Managing Expectations: Short-Term Comparisons and Headline Numbers
Investors are obsessed with short-term expectations
Over the past couple of years, we’ve experienced several economic shocks: COVID-19, inflation, interest rates, wars et al. For most companies, these events made year-over-year comparisons quite meaningless in 2022 and 2023.
Still, many analysts and investors continued to filter through the quarterly reports, adjust their short-term valuation models to justify low or high share prices (that’s what price targets are all about) and bombard management teams with short-sighted questions (as if they had a crystal ball on what would come next).
As we’re definitely going to have to withstand many more shocks over the next years, how should we deal with these external factors? How will they impact our modeled investment returns? As we oftentimes joke: anyone can build an IRR model; the question is whether the input makes sense…
On the topic of modeling investment returns, we narrow down our investable universe by setting conservative/realistic assumptions that leave plentiful room of positive optionality (i.e. our companies reinvesting excess cash flow at returns that exceed the calculated IRR).
Whether it’s by buying back shares (remember, an IRR model discounts cash flows, it doesn’t compound excess cash flow nor does it reflect the incremental returns shareholders get from reinvesting their dividend income) or reinvesting excess cash into growth CAPEX: we let our companies beat our expectations.
Cash flow visibility through stable working capital, investment efficiency, and controlling for cyclicality is critical to constructing a trustworthy IRR model.
Lastly, we only invest in stuff we understand. We want to own companies whose business models evolve but don’t get revolutionized. It’s very hard to pick disruptors and historically, impressive growth rates have tended to drop quite quickly. Meanwhile, high ROIC and steady growth will be much better sustained over long stretches of time.
Which companies can yield our desired IRR with a pretty stringent/conservative input (i.e. decent but still beatable growth expectations)? That way, we make sure we limit our portfolio to owning just the best risk-reward quality growth stocks.
The webinar and PDF material can be found below.