1.“The entire pursuit of value investing requires you to see where the crowd is wrong so that you can profit from their misperceptions.” A value investor seeks to find a significant gap between the expectations of the market (price) and what is likely to occur (value). To find that gap the value investor must find instances where the crowd is wrong. Michael Mauboussin writes: “the ability to properly read market expectations and anticipate expectations revisions is the springboard for superior returns – long-term returns above an appropriate benchmark. Stock prices express the collective expectations of investors, and changes in these expectations determine your investment success.”
Value investing is buying assets for substantially less than they are worth and, says Seth Klarman “holding them until more of their value is realized.” Klarman describes the value investing process as “buy at a bargain and wait.” It is critical that the value investor not try to time the market but rather make the market their servant. The market will inevitably give the gift of profit to the value investor, but the specific timing is unknowable in advance. If there is a single reason people do not “get” value investing it is this point. The idea of giving up on trying to time the market is just too hard for some people to conceive. For these people, timing markets is a hammer and everything looks like a nail. That you can determine an asset is mispriced now relative to intrinsic value does not mean you can time when the asset will rise to a price that is at or above its intrinsic value. So value investors wait, rather than try to time markets.
2. “When we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective. Most of the answers flow from having that perspective. …thinking like that is not easy…” When you treat shares of a company as an interest in a business (rather than a piece of paper to be traded based on mob psychology) you naturally think about private market value. Value investors have developed a valuation process for determining private market value that is very rational. The lynchpin of this valuation process is intrinsic value. While the process of determining intrinsic value is fuzzy (since methods slightly vary) that is ok, since the margin of safety can cover up small amounts of fuzziness if the margin of safety is sufficiently large (e.g., 25-30%). Investment firm Euclidean Technologies has articulated some of Buffett’s views on this valuation process:
“Buffett talks about book value as a measure of limited worth when estimating the intrinsic value of a business. After all, book value reveals very little about the operations of a company; it makes no distinction between a pile of cash and a company with productive assets, great products, and loyal customers. Instead, when evaluating intrinsic value, Buffett focuses on understanding the amount of cash that a business can generate and distribute to its owners. He calls this concept owner-earnings…”
In calculating a valuation of a business, many people fail to understand that value investing and growth are “joined at the hip.” Value and growth investing are not alternatives, but rather inextricably linked. Here’s Buffett:
“Growth is simply a component–usually a plus, sometimes a minus–in the value equation. Indeed growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.”
Some of the misunderstanding arises because some (but not all) value investors consider quality as a factor in valuation. Many people assume that looking at quality means a focus on growth, when this is definitely not the case. Quality relates to the ability of the business to generate higher return on invested capital. In his new book Tobias Carlisle explains the difference:
“Earnings—central to [John Burr] William’s net present value theory—were only useful in context with invested capital. Despite his obvious regard for William’s theory, Buffett could show that two businesses with identical earnings could possess wildly different intrinsic values if different sums of invested capital generated those earnings…. All else being equal, the higher the return on invested capital, the more valuable the business.”
Here’s Buffett on what drives the quality of a business:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”
Note that the way Buffett measures quality does not refer to reliance on a new growth input and most certainly not any macroeconomic factor. Quality is about relative return on invested capital!
Euclidean Technologies writes on return on capital:
“Buffett cares deeply about the magnitude and resiliency of a company’s long-term return on capital. Return on capital is simply the relationship between the earnings a company generates and the amount of capital tied up in its business. For example, a company that can consistently deliver $0.20 for every $1 in capital employed would show a robust 20% return on capital. To Buffett, this would be a higher quality business than another that delivered a lesser yield or showed deteriorating, or inconsistent, returns on capital. Moreover, this yield relationship between earnings and invested capital allows Buffett to view a prospective investment in relation to all other potential uses for capital…”
What determines long-term return on capital? The strength of any barriers to entry (a moat) possessed by the business. Unless you have a moat your profitability will inevitably suffer as competitors copy your success. If there is no impediment to new supply of what you sell, competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. (Econ 101)
3. “All-too-often, we feel like we are forced to take a decision. Warren Buffett has often said that, unlike baseball, there are no ‘called strikes’ in investing. That is a truism, but the point is that too many of us act like it is not true. Amateur investors, investing their own money, have a huge advantage in this over the professionals. When you are a professional, there is a whole system of oversight that is constantly saying, “What have you done for me lately!” or in baseball terminology, ‘Swing you fool!’”
“Most of the time the answers are not to invest and to do nothing.”
To profit as a value investor you must:
- find an instance where the crowd is wrong,
- that gap must be within your circle of competence, and
- the value of the asset purchased must substantially exceed the price paid (e.g., 25%), so you have a margin of safety which can allow you to profit even if you make a mistake or suffer from bad luck.
Since these three things happen at the same time only occasionally, most of the time you should do nothing. Since inactivity tends to be contrary to human nature, learning to be patient and yet aggressive when the time is right is a trained response. This is part of the reason why value investing is simple, but not easy.
4. “I’m trying to manage myself, not just my portfolio.” Most mistakes made by investors are psychological or emotional. The task of managing yourself is all about avoiding those mistakes. The work required to overcome emotional and psychological mistakes never ends. You will never stop making some mistakes. But hopefully you can at least learn to mostly make new mistakes and to learn from the mistakes of others. Paying attention and being a learning machine are essential. People who don’t pay attention are surprisingly common. As Seth Klarman writes in his book, Margin of Safety: “The greatest challenge for value investors is maintaining the required discipline.” As an example, to be a contrarian you must be willing to sometimes be called wrong by the crowd. That will be uncomfortable for most all people.
5. “Leverage can prevent you from playing out your hand, because exactly the time when markets go into crisis is when your credit gets called.” Leverage magnifies your mistakes in addition to your successes. Guy Spier is also saying that it can interfere with your ability to continue investing, since a called loan can take you out of the game. James Montier writes: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged, you can run into volatility that impairs your ability to stay in an investment – which can result in a permanent loss of capital.”
6. “Going forward, a 5% position will be a full position. An idea will have to be something absolutely extraordinary to become a 10% position and many positions in the portfolio are currently 2-4%.” It seems like Guy Spier has moved away from a Phil Fisher/Charlie Munger view on diversification, to something that is closer to what Graham himself believed. At these ownership levels, Spier is not at risk of being a closet indexer and yet he still has a comfortable level of diversification. His new view on diversification seems consistent with views of Ed Thorp as internalized by Bill Gross and Jeffrey Gundlach.
7. “Value investors probably pay far too little attention to the credit cycle. In my case, I think that I was utterly convinced that my stocks were sufficiently cheap, such that I could invest without regard to financial cycles. But I learned my lesson big time in 2008 when I was down a lot. I now subscribe to Grant’s Interest Rate Observer so as to help me track the credit cycle.” Howard Marks has said he watches the business cycle but he has never actually said what he does with what he sees in the cycle. Marks seems to use his view on where the business cycle may be as a signal to raise more cash or send it back to his limited partners. Guy Spier seems to be saying he treats the credit cycle as a factor, in some unquantified way. I find myself increasing cash gradually as markets reach prices that are on “the high side of fair,” but I doubt this is based on some rational process and I don’t see any magic formula. Warren Buffett says he never pays attention to macro factors. But he is Warren Buffett and you and I are not. Not everyone has his discipline.
8. “I do not use short selling. The fund has not shorted a stock since the 2002 to 2003 time frame. At that time I did short three stocks, on which I broke even on two and made money on one of them. The experience taught me that I was not going to be using short selling going forward for a slew of reasons. The first is the straightforward logic of the matter. The trend of the market is up, not down. Shorting stocks puts you against that trend and thus makes it more difficult to make money. … Second, the mathematics of shorting – when you short something and it goes [against you], it becomes a bigger and bigger part of your portfolio, thus creating increasing risk as things go against you, making it an unbalanced and unstable thing to manage. By contrast, when you go long something and it goes against you, it becomes a smaller and smaller proportion of the portfolio, thus reducing its impact on the portfolio. So there is a tendency for long positions to self-stabilize in a certain way – they have a stabilizing effect on the portfolio, whereas short positions have a destabilizing effect on the portfolio.” Ordinary investors are significantly at risk when they short stocks. When I say something like this, people tend to extrapolate and say that I must favor banning shorting stocks. No, I don’t favor a legal ban. That something is unwise for an ordinary investor does not necessarily mean it should be made illegal. That people like Jim Chanos can (1) profit and (2) perform a socially useful function does not mean an orthodontist or a bricklayer should be shorting stocks. If Guy Spier, Berkowitz, Pabrai, Buffett and Munger don’t short stocks (since it is “too difficult”) what chance of success does the ordinary investor have?
9. “If I’d not fallen under the sway of Warren Buffett, who knows, maybe I’d still be working at some skeezy place and if not committing financial fraud, then at least not serving society very well.” Guy Spier graduated from Harvard Business School and found out too late that he had gone to work for a business with questionable ethics. Guy Spier credits Buffett and Munger with leading him away from the dark side of Wall Street. This is a good thing. Guy Spier’s publisher describes his book as revealing “his transformation from a Gordon Gekko wannabe, driven by greed, to a sophisticated investor who enjoys success without selling his soul to the highest bidder.”
Spier himself writes: “I think it’s important to discuss just how easy it is for any of us to get caught up in things that might seem unthinkable—to get sucked into the wrong environment and make moral compromises that can tarnish us terribly. We like to think that we change our environment, but the truth is that it changes us. So we have to be extraordinarily careful to choose the right environment—to work with, and even socialize with, the right people. Ideally, we should stick close to people who are better than us so that we can become more like them.”
10. “We know in particular that there is a class of investors who get excited about stock splits – even though they do not change the value of the business or achieve anything else substantive. By not catering to that group, Berkshire already makes significant strides in that direction of having a higher quality shareholder base.” “Decentralized organisms are more resilient to having their legs cut off and Berkshire Hathaway is the same way… as opposed to a command and control organization.” Regarding the first point, having better investors is a competitive advantage for a business. It allows the business to invest for the long term and to be contrarian when it makes sense to be contrarian. Regarding the second point, Nassim Taleb points out: “In decentralized systems, problems can be solved early and when they are small.” Decentralized systems are more robust to failure. If you ask Buffett how Berkshire ended up this way, he will say that it is just his nature. And of course it has worked very well. Charlie Munger points out that for this approach to work you must have a seamless web of deserved trust in which the decentralized managers are given the freedom to manage what they do and sufficient skin in the game to be properly motivated/aligned.
11. “The idea that we are managing some finely tuned machine is just not the case. I’m just trying to get it right. 55% of the time or get it slightly better 55% of the time.” Guy Spier is pointing out that over time even a modest level of outperformance compounds in a beautiful way, if expenses and costs are kept low. Everyone will make mistakes but if you have a sound investment process you can be way ahead in the game. Mauboussin is the master of this area in my view: “While satisfactory long-term outcomes ultimately define success in probabilistic fields, the best in their class focus on establishing a superior process with the understanding that outcomes take care of themselves.”
12. “Mohnish Pabrai taught me to be a cloner. In the academic world, plagiarism is a sin. In business, copying other people’s best ideas is a virtue, and it is no different in investing. I would go further. In the same way that if I wanted to improve my chess, I would study the moves of the grandmasters. If I want to improve my investing, I need to study the moves of the great investors. 13F’s are a great way to do that.” As Charlie Munger likes to say, trying to learn everything yourself on your own from first principles is just too hard and takes too long. Learning from others and then working to extend that is the superior approach. Stand on the shoulders of giants whenever you can, but strive for more. The other key point about cloning relates to business strategy and the business strategies of businesses that one may choose to invest in. Anything you do in business and investing will be copied and cloned. Continued innovation and adaptation are essential to success.