Every great investor has an edge. Jim Simons employs a code cracking team, Ray Dalio demands radical transparency while Paul Singer deploys no-holds-barred activist attacks. One of the most common and lucrative edges I’ve seen exploited in markets is ‘Fighting the Fade‘. It’s in this niche many of the world’s most successful investors have cemented their track records; Munger & Buffett, Akre, Sleep, Smith, Polen, Lone Pine, Lindsell Train, WCM and Baillie Gifford.
Find The Edge In Fighting The Fade
At the heart of all successful investing is compounding and when it comes to this exponential function, two things matter - high rates of return and longevity. Over the long run just a few percentage points differential in annual returns translate to staggering differences in financial outcomes. It’s right here you find the edge in ‘Fighting the Fade’.
In his book, The Dhandho Investor: The Low–Risk Value Method to High Returns, Mohnish Pabrai coined an investment approach known as "Heads I win; Tails I don't lose much." Q3 2021 hedge fund letters, conferences and more The principle behind this approach was relatively simple. Pabrai explained that he was only looking for securities with Read More
Let me explain.
It’s a well known fact that few businesses can defy capitalism’s onslaught. Business success attracts attention, copycats emerge and so called ‘super-returns’ and high growth get competed away - they FADE. And while most businesses FADE, not all do. A few rare companies have defied competition’s mean reverting forces to sustain growth over the longer term. They possess some unique or idiosyncratic features that help them fight the FADE, delivering and maintaining those extra percentage points that drive the huge return differentials we discussed above.
Investors and analysts who misjudge the longevity of a company’s success will do so at the detriment of valuation. The typical discounted cash flow [DCF] model will specify financial outputs for a company over five or ten years. In the early years investors often apply high growth rates, after which forecasts assume capitalism’s brutality forces returns to a lower perpetual growth rate; usually a rate consistent with GDP (2-3%). This is the FADE and in a general sense, it’s appropriate. Just as no trees grow to the sky, no business can be larger than the economy they’re in. Compound at a rate much faster than the economy over a very long period of time and you eventually end up bigger than the economy.
The Non-Linear Effect Of Compounding
The non-linear effect of compounding means those businesses that can sustain success over decades, who ‘Fight the Fade,’ are worth substantially more than a typical DCF model would suggest. These businesses deliver those extra percentage points of return that get neglected in the valuation and can render companies on ‘optically high’ price-earning ratios as actually under-valued.
“Investors presume regression to the mean starts at the time of their analysis or, as CFA students may recognize, in year three or five of a DCF analysis! Investors use valuation heuristics rather than assess the real value of the business.” Nicholas Sleep
“It would seem that the unwillingness of many analysts to forecast strong growth out beyond 18 months to two years in the future is a significant factor in the valuation differences. The durability and longevity of extraordinary growth drastically changes what one might be willing to pay for a company. It can mean that we are willing to pay for growth at what seems like ‘an unreasonable price’ based on near term price multiples etc.” James Anderson
“Our ability to identify businesses that have the market opportunity, product distinction, competitive advantage and management skill to grow earnings and cash flow for longer than is factored into consensus expectations has distinguished our investment effort over the years.” Steve Mandel
“Since stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean, businesses whose returns do not do this can become undervalued. Therein lies our opportunity as investors.” Terry Smith
“From what is misleadingly labelled the ‘growth’ universe, we search for businesses whose returns are believed to be more sustainable than most investors expect.” Marathon Asset Management
Fading Growth Rate
“We are explicitly hunting the 3% of securities that do not mean revert, and the absence of mean reversion is our variant perception. Typically our expectations over the first year for these companies isn’t much different from consensus. What can be vastly different is what happens over two, five or ten years. The market in general will fade growth rates, earnings power and the multiple. We try to underwrite businesses we think can maintain growth and high returns for long periods of time.” Yen Liow
“We do not spend a lot of time building discounted cash flow models, but many people do. In these models, after five or ten years, the idea is to take the growth rate down to GDP. But we believe that doesn’t happen with great companies. Great companies can compound at over GDP growth rates for decades usually. So, the ‘market’ has a hard time pricing that. Essentially, we seek to buy companies at a discount to their intrinsic value. It may not appear that way when you pay 20-30X earnings. But the strength of earnings growth and length of time that a company compounds that growth is how we achieve our results.” Dan Davidowitz
“Most sell-side models go out a couple of years and then assume some sort of step-function down in growth or a terminal growth rate of some kind. Doing that might overly discount growth prospects that are more than a couple years out.” Rajiv Jain
“Structurally with the market, it’s very rare that even the third year of earnings is priced into these business [compounders] let alone the fifth, seventh or tenth year. When you find these companies with real durability that can compound for long periods of time, the optically high multiple, when in hindsight that was a smoking deal five years ago.” Jeff Mueller
“One of the hallmarks of the unique, competitively-advantaged businesses that comprise our portfolios is that we think they all possess the ability to grow their earnings base at a much greater rate, and for much longer, than the market typically expects.” Dan Davidowitz
The Good Times Won’t Last Forever
“It’s rational to assume that the good times won’t last forever. As such, prudent analysts will assume some amount of ROIC decay in their terminal assumptions. But, again, the billion-dollar question is, ‘How long will it take for ROIC to decay to WACC?’ Assume the decay is too rapid and you’re undervaluing the business; assume it’s too slow and you’re overvaluing the business.” Ensemble Capital
“The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.” Terry Smith
The investor’s quoted above have all exploited this wrinkle in accepted financial theory. They’ve done so by identifying and seeking the unique characteristics that allows a business to ‘Fight the Fade’; maybe it’s an exceptional business model, a special culture, adaptability, or capital allocation prowess. These rare great businesses not only don’t succumb to capitalism’s mean reverting forces, but in many cases become stronger as they grow. The key is where can they be found? Freshen up for Round 2.
“Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. Mis-pricing stems from a number of sources. One is the under-estimation of the durability of barriers to entry. Another is the under-appreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked.” Marathon Asset Management
Article by Investment Masters Class