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:

Chuck Akre Talks At Google:

Deep Value: Why Activists and Other Contrarians Battle for Control of Losing Corporations

Tobias Carlisle Talks at Google:


Active vs. Passive – the debate that can’t be settled:

Should you be active or passive?  That depends.  It should also be your second question.  Your first question should be “how much money am I willing to invest for 5-10 years minimum without feeling scared if that amount drops by 30-50%?”  No one has any clue what will happen tomorrow.  You must set yourself up for success.  And success only comes by controlling your emotions and sticking to your savings/investment plan when conditions are so scary that others aren’t sticking to their plans.

The next question I would encourage you to ask is “what is the purpose of my investments?”  For some this may appear to be a silly question.  The answer is obviously to grow them.  That is my goal too, but I also really enjoy picking the companies to make investments in.  I enjoy the process of reading earnings transcripts and regulatory filings.  It leads me down a path of trying to find out the truth about the world around me.

So, I am naturally inclined to pick stocks rather than invest in ETFs. But, in my pursuit I run the risk of realizing suboptimal returns.  When my life is over there is a chance an investment in the S&P would have outperformed my stock picks.  That is a risk I am comfortable with for a number of reasons, but you have to decide whether you would be comfortable with that risk as well.

Why am I comfortable with the risk of underperformance?  For starters, my goal is to make investments where the chances of permanently losing money is low.  Therefore, my perceived risk is lower than it would be if I were in an index fund.  Is that a logical conclusion?  No, because I am not a robot and I probably am overconfident in the business prospects I am investing in.

The natural response to what I just said is “well, then why don’t you just do what is logical?”  And the reason is I fundamentally don’t trust indexing.  I may be slightly conspiratorial or illogical, but I know in my heart that if things go really really wrong and I start reading about improper index construction I would bail on my investment. Bailing on your investment because of emotion is the path to financial destruction. 

There are many studies that show the average investor in a fund severely underperforms the fund that investor is invested in.  The reason is they lack the conviction to hold when times are tough.  As a side, sometimes it is difficult to hold when your investment is performing well.  That may sound a bit odd, but it is true.  Letting your “winners run” is a skill that must be learned.  I have cut many winners short and snatched greatness away in order to secure good results.

Investing “success” comes from doing what makes YOU comfortable enough to make the process work for you.  Investing failure is destined to find you if you compare your results to someone else’s results, an index, or some other metric AND deviate from your preferred style because you want someone else’s results.  First, those results are looking in the past.  Second, you must stick with their style when that style is out of favor.  You cannot borrow someone else’s conviction.

In closing, being a good investor requires knowing yourself and committing to be true to yourself.  So take time to think about your risk tolerance and your beliefs.  Not taking that first step ensures failure.  That said, it is only the first step to success.

The importance of ROIC and Growth

I’ve seen a lot of discussion lately about whether low ROIC businesses are better than high ROIC businesses.  ROIC means “Return on Invested Capital.”  There are a couple different ways you can define invested capital but for these purposes I am going to borrow Joel Greenblatt’s definition and call it PP&E + Working Capital.  I will note, however, that I also deem any additional necessary assets or liabilities as part of invested capital.  For instance, an airline has many assets via lease.  These are obviously necessary to the airline’s operations and therefore cannot be excluded from an invested capital discussion (an offsetting adjustment to add back rent and subtract hypothetical depreciation would be necessary in this instance).

Anyway, many people say high ROIC businesses are inherently better investments over the long term than low ROIC businesses.  Why is this?  Well, it is because a business with high ROIC tends to grow earnings per share faster than a low ROIC business BECAUSE there is not a need for reinvestment.  As Warren Buffett says, you dont want to own a business that consumes all of its capital and has none to pay back to its shareholders.  Instead, the perfect business can earn capital, require no additional investment and (a) invest that money back into marketing or some other channel to grow sales or (b) return the capital to shareholders.  Why? Because all of the cash is cash for the owners rather than cash for the business then the owners.

That said, there is nothing inherently superior to a steady state high ROIC business and a steady state low ROIC business.  Why?  Because if you are paying a multiple of earnings then the income statement will already reflect the cost of depreciation (and consequently your reinvestment rate, assuming the firm is run well) in both firms.  Therefore, the multiple you pay will be much more important to determine your success as an investor in a steady state firm.

However, nothing in this world is steady state.  Ideally you are looking at a firm that is growing.  And in a growing firm, take a look at the following (elementary) example.

Screen Shot 2018-11-08 at 3.53.43 PMAs you can see, the earnings growth rate of the firm has grown by 31.6% in each instance.  HOWEVER, the free cash flow distributable to the firm grew by 2.6 more units in the firm that requires no incremental capital.  If we assume a 5% free cash flow yield on this investment, the firm that requires no incremental capital to grow its earnings base will be worth 52.6 units more than the firm that requires capital.  Which is just to say that no incremental capital, combined with growth, can be an incredibly powerful force that lifts the value of your investments.  Hence the reason software firms are worth so much more than industrial firms.