What Should We Do Now?
A 24 Year Old's Guide to Managing Markets
In times of uncertainty, people tend to act irrationally. This exists in life and so it exists in investing. Across the spectrum - from professional to retail - when markets go south, decision-making skills tend to follow quickly behind. At a time when rational thinking is probably most important, it is usually the least applied. Everyone is a genius on the way up, and the market is stupid on the way down (myself included).
The current market environment is one that I and most of my peers have never experienced. Inflation is high & persistent, war is underway, labor and supply chain issues are affecting every industry, and there’s zero indication of the fed jumping in to bail us out (in fact it looks like the opposite). Basically, a lot of uncertainty is in the air. Uncertainty should be welcomed as it’s what creates amazing opportunities in the market; however, increased uncertainty also forces us to be more prepared, rational, and correct. For the last two years, it’s been hard to be incorrect. It’s much easier now.
In an effort to clear my head and hopefully be of use to readers, I decided to write down four guiding principles I am trying to stick to in these strange times; talking points I keep going back to when having conversations about the market. A lot of these may seem simple or basic to some, but they are helpful to me and I’m sure can be of use to others.
Four Principles
Forget the price charts.
Don’t even look at them. A stock that’s down relative to some unrealistic valuation it was at prior doesn’t mean a thing for forward returns. Peloton down 90% doesn’t make it cheap. Markets were irrational at the top and most stocks down 50%+ are likely reaching a “fair” valuation. Companies aren’t entitled to get back to their all-time highs. In fact, I’d bet most stocks down 75%+ right now won’t get back there. To quote David Einhorn, “What do you call a stock down 90%? A stock that was down 80% and then got cut in half.” Start off by dropping this notion of cheap vs expensive.Companies and their stock prices are reflexive.
When uncertainty increases and stock prices drop, companies get nervous and fundamentals deteriorate. Survival and cash-on-hand become top of mind for management, and as a result investment into the company is slowed down. This takes form in many ways - project and budget cuts, layoffs, hiring freezes, etc. all take place because management is less certain about their future. Investors also get nervous. They become less willing to provide debt or equity at cheap prices to fund your growth. This means you’re paying higher prices for capital or not raising capital at all, both of which can hamstring growth.
As an example on stock price reflexivity, let’s pretend you’re an engineer at Peloton and your compensation structure is $150k cash and 1,500 RSU’s, currently valued at $100/share. You think your comp is $300k+ all-in; however, by the time you’re granted the RSU’s the stock is at $12. Your stock-based comp has now gone from $150k to ~$22.5k ($12*1,875). Instead of making the $300k you expected, you actually make $177.5k (still not bad I might add). You’re likely upset and hurt and much less confident in Peloton returning back to $100+. What is stopping you from leaving to go get “refreshed” equity compensation at any big tech company that has also seen their stock price decline? Peloton will either have to pay you cash to make up the “lost” compensation, hurting their margins; or watch talented engineers leave the company. Not an easy decision for management and a very important question for investors.
[side note: I would add that this type of behavior can also be mimetic. If you see your competitor is cutting costs, you’re worried that it might work out and maybe you should be doing the same. “What do they know that I don’t?”]Be honest about your investing goals. Ask yourself, “what do I really want out of investing?” If this is a lifelong game for you and you’re determined to succeed, keep going. If you’ve had fun flipping stocks for the last 2 years but this isn’t something you want to allocate real time and money to, that’s great! Put most of your money in the index and save a couple of percentage points for gambling. (This is not financial advice. I don’t know if I have to say this but I see it all the time?) Remember that if you are successful, at some point you will be playing this game with significantly more money, how confident will you be in your positions when they are 10/20/50x higher?
Understand your edge (or lack thereof). Investing is a hyper-competitive game involving hundreds of thousands of players with (generally) the same information and likely greater intellect. What do you know about a company that hasn’t already been thought through and reflected in its stock price? Apple is releasing a new phone in September? Awesome! What do you think the company will look like in 10,15 years? What is management’s track record of innovating, executing, and doing what they say they are going to do? Most things that we think are important to a company’s stock price actually don’t matter, and only a few factors drive a majority of the returns (e.g. industry, management, culture, cash flows). To earn above-average returns, you must have some sort of variant perception of the market and the individual assets you analyze. Then you have to be right. What do you believe that the market doesn’t, and how confident are you?
Closing
In summary - (1) cheap vs expensive is measured by cash flow generated in the future, not by how much the stock price has changed in the past. (2) Stock prices do affect company fundamentals, both on the way up and on the way down. (3) Understand what it is you want out of investing and how much energy you’re willing to give it. (4) In every scenario ask yourself, “what is my edge?”
I hope these principles can provide some clarity for you in the way that they do for me. There is of course much more that goes on and things are never this simplistic, but I find it a good starting point when trying to think through opportunities with a clear head.
As always, feel free to reach out on Twitter or in the comment section, I’m always interested in feedback & further discussion.
Definitely feel like #2 is happening, folks leaving to “reset” their equity at another company. Sketchy companies more likely to layoff too which can destroy a company culture then it cascades to others leaving shortly thereafter. A flight to safety at big tech and default investable companies! Have you seen what David Sacks has said about that ?
Resetting of valuations could be a huge opportunity if you can place your bets right :)