2021 Annual Letter
Annual letter | 15 min read | Reflections on my second year of investing and betting on happiness
Originally published on midstoryventures.com in January 2022.
Second Annual Letter
To my friends on this value investing journey,
It is my pleasure to present to you my second Annual Letter. As I mentioned in my first letter, the theme of all my letters will be summarized by this quote:
“We enjoy the process far more than the proceeds.” Warren Buffett
Aswath Damodaran makes a similar point when he says that valuation is not an art, nor it is a science; rather, it is a craft. And like all crafts, you learn by doing. The more you do it, the better you get at it.
In these letters, I will document my journey as a business owner — the good, the bad, and the ugly. I hope by writing these letters, you will find some things that you can take away to improve your own craft as an investor.
Business Ownership: A Practical Idea
At the beginning of 2021, I set my sights on improving my decision-making skills. I wanted to be able to spot no-brainer opportunities. So, I created a case study series on that. Read the details of the case study here.
I would say it’s one of the best things I have done in my journey thus far.
Each case study helped me learn new ways to evaluate my decision-making process. I’ll summarize those “tips and tricks” in a little bit. But I think the most powerful effect from this year was a shift in my paradigm.
My paradigm shifted from being an investor to business owner.
It seems really nuanced, but I believe this shift, this “way of perceiving the world,” makes an enormous difference.
“Forget the noise. Investing is about owning businesses!” Francois Rochon
While I have historically talked about being a “business owner” more often than being an “investor,” I think the case studies have helped me learn a new layer of practicality to this concept.
Here are two ways I described “what it looks like to be a business owner” in last year’s letter:
FIRST IDEA
Benjamin Graham once said, “Investment is most intelligent when it is most businesslike.”
To me, the stock market is simply the most efficient and effective way to become a business owner. It gives me access to buy or sell thousands of businesses at ready price.
SECOND IDEA
Marcus Lemonis says: “If you don't know your numbers, you don't know your business!”
To me, it is a prerequisite as a business owner to not only know your numbers at all times. And I believe the ultimate test of this is the “Emergency Board Meeting.”
My first line of defense is to simply look at stock prices as infrequently as possible (see section above). My second line of defense is to know my numbers at all times.
I’m going to build on what I described in my first letter by adding a third component.
THIRD IDEA
“We view ourselves primarily as owners of businesses, and typically hold our positions for a very long time with very low turnover.” Li Lu
To me, the primary activity for a business owner is not buying or selling, but the owning. The owning is what matters.
Li Lu helps us see that this idea of business ownership is extremely practical. Here is how.
When I meditated on the idea of “owning” and let it really settle in, it helped…
...decrease my level of activity: A small business owner can only keep up with a handful of companies. Why would I operate any differently?
...increase my standards: A small business owner would be willing to wait for the best companies they see, knowing they will only own a few over their lifetime.
...increase my bets: A small business owner would be willing to invest a disproportionate amount of their net worth into one stellar opportunity.
...increase my holding period: A small business owner would make decisions knowing that they are in it for the long haul.
How have these ideas materialized in my journey?
Let me share a story of my first business decision.
I began my investing journey in 2020. I also bought my first business in 2020. I made the purchase at the height of the COVID-19 frenzy and the market downturn.
I have owned this business for a little more than a year and a half now.
At the time of the decision, I thought this was a no-brainer.
Since the initial purchase, I haven’t looked at the stock price. I do my best to focus on the business economics and the durability of the competitive advantage. And not much has happened in this year and a half. So for the most part, it has been business as usual.
But looking back on that first purchase, I can see that something in my process was missing.
Because when you own a business, things just feel… different.
Firstly, I learned that I am very sensitive to companies with changes in durability.
The simplest way to characterize durability is the premise(s) in which a business model and moat is built. In other words, durability is the consideration of customer perceptions, customer preferences, distribution channels, technological advancements, etc.
I have found that changes in durability trouble me the most because it is the hardest to track and evaluate. Not only does each individual item move at different speeds (some very fast, some very slow), it is timing and combination of all of them that can cause unforeseen disruption to returns.
Secondly, I learned that I have a personality that frequently doubts the strength of my margin of safety.
The price we pay is the thing we can control the most. But valuation is essentially a game of predicting the future. As one who started their investing journey right before COVID-19, my mind is deeply ingrained with the idea that anything that can go wrong, will go wrong (Murphy’s Law).
I have found that when I try to handicap more complex bets (anything that isn’t as simple as buying an above-average business at a below-average price), my mind starts playing tricks on me.
Lastly, I learned that I naturally fear changes in capital allocation.
More specifically, I seem to fear changes in strategic direction, such as exploring new products, business lines, distribution channels, etc.. The businesses I tend to look at are quite small, often starting as a one product or one business line company.
In companies with operators where strategic changes are tempting (if there’s a will) or possible (if there’s a way), I worry the most. I have found that when changes are announced, I default to a negative view every single time. It seems as if I prefer “lack of change” over change, even though I recognize that companies need to grow, adapt, and evolve.
These three lessons that I learned as a business owner are things that I can incorporate into my investment process. I expect that this continued focus on being a “business owner” will decrease the level of my activity, increase my standards, increase my bets, and increase my holding period — all of which are elements of an approach that minimizes permanent loss of capital and maximizes outsized returns.
Sharpening the Saw: Four Case Studies
At the beginning of the year, I planned to do ten case studies in total. But as responsibilities increased in other areas of my life, I was only able to do four: Movado, Tandy, Town Sports, and Wiley.
As a reminder, here is how I characterized the skill of decision-making in my Introduction to Traveling Through Time post:
DECISION-MAKING
Can you build the conviction to put a significant amount of your net worth into a business and hold it for the long-term?
Can you spot a “no brainer” opportunity right away, put something in the “too hard” pile, or identify what you would need to know in order to buy and hold for the long-term?
After reflecting on the case studies, I have walked away having a better grasp on four decision-making techniques.
#1 Pre-Mortem
While I have always been familiar with pre-mortem, this year I learned the importance of it to the decision-making process, since preservation of capital is the most important thing a business owner should be concerned about.
My approach to pre-mortem is to outline 3-5 ways that I would lose money in a transaction. In a real transaction, I would label these as “Hardcore Selling Conditions” in my investment thesis. These are actions or events that would make me consider the sale of the business if they were to happen.
#2 Maintenance Due Diligence
Even though we are passive owners by investing in the stock market, that doesn’t mean that we don’t have any work to do. The work we do is called maintenance due diligence.
Maintenance due diligence is the research work that you would need to do in order to maintain conviction. This is the ongoing work to make sure that the hardcore selling conditions (from pre-mortem) have not been met yet.
Growth due diligence, on the other hand, is the work you would need to do to increase conviction in your business decision, which is materialized in your position size or holding period.
Generally speaking, maintenance due diligence is the highest priority in the first few years of owning a business.
Therefore, thinking about maintenance due diligence before the purchase is the next step from a pre-mortem.
Maintenance due diligence tests (1) your circle of competence (2) your emotions and (3) your commitment.
These case studies simulated a 5-year holding period, but 5-years can feel like a long time. If you don’t know your business (unit economics) or industry (external forces) very well, then you could very well lose your conviction after a few years or even after a few months – even if nothing is threatening your investment thesis.
The 5-year period also tests your emotions. Unemployment might skyrocket, interest rates might rise, competitors may enter, lawsuits may be filed, fads might be explored, and more. Considering all the factors that could threaten your investment thesis, would you be steadfast to hold through it all?
The 5-year period also tests your commitment to the process. Are you willing to put in the time to keep up? Some businesses require a lot of maintenance due diligence. Others do not. If you aren’t intrinsically interested in the business, it will be very hard to do ongoing maintenance due diligence work.
And even if you love the business, if the maintenance due diligence work required as an owner seems excessive, then that should be considered. An investment opportunity that is a “logical” bet but seems too laborious to own might not be a business that you want to own. See Tandy case study on the difference between logical bets, no-brainer bets, and high-conviction bets.
By thinking about your emotions and your level of commitment before you purchase a company, you have a much better idea if you would be a good owner of it. Because being a good owner (holding) is just as important as being a good buyer (handicapping).
#3 Visualization
Visualization is the practice of imagining where a stock could go at its current price. It is best used in waterfall situations.
A waterfall is typically described as a company who produces cash flow, but the level and stability of business returns are average. In these situations, capital allocation is of the utmost importance.
This technique is best exemplified in my Town Sports case study. I imagined all the things that could happen, then determined what was very unlikely to happen. From there, I could imagine what might happen with the stock.
For example, I knew the company wouldn’t be content with giving up growth and paying dividends from the cash flows from its profitable, mature stores with stronger moats. I made this assessment based on the company’s history. From there, I was able to identify three ways the stock could go and determined that the most likely outcome would result in below-average returns.
#4 Simplification
Among all things the decision-making techniques I practiced this year, I think simplification was the most important. My goal was to make faster and better decisions. Simplification is the key to doing that.
I have found that simplification can be used in three ways:
Simplification through frames
Simplification through focus
Simplification through either-or
The starting point to efficient decision-making is having the right frames.
In most cases, there is only one correct way to look at a stock. Stocks are either value opportunities, growth opportunities, or quality opportunities.
While it is perfectly reasonable to pass on a net-net opportunity because you are a growth investor, it would be extremely incorrect to view a net-net opportunity with the criteria for a compounder.
The way you should view a stock will always be determined by four elements: price, capital allocation, unit economics, and growth.
I know I am usually operating with the wrong frame when I don’t want to invest in an opportunity but can’t prove what is wrong with it.
Once you have the right frames, you need to have the right focus.
Focus is ultimately about spending time on what is important and knowable. We will call these the “key factors.” The biggest shift for me here is realizing that not every key factor is equal.
Some key factors are more important than others. Some are more costly than others. Obtaining information on a key factor is not always easy. Sometimes it takes time and effort through scuttlebutt. It goes back to the maintenance due diligence test.
Making an investment decision is much more than knowing what the key factors are. It’s also about the work to obtain the key factors, at purchase and as an owner in the business.
#5 Focus
And lastly, once you have the right frame and the right focus, you can use an either-or approach to come to a very quick decision. These are the questions that I use:
Is it good, or is it bad?
Is it safe, or is it not safe?
Is it cheap, or is it expensive?
Is it an above-average business at a below-average price, or is it a below-average business at an above-average price?
At the end of the day, anything that isn’t a hell yes or a hell no should probably be in my zone of indifference, also known as my “Too Hard” pile. I want things to hit me over the head.
The Next Level: Unlocking Creativity
I recently read the book, A Technique for Producing Ideas. The premise of the book is that an idea is just a new combination of old elements. The book goes on to state that there are five critical steps that every idea must follow, whether it happens consciously or subconsciously.
Gather material
Meditate on the materials
Put the problem out of sight
The idea will come out of nowhere
Put the idea through the fire (feedback)
I live in Los Angeles, California, a city of creatives. I shared this framework with graphic designers, fashion designers, music artists, storytellers — and they all admitted that this is how they came up with ideas.
Take my friend who is a graphic designer for example. We were walking to lunch in Venice Beach and happened to pass by a building with a really unique neon sign hanging in the front of the window. He took a picture of it and mentioned the different elements that he liked.
He had no immediate use for it. He didn’t have a project that required neon elements. He was working on creating a design for a water bottle at the time. But nonetheless, he added it to his archive of materials.
I don’t know when he will ever use the inspiration. But I do know that he has a folder of these things that he likes to go back to when he is lacking inspiration. And he has, in fact, shared several instances in which he was able to start or complete a design with some of the elements that he has saved over the course of years.
Investing is a craft. And like all crafts, the ultimate outcome is an idea. And an idea requires a creative process.
The investors with the best processes have an element of creative flair in their process. They find new ways to frame or reframe an opportunity. And that’s why I want to dedicate this new year to incorporating creativity into my investment process.
Note: I did not say investors with the best track record. Instead, I said the investors with the best processes. Those are the ones I want to emulate. Over the long-term, the investors with the best processes should have strong marks on their track record. But there is always a huge element of luck.
First, I want to be better at gathering anything and everything.
As an artist, the only way to create a new idea is to see old ideas. As investors, the only way to identify an opportunity is to know what other opportunities look like.
The case studies from this year are a great example of gathering. I gathered patterns on stocks that performed well and ones that didn’t in this case studies series. I want to build on this accumulated pattern recognition by finishing the remaining case studies in the new year.
But it doesn’t have to be as advanced or as time consuming as a case study. It can be something simple like calculating the number of square feet at In-N-Out while I wait for my order. Since childhood, Warren Buffett has been known for counting/calculating anything and everything. Alice Schroeder once shared a story about how Warren Buffett recalled the prices, margins, and weekly volume for dozens of items in a Nebraska Furniture Mart. I don’t think he memorizes these facts for fun. The ability to recall these facts seems to be an integral part of his investment process as he thinks about the opportunity cost of investing in Nebraska Furniture Mart to other furniture stores or to other businesses in general.
Second, I want to be better at meditating on anything I gather.
In ancient Hebrew, the word “meditate” means to chew, swallow, regurgitate, chew again, and swallow until it is thoroughly absorbed. Meditation is curiosity in action, which is manifested in questions and analogies.
Taking the In-N-Out example, I could use the Five Whys method around the topic of square feet per store. I could also use in-class reasoning to compare In-N-Out’s square footage to Wingstop stops or across-class reasoning to compare In-N-Out’s square footage to chocolate manufacturers. All of these creative thinking exercises would improve my ability to compare restaurants in the future, or just compare different businesses in general.
In The Snowball, Warren Buffett had drawn a reputation for being “the fastest gun in the West.” And I think his ability to be swift and precise with his decisions was a result of the sheer number of things he gathered and meditated on. That’s where I want to be.
Betting Big on Happiness
Ever since I was young, I’ve wanted to be a business owner. Thanks to the stock market, now I am. But my journey doesn’t end here.
I want to become the best business owner possible. The more I succeed as a business owner, the more delight I can bring to customers, the more jobs I can give to employees, and the more wealth I can generate for investment partners.
Warren Buffett says that he tap dances to work. The readers subscribed to this newsletter are either full-time investors or aspiring full-time investors, so they too have experienced the same joy I have.
But then I read a story in the Book of Ecclesiastes about the richest man to have ever lived. At the peak of his success, he exclaimed:
“But as I looked at everything I had worked so hard to accomplish, it was all so meaningless—like chasing the wind.”
Ecclesiastes 2:11
And for some reason, that deeply resonated with me.
I really enjoy the craft of investing. I love the good that it could bring to the world. But I couldn’t understand why I had so many nights where I asked myself: What am I doing all of this for? Why do I feel like I am always behind? Why do I feel like my happiness is fleeting?
There is a parable in the Book of Matthew that goes along the lines of:
“The kingdom of heaven is like treasure hidden in a field. When a man found it, he hid it again, and then in his joy went and sold all he had and bought that field.”
Matthew 13:44
As a value investor, that made sense. When you find something that is better than anything that you have ever found before, you sell everything you can to make sure you have it.
I think we are all hard-wired as humans to pursue happiness. I think that is a very good desire. In fact, I firmly believe that is our ultimate purpose in life: to be happy. I think this parable challenges us to bet everything on happiness. But the parable also challenges us to make sure we are making the right bet.
Wherever you are in your journey, I encourage you to take some time to think about betting on happiness. I appreciate each and every one of you who has helped me on my journey as an investor and I look forward to our friendship for many more years to come.
Sincerely,
Ralph Molina
January 1, 2022