Investing Thoughts and Wisdom (mostly from others) – Part 5
I have a file full of notes and excerpts from investors that I’ve collected over the years. I’ve been meaning to organize it for a while, and now that this newsletter is started, I’ll use it as a reason to gradually do so (in several parts). [Previous posts: Part 1, Part 2, Part 3, Part 4.]
I used to read through this file a lot, but it got to be pretty long, which led me to summarize the key parts of my own philosophy (as of the present time) in a blog post titled Final Decision Checklist last year.
Please note: Nothing here should be considered investment advice or the best way to invest. These are things I’ve saved as reminders and notes to myself that I’ve found helpful in the past, and think they are worth sharing in case any of you happen to get an insight from any of it.
When first looking at a new idea, use this order for initial filters:
1) People – Ownership and Management Team: Does it seem like they understand capital allocation? Do they have the “capacity to suffer” by focus on long-term value and not near-term earnings? Are they owner-operators?
2) Circle of Competence and Conservative Balance Sheet. Is this something you’ll be able to understand, with effort, in a reasonable period of time? Is the company financed in a way that will allow it to survive and maintain flexibility even in the face of a severe economic downturn?
3) The intersection of the Quality of the Business and the Price being paid, which also determines the investing timeframe when considering an investment (see four categories below). While price and business quality are arguably the most important factors in determining an investment outcome, their merits take more time and work to determine. So before putting in that work, make sure the above items check out first, or else it may be worthwhile to move onto something else.
Four categories of investments:
In reality, it’s a continuum and many things fall in between the categories below. But it’s a framework that I’ve found useful when looking at investments, and thinking about potential purchase prices.
1) Competitively-advantaged, great business at an attractive absolute and relative earnings (FCF) yield. (Compounder)
7-10 year investment horizon, which is equivalent to the time it usually takes for market valuations to revert to the mean.
When looking at these investments, consider your base return as the free cash flow (FCF) yield. If it’s a true compounder that FCF will grow, and your return will be even better. Great and advantaged businesses should trade at a premium to the market and to the market’s historical average multiple, so by buying at, for example, a FCF yield of 7-8% and a good yield relative to the market’s expected return over the next 7-10 years, you should have any change in the multiple going in your favor and not against you—if you are right in your analysis. And remember that profits and margins can shrink, so don’t just assume a growth rate will be positive. Also remember that sometimes you need to normalize FCF to really figure out the core business economics when you have a great business reinvesting most (or all) of its cash flow…. Amazon is a great example of this, and Josh Tarasoff’s Amazon pitch at VALUEx Vail in 2012 lays the thesis out.
Compounders can also be managers or investment teams that reinvest cash flows or float at a healthy rate of return, in a flexible manner…..but keep in mind that these are very hard to identify ahead of time, it can be easy to be fooled by people, and that a bad business can overwhelm even the best operators and capital allocators.
The key is REINVESTMENT. Category 1a = MOAT + REINVESTMENT; Category 1b = MOAT + Fewer Reinvestment Opportunities (and thus, need to pay a cheaper price than for a business than can reinvest at high rates of return).
2) Good business close to or below liquidation value (tangible book value, after any adjustments). (or a Transformation into a good business)
Don’t give too much weight to fixed assets, especially if they are tied to commodities (it might be best to avoid commodity-related bets altogether, so make sure the investment thesis and the asset value don’t depend on a certain commodity price).
Still want to buy these businesses at good absolute FCF yields (low earnings multiples) and at a significant discount to private market values (which may involve breaking down different segments to determine their values and the prospects for the business to invest capital at high returns in those segments).
The expectation is for these investments to double over a 3-5 year investment horizon, and will more commonly be found in the small and micro-cap universe of stocks.
3) Below liquidation value. Can be either Work-Outs (no weight to fixed assets) or Capital Cycle plays.
Look for things that are FCF positive, or if not currently FCF positive, have a path to being there soon. And preferably look for investments that could potentially be Category 2 investments….maybe because it is a cyclical business where the cycle changes (e.g. insurance, mining services, shipping, etc.).
2 years or less for the investment horizon, so look for a catalyst for the value to be realized in less than 2 years.
Probably need to really understand the capital cycle because you want to buy these names when they are about to gain some pricing power. And capital cycle analysis is especially important if you are buying into industries tied to commodities, and/or when you have no choice to think hard about fixed asset values (e.g. shipping).
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Toby Carlisle excerpt from Deep Value about Graham buying net-nets and below liquidation value stocks (related to categories 2 and 3, especially):
Ben Graham allowed, however, that stocks trading at a discount to liquidation value did so because they “almost always have an unsatisfactory trend of earnings:”
If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.
Graham responded to these objections that, while these outcomes occurred in individual cases, there was a much wider range of potential developments that would result in a higher stock price. Graham’s list of developments reads like a modern activist investor’s list of demands, and it included the following:
1. The creation of an earning power commensurate with the company’s assets. This may result from:
a. General improvement in the industry.
b. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
3. Complete or partial liquidation
Graham proposed that the discerning analyst would lean toward those stocks for which she saw a fairly imminent prospect of one of these favorable developments emerging… The analyst would avoid issues that were rapidly dissipating their current assets and showed no definite signs of ceasing to do so. Even so, he wrote, there was “scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities.”
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Timing and Category 3, in regards to capital cycle investments – Excerpt from Capital Returns (5.5 – written in November 2012):
From a capital cycle perspective, the above situations only become attractive when stock market valuations fall to a fraction of replacement cost and a path opens up for dealing with the excess capacity. While the first condition is close to being met in many European sectors, the prospects for the second appears dim. In previous downturns, capacity adjustment has come as a result of interest rates rising to choke off inflation, leading to widespread bankruptcies and industry consolidation.
…With interest rates low and set to remain so, and banks prepared to prop up weak businesses for fear of crystallising losses, monetary policy looks very unlikely to precipitate a major reallocation of resources. Indeed, it appears designed to head-off such a denouement. Under such circumstances, supply side restructuring via industry consolidation also looks like a long-shot, especially as many European industries are already quite consolidated and face anti-trust barriers.
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4) Good business, at a good price, being run by people who seem to be doing the right thing and that understand capital allocation, but where the moat is either more narrow or its sustainability is hard to predict, and you don’t have downside protection by buying it close to or below tangible book value.
Easier to fall for value traps in these types of investments, where the margins—and thus earnings—erode, maybe because of increased competition (never underestimate the ability high returns to attract competitors, and remember that even one competitor is enough to ruin a business), or maybe because the company was riding a trend, fad, government regulatory tailwind or credit bubble that comes to an end.
Do extra work to develop a unique insight into these types of investments.
Make sure reasonable assumptions lead to an expected IRR of 26% or more (a fifty-cent dollar that reaches full value in 3 years, or one that takes 5 years but that is also growing that value by 10% per year). Without sufficient downside protection in the form of a moat or asset values, don’t settle for a lower expected return.
Remember that if a good return on capital business can't reinvest and grow, it may be worth a lower multiple than the return on capital of that business might lead one to believe. So to be a truly good business, it must be able to continue to reinvest at those good returns on capital.
Excerpt from Chris Mayer’s book 100 Baggers on the importance of reinvestment to having a good business:
ROE alone does not suffice. Jason looks for another key element that mixes well for creating multibaggers. “The second piece requires some feel and judgment. It is the capital allocation skills of the management team,” he said. Here he ran through an example.
Say we have a business with $100 million in equity, and we make a $20 million profit. That’s a 20 percent ROE. There is no dividend. If we took that $20 million at the end of the year and just put it in the bank, we’d earn, say, 2 percent interest on that money. But the rest of the business would continue to earn a 20 percent ROE.
“That 20 percent ROE will actually come down to about 17 percent in the first year and then 15 percent as the cash earning a 2 percent return blends in with the business earning a 20 percent return,” Jason said. “So when you see a company that has an ROE of 20 percent year after year, somebody is taking the profit at the end of the year and recycling back in the business so that ROE can stay right where it is.”
A lot of people don’t appreciate how important the ability to reinvest those profits and earn a high ROE is. Jason told me when he talks to management, this is the main thing he wants to talk about: How are you investing the cash the business generates? Forget about your growth profile. Let’s talk about your last five acquisitions!
Chuck Akre’s 3-legged stool (also via Chris Mayer’s book 100 Baggers):
Akre’s approach is simple and easy to understand. He calls it his three-legged stool. He looks for:
1. businesses that have historically compounded value per share at very high rates;
2. highly skilled managers who have a history of treating shareholders as though they are partners; and
3. businesses that can reinvest their free cash flow in a manner that continues to earn above-average returns.
We’ve talked about all of these in this book.
As he told me, though, the older he gets, the more he whittles things down to the essentials. And the most essential thing is that third item. This is the most important principle behind the 100-bagger. In one of his letters, he puts it this way: “Over a period of years, our thinking has focused more and more on the issue of reinvestment as the single most critical ingredient in a successful investment idea, once you have already identified an outstanding business.”