The Evolution of a “Value” Investor

I have a tendency to need to make my own mistakes.  I wish I could learn from others more quickly, but it seems as though personal experience is my only reliable teacher.  So, it is with some hesitancy that I have to admit that only recently have I understood the growth investor’s mindset.

I initially got interested in investing when my grandmother’s friend, John Runnette, sent me The Intelligent Investor, The Battle for the Soul of Capitalism, and Common Sense on Mutual Funds.  Mr. Runnette must have had a sick sense of humor because 2 of those books are written by John Bogle, who founded Vanguard.  The other, written by Benjamin Graham, is the layman’s version of Warren Buffett’s bible.

My personal experience left me thinking there is no way markets are rational.  I lived through the 1999-2001 period and John sent me those books in 2009.  Thus, I was in the middle of watching the second gut wrenching crash in a decade.  Therefore, the idea of a market portfolio was inherently unacceptable to me because I “knew” that was a silly idea.  Surely, the “enterprising investor” as Graham described him/her could outperform those silly indexers.  Right?  Well, it turns out this is a very difficult game.

My dad likes to say “I knew all the answers and then the questions changed.”  That is how I am beginning to feel about investing.  That said, the fundamental tenant of viewing a stock as a part ownership interest in a business AND paying a reasonable price for that interest will never go away.  What I’ve learned over time, however, is the previous sentence is far more nuanced than it may appear.

What is a reasonable price to pay?  The answer to this question depends on a number of factors, but the most important components are whether the business (1) is growing or shrinking and (2) requires additional investment to grow or shrink?  Please see the post on The Importance of ROIC and Growth for more information.

A business that is both growing and doesn’t require additional investment should grow in value over time.  In fact, that growth is likely exponential assuming the ability to grow continues over time.  Therefore, you can pay a lot more for the existing business because the growth in value will probably bail you out.  In the long term, if you identify a company like this early enough in its lifecycle then its hard to see a scenario where you will lose much money (especially if you repeat this process a number of times).

I have made serious errors is investing in companies that are in decline but they are selling at “discounts” to my estimate of what they are currently worth.  The problem with these situations is the business value is eroding over time and the value can decline below your entry price.  While I believe there is merit to the strategy of buying these kind of companies (see Tobais Carlisle’s book Deep Value), I think the only suitable approach is through an ETF (the cost effective option; Toby is releasing the ETFs with ticker symbols ZIG and ZAG shortly) or very diversified portfolio.  This is because the stratefy depends on mean reversion and requires a large number of bets to work.  Any one “cheap” business losing its value can go to $0.

It took me a very long time to realize that cheap relative to today’s value is not the only definition of value investing.  Further, it took me a long time to realize that cheap relative to today’s value tends to realize investment results via an investment “rerating” or increasing in market value.  This creates a problem because there are many times those investments don’t have too much organic growth (though they can).  Therefore, when the investment increases to an investor’s estimate of its true value that investor needs to sell and find the next idea.  The downsides of that approach are the investor (1) pays capital gains and (2) has to find the next idea.

Therefore, an investor can find him/herself with too much cash relative to what they would prefer.  Having too much cash may not sound like a problem.  In practice, however, having cash can create the feeling of needing to deploy it.  That feeling has led me to make mistakes (this is a common problem).

All of this is to say that my approach is now to attempt to limit my investible universe to companies that have long growth paths in front of them and don’t require much incremental capital to grow.  I will always be attracted to “underpriced” situations but hope to spend much more time looking for great businesses that can grow and trade at reasonable prices.  Easier said than done…

Recommended Reading/Viewing:

100 to 1 in the Stock Market:  https://www.amazon.com/100-Stock-Market-Distinguished-Opportunities/dp/1626540292

Chuck Akre Talks At Google: https://www.youtube.com/watch?v=O38I7QIc_eQ

Deep Value: Why Activists and Other Contrarians Battle for Control of Losing Corporations https://www.amazon.com/Deep-Value-Investors-Contrarians-Corporations/dp/1118747968

Tobias Carlisle Talks at Google: https://www.youtube.com/watch?v=1r1vJZ80Z7I

 

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