How I Invest #2

Continued thinking on the subject

I expect my investment philosophy might change over time, so this section will attempt to capture its evolution. My initial thoughts are here. I hope you find it useful in contextualizing my work.

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What I intend to accomplish governs how I invest. I could index my money and guarantee an attractive compound return. So why spend the time? (And it’s quite a lot of time.)

1. The opportunity exists to do better. Markets aren’t efficient. Enough evidence proves individuals can earn superior returns if they repeatedly demonstrate good judgment and patience. Not easy, but doable.

2. I own the risk of participation. I’m 23 years old. I invest my own money. I can afford to take a risk, and I want to play the game. To my mind, the prospect of long-term outperformance outweighs the possibility of underperformance. A slightly better return, compounded over many years, can produce an order of magnitude difference in results.

3. I believe I’ll succeed. An old saying goes something along the lines of, “if you don’t think you can win, you’ve already lost.” The stock market is a competitive marketplace, but the quality of my judgment will ultimately determine the level of my success. I have faith in my ability to do well.

4. I enjoy the game. Some play the game professionally. I don’t — so I’m free to walk away at any point if my reasoning changes. But it likely won’t. I enjoy the competition, the challenge, the psychology, the research, and the real-life stakes.

Away from the index

The last few years have seen a drastic change in my approach to investing. I went from indexing around 70% of my money, dabbling in individual stocks, to 100% concentration in six companies (two representing >60% of my portfolio).

Two factors influenced this change: greater confidence (having had a few years in the game) and an improved opportunity set (or at least what I perceived as one). Said differently, I learned how to handle my emotions in the context of the market, and I discovered compelling arguments where I was (am) comfortable parking money for an extended period of time (call it 7-10+ years).

Some of you might think this concentration comes with excessive risk. Fair. But diversification naturally drives towards an average outcome — exactly what I’m trying to avoid. Concentration heightens the range of possible outcomes, which I’m fully comfortable with. Real risk can only be known with hindsight. I expect the concentration and duration of my investments to be the difference-maker in my returns over time.

Confidence

Throughout this shift, I’ve continually wrestled with the fine line between conviction and foolishness. The wisdom of my decision is impossible to know in advance, but it requires a steady commitment nonetheless.

To be a great investor, you have to be confident; disagreements are inevitable. But you can’t be too confident. You have to be acutely aware of the limits to what is knowable and willing to change your mind when the facts change.

But what are the “facts”? When do they change? How do you determine if it’s time to double down or throw in the towel?

These are challenging questions — every investor can answer differently. The “facts” are whatever you believe them to be; the story is what keeps you at the table. This is the inherent difficulty of investing (felt most acutely by those, like me, who lack experience): you have to make decisions under uncertainty.

Remember Bill Ackman’s experience with Netflix. He bought over $1 billion worth of shares in January 2022 for what was intended to be a long-term investment. Less than three months later, he sold the entire stake at a $400 million loss. His opinion was the facts had changed, the story didn’t hold up, and the answer was to sell.

But the facts didn’t change, despite appearing to at the time, and the story remained intact. Today, his investment would be worth ~$1.5 billion. This isn’t to pick on Ackman — his track record speaks for itself — but it’s one demonstration of the difficulty and uncertainty involved in every investment decision. Even the greats make the wrong decisions.

What I’m getting at is simple: There’s no science to the game, and answers are rarely found from an examination of the most recent quarterly report. Investing is a game of judgment, and you’ll undoubtedly be wrong from time to time.

Embracing this fallibility is important, at least to me. Recognizing mistakes are inevitable means I’m more comfortable standing by my judgment when others question its wisdom. Why would they know the future any better than me? At least this way, when I’m inevitably wrong, I’ll be wrong on my own account — not because I took someone else’s ideas for my own or caved in to the pressure of the market.

Besides, if you’ve done the work, it pays to be confident. Trusting your judgment is a prerequisite to long-term investing success, though it’s equally important to recognize it’s all part of a maybe-futile exercise in predicting the future.

Ultimately, there is no solution to our dilemma. We have to tread that fine line between conviction and foolishness and simply do our best to accept and integrate valid counterpoints to our arguments.

This is what I consider doing the work: after developing an argument, we have to continuously seek new information to disprove that thesis. Only doing the work provides a reasonable basis for confidence in our judgment.

Long duration arguments

Long duration arguments with the market differ from short-term arguments. Long duration arguments involve a core misunderstanding around the durability of a business. Short-term arguments involve a disagreement over what will be reported vs. what is expected by the market in the near-term.

Short-term arguments can be lucrative and a source of rapid returns. But they add complexity. And frankly, who cares about next quarter or next year? For those of us who are more fundamentally-minded and investing truly patient capital, we’re talking about impacts to 1-5% of the intrinsic value of a business. The terminal value is the ultimate arbiter of value.

If a significant adverse development occurs that’s likely to impact the long-term viability of the business, that changes the story. But if the company misses consensus for the quarter, who cares? How many times has Apple missed estimates in its life as a public company?

Short-term arguments are not my game. My game attempts to minimize the number of inputs to a decision and focus on the few that matter. Long-dated arguments take years to manifest in the market’s opinion of a company and require a certain commitment to what may be a controversial take at the time.

Long duration arguments are simple at heart. My thesis in Planet Labs is predicated on a basic idea: the market fails to appreciate the compounding value in a daily scan of the Earth and the advantage conferred on the only (first) player to operationalize the capability. It’s an argument for the undervaluation of long duration growth. Only time will reveal the validity, but I’ll be along for the ride.

Costco is a more concrete example of a successful long duration argument. For a long time, it was a low-margin retailer with a limited SKU count. But what was commonly interpreted as the bug turned out to be the defining feature of the business model. The case with Amazon is similar. For years, it was an unprofitable online retailer with no competitive advantage. Only later did the market discover its source of durability came from a confounding level of investment in its fulfillment network.

The market often makes these mistakes with unique companies. Its viewpoint is bound to the expectations embedded in consensus analyst forecasts. If those forecasts are not met, the impact is extrapolated to a longer period of time. But one quarter or one year rarely impacts the long-term durability of free cash flow.

Operating from a different perspective

To develop an argument, I take the exact opposite view of the market. Rather than ask the same questions, I come up with my own and pursue them to an end. I build a unique viewpoint based on those questions and compare that to what is commonly accepted by the market. If they’re the same, it’s onto the next idea. Playing someone else’s game is not a recipe for making money. But thinking from a different perspective, and a longer-term one, just might be.

Instead of applying a magnifying glass to the quarterly report, I zoom out. I recognize its (in)significance in the broader context of the company’s lifecycle. Where is the market’s attention focused right now? What might be missing from that lens? What’s unique and/or misunderstood about the opportunity?

This philosophy comes after several years of experimenting with short-term arguments and plain old guesses. It suits my unique circumstances, given a multi-decade investment horizon, and I’m confident this approach will produce acceptable results over time. But not too confident. Things can change. It’s a probability game after all — everyone’s just playing the odds.