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Let me begin by saying this isn’t some blog that consists of deep dives on high quality businesses that I want to hold forever. It took me some trial and error of strategies but I found being some compounder bro is not for me. I can’t be a growth investor as I couldn’t get past the valuations, and don’t really see the value that new sparkly tech company brings. I’m from an old school value mentality so I’m going to lean into it. Thankfully, I’m not some traditionalist quantitative value investor. I consider myself a trader, trading macro themes predominantly and otherwise finding value where I see fit. I sometimes buy into ugly situations or ugly companies and most of the things I buy I only plan on owning for 1-5 years, but that’s not a hard and fast rule. Ugly situations can be great sources of value but I don’t want to invest in cigar butts. Most things that are undervalued, stay undervalued. Instead, I want to find value where there is an upcoming catalyst or an inflection within the business. Perhaps the macro environment is changing favourably, something in the business, whatever it is, something has to be changing because when a catalyst or an inflection happens for a business, the market has no choice but to take notice. Most of the time this stems from macro, as a lot of value is found in cyclicals when the secular tailwinds are shifting. By understanding the macro environment, one can know figure out when those sector tailwinds are shifting. Most of my trades start from a macro prospective. Some trades, don’t fit into any of the above and that’s ok. My only two hard rules are no political trades and no biotechs. This particular blog won’t be about macro factors but macro will be a theme in future writing. Instead let’s look at some of the factors that go into finding the kind of companies I like when I identify a theme, inflection or catalyst.
I want to do my best to get outsized gains as the game as I see it, is all about managing risk to reward. I’ve already written about how I identify something that in my mind is cheap, here. In my opinion finding things that are cheap or companies that offer opportunities for outsized gains often involve smaller companies. For one studies show that small caps consistently outperform large caps over longer periods of time. Another point is it’s very hard to find a large cap company that will go up 3-5x over the next 5 years. Could it double? Sure. It could also triple although it’s unlikely. People often stay away from small caps as they can be speculative, volatile and risky, to which I don’t disagree. Events in the past year have shown larger companies can share many of the same characteristics. Investing in anything is inherently risky, situations and conditions are always changing. If you’re willing to take the risk of a large cap declining 50%+, you may as well own a smaller company that can at least reward you 3-5x. It’s rare that you can find a large cap that can offer the same upside. How can small companies with this 3-5x upside exist in the market with so much information availability. Well, the truth is they just don’t generate the same amount of banking fees. So the street pays less attention. Retail investors pay less attention because they’re not going to hear about it on CNBC. It takes time and effort to find these companies. They’re more often to be mispriced, they can grow quickly and management often has significant equity in the business. This combination can lead to spectacular returns.
Now I don’t invest exclusively in small caps. I’m open to find value where I can find it. Large cap or small I’m focused on future earnings, preferably ones that are rapidly growing. Despite them sometimes forgetting, investors pay for earnings. The growth in earnings is what drives the upside. Most businesses have troubles growing more than 40% a year. You need middle management. You need more complex accounting and reporting systems. You need better infrastructure. It’s hard to race ahead and eventually companies that grow too quickly stumble. It’s usually these growth companies that are priced for perfection and when they stumble, they implode. So how you do you get lower risk growth? Like I said before, it’s about earnings growth. Sometimes investors forget and only focus on revenue growth as a promise for future earnings growth. But as savvy investors we realize it’s all about earnings growth and we don’t actually need that much revenue growth to see huge growth in earnings. We can find these companies by identifying companies with good operating leverage. If incremental revenues carry very high margins, then small increases in revenue can lead to big results.
Take the above business a 20% increase in revenues leads to a 100% increase in profit. In four years, our company has less than doubled the size of the business in terms of revenues. However, the income has gone up five-fold. That’s powerful earnings growth. More importantly, it’s low risk growth. 20% growth a year is manageable and less likely management will screw up. They have time to plan ahead and manage the needs of the company. Something to be extremely aware of is that gearing works in the opposite direction too.
With all that said, the company that I will write about first that matches closely with what’s described above is Transocean LTD ($RIG). I’ve talked a little about it in this discord chatroom here. You can join and search for it, as well its a chatroom with many knowledgable traders to discuss ideas and markets. If you have anything you’d like to add or discuss, please leave a comment. I can also be reached on twitter. Happy New years and be on the look out for my deep dive on $RIG.