Catching Knives, The Myth of Cash on the Sidelines, & Conviction Investing
Market Talk, Edition 73, April 16th 2023
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Recent posts: Memos I have shared since the last Market Talk.
Stanley Druckenmiller at The Lost Tree Club (here)
(NASDAQ: KRUS) A Hole in the Pocket (here)
(NASDAQ: KRUS) Five Days Later (here)
Four editions of Charts Charts Charts (here)
What's On Dimon's Mind? (here)
Slowing Down (here)
Buffett gives the seal of approval for Japan (here)
Comments from Me
After pollingwhether I should create a separate category within Investment Talk for journal notes related to companies I follow instead of having a separate newsletter, you told me that most of you want them in the main newsletter or that you are indifferent. A surprising number of you like turtles also. I listened, and have created a new section for those types of essays.
5x Must Reads
Here are 5 pieces that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.
1) Giverny’s Annual Letter
Source: (Giverny Capital)
François Rochon, the founder of Giverny Capital, has been trumping the S&P since the early 90s and has an impressive track record. Their annual letters always make for an enjoyable read. In this edition, there is great discussion around the difficulty in assessing when a drawdown represents an opportunity and when it doesn’t and the margin of safety. Despite the drawdown in some names over the course of the last few years, Rochon feels that “several popular stocks in 2021 that fell sharply in 2022 could follow a similar course in the years to come.”
There is also some great discussion on the fund’s 5Y post-mortem, owner’s earnings, bitcoin, and the outlook for 2023. Giverny has a tradition of sharing a podium of errors in each annual letter and this year the gold medal was awarded to LVMH, the world’s largest luxury conglomerate. The error lies in his decision not to acquire the company when he had the chance to in 2011.
I enjoyed this section because it allowed me to live vicariously through its context. I have not followed the company for a decade, but a few months ago decided I would like to own it at the right price. Since then the share price has done nothing but appreciate, and the business continues to demonstrate reliance in an uncertain macro environment. It’s the law of the market. Whenever I buy something it falls. Whenever I want to buy something, it climbs. I will be exercising patience, however. I get the feeling that optimism for LVMH is at an all-time high as it trades at ~26x NTM earnings. While it has been higher, I think waiting for something closer to 16x to 20x is more acceptable. However, you will notice those occasions are quite rare.
2) A Share Bought is a Share Sold
Source: (Lewis Enterprises)
If you’ve ever heard of the phrase “cash on the sidelines” you will enjoy this rebuttal to that notion from LE. The saying has got a lot of airtime recently as inflows to money market funds reach all-time highs (as much as $5.3 trillion held in MMFs last month).
The author eloquently breaks down why the notion of cash on the sidelines is so misunderstood, scattered with both academic and layman explanations and practical evidence.
“The philosophical or practical existence of sidelines, or of people proverbially leaving them, is shorthand for a broader shift in risk appetite hitting an equity market with increasingly less capacity to meet the demand”.
3) Mental Liquidity
Source: (Morgan Housel)
Changing your mind is hard for a variety of reasons. We might be blissfully ignorant of the counterfactual evidence. There might be a sunken cost fallacy at play. It might be embarrassing to admit we were wrong. It’s possible that we take an opinion to spite someone with the opposite view. A large facet of our personality may be tied to the opinions or stances we hold. We may simply be stubborn and resistant to change. This rigidness, being unopen to new perspectives, is what Housel defines as mental illiquidity.
Sometimes a little stubbornness is needed. As Einstein, a man of science, once said; “one cannot make a theory out of a lot of ‘maybes”. As far as it concerns investing, which many consider an “art, not a science”, conviction is the double-edged sword that creates fortunes and destruction. You have to be sure of yourself to part ways with capital, but you can’t be so sure of yourself that you are resistant to changing your mind. They say when the facts change one can change their mind, but it may be the case that the investor is wrong about their dedication from the outset. Conviction is typically thought to be tested in moments of crisis; when the share price is hurtling towards the x-axis. But in reality, it is being tested every minute following the decision to research a company; and even more so once an issue is purchased. Often the investor won’t think about their level of conviction until they are forced to.
Two solid pieces of advice from Housel on the matter:
Be careful what beliefs you let become part of your identity.
- One of the biggest red flags in my mind is people who are known as the “[insert stock] guy”. I admire the passion and dedication, but regardless of whether or not the outcome of the stock in question is favourable, I can’t help but think about the echo chamber of confirmation bias they have created for themself.
Most fields have lots of rules, theories, ideas, and hunches.
- The same is true in investing. We model cash flows to make us feel better about the lack of control we have over the future. But at the end of the day, most investing is just educated guesswork.
It goes back to the saying; strong convictions; loosely held.
4) Life is Short
Source: (Paul Graham)
Thank you to Jack Raines for sharing this 2016 essay from Paul Graham about the fragility of life. It helped me draw conclusions on an essay I was writing at the time about slowing downand how novelty can improve our perception of time. Like a hearty meal, life is something to be savoured. Taking time to savour and appreciate life's experiences keeps you present in a world that increasingly pushes us to spend time agonising over the past, worrying about the future and comparing ourselves with others. Wasted pursuits.
Sentiments like these often come from those who have aged enough to learn them. I want to absorb the lessons while I am still young.
5) The Art of Catching Falling Knives & Conviction Investing
Source: (Ian Cassel, here and here)
After an absence stretching more than a year, it was great to see Ian Cassel writing again. The discussion of investments has infinite replay value on account of its lack of nuance. Because of this, investment maxims are seldom a one-size-fits-all. What better contrasting subject matters than the art of catching falling knives and conviction investing?
Typically, the former requires the latter. To catch a falling knife, there has to be some element of conviction that what you are doing is the right play. Sadly, the conviction is unwarranted, misguided, and more than likely a costly mistake. The reality with conviction investing is that you may only have a small population of big winners in a lifetime; here Cassel suggests 10-20. The hundreds of other ideas you have during that time, are likely to disappoint.
It’s a well-accepted facet of investing; akin to Buffett’s Punchcard analogy. Buffett suggests investors imagine their lifetime investment scorecard as being limited to a set number of acquisitions (let’s say 20). When purchase decisions are finite, you are bound to scrutinise them to a greater extent; waiting only for the fattest pitches. The no-brainers. The ones that come along once every 3-4 years that you get excited about. But sometimes that conviction is misleading, and that’s when investors get caught up catching falling knives. A falling knife is the less attractive second cousin of a fallen angel; which is a once-great business that has fallen on hard times. The investor has to determine if this wing-clipped angel is the victim of hyperbolic negative sentiment with weak grounding, or if it has truly passed its prime. Fallen angels may take some time to reap returns; quite often under a turnaround project.
A falling knife, however, is typically personified by a rapid decline in share price; which can occur for various reasons. When examining such cases, the investor is hoping for an equally sharp recovery in share price. It’s an opportunity to buy the dip in a business suffering from a misinformed voting machine. At the point of decline, nobody can be sure if it represents an opportunity (e.g when META traded in the low $90s late in 2022), or something which, if clasped, will cause the investor to bleed. At the time I believed META was not a falling knife and bought shares in a tax-exempt account. I sold them ~3 months later after surpassing a 100% return, largely because I already own too much META in another account.
After a stock falls 50%, people assume “there’s no way it can get cut in half again”. I am here to tell you, it can. After I acquired a speculative position in PLBY a few years ago, at ~$12 per share, I eventually sold at $6. I am thankful I came to my senses and avoided doubling down because the market valuation would continue to fall another 75% over the next twelve months. As Cassel puts it, the art of avoiding falling knives is determining if the decline is business-related or not. In this case, it was certainly business related, and so I exited the investment with my tail between my legs and some important lessons under my belt.
Here is some other great stuff worthy of your time.
• JP Morgan: Guide to Markets, Q2 2023
• Roiss: (-40.2% YTD) What happens when you disregard your own rules
• Ian Cassel: Three Golf Stories About Investing
• Arda Capital: Messy Middle and When Religion Isn't Enough
• Best Anchor: Conversation With Shree Viswanathan of SVN Capital
• Investor’s Chronicle: Joel Greenblatt interview
• Asian Century: Playing Red Roulette
• Giverny Capital: Annual letter
• Neckar: Steve Jobs in his own words
• Farnham Street: April letter
Company Related Write-Ups
• The Science of Hitting (ABNB): A Rebuttal To "Problems At Airbnb"
• GQ (AAPL): Tim Cook on the future of Apple
• Vest Rule (APG): APi Group write up
• Invariant (UG): United-Guardian: Durable Dollars
• Fairway Research (SDI): SDI Group plc, Deep Dive
• From 100k to 1m (ULTA): Ultra Beauty write up
• Apricitas: A Historic Labor Market Recovery
• Apricitas: The Disinflationary Process Continues
Please be sure to visit the publications of the mentioned writers!
So much Information. Thanks. Especially the segment “most investing is just educated guesswork” resonated very much with me
The "JP Morgan: Guide to Markets, Q2 2023" is always 🧑🏽🍳 🤏🏽+👄