What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Some of the greatest opportunities in the financial markets are those where value is allowed to be cultivated through an incentivized management team. The more difficult to assess the value of a company, as a result of a mix of esoteric assets and restructured operations, the more likely it is that the market will misrepresent the value of the company. The smaller the market cap, the greater the discrepancy in value.
The aforementioned are all fairly obvious points to the experienced investor. Obviously, in areas of the market where less individuals and institutions are paying attention, those areas will be prone to substantial dislocations in value. And perhaps even more obviously, individuals are driven by incentives. Without them we become lackadaisical, mouth-breathing neanderthals that would be perfectly content spending our days trying to beat the high score in Candy Crush. Incentives drive human behavior, creativity and in the end, the realization of value in undervalued corporations.
What is missing from the formula is everything that takes place in between the realization that value exists in a company and an incentivized, experienced management team put in place to expertly help in realizing the value. There are literally countless individuals who have spotted the correct alignment between value and incentives, yet there are few who are consistently able to outperform the market. The realization, in fact, that a value/incentive aligned situation exists is very often a consensus event.
A consensus value event is one where a majority of individuals observing the company believe that value exists in the corporation and eventually the share price will be substantially higher.
A consensus value event is not attempting to pick the bottom in a violent, macro driven decline in oil, for example, as we experienced exactly 12 months ago. A consensus value event is also not attempting to pick the exact bottom of the financial crisis by purchasing a basket of stocks in March of 2009. These are contrarian value events, which is a topic for another letter.
The difficulty investing in a consensus value event comes from an inherent conflict with the basic functioning of the financial markets, generally. Consensus is essentially an abomination in the financial markets. Markets will go through inordinately painful measures that completely lack any rationality to eradicate consensus allocations and investments in the markets. In fact, many popular quips exist that attempt to simplify the action: The markets can stay irrational longer than you can stay solvent; losers average losers and so on.
In order for the markets to eventually realize the value in a consensus event a set of extraordinary actions both in time and price need to take place as a prerequisite to value creation. In a vast majority of cases, one, the other or both take place before any value is realized.
The functioning of volatility in the stock price dulls consensus opinion considerably as it creates discomfort among a majority of shareholders. As a result, an investor's focus will often times be distracted from the primary reason they invested (value), instead focusing on the immediate pain and uncertainty they are experiencing. Pain and uncertainty have the uncanny ability to create irrational patterns of thinking that essentially illuminate dark corners where all types of scary eventualities lie. In other words, pain and uncertainty move the mind away from fact based thinking into fear based thinking. In that state fact and fear based thinking become indistinguishable from one another, creating errors in judgment that only become apparent in hindsight.
The functioning of time in a stock price takes on a much different influence with similar consequences as volatility. The longer a stock takes to realize the value that is apparent, the more susceptible an investor becomes to irrational influences, whether from competing investments or divergent opinions. The facts of a company may not have changed for the entirety of the holding period. However, the very nature of a prolonged wait acts towards dissuasion of the entire investment thesis. Eventually, investors either decide to sell out entirely before the value that they knew existed is allowed to be realized or they sell out at the very initial stages of value creation following the prolonged wait, missing out on the extraordinary gains they were sure existed at the onset of the investment.
This brings me to the point of this piece: Consensus value opinions typically end up working out, just not on the same timescale that a majority of investors are comfortable with or expected.
Reminding me of the quote from Jeff Bezos that I included in last month's letter:
Our first shareholder letter, in 1997, was entitled, “It’s all about the long term.” If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn. We say we’re stubborn on vision and flexible on details. In some cases, things are inevitable. The hard part is that you don’t know how long it might take, but you know it will happen if you’re patient enough. – Jeff Bezos