Journal of Emotions - #1 Fortune Telling
Predicting the unpredictable is a fool's errand
04/23/2022
Predicting the future is inherently difficult. Many of the great trades that have yielded incredible returns based on market predictions were singular, non-repeatable events. For example, the name Michael Burry is mostly associated with the 2008 housing crisis. Since then, he has not made the news with a similar insight. As far as I know only George Soros has demonstrated repeatable success in trading the future and he has had his share of luck.
On the contrary the “Super investors of Graham and Doddsville” have demonstrated success repeatedly by ignoring the macroeconomic future and focusing on intrinsic business value to create long term success. Simply based on the historic track record of some investors it seems obvious, at least to me, that trying to become a fortune teller is a fool’s errand.
The pandemic is said to have accelerated the shift of consumer spending from brick-and-mortar retail to ecommerce. The news in the last two years have made this appear to the laymen as if this shift was inevitable, and that the pandemic just made it happen faster. Now that the first quarter of 2022 has come to an end, we can see that this was not true. Ecommerce spending is back down to 2019 levels.
The same is true at Netflix. Who would have predicted that the pioneer of bench watching, account sharing, and the ad free business model would find itself in an environment where all the things that made it unique would now be questioned and most likely changed? Bill Ackman certainly did not, and it cost him $400 million. He freely admitted that he was wrong about the prospects of Netflix. His business analysis was correct, but his prediction of the future was not. If Bill can’t do it, I certainly cannot do it.
There is an important lesson to be learned. Investing, specifically our value focused approach, is a balance between buying future growth potential (fortune telling) and paying a price that secures us against being wrong. Once again, the margin of safety becomes the iron rule, the one constant we can hang our hats on, because if we’re wrong about the growth prospects, like Bill was, we better have paid a price that didn’t include the growth.
Mohnish has such a simple test for having a margin of safety that most people will most likely overlook it. A business that generates consistent free cash flow is worth 10x that free cash flow. A business that grows may be worth 12x to 15x free cash flow. A simple filter to see if a company is worth even investigating further is to take the market cap, multiple it by 0.1 and see if that free cash flow even falls into the realm of the probable. Then, if there is no growth check if you can buy it at 50% off. If there is growth you can adjust the margin of safety. Such a simple concept.
Meta was recently selling at 10x Earnings if one factors in the $10 billion investment into RealityLabs. For Mohnish this was a clear buy without much risk, because the company was quite likely to continue to produce free cash flow in those ranges. He thinks Meta is a sure double. One could basically buy Meta at 10x Ad revenue, not factoring in WhatsApp or RealityLabs.
It is simply not possible to be a fortune teller in my view. I stay away from fortune telling, by simply ignoring my hopes, dreams and emotions when evaluating growth potential. How do I do that? 10x free cash flow as one of the first filters in determining if I should start to research the company in depth. This will eliminate a lot of great returns for sure, but it will also eliminate a Netflix type loss.
Margin of safety is king.