by Taleb, is about Risk Management. Serendipitously then, there is a connection between his concept and our little acronym.

First and foremost, SWAN Investing is mostly about Risk Management. If we want to sleep well, we need to minimize Risk as much as we can. We define Risk as “permanent loss of capital”. This happens when we don’t know what we’re doing. When we don’t know what we’re doing, it’s a game of musical chairs. There is no way to tell when the music stops.

“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.” – Warren Buffett

Our definition of Risk – of losing money because we don’t know what we’re doing – is not the industry standard. Wall Street, taking a cue from academics, resorts to fancy definitions like Standard Deviation, Value-at-Risk, Conditional-Value-at-Risk and so on. None of them capture Black Swans. They actually reinforce the ubiquity of White Swans because they’re based on past data. This is dangerous.

We operate with the notion that Black Swans are everywhere. We can’t quantify that risk, but we can do our best to steer clear. We operate with the humility that no amount of research or fancy models can capture all states of the world or all scenarios – replete with probabilities and magnitudes – and spit out a “true intrinsic value” of an asset. That’s impossible. We fully concede that there will always be an element of “we don’t know” in any investment decision. Our job is to minimize that, and account for any “unknown unknowns”, so we can sleep well at night. Black Swans are unknown unknowns – technically we know that they exist, but we don’t know anything about them in terms of the probability or magnitude of their wrath.

“In my investing career I operated on the assumption that all investment theses are flawed…The fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced. The point was made by John Maynard Keynes when he compared the stock market to a beauty contest where the winner is not the most beautiful contestant but the one whom the greatest number of people consider beautiful.” – George Soros

There are 3 ways in which we account for Black Swans:

1. Thematic Research
2. Margin of Safety
3. Expectations Investing

Thematic Research is often seen as a “top-down”, pie-in-the-sky thinking. But that’s not why we do it. We do it, first and foremost, so we don’t play the wrong sport. Secondly, we look for Positive Optionality – the prospect of massive upside at low downside risk. And third, our Thematic Research informs our bottom-up valuation of a company. We like data and context when we estimate a reasonable price. Speakin’ of which…

We’ve taken Soros’s theory, “…all investment theses are flawed…” to heart. Intrinsic Value is a mirage – because nobody knows all the moving parts well enough to accurately predict the future. Nobody knows where the Black Swans are. But we know they’re there. So, we take Buffett’s suggestion and always apply the Margin of Safety principle.

Margin of Safety refers to the idea of always buying something for much less than what it’s worth. Margin of Safety = What something is worth minus What you pay for it. Simple enough. But the concept assumes that we know what something is worth. Since all investment theses are flawed, we don’t really know what something is worth. So, how do we apply a Margin of Safety?

We reverse-engineer the process.

Expectations Investing

We ask ourselves, “would we buy this stock at current prices?” We would, if there is enough Margin of Safety. But we don’t know what the stock is really worth. No problem. Let’s assume our requisite Margin of Safety – we usually require 30% - and tack that onto the current price. So, do we think this company/stock is worth current price + 30%? For example, if a stock is trading at $10 today. Do we think this company is worth $13/share? If so, it’s a buy.  

The answer to the question, “do we think this company is worth $13/share?” is subjective. But it involves some computations. Using $13 as our starting point, we back into: Revenue Growth baked into the price. Now the question changes to: “do we believe that this company can increase revenue at this rate?” To answer that question, we make some assumptions about a company’s cost structure and continuity in its capital allocation decisions. This is exactly how our Watch List is set up. More on this later. Ultimately, the answer to the question is highly subjective.

The answer depends on 3 main factors:

1. Thematic Vectors:
   • Is the company playing the wrong sport?
   • Is there a chance of a massive thematic tailwind propelling future revenues?
2. Durability of Competitive Advantage:
   • What is the company’s competitive advantage?
   • Does it have an Economic Moat?
   • Will the company survive an onslaught of competition? Why?
3. Management Quality & Strategy:
   • What is Management doing to fortify competitive advantage?
   • What is Management’s strategy to increase revenue?
   • What is the strategy to control costs (operational and capital) and make the business more scalable?

These are factors we research and analyze for days before we make an investment decision. It starts with a top-down view of the world and the market. But the bulk of the analysis is very much bottom-up. You’ve probably noticed that each of the factors listed about Risk Management. Well, we like to sleep well at night.

We like to invest in Comfortable Businesses at Comfortable Prices. A Comfortable Business:

1. Plays the right sport – thematically
2. Has a durable competitive advantage, which means it will thrive for years to come
3. Has a clear, believable strategy to remain in business and win in the sport its playing…

A comfortable business usually trades at an uncomfortable price. But, occasionally, it trades at a comfortable price IF the “revenue growth we need to believe” to buy the stock at its current price is reasonable. That’s our key metric. Since we have the humility to say we will never know the intrinsic value of a company (we can calculate it precisely but not accurately – nobody can), we flipped the question.

“Invert, always invert.” – Charlie Munger

Expectations Investing (conceptualized by Michael Mauboussin) releases us from the arrogance of “calculating the intrinsic value” of a company and its stock. Instead, it allows us to be more nimble and more reasonable in our approach. It allows us to account for the Black Swans that we know are out there. It also guides us towards investment opportunities with the best Return/Risk ratios.

“The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.” – Howard Marks

To us, low Risk is about protecting the downside – minimizing the cost from not knowing what you’re doing – without sacrificing the upside. The upside is that 10-15% Annualized Return number we need. We need to maximize the probability of achieving this return as best we can. This is the last step.

Pari-Mutuel System

We’ve realized from experience and observation that the best chance of winning – achieving our return objectives – comes from investing in businesses which have two attributes:

1. Their stock prices have believable growth stories baked into them…and….
2. Their businesses are scalable – they have operating leverage built into them…

Operating Leverage – high fixed costs, low variable costs – is still an underappreciated metric in equity investing. But it’s super-important for winning. While revenue growth may be top of mind for most investors, Free Cash Flow growth is usually an afterthought. Yes, we’re surprised too. If a business has operating leverage, meaning that as revenue grows most of the costs remain the same, its Free Cash Flow growth is likely to surpass its Revenue growth. This is underestimated in the market for two reasons:

1. Short-termism
2. Linear Thinking

This “blind spot” is an opportunity to maximize our chances of winning. Let us explain this concept using a couple of observations from two legends of investing.

Recall Soros’s observation, which we quoted earlier:

“In my investing career I operated on the assumption that all investment theses are flawed…The fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced. The point was made by John Maynard Keynes when he compared the stock market to a beauty contest where the winner is not the most beautiful contestant but the one whom the greatest number of people consider beautiful.”

To put it bluntly, Soros tells us:

1. “Intrinsic Value” doesn’t matter.
2. You win if others like what you have.

If we may be so bold, we think Soros’s observation is correct – in the short term. In a long-term scenario, we think Charlie Munger has a much better analogy:

“To us investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”

How do we look for “a horse with one chance in two of winning and which pays you three to one”? In our experience, it’s the horse that has:

1. the most believable growth stories baked into their stock price…AND
2. the most scalable business with the highest operating leverage…

In the long run, that’s the horse we should bet on. For the sake of diversification, we’ll bet on 20-25 such horses with the best odds of winning. They’re hard to find. But that’s why we do the work. We don’t spray and pray. We bet, with a lot of deliberation, so we can sleep well at night.

Best chances of winning + Low chances of permanent loss = Sleep Well At Night Investing. 

Many Happy Returns.