In the previous article, we explored how fear can create compelling investment opportunities. Today, we'll delve deeper into a crucial aspect of successful investing: inversion.
The Power of Inversion in Investing: How to Make Smarter Decisions When a Business Goes on Sale
In the world of investing, a great business can suddenly appear “on sale” due to external events that create fear or uncertainty in the market. But how do you know if it's a true opportunity or just a temporary setback? The key to making smart investment decisions in such situations lies in creating a deep understanding of the company’s future potential and employing a technique called inversion. This approach helps you flip the script on your reasons for owning a business, ensuring you’re not caught off guard when things change.
In this post, we’ll explore how the inversion technique works, why it’s important for evaluating businesses that may go on sale, and how you can apply it to make more informed decisions in your own investing strategy.
Understanding Why a Business Goes on Sale: The Role of Fear and Uncertainty
Great companies can find themselves “on sale” when fear and uncertainty enter the equation. These events can range from internal crises (such as a product recall) to broader market downturns (like economic recessions). When these events occur, they create doubt about a company's future, leading to a sharp decline in its stock price.
But how do we, as investors, separate short-term noise from long-term opportunity? This is where a deep understanding of the business and its future prospects comes into play. Before making any investment decision, it’s crucial to know the “story” behind the company — why it’s a good investment in the first place, and what could derail that investment.
The Inversion Technique: Turning Arguments Upside Down to Make Better Investment Choices
One of the most powerful tools in evaluating a business is the technique of inversion. The idea is simple: for every reason you have for wanting to own a business, you need to challenge it by flipping it upside down. In other words, you look at your reasons for buying a company and ask yourself, “What could go wrong here?” and “What would make this a bad investment?”
This process forces you to critically analyze the company’s potential, risks, and the assumptions you’ve made about its future. If you can’t find a solid rebuttal to your inversion, it may signal that the investment isn’t as strong as you thought, or that the company’s “story” has changed.
For example, let’s take Netflix — a popular company that many investors consider a solid choice in the streaming industry.
Case Study: Why Netflix Might Not Be the Dominant Streaming Service Forever
Let’s say you’re interested in buying Netflix because it dominates the streaming industry. It’s profitable, it has a strong brand, and it operates within a flywheel model: the more users it gets, the more movies it can produce, which attracts more users, and so on. This self-sustaining growth makes Netflix an attractive option for investors.
But in order to make a sound investment decision, you need to use the inversion technique. Let’s start with the argument for owning Netflix:
Reason to buy: Netflix dominates the streaming industry and has a flywheel model driving its growth.
Now, let’s flip it:
Inverted argument: Netflix is facing increasing competition from powerful companies like Disney, Apple, and Google. These companies have massive resources and established audiences, making Netflix look like a small player in comparison. What if Netflix gets overwhelmed and loses its competitive edge?
To effectively use inversion, you need to rebut this argument. Here’s how that might go:
Rebuttal: While Disney, Apple, and Google are formidable competitors, they all have other business interests that take precedence. For example, Apple is focused on hardware, Disney on theme parks and media, and Google on search and advertising. Their streaming services may struggle to compete with Netflix’s specialized focus on content and subscriber growth. Plus, Netflix has built a loyal user base and a massive content library over years, which will take a lot of time and money for competitors to catch up with.
When the Story Changes: Knowing When to Walk Away from an Investment
Sometimes, despite your best efforts, the inverted argument doesn’t have a solid rebuttal. If this happens, it means that the company’s story has changed in a way that makes it a poor investment moving forward. In such cases, it’s important to recognize when it’s time to sell or not enter the investment in the first place.
Take Netflix again: if the competition from major players like Disney and Apple had caused Netflix’s subscriber growth to slow significantly and its content library to diminish, it would fundamentally change the investment thesis. If these negative trends were irreversible, then the “story” that made Netflix a strong buy would no longer hold up, and the company would no longer be a good investment.
How Inversion Helps You Avoid Costly Mistakes in Investing
The power of inversion lies in its ability to challenge your assumptions and force you to think critically about your investments. By examining the potential risks — the “what could go wrong” scenarios — you can avoid making emotional or hasty decisions driven by short-term market fluctuations.
Inversion also helps you see the bigger picture. While the market may be focusing on a short-term crisis or event that drives the stock price down, inversion forces you to consider the long-term health of the company. If the company’s fundamentals remain strong, and the crisis is temporary or fixable, then the market’s fear-driven sell-off may actually create an opportunity to buy at a discount.
For example, during the 2015-2016 Chipotle E. coli crisis, institutional investors sold off their shares, fearing prolonged recovery. However, patient investors who understood the business's long-term potential saw the drop as a chance to buy at a lower price. They understood that Chipotle’s core business — its brand, customer loyalty, and ability to fix the crisis — would eventually bring the stock back up.
Conclusion: Inversion and the Long-Term Investor
In the end, the key to successful investing lies in understanding the business, its story, and the events that might cause its price to drop. By using inversion, you can critically analyze your reasons for buying a company and ensure that you’ve considered all angles before making a decision. If the company’s story remains strong, even in the face of fear-driven market sell-offs, you may have found a golden opportunity to buy.
Investing is all about the long-term, and applying techniques like inversion allows you to stay focused on the fundamentals while avoiding costly mistakes driven by fear and uncertainty.
