125 - Phase Change Investing

Mental Models discussed in this podcast:

• Phase Change (Chemistry)
• Earnings Power
• Consolidation Period

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode125

Phase Change Mental Model

• In Chemistry, you have the mental model of a phase change.
• Think: Solid, Liquid, Gas
• In order to exercise a phase change youhave to increase the energy in a fluid. Increasing energy causes the temperature to rise, but when a phase change is close to occurring, the temperature will stop increasing for a period of time. 
  • During this time, you have to keep increasing the energy, but the temperature will stay the same.
  • Why?
  • The excess energy is being applied to changing the phase of the fluid. This pause is incredibly important and the amount of energy needed to change phase is the "latent heat." 
  • In the same way, you should try and profit from businesses undergoing a phase change.

Applying the Phase Change Mental Model to Stock Investing

• Two ways to look at this:
  • Underlying earnings power
  • Shareholder base changes
• Underlying Earnings Power
  • Often, stocks may be stuck in a trading range for a period of time, months, maybe years. On the surface (via the stock price) no change appears to be occurring. However, under the surface, the company is improving, cutting costs, building new products, and pleasing customers.
  • Then all of a sudden, th e company breaks out to new highs as eanrings go up 50%, 100%, or 200% when a new product launch occurs and operating leverage plays itself out.
• Shareholder Base Changes
  • There are a diverse set of possible shareholders you need to be aware of. 
  • Types: 
    • Deep value
    • Value
    • Growth
    • Momentum
    • Speculators
  • Sizes:
    • Retail
    • Institutional Investors
      • Active Funds
      • Passive Funds
  • It can take a long time for a shareholder base to change over and that's one of the things that can occur during this consolidation period. Deep value sells to value, value sells to growth. Retail sells to Active funds, and active funds sell to passive.
  • If you want above-average returns, it can help to ride the wave from one set of investors to another.
  • If you can buy stock as a retail investor when NO isntitutional investors are involved and then wait long enough to sell to institutional investors, you can be bneefit from massive multiple expansion as the liquidity that they bring forces the stock price up faster than earnings. 

Phase Change Investing Applied to My Portfolio

• I want to buy stocks when they are nano-caps, trading for sub $50m and sell them after they have 10-20x becoming Small-Cap companies. The goal is to hold them through their nano-cap and micro-cap phases when there are no institutional investors and sell them once they are in the $500m-$1bn+ range.
• At that time, ETFs, mutual funds, and hedge funds will be involved and I may be able to benefit from buying at sub 10x P/E multiples and sell at 25+ P/E multiples to these passive investors.
• This process may take many years, but it can lead to supercharged returns. 

Summary:

A phase change occurs when excess energy is added to a fluid. For aperiod of time, energy rises without temperature changing. Investors can learn from this mental model how to seize investing opportunities during consolidation periods.