“The biggest mistakes I’ve made by far are mistakes of omission and not commission.” (Warren Buffett)
This blog post is dedicated to providing a behind-the-scenes look at how subjective considerations can influence the compilation of the monthly Top 10 for the newsletter, with a particular focus on our EVA Monster candidates. While the backbone of the underlying process will always be the quantitative ranking of our investable universe constituents based on their total return potentials, we argue that a more nuanced approach produces a better outcome. This, in fact, reflects the thought process behind how our analysts manage their own money, which has to be consistent with the newsletter, as this is a pillar of our integrity.
The problem with a purely quantitative ranking is that a mere total return potential figure does not fully reflect the range of possible outcomes. As a quick recap, a good rule of thumb is that we expect our typical EVA Monster to deliver an annualized fundamental return of 10-15%, comprising the firm’s EVA growth potential, share buybacks, and dividend yield. Since we derive our total return estimates by incorporating the impact of valuation, it’s unsurprising that when the total return potential significantly exceeds 10-15%, betting on a valuation rebound will likely play a pronounced role for an investment candidate.
A common theme in those situations is a rather pessimistic market perception, requiring a case-by-case evaluation with a contrarian mindset. “The best thing that happens to us is when a great company gets into temporary trouble. We want to buy them when they’re on the operating table.” The intent from this classic Buffett adage is easier said than done, as these stocks often turn out to be difficult to hold amid periods of turbulence. We reckon that when a company of EVA Monster caliber (head and shoulders above the typical S&P 500 member in quality and growth terms) gets into a dire situation, there is a good chance it will recover, much like an elite athlete having better odds on the operating table compared to a chain-smoker. Suppose an EVA Monster trades with close to zero or a negative Future Growth Reliance ratio (implying that its EVA could stagnate or shrink from the current level). In that case, it is usually a “heads I win, tails I don’t lose much” scenario. Sometimes, the market will be right, and the competitive position may have suffered damage beyond repair, serving as a bitter reminder that even though probability is on our side, this does not mean certainty. While these investment situations could offer favorable risk-reward ratios, we must also acknowledge that not all of us have the same tolerance for bearing the inherent volatility that almost always accompanies such cases.
Let’s now consider the concept of “hitting the sweet spot”. We refer to a select group of companies as “crème de la crème,” highlighting their superiority even within our elite EVA Monster universe. The common thread among them is the combination of an unassailable competitive position, exceptional reinvestment opportunities, and, more often than not, a high degree of revenue stream diversification. Microsoft, Amazon, Alphabet, LVMH, L’Oréal, and Hermès serve as prime examples of this class, although it’s important to note that this labeling represents more of a spectrum than a clear-cut categorization.
Occasionally, some of these top-tier companies come close to reaching the upper echelons of our coverage in terms of their respective total return potentials, albeit this isn’t sufficient to qualify them for the Top 10 on a quantitative basis. While our sample size is somewhat limited, we have numerous examples where companies like Microsoft, Hermès, or LVMH briefly traded at levels offering double-digit total return potentials, only to swiftly reverse their share price trajectory and perform remarkably well in subsequent periods. Hindsight is 20/20, but we argue that seizing such opportunities and including these juggernauts in the FALCON Portfolio would have been the right decision. Quoting Buffett again: “The biggest mistakes I’ve made by far are mistakes of omission and not commission. I mean, it’s the things I knew enough to do. They were within my circle of competence, and I was sucking my thumb… Those are the ones that hurt.” In these specific cases, the mistake of omission was caused by the intention to avoid compromising on the prospective return, thereby missing out on rare opportunities to become an owner of these world-class businesses.
When crunching the numbers, we must draw the line of “enough” for the total return potential somewhere, so we’ve set the goal to achieve a comfortable double-digit annualized investment return on a portfolio level. Generally, our standard approach is to pull the trigger midway between our “accumulation” and “full position” price thresholds. In practice, this means including a stock in the FALCON Portfolio when our modeled total return potential hits ~18%. This serves as a built-in margin of safety, as even if we are not entirely correct, achieving the targeted 12% total return still seems within reach.
However, there is an important distinction: the more confident we are in our modeling and the narrower the range of outcomes, the lower margin of safety should be demanded in total return terms. We argue that it is worthwhile to consider building a position in the top-notch companies even if their total return potentials “only” reach 12%, reflecting our stronger conviction that they can deliver on their modeled EVA growth trajectory. For these EVA Monsters, we would contemplate subjectively catapulting their stock into the newsletter’s Top 10, possibly coupled with inclusion in our FALCON Portfolio if they are not already members. As luck would have it, a subsequent collapse in share price can happen anytime, so buckle up for that as well. Taking advantage of those situations is the straightest path to long-term wealth building.
One thing is for sure: no matter how outstanding a business may be, its stock can always be too expensive, so we are not willing to compromise beyond a certain point. Therefore, if our model shows a single-digit total return potential, a company will never be subjectively promoted to the Top 10, let alone become a Top Pick. In such cases, we have high conviction that the valuation component could act as a headwind over the long term, likely leading to subpar investment returns. While we might be wrong at times, it is worth keeping the good old process-outcome matrix in mind to systematically judge the results of our decision-making framework. Now let’s see what the FALCON spots this time!
