In late 2008 a journalist called me to ask my opinion about General Motors (GM). I asked him why he was reaching out to me since my focus was on small cap stocks. He replied that General Motors was a small cap stock. I couldn’t believe it, but he was right. After losing billions in market cap, General Motors was technically a small cap stock – amazing. Nevertheless, I still didn’t have an opinion on their business or stock as I didn’t follow the company closely.
As investors, “I don’t know” is probably something we don’t say enough. While it would be nice to know everything about every investment, there is simply too much to know. Over my career, instead of attempting to know everything, I decided to remain focused on a defined opportunity set.
My opportunity set consists of high-quality small cap stocks with market capitalizations between $100 million and $5 billion. My definition of quality is simple. I like established businesses that have operated through multiple profit cycles. The more cycles the better. Long operating histories are helpful in determining a company’s normalized cash flow. Furthermore, I’ve found that companies that have survived many booms and busts frequently possess traits one would expect of a high-quality business. Survivors often have enduring qualities setting them apart from their less fortunate peers that are no longer in business. Many companies on my possible buy list are market leaders as they’ve gained market share each profit cycle. I like growth, but growth that is sustainable or predictable. In effect, the majority of my opportunity set consists of companies I believe I can value.
One of the drawbacks of having a focused opportunity set is having to frequently say “I don’t know”. It’s not something I like to admit, but I don’t have sufficient knowledge of most companies to provide actionable feedback or opinions. For example, my friend Lawrence (he goes by Larry, but I like to call him Lawrence because he’s so smart) recently asked me about Medtronic (MDT). Medtronic has a $100 billion market cap. It’s a huge company that would take days if not weeks to properly analyze and value. While it may be a great business and investment, without doing the necessary work, it’s impossible for me to know its worth. Sure, I could give it a quick overview and come up with some nice bullet points to make myself sound knowledgeable, but that wouldn’t be fair to Lawrence. If I don’t know the business well and I’m not confident in its value, my comments could unnecessarily put Lawrence’s hard-earned capital at risk. Therefore, instead of providing him with an opinion without proper due diligence, I simply responded that I didn’t know.
Outside of my opportunity set, there are a limited number of companies I’m comfortable commenting on. In fact, I don’t know a lot of things when it comes to investing. I don’t know exactly how or when the current market cycle ends. I don’t know when valuations will matter again. I don’t know when central banks lose control and free markets return. I don’t know the next time I’ll be fully invested. And I certainly don’t know the near-term direction of stock prices. But I get asked about these things frequently. I wish I knew, but I don’t.
Acknowledging what you don’t know is also very important in valuing businesses. Measuring what you don’t know is subjective. Typically the more you don’t know the higher rate of return you should demand on an investment. This is often called the risk premium and it should be included in your discount rate when discounting future cash flows. If investors knew everything, including the future, a risk premium would not be required. Interestingly, with current normalized earnings yields similar to that of many risk-free (coupon, not price) government bonds, investors are not requiring much of a risk premium. Based on current prices, investors seem to know quite a lot about the future — their crystal balls are clear.
I’ve never been so certain of any equity investment that I eliminated its risk premium. There is simply too much about the future I don’t know. As Lawrence would ask, “Well then Eric, what do you know?” I know future cash flows of businesses are not risk-free. I also know my opportunity set has never been this expensive. I know if I were to fully invest today I’d make a lot of mistakes and would most likely lose considerable capital. I know when I screen for stock ideas, the valuations of many of the small cap stocks I analyze literally upset my stomach. I also know, that similar to every cycle before it, the current market cycle will end. And finally, I know discipline and perseverance will be essential in surviving and eventually prospering once this cycle ends and opportunities return.
Attempting to know everything is difficult and can distract you from knowing a lot about what’s important. In my case, that’s my opportunity set. In order to properly implement my process and discipline, I need to remain focused and acknowledge there is a lot I can’t and don’t know. As Stuart Smalley liked to say, “And that’s OK.”