Physics Wins
You cannot escape physics. The value of every investment starts at zero. Entropy is our natural state (thank you to the Second Law of Thermodynamics) meaning that we are constantly fighting the destruction of value. There is always a force, equivalent to gravity, pushing an investment down. Value is created by the efficient use of capital and the created, sustainable competitive advantage. Consistent investment in a thoughtful portfolio will create sustained value, but it is work, and you will always be fighting natural physical forces. One recent example is the financial crisis of 2008 to 2009. 40% of the average equity value was destroyed in this time. However, if one invested consistently at the height of the market and continue to invest through the crash and then ultimate recovery, and investor still earned over 9% annually. Thoughtfulness, consistency, patience, and determination is the most effective way to fight gravity and thermodynamics.
The most important way to fight physics and the ultimate effect of gravity is to determine what you are looking for first. Highlight growth, disruption, sustainability – what will have a long-term value creating effect. What sectors make the most impactful difference? Recently, as we look at technology, biotechnology, and other important sectors, we see above average returns because of the impactful nature of the sectors. But technology is also permeating finance (Fintech) and entertainment (streaming services) that are disrupting incumbents and creating disproportionate value to the new entrants. Is this sustainable? Will the disruptors capture value, or will more established companies ultimately win?
Ptolemy vs Galileo
For many years, the model of our solar system, as developed by the Egyptian astronomer Ptolemy, had the earth at the center of the solar system with all other planets revolving around it. This made a lot of sense given the basic assumption that the earth was the center of the universe. However, as observations continue to be more refined, the simple model needed to be adjusted to almost impenetrable complexity in order to account for the motions of planets – that is, if the earth remains at the center of everything. Complexity heightened because the fundamental assumption about the earth being the center of the universe was flawed – as we now know. But sticking to previously assumed beliefs led to inaccuracy and a jumbled and absurd looking model.
Starting with a clean sheet of paper, Copernicus changed the model, and all the observations made much more sense. It was Galileo and his telescope that confirmed more accurately the orbits of the planets. The Ptolemaic model was cast onto the junk heap of history. The lesson here is that historical bias and a failure to comprehend what new observations or accept fundamental changes to previously “assumed knowledge” eventually cause profound inaccuracy along the lines of the Ptolemaic model.
Observation, questioning assumptions, testing models, and assuming no knowledge regardless of historical experience are the only cures for gravity.
This time it’s different
No, it isn’t. Those who do not learn from history are destined to repeat it. While that may or may not be true, those who fail to learn from history will make uninformed decisions.
Technology has dominated before and valuations to those dominant technology companies (IBM in the 1970s or perhaps Amazon or Apple today) expected perfect implementation and these businesses to scale to monopoly-like profitability. While this may prove relatively long-lasting, it certainly is not permanent, and no business plan is implemented perfectly. Ultimately, physics will win – but when?
In the 1970s, IBM was almost 10% of the value of the S&P 500. After decades of tremendous growth in valuation, the stock essentially flattened and produced little return from then on. In 1999 Microsoft was 6%. Its stock was essentially a flat line for more than 15 years afterward. Today, the S&P 500 is composed of Apple (5%), Google (5%), Amazon (5%), and Facebook (4%). We have seen extraordinary growth and value for each of the securities. Is it different this time? Valuations always get ahead of themselves. Attractive businesses are highly valued by the market. But the market is irrational and ultimately, while no individual can withstand the illiquidity long enough, a patient investor knows that physics will win. The aggressive valuations ultimately returned to earth, and there is a reversion to the mean. Will this happen for the securities? What is sustainable? Where are any of these companies only look at its value over time, how it implements its business plan, capturing cash flow and ultimately determining its future value. These are the important questions to ask – remembering that there is no cure for gravity.
Valuation – what would you need to NOT be able to have it?
High valuations can be sustained so long as the business delivers more value than the relative cost. One way to think about value is not so much what something costs today relative to what you think it may be worth, but rather, what would someone have to pay you to do without that investment?
Let me illustrate this point with a simple example I have borrowed from Steven Pinker. Think about the value of refrigeration to any household. The average cost of a refrigerator in the United States is about $500. But refrigeration delivers extraordinary value, the ability to store food, the savings from efficient shopping, access to foods that can be preserved, etc. What would someone have to pay a household for that household to give up its refrigerator? It certainly would need to be much more than $500 because the refrigerator delivers so much more than $500 value, even though it costs about $500. This is an example of an excellent investment – the present value of a refrigerator is much higher than the current cost. We might need to be paid many thousands of dollars or more to go without this convenience. I think this is an excellent way to think about the value of an investment.
Earlier we discussed that perhaps the most important investment decision one makes is not what to buy, but when to sell. I would argue that the single greatest investment mistake people make is selling a good investment too soon. Here is one font problem that can help avoid this, and it’s related to the issue with refrigeration. They may be no price at which we would sell all refrigerator never to have one again. That is indicative of long-term value that is truly sustainable. So now here is the thought problem: what would you have to sell an investment for to never be able to buy it again? In other words, you only Apple or Amazon (two highly valued stocks as we speak), but you may have made a good return as a shareholder, but should you sell today or continue to hold? What if I told you that whenever you sell the stock you can never buy another share again in the future, regardless of what happens. I believe this would cause you to think much more carefully about whether to sell. I submit that all selling decisions should have this refined filter. It keeps one from making fundamental selling mistakes. When you know an investment is really done, and it will revert to the mean, and the extraordinary returns you’ve enjoyed are not coming back, you’ll be comfortable selling that stock knowing you will want to buy it again because it will simply be an average holding from now on. But, if you feel there is still an opportunity for this company to thrive and, even though it may currently be at a high value when he may have earned a relatively high return by owning it, there is still much more return to come. Much like owning Apple at a dollar 10 per share in the late 1990s, or Amazon at six dollars per share in 2001, there is much more value to be gained. At some point, gravity will take over, but this thought problem is a good test for your thoroughness and understanding of when it is time to exit and redeploy capital elsewhere.
We have seen this before and we will see it again. Valuable companies will be created and will outperform the market, but eventually, nothing escapes physics.
Industries cannot escape centralization either. New industries start out decentralized and fragmented – think of the computer industry, software industry, even the automobile industry (it went from over 1000 car companies at the turn-of-the-century to three US-based car companies in the 1950s) focus and centralization is something that cannot be avoided by any industry, especially innovative and disruptive market sectors. A current example or disruptive technologies such as cloud computing and online advertising. 20 years ago, this was fragmented among many businesses, and now Google and Facebook control 60% of the online ad business. There were over six search engines 20 years ago, now Google is more than 80% of all Internet searches. Online retailing was fragmented but is now centralized through Amazon controlling over 40% of all online retailing. Value-added businesses create specific market niches and centralize their content around their focus. This is the natural evolution of every market and while it gets a lot of attention today because of the global monopoly-like position of companies like Amazon, Apple, Google, and Facebook, it is the natural evolution of any industry. What is happened is that there is now immediate access to global markets. A handful of companies can now grow to tremendous, centralized dominance and a disruptive competitor is highly unlikely once these companies have earned their positions.
