Front-Run Challenge! - On investment (30)

Perfect Opportunities may be very Limited

BEDROCK’s primary investment methodology is similar with that of GARP (growth at reasonable price) , which works fine in the past, though BEDROCK puts more emphasis on the quality and competition advanteges than purely the growth rate and valuation. BEDROCK believes that if use with caution and patience, GARP strategy can acchieve great results in the future. The legacy value investors focus on margin of safety and tend not to overpay for its current value. Of course, Ifyou can find an opportunity which price is almost always in tandem with its value, congratulations, you will have theeasiest and safest investment result.

There are many great examples and following are historic price and valuation movements of Google and Apple. Clearly, when the value accretion is gradual and consistent, and the stock’s price aligns with its fundamental and never becomestoo stretched, legacy value investors would be happy to buy, hold and enjoy the run. That’s not very hard for them.

The Front-Run Challenge

However, especially recently, with the excessive liquidity and the permeated optimistic mood, investors are more and more willing to front-run any opportunities they deem possible. Front-run is like ‘raise’ in a poker game, which we elaborated the game strateges in preceding articles: Investment vs gambling, and our strategy.

When front-run abundant and may be persistent, legacy ways of looking for margin of safety can be difficult. Besides, abandon a great opportunity only because it seems overvalued by current financial standards can be short-sighted and extremely disappointing when looking back.

We never say we should accept any valuation once we consider the growth is great, only that we can be more generous if we can be more open minded and forward looking. Consider the following example: an opportunity of a company has a moderate 50% or even 100% over-valuation than its peers but has a potential to 10x, 20x or even 100x its earning in coming years can certainly generate more than satisfactory returns.

Still, we should keep in mind that because we overpaid its current value proposition, we should be careful its outcome may severely deviate from our previous expectation, since nobody is really fortune teller. And there are 4 scenarios we consider would exist:

Scenarios 1: Pure speculation on fantasies

People tend to get overly excited when new things, new tech, new markets, etc., come that they lack experiences toproperly value, especially with surplus liquidity.

Famed examples are: 1999-2000 tech bubble, 2007-2008 real-estate bubble, 2014-2015 tech bubble in China, and most of the theme speculations. Of course, bubble can last long but it will burst in the end.

Scenarios 2-4: You get what you pay for.

Even if luckily what you project of the fundamental is all right that it is truly in a long term up trend. However, since current price is a way ahead of its fundamental, any disappointment can cause severe volatility. Price can be somehow crashed (scenario 2), or stagnant (scenario 3), or turning to a more gradual and gentler up trend (scenario 4), all depends on how much excitement the fundamental can beat the expectation, no matter the fundamental is up or down, especially in the short-term.

Scenarios 5: It can last long...

For some rare and truly great business, investors’ faith can hold up pretty strong and long-term. It may converge to its value once or while, but you will never know when. Sit still and hope for the price to fall, which might never realize, may miss out some truly great opportunities.

Open-Minded but with Caution

For BEDROCK, we believe the right strategy facing overprised market and abundant front-runs is to stay calm and patience. We never say we should keep a strict ‘current price = current value proposition’ cliché. Just that we should always keep the risk/reward/probability matrix in mind and keep our investment disciplined, for example Kelly criterion is a great way of dealing with them.

The only situation we choose to overpay its current value proposition is that: 1, we believe that we should cherish the long-term growth potential and that the long term return vs overpay risk can be justified; 2, even if a severe draw back presents, our portfolio can still be able to absorb or handle the hit (if we are properly diversified and deeply understand its fundamental, we can avoid being panic when price plummets).

You don’t know what you don’t know

No matter how hard we try, we can be irrational in a way we might not even notice, due to various biases, e.g. overconfidence, anchoring, confirmation, etc. Giving away the protect from ‘margin of safety’ means a direct face with the delimma of ‘you don’t know what you don’t know’, facing more risks you don’t even considered before hand.

You may win once or while, but as mentioned people tend to have biases, even the best analyst can make severe mistakes when assigning the right win/loss ratio and probailities, thus the consistency of winning is clearly at risk. In short, the world is complicated and hard to predict and we have to admit our shortcomings.

The problem of being too subjective

Another problem of dealing with front-run challenge is that all the calls are pretty subjective since you have to look further into the future. 1, the further you look and more subjective your analysis is the riskier of making mistakes; 2, much harder to reach a concensus among team members as others do not have the experience, expertise and confidence as you are.

An investment system too much rely on the instinct of one person is very risky and can not guarantee a long-term success.

The job is too tough that it’s better paid well!

Clearly, a game abundant with front-runners can be tough and much riskier that we should be more careful and thoughtful than ever. Even tough, we may loose some standard valuation wise, we should never relax our standards in the target choosing and fundamental assessment. At end of the day, we should always focus on the truly great opportunies with some valuation adjustments. All in all, we still need to focus on the best 5% when dealing with the tough challenge.

对BEDROCK产品感兴趣的同学，欢迎后台留言，我们会尽快回复 

欢迎阅读往期内容：

1. 笨蛋，重要的是环境！--罗闻全教授的适应性市场假说

2. 投资vs赌博，我们的策略- 投资思考随笔（29）
3. 投资思考随笔21-疫情对投资的影响推演和思考