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The Underrated Advantage As An Investor

Most people seek to find an edge in investment in making money in the shortest time frame possible. A common consensus among value investors is to screen and locate stocks that are mispriced by the market by means of information arbitrage. This makes it more exciting to uncover a small cap stock that can be the next Amazon, Tesla, Netflix or Facebook – something that the market haven’t noticed yet. However, given today’s technology and information network, information travels faster than ever before. The informational gap between small cap stocks and large cap stocks is smaller than many of us realise and informational advantage over others is not as easy to obtain as before.

However, the most underrated advantage to have as an investor is time. This creates a huge advantage for investors who choose to focus on a longer time horizon. Just as investors we are looking for companies with quality management that focus on creating long term shareholder value, we also must be patient and focus on the long term vision of the company. As investment time frames continue to get shorter and shorter, the advantage of an investor with a long time horizon is increasing.

Benjamin Graham, who wrote the timeless classic The Intelligent Investor, wrote that in the short run the market behaves like a voting machine; however, in the long run it resembles more of a weighing machine. Short term volatility due to fear and other market emotions can drive short-term market fluctuations, resulting in a disconnect between the share price and intrinsic value of a company’s shares. However, in the longer term, the characteristics of a weighing machine weighs in on a company’s fundamentals and competitive edge and will eventually cause the intrinsic value and market price of its shares to converge.

Source: Euclidean Technologies Management

The majority of investors place more emphasis to gain an advantage on whether or not a company will be able to beat analysts’ expectations in the next financial quarter, which is mainly just noise in terms of what really matters to a company’s long term value. CEOs have complained often about the process in which companies try to meet the expectations placed on them by Wall Street analysts, and markets move on those results. This makes short-term underperformance resulting in a potential selloff. In fact companies can shortchange their long-term interests by trying to meet short-term goals.

The key factor when choosing companies should be to invest in companies with a durable competitive edge. While there is nothing wrong with paying close attention to near-term results, they are of secondary importance. Instead try focusing on determining that the long term competitive advantage of a company remains intact.

“Nobody buys a farm thinking if it is going to rain next year. They buy it because they think it’s going to be a good investment over 10 to 20 years” -Warren Buffett


“One of the consequences of such a short investment time horizon is that investors have begun to fear short-term market events and volatility as much or more than the factors that shape prospects for long-term economic and profit growth that drive stocks over the longer term.” – Jeff Kleintop.

Therefore, too much emphasis is on the next quarter’s earnings and analysing any potential catalysts that can help beat or miss expectations. Long-term investors are willing to buy into an uncertain short-term outlook could have purchased stocks of a quality company. The buyer of the stocks can have a very different time horizon compared to the seller who was selling shares simply because of a bad near term outlook. Most investors own stocks for short periods of time; while moats or the competitive edge of a company matter in the long run.

“When forced to choose between optimising the appearance of our GAAP accounting and maximising the present value of future cash flows, we’ll take the latter.” – Jeff Bezos, 1997.

Therefore, it is more important to shut out the near term noise and maintain the mindset of a long term investor. Thinking long term seems much harder than it is to execute amid news headlines and analysts’ opinions. The best part is that as long as Wall Street focuses more on the short-term, the advantage of long-term investing will keep increasing. Therefore, instead of focusing on the short-term changes in price, try focusing on the long-term changes in moats. This can give investors a significant edge.

The Last Mover Advantage in Business

“Escaping competition will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.” – Peter Thiel

First vs Last Mover

Humans love to be first – the first to get the latest Apple iPhone or be the first to watch the latest Avengers movie. In business, many businesses understand the importance of being a first mover to be a leader in their markets. If a company can be the first to enter or create a market, then this business is able to capture market share by being ahead of the potential competition, be seen as a innovator and establish brand loyalty.

However, in today’s rapidly changing world, being a first mover may not be such a huge advantage. In fact, the first-mover advantage is actually turning to a first-mover liability. With today’s technology advancing at a fast pace, competitors can catch up quickly and erode the first mover advantage. Successful businesses today may hold its value if it can maintain its current cash flows for the next few years. However, increased competition will see its profits starting to erode.

As PayPal co-founder and early Facebook investor Peter Thiel notes, “First mover isn’t what’s important — it’s the last mover. Like Microsoft was the last operating system.”

Google was definitely not the first search engine on the internet. Yahoo existed way before Google. Yet Google was the last big mover for search engines and has dominated ever since.

Why is this so?

The late mover arrives studying the first mover’s mistakes and areas of improvements without outlaying huge capital. This leaves them in a good position to judge if a market is worth entering. In this way, it has learnt from the first movers. Innovation often combines the best elements of products and services that already exists; it may copy but able to avoid their mistakes. They can then innovate from that point forth. They then make the last great development in a specific market and enjoy years of monopoly profits.

The Question of Overvaluation

The value of a business today is the sum of all the money that business will generate in the future. Or in more technical terms, by projecting the cash flow generated by the business against the rate of return wanted for the risk that the business represents.

Ironically, it’s also partly the reason for the huge premium on tech companies – the expectation of future cash flow through monopolization of the market by possibly being the last big mover.

Network effects are important in building these companies. They often are loss-making for a few years as it builds up its moat, and that means delayed profits. It is important to note here that the moat of the company is indeed strengthening rather than weakening. The network effect will help the last mover to grow at an exponential speed once it starts to gain traction. This makes it hard to stop, even for the first mover. Huge market share is not enough if the company is not able to generate enough profits or to be able to acquire or block competition. Being a visionary has its benefits, but it is not a must for long-term success.

Sometimes new ideas are just overrated.

Examples:

Amazon: Book Stacks Unlimited founded in 1992 was actually the first Internet bookstore. 2 years later, Jeff Bezos launched Amazon, and blew past Book Stacks Unlimited by capitalizing on the originator’s lack of promotion. The rest they say is history.

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Source: Business Insider

Facebook:  Facebook was definitely not the first social network. Remember Friendster and MySpace? In fact, MySpace dominated social media before Mark Zuckerberg’s smaller Facebook gained traction. More recently, Snapchat who created the disappearing Stories feature and face filters has seen its first mover advantage robbed by Facebook.

“In order to improve your game, you must study the endgame before everything else, for whereas the endings can be studied and mastered by themselves, the middle game and the opening must be studied in relation to the endgame.” – José Raúl Capablanca

 

Recurring Revenue: All About Predictability

Before even investing in a company, it is vital to understand how a company generate its revenue and more importantly, how predictable it is. As an investor, one of the key priorities is to reduce risk and that comes hand in hand with predictability. Therefore, a company with a stable recurring revenue stream makes it easier to project and value as compared to a company that generates revenue from one-off sales.

There are mainly two types of revenue—recurring and non-recurring. Companies that earn a large portion of their revenue from recurring sources are easier to project and valuate. It is a much more stable source of revenue. Examples of recurring revenue are usually in the form of subscriptions, services, franchise and licensing. On the other hand, non-recurring revenues are not as stable. Examples of this include a one-time service or a single consumer product sale. Compare a monthly Netflix (NFLX) subscription vs purchasing a pair of sneakers. It is much easier to project future revenues for these types of businesses because the starting base of the business isn’t zero. Recurring revenue allows new sales to be added to the existing revenue base instead of simply replacing lost revenue.

Furthermore, having a much more predictable revenue stream will enable to management to have a better projection ahead on how much to budget for expenses and how much to invest for growth or expansion. In this way, recurring revenues enables downside protection of the business.

On the contrary, businesses that generate revenues from one-off transactions or those that depend on continually selling the same number of products to maintain their sales from the prior year. These types of businesses include consumer-products businesses. These types of businesses depend on orders that come in one at a time, with no guarantee or predictability in the revenue stream, and are therefore more difficult to value.

It’s all about predictability.

Recurring revenue has a certain level of predictability built right in, and paying attention to important statistics such as customer churn rate can help you make that revenue even more predictable in the future. Determine whether a business is retaining its customers or if it is constantly turning them over (churning them). The longer a customer is retained by a business, the more profitable that business becomes. Most of us acknowledge that it is more expensive to gain a new customer than to retain a valued one. Another reason: A loyal customer base generates more predictable sales, which can improve profits. In the long run, the businesses that spend time cultivating long-term relationships with their customers are more likely to succeed.

Examples of companies with recurring revenue streams:

– Apple (AAPL)

– Box Inc (BOX)

– InterDigital (IDCC)

– McDonalds (MCD)

– Microsoft (MSFT)

– Netflix (NFLX)

– Universal Display (OLED)

Diversification: “You call that a position?”

“[Soros taught me] it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – Stanley Druckenmiller.

The conventional wisdom a typical investment advisor will say, “Diversify your risks. Your portfolio should be divided among equities, bonds and cash.”

However, what irks me the most is when it is mentioned that to have higher return equates to taking on higher risks. Equities carry higher risk than bonds. Therefore, it is important to diversify your portfolio among the various investments of the various risk levels. This logic cannot be more flawed; diversification for its own sake is not at all sensible.

As an investor, my key tasks are capital allocation based on the expectancy of your return on invested capital and more importantly, risk reduction.

The best investors such as Warren Buffett are terrific risk managers. To George Soros, success in investment comes from “preservation of capital and home runs.”

Diversification may minimize risk, but at the same time, it can have an adverse side effect on profit potential. Having too many holdings can assure that even a spectacular gain in one holding will have a diluted effect on your portfolio value.

Concentration in a small number of investments will make a difference. Concentration results from the way an investor approaches and selects his investments. In this way, opportunity cost is considered. After all, the top 5 stock ideas are likely to generate a higher returns than the 50th stock idea on the list. Therefore, when you have tremendous conviction on a trade and when the opportunity presents itself, make sure you go for it to make a real difference to your wealth.

However, there are no guarantees, and even the best investors makes mistakes. But the idea is to approach diversification based on your assessments on the risks they entail and the expectancy of your return on invested capital rather than allocating capital in many different investments you own for the sake of it.

“Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.” – Warren Buffett

Think about this for a moment:

Compare two portfolios. The first portfolio is diversified among 100 different stocks; the second portfolio is much more concentrated, with just 10 stocks.

Now if one of the stocks in the first portfolio doubles in price, the portfolio value rises just 1%. However, the same stock in the second portfolio will cause the portfolio value to rise 10%.

Now what you think is easier to do?

– identify one stock that is likely to double in price;

– identify 20 stocks that are likely to double?

An investor that knows a lot about a few investment holdings will be better off than knowing only a little about a long list of holdings.

The reality is that when you look at those who achieve the greatest wealth, almost none of them ever diversify, or at least throughout most of their years. Imagine if Bill Gates, Mark Zuckerberg, or Jeff Bezos diversifying into the S&P 500 after their companies’ IPO, they’d probably have a fraction of the wealth they do today.

“I can’t be involved in 50 or 75 things. That’s a Noah’s ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things.” – Warren Buffett