Monday, March 24, 2014


Below is an investment letter I wrote in February of last year. The essence of what I was trying to get at is essentially what Sanjay Bakshi was saying (though more clearly and elegantly than I did) in his recent interview with Vishal Khandelwal in this excerpt:
So, to summarize, if you are going to invest like Ben Graham, then your sources of margin of safety are different than if you invest like Warren Buffett. You just have to be aware of those sources and also of their limitations. 
I also strongly feel that when it comes to moats, it makes sense to think in terms of expected returns and not fuzzy intrinsic value
What will not work is to apply the same methodology to every business. 
For example, in my view there is a way to invest conservatively in businesses which are likely to experience a great deal of uncertainty. But you simply can’t use that approach when dealing with enduring moats. And vice versa. 
You need to have multiple models to deal with different situations to avoid the “to-a-man-with-a-hammer-everything-looks-like-a-nail” trap.
The key is that the quality of a business and the sustainability of its competitive advantages makes an enormous difference in how it should be valued. A P/E ratio of 10 or 20 or 30 or whatever number means little unless you have some insight into the quality of the business and the sustainability of that quality going forward. In the letter below, I separated investments into four categories, but that is just one way of viewing things. Reality is probably more of a continuum instead of set categories and one that can change quickly when innovative competition comes along.

Filters - by Joe Koster (February 21, 2013)

“We really can say no in 10 seconds or so to 90%+ of all the things that come along simply because we have these filters.”  –Warren Buffett (as quoted in Seeking Wisdom: From Darwin to Munger)

Besides running screens and paying attention to stocks on our watch list, when looking for new places to invest, we also read other people's write-ups and hear other people's ideas all the time. This can be a useful thing because a lot of these ideas are great, the people are usually smart, and it is another tool to search for potential things in which capital could be put to work. But the human mind is made to fall for stories and miscalculate the odds when a good narrative is in place, as has been usefully described by the work of Nassim Taleb and Daniel Kahneman, among others.

Filters are an important—though certainly not guaranteed—way to help limit mistakes, whether from the narrative fallacy or from other potential errors. By not even thinking about things that don't pass certain filters, you'll probably miss plenty of good ideas, but you'll also avoid plenty of good stories that turn out to be bad investments. And as it takes a 100% gain to make up a 50% loss, for example, it is probably much more important to avoid the losing investments than it is to try and pick every winner. Or as Howard Marks often says, if you avoid the losers the winners will take care of themselves.

So whether potential investment ideas are your own or those of others, I think the most important thing isn't necessarily the number of things you look at, but rather knowing when you should stop looking at that idea and move on to something else before your own psychology makes you see things that may not really be there. In an interview with my friend Miguel Barbosa last year, Alice Schroeder mentioned this in regards to Warren Buffett’s filtering process:

Typically, and this is not well understood, his way of thinking is that there are disqualifying features to an investment. So he rifles through and as soon as you hit one of those it’s done. Doesn’t like the CEO, forget it. Too much tail risk, forget it. Low-margin business, forget it. Many people would try to see whether a balance of other factors made up for these things. He doesn’t analyze from A to Z; it’s a time-waster.
And to elaborate on this point, let’s return to one of my four favorite books, Peter Bevelin’s Seeking Wisdom: From Darwin to Munger. In Seeking Wisdom, Bevelin mentions a comment that Buffett made in 2001 where he described his thought process:

At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.
- Can I understand it? If it passes this filter,
- Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
- Is the management composed of able and honest people? If it passes this filter,
- Is the price right? If it passes this filter, then we write a check
I think filters are some of the most important things to spend time developing well in order to become a great investor. If your filters are good enough, you can save a lot of time and, hopefully, avoid a lot of mistakes.

I discussed some of the things we seek when looking for investments in “The 4 Gs of Investing” and by and large, they are very similar to Mr. Buffett’s. In one area, though, our philosophy is closer to the way Buffett managed money when his capital base was much smaller, rather than the way he manages Berkshire’s much larger base of capital today. That area occurs at the intersection of quality and price.

Though our preference is for companies with sustainable competitive advantages, we are willing to consider other businesses, at the right price. When looking for investment ideas, I’m looking for stocks that fall into one of three different categories, with some consideration given to a fourth category.

1) Competitively-advantaged, great business at an attractive absolute and relative free cash flow yield

With these investments, we take a 7-10 year investment outlook when considering the investment, which is equivalent to the time it usually takes for market valuations to revert to the mean. The thought here is that with a great, competitively-advantaged business, free cash flow (FCF) is more predictable and that the most important action in determining the right price at which to buy shares is figuring out the FCF the business is currently throwing off, and the prospects for that FCF to grow in the future.

If the FCF multiple the market places on the stock doesn't change, we expect our return to be the free cash flow yield plus the growth rate in that free cash flow (after all capital expenditures, since we are considering growth in the equation). Though we have to remember that we may not get rewarded by the market for the FCF not paid in dividends, so the return might just be (and is maybe even more likely to be) FCF growth per share plus the dividends we receive, assuming the multiple stays the same. As great and advantaged businesses should trade at a premium to the market and to the market’s historical average multiple, by buying into these businesses at a minimum absolute FCF yield (say, 7 or 8%) and a good yield relative to the market’s expected return over the next 7-10 years, we should have any change in the multiple going in our favor and not against us, if we are right in our analysis.

2) Good business close to or below tangible book value (after adjustments)

With these investments, we are looking to find a good—though maybe not competitively-advantaged—business in which think the stock can double over a 3-5 year period, and has downside protection. We still want to buy into these businesses at good absolute FCF yields and also at a significant discount to private market values. But if a business doesn’t have significant and sustainable competitive advantages, earnings predictability is usually lower and the odds of an unexpected and unpleasant surprise increase, so we also want to buy our shares fairly close to tangible book value (or maybe just book value, depending on the nature of the intangibles), and adjust that book value by, for example, putting a big discount on fixed assets, especially if they are tied to the price of a commodity. 

3) Below liquidation without giving much (or any) weight to fixed assets, especially if they are tied to commodities

These are businesses that aren’t great or good businesses, but that are still FCF positive and trading at a significant discount to liquidation value, after giving most of the weight to current assets and assigning little value to fixed assets. We prefer to enter a position in this category at around two-thirds of our adjusted liquidation value, and take an investing timeframe of 2 years or less. As such, we also want to identify a catalyst that we believe will occur within that 2 year period.

4) Good business, seemingly good price, run by people that seem to understand capital allocation, but where the sustainability of a competitive advantage is hard to determine and there is no downside protection in the asset values

This is the category that, philosophically, gives me some trouble. It is easy for me to pass on bad businesses at bad prices, businesses where I don’t like the management team, businesses that don’t fit into any of the first three categories above, or things that don’t meet other ownership, management, circle of competence or balance sheet filters. But when I see a good business, that may have at least some kind of competitive advantage (though maybe not a very large or sustainable one), trading at when seems like a good price, temptation enters. I think the most important thing about these is to really make sure to go the extra mile when trying to figure out if the future economics of the business could be considerably unlike the past economics, because if you are wrong about the earning power of the business and the profit margins of the business erode, you could be setting yourself up for a significant and permanent impairment to capital.

Though we haven’t been able to find much in the market at the current time that fits the first three categories, there are some businesses in this fourth category that are getting close to consideration. Coach (NYSE:COH) and Strayer Education (NasdaqGS:STRA) are a couple of examples in which we haven’t purchased any shares yet, but that fit this category. They have historically been good, high return on capital businesses and the companies have opportunistically repurchased shares at attractive prices. Our focus is on the first three categories, but if we can develop any unique insights on those or other businesses in the fourth category, they could find their way into portfolios, though we will be careful to limit the percent of portfolios actually invested in that category.

Though these are some of the rules and filters that guide our process today, it is also important to remember that things change and flexibility of the mind is an important trait to have in order to succeed over a long period of time. Or as Seth Klarman, in one of my favorite investing quotes, said: “To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don't when they don't.”