When Buffett first started out, he had a true information advantage. Other investors just didn’t know that Sanborn Map had an investment portfolio worth more than the entire market valuation of the company. This was an incredible opportunity and he took advantage of it.
This doesn’t exist anymore. (If you find it, please email me). I want to discuss two things: where the information advantage isn’t and where I think it is.
First, Warren Buffett devotees understand on a surface level what sort of information advantage Buffett had when he started out. Assuming this still exist, these investors set off on a journey to look under enough rocks and through enough haystacks to find the next Sanborn Map. What they find is typically a business whose valuation appears to significantly differ from larger companies, where the information about the larger companies is much more readily available.
The thesis follows that the “multiple” of earnings on the smaller company will converge to match that of its larger peers once the information about the smaller business becomes more readily available. The investor can easily make this happen by writing and discussing this information arbitrage with other investors.
What investors typically find in these situations is a poor business valued at a fair price to reflect the uncertain prospects of the business given its size and the industry in which it operates. My point is that the investor starts out with a hammer looking for his nail. The hammer is that “I need to look in markets where there is less information to find my nail.” The problem here is the investor is searching among fairly poor businesses. Buffett did this too, but when he found his needle, it was so obvious because the assets on the balance sheet were so much larger than the market valuation of the whole company that is was simple arithmetic. He really didn’t even have to examine the future prospects of the business.
This just doesn’t exist today. You have to examine the quality of the business. You just don’t have the mathematical under-valuations Buffett had. Any under-valuations that exist now are perceptions about the future cash flows and that requires an examination of the quality of the business.
Where is the information gap today?
My personal thought and the approach that John and I have come to see as enormously valuable is what we both call “time arbitrage.” We didn’t invent the term, as you can see by this investor letter from 2008:
“Our investment strategy has always reflected a time arbitrage in that we position ourselves to benefit from having a significantly longer-time horizon than other market participants.”
This is a fancy term to say the following (I am going to use Apple as an example): the stock market is currently valuing Apple based on how many iPhones it is expecting Apple to have sold in the last 90 days, whereas we are focused on what the value of Apple is going to be in the next 3-5-10 years.
The focus of this idea can be summed up in the following question: Are you worried about the next quarter or are you thinking about the health of the businesses in 5 years. John mentioned to me an analyst he heard saying (in reference to Apple’s upcoming quarterly earnings) that they were “cautious into the print.” John then joked about CNBC publishing the archives of everything Buffett has ever said on Apple: “I don’t think you will find ‘cautious into the print’ anywhere in those archives.” He is exactly right. Buffett is not focused on the preceding 90 days or the following 90 days, but is focused on the longer-term health of the company. (Side note: Buffett can be wrong, as was the case with IBM, but his focus was and is always the long-term health of the company).
This idea is much harder to implement than it first appears. Remember that great quote above about time-arbitrage, well, that quote was from 2008. Here is the most recent quarterly letter from that same investor.
“We looked at our 20 largest longs and 20 largest shorts to see how many had positive and negative earnings reports announced in the quarter. We defined positive and negative on a case by case basis, based on what the market seemed to care about. For example, Tempur Sealy International met EBITDA and earnings expectations, but missed on revenue. The market cared more about the revenue miss so, for the sake of this exercise, we called that a miss. Similarly, Netfiix (NFLX) missed EPS expectations and guided to much higher than expected future cash burn, but exceeded revenue and subscriber targets. The market loved the release, so we counted NFLX as a beat. All told, of our 20 largest longs, we judged 13 to have beaten expectations, 4 to have met expectations and 3 to have disappointed. Of our 20 largest shorts, 9 beat expectations, I met and 10 missed expectations. We then looked on a weighted average basis at how the stock prices reacted on the first trading day after earnings were announced.”
Earnings expectations, first day of trading, guidance, cautious into the print, all of these terms become the lexicon of the long-term investors slowly morphing into the hyper short-term focused investor. This garbley gook of language is mind-boggling.
Have you ever heard Buffett talk about the first trading day following earnings or the earnings expectations?
I am making two separate points here.
First, the man with the hammer looking for the information advantage is never going to look at Apple because he doesn’t think there is any way that there is an information advantage. And second, the information is all the same for all investors, but some investors are focused on what that information means for the next 90 days and others (very few) are focused on the what that information means for the next 5-10 years.
I think the only information advantage that exists in the market today is recognizing that everyone has the same information and then proceed to look for a company where the market has valued this company on the basis of its next 90 days and that valuation is dramatically different from your view of what the company is going to be worth in the next 5 years. This isn’t complicated, this won’t win John and me any stock-pitching contests, but this idea is dramatically different from Buffett’s original approach. I think it is helpful to understand where the opportunities exist and spend your time looking with the right approach.
The book (and movie) Moneyball is a great example of this idea.
The entire baseball league is focused on a few sets of metrics, mainly home runs, RBIs and speed. The Oakland Athletics decide instead that On Base Percentage, how often someone gets on base, is the key factor in determining whether a team scores more runs and therefore wins more games.
Applied to Apple, we can see that a large number of investors are focused on iPhone sales in the most recent quarter or the guidance for the upcoming quarter of sales. Instead, one might focus on the ever growing base of Apple devices in use (installed base), Apple Watch, Air Pod and Apple Music adoption. All of these data points create a picture of a business with hugely sticky customers for years into the future. The ecosystem of Apple becomes so strong that the long-term value of the company is much easier to predict given the recurring nature of its customers.
One final point about information advantage and market efficiency. Apple’s market value has fluctuated by about $150B in the past 3 weeks. This fluctuation in a company so well known continues to astound me.
Matt Brice is the portfolio manager at The Sova Group and can be reached at email@example.com. Disclosure: Matt Brice and The Sova Group clients own shares of Apple.