Great Stocks Evolve But Most Investors Don’t

Almost every winning stock was once a deep value stock, value stock, GARP stock, and growth stock. It was once cheap, expensive, loved, and hated multiple times during the journey. Businesses are constantly changing which means sentiment is constantly changing. Great stocks evolve but most investors don’t. 

In 1999, Microsoft was trading at an 80 PE (Price to Earnings ratio). High PE means high expectations. Growth and hypergrowth investors were piling in.

In 2009, Microsoft was trading at a 9 PE. Low PE means low expectations. Growth investors were selling and deep value and value investors were buying.

In 2016, Microsoft was back to a 40 PE. Value investors were selling and growth investors were buying again.

Few outside of Bill Gates can hold for the entire duration.

Over the last 40 years WalMart has traded in a 10 to 60 PE range. It attracted deep value investors and growth investors. A majority of multi-decade multi-baggers were valuation roller coaster rides.

In a perfect world monster winners would look like AutoZone that stay in a narrow 13-20 PE valuation band for most of its epic run. It's easier to hold on when the business never gets too expensive.

Valuation is a hard topic because we all value different things and we all value things differently.

Stock pickers tend to silo themselves into one or two valuation camps: 

Stock picking means finding businesses today that other investors will value more than you later. When you sell a winner, you sell it to someone that sees more upside than you.

Each valuation camp sells a winning stock to a person on the right, and they sell a losing stock to a person on the left.

Deep value investors will sell a winning stock to value investors.

Value investors will sell a winning stock to GARP investors.

GARP investors will sell a winning stock to Growth investors. 

The group to the right sees more upside than you.

It's the same in reverse.  

When you sell a loser, it’s to someone that sees more value than you.

Growth investors will sell a losing stock to GARP investors.

GARP investors will sell a losing stock to Value investor.

Value investors will sell a losing stock to Deep Value investors. 

This leads to an interesting question. Is it wrong to stay locked into a valuation camp?

Michael Melby at Gate City Capital has put up a 22% net CAGR for 14 years in a deep value strategy. He buys businesses at half of intrinsic value and he’s right more than he's wrong. He’s done very well staying rigid and sticking to his valuation camp.

Turtle Creek has put up 19% CAGR for 25 years. They build precise models around valuation and intrinsic value. They actively trade around positions because market prices change quicker than intrinsic value. They buy more as the gap between intrinsic value and market value increases and sell as the gap closes. They are value investors and stay in their lane.

Warren Buffett’s best returns were when he was the most rigid - when he was a high turnover deep value cigar butt investor. Buffett had 100% turnover per year in his peak return years. 

You know what is interesting? 

The more rigid, narrow and valuation focused you are the shorter-term you should be. If a stock must trade 50% below your assessment of intrinsic value, you are saying there is 100% upside today. To get a 25% CAGR you must capture that return within three years. Preferably sooner.

The best deep value investors have higher turnover because they are proven right quicker. As long as you are really good determining intrinsic value and can replace what you sold with other higher IRR opportunities you can do really well sticking to a narrow focused deep value/value valuation camp.

Warren Buffett and many others started on the left side of the valuation spectrum and moved to the right. His success forced him to lengthen his duration which meant focusing more on quality.

Even Ben Graham became more of a growth investor at the end. It’s just easier to invest with a tailwind. Graham said, “It sort of speeds things up a bit.”

Buffett evolved toward growth but he still wants to buy cheap. He is just willing to hold on a little longer to capture the right tail of returns. But he certainly doesn't hold forever.

Buffett only holds 8 stocks in the public portfolio for more than 10 years. 8 out of the ~250 stocks he's owned over the decades. Even for the best "long-term" stock picker in the world, only 4% of stocks he's purchased deserve to be held long-term. The rest deserve to be sold.

Every stock picker is unique. There is no right or wrong way to play this game. Some do very well sticking to their valuation camp. They stay narrow and rigid which means higher turnover.

Others successful investors learn to widen their valuation spectrum and hold a little longer. Some do this out of necessity because higher turnover is harder to do with higher AUM. Some learn to hold a little longer because they can't find new high IRR opportunities fast enough to replace the old ones. Some learn to hold a little longer because they don't want to burnout like Peter Lynch did. They want to go the distance.

It’s extremely difficult to capture the right tail of monster winners because the underlying businesses are constantly changing and evolving.

Great stocks evolve. Most investors don’t. And that's okay.

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