TLDR:
fundamental investing is timeless* because the future is uncertain
*(if there’s liquidity)
In this essay, I attempt to explain why fundamental investing is timeless (and why it’s a business) through the lens of valuation and understanding trends. And I acknowledge what I say is easier said than done—the writing reflecting my naivety—but I hope it’s somewhat insightful.
The fundamental equities business is an ideas (and fees) business where the largest asset are the employees who attempt to generate idiosyncratic (stock-specific) insights, that can be monetized through the stock market. Value is created when one can monetize differences between expectations and reality, sans trading costs (+alpha decay), employee salaries, office rent, Bloomberg Terminals, “alt data” sets, etc.
Value creation can be misunderstood if “value” is misdefined. Value is the sum of the present value of all future expected cash flows, and value is created when one’s return on invested capital > costs. Unlike the Law of Conservation of Mass, value creation is limitless. Value is NOT created by rearranging assets (stock buybacks, accounting tricks, etc.), value is only created when returns - costs > 0 , thus affecting future expected cash flows—the key words are ‘future’ and ‘expected.’ (Thanks Ben & Anish for instilling this in me)
For example, this summer, I lost my keys on a Thursday night, but because I had an Apple AirTag on them, I was able to find them early Friday morning, and get into the office like usual. As a consumer, what is the worth of this product? If you lose keys, a wallet, or a bag, there is a huge cost in getting your IDs replaced, new credit cards sent, the loss of time and sentimental value, and the monetary loss of your items. Or, for $25, you can locate your lost items (with a product that gets better the more iPhone users there are. Network effects!)
There are 1.46 billion active iPhone users—what if half of them buy AirTags? You can do some napkin math, valuing this product line alone for tens (or hundreds) of billions of dollars. Combine the rest of Apple’s products with the productivity gains they offer, and its not unclear why AAPL 0.00%↑ is *currently* valued at $2.747 trillion. Now, this is all “priced in” to the current market valuation, and investors expect Apple to continue selling this product (and others) in the future—if there is a change in future expected cash flows, valuation will shift accordingly.
When products (or services, acquisitions, clinical trials etc.) are announced there is new information that must be evaluated—everything is a Bayesian probability (thanks Theo). Market participants have a set of views/beliefs (“priors”) which are then updated continuously as more evidence comes out and ideas are better understood. We all hold biases and thus cannot accurately evaluate how a product, macro theme, etc. will impact a business—but, the people that can best understand this are a company’s management team [or at least should be]. Management teams have the bird’s eye view on their business landscape and the more one interacts with them, the better one can understand businesses and their products, failures, etc. Supplement these interactions with your research, and you can gain/lose conviction for your ideas. Every conversation is a learning opportunity—the more reps, the better.
Besides, how are you buying a business without knowing who runs it? That’s like hiring someone solely on their resume without interviewing them.
Investing = Ownership
Again, the key words are ‘future’ and ‘expected.’ It’s never about today—its about tomorrow and the day after, so focus on the secondary and tertiary effects. Equities are forward-looking, with most of the “value” (sum of the present value of all future expected cash flows) lying in years 10 to 30, not the next 10 years. (Roughly 1/3 of equity value from next 10 years of cash flows, and 2/3 of equity value lies in the next 10 to 30 years). The weighted average of every market participant’s disparate opinions creates the ‘stock market.’
If most equity value lies in the next 10+ years, and management teams often do not have visibility beyond a year, there’s uncertainty and potential for volatility, ultimately creating monetizable opportunities—this is the business of fundamental investing.
Uncertainty is opportunity.
By the time the right moment is consciously perceptible, it is already too late
三島 由紀夫
Now, onto the second part of value—how is cash flow created? Cash flow is generated when businesses solve problems to meet consumer needs. Essentially, “Will people buy this?” Businesses create products for what people need and will need. I emphasize “will” as how many businesses were once under appreciated, and now we cannot live without? What businesses will we need or are yet to be created?
And remember, things will never return to how it “used to be,” so innovate or die.1 Read Engines That Move Markets, its great. (Thanks Ethan for the recommendation)
And do not undervalue utilities and energy—that’s our lifeline. Water is too important, so go look at Japan’s Premium Water Holdings (2588:TYO)—once you try good water, you can’t go back.
Now that we know what ‘value’ is and how its created, how can I make an actionable idea? There are plenty of signals (sentiment analysis, geolocation/satellite data, real estate, etc), but your lived life—even the Art around you—can be a massive signal. (Art defined as literature, paintings, music, film, fashion, food, architecture, jewelry and more)
What do you (and others) buy and how do you (and others) spend time?
All profoundly original art looks ugly at first
Clement Greenberg
Art is reflection. Artists reflect their current lives, experiences, and world around them to create art—its a reflection of the times. We often view new phenomena or trends as unattractive or ‘dumb,’ but they can become familiar, growing into something unavoidable. All profoundly original ideas look ugly at first.
Let’s start with fashion: trends are manufactured. Contrary to popular belief, fashion trends are created by textile manufacturers, not fashion houses—they make the canvas for designers, who later show their creations at fashion shows, six months later. So, when one sees a particular color or pattern suddenly become popular, look not at the designers but the fabric manufacturers—they are the source. Where else is this insight applicable?
Understanding whether trends are cyclical (or not) provides one relevant precedent for future decisions. In some areas, trends are like pendulums, moving back and forth, while others aren’t. For example, over the past decade, the popularity of Japanese whiskey has grown with demand exceeding supply, increasing costs of the best spirits (Yamazaki’s single malt, Suntory’s Hibiki, etc) and creating a market for cheaper Japanese whiskeys—go to duty free stores in Japan (or Taiwan), and there’s thousands of bottles everywhere. This has happened before, though at a much smaller scale, in Japan. When whiskey became popular years ago, the following Japanese alcohol trend was Shōchū. Fast forward to today, a few bars in New York are beginning to sell flights of Shōchū, some bartenders even receiving diplomas as “Shōchū Advisers” (shoutout Bill at Odo on 20th St). The consistent “winner” in Japan though, is beer (取り敢えずビール) and saké, with increased competition from the rise of imported table wines in Japan. With decreasing strength of the Yen, there’s even more precedent for the increase in domestic Shōchū production for consumption and export.
[There’s a corollary with Tequila, too; pre-Covid, Tequila brands weren’t as popular (and thus undervalued), but after Covid, there’s people getting Mezcal licenses and taking Tequila Maestro classes. Or look to the popularity of Monster (MNST) and Celsius (CELH), or even Lululemon (LULU)—consumer trends are powerful.]
For music, lyrics can [unconsciously] signal the start (or continuation) of trends and must be paid attention to. The stainless steel watches (Nautilus, Royal Oak, Overseas) from Patek Philippe, Audemars Piguet, Vacheron Constantin and brands like Richard Mille were in hip-hop/rap lyrics starting in the early 2000s, but these watches did not become “mainstream” and appreciate in value until the mid to late 2010s, when more people knew about them. With social media, the “signaling of wealth” became even more “popular” and accordingly, the price of luxury watches doubled, tripled, even 10X in price (similar hype to “reselling” sneakers and clothing").
Another music example: a British rapper (Central Cee) has a lyric from a few weeks ago, “She injecting with Ozempic, tryna stop her hunger”; even groupies (that are not diabetic) continue to use GLP-1 agonists—it’s normalized now, things will never return to how it “used to be.” Trends are extremely important because GLP-1 agonists had been talked about for years (with celebrities using them to lose weight), and yet the market caps of Novo Nordisk + Eli Lilly more than doubled, adding hundreds of billions of dollars in value during this year alone—there’s tremendous value in understanding what is under-appreciated.
On the flip side, you can also view certain moments as the beginning of the end of trends; if a product becomes extremely popular but has low repurchase rates or “replay value,” its going to shit—even if the valuation is outrageously high (and has the appearance of growth—focus on ROIC, then growth!!). Like Oatly (OTLY) or Beyond Meat (BYND), many people tried it once or twice, but they do not repurchase these items—there’s a reason why it sits on shelves, its not good. You couldn’t even pay me to eat Beyond Meat jerky, its pure garbage. (But again, there can still be an opportunity, if the products become better or there’s an under appreciated insight not priced in).
The interesting aspect of markets is that there’s ALWAYS an opportunity—if you’re flexible.
There’s various reasons why trends become trends but an interesting explanation is Rene Girard’s mimetic theory, derived from the 10th Commandment (Thou shalt not covet): Man is the creature who does not know what to desire, and he turns to others in order to make up his mind. We desire what others desire because we imitate their desires. (read Girard’s I See Satan Fall Like Lightning—that’s why I chose the image by Gustave Doré from Paradise Lost)
Life is imitation (mimesis) and life imitates Art—full circle.
So, how does one refine their understanding of trends? Curiosity. Being curious of the world around us and highly sensitive towards benign and strange/bizarre occurrences can augment perspectives, ultimately improving one’s decision making.
The excerpt below is on music and love, but exchange the ‘music analogies’ with something you do not understand, and it can shape your thinking on how something under-appreciated, becomes appreciated. Read it slowly
One must learn to love. — This is what happens to us in music: First one has to learn to hear a figure and melody at all, to detect and distinguish it, to isolate it and delimit it as separate life. Then it requires some exertion and good will to tolerate it in spite of its strangeness, to be patient with its appearance and expression, and kindhearted about its oddity. Finally there comes a moment when we are used to it, when we wait for it, when we sense that we should miss it if it were missing; and now it continues to compel and enchant us relentlessly until we have become its humble and enraptured lovers who desire nothing better than the world than it and only it. But that is what happens to us not only in music. That is how we have learned to love all things that we now love. In the end we are always rewarded for our good will, our patience, fair-mindedness, and gentleness with what is strange; gradually, it sheds its veil and turns out to be a new and indescribable beauty. That is its thanks for our hospitality. Even those who love themselves will have learned it in this way; for there is no other way. Love, too, has to be learned.
Fundamental investing is difficult because its a layered optimization problem. On top of creating ideas, you manage a finite amount of capital to maximize returns on your high conviction ideas, while reducing factor risks on those positions. Each idea you research and position you take has a huge opportunity cost. You are marked to market everyday and can see PnL by the second. And the table stakes (alt. data, etc.) rise every year—just to stay competitive. Its the most transparent of professions and you cannot hide. On the flip side, if your hit-rate is slightly above 50%—you have a lucrative business.
To create value, one must efficiently enter/exit and manage positions (Transfer coefficient), one must have actionable and differentiated insights (Information Coefficient), and one must have many, many independent bets (N). That’s what Grinold and Kahn’s law means:
IR = TC * IC * sqrt(N)
Information ratio = Transfer coefficient * Information coefficient * sqrt(# of Independent bets)
In a fireside chat last year, I remember Steven Cohen saying this industry is an “ideas business”—thats the purest way to describe fundamental investing, its stock picking. The aim is to monetize the change in ideas: ∆ ideas = future - present
The present is fluid, everyday there’s more information to update yesterday’s opinions and biases. Under appreciated or over appreciated, undervalued or overvalued, it is all perception—the market’s current opinion on “value.” But, at the end of the day, something is only worth what someone else is willing to pay for it—if there’s no liquidity, your assets are worth nothing. There’s a delicate balance between generating ideas, position sizing, confidence/conviction, but the real thing that matters is liquidity—focus on the Federal Reserve, as Druckenmiller says… [and the Bank of Japan, too]
“Ideas” are cheap as you only make money if you have an active position; you are paid for conviction—the hindsight biases and FOMO are the curses of fundamental investing. Oh, and remember, something is never too expensive to buy, or too cheap to sell. And, you will lose money, so we might as well get used to it. (Remember, a 52% hit rate = losing money 48% of the time)
All that being said, fundamental investing works and is timeless because the future is uncertain. Uncertainty is opportunity. When we think “I don’t understand,” this mental confusion/frustration is always an opportunity. It’s easy to shake off when we do not understand something, but so doing, we stunt growth and limit future opportunities. Remember, there’s always something to learn and new ways to augment our thoughts and beliefs—so, embrace the strange and odd.
Treat a man as he appears to be, and you make him worse. But treat a man as if he were what he potentially could be, and you make him what he should be.
Johann Wolfgang von Goethe
And go check out the Gyoseki and their Fundamental Equities competition; its a company founded by Hironobu Katoh to help fundamental investors:
https://gyoseki.com/competition/about_2023_q3
Thank you to for reading this far and thanks again to all the great mentors I’ve had these past years. I was reading over my past notes and felt I needed to distill down what I’ve learned into something digestible. And I happened to come across (again) a talk at GS with Ken Griffin (this essay is heavily inspired by that talk), where he speaks on the “timelessness of fundamental investing,” the structure of LTCM and how that allowed Citadel to survive in 2008, how future risks will be completely different than those of yesterday, and how university is where you learn how to learn. This was advice my great grandfather always said, so it was interesting to see how wisdom transcends languages; I wrote about that here.
Steve Cohen’s Fireside chat
gotta learn to learn more