“You can borrow someone’s ideas but not their conviction.”
Several members sent us anxious emails after learning that “superinvestor” Mohnish Pabrai had sold ~80% of his Alibaba holding during the third quarter of 2021. While monitoring the 13F filings of renowned investors may be useful, we never advocated mindless coat-tailing, so let us share the thought process that runs through our minds when we bump into news like this.
We wholeheartedly agree with Bill Nygren of Oakmark Funds, who says, “the reason people have so much trouble with the sell decision is because they didn’t have a well-defined buy decision. If you really know why you decide to buy a stock and why you own it, then the absence of those reasons becomes the reason to sell.” At the FALCON Method, we didn’t just copy Pabrai and the other “superinvestors” (in fact, we had bought Alibaba before most of them disclosed their positions); we did our homework and built the investment thesis from scratch. One should only use the 13F info as input to start their independent analysis since borrowing an idea is seldom enough to take you to the finish line; you will need conviction.
After days of in-depth analysis, our team of analysts tends to invest a couple of hours in summarizing the investment thesis, identifying the most important drivers of performance, and listing the key metrics to monitor with every company. We also put together a short and simple premortem that forces us to build out that side of the probability tree where things don’t work out. It’s important to note that the premortem process occurs before an investment decision is made. We basically assume that we are in the future and the decision we made has failed. We then provide plausible reasons for that failure. Psychologist Gary Klein’s research shows that premortems help people identify more potential problems than other techniques and encourage more open exchange because no individual or group has yet invested in a decision. Without a premortem, we don’t see as many paths to the future in which we don’t reach our goals, while in reality, that can be a pretty robust part of the probability tree.
Once we are done with this process, we know exactly what to monitor closely with each and every company we invest in. As for Alibaba, the number of active China accounts and the gross merchandise value give us valuable clues on the level of disintermediation risk, while the cloud segment’s revenue, margin expansion, and market share dynamics may show how the “Amazon
story” is playing out. We have minimum thresholds for revenue and EVA per share growth, as well as for the EVA Margin, and the violation of these levels would prompt us to revisit our thesis. That said, we don’t believe that a single quarter’s results could be enough to make us change our minds.
The first thing we tend to check when news like Pabrai’s sale hit our mailbox is whether our well-defined investment thesis is broken. All in all, the list of valid reasons to sell a stock is relatively short: (1) We were wrong, (2) the stock became overvalued, (3) or we have a much better investment idea and need to free up capital. With Alibaba, number one is too early to call. Number two seems out of the question unless we assume the imminent collapse of the firm’s fundamental business performance. As for reason number three, the bar set by Alibaba’s total return potential looks way too high to justify a sell decision at this point.
Before moving on, we’d like to remind you that widely acclaimed investors will never call you before they sell (or buy) a stock, so managing your portfolio does require independent thinking and conviction that is based on in-depth analysis. Your emails reveal that most of you think Pabrai must have some insider information that led him to reduce his Alibaba position. While he may have an even better investment idea, history proves that selling a compounder is almost always a mistake. Warren Buffett’s Disney and McDonald’s investments come to mind, but you can also think of how Carl Icahn missed out on tremendous amount of gains by selling Netflix and Apple, or how Fundsmith’s Terry Smith screwed up with his Domino’s Pizza exit. Yes, Virginia, even “superinvestors” make such costly mistakes, which shows that they seldom (if ever) have that kind of insider info you suspect to guide their decision-making. Joseph P. Kennedy, former chairman of the Securities and Exchange Commission, whose son was President of the United States, put it perfectly: “If I had all the money that has been lost on inside information, I’d really be rich.”
As for managing EVA Monster positions, Howard Marks’ thoughts come to mind: “There’s a joke going around that in the factory of the future there is one man and one dog. The dog’s job is to keep the man from touching the equipment, the man’s job is to feed the dog. Most investors, in the same way, need a dog that has the job of keeping them from putting their hands on the portfolio.” We believe that we are best served by doing nothing as long as the EVA Monster characteristics of a business remain intact. If it feels uncomfortable holding Alibaba at this point, rest assured that this is, by definition, part of successful investing. (If your sleep is ruined, you may have to revisit your position sizing, though.)
Many of you keep asking us about the evolution of the FALCON Method and whether we are abandoning the income-focused approach we employed back when this service started. We are always on a hunt for quality dividend payers that are marked down. As the years went by, however, the pricey institutional-level data clearly supported our experience that there was a strong correlation (82%, to be more exact) between where EVA (Economic Value Added) goes and the level of shareholder returns. Take a look at this picture and see some examples to alleviate your doubts.
Investing for income alone is a mistake, the price of which is a subpar total return that negatively affects one’s future purchasing power. While we love passive income, only a snake oil salesman would try to persuade you that quality dividend payers are attractively priced in today’s market. Please do yourself a favor, and relinquish your focus on the entry dividend yield parameter as long as the scarce breed of high-quality growth companies may be the last mispriced assets. (Since it is almost impossible to overprice them based on the near-term multiples that most investors are fixated on).
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