The Compounder Pond Is Where The Fish Are

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Includes: NFLX
by: Long Hill Road Capital
Summary

The vast majority of the value of a rapidly-growing compounder is attributable to cash flows generated in the distant future.

That makes these businesses harder to value, or at least, the range of possible values tends to be wider. That tends to cause significant stock price volatility because investors extrapolate.

The result is these businesses are more likely to be wildly-mispriced at any given time than non-compounders.

I consider this part two of Why Compounders?, which I published last year.

Charlie Munger says the first rule of fishing is to "fish where the fish are." As a metaphor for investing, he is suggesting that investors look at pockets of the market that are more likely to offer attractive investment opportunities.

That can mean different things to different investors. For example, some investors may find more opportunities in small cap or micro cap stocks due to less competition from large institutional investors. Other investors might look at emerging markets or obscure frontier markets for the same reasons. Others may look at more unique corporate situations like spin offs, split-offs, rights offerings, contingent value rights, restructurings, post-reorg equities, and other complex transactions.

However, as you know, the pond I choose to fish in most often is the Compounder pond. By the way--and this is a tangent--don't confuse me for a "growth investor." Or a "value investor" for that matter. As anyone who has read Buffett's letters to Berkshire shareholders knows, "growth versus value" is a misnomer. All intelligent investing is looking to buy something for less than it is worth. That could be a house, a rental property, a farm, a business whether publicly-traded or not, or any asset.

To figure out what something is worth, you have to look at valuation drivers like growth, margins, returns on capital, capital intensity, and other factors. Growth is simply one component of what determines value. That's why it's a pet peeve of mine when anyone talks about "growth stocks" and "value stocks." Drop the meaningless labels and focus on price versus value. Any business, whether it is growing or not, is undervalued at one price and overvalued at another.

Growth versus value is like separating basketball players into two groups: 1) those who shoot a high free throw percentage and 2) those who are skilled. Free throw percentage is important, but it is just one of many factors that determines skill.

Back to my point though. Why do I fish in the Compounder pond? In addition to the reasons I wrote about in Why Compounders?, Why Do I Focus On Inevitables?, and The Last Investment Edge, I fish in this pond because... shh, close the doors...

Compounders are more likely to be wildly-mispriced at any given time than non-compounders.

I don't hear this point discussed, so that may be controversial. Let's start with the definition of value: the present value of all future cash flows. Compounders tend to have the opportunity to grow for many years, if not decades, so the vast majority of their value is derived from cash flows they will generate in the distant future. That's how the math works. But the future is uncertain, so a reasonable range of values for compounders is often extremely wide.

For example, Netflix's (NFLX) global subscriber base may mature near 300 million, 500 million, 700 million, or more in the distant future. Average revenue per user may be $15 or $20 or $30 in the future if they load the service with enough attractive and diverse content. The company's consolidated operating margins may reach 30%, 40%, 50% or higher eventually. Other factors like interest rates, tax rates, working capital intensity, and capital requirements could also vary widely. Given the wide range of possible future scenarios, there is also a wide range of possible business values.

When valuations are derived heavily on cash flows that will occur in the distant future, stock prices are often more volatile than average. Why? Because markets tend to extrapolate the recent past into the future, and extrapolating a small change in assumption forward for 20 years makes a huge difference to the present value of future cash flows. So when Netflix has a "bad" quarter and markets extrapolate, look out below. And likewise when Netflix has a "good" quarter, look out above.

So as a long-term investor who hopes to own businesses for a decade or longer, that extreme volatility is so helpful. Why? I maintain a few different scenarios for how Netflix's business might evolve over the long term, and there's a certain set of assumptions that I'm comfortable relying on. That set of assumptions drives my base case valuation for Netflix. So when the company reports a "bad" quarter or the stock sells off hard with tech stocks, the resulting discount to my base case valuation is much more likely to provide an opportunity than with other sorts of businesses.

Why? Think of the opposite type of business: a no-growth or slow growth business with stable margins. The range of possible futures for that business is far more narrow, so it's range of possible values is similarly narrow. As a result, it's going to tend to have a stock price that's also far less volatile. Certainly, those stocks can also get mispriced, but rapidly-growing compounders are both mispriced more often and have the potential to be far more mispriced.

Further, if a certain compounder isn't mispriced now, it probably will be in the not-so-distant future.

The market can be volatile, and the stocks of some compounders can be even more volatile. For example, let's say in May of last year, you did the work and concluded NFLX is most likely worth within the $350 to $450 per share range. NFLX was within that range from May of 2018 through October of 2018, so you may have concluded there was nothing to do with NFLX during that time period but wait. With the fourth-quarter market carnage, NFLX traded as low as $231 per share. The fourth quarter was an unusual period, but it does happen from time to time. It also happens to individual stocks from time to time even when the market environment is fairly placid.

Of course, none of this is meant to suggest identifying and investing in a wildly-mispriced compounder is easy. It's not. It's extremely difficult. Like Munger says, "It’s not supposed to be easy. Anyone who finds it easy is stupid." But the rewards are worth the trouble for those who can value businesses reasonably well, remain unemotional about volatility, and maintain a long-term perspective.

Conclusion

I fish in the Compounder pond in part because I believe I'm more likely to find wildly-mispriced opportunities. Their range of possible outcomes is wider, their businesses are harder to value, their stocks tend to be far more volatile, and as a result, I'm more likely to find the biggest opportunities.

Disclosure: I am/we are long NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.