Shed light on your analytical blind spots – with Jake Taylor

Value investor, author and podcast host Jake Taylor recalls a striking piece of insight he had on market valuations in 2015 – but which still left him ‘blind’ to a great chance to buy into Google

15/08/2022

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

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It is a cruel irony of investing, or indeed any other kind of in-depth analytical process, that no matter how hard you work to give yourself the clearest possible view of a problem, that work itself risks introducing a blind spot that will prevent you from reaching the solution all your efforts deserve. Take, for instance, the “25% compounded a year” ‘mistake’ rued by our most recent guest on The Value Perspective podcast.

“Back in 2015, I had an insight that the quality of the value opportunity set at that time period was especially weak,” says value investor, author and podcast host Jake Taylor on his second visit to our microphone. “Investors often look at how expensive the general market is but what can get lost in there is the bell curve around that average valuation – and that bell curve can have a tighter or wider distribution.

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“The bell curve could be especially tight – let’s say the market-average valuation is 15x earnings, with the cheapest 10% of stocks at 14x and the most expensive 10% at 16x – and that is one opportunity set. On the other hand, let’s say the market average is 25x – so a much more expensive market – but the cheapest 10% is down at 5x earnings and the most expensive is at 50x. Well, now we have a very wide spread.

Look beyond averages

“The important thing about my insight was that it is not just about the market average – it is what do the tails look like? In other words, look at the distribution with a bit more granularity and consider the dispersion of valuations – between the most expensive and the cheapest. Looking back at 1999, for example, what I found was you had a very expensive market but you also had an incredible dispersion.

“What that came from was the narrative at that time that the ‘new economy’ stocks were going to take over the world – so they were very expensive and they were dragging the averages up. At the same time, you had a bunch of bricks-and-mortar, boring ‘old economy’ stuff that was just being thrown in the garbage – and there was tons of value to be had there.

“So even in an expensive or what you might think of as a ‘bad’ market – because it was going to have to correct – you still had a ton of value you could buy at that time. And what we ended up seeing was those value investors having positive returns when everyone else had negative returns – and that is how you get to look like a genius, right?”

Fast-forward to 2008, however, says Taylor, and you had a much tighter dispersion of valuations. “That meant you did not see that same kind of outperformance from value investors because their opportunity set was not that good,” he explains. “In 2015, it was even tighter – an expensive market with a very tight distribution around it – and my view was that value opportunity set was not projecting very good returns from there.

Cheap optionality

“That ended up coming true – but what I was not smart enough to realise was that, well, if the dispersions are tight, that probably means some of the higher-quality, maybe higher-growth, companies are mispriced to the other side and maybe there is actually a lot of cheap optionality embedded in those businesses that I could have bought.

“And one of them happened to be Google where the business was mispriced but I wasn’t smart enough to take the leap from, oh, value is not good right now to, well, then look somewhere else. I just threw up my hands and said, oh, I guess I should hold cash because there is not a lot of cheap stuff to buy. I wish I was smarter back then!”

Not wishing him to dwell too long on what might have been, we ask Taylor how the distribution looks now. “The last time I did the analysis, it was an expensive market with a reasonably wide distribution – but I do not think the cheapness of today’s value set is as cheap as back in 1999,” he replies. “Very roughly – like, we are painting with a crayon here! – I would expect outperformance from value, but not amazing absolute returns.”

Learning experience

So was 2015 a learning experience for Taylor? How exactly do you shed light on your own blind spots, which – by definition – you cannot see? “Let’s jump back into the Google example,” Taylor replies. “What I missed for the next five or six years from 2015 was that I was trying to be a good Bayesian forecaster – you know, what can I expect for Google’s top line? For its profit margins? For its share count?

“So I did that same exercise we talked about earlier – and I was slating a lower top-line growth rate because, when you look at the base rates of big companies, it is really hard to keep growing at such an amazing clip. When you get that big, it is hard to keep posting 20% annualised growth rates on your top line because you just start to saturate your market – you know, elephants can only get so big and trees can’t grow to the sky.

“What I missed, though, was the base rates for some of these tech companies defy all of the other base rates you would have looked at historically – and that comes back to our conversation about returns to scale and network effects and some of these other technology-enabled profits that have just not been available before now. So I was using the wrong set of base rates to inform my decision-making – that was a blind spot.

“So my mistake came from trying to do what I thought was right but using the wrong data for my analysis. It was a ‘sin of omission’ I would pick up later – and probably would have picked up sooner had I been better at documenting why I was passing on stocks. Maybe I would have discovered the error faster, corrected it and not kept making it for five more years – a ‘25% compounded a year’ kind of mistake in opportunity cost!”

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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