How many of your successful investments have occurred on the timeline that you originally predicted? How many times do you ever remember saying, “Well that happened a lot quicker than I thought”? Not often enough, right. In reality, a majority of my successful investments took longer, in some cases a lot longer than I originally expected. This just proves that even with our winners, let alone our losers, our expectations are too high.
A big part of successful investing is spent navigating the gap between expectation and reality.
[Expectation] <————————————-> [Reality]
Developing the conviction to hold and forming realistic expectations go hand and hand. Often times it’s not reality, but it’s our unrealistic expectations that set us up for failure. In my last article, Think Different and Better, I mentioned and linked to an excellent interview with Josh Tarasoff. An investor I follow tweeted a powerful snippet from the interview which I’ve posted below:
True conviction can only be obtained by trusting your own research over that of others.When you put a lot of time into due diligence, scuttlebutt, and talking to management, it’s easy to find yourself in your own “personal echo chamber”. Positive thoughts are magnified. Negative thoughts are magnified.
Let’s explore this a bit further.
Finding something new to invest in is fun. Doesn’t it feel really good to buy a new company? It’s also why it’s incredibly hard to hold onto existing positions. The infatuation and rush of excitement you feel when you think you found a gem that was hidden in plain sight. The hours, days, weeks, of due diligence that ultimately confirm this initial belief. Your personal echo chamber is filled with over-confidence and high expectations for the future. How smart you are for finding this special little company. You might already be thinking about how to spend the embarrassment of riches that will soon be bestowed upon you.
We investors are such fickle creatures. Immediately after we are done buying a position, our enthusiasm starts to fade. We would have cursed the stock if it would have moved higher as we bought our position, but now that we are done buying, we curse it for not immediately moving higher. This universal human desire for immediate gratification is our greatest adversary.
If the stock doesn’t move higher 2-3 months after we purchase a position, we really start to question ourselves. The realization sets in that you aren’t going to get rich tomorrow. Even though you did due diligence into the business and everything is fine your expectations remain anchored to the stock price. The negative echo chamber starts up and your expectations drop through the floor.
What I’ve described above is what we all go through in various degrees. It’s amazing to me how even a long-term investor like myself can’t help but feel despondent when gains aren’t realized quicker than I thought. This leads to an interesting question.
How many companies have you owned where you genuinely liked them more as time went on (years)?
For me, very few. I would imagine many microcap investors would answer the same way. I think the reason for this is twofold.
First, most microcaps are story stocks and many microcap success stories are short lived fad stocks. So, it’s almost impossible to like them more as time goes on because many won’t exist as time goes on. It took me a few years, early in my journey, to be able to resist the urge to go down quality chasing story stock and storybook returns. Most story stocks don’t have happy endings. Don’t invest in great stories. Invest in great businesses. Similarly, many microcap success stories, past and present, are or were fad stocks. They are one or two product companies that have caught some sort of consumer-commercial tidal wave but have a short shelf life. They grow very quickly while on the tidal wave until the wave hits the shore. It’s hard to find a quality business with staying power, a business that you can own and not rent. Focus on quality businesses.
Second, investors typically underestimate how difficult it is to grow a small company into a larger company. When you come up with your guesstimates, everything always looks good on paper. Quarter to quarter growth is always linear. Year to Year growth occurs like clock-work. Right? No. If you’ve ever run a business you know this isn’t the case. The truth is businesses are complex organisms. [Note: I think you’ll enjoy this article, Why do cities live forever and companies don’t?] With most businesses, to double revenues, you have to triple the employees. This isn’t easy. Managing customer relationships while growing isn’t easy. Managing cash while growing isn’t easy. Many founder led businesses reach a breaking point around 25 employees. The will power of the founder can only take it so far, and for the company to reach the next level they need to hire great people to support their growth. Culture (or lack thereof) also becomes engrained at this early stage. Growing a company is difficult, let alone a public company. I’ve found it’s always those that have never run a business before that are adamant they can run someone else’s business better. All growing businesses suffer growing pains. As investors make sure you have realistic expectations for growth and profitability.
On many occasions, it’s management themselves that try to set expectations by issuing guidance or worse yet telling you things in private meetings that they shouldn’t. This is a big red flag, and guidance is always a bad idea. All guidance does is reinforce short-term thinking. It’s not management’s job to set expectations. It’s management’s job to execute.
The best way to combat high short-term expectations is making reasonable long-term expectations. I like to use three or five year estimates and gauge quarterly and annual business execution against these estimates or expectations. One thing I always keep in mind is all businesses, even great ones, have a quarter or two where they stub their toe, or suffer growing pains. You need to know your positions better than most to be able to judge a temporary setback (hold) from a permanent change to the investment thesis (sell).
The key to successful investing is finding and buying great businesses early and holding on with a death grip. In life and investing, our disappointments often lie in our assumptions. When we have the wrong assumptions, we have the wrong expectations, and we get disappointed with the company. If we aren’t grounded in reality, or are anchored to the stock price, our personal echo chamber can manipulate us into selling a great business. A big part of successful investing is spent navigating the gap between expectation and reality. The hardest part is deciding whether to fill that gap with trust.
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