VALUE: After Hours (S08 E01): The Price Asks the Question: A Mental Model Every Investor Should Know

During their recent episode, Taylor, Carlisle, and Gary Mishuris discussed The Price Asks the Question: A Mental Model Every Investor Should Know. Here’s an excerpt from the episode:

Gary: And so, I think this is kind of an important mental model that you have to answer a certain number of questions to be correct on investment, but those change. And as Buffett says, investing is like a multiple-choice test, but you get no penalty for passing on as many questions as you want to pass on until you find one or two or three, you’re like, “Yeah, I’m pretty darn sure I have a good answer for this one.” That’s the thing PHINIA for me, was that I don’t know the answers to the tough questions that you’re asking, which are legitimate at a higher price, but at that price I didn’t need to know that.

Tobias: Yes. So, you–

Jake: Do the questions get harder or easier over longer time horizon? So, I’m thinking if you could say you know the culture of a company is leading it in the right direction and like 10 years from now you know it’s going to be a better business than it was today because all the momentums are in place and it’s easier to make that bet maybe sometimes than what’s next quarter going to look like.

Gary: This is an awesome point to bring up because I’ve seen this chart floating around, you’ve probably seen it too, where it’s like as time horizon approaches infinity, basically the only question you need to answer is management. And essentially, if you are thinking about an intermediate timeframe, let’s say three to five years, which a lot of value investors, I think, may focus on that time frame, and I think rightfully so, because it’s long enough to get past most people’s kind of like the most competitive part of the market, which is 0 to 12 months. So, I think like two years to five years is pretty good for special situations, reversion to the mean, all those kinds of patterns, if you will.

Then, the question you’re asking as well, is it easier to say, okay, I can’t answer the path there, but I see this is an amazing culture. It’s getting better and therefore I know the destination. I don’t know exactly how it’s going to wiggle there, but I can just kind of– I think the answer is yes, but I suspect the degrees of difficulty is very, very high. And I think there’s a couple of things involved to unpack. One is–

So, I was mentoring one of my interns and we were rereading Nick Sleep’s letters. They’re kind of classic now. Many investors, he transitions from this like

but approach to “Hey, Costco, Amazon, Berkshire, shared economy scale, great culture, big moat, fire and forget.” And what I try to– And I think that’s amazing, great skill, kudos. No criticism whatsoever. The challenge is how many false positives are you going to have along the way? And that’s going to vary by whether you’re Nick Sleep or me or someone else. And also, everything looks more obvious in hindsight. You can go and find a whole bunch of articles that were saying how amazing Kmart was and will Walmart survive or something like that in the early days.

So, I think I worry that your insight is exactly right. And I think the huge wins like the 100x returns or 50x returns over decades probably come from or have to come from that kind of insight. But then, the challenge is, A, is it within your circle of competence, your being whoever is doing the investing. And also, how many other ones that you’re going to pick thinking that they’re Costco but it turned out maybe they’re BJ Wholesale or whatever or thinking you have a Riley Automotive and you get Advance Auto Parts. And also, what kind of price are you paying for that? Meaning when you’re wrong on that inside, how much money do you lose? If you’re paying 40, 50 times earnings at whatever Costco’s at today and you turn out to be wrong either about the magnitude of their investment opportunities or the culture changes over time or whatever, how much are you losing on the ones you’re wrong?

So, I think the answer is yes, true. But I always encourage people I mentor and my students is don’t try to copy people or clone people. Figure out your strengths and weaknesses and figure out what’s within your circle of competence. Learn from a bunch of other people, but then put it through that filter of what can you do really well. So, I’m not sure I can do that really well, but I respect people who can.

Tobias: I think we’ve great– [crosstalk] Just that it’s so competitive from 0 to 12 months. But then also, like there’s no– Quantitatively, there’s nothing predictive beyond five years. I can’t find anything that works in year six and seven and beyond. Like, you get the bulk of the prediction sort of in the early part out to five years. So, it’s a good little– I think two or three to five is the right sweet spot. Sorry, JT.

Gary: Yeah. And I think it depends on like so I kind of have a collection, if you will, of investing patterns that I try to find and I think that time horizon would probably match the pattern. To use an example, if you use a turnaround as an example and I don’t say specialize in turnaround, but it’s one of the patterns I’m comfortable with and I’ve made a lot of mistakes and learned through those mistakes. And the turnarounds kind of follow this arc where new CEO comes in, assesses the problem, formulates the plan, begins implementing, blah, blah, blah. And there is a certain natural timing to those steps that doesn’t matter if you have AI and robots or not. The human component of that of changing culture, changing behavior, changing incentives, there’s just a human element that paces that.

And I think that is a beautiful pattern because the turnarounds, for example, what I found is you don’t do anything in the early kind of 0 to 24 months most of the time. You wait for the implementation. You wait for early evidence that it’s tracking. And usually, that means you have to monitor KPIs before they hit the bottom line. So, you’re not looking for EPS change or free cash flow change necessarily. You’re looking for whatever the intermediate metrics which are going to lead down the road to bottom line success. And then, your probabilities shift drastically because you know most turnarounds two-third plus don’t turn. Once turnarounds start to turn, very few of them go back down. And so, in that sense, you can actually–

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VALUE: After Hours (S08 E01): The Price Asks the Question: A Mental Model Every Investor Should Know

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