In this talk, he was asked to speak about his approach to value investing. Here’s the key takeaways we had.
His key focus: Businesses that are growing their intrinsic value over time.
There are three buckets of companies:
1. Companies growing their intrinsic value per share – Focuses on this bucket
2. Companies shrinking their intrinsic value per share
3. Businesses you don’t understand (i.e. outside your circle of confidence)
Qualities a business must have to invest in it:
1. Businesses you understand
2. Businesses that are growing their value per share and reinvesting their earnings at high rates of return
3. Businesses with durable cash flows – Will survive economic downturns, shocks, etc, which will inevitably occur (and ideally they can take market share when this does occur)
4. Capital allocation - They think like owners rather than employees
5. Need to have value – a gap between current share price and intrinsic value per share
The goal as an investor is to build a part ownership in easy to understand businesses that will be earning more in the future. You will never eliminate errors but this mindset will help reduce errors.
Getting an Edge
Everyone is trying to buy good business at cheap prices. So to build an edge you can:
1. Information advantage – Find information that others don’t have (highly competitive).
2. Analytical advantage – Taking the same information but interpreting it differently.
3. Time arbitrage – Taking the same information but using that information in a different time horizon (such as thinking long-term when the market is thinking short-term). Most of his investments.
1) Information advantage
Information advantage is how Warren Buffett made a sizeable amount of money in the 1950s, turning pages of the Moody’s manual, in a way turning over rocks. (However, this approach is much harder today).
For example, Warren Buffet’s purchase of Western Insurance – This was a profitable business trading at 1x earnings. Trading at $1 in 1949 and went all the way to $95 in 1955, a 95-bagger. Warren Buffett found it by flipping through the Moody’s manual and it had $16 of earnings per share and it was trading between $12-20. This was a low hanging fruit and he was up 75% that year, partly because of this and also GEICO.
Joel Greenblat is a fund manager who had a ~50% annual return from 1985 to 1994 and focused on special situations including situations like spinoffs (a company selling a division). Now there are so many people are looking at spinoffs it is not the hidden playground for value investors it once was. There are structural reasons why spinoffs still work and reasons he looked at them but every large hedge fund in American probably has a dedicated analyst reading every single form 10 that is filed.
However, the challenge is that today it is much easier to gather information. For example, some hedge funds pay for satellite imagery of farm fields and Costco parking lots to get an advantage.
2) Analytical Arbitrage
Informational advantage is hard to have but as smaller investors we can take the same information and think about it in a different way. For example, Apple. The largest stock in the market. There is no information about Apple that isn’t already known, but it traded at $90 in January, $110 in March, and back to $90 in May, and up to $115 or so now [fall 2016]. These are $100 billion swings in the valuation of that business. There is no way that the value of the business to a private buyer would change that much over that period of time.
Approach 1 - Thinking about something differently. Example: Apple’s high margins. There are two perspectives you could have: 1) Apple is a consumer electronics business. The hardware business is very competitive business, and if a company has high margins another company is going to come in and attack those margins, and Apple’s margins will in turn revert to the mean. The alternative, 2) Apple is a consumer brand like Nike, Coca-Cola, Starbucks, and this is why Apple has higher margins to begin with and sustainability in high margins.
Approach 2 – Give more weight to long-term factors. The market does a good job of judging short term data points like earnings growth, but a poor job at predicting long-term probabilities and fundamentals. There are many examples of companies that compounded 20% every year for long periods of time, and in turn were undervalued. For example, if you are an engineer at the top of your class you might want to work for Google or Facebook, or hot tech start up, but you don’t want to go to Yahoo. The best companies get the best and brightest talent and this widens their moat over time.. but this is very difficult to measure and, in turn, aren’t given as much weight as they should have.
Markel Corporation Example – A great insurance business that invests in stocks instead of bonds. As an insurance company, if you can maintain profitability and underwriting volume, it makes sense to invest shareholder capital in stocks, because shareholder capital will be permanent capital under this scenario. They have created a compounding machine increasing book value from $3 in 1986 when it IPO’d to over $600 today, 19% annualized over 30 years. Why was Markel so mispriced for so many years, where you could have bought it at almost any price it traded at over that period and subsequently compounded your capital at high rates? 1) One view could have been, insurance is a bad business, volatile, no pricing power, it’s a commodity product and returns on equity are mediocre and so Markel’s high return on equity will revert to the mean at some point. An alternative view could have been 2) Markel is a good business because of its culture, prudent underwriting focus, the owner-oriented management team, and their investment approach that they have is a sustainable advantage. But these things are hard to measure. See his post on Base Hit for more information on this case: http://basehitinvesting.com/markel-mkl-a-compounding-machine/ and also the follow up “A Compounding Machine” http://basehitinvesting.com/markel-mkl-a-compounding-machine/
Fun example: Say there is a disease and the odds is 1 out of 1,000 of getting it, and your friend tests positive in a test with 99% accuracy. What is the chance your friend actually has the disease? The odds are 9%.
3) Time Arbitrage (most of his investments)
If you are willing to maintain a three to five year time horizon while most analysts are focused on the next quarter, I think you have an advantage. There is no information or analytical advantage. Instead it is a willingness to buy stocks that others are selling for short-term reasons (short-term expectations, quarterly results, overall market fear) that do not affect the long-term value of the company. Joel Greenblat would talk about drawing a string of the stock price today to where he thought it was going to be in 3-5 years – and he would say “If I buy a stock at $40 and thought it was worth $80 in 3-4 years, I don’t care if it goes to $30 before it goes to $80, so long as it gets to $80 that’s all I care about”. But a good percentage of investors will not want to own a stock if they think it will go from $40 to $30 over the short term. This is just human nature.
Bank of America BAML, 2016 example) – $17 to $11 and back to $17 just in this year alone, a $65 billion dollar swing in value. There were fears that 1) low oil prices would impact oil producers, creating massive defaults and wreak havoc in banks energy books and 2) could lead to a recession with more domino effects and credit losses. And 3) there was also counter-party fears in Europe. These were legitimately possible fears that were likely to impact short-term earnings but none of those three were likely to impact the long-term earning power of Bank of America. They are well capitalized with a sticky customer base and a low-cost deposit franchise. Bank deposits have grown every year almost without fail since 1948 at an average rate of 7%/year and BAML and other large banks will get their share of deposits. So you have 1) Really attractive deposit franchise, 2) bank that has simplified its cost structure and cutting costs, 3) well capitalized, and 4) sticky customer base leads to strong and stable earning power. If you could look and analyze all of those things and think about the bank over the long-term (3-5 years down the road), you could come to the conclusion that you could get the stock for a cheap price relative to earning power.
Some numbers: BAML had $190 billion of tangible equity, doing about 10% return on equity, $19 billion of profits, approximately 11 billion shares outstanding, equating to a $1.70 per share in earning power. The stock declined to around $12 in June equating to 7x earnings, which I think is a low price for a stable profitable bank.
Time arbitrage, why does it work? – I think focusing on the long-term is difficult because 1) it takes a lot of patience (short-term underperformance, where a stock does not do what you think it will do in the near-term, unwillingness to hold on to things that might have a pessimistic short-term view. 2) Most investors want quarterly results, and most money managers try to accommodate these short-term demands as their jobs depend on keeping their clients happy (“I don’t care what Apple will look like in three years, I want to know how many iPhones they are going to sell this quarter”). 3) Persuasiveness of short-term mindset due to speed of technology change, social media, wall-to-wall television coverage, and even corporate management teams are affected by this.