Picking the Hill for Your Snowball

Tradeoffs in investing and staying on the right hill

Simple analogies are usually the best way to convey investment lessons. We like to compare studying stocks to analyzing an apartment building. Similarly, we tend to think of our portfolio as a snowball. Our goal is to maximize the size of the snowball while at the same time, and even more importantly, bringing to an absolute minimum the chance the snowball stops rolling, melts, falls apart, or flies off a cliff.

Even starting with just a small handful of snow you can produce a tremendous snowball if the conditions are right. There are only a few variables investors need to consider when getting their snowball rolling, specifically;

• The length of the hill

• The slope of the hill

• The type of snow on the hill

• The absence or presence of cliffs on the hill

The beauty, and the challenge, is you can choose which of these variables you seek to maximize. The catch is, you can’t maximize all of them (at least no one I’ve ever encountered can). In other words, you can elect to try to build a large snowball by rolling it down a very steep hill (i.e. swinging for the fences) or by giving yourself a very long runway. Unfortunately, there aren’t many hills that are simultaneously extremely steep, extremely long, and devoid of cliffs, and those that hunt for them often end up falling down a crevasse.

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Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts are often an excellent fit for Eagle Point Capital’s long-term investment approach. Eagle Point manages separately manage accounts for retail investors. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.

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The Length of the Hill

This one is pretty straightforward and shouldn’t be controversial. The longer the timeline, the likelier it is that the snowball will compound to a consequential size. While this is the most understandable variable to build into an investment plan, it’s also the hardest one for people to accept and stick with. Everyone claims to be a patient, long-term investor. That is, until they get impatient, and wish to become rich quickly. It reminds me one of my favorite Charlie Munger quotes:  

“We get this question a lot from the enterprising young. It’s a very intelligent question: you look at some old guy who is rich and you ask, ‘How can I become like you, except faster?’”

Or perhaps said even better, the classic Buffett quote:

“You can't produce a baby in one month by getting nine women pregnant”

There is no substitute for time and patience in building wealth through the stock market. There’s almost no way around it; either accept the fact that you won’t get rich overnight, or turn to the other variables for some help, which brings us to the slope of the hill.

The Slope of the Hill

The slope of the hill you decide to roll your snowball down is the annual rate of return for the portfolio. It’s easiest to think in extremes. A hill with a very gradual (at times imperceptible) slope might be U.S. Government Bonds that generally earn 4% or less per year. A hill with a steep 45-degree slope is a leveraged derivative of some speculative type (cryptocurrencies, commodities, leveraged ETFs, etc.) with very high targeted returns (and even higher risk, more on that later).

A happy medium for us is to seek businesses that are stable but growing (they won’t excite “growth” investors, whatever that means anyways). They have some capacity for reinvestment, but can also return substantial amounts of cash to us. These businesses represent hills that have a steep enough slope to compound capital at attractive rates without subjecting us to the risks getting out of control.  

Obviously, a steeper slope means the snowball has the chance to get larger faster. All else equal this is great, but all else is never equal because capital markets rarely offer free lunches.

The Type of Snow

If you’ve ever had a snowball fight or built a snowman you know that wet snow is the best for making snowballs. Wet snow packs well and picks up additional snow as it rolls. It grows with minimal effort. In a similar way, high quality businesses build value and earn disproportionately high returns in relation to the capital employed in the business; their value grows with comparatively little effort.

Time is the friend of the good business. These businesses can usually reinvest a portion of their cash at high incremental returns and return substantial cash to shareholders, meaning the snowball grows in multiple ways. We write about these businesses all the time and you can find many examples in our archives, some of which we own and some of which we follow closely. Characteristics of these businesses usually include high returns on capital, identifiable and ongoing competitive advantages, stable and rational industry structures, and predictable end markets. They are simple, predictable, and profitable.

Conversely, dry snow doesn’t grab additional snow very well and falls apart easily. Low quality businesses need to reinvest lots of capital just to stand still. It takes tremendous effort to keep them the same size, let alone grow them. These snowballs have trouble building and often melt.

Time is the enemy of the bad business. Some examples of “dry snow” companies are highlighted in our article about how to spot value traps. These companies are usually on hills with an abundance of potential pitfalls.

The Presence of Hazards

Barreling down a mountainside at top speed is fun until you fall off a cliff.

Hill’s with less steep slopes make it easier to foretell danger ahead and give you time to react should trouble arise. These hills have risen more slowly and stood the test of time. To us this takes the form of predictable and stable industries not prone to irrational and savage competition. The pharmaceutical distribution market, aftermarket auto parts space, and home improvement industries are a few good examples.

Rapidly changing and fiercely competitive industries make it hard to predict danger; you never know what the competitor is going to resort to. Technological change arises overnight and makes products obsolete and price wars erupt and force industry profits to converge to zero. The automotive, airline, consumer electronics, and a myriad of tech industries are great examples. In other words, hidden crevasses capable of destroying the snowball are omnipresent on these mountains.

Nvidia is a timely example of a snowball that has rolled down a near vertical hill the last few years – the snowball has gotten huge really quickly! I’m probably using this example because we’ve never come close to owning the stock, but I’ll use it anyways; it sure seems like there could be some hidden crevasses on that hill. Hills don’t get that steep without some ice falls and unstable snow.

Normally if a business’ revenue can grow by 5x over five years, like Nvidia’s has, it means that revenue can shrink very quickly as well. For example, Nvidia’s revenue is essentially big tech’s capex. Their customers are in a spending mood, and that’s great for Nvidia while it lasts. However, we’ve seen how quickly big tech can cut capex when they feel the need to show higher profits, and it’s likely (certain?) to happen again.

Additionally, Nvidia is the only game in town for certain types of chips – for now. When competition catches up, prices are sure to come down. It wouldn’t shock me if this coincides with a slowdown in capex spending, a double whammy of a crevasse in the hill. Combine these factors with a tremendously high starting valuation and the results could be…less than great from here. Is the stock priced for such a possibility? Maybe, but unlikely.

Perhaps I’m dreaming up superficial risks and I just don’t appreciate the durable competitive position around the business. That’s fine, I just won’t make any money on Nvidia or other similar companies. On the other hand, I won’t lose any money should a cliff emerge in the seemingly pristine mountainside that has been Nvidia’s hill the last few years.

The price paid for a business is the other indispensable risk mitigant. Think of it as a safety harness for your snowball. If you pay a low price in relation to the underlying earnings power, your snowball can survive the inevitable bumps without incurring irreparable harm. The predictability of the business and industry combined with conservative purchase prices should help keep your snowball from falling off a cliff.

The Importance of Keeping The Snowball on the Hill

Investing is a game of tradeoffs, and you need to find the ones you are willing to make. In keeping with the snowball analogy, our approach is to first pick the right hill. We’re willing to give a little on the slope in order to minimize the presence of danger and make sure we have lots of wet snow and a long runway.  

The most important thing to us is to avoid taking the snowball off the hill and onto flat territory, or worse. In practical terms taking your snowball off the hill means moving to cash when you’re afraid stocks might have a rough stretch (i.e. spending a lot of time on a flat surface) or rolling your snowball off a cliff (taking undue risk and impairing your capital). By the way, ALL snowballs will encounter flat spots and roll backwards at times, that’s part of the game. The idea is to minimize the harm felt from those periods, not eliminate them all together.

A common mistake I see, particularly in private/alternative markets, is committing to a seemingly high returning fund but one that doesn’t keep the capital deployed for very long. This is the deception of using IRR as a benchmark. Even if the quoted returns seem good, if your capital isn’t at work for very long, so what? Here is a great graphic courtesy of Andrew Hakim - our partner who oversees our sister company Eagle Point Funds which also makes private investments - that illustrates the point.  

In this example, let’s say you commit $1M to a private fund that targets attractive 20% IRRs. The catch is, those quoted IRRs are only calculated from the time your capital for each investment is called, not from the moment you commit the $1M (which you’re legally on the hook for) to the fund. From the investors perspective, the clock starts the minute you commit to investing the $1M, because you need to set that capital aside until it’s called. While it’s waiting to be deployed, it’s likely to earn very little.

Here’s an example of what the cash flows look like:

The Illustration above assumes each investment earns a 20% IRR over the 4 years it is deployed (which would be a great result and is not easy to achieve), and this is the returns figure you’ll be quoted from the investment manager.

However, from the investor’s point of view, the clock starts in year 0 when the capital is committed. Taking into account the full timeline and the rolling nature of the investments and their returns, the investor realizes a 13% IRR, a 2.7x MOIC over 7 years. Still good, but a misleading result when you believed you were getting 20% returns. If the capital was deployed the entire time at 20%, the multiple of invested capital would actually be 3.6x.

Instead, pretend you pursue a less steep but longer slope approach. Instead of targeting 20% returns, you settle for 13%; still great and very tough to achieve, but much more doable than 20%. Instead of seven years you have a 15-year timeline. The key here is you deploy all of the capital right away and let it keep compounding.

In this example, you end up with 6.3x your money over 15 years, instead of 2.1x after 7 years, even though your quoted annual return is far lower. Which approach is more sensible and repeatable?

Of course, you could argue that one could pursue the first strategy and then redeploy into another similar vehicle for the next 7 years and maybe your results are close to the same. While in theory this is true, it rarely plays out that way. There are tons of frictional costs (in the form of fees and taxes) and getting in and out of investment vehicles never happens simultaneously. It’s also far from a guarantee you’ll find another similar private fund earning 20% per year. Psychological forces of trying to time things just right as you hop in and out of investments are working heavily against you as well.

This illustrates one of the most important quotes in investing: “you can’t eat IRR”. Always beware of high quoted returns over short time periods and ask yourself if you’re better off focusing more on the length of the hill instead of getting allured with the slope.

Finally, remember to pick your hill and then stick to your game. Don’t get upset because someone else picked a steeper (and riskier) hill and just so happens to be getting rich faster than you for a short period of time. Don’t hop from hill to hill, trying to chase the latest fad. People on other hills are playing a different game and rolling down a different mountain.  

So get out there, find some wet snow, find a hill that’s long and has a reasonable slope and, above all else, stay on that hill!

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Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts are often an excellent fit for Eagle Point Capital’s long-term investment approach. Eagle Point manages separately manage accounts for retail investors. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.