There were good questions in the recent posts:
Smufty2:
Would any different approach to IV10 made the
AAPL>>GOOG>>BRK>MKL result the prediction rather than MKL>>BRK>GOOG>AAPL which was the original prediction?
ultimatespinach:
The terms you use “no tolerance” for economic risk, “no chance” of normalised earnings disappointing – leave little room for interpretation.
They interestingly share the answer them so I will post in this separate thread. Stock splits were missed WRB and AAPL, and all firms outperformed the market over the period held (MKL was purchased in 2010 and sold in 2017 – 2019 when the IV10/price was rather low - a huge advantage of the Manlobbi Method is knowing when to sell (not for exact timing of course but to remove low yielding situations and replace with higher yielding ones), and not only when to purchase. This is something that other investment approaches are amazingly confused about.
Regarding the relative performances, and ultimatespinach’s point about it being impossible to avoid risk, the rest of the Steadfastness chapter really needs to be held in mind, because the opening paragraph of chapter 7 is just getting us warmed up to the subject of Steadfastness (the firm will be around in 40 years, and normalised earning remain above the expected level for the first 20 years). The term “expected level” of earnings is describing not the central estimate of earnings. We want that the earnings will remain reliably above some lower bound of earnings which I often underline in my posts on this board.
When listening to a riddle, or humour, before we “get it” the narrative seems strange and meaningless. Then suddenly everything clicks together. Friends have describe that this is what they experienced when reading the full Manlobbi’s Descent. As with my main profession in art, in the book I removed everything I could that was not absolutely necessary.
The important two related observations about the Manlobbi Method are:
-
The IV10/price ratio is not the same as the central estimate of the 10-year return. As the IV10 is calculated from a lower bound of earnings almost certain to be exceeded, the IV10 is always lower than the central estimate, but for more predictable firms, the IV10 is closer to the central estimate. The diagram below illustrates how this varies between a less predictable and a more predictable situation.
-
Steadfastness is not the same as the investment being economically reliable, or the same as the situation having an economic moat. Just one of two paragraphs in the whole “Steadfastness filter” chapter were (pleasantly by ultimatespinach) quoted, but really one has to read the whole chapter. Steadfastness requires the 20-year earnings to be above some expected level defined by yourself, and only by yourself - but once again this expected level is not the central estimate but some lower bound that you believe is certain to be achieved.
These are not technical quirks, but the much of the main mechanism as to why the Manlobbi Method gives you a huge advantage over others.
The more narrow the range of outcomes (ie. the more predictable the firm is), the closer the lower bound earnings are to the central estimate of earnings. In the following examples, we can imagine forecasting earnings over the next 10 years and applying a fixed multiple, as 20 x earnings, as a proxy for tracking intrinsic value, IV(t) over time. The first firm below has less predictable earnings, so the IV10 (which is based on the lower bound) is very low, even though the central estimates for earnings in the 10th year might be exactly the same:
Less predictable (or less understood) firm:
.<- Optimistic IV = $10
. .
. .
. .
. . . <- Central estimate for IV = $6
. . .
. . .
. . . .
. . . . . <- IV10 (lower estimate) = $2
IVO-> . . . . . .
^ ^
| |
Year 0 Year 10
More predictable (or more well understood) firm:
. <- Optimistic IV = $8
.
. . <- Central estimate for IV = $6
. .
. . . <- IV10 (lower estimate) = $4
. . .
. . .
IVO-> . . . .
^ ^
| |
Year 0 Year 10
As this applies to Apple, I knew that Apple would make a certain amount of money for sure but as this was far below my central estimate, it was still good enough to purchase, but didn’t have the mega 7.0+ IV10/price that would have ensued if I was basing my predicting upon the central estimate. As a corrolary, in a year when Apple had slightly declining revenue, the quote declined massively, and the IV10/price was incredible – I posted on the Apple board that it should be puchased, and that the revenue decline was of a temporary nature, but I assure that Wall Street will have been revising their long-term earnings forecasts down, and “rationally” selling the stock. The Manlobbi Method did not succumb to this stupidity of standard professionalism.
Ready for a further departure from Wall St? Furthermore, the same firm will have a different distribution of expected results based on who is observing the firm. So one investor may have more insight into a company and have the IV10 calculation quite closer to the central estimate - the range of outcomes being more narrow. Another investor may not deem it Steadfast at all, or even if Steadfast have a much larger range out outcomes such that the IV10 calculation produces a low value, so it is anyway not an interesting investment.
The formulation of Steadfastness (in Manlobbi’s Descent) isn’t arbitrary but a range of purposes and many of them are psychological. Call yourself rock solid rational and any concern for the psychological only for the weak, but think if you are more susceptible to psychological error than it seems. The Manlobbi Method protects you from this pretty seriously. If the IV is moving around with more fragility, as you desperately optimise your calculations, you will find yourself selling at lower quotes than you purchased, along with the sophisticated quant algorithms and tips within Bloomberg articles.
Some of the corollaries, such as the diagram above (IV10 being much higher if the firm is more predictable, even though the central estimate isn’t necessary higher), aren’t even mentioned in the chapter 7 about Steadfastness.
One of the main goals of Steadfastness is that when there are quotation declines, your IV10 calculation is more immune to being updated - it will generally be preserved through all news stories, so that you can then, and only then, exploit the changes in the IV10/price ratio, with the IV10 being stable and the price unstable.
In case of Alibaba, my IV10 calculation is below my central estimate, but is not greatly effected by the recent regulations in China. If I was basing the earnings on a central expectation, my earnings forecasts would be far more fragile and the IV10 would have been revised down greatly more during 2021 thus leading to even likely selling below the quotes at which I purchased, as Wall Street would more conventionally calculate.
If Alibaba’s earnings would continue to grow as they did the last five years, then the IV10/price have been colossal even January last year, calling for a massive allocation, and then having to sell the stock as the short-term view of earnings declined steeply in the middle of the yea. My earnings forecast for Alibaba were never exciting, but were only marginally revised down during the year, so the IV10/price ratio rose substantially over the course of 2021.
I don’t want to focus on Alibaba, though, and the main point of this post is to get a clearer idea of Steadfastness and IV10/price. In a nutshell, the IV10/price method does not only aim at longer-term market inefficiencies but sets us up to be more immune to the psychological pressure of selling at market lows, plus giving us more power to allocate capital during severe price declines.
It was also suggested that nothing can pass the Steadfastness filter. There is a lot of truth to this, and that is why I believe most so called investors are much more gamblers than they allow themselves to admit - in a sense they are “going with the flow” most of the time, and the internal narrative is that things worked out in the past so hopefully will continue. But true investors are able to have surprisingly certain investment return outcomes by looking not a historic trends, but the mechanics of what they actually are purchasing. A good example of a Steadfast investment is your own house. You know everything about your house and how it produces a cash flow. You can work out the going rent and subtract normalised repair costs. If you write a contract of ownership over your house and issue it as shares, even if the quote for that contract moves up and down wildly each year, you will know what the IV10 is almost precisely - you just add up all then rent accumulated, and add it to a reasonable capitalisation of the house based on rent 10 years away (you might assume 4% inflation so you can give it a multiple of 1.04^10/0.05 based on a 5% earnings yield at year 10). For example, if the rent today is $20K this year, then it collects around $250,000 over 10 years with rent inflation. If you get small 1.5% bond return on that as it is collected, let’s call it $270,000. But for the IV10 we need to add both this “booked rent” but the house value itself. The rent at year 10 with 4% inflation is $20K * 1.04 ^ 10 or about $30K, and if the house sells at a 5% yield at year 10 then you have 30K/0.05 or $600K for the house, $270K for booked rent, so a total of $870K for the IV10. To calculate the true IV10, you would assume rent conditions are pretty bad with non-vacant periods, such as having problematic tenants based on your knowledge of you area, so you might revise the booked rent down. In any case, if we assume IV10 is $800,000, and the house can be purchased for $500,000 today then the IV10/price ratio is 1.6, and the situation is Steadfast despite having almost no diversification, no network effect, and no sophisticated arguments for its economic moat. For someone else not trusting the contract, or having a language barrier, the same situation might very well not be Steadfast. Steadfastness is a function of the observer and not just a question of fact as to how earnings ensue.
As you move from you own house, to a contract involving ten houses, has the 10-year “economic reliability” increased or decreased? It depends on the management and debt policy, and with every situation you have to view the question of Steadfastness separately, but you should not assume that you cannot find businesses that are as reliable as the future of your own house. On the contrary many firms are even more economically reliable. Usually for such firms, the IV10/price is really low and not interesting, but sometimes you find something that is both Steadfast and carrying a high IV10/price and these are the situations you want to jump on with everything. This is where the treasure of real long-term market outperformance lies.
- Manlobbi