"And Then What?"

A hack I use to try and think long term

If you are reading this, you more than likely understand the importance of long term thinking. Why else would you want to invest where you sacrifice enjoying your money today to let it grow into something much larger in the future. If you are a regular reader of this substack, then you are also not a short term trader and focus on long term business fundamentals. Whether it was Buffett, Graham, Lynch, Fisher, Pabrai, or someone else, you probably believe (like I do) that the short term is just noise. Though the short term may give you some input, it is something you usually don’t act upon.

What does the short term mean? For some, the short term is the next 10-15 minutes but for others, short term can mean a day or two. At the peak of a speculative run, the “long term” seems to be about 6 months. But I digress as that is not what this post is about. Some see it as a couple of weeks or a month. My personal experience is that, when it comes to the market, most people think in terms of 2-4 quarters. It seems like many participants want to buy shares in companies that are going to show strong profitability in the next 2-4 quarters. They also typically shun businesses that are about to show weaker numbers, despite the 2-3 year outlook being reasonable. The market has the tendency to discount uncertainty more than poor performance. What I mean when I say this is that something with an uncertain (although potentially positive) future may trade at a lower (or lower) valuation than another business that can have a more negative future.

Let me go into a bit more detail here. I don’t think that most market participants intend to think in timelines of 2-4 quarters, but I think our psychology nudges us there. It’s very hard to own a company when you know the next couple quarters are gonna be stinkers. The market may have this factored in or it may not. You run the risk of them reporting something poor and the market selling off the stock. And since you are only in for the next couple quarters, you potentially sell out at a low. The problem with this (in my opinion) is that almost everyone you are competing with is doing this as well. How can you expect to perform better than the market when you *ahem* are the market? I mean when you are stuck in traffic, you are essentially someone else’s traffic.

This is a fine line of course. If the market has given a company a high terminal value then, theoretically, it’s thinking very long term. That’s at least what I used to think. Now I think it’s more about what has recently happened and will continue to happen. If over the last 5 years a company has sales rising 8-10% per year and the share price has risen higher than that, why would you expect otherwise? I think the longer something happens the more likely people think it will continue to happen.

What I Do

I feel a key part of my (potential) advantage is I think longer than the timeframe the market usually does. Jim O’Shaunessey calls this Temporal Arbitrage. For instance, I’m taking a look at a business to put my capital into, I have a hack/trick/heuristic/whatever-you-want-to-call-it that I ask myself, “and then what?”

This looks something like, “XYZ company looks like it will continue to perform well for the next 2 years given the release of a new product…. and then what”?

In my experience, looking beyond 2-4 quarters is key for my successful investing. There is a massive amount of intellectual horsepower going into predicting the next 1-2-3 quarters. Analysts will attempt to look out 2-3 years but they don’t seem to have much success with that in my experience. However, looking past the 2-4 quarter mark is where I do well and have had success. No one wants to buy a company that looks like it will put up poor numbers for a couple of quarters. They want certainty. The issue is that by the time it’s “certain” the stock has usually recovered. How many times have you heard someone say “I’ll wait until the business looks stable, then I’ll buy back in.” and they actually buy back in?

Some Examples

Let’s take a look at what can happen when you look out 2-4 quarters without asking yourself “and then what”. These are all theoretical examples, but I have experienced many of them first hand (and probably will be subject to them again at some point).

1. Cyclical business tied to a commodity

You are looking at an oil company that looks like the business is going to show strong profitability in the next two quarters. You estimate the amount of FCF and put a multiple on it to get a fair value. It turns out there’s a large discount, so you buy shares. The shares, however, end up drifting downward with the commodity, despite the next couple of quarters unfolding pretty much on point or better than what you expected. There are many reasons why this could happen. One of them was you didn’t think about “and then what?”

In this example, the market was pretty accurate in its assessment of the business. It knew the next couple of quarters were going to be bangers but sniffed out lower commodity prices affecting the business in the “then what” timeframe. The market was, essentially, forward looking

2. Consumer facing company with negative economic headlines

Your friend says he is looking at a stock, in a business, that is exposed to consumer discretionary spending just as it seems we are entering a recession. You look at your friend like he has two heads and laugh “you don’t own that in a recession”. Meanwhile, shares are stable and start trending up as the news and economic data points look pretty terrible. The company even reports earnings were less than stellar. The valuation (based on ttm numbers) is really high. What gives? Sure the business was hurt, but after that it recovered and made inroads with the consumer. Well, the economy bounced back like it always does and the consumer started spending again. The company’s products were back in demand.

3. Topical company on X with more interest than the Tyson vs Paul fight

You are certain the legalization of cannabis is going to mean higher demand for the drug in the long term. It’s just a matter of time before the various levels of government get onboard and tax it like all good bureaucrats do, because they need the tax revenue. The company you invested in grows a variation of the product to sell to consumers. You were 100% right in your top down assessment of the situation. It was legalized. It is now used by more Americans than alcohol but all the capital that poured into the industry drove down prices. And those bureaucrats couldn’t get on the same page. Your shares tumbled. Now, the outlook is murky and profitability is poor. Let alone the nose-bleed valuations need to unwind and the shareholder base needs to churn through all the people who owned this due to hype.

4. Disruptor with potential

You buy shares in a company which has some sort of technology that is going to disrupt their industry. They claim the TAM is huge. Your friend who works in the industry validates the claim and says “yeah the product is the real deal”. You buy shares due to the low market cap relative to the TAM. 3-4 quarters later, your shares have lost half their value despite them winning a bunch of new business. While they may have acquired the business, it turns out they perhaps weren’t great at pricing or had cost overruns or product adoption stalled and it doesn’t really look like they will make a bunch of money from this innovation. The market cap was low, but the business never fully takes off and customers are not that sticky.

5. Amateur dividend investing

You buy a company that has a high dividend yield. The business is facing some headwinds, but they have lots of cash. You believe it is unlikely they would cut the dividend after all these years, as it would hurt the share price. However, it turns out the board is fine with a dividend cut because it has the potential to stabilize the business. They aren’t sure how deep the downturn will be and how long it will last, so they want to have as much capital as possible. Plus they may want to pick up some competitors on the cheap when the industry gets hit, which is actually what they should be doing. With no steady earnings or dividend to support it, the stock enters no man’s land. It is relentlessly sold by the dividend boomers and drops 50%.

What to do about it

This will be an underwhelming response but I would say the focus for you is to find the investing style, including timeframes, that work the best for you in your situation. I know this may sound like a cop out, however, this is what I have found to work for me. If you want to play this game, you will have to find what is ideal for you even if it is an uncommon or unfavorable choice. While I have (mostly) found what will keep me in the game the longest, I still welcome and understand it will evolve over time.

I hope you enjoyed this post. I would love to hear your perspective on this.

Thanks for reading.

Dean