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What Makes Deepwater Different?

The best way to answer how we should be different from other growth investors is by posing another question: What makes a bad growth investor?

Before we worry about being different, we should worry about avoiding the common mistakes that make a bad growth investor, many of which were relearned through the current bear market.

By merely avoiding the common mistakes of other growth investors, we will set ourselves apart.

Bad growth investors tend to do three things:

1. Not respect the rarity of the great company.

The trend of the past decade plus has been the unyielding stock success of growthy tech led by the majors Amazon, Apple, and Google. This has encouraged a generation of growth investors to seek quality businesses they can own forever to enjoy returns like those of our megacap leaders.

But what’s lost in the pining for the next megacap tech stock discovery is that such investment circumstances are exceedingly rare. They require breakthrough technologies on the scale of the Internet or smartphone. They require incredible products that create valuable experiences for customers. They require competent management.

Most technologies disappoint, most products are average, and most management teams aren’t great. That means most promising growth companies aren’t indefinitely great. They’re finitely great. And that’s ok.

Lesson one of the current bear market is that your default expectation should not be that you buy companies to own forever. The exceedingly rare indefinitely great company must definitionally be an ‘everyone company’ — sell something that everyone wants or needs. If a company isn’t an everyone company, their market will run out long before you can own it forever.

A portfolio of 15-25 stocks should perhaps target a few companies worth owning for a very long time, but assuming every one of those is going to be a permanent holding is unrealistic.

Poor investors hang on to tired companies and themes too long. More often than not, you’re going to have to decide when to sell your now-not-so-growthy growth company. Good growth investors don’t ride them down to irrelevance. The best time to do this is before the growth market either proves to be less attractive or sizable than originally thought or when a decent growth market becomes lost in the consensus of acceptance.

2. Fall Prey to the Haze of Mania. Growth investing works best when markets get frothy, creating a reflexive desire for the any and all growth assets.

In these frothy markets, aggressive growth investors enjoy spectacular performance…if they’re smart enough to know when to get out. Froth-driven spectacular growth of growth investments always falls to spectacular declines as markets more rationally assess company prospects.

The hard part for the growth investor is that he should sell assets precisely when it seems like his investments will never go down again. Poor growth investors stay at the party too long, whether because of mandate, mentality, or both.

3. Hold an irrational view of future cash flows necessary to justify an investment.

The price of an investment demands a certain level of future cash flow generation given some hurdle rate. When valuations of growth assets become irrational, whether through market froth or idiosyncratic froth, poor growth investors make increasingly unsound assumptions about the long-term prospects of the business to justify the valuation. In many cases, poor growth investors likely define no real assumptions around future growth and rather rely on narratives to support the idea that the stock could go higher.

This narrative approach has a place in growth investing. The best opportunities often end up far larger than the market appreciates, making participating companies great investments. Some level of logic suspension is required to find the best opportunities, but it should be balanced with a realistic understanding of what must happen in the future to justify price. As a simple heuristic, a company is going to have to generate roughly it’s market cap back in free cash flow and remain a going concern over the next decade or so to be a great investment. It doesn’t have to do any of those things to be a great trade.

For Deepwater to be different on the way to great, we must invert these practices of the bad growth investor:

  1. We must exit themes that are no longer promising beyond the dreams of the market. And we must thoughtfully exit stocks that are not great, own-forever companies.
  2. We must remain cognizant of froth and the things that reverse it; e.g., Fed action (same in 2000s).
  3. We must respect what a stock price demands from future performance. There will be many promising companies with incredible markets that never find ways to generate enough cash flow to be great investments.

If we can do those things, Deepwater will be different from other growth investors. And I think we will be great.

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