Investing used to mean buying shares in a company where you knew and liked the product, with an expectation of a return many years later. That formula was used by a generation of investors who revere Warren Buffet as the master of the art. He has always avoided tech, despite being good friends with Bill Gates, because he likes to invest in what he knows and he says he does not understand tech. What if he was starting out now, a digital native but with the same great investing skills
This thought experiment is worth doing because when software is eating the world, it is no longer prudent to ignore tech.
During normal times, the proven route to risk adjusted return on capital is to invest in companies with a long track record of consistent earnings growth (typically low tech). They are the safe, proven “incumbents”. Even if the growth rates are not that great, the consistency creates good returns. Warren Buffet became one of the richest men in this world with this strategy. His friend, Bill Gates, became one of the other richest men in this world with the exact opposite strategy – invest in disruptive change.
If Warren Buffet was a digital native starting out now, he could not afford to ignore tech because during disruptive times, when “software is eating the world”, capital invested in these “incumbents” is more at risk. For example:
- Hotel chains are at risk from AirBnB.
- Retail chains are at risk from Amazon and other e-commerce.
- Traditional Media is at risk from Google, Facebook etc.
- Banks are at risk from Fintech startups.
So investors need to get on the right side of the disruption waves by investing early, but investing in first time funds or early stage startups is too high risk. The style of long term greedy investing practiced by the masters of investing in the 20th century (such as Buffet, Templeton, Lynch) has moved to private equity (from Venture Capital to Leveraged Buy Out). However, you need access to get into deals like that and that is not possible for an outsider just starting out. They need to find great companies in the public market. Private Equity would not be an option for the digital native version of Warren Buffet who is starting out now.
The style of these three masters of 20th century investing (Buffet, Templeton, Lynch) has four things in common:
- Love the product before looking at the company. Warren Buffet is famously a lover of Coca Cola the product and the company. If you are a digital native, you probably have plenty of tech products that you love. The old masters of investing did not know and love tech products.
- Margin of safety on valuation. The great investors don’t fall into value traps (“cheap for a good reason”). Nor did fall into hype traps (hot overvalued concept stock). They look for great growth stocks that are reasonably priced (“growth at the right price”).
- Competitive Advantage Period (CAP). In tech we can see competitive advantage come and go. This is what we call disruption. One reason Warren Buffet likes consumer companies like Coca Cola is that they have very long CAP periods. Imagine a science fiction future. It is easy to envisage Coca Cola in that future.
- Classic financial analysis. This is when the traditional analysis of balance sheet and P&L statements is needed. Don’t bother doing this hard work unless the first three line up.
Let me give you one story from my own experience to illustrate this. In 2003, I closed a deal and was given a Mac laptop and iPod as a present. Having had a very early Apple product but then had many years in Microsoft land, this was a joy. Looking at Apple stock I could see that it was totally undervalued. I did not at the time have any analysis framework for Competitive Advantage Period but my gut told me the people would be using computers and listening to music far into the future.
One misconception is that just the first (love the product) is enough. It is not enough to say, “I like using Faceboook/Twitter/Uber” so I will buy the stock. You use that as the first step in the 4-step process outlined above.
In ye olden days, lots of individual investors bought stock based on this long term-greedy love the product approach. The reality today is utterly different. Computers do about 75% of stock market trades today, using High Frequency Trading (HFT) algorithms that look at things like words in a speech by Yellen and sentiment expressed by day traders on Twitter.
Online stock trading in the 1990s was disruptive and started to democratize stock investing. The next wave will come from XBRL (currently in the slough of despond). XBRL will democratize stock analysis in the same way that social media democratized HTML.
The current focus on HFT in a few mega cap stocks or ETFs (where there is enough liquidity to enable HFT) opens up a big window of opportunity. Today we have a well-regulated public market with small cap stocks trading in a very inefficient way (i.e. offering great opportunities to investors) just at the same time when XBRL is making it possible for retail investors to easily crunch the data without help from any Wall Street intermediaries. Looking at the Daily Fintech Index we can already see these companies being acquired (for a premium). Wall Street does not care about these thinly traded small cap stocks, so these early adopter tech-enabled retail investors will have a “field day”.
When this will happen I don’t know. There is a big difference between imminent and inevitable. When it does happen, it will help reduce inequality and promote financial inclusion. So I hope that it will happen.
The old investing masters were long only. The digital native versions will be more comfortable going short. This is hard because of the difference between inevitable and imminent. It is inevitable (IMHO) that hotel chain profitability will suffer due to AirBnB, but judging precisely when that will hit a particular stock is very hard and in shorting you lose big time if you timing is off.
Shorting matters because a lot of the disrupters are not yet public and when they do go public they probably won’t pass the margin of safety test. Some investors have bought into hot private stocks in secondary markets before those companies go public. An investor emulating the old masters would never buy private stock on secondary markets because that does not enable the last of the four stages – the boring old Classic Financial Analysis.
So if you buy into a disruption thesis such as that that hotel chain profitability will suffer due to AirBnB, you cannot buy AirBnB stock. So your only way to play that thesis is to find hotel chains to short.
This is partly cyclical. When the market enters the next bear market (don’t know when, this is inevitable but not necessarily imminent), there will be plenty of publicly traded companies where you can find margin of safety and invest long only.2 - Readers Like This Post