Q1 2024 Market Commentary

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In the last few months, investors have lost two of the best thought leaders in the business. Charlie Munger, who passed away shortly before his 100th birthday, is probably best known for his lifelong partnership with Warren Buffett, cutting through noise to focus on what matters and explaining it with elegance and wit. Daniel Kahneman, who passed away at the age of 90, was one of the first practitioners of behavioral finance and has identified many ways our mind prevents us from making correct decisions.

In “Thinking Fast and Slow”, co-written with Amos Tversky, Dr. Kahneman defined biases such as the anchoring effect, availability heuristic, and confirmation biases because our brain is honed to make quick decisions to survive in dangerous situations. While these shortcuts may be helpful when chased by a tiger, they are a hindrance in situations where success depends on looking beyond the obvious.

Markets comprise thousands, if not millions, of participants at any given point operating with all the publicly available information. These participants make decisions that, while flawed or biased, individually add up to the total that generates the “wisdom of crowds” effect first noted by statistician Francis Galston, who asked 800 visitors to the country fair to guess the weight of an ox. While individual guesses ranged from 1,074 to 1,300 pounds – the average guess was 1,207– remarkably close to the animal's actual weight.

Taking the country fair example further, according to Prof. Kahneman, the same crowd, if presented with ten oxen, each weighing about 1,200 pounds and the eleventh animal being visibly different in size, would more likely than not be further away from the correct answer due to the anchoring effect that the prior measurements would have.

The anchoring effect is relevant not just in country fair antics but also in stock market analysis. The anchoring effect and recency bias combine to create perceptions in investor’s minds. The companies that have done well recently are assumed to continue to perform well into the future, even though the reasons for good performance may no longer exist. A case in point is the U.S. megacaps, whose valuations continued to go up in Q1 well ahead of the revenues and profits of the underlying companies.

The opposite can also be true. A high-quality company struggling temporarily is often assumed to remain in a predicament for the foreseeable future. In the past, we had found several attractive investment opportunities amongst the companies that were going through temporary difficulties, including Chipotle (CMG) in 2017, when it was going through the food safety scandal and Arista Networks (ANET) in 2020, when their major customers paused purchasing to design the next generation of data centers.

When a growth company struggles and then restores revenue growth to the previous trend, the shareholders benefit from earnings improvement and quiet often multiple expansions back to earlier levels. Both of the above companies recovered from difficulties and have generated exceptional returns for their shareholders.

COVID-19 which disrupted and/or accelerated normal demand patterns in practically every industry had an outsized impact on results of many public companies. I believe these disruptions and subsequent revenue volatility created a number of opportunities in the market.

In his tribute to Daniel Kahneman, Jason Zweig, who helped write “Thinking, Fast and Slow,” said that behavioral finance is, first and foremost, an exercise in self-reflection and a study of one's own mistakes. “Fortunately”, over the eleven years that we have been running the strategy, we have made plenty of mistakes that give us material to analyze to minimize the number of bad decisions in the future.

When we look at US market, we classify our investments into three categories: Cash Flow Growth at Reasonable Prices, Growth with Temporary Problems, and Value with a Moat. Out of the 139 investment decisions we have made over the years, the biggest portion (60) is attributed to the “Value with a Moat” category, which has generated the lowest gross returns.

Given this performance, it is tempting to dismiss the whole Value with a Moat category as “uninvestable,” but that would be succumbing to the recency bias given that value companies usually outperform the market but haven’t done so in the last five years. Instead, we looked at the companies we bought and assigned them further attributes such as High Leverage, Declining Addressable Market, Declining Margins, etc.… While each of these measures impacted performance, one characteristic, the declining addressable market, seems to be overwhelmingly to blame for many of our poor decisions over the years. The analysis showed that out of 60 value investments that we made, 25 purchases were of companies with declining addressable markets, generating an average performance of zero! The remaining 35 investments in the category have done reasonably well, with an average gross IRR of around 20%.[1]

Since Daniel Kahneman’s passing, there have been a number of articles that explore his contribution to the field of finance. Possibly the best tribute should be continuous analysis of own actions in order to eliminate the biases he helped identify.

[1] The Gross average returns are calculated based on the average of annualized IRRs of each investment in the category. The past performance of these securities is no guarantee of future results.