On Waiting For a Fat Pitch and Swinging Hard
My thoughts on Catalysts, the META Drama, 3M and the Stanley Druckenmiller interview
I was listening to the new Stanley Druckenmiller interview (link at the end) when I heard him express the following idea that is usually repeated by great investors:
I think one of the most important things to do is not to play when you don't see a fat pitch" (…) I've always thought that the way to build a long-term track record is when you really see the ball, swing really big and when you don't see the ball, don't swing.
Stanley Druckenmiller.
We have all heard some version of this idea from great investors such as Warren Buffett. Usually, their investing style revolves around building a cash position, staying inactive and waiting for a fat pitch. Once they recognize the “perfect” idea, which usually is one with a high margin of safety (low downside, high upside), they size it really big, they size it much bigger than most fund managers or individual investors would. Patience rewards them with the ability to take advantage of market volatility and mispricing with concentrated high-certainty bets.
On the other side, I’ve seen so many supposed fat pitches on Twitter get destroyed by the market that I have stopped counting. Obviously, when I started investing, I also thought I had found a fat pitch that ended up losing me over 50% of a concentrated bet. The problem here is obviously getting the fat pitch wrong and losing big in size and averaging down a loser that you thought was a fat pitch. So, if you are going to size the position big, you need to make sure that it really is a fat pitch. You need a high degree of certainty, but you need to recognize that many times, a stock going down comes with a lot of uncertainty, so naturally, most stocks that go down should be a pass.
DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument. Please do your own research. My analysis could be totally wrong and the stock could have negative returns. This information is for general purposes only and should not be considered as investment advice. I am not a financial advisor and do not offer investment recommendations.
DISCLOSURE: I currently own META shares but I do not own MMM shares.
What situations qualify as a fat pitch?
First of all, we really need to understand what we are looking for. There are tens of thousands of stocks to buy out there but only some of them will strongly outperform the markets in the next years.
First of all, I will show you an example of the most recent fat pitch I have found. Although I did take advantage of it, I did not size it big enough. It just helped me recover all my previous losses and left me with some gains. Let’s talk about Meta Plaforms META 0.00%↑ .
This is a very interesting one indeed. For those of you who have not been following the Meta Platforms drama, this is a short summary:
META disclosed that their Reality Labs segment had growing operating losses of over 10 billion USD per year.
META had two other problems: Apple’s privacy changes made their ad campaings much less efficient for advertisers and TikTok was taking market share with their short-form videos.
The stock started tanking from ~300 to ~200. The market feared that the profitable segment (Family of Apps) would decline while a growing unprofitable segment (Reality Labs) was reducing operating margins.
While the two problems were still being adressed. META kept telling investors through guidance that total expenses would keep growing although revenue was flat. The stock kept tanking from ~200 to ~90, the stock was at about a single digit Price to last years Earnings, however, Earnings were expected to decline a lot.
So here comes the fat pitch: Suddenly there was a total change in capital allocation. Mark Zuckerberg announced he would Lay Off 10% of employees while targetting lower expenses and announcing there would be more steps toward a more Efficient company. That day the stock went up around 5% but remained below ~100, and I bought a big lot. Additionally, the Apple and TikTok problems were getting solved.
There clearly was a catalyst that created the fat pitch, you really had it all:
Undervalued company
Move to a shareholder-friendly cost structure
Share buybacks with all Free Cash Flow (net of Share-Based Comp.)
The company did exactly what the market was begging for it to do
The company solved the two biggest challenges: Apple and TikTok.
So… What can we learn from the META drama?
The stock remained Undervalued during most of the drawdown. However, you could’ve bought at 220, 200, 180, 160, 140 or 120 USD and the stock kept going down. The market was relentless. It was only once the catalyst appeared that you really could buy with high certainty and margin of safety: The change in capital allocation in such an undervalued stock meant that there was a lot of upside and low downside.
A patient investor who waited during all the drawdown without buying until there was a more certain situation got rewarded with a very rare and unique opportunity to buy in size with a huge margin of safety.
Will there be other situations like this in the future?
Absolutely, there will be situations like this, we just have to be ready and know what we are looking for. There was a short time-window to act, so only if you were patiently following the stock during all the drawdown you could’ve taken advantage of this unique situation.
Does a Fat Pitch really require a Catalyst?
I think a Fat Pitch doesn’t always require a Catalyst, but it certainly helps. If you are buying great businesses, quality compounders, maybe the fat pitch is waiting for them to reach a valuation way below their historic average. If the valuation is low, and you are expecting earnings to grow, you have a potential margin of safety situation without a specific catalyst.
For example, in 2016, Warren Buffett bought Apple in size at a low P/E Ratio and I do not think there was any special catalyst. Apple did spent 31 Billion USD on share buybacks that year which is sort of a catalyst, but not a big one that ensured Buffett that the stock would go up. However, the low valuation combined with the expected earnings growth was enough to constitute a very good Fat Pitch.
About Stocks Going Down
Something that I have learned in my first 5 years of investing is the fact that a big drawdown in any stock doesn’t mean it will go back up. Usually stocks go down for a reason, maybe the reason is wrong, but until the reason they are going down reverses, there is no need for them to go back up, they might just stay low or even keep going down. I have seen many value investors get trapped like this.
For example, the reasons why MMM 0.00%↑ is going down are pretty clear:
Legal issues associated to quality problems with their military-grade earplugs. Over 200.00 plantiffs are suing the company that might have to pay 10-20 billion USD according to estimates. If 3M finally had to pay 20 billion USD, it would represent around 4 years of pre-tax Operating Income.
A 3% Revenue Decline made Operating Income drop 28% in FY2022 due to lower demand of their products.
Currently the stock is at an 11.55x Price to NTM Normalized Earnings estimated by analysts while the mean for the company is 17x. This valuation was not seen since over a decade ago!!
Many value investors started accumulating shares on the way down and have seen their investment keep decreasing in value. It looked cheap at 15x, and it looks even cheaper at 11.5x forward earnings, however, there is no “Catalyst” that should make the stock go up right now. Is it a fat pitch? I would say no. It might be a good investment but I think it certainly does not constitute a fat pitch for me. After all, the company might end up paying 4-5x forward earnings to the plaintiffs which would put it at around the historical mean valuation.
Of course, a Catalyst would constitute any event that reverses any of the stated problems above that are weighing on the stock price resulting in:
Certainty on the legal issue with a lower than expected final payment that settles all the cases
Revenue growth and margin expansion
This are just my current thoughts on how to interpret what constitutes a fat pitch. Definitely a stock going down is not a fat pitch if there are strong reasons for it to go down. Usually a fat pitch involves a reversal of what made the stock go down. Earnings dropped? You need to predict that earnings will go back up. There is a problem with a competitor? You need to predict that it will be properly addressed.
So what is a Fat Pitch according to Oscar?
I think a fat pitch is when you see the problems that caused a stock to go down, be reversed all of a sudden, in a way that you can predict with high certainty that the stock fundamentals will improve, all while having a low enough valuation to get a huge upside (and low downside if you are wrong). There’s no need for the stock to be going down though, sometimes stocks at all time highs can also experience positive inflections that vastly improve the business fundamentals.
So that’s all for today, remember to subscribe to receive more emails like this one and check out the Stanley Druckenmiller interview below.
Great explanation of your point of view, very illustrative. Thanks for the writing.
I can relate to your story on Meta with my investment in Kaspi, where I was a buyer all the way to July 2022. The political situation in 2022 in and around Kazakhstan hammered the valuation.