5 Lessons I’ve Learned The Hard Way
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I’d like to take this week to share some lessons I’ve learned the hard way.
Investing in unprofitable companies exponentially increases your likelihood to lose money
With any of these lessons, you’ll find exceptions. But notice that I didn’t say you can never make money on a company that is losing money. Maybe they truly are reinvesting because the opportunity set is amazing. But I’ve also found that the narrative around losing money is strange. Did you know Amazon has had positive cash from operations every year since 2001 and GAAP profitability for the past 15 years? People have different definitions of profitability, some use free cash flow, some use GAAP net income, some use adjusted EBIT, whatever it is – if cash is going out the door that means the jury is out if the business is actually good or not. If you can’t bring in cash, you have a charity and not a business. If the business itself can’t make money, why do you think you, as an investor, will make money?
At the very least, the company should be cash from operations positive. If they have to continually spend money on capex and there never is any true free cash flow, then that should be worrying. But cash from operations is a very pure number in a lot of ways. If there is excessive stock-based compensation, it’s also important to track share dilution as that is a real cost.
Like I said, everyone will have a different definition but cash from operations is a baseline and the ideal is still profitable after stock-based comp so GAAP profitability. You should look back at Google or Microsoft’s S-1’s – they were insanely GAAP profitable. The truly great businesses will make money. The cash burners like Uber and a lot of early software companies may be great at scale but they also benefited from the timing of cheap capital. It’s hard to say if Uber would be pumping out cash like it is if they were profitable from Day 1. They knew the network effect was of utmost importance so they made the trade-off. But Lyft did the same thing and just didn’t quite have the same brand strength. The point is that there are always exceptions but the truly great ones can charge what they need to because the product or service is so much better than existing alternatives.
There is information in the price of the stock but don’t let it fool you
The market isn’t dumb. Mr. Market can get excessively optimistic and unnecessarily pessimistic at times but for the most part, he isn’t stupid. The price of a stock can sometimes carry important information and other times, it can trick you. Doing your homework will tell you the answer as to which is likely to be the case. If a stock is constantly hitting all-time highs, maybe you should take another look as other people are clearly seeing something exciting. Likewise, if the stock can’t stop going down and you have no idea why, then that should be extremely worrying. If you can explain why the stock is going down and you think the reasoning isn’t solid, only then can you double down. But even still, you might be missing something. This tension between humility and conviction is the essence of wise investing. But if we’re constantly at the whim of the stock price, it will be very difficult to be long-term. Your criteria has to fit your time horizon. If you are a day-trader, then your criteria has to be daily price action. If you have a decades-long viewpoint, you can’t have the same criteria as that day-trader. You’re playing a different game. Your criteria has to be the durability and depth of the competitive advantage and the quality of the people at the company. But to completely ignore price action, I’ve come to find, is an act of hubris. The price action may be trying to tell you something. It could certainly be wrong, but using it to your advantage – to peak your curiosity about stocks that are going up a lot and down a lot – can be fruitful.
All that matters is the future
This could be an addendum to point #2, but just because a stock has gone up a lot doesn't mean it’s a bad investment and vice versa, just because a stock has gone down a lot doesn’t make it a good investment. By and large, the thing that makes something a good investment is the earnings trajectory of a business. If the first thing you do is pull up a stock chart and see that a stock is up 100% YTD, that should intrigue you rather than disappoint you. It’s all about curiosity rather than preconceived notions. If the earnings of that business are up 200%, then the stock actually got cheaper over that year. Ultimately, all that matters is the future but the past and present have information in them that should peak your curiosity. There is a premier venture capital firm, Benchmark, that often talks about how seeing the present very clearly is better than trying to predict the future. I’ve found that to be true as well. Practically, that looks like following the money. Where are customers spending lots of money and how is that showing up on company financial statements? But it isn’t always that simple. Sometimes, there are short-term demand boosts and one-off events so it’s important to investigate further and look into the durability of the earnings. Not all earnings are created equally. A 90%-of-revenue customer may be ramping up but they could stop ordering next year. Or global pandemic could occur (cough Zoom cough). Or interest rates were low (cough Upstart cough). (Remember – these are lessons learned the hard way!)
Trust in management enables long-term holding
Businesses are just collections of people. Moats don’t create themselves. People create products and services and then moats form over years of customer habits and ecosystems that coalesce around those products and services. I don’t think it’s the norm for someone to say they want to create a business for the sole purpose of a network effect or switching cost. Moats and financials, for that matter, are outputs. The inputs are the decision making, work ethic, and circumstances of people in those businesses. So if you can’t trust the people, you can’t trust the inputs to the very things that drive long term stock prices – moats and earnings. Buffett says that he’d rather have a strong business that could be run by a monkey but trust in people is one of his primary criteria. When he says that I think it speaks more to bad businesses and how even extremely talented people likely can’t turn them around.
Gaining trust is a process. Practically, I try to match up what management teams say and what actually happens. It’s hard to predict the future so it’s important to give them leeway but if they say they don’t need to raise money and then they raise money a couple months later (cough Alarum cough), then it’s hard to trust them. The guidance game is a form of this too. If management guides for one thing to keep the stock price up and then results come in much lower, they either are in a fragile business, they don’t know their business well, or they are stretching the truth.
It’s amazing how much information is out there. Between interviews, 10-k’s, transcripts and social media there are a lot of sources to match up words with actions. I’ve found that to be a much better form of gaining trust in public markets than speaking to management teams. To become a CEO/founder you honestly have to be a tad delusional because starting and successfully running a business is so difficult. So oftentimes the CEO isn’t lying, they just genuinely believe their excessive optimism. In fact, they HAVE TO believe in themselves or they wouldn’t be where they are. Layer in charisma and it’s awfully hard to not get sucked into the orbit of an amazing CEO. The difference between the great ones and the ones that can’t be trusted is long-term moats and earnings power. So, in a sense, public markets are easier because so much information is already out there. Venture capitalists that don’t have financial statements must make judgment calls and therefore deserve to get compensated for that risk.
Where the huge money is made is where the exceptions to all of these lessons come together. If you truly know the CEO and have built a relationship but there are external circumstances that appear to diminish trust, then when people come to trust him or her later, you will reap the reward from the change in the earnings multiple. In a way, a P/E ratio is like a trust indicator. A very high multiple means that market participants trust that company a lot. So if you can build trust before others, that’s where big money can be made. Likewise, if the stock goes from losing money to making a lot of money, that is where serious multi-baggers can come from.
It’s more about the direction than the absolute
Continuing off the last paragraph, big money is made in the directional change rather than the absolute. If everyone knows something is a good business, there is less room for a big move. That’s not to say that good businesses can’t be good investments – time is the friend of an amazing business. It’s just that when something goes from being hated to less hated you can make money and you can lose money when something goes from extremely loved to just loved. It’s more about the direction because the market is a pari-mutuel system, meaning that the expectations of the game is just as important as the actual game. So a company that grew revenue 15% but last quarter grew by just 5% could be a much better investment than a company that grew revenue 30% but it dropped from 50% in the previous quarter. Expectations matter.
This applies to the macro environment as well. The trend in interest rates can matter more than the actual amount. Or the growth rate in GDP may matter more than the absolute. Understanding the drivers of acceleration or deceleration is key to understanding if a trend is sustainable. I’ve been awed by how many times the thesis of one business segment that is growing faster than the overall business surprises the market when revenue accelerates. Maybe it’s because the algos haven’t yet figured a way to use natural language processing to arb that out yet or maybe they’ll figure it out real soon but the direction matters more than the absolute.
I could go on and on (since I’ve made so many mistakes), but that’s it for this week. Onwards and upwards. Now the important thing is to not make the same mistakes again. If we do that, the results will inevitably follow.
All the best,
Ryan
You can also read the Q3 Infuse Partners letter if you’re an accredited investor. We include a write-up on a small company we were actively buying during the quarter.