This article is the final in a 6-part series examining how the drivers of value…
“Not all those who wander are lost.” JRR Tolkien
One of the most frequent monsters in investors’ collection of nightmares is “thesis creep.” This is when the dynamics have changed to the point where you can barely recognize the original reasons why you invested in the company in the first place. We are witnessing thesis creep in TripAdvisor’s hotel business as we speak.
But as it happens, I also just finished listening to a terrific book, The Beginning of Infinity (thank you to Dan Roller at Maran Capital, if you’re reading this!) in which physicist David Deutsch explains that the fundamental way humans have grown is by generating ideas. Generating ideas doesn’t come from data analysis, it comes from creative, right-brain thinking. As psychologist Gary Klein has shown, insights come when we least expect it, but they come from original thought, not by analyzing data. And those original ideas need to be tested and criticized in order to be validated and improved upon. The beginning of “unlimited knowledge growth,” lies in the concept of fallibilism. Only through correcting misconceptions from the past and hoping to find and change mistaken ideas that no one today finds problematic, can we initiate the process of “unlimited knowledge growth,” as Deutsch writes.
Now, I completely understand that thesis creep could identify subjective bias in an investor, and thus investors are correct to throw a red flag whenever he or she realizes it’s happening. Yet, as psychology Professor Daniel Kahneman has advised, truth seekers who’ve developed a process and an algorithm to help eliminate noise have taken a major step at improving the signal of information coming to that otherwise inherently biased human. While algorithms can help filter noise, the real world is inherently more complex and demands flexibility in judgement. Thus, we’ve found the only way our framework has been useful to us was to demand consistent evolution.
Armed with a honed (and continuously improving) process to eliminate noise, we should be less prone to subjective bias. Our ranking framework has no input for cost basis or initial investment date. It doesn’t consider how well we’ve done. While we keep track of old assumptions, the only thing that matters is our assessment of the current opportunity. The only thing the algorithm cares about is, what is it worth now? It helps us eliminate errors of omission, which is another way of saying it lowers opportunity costs, while also helping us prioritize our time, efforts and portfolio weightings. And everything we own must be continuously justified against the opportunity set.
When Thesis Creep is a Good Thing
Deutsche has posited that the only way to generate knowledge is to continuously evolve one’s thinking. It’s the definition of “thesis creep.” Some of our most successful investments were opportunities where the thesis creeped materially throughout the holding period. When we invested in Fiat, the thesis was similar to our successful investment in Ford, whereby it would consolidate the platforms and engineering efforts with Chrysler, saving significantly on capital spending, and thereby improving capital returns. This surely happened, yet even more of the returns were generated by a secular shift to SUVs and trucks, which powered Jeep’s stellar global performance. Sergio Marchionne himself pivoted on his 4-year investment plans and lowered spending on Alfa Romeo and Fiat to reinvest further in Jeep and Ram. They were very wise moves that powered the stock significantly higher even while the stock’s valuation multiple shrank. Since we still own Fiat through our Exor position, the thesis has once again shifted as it embarks on another merger, this time with Peugeot, and looks set to offset macroeconomic weakness through material cost savings.
Similarly, our investment in Ferrari was based on the company being able to gradually increase production given stretched waiting lists and a more diverse product portfolio. Given incremental profit margins are north of 70%, this was going to be very material for the company’s profitability. It has been, but the real kicker in the past 18 months was the brilliant Marchionne plan to introduce the Icona series. These are re-imagined versions of the company’s past iconic cars. They will be a permanent part of the collection, which brings the singular profit tailwind of a limited edition series to the regular operating profit of the company. By far, Icona will be powering the next few years of results at Ferrari and has already powered the stock to a breathtaking valuation. Icona was a thesis creep.
We could go on and on with positive case studies of thesis creep, as well as a good number of negative case studies, but thesis creep also showed up in our most successful biotech positions, oil & gas positions and in Live Nation, another Liberty-controlled company. In fact, when the thesis changes in a positive way, the same care and attention should be paid to the development and the opportunity should be re-assessed. Although the stock has likely reacted positively, it could have significantly under-reacted to the new fundamental range of possibilities. That’s as clear a buying opportunity as we can hope to have.
If we’re going to hold a stock for multiple years, it’s hard to own something where the opportunities aren’t dynamically changing. But furthermore, we’ve witnessed over a shorter time horizon of just a year or two, it’s actually the developments which the market was least expecting that drive the stock returns. “Of course,” this is true, we would say. Yet, we must also be humble enough to admit, we’re probably not going to be able to legally know that development before everyone else. That means by definition your returns are going to be driven by unexpected events and a changing thesis.
Post Catalyst Investing
Many investors still follow a catalyst-based investing process, whereby they outline the reasons why they will own a stock over a specific time period. More thorough investors might even conduct a “pre-mortem” and imagine all the ways the stock could turn out to be a failure. As signposts are triggered, it catalyzes actions the investor has decided upon at the inception of his investment. The problem with this approach is that stock reactions to catalysts are becoming increasingly unpredictable. Counter-parties are now mostly robots or other investors with a 1-2 week time horizon. If the stock hasn’t positively reacted to your bullish catalyst when it gets announced, as we estimate is the case in a solid majority of catalysts in recent years, should you really sell it? That was clearly part of the original thesis, and when the dreaded thesis creep enters the scenario, most investors will exit a position. But if the developments are positively surprising you in an investment, and the stock fails to reflect it, is the right thing to sell it? We think the right approach is to re-assess the situation with a pair of fresh eyes. You may want to buy more rather than exit in this case of thesis creep.
Of course, we want the thesis-creeping developments to go in the positive direction, as opposed to trending downhill. In our framework, we assess the “preconditions,” that drive performance as the qualitative factors we look at: management, governance, customer satisfaction, employee engagement, among many others. These are the factors that drive performance to the top or bottom end of the range of possibilities. We are unapologetic about being post-catalyst investors, though of course, we can’t help but do pre-mortems and foresee a roadmap of triggers where we think our version of reality will prove the markets’ incorrect and lead to positive or negative surprises.
My friend Chris Mayer recently used David Deutsche’s book to extrapolate another investment lesson: good management teams with significant skin in the game have a way of overcoming the difficulties that are presented to them. They solve problems so the investor doesn’t have to worry about it. In his recent article (click here to read it), Chris quoted a pithy answer Warren Buffet made to a question about how closely he follows Apple. “Well if you have to closely follow a company you shouldn’t own it!” Buffett has always demanded management teams with skin in the game and a natural passion for overcoming the problems presented to them.
Another good friend, Bill Carey at Cortland Associates, joked about the perils of thesis creep in saying, “First it’s a growth stock, then it becomes a GARP stock, then it becomes a value stock, then it becomes a turnaround, and then finally it ends with a restructuring story. There’s always a reason to justify owning something.” Bill has avoided thesis creep his entire successful career by lowering the number of variables that drive the business models he invests in. He seeks simplicity, low capital intensity, low labor intensity, and generally less stakeholders that can damage the thesis. A lower concentration of these essential corporate elements reduces the risks that any of the stakeholders’ decisions can change the thesis materially.
That means Bill has done incredibly well by combining both a valuation discipline with business models today that are universally acknowledged to be “high quality,” such as major internet properties, exchanges, payments processors and database companies. The only problem is that while those were viewed as “boring” stocks for much of his career, professional investors have herded into them over the past few years. While many of these stocks seem boring and without a “catalyst,” the herd has correctly realized that the risks of the thesis changing in these companies over time is low. While they’re not risk-free, investors have pushed the earnings yields of these companies close to the risk-free rate of today: essentially nothing. I’ve tried to help Bill, in vain, find opportunities elsewhere, as many of his past favorite positions have also reached breathtaking valuations. It’s likely he’s going to have to familiarize himself better with thesis creep over the next decade.
The wandering TRIP
TripAdvisor doesn’t fit that “quality” mold of having very few thesis-changing risks. While it has hundreds of millions of people who use the site, the monetization channels have historically been very concentrated to Expedia and Booking, and the company has the chronic, now acute, Google problem. One decision by one actor (in this case, Google) can lead to thesis creep. And while we’ve never assumed hotels would be a great business for TripAdvisor except in our most extreme bullish scenarios (<10% probability), we hadn’t anticipated it could lose 15-17% of its business in a shorter time frame.
Our approach to a position that is failing to launch or is performing contrary to our positively-skewed range of outcomes is to throw out all of our old assumptions. We have to re-underwrite the investment with a completely fresh set of eyes and assumptions. Chris has taken time to come up with his own assumptions on TripAdvisor, and while they diverge from my assumptions from earlier this year, we both ended up at the same outcome a couple of weeks ago: the company can digest “The Google Squeeze,” and still capitalize on the very important and significant addressable markets of Experiences and Dining in addition to the advertising monetization potential.
As we detailed in a new research note to our investors this morning, Google has moved to aggressively eliminate unpaid links from its hotel search results pages, despite nearly half of this traffic including the word “TripAdvisor” in it. We could hardly characterize this as user-friendly and it risks turning the company’s valuable search tool into the yellow pages. Yet, we now assume that up to 16% of the company’s revenue (the total revenue generated by this free traffic) could be eliminated over the next few years. We had previously assumed this SEO traffic was defensive, and now we only believe half is. This development has resulted in a creeping thesis at TripAdvisor.
But as opposed to mindlessly selling something due to “thesis creep,” we decided to purchase more shares after we completely re-assessed the situation. Half of the company’s revenue is growing north of 25% going forward, which combined with cost cutting plans, allows the company to continue growing profitability much more quickly than consensus estimates. The management of the company over the next few years will determine whether or not this was a good move. The future is in the hands of a very capable board and a very entrepreneurial CEO. TripAdvisor CEO Steve Kauffer has a great reputation in the travel industry, but perhaps not on Wall Street. True greatness is born of difficult times, so the next couple of years will determine whether his travel industry or Wall Street reputation survives.
This Process Has Already Worked
At the beginning of the year, we wrote “Boiled Frog Prevention,” in which we talked about our then most recent mistake, Flybe. The opportunity had been a slowly deteriorating situation where dramatic downside deviations had emerged. With the emergence of Brexit, we had focused on the passenger weakness and figured it was digestible. Instead, we should have focused on the fundamentals completely out of the company’s control: foreign exchange. The company’s cost base heavily skewed to US dollars but it could only sell tickets in pounds. A most material development happened over our holding period, but we under-reacted to the development. This led to a process improvement at GreenWood whereby a new set of eyes must completely throw out the old assumptions on a stock if it fails to perform in line with prior assumptions.
As it happened, we had a new set of eyes join the company just months before, and Chris re-underwrote Flybe, Telecom Italia, and Piaggio. Our mutual conclusion from that exercise was to sell Flybe, locking in a ~50% loss rather than the 99% loss that materialized over the next couple of months, continue to hold Telecom Italia, and actually buy more of Piaggio. All three decisions have turned out to either add alpha for us this year, or save us from a worse loss. Prior to Chris re-underwriting TripAdvisor a few weeks ago, he re-underwrote our coinvestment this summer. The process only reinforced our conviction in the opportunity and allowed us to buy more before we became restricted. It’s still early days, but it turned out to be the exact right decision. However we admit, the thesis didn’t really change in all of these scenarios, it was more a “failure to launch.”
In trying to eliminate human bias from decision making, many people find it easier to rely on rules of thumb or checklists. They help investors avoid past mistakes when they overlooked something material. We’re human and have flaws. Checklists won’t let you overlook anything material as, can often happen. Yet, as popularized by Atul Gawande, checklists are designed to work even when the pilot or nurse doesn’t have their full faculties present. It should work even when they are exhausted from working over 12 hours. Because the downside of their mistakes have life-changing consequences.
Investing is not an unconscious process, it’s a highly conscious process and should be the start of “unlimited knowledge growth,” as David Deutsche puts it. It should be one where we constantly challenge assumptions, particularly when our views diverge from Mr. Market’s. We call this the “expectations gap,” and have focused on building out this behavioral aspect of our ranking framework. Our greatest mistake this year was not being aggressive enough on position sizing even when this expectations gap shrank in TripAdvisor and a couple other positions. We cut TRIP in half this summer, but we should have clearly cut it further.
Could we suggest a new way to view thesis creep?
Perhaps we let it trigger a complete re-evaluation of the opportunity on a go-forward and unbiased basis rather than causing us to run for the hills, as most other well-trained investors do. And we should do this re-evaluation when both a positive thesis creep occurs as well as the negative ones. The conclusions with a fresh pair of eyes may surprise you. The minute that you can’t stand to look at something is usually the moment every other investor can’t stand it either and is capitulating. Do you really want to be that guy? We’d rather be on the other side of that trade in the price-agnostic selling.
We realize this view may be controversial and you may have strong opinions against it. We’d love to hear from you if you do. We’re more concerned with being right than sounding right. In fact, by proving us wrong, you’ll be helping us creep another thesis!
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