How Investment Paradoxes Impact Decision Making

Active equity managers face many investment paradoxes. Markets are inherently volatile and can be irrational. Long-term consensus expectations are often misestimated, all of which should create inefficiencies in security prices. And yet, most active managers fail to outperform their respective benchmarks. As Senior Equity Portfolio Manager, I’m specifically responsible for the Intrinsic Value Strategy, an internally-managed domestic equity strategy that is often part of a broader US equity allocation in our client portfolios. I was recently asked how the Intrinsic Value Strategy can outperform one of the capital market’s most competitive benchmarks. The answer lies in how we respond to the undermentioned investment paradoxes.

Countless forces influence stock prices, ranging from underlying business fundamentals to macro factors and market sentiment. Stock prices ordinarily follow unpredictable and nonlinear patterns. Even some of the best-performing stocks over the past two decades consistently displayed nonlinear stock price movements. For instance, Alphabet has performed exceedingly well since its IPO in 2004, returning 6,710% (or 27.50% annualized) through the end of 2021. To have achieved this result, an investor would’ve needed to endure a flat stock price for five years (from the end of 2007 to the end of 2012). From the end of 2017 to its lows in March of 2020, its share price was once again roughly flat. However, Alphabet’s stock price quickly tripled in value shortly thereafter. Amazon’s rise has been even wilder, as it took six years to recover its 95% decline after the dot-com bubble burst. Amazon’s share price has experienced several long periods of high volatility and little price progression, not dissimilar to the past eighteen months. Still, Amazon’s stock is up 222,189% (or 36.70% annualized) from its IPO in 1997 through the end of 2021. Skillful investors can uncover unique business insights, but none can pinpoint when such insights will be recognized by the market. Many active managers feverishly attempt to outperform in the short-term at the expense of the long-term; however, we believe that long-term outperformance cannot be achieved without encountering periods of underperformance.

Underlying business trends also display nonlinearity. Fluctuations in demand, supply-chain disruptions, and numerous other reasons can cause business fundamentals to appear uneven. Reinvestment can also lead to lumpy business results. High levels of reinvestment not only burden financial statements but also mask a company’s underlying profitability. For instance, Amazon Web Services (AWS) began offering its cloud computing infrastructure to businesses in 2006, approximately six years after its founding. At the time, Amazon was diverting significant profits from its e-commerce operations as the company was building one of the world’s most important cloud computing platforms. This undertaking depressed the profitability of its e-commerce business and artificially inflated valuation multiples, leading most to conclude that Amazon was unprofitable and traded at an egregious valuation. Today, AWS has a commanding lead in cloud computing infrastructure, with a rapidly growing revenue run-rate of $60 billion at operating margins of ~30%. In a similar vein, the creation of Amazon Logistics (AMZL) in 2015 required enormous investment. Over this short period, AMZL has built a logistics network that includes approximately 260,000 drivers, 50,000 trailers, 85 airplanes, and 800 global delivery stations. Amazon is already delivering an estimated 60% to 70% of its packages. By early 2022, Amazon will be the largest package delivery company in the US, overtaking UPS (founded in 1907) and FedEx (founded in 1971).

Amazon’s historical stock price movement nicely demonstrates the paradox of value-creating reinvestment, as increased reinvestment regularly results in negative share price reactions, even though Amazon’s capital allocation has created immense value. Some investors might be incapable of accepting underperformance and would rather try to “time the inflection” in Amazon’s earnings. Others might be concerned that increased reinvestment reduces Amazon’s profitability, which only increases its already high valuation multiples (we have learned the hard way that some of the cheapest stocks can have elevated PE multiples; some might not even have reported earnings). As long-term investors, we will gladly exchange the intermediate-term burdens of internal reinvestment, as long as we believe the business is creating economic value.

Equity markets are highly competitive, so it is indeed difficult to identify mispriced qualitative insights. And since the future is undeniably uncertain and underperformance can result in adverse business consequences, active equity managers often opt to diversify across hundreds of stocks to “manage risk.” This is quite sensible, as a portfolio that resembles its benchmark will naturally have a narrower range of relative outcomes. However, if one defines risk as the probability of capital impairment (i.e. losing money), then focusing on a select number of great businesses with asymmetric risk/reward profiles is vastly superior. Regardless of the size of an organization’s research team, identifying 50 truly attractive stocks is challenging — let alone finding 100 or more. Incrementally adding average to below-average businesses will only increase risk, not decrease it. Paradoxically, we believe that concentration is an effective way of managing and reducing the risk of capital impairment. We recognize that the explicit costs of portfolio concentration come in the form of increased volatility and periods of underperformance. Our objective is not to reduce the Intrinsic Value Strategy’s volatility or to outperform in every quarter. We have some tolerance for volatility, as volatility provides long-term investors with exploitable opportunities. Our primary objective, however, is to sustainably earn above-average returns while minimizing the risk of capital impairment.

Overall, we believe that it is possible to gain an edge over markets by maintaining a long-term orientation. Markets are certainly comprised of smart and highly incentivized participants, however, they are driven by human behavior, which can be either rational or irrational. Time horizons across equity markets have also continually compressed over the past 50 years. Today’s average stock holding period is often measured in months instead of multiyear holding periods in prior decades. Consequently, fundamental expectations tend to be most efficiently priced in the short term, while the market’s efficiency begins to fade beyond a year or two. Said differently, equity markets are susceptible to the extrapolation of near-term trends and miscalculation of long-term growth. Even the largest and most covered stocks (e.g. Alphabet and Amazon) can have long-term expectations that are inefficiently priced. With the fullness of time, the economic value created or destroyed by a company will be reflected in its share price. Active managers must have a well-constructed investment philosophy and repeatable research process to identify attractive equity investments; however, discipline and patience ultimately dictate whether such investments translate into outperformance.