Being Idle With Confidence
In very simple terms our goal at Phronimos is to acquire shares in either 1) outstanding businesses at a reasonable price, or 2) in reasonable businesses at an outstanding price.
Almost by definition it will be harder to find outstanding businesses that we can acquire at a reasonable price, simply for the fact that most outstanding businesses are widely recognized as such, and when investors generally are feeling optimistic, they bid up the prices for these terrific enterprises to levels that make an investment in their shares more of a speculative endeavor.
With the US equity market up north of 30% in 2019, and significantly more for the leading US technology firms, it is particularly difficult indeed to spot great businesses trading at anywhere near what we consider to be a reasonable price. It is undoubtedly true that the "Big Five" (Apple, Amazon, Microsoft, Google and Facebook), represent formidable businesses, with good growth, high returns on capital and strong free cash flow, supported by strong barriers to entry, massive scale, monopolistic characteristics in their industry vertical, low marginal unit costs, network effects and so forth. The unrelenting rise in their share prices (the "Big Five" now represent US $ 5 trillion in aggregate market value, greater than the entire market capitalization of all the companies listed in Germany) has conditioned investors to the view that investing in these leading companies, no matter the price, is the correct strategy.
And for a decade or more now, they have been right! The high ex-ante prices paid have been justified by the ex-post increase in earnings and cash flows.
So do we join them? When these companies are so obviously the winners and disrupters of our generation, and have outperformed so mightily, it is very hard to withstand the temptation.
It is precisely times like these, however, when it pays to listen to the wisdom of those that came before. While the industries and the names of the companies are different, this phenomenon of strong businesses outperforming everything else and trading at rich valuations, and the questions it poses for investors, has occurred many times before.
Writing in 1942 for the 6th Edition of Security Analysis, Ben Graham posits exactly this question:
Is it better to invest in an attractive enterprise on unattractive terms or in an unattractive enterprise on attractive terms? The popular view unhesitatingly prefers the former alternative, and in doing so it is instinctively, rather than logically, right. Over a long period, experience will undoubtedly show that less money has been lost by the great body of investors through paying too high a price for securities of the best regarded enterprises than by trying to secure a larger income or profit from commitments in enterprises of lower grade.
Here Graham seems to acknowledge the wisdom of sticking to the large, leading companies even at unattractive prices. But note his wording, that "less money has been lost"in investing this way, not that the most money has been made. And while instinctively correct, it does not follow logically. According to Graham, an analysis of the strength and quality of the business alone is insufficient to justify an investment. In his delineation of what constitutes investment versus speculation, he writes:
It is unsound to think always of investment character as inhering in an issue per se. The price is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another...
At a certain price, investing in even the best companies does not comport to the standard of investing, but rather this so-called "investment" can be accurately defined as speculation in the common stocks of strongly situated companies.
Graham explains that partly this is because paying too high a price simply doesn't allow for the vicissitudes of fortune.
It is natural and proper to prefer a business which is large and well managed, has a good record, and is expected to show increasing earnings in the future. But these expectations, though seemingly well-founded, often fail to be realized. Many of the leading enterprises of yesterday are today far back in the ranks. Tomorrow is likely to tell a similar story.
Google, Amazon, Microsoft, Facebook and Apple (and a host of other high-flying technology companies) might be fabulous businesses today, seemingly indomitable, and certainly priced that way, but the future seldom turns out the way we expect. In his own day, in the midst of WWII, Graham was referring to the railroad stocks, which had once been the undisputed darlings of the market.
So what do we do?
We continue to do our research, even if our insights might not be actionable at this point in time. We read annual and quarterly reports, listen to earnings calls and try to understand different businesses and industries better, even if nothing we do leads to an investment decision this week, month or even this quarter. Sometimes doing nothing is actually the hardest thing to do.
Rainer Maria Rilke put it far better than we could ever hope to do:
In any case, it is very important to be idle with confidence, with devotion, possibly even with joy.