Thinking in Bets
Like a typical investor at his start, I learnt some expensive lessons on what are the characteristics of good stocks. Warren Buffet has evolved over years and has moved from “buying good businesses at cheap prices” to “buying fantastic businesses at good prices”.
I understood this principle well but what are “GOOD BUSINESSES” really? That’s where I stumbled.
As we understand a concept completely, we become indifferent to it and the focus shifts on a newer adjacent problem, a specific. Let’s step back and look at how geometric progressions are created.
Business spit out dividends and capital appreciation is captured in the stock price. Ultimately at the end of business, the book value will be liquidated and we’ll get it as dividend. This is fantastic in theory but what happens in real life?
Management Biases
Anchoring effect prevents good businesses being liquidated once they’re at their peak and start booking losses. Warren Buffet struggled for almost a decade before liquidating BRK’s textile business and converting the cash into a holding company. If Buffet can drag on for 10 years, we should expect worse managers to destroy quite some value. This process of a profitable business converting to a loss-making or zero profit business is slow and we could see it on the balance sheet. Being aware of this change as worst case scenario, we can plan our exit early.
Finding Highly Probable Pathways
As long term investors, predicting demand of the material 10 years from now is required and it can only be predicted for some things, which have moats. No one can predict the future but we all can agree that 10 years from now, people will eat salt, drink coke, use internet, etc. Additionally the economics satisfying the demand should be such that free cash can be realized. Money can be earnt through various means like using brand value for pricing product high (Apple), having a low cost supply chain (Coke), having a patent over a technology, or practically owning a market completely (Google). For these companies, “going concern” is a correct assumption for following 10 years and we can expect them to have nice conservative growing rates.
Looking out for these characteristics will give us an estimate of high probability trajectories that a business can follow, a conservative estimate of cash flow (high trajectories) that a business can spit. Betting heavily on these highly probable wins will earn money.
A growing geometric progression will sum to infinity but a finite progression will sum to something small. A good multiplying ratio (r) will be justifyable for a high paid price, but a fantastic one will be at an okay multiple with an insane r. It’s a no brainer.
Later, we’ll look at how fractals are visible in markets and what happens today, what causes have effect on markets in what timelines.