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Inputs vs. Outputs

Investing is a results game. If you run a fund and drastically underperform for 20 years, you don’t have an argument. Index funds would have been better for your investors.


But at the same time, investing is a process game. Focusing solely on results puts you in a position to make suboptimal decisions. For example, it’s November and you’re trailing the market by a few bps. Might you force a trade to beat the market that year?


So we’re left with a conundrum; we must somehow focus on the process but also get feedback from the results. Yet, there’s another layer. If you underperform for a little bit (like Charlie Munger did from 1972-74) there may be not something wrong with your strategy.



But at a certain point, you will wonder, “Do I need to update my views?” It’s tough to know when to keep conviction and when to change your mind. The fortunate thing about investing is it’s all about valuing something. If you consistently pay more for something than it’s worth, you’ll underperform (the solution isn’t necessarily to buy low multiple stocks).


While there are a lot of valuation methodologies, an asset’s worth is derived from the present value of its future cash flows.


To break this down a little more, the output of a DCF is the value of a company. The inputs are financial metrics (how much will the top-line grow/contract? margins? etc.)


So that means, from an investor’s perspective, a company’s value is derived from its financial inputs.


But let’s think about it from the perspective of the person actually running the business.

The financials are an output, a result of many, many hours of hard work, thought, strategy, meetings, mental models, etc. (the inputs).


That’s where quantitative and qualitative investors diverge. One focuses primarily on a business’s outputs and the other, the inputs.


But just like investors, an entrepreneur should use the outputs as sign-posts to gauge whether his/her strategy is working, thereby changing the inputs if it isn’t. Fortunately for the entrepreneur, feedback loops are shorter (customers either buy or don’t buy whereas market prices can dislocate from true business value for a long time).


Let’s recap. Financial metrics, which are the inputs for investors, are actually outputs for entrepreneurs. Often this creates tension. A classic example is if some investors are focused on bottom-line improvements while a CEO is looking ahead to grow the business in the long-run. Input vs. output.


But what if investors turned this idea on its head? What if, instead of viewing financials only as an output, we viewed it like entrepreneurs? (a feedback loop to understand if the inputs are trending in the right direction). This doesn’t mean investors can’t rely on the financials. The quantitative and qualitative work together; notice that you rarely hear those words used to describe an entrepreneur.



Yet it’s not easy. As a public market investor, in the US alone, you have about 4,000 choices. If one company’s financials aren’t great, why not just move onto the next one? What’s to keep you from moving on besides the good ole’ endowment effect?


This is tricky because, as investors, we need a way to cut through the noise. While running one business is feasible (though ridiculously hard), figuring out the entrepreneurial inputs for 4,000 businesses is impossible. We wouldn’t have that sort of time in 100 lifespans. So we resort to financial-metric pattern-recognition to see if a company is worth looking at (valuation metrics for “value” investors and ROIC/top-line growth for “growth” investors). Because of time limitations, this makes sense.


However, I believe focusing on the inputs of a business is extremely underrated. If we’re business owners, after all, wouldn’t it be a good idea to spend more time understanding the customer value proposition than worrying about 2 bps of gross margin deterioration? Input vs. output.


Yet, the other part of my mind thinks “Well, that’s nice and all, but the financials are the only evidence we need. Otherwise, we’re relying on soft observations.”


This is the problem with investing; it’s black-and-white but at the same time, it’s not. There are always two sides to the story.


I’ll allow Jeff Bezos to make my original point:

“Senior leaders that are new to Amazon are often surprised by how little time we spend discussing actual financial results or debating projected financial outputs. To be clear, we take these financial outputs seriously, but we believe that focusing our energy on the controllable inputs to our business is the most effective way to maximize financial outputs over time.


A review of our current goals reveals some interesting statistics:

• 360 of the 452 goals will have a direct impact on customer experience.

• The word revenue is used eight times and free cash flow is used only four times.

• In the 452 goals, the terms net income, gross profit or margin, and operating profit are not used once.


Taken as a whole, the set of goals is indicative of our fundamental approach. Start with customers, and work backwards. Listen to customers, but don’t just listen to customers – also invent on their behalf. We can’t assure you that we’ll meet all of this year’s goals. We haven’t in past years. However, we can assure you that we’ll continue to obsess over customers. We have strong conviction that that approach – in the long term – is every bit as good for owners as it is for customers.”

The richest man in the world might be onto something.


I hope to drill down on this concept over the coming months and include some specific inputs investors might be well-served to focus on.


Again, I’m not saying that financials are useless and only qualitative data points are helpful. I just think certain inputs like customer value proposition, how energized employees are, the CEO’s time discipline, humility, the company culture’s willingness to try new things, etc. are underrated and would be value-additive to your investment process.

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