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  • Chris Mayer

Ouch

“Ouch.”


That’s how Jeff Bezos started his 2000 letter to shareholders. Amazon’s stock was down 80% when he wrote his letter.


“Nevertheless,” Bezos wrote, “by almost any measure, Amazon.com the company is in a stronger position now than at any time in its past.” He then proceeded to list a variety of those measures - sales growth, gross profit, etc.


Well, I think there are a number of fund managers who may want to copy Bezo’s idea in their letter to investors in 2022, barring a big rally to year-end. (And a hat tip to Rob Poiner at Edgeworth Capital, who brought up Bezo’s 2000 letter in a recent convo).


I know for me, Bezos’s letter resonated. Not that I’m down 80%. I’m roughly pacing the S&P 500 so far this year. But, with nearly all Q2 earnings reports in hand (Copart being the only exception), I can say my companies are firing on all cylinders. Yet, the stock prices tell a different story.


Evolution AB (EVO), for example, has been the biggest drag on my performance this year. As I write, the stock is down 35% in local currency terms. Worse in dollar terms. Yet, in the second quarter sales were up 34% from a year ago. Operating profit up 38%. Operating cash flow per share, up almost 50%. Margins are up, too. The balance sheet has no net debt.


At a high level, the company is doing very well. There are things to nitpick, as with any company. EVO shareholders will complain about the tepid buybacks or the dividend or fret about this and that. But overall, this is a company performing at a very high level. Just looking at the numbers, you would not guess the share price would be down at all, much less 35%.


All of my companies that have reported so far, have been reporting numbers that are very good for that company. There is no reason to sell anything. If you’ve been reading this blog, you know I aim to own businesses for a long time. I’m looking for those big wonderful multi-baggers (with those fat tax-free gains). The only way to get those is by holding on to a stock for a long time. That means holding on through periods like this. It also means holding on even when valuation gets ahead of itself.


“Aha,” you say, “I was wondering when you were going to talk about valuation. Amazon’s valuation was ridiculous in 1999.” Yes, that is the elephant in the room. But valuation is a tricky thing to assess, as we will see.


I did not buy Evolution at 50x earnings - which is roughly where it was trading near the peaks last year. But I did own it at that price. You may say there is no difference and I ought to have trimmed. I would beg to differ.


The logic of 100 baggers is clear on this point. If you buy great companies and you’re constantly trimming them when you think they seem expensive, you are apt to make some very costly mistakes over time.


For one thing, most of the time it is difficult to tell if a stock is too expensive – if you have a long-term time horizon of, say, a decade out. Terry Smith, of Fundsmith fame, likes to run these scenarios where he looks back and figures out what price-earnings ratio you could’ve paid for L’Oreal or whatever and still enjoyed a market-beating return. The numbers are striking – sometimes you could’ve paid over 100x earnings! They are extreme examples, but still.


I once ran the numbers for Copart. You could’ve paid ~67x earnings in 2011 and still made 4x your money over the next decade. (It was actually only trading for ~22x in 2011 – a great bargain!)


So, having a databank full of such examples, I loathe parting with a single share of a great business even at 50x earnings. First, great businesses are hard to find. And second, it is easy to make a lot of mistakes trading around names. I find the less I transact, the better.


Note: The above is not meant to give myself a license to pay high prices. I try hard to build in some margin of safety. But for me it comes from the quality of the business, not just the price. A business that generates a 25% return on capital and can reinvest and continue to earn that kind return for decades is… well, it is worth a lot of money.


So, I spend most of my time, when analyzing a company, on the elements that protect such high returns. Competition is a big one. The incentives of management is another. And then you have to keep a careful watch and make sure these things don’t degrade over time.


Another point on valuations: They can come in quite fast for a growing business. Evolution, for example, was trading at ~50x earnings late last year. As I write, it now trades for about 16x the consensus guess for next year with a prospective free cash flow yield well over 6% (per Sentieo). Unless the underlying performance of the business takes a big downward shift, today’s price is going to look absurdly cheap in the future. These are times to add to the position, if anything, not sell.


Anyway, I don’t mean to pitch Evolution. I’m just using it as an example from my portfolio. It is one of the more extreme examples in my portfolio. But the song is similar throughout: Businesses are performing at a high level, but stock prices are down a decent chunk year-to-date.


If I were writing my shareholder letter today, I might follow the general outline here. I wouldn’t bother trying to explain why share prices are down. The market is an extraordinarily complicated system. There are many factors involved. I could create a plausible sounding narrative of why prices are down. But it would be a hypothesis only. And I would have wasted brainpower on something basically unknowable and that is in the past anyway. Worse, I might unwittingly marry myself to some narrative that is wrong.


I would just show this chart, from Charlie Biello:


We’ve experienced the 5th worst 167 trading days since 1928. It’s been a tough environment for most stocks to go up. That's worth knowing and frames the price declines I see. I don't need to concoct some theory as to why. Following the philosopher William James, I ask myself what’s the cash-value of such a theory? Am I going to be able to predict when things will turn around? I don’t think so.


In my opinion, it doesn't do much good today to try to explain what just happened in any detail. There is nothing to be gained. I'm focused on what's ahead, not behind.


If I were writing my shareholder letter today, I’d just admit to my investors:


Hey, I didn’t see this coming in 2022. But we all knew this would happen at some point. Ups and downs are part of the life of an investor. Bear markets happen. As you know, I’m not trying to navigate the twists and turns. (The odds of successfully trading around the market's swings are considerably long). I’m looking to find some of the best businesses on the planet and buy them at good prices. Then I let them do their work for us. As long as they are compounding capital at a high rate and seem likely to continue to do so, I’m going to leave them alone. I’m confident that the stocks we bought will be worth a lot more money ten years after we’ve bought them. Nothing that has happened in 2022 has altered that course. We are on track.


Or you can borrow again from Bezos in 2000:


“So, if the company is better positioned today than it was a year ago, why is the stock price so much lower than it was a year ago? As the famed investor Benjamin Graham said, ‘In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.’ Clearly there was a lot of voting going on in the boom year of ’99—and much less weighing. We’re a company that wants to be weighed, and over time, we will be—over the long term, all companies are. In the meantime, we have our heads down working to build a heavier and heavier company.”


Of course, we know how that worked out for Amazon.


Thank you for reading.


***

Published: September 1, 2022

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