The Three Key Traits of 100 Baggers | Chris Mayer and Robert Hagstrom on Finding Great Compounders

Key Concepts

• Perfect Business/Stock: Generates cash beyond capital needs, earns above the cost of capital, has decent sales growth, and is sustainable long-term.
• Excess Returns: Earning returns above the cost of capital.
• Cost of Capital: The required rate of return a company must earn on its investments to satisfy its investors.
• Drawdowns: Temporary declines in the value of an investment.
• Errors of Omission: Failing to invest in a stock that subsequently performs very well.
• Long View/Long-Term Investing: Holding investments for extended periods, resisting short-term market fluctuations.
• Time Arbitrage: Exploiting differences in investment horizons between market participants.
• Behavioral Advantage: Gaining an edge through psychological discipline and long-term perspective, rather than solely analytical prowess.
• Economic Attributes: Fundamental characteristics of a business that drive its value and profitability.
• Returns on Capital (ROC) / Return on Invested Capital (ROIC): Measures a company's efficiency in generating profits from its capital.
• Gross Margins: The percentage of revenue remaining after deducting the cost of goods sold.
• Total Addressable Market (TAM): The total market demand for a product or service.
• Owner Earnings: A measure of a company's true earning power, adjusted for capital reinvestment needs.
• Free Cash Flow (FCF): Cash generated by a company after accounting for operating expenses and capital expenditures.
• GAAP Earnings: Earnings reported according to Generally Accepted Accounting Principles, which may not reflect true cash generation.
• Circle of Competency: Investing only in businesses and industries that an investor understands well.
• Network Effects: A phenomenon where the value of a product or service increases as more people use it.
• Incumbents: Established companies in a particular industry.

The Perfect Business and Stock

The discussion begins by defining a "perfect business" as one that generates cash flow exceeding its capital requirements, earns returns above its cost of capital, and exhibits decent sales growth, all while being sustainable over a long period. This forms the basis for identifying a "perfect stock."

Defining Perfection

• Robert Hagstrom: Defines a perfect business as one that generates cash beyond its capital needs, earns above the cost of capital, and has decent sales growth, with the crucial element of longevity.
• Chris Mayer: Initially suggests there's no perfect stock, referencing Marty Whitman's adage that "every business has something wrong with it." However, playing along, he defines a perfect stock as one that "goes up all the time." This is reverse-engineered to businesses that can generate returns on capital well in excess of their cost of capital for a very long time. He also emphasizes owning stocks he can "forget about."

Developing Conviction for Long-Term Holding

The conversation shifts to how investors maintain conviction during market volatility, negative headlines, and unexpected events.

The Changing Market Structure and Behavioral Advantages

• Robert Hagstrom: Notes a significant change in market structure over the last 5-10 years, characterized by increased speed and magnitude of stock price and volatility changes. He believes this is nerve-wracking for individual investors. His strategy involves focusing on the economics of the businesses owned, essentially "pretending like there isn't a stock market" and evaluating companies based on their operational performance and industry trends.
• Chris Mayer: Agrees with the observation of increased speed in market reactions. He highlights that deep research builds confidence, allowing investors to discern whether market downturns represent fundamental impairments or temporary issues. This understanding is key to maintaining conviction.

Sources of Inefficiencies and the Long View

• Robert Hagstrom: Identifies three sources of market inefficiencies: informational (less prevalent now due to regulations like Reg FD), analytical (the work of doing the analysis), and behavioral. He believes behavioral inefficiencies are where investors can gain the most significant edge. He also points to "time arbitrage" as a key behavioral advantage, emphasizing the long view. Many self-proclaimed long-term investors falter when faced with market adversity.

Behavioral Mistakes and Errors of Omission

The panel delves into personal investment mistakes, particularly focusing on "errors of omission."

Personal Mistakes and Regrets

• Robert Hagstrom: Admits his mistakes are rarely analytical but rather in misjudging how long a company's high rates of return on capital would last. He spends significant time assessing the durability of competitive advantages. He also recounts instances of selling too early, only to see stocks rebound.
• Chris Mayer: Considers errors of omission the most painful, citing missed opportunities like Apple and Netflix. He regrets not buying Apple despite using its products and recognizing its strong balance sheet and returns, especially after Warren Buffett's investment. He also laments missing Netflix, which he saw as a potential "10-bagger" but passed on due to concerns about the streaming landscape mirroring the decline of traditional media. He also mentions Monster Beverage as a missed opportunity he wrote about.
• Bogum Baronowski: Highlights the commonality of buying "too cheap" stocks early in careers and the pain of omissions. He emphasizes that a perfect stock is often only knowable in hindsight.

The Nature of Investment Mistakes

• Chris Mayer: Notes that identifying investment mistakes can be difficult, as short-term performance can be misleading. He emphasizes that errors of omission, where a potentially great investment was passed up, are particularly vexing. He also shares a past mistake of adhering too strictly to buying deeply undervalued stocks (like those trading at net cash) and selling them too soon, missing out on long-term growth plays like Visa and Mastercard.

Management Quality and Red Flags

The discussion turns to evaluating management teams, a crucial qualitative aspect of investing.

What to Look For in Management

• Chris Mayer: Values founder-led companies with significant insider ownership. He also looks for management's communication style and focus on shareholder value. He appreciates subtle indicators like cost-consciousness (e.g., flying business class only when necessary) and modest headquarters.
• Robert Hagstrom: Emphasizes management's willingness to admit mistakes publicly, as this often leads to correction. He also values founders and those with substantial stock ownership. He notes that regulatory changes (Reg FD) have made direct communication with management more challenging, forcing a reliance on public disclosures.

Red Flags in Management

• Chris Mayer: Identifies obvious red flags like self-dealing and excessive compensation, though he cautions that these are situational. He highlights unique cases like CEOs taking a dollar salary due to significant stock ownership.
• Robert Hagstrom: Expresses concern about management's reluctance to admit problems due to fear of lawsuits, which hinders transparent communication. He also views aggressive diversification into unrelated businesses as a major red flag, especially when a company has strong core competencies and high returns on capital.

Quantitative Metrics for Screening

The panel discusses specific quantitative metrics used to screen for potential investments.

Key Metrics and Their Rationale

• Chris Mayer: Prefers companies with gross margins over 50% because empirical research suggests they are "sticky" and tend to persist despite competition. He also looks for a large Total Addressable Market (TAM) to allow for long-term growth and capital deployment. He uses a 20% return on capital as a benchmark, acknowledging it's somewhat arbitrary and a sliding scale.
• Robert Hagstrom: Focuses on a 15% or higher Return on Equity (ROE), but more importantly, emphasizes Return on Invested Capital (ROIC) as the driver of compounding. He notes that the market's long-term average return is around 10%, and he seeks businesses significantly exceeding this, ideally in the 15-30% range or higher.

The Disconnect in Market Valuation

• Chris Mayer & Robert Hagstrom: Both question why the market doesn't price in differences in Return on Capital when valuing companies. They argue that a company earning a 50% ROIC should not trade at the same Price-to-Earnings (P/E) multiple as one earning 10% ROIC, even with similar growth rates. They find it illogical that commentators often overlook ROIC when comparing stock valuations.

Owner Earnings vs. GAAP Earnings and Free Cash Flow

The importance of focusing on true cash generation rather than reported earnings is a recurring theme.

Understanding True Earning Power

• Robert Hagstrom: Explains "owner earnings," a term coined by Warren Buffett. It involves adjusting GAAP earnings by subtracting normalized capital expenditures and changes in working capital, and adding back non-cash charges like depreciation and amortization. This provides a clearer picture of the cash an owner can extract from the business.
• Chris Mayer: Emphasizes Free Cash Flow (FCF) as a similar concept. He highlights that companies converting a high percentage of net income to FCF are generally higher quality. He also touches upon the challenges of accounting for intangibles in industries like technology and pharmaceuticals, where GAAP accounting may not accurately reflect economic value creation.

The Limitations of GAAP

• Chris Mayer & Robert Hagstrom: Both agree that GAAP earnings can be misleading. They cite examples like Amazon, where aggressive expensing of growth-related items obscured its true cash-generating ability. They reiterate that GAAP is a starting point, not the end point, for financial analysis.

Navigating Industry Changes and Circle of Competency

The discussion addresses the challenges of investing in rapidly evolving industries and the importance of staying within one's area of expertise.

The Evolving Landscape

• Chris Mayer: Stresses the importance of the "circle of competency," advising investors to stick to industries they understand. He finds biotech particularly challenging due to its complexity. He also emphasizes the need to genuinely like the businesses one invests in to maintain long-term interest and research.
• Robert Hagstrom: Expresses difficulty in valuing healthcare and biotech due to the uncertainty of drug pricing and success rates. He also notes that the consumer staples sector, once a reliable "sleepy neighborhood," is no longer as safe or as high-returning as it once was due to increased competition and changing consumer preferences.

Understanding Technology and Network Effects

• Robert Hagstrom: Discusses how understanding network effects, as described by Brian Arthur, helped him and others grasp the moats of technology companies. He believes that in areas like large language models (LLMs), only a few dominant players will emerge due to the capital intensity and network effects. He notes that these companies often prioritize user growth over immediate profits.
• Chris Mayer: Acknowledges that technological change is constant and requires continuous attention. He highlights the importance of management teams that are responsive to new technologies like AI and can demonstrate tangible benefits. He also references Roy Amara's law, which suggests that the impact of technological revolutions is often overestimated in the short term but unfolds over longer periods.

The Rarity of Great Businesses and Portfolio Management

The conversation concludes with reflections on the scarcity of truly exceptional businesses and effective portfolio management strategies.

The Bell Curve of Businesses

• Bogum Baronowski: Compares businesses to a bell curve, with most being mediocre. He highlights that investors should focus on the outliers – the truly exceptional businesses. He references research suggesting that only a limited number of stocks (around 100-200) have historically been worth fishing in.

Strategies for Managing Omissions and Valuations

• Bogum Baronowski: Offers two strategies to combat errors of omission:
  1. Start with a Small Position: If convinced of an idea, begin with a small stake to gain conviction and allow it to grow into a meaningful position.
  2. Be a Value Buyer and a Growth Holder: Buy at an attractive entry point but resist selling even when a stock becomes overvalued or overhyped, as it's difficult to re-enter good ideas later.
• Chris Mayer: Agrees with the "value buyer, growth holder" approach, emphasizing that a good business can continue to compound even at higher valuations. He also highlights the natural portfolio management that occurs when successful investments grow larger and less successful ones dwindle.

The Evolving Market and Incumbents

• Bogum Baronowski: Observes that the dominant companies in market indices have changed significantly over time. He notes the unusual current trend of incumbents in emerging waves like AI also being the top performers, contrasting with historical patterns where new technologies often created new leaders.

Conclusion

The discussion underscores that while the definition of a "perfect business" is relatively clear – one with strong cash generation, high returns on capital, and long-term sustainability – identifying such businesses and holding them through market volatility is exceptionally challenging. The participants emphasize the importance of a long-term perspective, behavioral discipline, a deep understanding of the businesses owned, and a focus on true economic value rather than accounting figures. Errors of omission are a significant source of regret, highlighting the difficulty of consistently identifying and acting on great opportunities. The conversation also reveals that while principles of investing may be agreed upon, the execution and the specific stocks chosen can vary widely, reflecting the personal nature of investment decisions. The market itself is dynamic, with the landscape of leading companies and even the nature of "safe" sectors evolving over time.