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.”
