An inflection point is an event that results in a significant change in the progress of a company, industry, sector, economy or geopolitical situation and can be considered a turning point after which a dramatic change, with either positive or negative results, is expected to result.
There are many types of fundamental inflection points:
Turnarounds (with a major catalyst sparking the revival)
A new fast growing product/segment, ideally whose early growth has been hidden by a larger flat or declining segment
A major demand side break-through such as a new distribution agreement
Growth company tipping in to profitability (with strong operating leverage)
Hyper growth company that has has just ‘crossed the chasm’ (a topic for another update)
All of these have one thing in common, which is a very rapid rapid acceleration in the rate of improvement in fundamental performance.
“Turnarounds seldom turn” — Warren Buffett
Value investors look for businesses that have had some fundamental setbacks (the dip in revenue and profit). But more importantly, they are looking for situations where the market has over-reacted to the bad news (the share price plunge) and the shares are undervalued. They purchase shares during the troughs of the market’s despair and hope to sell later, when the market’s mood has improved.
Value investors are cursed with being early. That means suffering through significant further price falls before the company’s performance improves.
The traditional value investor is left holding the bag on to a company that looks cheap, but where performance continues to decline. The ‘cheap’ often just keeps getting ‘cheaper’. This slow-motion train wreck is known in the industry as a value trap.
A better approach
Instead of purchasing purely based on an estimated discount to intrinsic value, we can also wait for indications that a fundamental improvement is already well under way. We can wait for the fundamental inflection point:
By waiting until the inflection point has already started we avoid the worst of the losses that long-term holders have suffered. In turn we also miss out on some of the gains, since we are unlikely to be buying at the absolute bottom. But that also means we join in just when the fun is really getting started.
When executed well, this focus on inflection points can radically enhance our expected returns:
Reduce the number of severe ‘value trap’ blow ups. This helps us win big, lose small.
Reduce behavioural biases: less pain from holding falling shares means less temptation to sell at the worst possible time.
Shorten the average holding period. This is a key part of generating high annualised returns i.e. it is better to make 50% in six months than to wait two years.
Higher ‘hit-rate’ which allows greater concentration i.e. the number of profitable trades as a percentage of all trades increases.
Read more: The Hidden Power of Inflection Points