Brian Bares: Finding an Edge; creating a moat around an investment process

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[H/T @iancassel]

Edge and investing

A couple of days ago, John Huber wrote an excellent blog post called What is Your Edge? I recommend it if you haven't read it yet, and (cue the confirmation bias) pretty much agree with every he said. As someone who spends much of my time looking at small and micro-cap stocks, it got me thinking about a couple of things that I wanted to write down here, as the writing process helps me keep thinking out loud.

First, I think this statement is entirely true: 

I also think that many investors think they have found information in small-caps that others don’t have. One of the advantages of writing a blog is I hear from a lot of readers, and in the past when I have mentioned small cap stocks, I’m amazed at how many people have already researched the company I’m looking at, and have found the same information I found.

As both an investor and a blogger, I've experienced the exact same thing. It is hard to get an information edge in today's world, and if you are looking at small and micro-cap stocks, there are likely plenty of other people looking at the same ones, at the same time. I think the reason this happens much of the time has to do with earnings-multiple obsession. I think many people that claim to be following a value/Buffett and Munger approach to investing are actually taking the Ben Graham approach of going to the grocery store every day and seeing what's on sale (i.e. what looks cheap based on a given multiple), as opposed the Buffett and Munger approach of going to the grocery store every day and looking at one's favorite items (i.e. the types of businesses one would really like to own if they ever go on sale).

This isn't just about quality vs. cheap, or growth vs. value. As Buffett and Munger stress, growth is simply a component of value (sometimes a positive, and sometimes a negative) and almost everything is a bad value at one price and a good value at another price. But with small companies, there is often less of a chance for a durable moat to have formed around the business, which means extrapolating current earnings too far into the future (as a multiple is essentially implying) can often lead to what many people call a value trap—something that looks cheap on the surface but where margins, and thus earnings, may be at risk going forward. In other words, while it may be a good place to look, it also may be more likely that the business deserves to be trading at that low multiple. As Brian Bares said in an interview a couple of years ago, when asked about the biggest mistake investors make:

I would say that—especially to the value crowd that sort of follows the Buffett/Munger philosophy—it's this mistaken notion that a low P/E stock can potentially outperform.... Companies with low valuations on rule-of-thumb metrics like price-to-earnings, price-to-cash flow, price-to-book are often indicative, even in the small and micro-cap space, of broken businesses.

What might be the reasons for these so-called "value traps?" From what I've seen among smaller companies, the major reason has to do with underestimating the role of competition (which includes competitors that may not even exist yet, but that may be enticed to enter the industry if returns on capital are attractive, or capital is plentiful). As Charlie Munger has said: "We have found in a long life that one competitor is frequently enough to ruin a business." That quote is one that I always keep close at hand, as is this excerpt from Ed Chancellor's introduction to the book Capital Returns:

From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm’s profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt. Conversely, a focus on competitive conditions should alert investors to opportunities where supply conditions are benign and companies are able to maintain profitability for longer than the market expects. An understanding of competitive conditions and supply side dynamics also helps investors avoid value traps (such as US housing stocks in 2005–06). 

Of course, the thing we are all looking for is a low multiple that doesn't deserve to be low because there is a long runway of profitable growth ahead. And if it doesn't deserve to be low and the growth transpires, then you are likely to get a re-rating as well as the growth, which can lead to the big home runs. But simply depending on a re-rating from a low multiple to justify investment is a tough game to play. And if one is willing to look 5-10 years out instead of the next quarter or year, then the multiple—unless at an extreme and especially at the higher end of that time frame—matters much less than whether or not one was right about the business. There's less competition in thinking this way, no matter what size company one is researching. As John concluded his post: 

In summary, I think the “edge” is less about knowing more than everyone else about a specific stock, and more about the mindset, the discipline, and the time horizon that you maintain as an investor. Thinking long-term is a commonly talked-about potential advantage, but one that is much less often acted upon. If you are a professional investor that is set up to capitalize on this, or an individual investor who has the right mindset, you can give yourself a significant edge in the stock market.

Below is a Peter Lynch example that I like on how important the long-term compounding of earnings growth per share can be. If you pay a 20x multiple for Company A and the multiple stays the same at year 10, you get 6-bagger. If you pay 10x for Company B and the multiple stays the same, you get a 2.5-bagger. And even if the multiple contracts on Company A from 20x to 10x, you still end up with more money than company B. 

As a final note, it's also important to remember that looking and thinking long-term shouldn't come at the expense of the anecdote to hubris, overconfidence and, as Ben Graham described it, the "vicissitudes of time": Margin of Safety. 

Value and growth investing...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

A common misperception among professional investors is that there is a bright-line distinction between value and growth investing. This is a legacy belief that was driven largely by institutional consultants. They have attempted to group managers whose portfolio characteristics clustered around low prices in relation to book value and earnings as value managers. Conversely, a manager with a portfolio filled with companies that exhibit growth in sales or earnings are considered growth managers. If a small-cap manager engages in fundamental company analysis with any regularity, the irrationality of this model becomes readily apparent. Growth (or lack thereof) is simply incorporated into the mathematics of appraisal. No manager, growth or otherwise, is attempting to purchase a security at a steep premium to estimated appraisal. The industry perpetuates the myth that value managers are concerned with buying statistically cheap securities and that growth managers do not care what they pay. Nothing could be further from the truth. 

The previous section included a discussion on the pros and cons of relying on historical accounting data for valuation. Appraising an operating business is almost always about the future profits attributable to owners. If expected profits are discounted appropriately and adjusted for capital structure, then an appraisal should reflect all variability within the various line items on the income statement. Both value and growth managers are correct to attempt to purchase at a discount to appraisal. Conversely, both are likely to be wrong if, in the case of value managers, they blindly purchase stocks with low relative price-to-book values without considering the future of the company and, in the case of growth managers, they blindly purchase fast-growing companies regardless of valuation.

Starting with a qualitative search...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

Most investment processes begin with quantitative elements like filters and screens. The qualitative work is often left for the latter stages, after suitable investment candidates have been identified. Investment processes are often structured in this quantitative-first order for two reasons. First, it is more convenient for the manager to reduce the size of the opportunity set to a more manageable list of companies. Second, institutional investors often demand a step-by-step process that can neatly illustrate the filtering of thousands of companies into a final portfolio. But convenience and marketing should not be the drivers of a robust investment process. Managers who understand the hidden dangers of screening and strict adherence to quantitative investment processes should instead start with the qualitative search for competitive advantage and management talent. By compiling a list of qualitatively superior companies first, and limiting valuation work to these, a small-cap manager prevents being drawn into seductively cheap subpar ideas.

The temperament needed to be a great research analyst...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

The temperament needed to be a great research analyst is similar to what is required for investigative journalism. A genuine curiosity and interest in business is required. A nose for a story also helps. By digging deeper and following intuition, a good analyst is able to gather certain relevant facts often overlooked by lazy competitors. An important trait of a good analyst is being able to define the limits of understanding. This self-awareness comes only with experience. Often an analyst without this ability genuinely professes an extensive understanding of a specific company or industry. But in reality, this knowledge may be woefully lacking when compared with other analysts. The analyst may suffer from what is known as the Dunning-Kruger effect, where a person’s own inexperience prevents recognition of that inexperience. Only through improved skill and experience can an analyst enhance the metacognitive competence that allows for the recognition of the limits of ability. Reading competitive research and talking to industry contacts after a thesis has been formed can help analysts get a sense for how much understanding is enough.

The truly exceptional business...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

The truly exceptional business can operate with little capital. When U.S. securities markets function normally, most healthy businesses have no trouble securing needed capital. This means that great business opportunities whose only competitive hurdle is access to capital are likely to be exploited, and the economic profitability of industry participants inevitably suffer as a result. Exceptional businesses enjoy competitive positions that are more nuanced. Their competitive protections enable pricing power over their customers and control over their input costs from suppliers. This means that they can maintain and increase profitability without having to spend excessively to protect their turf. 

Companies that have sound competitive positions but operate in industries where expensive machinery is needed for production expose themselves to inflationary pressures. Current capital outlays that are needed to maintain equipment may end up costing a fraction of what is spent on similar outlays in the future. Analysts should be aware of this hidden cost when entering periods of anticipated high inflation. 

An analyst can become adept at qualitatively assessing the capital needs of a business and the follow-on effects that inflation would have on future capital outlays by studying the growth patterns of similar businesses. It is often the case that businesses require little capital to grow while maintaining their competitive position because the industry itself allows it. In industries like information services, software, and precision instruments, companies stake out competitive territory with products that may become universally adopted. Other companies in the industry often cede this territory willingly rather than spend enormous amounts of capital in a futile attempt to gain meaningful market share. The winners are left with the enviable position of dictating pricing terms to their customers without fear of a competitive response. 

A company that has a unique competitive position that allows high returns on investment and has plenty of opportunity to reinvest back within the business at similarly high rates is especially compelling for the buy-and-hold investor. The internal growth prospects create a natural allocation mechanism for capital within the business, and management’s task is relegated to protecting and expanding the company’s competitive turf. These situations are the ones qualitative analysts seek.

The linkage between returns-on-capital and competitive advantage...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

The small-cap manager should attempt to understand the linkage between returns-on-capital and competitive advantage. The latter drives the former, but the former is also indicative of the latter. If an analyst discovers that a company exhibits high returns on capital employed for long time periods, it is likely that the descriptive qualities of the business will reveal a competitive edge. This symbiosis may support the case for a quantitative screen using returns on capital as a factor; however, companies that exhibit sustainably high internal compounding are more likely to be priced as superior businesses, given their success. A better approach is to find those businesses that exhibit competitive advantages but have yet to post stellar financial results. These rare situations can be a source of high total returns for the astute manager.

Competitive forces and competitive advantages...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

If a company is earning far in excess of its cost of capital, it is likely to attract competition. Competitive forces chip away at economic margins in a capitalist system so that participants generally end up earning their cost of capital. The exceptions to this dynamic are companies with unique competitive positions. The competitively advantaged company can lever its position in the market and earn sustained economic profits.

... 

Most fundamental analysts understand and acknowledge that the goal of competitive analysis is to identify the qualitative characteristics that enable a company to earn sustained profitability in excess of its cost of capital. What many investors fail to realize is that this quest is premised on another assumption: As long as a manager does not overpay for a business, sustained above-average internal business compounding should lead to above-average total stock returns, given a long enough time horizon. This is because increases in stock price necessarily follow the growth in value of the underlying business. In the short term, a company’s stock price may be volatile and appear to reflect the highs and lows of market emotion; over longer time periods, it will tend toward an average appraisal or intrinsic value. This outing of value happens in many ways. It may occur through information dissemination and the aggregate actions of market participants. It may be the result of a tender offer for the company. The company itself may help to out intrinsic value through the repurchase of stock or payment of special dividends. In any case, the manager’s chain of logic should begin with the assumption that stock prices follow internal business compounding. And since managers are looking to experience above-average stock-price performance, they should be pursuing the competitive characteristics that allow for above-average business compounding. 

Quality and value...

From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:

Factor screening on any of the aforementioned ratios suffers from a major flaw: Company value is determined by all future free cash flows discounted to the present. Rudimentary ratios fail to capture what could, should, or would happen to a company beyond the next year or two. Historical cash flows, book value, earnings, or momentum in the growth of any of these factors may not be comparable with what happens in the future for dynamic companies undergoing change. This renders these ratios useless as indicators of value. The key determinants for predicting the future earnings power of a company are actually qualitative. Factors like competitive positioning, industry growth, and the capital allocation ability of management are not adequately captured by simple ratios.

Brian Bares quote on the biggest mistake investors make

From his interview with The Manual of Ideas:

I would say that--especially to the value crowd that sort of follows the Buffett/Munger philosophy--it's this mistaken notion that a low P/E stock can potentially outperform...Companies with low valuations on rule-of-thumb metrics like price-to-earnings, price-to-cash flow, price-to-book are often indicative, even in the small and micro-cap space, of broken businesses. They are value traps. They are poor competitive businesses run by management teams that are treating the company as a personal cash machine. They may essentially be a declining annuity that deserves to be valued at, say, 7 or 6 times earnings, 3 or 4 times cash flow. So this idea that low P/E stocks outperform over time, I know has been reinforced by research (Fama and French and others). I sort of view low multiples as an indicator, telling me that it's probably a chronically under-earning business on its capital base, indicative of a poor competitive position. That's the thesis that I start out with when I see that sort of valuation. It's not always the case, but it more often than not is reinforced...That's where the screeners really get led into poor performance; in the identification of these companies that frankly deserve to be cheap.

................

Related link: Quotes on the mistakes investors make…

Quotes on the mistakes investors make…

I’ll keeping adding to this over time, as I come across quotes to add to it. If you have any, feel free to pass them along (valueinvestingworld@gmail.com), especially if they are from Mr. Buffett or Mr. Munger.

Ray Dalio: “The biggest mistake investors make is to believe that what happened in the recent past is likely to persist.”

Tom Russo: “I think…it’s the inability to do nothing for a long period of time. The inability to do nothing is what most people get tripped up on.”

Howard Marks: (1) "I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it." (2) "The main mistake that people make , be they individual or professionals, is that they allow themselves to be affected by emotion. Emotion is the enemy."

Ed Thorp: "Looking to outside sources for guidance in their positions. The belief that you can watch CNBC and get useful advice is very misguided. You really have to formulate your own opinion and not rely on so-called experts."

Michael Shearn: “The three most common investing mistakes relate to the price you pay, the management team you essentially join when you invest in a company, and your failure to understand the future economics of the business you’re considering investing in.”

Charles de Vaulx: "If I have to mention one mistake, one overwhelming mistake is the inability of investors, be it individual or professional investors, to pay enough attention to the price. I think investors pay way too much attention to the outlook and not enough to the price. When they wait for the sky to be blue or at least for the gray sky to become bluer and when the outlook looks better, they will want to buy, but typically it’s too late. It has already been priced in.....If there was a second mistake I could comment on, it’s these two types of investors – those that trade too much, which is not healthy, and those that have too much of a buy-and-hold mentality."

Brian Bares: "I would say that--especially to the value crowd that sort of follows the Buffett/Munger philosophy--it's this mistaken notion that a low P/E stock can potentially outperform...Companies with low valuations on rule-of-thumb metrics like price-to-earnings, price-to-cash flow, price-to-book are often indicative, even in the small and micro-cap space, of broken businesses. They are value traps. They are poor competitive businesses run by management teams that are treating the company as a personal cash machine. They may essentially be a declining annuity that deserves to be valued at, say, 7 or 6 times earnings, 3 or 4 times cash flow. So this idea that low P/E stocks outperform over time, I know has been reinforced by research (Fama and French and others). I sort of view low multiples as an indicator, telling me that it's probably a chronically under-earning business on its capital base, indicative of a poor competitive position. That's the thesis that I start out with when I see that sort of valuation. It's not always the case, but it more often than not is reinforced...That's where the screeners really get led into poor performance; in the identification of these companies that frankly deserve to be cheap."

Ben Horowitz (on start-up companies and founders, but it relates to all investing): "There are so many mistakes…I think probably the most common mistake is trying to be consistent. What happens is you get an idea, you sell people on the idea—investors, the employees—and you get into it and the idea turns out to be wrong. But you want to be consistent and you hold onto it longer than you should…It’s better to be right than consistent. And that’s a very hard thing to learn, particularly early in life."

*****

Warren Buffett, from his 1989 letter to shareholders:

Mistakes of the First Twenty-five Years (A Condensed Version)

To quote Robert Benchley, "Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down." Such are the shortcomings of experience. Nevertheless, it's a good idea to review past mistakes before committing new ones. So let's take a quick look at the last 25 years.

o My first mistake, of course, was in buying control of Berkshire. Though I knew its business - textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way - in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras - unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o - three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, "My Wife Ran Away With My Best Friend and I Still Miss Him a Lot."

I could give you other personal examples of "bargain- purchase" folly but I'm sure you get the picture: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first- class managements.

o That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire's textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand.

I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn't been so energetic in creating examples. My behavior has matched that admitted by Mae West: "I was Snow White, but I drifted."

o A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problems must be tackled as was the case when we started our Sunday paper in Buffalo. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we've done better by avoiding dragons than by slaying them.

o My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative." In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

o After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy of itself will not ensure success: A second- class textile or department-store company won't prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner - or investor - can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We've never succeeded in making a good deal with a bad person.

o Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn't make. It's no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge.

o Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn't have liked those 99:1 odds - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also.