Control Yourself

When you buy a stock, you are betting that the business trajectory will stay the same or get better. No one ever buys a stock thinking the business will get worse. What is interesting is how often the business does get worse. It happens more often than we like to admit. In fact, it’s probably the base case, and yet we are always “surprised” when things get worse. 

Long only stock pickers are naturally wired “bullish” when we like something. When we like something, we want to like it more. When we own something, we look for reasons to own more. We seek confirming evidence to own more. 

It’s more fun to focus on what could go right and what could accelerate growth - Not what could go wrong. When we buy something that is growing 20%, we only think about it growing 30%, not dropping back to 10%. 

When a company disappoints us, 50% of the time it’s management’s fault for overpromising and underdelivering. The other 50% of the time we still blame management, but we are normally to blame. 

It’s hard to control the bullish echo chamber in our brains. It doesn't take long for our expectations to get a full standard deviation away from reality. It’s hard to control yourself. 

When a business is doing well, we take the highest quarter ever posted and annualize it to justify the stock being cheap. This sometimes works but it often doesn’t. 

Every successful business must invest ahead of growth. This creates challenges and unforeseen bumps in the road. Growth often comes in stages with higher plateaus. It’s similar to a stock price that goes up too far and then it takes 12-24 months for fundamentals to backfill into the valuation. It’s the same for a business where people, processes, scale need to backfill before it can take the next leg up.  

I’m invested in a small microcap business right now who has maxed out their office space and warehouse. The current office space is in the same building as the warehouse. It might seem like a small thing, but management likes everyone under the same roof. They like management, marketing, sales, in the same building as the warehouse. It creates a culture where everyone is just a short walk away. Most larger warehouses in the area that are available don’t have a large enough office. It’s lead to a few quarters of sales plateauing as they assess the next step. The positive side effect is they are overearning because they aren’t investing (yet) for the new building that is necessary. And of course that is the quarter we all want to annualize.

We stock pickers like to think that small businesses are excel spreadsheets where we adjust some inputs, and the outputs take care of themselves. No friction.  Revenue and income linearly progressing up and to the right every year. 

We forget that businesses are simply groups of people aligned and incentivized to solve a problem. When a small business grows up. Real people need to be hired. Real people need to be fired. Real people need to be trained. Real people need to sell more to other real people. Real people need to deal with all the “Whac-A-Mole” issues that no one prepared for. 

I can’t tell you how many times I’ve been slightly disappointed by a quarterly result, and when I talk to the CEO, he/she is genuinely happy with the results. They respond, “You have no idea what we had to deal with. The team really rallied together to make this a good quarter.”

Perhaps a key person left, supply chain disruption, a random fire destroyed inventory, a large order got pushed or cancelled, etc. This is what 90% of small business is – the messy “making the sausage” – that stockholders never see. We just see the numbers and analyst estimates. 

This is why guidance, especially for small businesses, is dumb. Guidance puts management in a position to lose credibility by not hitting short-term targets they can’t control. Yes, they can directionally control them but not exactly control them. 

Let me ask you this.

When a company you own or follow issues guidance does it make you want to buy or sell? 

Sell.

Why? Now you know the future. Guidance takes away the fun part of stock picking - anticipation. Now you know what management thinks about the future. The guidance provided is also a conservative number that causes more questions than answers. Then something unforeseen happens and they grow 17% instead of 20% and the stock drops 20%. If the company wouldn't have guided investors and grew 17% the stock would be higher with no disappointment. 

When a company doesn’t give guidance, the investor is left to do the work themselves and form their own opinions. If the company doesn’t hit my overly optimistic expectations – I’m to blame. Not the company. When management provides short-term guidance, it shows a lack of discipline and self-control. They’ve been told by bankers, analysts, short-term investors to give guidance. They give in and then they get the shareholders they deserve. 

It's our own expectations that get us in trouble. How many of your successful investments have occurred in the timeframe you originally predicted? How many times do you ever remember saying, “Well that happened a lot quicker than I thought”? Not often enough, right. Most of my successful investments took longer, in some cases a lot longer than I originally expected. This proves that even with our winners, let alone our losers, our expectations are too high.

If your thesis takes 12-months longer to play out what is the risk? Dilution. This is why profitability is so important and why the multi-bagger magic formula is finding a small company that can grow revenues and earnings and not dilute. The last part is key, so you can afford to wait longer. 

I try to always keep my timeframe to 3-years. I also encourage companies to issue 3-year goals over annual guidance. It keeps investors and companies aligned with a longer-term focus. It acknowledges the shorter term will not be linear like an excel spreadsheet. 

I like to hold my short-term expectations like a tube of toothpaste – not too tight. Give a company a little room to disappoint you in the short-term and a lot of room to exceed your expectations in the long-term. 

You can’t control the short-term. Control yourself. 

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