What if Something Good Happens?

The case for patience and optimism

Photo by Nathan Dumlao on Unsplash

The following is an excerpt from a letter sent to clients a few years ago that I think has evergreen ideas. Re-sharing this post is especially timely, given all of the cloud hanging over financial markets—and the world for that matter.

If there is any stereotype about value investors that is almost always true, it is that we are early. While we may not show up to meetings on time and occasionally forget that we had a call—and thus show up late—when it comes to putting money to work, we tend to be early. Specifically, we get excited about stocks that have come down a fair amount and buy them with a large margin of safety, but well before they bottom. Or, we get nervous about stocks that have appreciated meaningfully, especially when the value approaches the conservative “base case” we originally underwrote, and thus sell them long before they reach their potential. It occurred to me recently that both of those tendencies regarding being early are at least some extent tied to the same behavioral bias: anchoring. For those of you who don’t go around identifying and quoting common investment biases, anchoring occurs when we form a specific reference point (a price target for a stock, for example) and then our subsequent decisions and actions are highly influenced by that anchor. A brief example might be helpful here. Let’s say that you buy shares of Anchor Specialty Products (Ticker: ANCHR), a company that produces best in class anchors for large ships. (Not a real company by the way.) In the process of your due diligence, you inevitably come up with a price target or some estimation of the value of the company. Given the amount of work that goes into that process—both qualitative and quantitative—whatever that number you came up with would be highly influential and likely to become a reference point or anchor that you might find quite challenging to move away from. In other words, even if the facts and circumstances had changed, if the shares of ANCHR hit your original price target, the anchoring bias might contribute to you selling the shares far earlier than you should.

Now, there are a number of relatively straightforward ways in which to counteract the desire to sell a stock simply because it hits your pre-determined price target or value. First off, you could ask yourself what John Maynard Keynes would do in such a situation. Whether Keynes ever uttered the phrase “When the facts change, I change my mind. What do you do, Sir?” is almost irrelevant. The concept remains very important for investors. As Philip Tetlock discussed at length in his great book, Superforecasting, the best handicappers and forecasters adeptly adjust their perception of the likelihood of various outcomes by incorporating new information as it comes in. From an investment standpoint, what that requires is updating your qualitative assessments and quantitative models of a company as you learn more and as events occur. If the facts change in a positive manner, you update your estimation of intrinsic value accordingly. Of course, there is always a risk of extrapolating current success into the future while ignoring the transiency or cyclicality of results. In that case, there is the risk of overvaluing the company and watching the stock become what is lovingly known as a “round tripper”.

But honestly, I haven’t found that to be the most pressing issue. I actually think most value-oriented investors, myself included, have the opposite problem. We are unable to hold onto true compounders for a variety of reasons, with maybe the most salient one being that we undervalue the company relative to its long-term prospects. We have heard the phrase that “no tree grows to the sky” too many times. And, we have so deeply internalized the massive drawdowns we have seen when growth darlings inevitably disappoint that we underweight the probability that we have identified one of those great companies that can continue to grow its revenue and cash flows—and become far more valuable than we first imagined.

Taking a step back, there are right and wrong reasons to sell too early. The right reason to sell too early is to mitigate the downside risk in what we would call a Graham stock, a mediocre business that is bought at a large discount to intrinsic value—with the intention of selling it when some of the gap between the value and the stock price has closed. If you own one of these stocks and you were right about mean reversion or a cyclical recovery, you might be fine missing the ultimate top in the stock because you believe (or know from experience) that the company doesn’t have compounding characteristics and is simply a good “trade” at certain points in its lifecycle. In this case, you would rather sell too early and put the capital to work elsewhere than try to eek out the last 10% gain in the stock.

The wrong reason to sell too early is tied to anchoring but also to another insidious psychological bias that I will call “inability to embrace your own success.” Value investors are, by their nature, contrarians. They often buy things that other people are selling—what Warren Buffett calls being greedy when others are fearful. On the other hand, they tend to sell things that other people are excited about—what Buffett calls being fearful when others are greedy. I have learned over the last decade that, at times, innate contrarianism can have its drawbacks. The reason is that if you own a great business that is performing well, has long-term secular tailwinds, and is managed by great people, the last thing you want to do is sell that business just because it hit your likely-too-bearish price target or because you are nervous that there is a cliff around the corner. In other words, it pays to actively consider what you would do if something good happens.

However, in my experience, embracing investment success can be hard for contrarians. Congrats, you picked a stock that has done everything you hoped it would— and maybe more. In that situation I think a lot of people, (again, myself included) would start to get really worried about the fact that other people are seeing what I saw in the company. The contrarian knee-jerk reaction to being proven right and having other people agree with you is often to take the other side and start trying to exit the investment. People assume that failures are harder to deal with than is success, but I would argue that it’s frequently easier to learn from your mistakes than it is to embrace your success. This is especially true for those of us who did our undergrad at the Benjamin Graham School of Cigar Butt Investing and then later did a Masters in Compounding at the Buffett School. The ghost of Ben Graham and the inherent pessimism about the world associated with that is hard to escape from completely.

What can be done about that? As I have discussed before, successful investing has a lot to do with controlling your own emotions and biases—and being intentional about it. In other words, recognize a bias and proactively try it mitigate it. I don’t think there is a silver bullet solution (there rarely is) to alleviating the “embracing your own success” bias. However, I do think there are a few things that come with experience that are most certainly helpful. The first is patience. I would argue that the main benefit I have derived from being the host of the Compounders podcast is that I have heard from dozens of Chairmen and CEOs about the value of being patient as a leader and as a capital allocator. Cultures, businesses and people take time to change and thus outside investors must understand that immediate results are quite unlikely to appear. My takeaway is that I should be more patient with stocks that “work” and with those that go down after we buy them. Having infinite patience is usually a mistake, especially in situations where things are not going well. But, a prudent amount of patience is required before you declare success or failure in any investment.

The other solution, which may be directly tied to patience, is to develop the ability to be content with inaction. The investment world is full of people who are predisposed toward action. What else is the endless chatter on CNBC and the entire universe of people trying to predict and then trade of off quarterly earnings about? The idea of “letting it ride” might sound like a very SoCal mentality but I think there is a lot of merit to letting your investment premises play out without feeling the need do something. A stock goes up a lot and is now slightly above the weighting in the model? Just chill. Or, a stock is down from where you bought it and the discount to intrinsic value is even larger. Then buy a little more. Or don’t—the stock doesn’t know or care that it went from a 5% weighting to a 4.5% weighting. My point is that the ability to balance your innate contrarian reactions with the ability to do nothing is likely a required skillset as it relates to consistently besting a very difficult to beat stock market.

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There is not a lot I would go back and change in this piece. In fact, the more compounder-oriented managers I have interviewed, the more I think that Seth Klarman, who was channeling Ben Graham in his book Margin of Safety, may have inadvertently led an entire generation of value investors (again, myself included) into being too worried and pessimistic. The answer, as always, is to be balanced. Upon re-listening to the Compounders interview I did with Bo Knudsen of C Worldwide, I was struck by how unconcerned he was about short time valuation metrics as well as his willingness to be patient. He suggested we focus more on the company than on the valuation because good companies that have what he called deep domain expertise, do indeed find a way to create value in unexpected ways. C Worldwide’s successful investment in Novo Nordisk is an example of that. Who says we can’t all have a mini-Seth Klarman sitting on one shoulder and a tiny Bo Knudsen sitting on the other? Let them battle it out until we find securities that offer substantial upside in an optimistic scenario and a margin of safety if things do not go as planned.

I am writing this in the middle of the busiest earnings release week of Q3 2023. Each day this week I have had a stock up 15% or down 15%, and one one day I had three stocks that experienced moves that large. Clearly, the intrinsic value of companies doesn’t change that much in a day. But that is not news to anyone who focuses on businesses more than on stock prices. But in watching all of this happen, it occurred to me that, in anchoring to the volatility of public markets, investors inevitably begin to think these movements are normal—or better said that public equity volatility is the standard we use to evaluate and compare all other asset classes. I would argue the opposite. Maybe the lack of volatility in the value of a private business each 90 day period should be what all investors consider “normal.” PE firms are only volatility laundering relative to a manic stock market.

Ben Graham taught us about the moodiness of Mr. Market and suggested public investors take advantage of his swings between fear and greed. It would seem to me that Mr. Market’s mood swings are there to serve private equity investors with stable capital bases and 7-year fund lives far better than a typical public equity investor who has neither of those. Plus, the structure of private capital makes those investors well-suited to benefit when something good does happen with their companies because they aren’t necessarily under pressure to sell and no consultants are bugging them about why a certain position has become X% of the portfolio. They can do nothing for a long time without looking silly or wrong. What an asset in a world where public market peers’ returns are evaluated every quarter and each day the market tells them what it thinks of their stocks.

In closing, I have a developed a new appreciation for any investor who is not only positioned to pounce when people are despondent but also has a runway to embrace success. That would seem to solve a lot of the issues I discussed in the original piece shared above.

Trying to become better at befriending volatility,

Ben Claremon