The Most Important Thing

Year-end thoughts on making money, volatility, inflation & Build-a-Bear Workshop

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In a year where many investors found themselves on the wrong side of reason, it is worth reckoning with how to pursue investing in light of the human ego and the desire for order amidst entropy.

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In my mid-twenties, I took a hiatus from asset management to open a butcher shop with two partners. I would be the “business guy,” which meant keeping the financial plates spinning and finding ways to make payroll, while my other two partners were trained whole-animal butchers from New York. As a whole-animal butchery, primal cuts would be delivered directly from farms. We would then break them into sub-primals for the case and produce various value-added products like sausage, deli meats, and charcuterie.

We considered ourselves craftsmen—artisans re-establishing a lost tradition. A particular sausage might be “Sage and Toasted Mustard Seed,” which required someone standing over a gas range to toast mustard seeds. We would get creative with less popular cuts. For example, we used beef tongue to make pastrami to sell cuts like beef tongue to unadventurous suburban customers. We won a national award for the beef tongue pastrami, one for a Tasso Ham, and another for a Pâté de Campagne.

The Shop

None of this was particularly profitable, and after four years of what felt like a constant fistfight to stay above water, my partners and I eventually decided to move on to careers that could support a family and didn’t require year-round stress over costly, highly perishable inventory. We had committed and sacrificed so much to be great, dogmatically committed to our standards, and respected as much by our contemporaries as our customers. Yet, the reward was never more than simply being able to do it for another year.

A year or so after the initial pain and shame of closing down subsided, I was reflecting on where we went wrong with my former business partner. His diagnosis was so clarifying and precise that I have never forgotten it: “Making money was important to us, but it wasn’t the most important thing to us.” Nearly a decade later, having ostensibly been a professional investor for most of that time, those words are ringing in my ear.

I have attended an investing conference with my friend Cal for the past few years. The conference is held in a small college town, usually with only thirty or forty attendees. The twenty-odd presentations range from stock pitches to philosophical inquiries to academic postulations. This year, one investor pitched MasterCard, trading at nearly 30 times earnings, and another pitched a Chinese biotech company whose name I forgot as soon as I heard it trading at 3 times EBITDA. These investors were considered thoughtful, judicious capital allocators by their peers. But, by the end of the day, after additionally hearing pitches for Zoom and a lengthy quantitative study of losing trades, it became evident that making money was not the most important thing for the vast majority in attendance.

Their jobs were to make money, and to a one, they would say they were focused on that goal to the exclusion of all others, but for most investors (myself included), this is a conceit that must be overcome. Some investors seek validation of their cleverness, others want to be rewarded for their piety to certain investing dogmas, and others crave the prestige and respect that comes from simply being entrusted with capital.

These are psychically necessary to a degree. The market can and will undoubtedly move against you at times, and for someone too emotionally wedded to their P&L, this can be existential. In the same way, these private motivations keep investors grounded; they can also blind them to paradigm shifts and make them feel entitled to specific outcomes. In a year where many investors found themselves on the wrong side of reason, it is worth reckoning with how to pursue investing in light of the human ego and the desire for order amidst entropy.

Every investor must arrive at their own distinction between gambling and investing. Speculation, as distinct from arbitrage, involves risking capital with uncertain returns. Even if true, the conviction that some risk may be mispriced does not guarantee positive returns. Likewise, the “prudent” path of passively investing in market returns guarantees merely average results that hold a similar disregard for uniformly positive results. Most investors claim they do not want to lose money, but in practice, they either take foolish risks to make it quickly or, with great discipline, lose it slowly.

There is no surer path to looking like a fool than to claim that a paradigm is shifting. Notwithstanding, I do expect a markedly different investment environment over the next 10 years. One in which public market investors will have to tolerate much greater volatility and far wider dispersion of outcomes for securities. Without the brisk tailwind of falling rates, assets will have to earn an economic return, not merely a financial one. That is, investments must perform above the cost of capital, with future profits and cash flows being more severely discounted.

Economist John Kenneth Gailbraith wrote of the permanently bullish, "[D]elusion lies in the conception of time. The great stock-market bull seeks to condense the future into a few days, to discount the long march of history, and capture the present value of all future riches.” Many investors, professional and amateur alike, have only known of a general upward trend in asset prices, a period where risk equaled return instead of being merely related to it.

Here, I must make a small, illuminating confession: The preceding paragraphs were initially written at the end of 2022! I won’t subject you to the trope of recounting the insanity of asset prices over the past twenty-four months, aside from mentioning that a $100,000 portfolio split evenly between Microstrategy and Bitcoin purchased at the time of writing would now be worth $1.3 million.

I’ve spent much of the past year wondering what, if anything, can be learned from this kind of rapid wealth creation, seemingly independent of the financial “gravity” that is supposed to envelope markets. The following are some still-forming thoughts to that end:

Volatility Leaks

This year demonstrated that asset price volatility is an extremely powerful force. While policymakers can attempt to suppress it, it cannot be eliminated and will effectively find ways to leak out both into markets and society. Where those leakages will express themselves is inherently unpredictable, be it the issuance of zero coupon convertibles to a company whose core business is in terminal decline or the assassination-style killing of a healthcare CEO on 6th Avenue. Volatility suppression is a form of financial repression that causes asset prices to come untethered, and the resulting, seemingly random, wealth creation sows social unrest.

Since the end of 2023, financial conditions have eased, first in anticipation of Fed cuts and then with their confirmation. Volatility came down concordantly, but it began spiking again in the summer of this year. Volatility is an input to measures of financial conditions, but I would argue that it's more of an output. Rates and liquidity are “fingers in the dike,” but eventually, volatility will find other cracks through which to escape.

Investors should monitor the degree to which volatility is or isn’t expressing itself in markets and consider ways to get exposure to it when it is inorganically low. For many, especially value-minded allocators, this will often mean having positions in securities that one would typically eschew or offering a few sacrificial bips to hedge the near-certain release. These positions can and should be rapidly monetized on volatility spikes, leaving maximum flexibility for purchasing dislocations and mispricings.

Shareholder Constituencies

The world of asset management is increasingly dictated by relative performance, either explicitly through passive investment vehicles or derivatively through index benchmarks. In addition to value, quality of management, and catalysts, the fundamental or bottom-up stock picker should be attuned to the make-up of the shareholder base.

This is especially important if you are drawn to out-of-favor securities. In special situations, deep value, or balance sheet-driven re-ratings, the ultimate driver of performance will be when a security moves from out-of-mandate to in-mandate for some larger pool of buyers.

Instead of lamenting that “the market isn’t getting it,” investors should work to develop a view on what conditions would make not owning a particular security a more active decision for institutional buyers.

Inflation is Hard to Measure But Easy to Know

We have seemingly left behind the world where inflation was just “low.” The Fed has conditioned us to believe below 2% is low, and thus the corollary that inflation above 2% is simply “high.” Every month, the financial press tortures the statistics into narratives that support falling, stabilizing, or rising inflation. High and rising, or high and falling, may “sell a lot of newspapers,” but I don’t think it matters nearly as much in practice as being suspended in high territory.

For an investor typically satisfied with merely respectable (as opposed to extraordinary) nominal returns, inflation and the real threat of financial repression should weigh heavily.

The Most Important Thing

At 15, I cajoled my parents into funding a $1,000 Scottrade account. The first security I purchased was Build-a-Bear Workshop BBW 0.00%↑ . The company was on the leading edge of “experiential retail.” In brief, the concept was to create a premium experience via customization. A BBW customer would select, for lack of a better word, a hide that they would stuff and accessorize. The experience created a unit price at a significant premium to similar quality stuffed animals.

When I purchased those initial shares in 2005, the company generated $1.35 per share of earnings from $361 million in sales. Net margins were just 6-8%, but the company achieved more than $300,000 in sales per employee. If memory serves, my shares were purchased near $29, or a $500m market capitalization. To be clear, I was a high schooler who could barely spell DCF. My analysis was highly “Lynchian” -- a location had opened in a new mall near me, and I noticed it was consistently busy. I even purchased a bear for my girlfriend as part of my diligence. While she was neither impressed nor particularly pleased with the gift, I thought the experience was good. Additionally, there was some wisdom in retailing premium-priced toys, matching the per-store revenue of larger retailers with a much smaller store footprint.

The 21 times earnings I paid was a significant premium to the S&P’s multiple of 15. If I had intended to hold until today to earn an 8% annualized return, I would have needed nearly 10% earnings growth for the past 19 years, assuming the multiple compressed to the then-market multiple.

I ultimately ended up selling whatever was left of my position to pay for textbooks, but the stock has spent most of its (and my) life well below $29. In fact, at the end of 2020, the position would have been down 85%. However, in the glorious year of 2024, Build-a-Bear Workshop is up 90%. Moreover, it is trading at a sober 12 times earnings compared to the broader index’s 24 times earnings. Had I coffee-canned by BBW shares, I’d be looking at a 78% total return (3% annualized) inclusive of dividends.

Source: Bloomberg, LP

Upon reflection, making money on my Build-a-Bear investment was important, but it was not the most important thing. I wanted to learn. I wanted to be right. But I also wanted to make mistakes. I wanted to pay the tuition for experience to get better. When do these motivations truly cease for the professional or committed amateur investor? If anything, they intensify as the market is reliably humbling. New motivations and drivers join them as you progress through your career. Left unchecked, these become deleterious to the task at hand. Howard Marks writes in his own The Most Important Thing,

The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

The challenge isn't to eliminate our psychological drivers but to harness them and be humble enough to be honest about what drove them. The market will always be our teacher, ready with both rewards and humbling lessons. The question isn't whether we'll pay the tuition but what we'll learn from each expensive class.

- Hunter