Normalized Performance Analysis
Our investment approach at Recurve Capital is to find Builder Companies and own them patiently over long-term investment horizons. Many investors try to execute the same approach. After all, every investor has dreams of buying and holding massive long-term winners. Berkshire Hathaway since the 1960s. Amazon, Google, and Meta since their IPOs. Chipotle. More recently, stocks like Nvidia and Celsius Holdings have captivated investors over the last 5-10 years. It’s easy to look at long-term charts and assume holding over whole period was easy. It’s much harder to sit through 1-2 years of flat performance, let alone 1-2 years of negative performance. In this post, we will discuss in more detail one of the frameworks we use to we implement patient, long-term investing: Normalized Performance Analysis.
Background Discussion
When performance is good and a stock goes up and to the right, most investors feel psychologically safe. We tell ourselves things like “the thesis is playing out,” “the market is recognizing what we’ve been seeing all along,” “finally our patience is being rewarded,” etc. Few investors are emotionally consumed by the patience required to hold a stock that is currently performing well and keeps going higher. Unless they are in a speculative position they don’t believe in longer term, most investors enjoying great performance shift their attention to the positions not performing as well.
Our patience is tested when things aren’t going so smoothly, when fundamentals are a little bit questionable for some period of time, and especially when stock prices start declining sharply. As a long-term investor hearing strengthening arguments from the bears, you may begin to believe the stock is telling you something – that you’re dead wrong.
I had a debate with my first boss in 2008 over Crown Castle (NYSE: CCI). I had done significant research on the cell tower industry for years, and especially on CCI’s balance sheet in 2008 – mostly to understand the risk to the equity, but also because we were looking at buying some tranches of the company’s Tower Revenue Notes (tower lease securitizations), which were yielding in the mid-teens at the time (an amazing deal – if CCI defaulted on them, we’d own the underlying cell towers). The stock had fallen from $35 in September 2008 to less than $9 at the bottom in November. When the stock approached $10, my boss came to my desk and said, “The stock is telling you it’s going to zero. Look at how this thing is trading!” As a young associate (and in my first financial crisis), my response was: “I’ve looked at this from every angle and it’s not going to zero! If CCI is at risk, our entire portfolio will be worth nothing.” This became a debate memorialized on the white board. He thought I’d eat my words, and I worried that I would too!
Crown Castle’s performance during the financial crisis
CCI recovered to $20 by January 2009, returned to $35 within a year, and was over $70 in 2013. The stock was a 2x from September 2008 to early 2013 and a 7x from November 2008. It kept going higher, peaking above $200 in 2021. I use this example because even a bullet-proof business with long-term leases can be caught off guard when the market turns quickly. It is easy to look at a chart and say “Wow, what an opportunity to buy in November of 2008!” It’s also easy to observe that a patient investor would have made significant returns in CCI if he simply held on from the mid-2000s to the early 2020s. But how many people got shaken out in the stress of the global financial crisis at $20, $15, or $10, when all one could feel was fear and panic in the market? Of those who sold, how many were willing to buy back the stock on at $15, $20, or $30 to generate good long-term returns? Most participants likely sold on the way down and either never reinvested - or did so much later.
Holding volatile mark-to-market securities patiently is a superpower that most market participants don’t have the stomach for. Regardless of how it looks in historical charts, where years of agony in real-time can be observed in seconds, there is nothing easy about the inevitable period of underperformance that will occur. Nvidia endured two -50% drops in 2010 and 2011. It endured another -54% decline in 2018, and a -30% decline during Covid. Nonetheless, a patient investor in Nvidia made a killing. However, it’s not so simple or easy.
For every Hermes, up +166% since December 31st, 2020, there is a Kering which is down -39% over the same period. Even when our stocks go up and our long-term patience is rewarded, at some point a stock can outperform so much that we begin to lose sleep over its valuation. How secure does the Hermes investor feel when its valuation rose from 30x P/E to 52x over the last three years, all while the interest rate environment has become less favorable and other luxury companies are reporting slowing demand?
How do we sort through when to hold, when to add, and when to sell? In short, how can we tell when we should be patient or when we should exit because we are wrong?
Normalized Performance Analysis
Bursts of underperformance and outperformance happen for a variety of reasons, but there is always a reason - demand trends changing , competitive intensity changing, interest rates changing, and more. Generally, we evaluate our Builder Companies based on what we think they can generate in revenue growth, margin expansion, and free cash flow per share over a medium-term period – at least 3-5 years. However, progress doesn’t happen linearly and there can be deviations (up and down) and discontinuities that make progress toward our medium-term targets more difficult to discern.
These deviations and discontinuities can be good, accelerating our path to returns with bursts of outperformance, or bad, causing the opposite effect. In both cases, it’s important to know how our companies are performing relative to a normalized trendline. We use normalized performance as our primary way of evaluating companies. We’ll walk through a dramatic current example to illustrate this point: Carvana.
Carvana Case Study
Carvana has experienced a multitude of deviations and discontinuities in its business over the last four years. It saw a massive slowdown during the Covid shutdowns, followed by a surge in demand for about 1.5 years immediately afterward. When the Fed raised interest rates rapidly in response to inflation in 2022, used car demand slowed rapidly due to record-high prices and rising higher rates, and Carvana’s growth decelerated sharply. Additionally, capital markets winds shifted, causing the company to focus its efforts on efficiency and profitability rather than growth, further pressuring unit volumes temporarily. The company experienced a double-whammy of slowing demand and markets prioritizing cash flow above growth – all within a compressed time frame.
The chart below attempts to capture our interpretation of Carvana’s deviations and discontinuities from the normalized trendline since the Covid-affected era began, and an optimistic potential recovery path back to trend. Of course, many other future scenarios are possible.
In a business with high operating and high financial leverage, these deviations and changing macro winds caused significant volatility in Carvana’s stock. Carvana appreciated significantly in 2020 following the post-shutdown demand surge (~10x gain trough to peak), only to fall -99% from peak to trough in 2022. See below:
If Carvana returns to healthy growth, closing the deficit compared to its prior trendline, patient long-term investors will be rewarded - similar to the Crown Castle example above. However, many patient long-term investors are still heavily under water relative to Carvana’s peak. Opportunistic long-term investors had (and continue to have) a chance to buy more shares during this drawdown. A -99% decline causes most investors to exit their positions. Most cannot stomach the volatility and career risk of holding their position through such a severe drawdown.
Assessing current results vs. expectations of normalized performance is a repeatable way to properly contextualize stock price movements and fundamental developments. We perform this exercise a lot. It allows us to zoom out and think about the longer-term trends happening in a business without overly rewarding or penalizing a company for near-term deviations. However, this approach also has challenges that require thoughtful and objective diligence. In particular, we must assess if deviations are temporary or permanent, and how the future outlook has evolved. What if those curves never converge, and the company will remain permanently above or below prior trend?
In addition to analyzing normalized performance, we rely on our Builder Company framework to assess businesses qualitatively and quantitatively. Does it make sense that the target business should be winning or losing share permanently? If the company is suffering share losses currently, have we been wrong about our assessment of its advantages, or is something else impairing it? Can we figure out which trends should be extrapolated and which should be normalized? It’s an iterative and recursive process that sends us down many different rabbit holes of research that help us develop strong, independently-generated views corroborated by real evidence. Hoping a slowdown is temporary is not a strategy.
While of course every analyst and investor makes predictions of the future, we never know for sure – there will be additional deviations up and down in the future, as well as changing macro winds. As long-term investors, we must probabilistically weigh our best guesses at the future outcomes and compare those to what the current valuation implies to identify if there’s an attractive investment opportunity. Some great companies can become bad investments due to poor (high) valuations, just as companies trading at great valuations can turn out to be bad investments due to poor future fundamental performance. Our job is to find great companies at valuations that attractively handicap our view of the range of future outcomes. Essentially, our goal is to find Builder Companies trading at valuations which value our view of the future at a large discount.
In Carvana’s case, it’s not hard for us to believe that the company can return to growth and rapidly ramp its volumes to utilize its vertically-integrated infrastructure as quickly as possible. The company delivers value to customers via multiple dimensions that matter: selection, convenience, value, and more, all of which should translate into long-term gains in market share. Carvana’s focus on internal operating efficiency should allow the company to grow more efficiently than when it was in high-growth mode. It also now has the benefit of growing into fixed asset-based infrastructure, rather than building its massive reconditioning and logistics machine while growing. We like the company’s chances to generate growth outcomes well above what is implied in the current stock price, which makes Carvana an attractive investment to us. While returning to its prior unit growth trendline would produce an amazing outcome, it isn’t necessary to be that optimistic to own the stock today. The primary uncertainty facing the company is just how fast it can grow while remaining profitable, and that question has yet to be answered for many investors.
Closing
The Carvana example was the most extreme case of patient, long-term investing that I have experienced in my 20-year career, including 2008, but the emotions around drawdowns are similar and familiar for all stocks (although a -20% feels different from a -50%). All multi-year investors will face setbacks and strengthening arguments from bears at various points of their ownership cycle. Being able to look through the short-term gyrations and properly assess a company’s normalized performance – qualitatively and quantitatively – is an essential framework to help us find our way through the inevitable fluctuations in fundamental performance and equity performance.
This framework also helps assess what to do when a stock starts “working.” Short-term investors may have exited or reduced their positions in a stock like Carvana after it rose from $4 to $20 or $40. A 5-10x return within a year was an incredible outcome and should be celebrated. However, the opportunity for us as long-term investors is to zoom out and assess the optimal course of action based on an unemotional, thorough assessment of our views in relation to the company’s valuation to determine the quality of the investment opportunity, not base our decisions based on recent stock performance.
