Unchanging Truths

Many of us have seen some variation of the following advertisement for an online brokerage: A well-dressed businessperson stands on a busy metropolitan street corner mid-day, carefully surveying the scene.  This person, acutely aware of their surroundings, notices what others presumably do not… that an abnormal percentage of people are wearing the same brand of shoes, a brand that is a new entrant to the market!  With a slight smile on their face, this very-observant individual logs on to their trading account via their smartphone and buys shares of Company X, the maker of the hot new style of footwear.  The ad cuts off there, but we are left to imagine the rich rewards undoubtedly awaiting Mr./Ms. Observant.

Or perhaps you have seen the recent advertisement featuring actor Matt Damon encouraging people to invest in cryptocurrencies.  He walks past multiple images in the ad, including a climber summiting Mount Everest and the Wright Brothers, before stopping next to a picture of Mars.  He then encourages investment in crypto by saying, “Fortune favors the brave.”  The message is clearly, take a chance by being an early adopter and ultimately become a hero!

I guess you could get lucky standing on a street corner looking for new trends or investing in crypto, but I also am not suggesting you give it a try.  At Provident, we spend much more time at our desks researching companies than on the streets looking at footwear or trying to uncover the next Dogecoin.  However, the approach suggested by these types of ads highlights one way to make money investing—identify a trend, get in early, and ride the wave as others gradually come to the same conclusion.  I would argue this is not the best approach to maximize risk-adjusted returns, but it can work.  If one identified Amazon as a key driver/beneficiary of the secular trend toward e-commerce in the late 1990’s, bought the stock and held on, they have been handsomely rewarded.  Of course, holding the stock over that time would have required an iron stomach due to the volatility, but the point still stands.  Other, similar stories where investors felt they were on the front end of a trend have often not worked out quite as well.  For example, see AOL, eToys.com, and Theranos.

Speaking of change and Amazon, Jeff Bezos has said: “I very frequently get the question: ‘What’s going to change in the next 10 years?’  And that is a very interesting question; it’s a very common one.  I almost never get the question: ‘What’s not going to change in the next 10 years?’  And I submit to you that that second question is actually the more important of the two.”

This is a very interesting statement coming from somebody who has quite clearly been a beneficiary of change.  Bezos did tie the “what isn’t going to change?” question back to Amazon by indicating you can build a business around things that are stable over time, and he built Amazon around the immutable consumer desire for low prices, fast delivery, and vast selection.  I bring up Bezos’s comment because I generally believe it is important to understand what is also not going to change in investing.  Knowing what is unlikely to change, or what is likely to change more slowly than most expect can also prove a valuable, though less glamorous, insight.  Try making a commercial of someone coming to this conclusion.

This is an unproven personal belief, but I lean toward thinking there is a tendency to overestimate the pace of change versus what actually occurs.  I feel there are occasional bursts where change significantly accelerates, but in the interim change occurs more slowly than generally believed.  The difference between consensus expectations and reality is where the rubber meets the road in investing, and money can be made finding business models that are more durable than the market believes.  This is where figuring out what isn’t going to change can really pay off in analyzing individual companies.

It is also applicable more broadly.  Given some of the wild market activity over the past year, punctuated by “meme stocks,” NFTs, and cryptocurrency, some believe perhaps the game has changed for investors.  Maybe it has.  However, I’m fairly certain another thing that isn’t going to change anytime in the foreseeable future is that companies are ultimately worth the sum of their future cash flows discounted at an appropriate rate.  It has been true forever and it will be true going forward.  There is no new, trendy way of appropriately valuing assets.  The art is in figuring out how large those cash flows will be, when they will arrive, and the appropriate discount rate.  These are impossible to guess with complete accuracy, but happily total accuracy is not required to result in successful investments.  Plus, the process is more repeatable than looking for “once-a-decade” game-changers.

This leads to a couple of final points.  First, the meme stocks that soared to fantastical heights a year ago could ultimately prove worthy of the valuations the market has assigned, but I can say with near certainty they are not worth it based on their current business models. The cash flows for most meme stocks simply don’t come anywhere near justifying it.  That doesn’t mean these companies can’t start some wildly profitable new line of business, but that is what will be required for shares not to ultimately go meaningfully lower.  Secondly, fundamental research can lead to peace of mind when markets get turbulent.  Markets have sold off to start the year and Fed tightening could lead to more volatility than we have seen in the recent past.

The stocks we have invested in have been purchased for fundamental reasons, because they typically generate solid, growing cash flows and we find the discounted value of those future cash flows attractive relative to the current price.  We won’t always be right, but adhering to this unchanging truth usually works out better than investing in something requiring unusual bravery.

James M. Skubik, CFA