3 Thoughts From Last Week:
Are we in a bear market yet? The market did something over the past few weeks I don’t think it has done in a while: there was a clear lower high. All this means is that the short-term price peak in the S&P 500 we hit at the beginning of February was significantly lower than the all-time highs that were hit at the end of 2021 and the start of 2022. Why is this potentially significant? Because lower highs are hallmarks of extended bear markets and downturns. If you look at the S&P 500 charts for 2000 - 2002 and 2007 - 2009, the market consistently dipped, made back some of the losses, and then dipped again. This type of false hope (which was clearly exhibited at the beginning of February) can grind people down psychologically if it goes on for multiple years, and is the recipe for fantastic buying opportunities near the bottom of a bear market. To be clear, I have no idea whether an extended bear market is coming. We could hit all-time highs in April for all I know (although it would surprise me a bit). However, for long-only fundamental investors like myself, studying historical market patterns can be helpful so you are not overly surprised by where prices move in the short run.
Stock-based compensation is a disease. This thought was inspired by the great FT piece linked in the “Good Reads” section below. Check it out for an explainer on the topic. I think stock-based compensation is, in almost all circumstances, worse than cash compensation. Why? A few reasons. One, it puts too much leverage on something management cannot control in the short-run (the stock price). Stock price leverage creates unnecessary fragility that can make things much worse than they need to be if/when shares fall 80%. Two — and this is the obvious one — it slowly dilutes the existing shareholder base. Three, it unnecessarily restricts employees, forcing them to get compensation in ownership of a company where all of their earnings power (in most cases) already comes from. Why do we think that is a smart move? How is an all-cash salary of the same value, which you can allocate to buying the same proportion of stock you would have gotten in the form of options/RSUs if you want to (or literally anything else), not better in every way? And for the readers thinking “but what about aligning management/employees with shareholders?”, executives getting paid millions or in some cases tens of millions of dollars a year can buy shares of their stock on the open market if they want to. As an investor, I wish more companies followed Taiwan Semiconductor Manufacturing and Constellation Software by not messing with stock-based compensation at all. (And it should be noted, not having SBC has not stopped either of these companies from creating plenty of value for shareholders over the last few decades).
As an investor, you have to be water. I’ve been thinking of doing a longer-form piece on this for the fund and/or CCM site, but I’ve been procrastinating so long I’m going to force myself to get at least some of the thoughts out now. Here is a quote from Bruce Lee: “You must be shapeless, formless, like water. When you pour water in a cup, it becomes the cup. When you pour water in a bottle, it becomes the bottle. When you pour water in a teapot, it becomes the teapot. Water can drip and it can crash. Become like water my friend.” While applicable to many aspects of life, I think “becoming water” is a great metaphor for portfolio management and making sure you never have a permanent loss of capital (among other things in investing). Water never fights against the current, it literally is the current. Water always forms itself to the easiest path, never trying to climb any uphill battles. For investors, having a “water” mindset can help you manage your portfolio for whatever market environment you are in. If “water” was investing in 2011, it would have flowed to the easiest opportunity set at the time, which was high-quality compounders. In 2007, it would have avoided financial stocks and leveraged garbage. In Spring 2020, it would have flowed to some of the best risk/reward opportunities, which were high-quality digital businesses getting an accelerated tailwind. In late 2020 and early 2021, “water” would have avoided the speculative bullshit and flowed to the best risk/reward, which was FANMAG + defense + tobacco + energy+ value factor stocks. Or, in times like 1999 or 2000, when there was nothing to “flow” to, water would have sat still, waiting patiently for the moment to crash. You might read this and think “water” is just hindsight bias, but all these market environments were easily identifiable. It is only those with the willingness to act rationally when everyone else is fighting against their long-term best interests when you can make a fortune, or, on the flipside, protect yourself from losing it all. I would argue the top investors with multi-decade track records, like Buffett, Munger, Tepper, Druckenmiller (although he temporarily resisted at the top of the dotcom bubble), and Thorpe all flow like water, taking the opportunities presented to them and resisting the urge to force opportunities because they want them to happen.
See you next week,
Brett
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