“Warren Buffett, in Berkshire’s annual letter to shareholders for 2004, devoted a section to [Lou] Simpson titled “Portrait of a Disciplined Investor,” saying Lou’s picks had produced an annual average return of 20 percent since 1980, compared with 14 percent for the Standard & Poor’s 500 Index.” – Bloomberg
“I pondered for eight years what makes Lou knock the cover off the ball,” Byrne said. “Lou is very bright, with an economics background from Princeton. But the woods are filled with bright guys. It has more to do with his personality. He is very, very sure of his own judgments. He ignores everybody else. He gets one or two really strong ideas a year and then likes to swing very hard.” -Jack Byrne
Lou Simpson is a man of few words in the press, so I have added thoughts from other value investors below a bit more than usual.
1. “When you ask whether someone is a value or growth investor – they’re really joined at the hip. A value investor can be a growth investor because you’re buying something that has above-average growth prospects and you’re buying it at a discount to the economic value of the business.”
I picked this quotation to start this blog post to illustrate how Lou Simpson and Warren Buffett “think alike.” Here’s Warren Buffett on the same point: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive…. Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”
The idea that an investor might buy a stock regardless of whether it is available at a bargain price simply because the business is growing is foreign to both Buffett and Simpson. Charlie Munger agrees: “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle.” What you want to find is a bargain, which takes a lot more work that just finding a business that is growing revenue a lot. There are some very high quality growing business that you would be nuts to buy at a high enough price and equally nuts not to buy at a low price. A high growth asset can be very risky if you overpay for it. Howard Marks points out: “When someone says, ‘I wouldn’t buy that at any price,” it’s as illogical as, “I’ll take it regardless of price.’”
2. “Investors are going to make out a whole lot better if their whole emphasis is on owning businesses.”
“Invest in high return businesses run for the shareholders.”
“Return on capital. That really tells you a lot. One of the basic problems is that there is so much noise around earnings that you really have to rip apart the financials to understand what the real numbers are. It’s really the basic returns on equity capital [that are] important, but sometimes they’re not obvious. Even so, I think you have to look at a lot of things. You have to figure out what the earnings growth rate of the company will be over an extended period of time, and then apply a discount rate to it so you can come up with the best valuation. It’s easy in principle but it’s extremely difficult in practice.”
One of the four bedrock principles of Ben Graham–style value investing is that a security represents partial ownership of an actual business and should not be treated as a piece of paper to be traded based on investor psychology. This means that understanding the business itself is essential to understand the value of a security. To be a value investor you must dig deep and do research on how the business operates, its markets and its competitors. Charlie Munger argues: “All intelligent investing is value investing — acquiring more than you are paying for. You must value the business in order to value the stock.” If you find this process boring or can’t find the time to do it, it is very unlikely that you will be a successful investor.
Ben Graham once said: “Investment is most intelligent when it is most businesslike.” What he means is that to understand a stock or bond you must understand not only the business but business generally. Seth Klarman in a Charlie Rose interview once said: “I think Buffett is a better investor than me because he has a better eye towards what makes a great business. When I find a great business, I am happy to buy it and hold it. [But] most businesses don’t look so great to me.” Daniel Kahneman has a nice take on this point arguing that people like Lou Simpson or Warren Buffett are not in the business of stock picking; they pick businesses and managers. Lou Simpson again: “One of the things I have learned over the years is how important management is in building or subtracting from value. We will try to see a senior person and prefer to visit a company at their office, almost like kicking the tires. You can have all the written information in the world, but I think it is important to figure out how senior people in a company think.”
3. “Even the world’s greatest business is not a good investment, if the price is too high.”
“We try to be disciplined in the price we pay for ownership even in a demonstrably superior business.”
“Pay only a reasonable price, even for an excellent business.”
The second bedrock principle of Ben Graham-style value investing is that a security must be purchased at a sufficient bargain to intrinsic value that it provides the investor with a margin of safety. Buying securities at a significant discount to intrinsic value (e.g., 25%) creates a margin of safety which can protect against mistakes. In an ideal situation a value investor feels like they are “buying a dollar for 50 cents.” This opportunity does not happen often, but when it does, the value investor should load up the truck (buy a lot of the asset; bet big). If you have a margin of safety when buying assets you don’t need to precisely predict intrinsic value. Roughly right is enough and far better than precisely wrong. Securities that represent a partial interest in some businesses are selling at a price that is significantly less than their intrinsic value and some are not. Paraphrasing Seth Klarman, at one price a partial interest in a business “is a buy, at another it’s a hold, and at another it’s a sell.” When you buy a partial stake in a business at a price that represents a margin of safety you can make an idiotic decision and sometimes still do OK. And when you are right you can do even better financially.
4. “Over time, the market is ultimately rational, or at least somewhat rational.”
“Attempting to short-term swings in individual stocks, the stock market, or the economy, is not likely to produce consistently good results.”
The third bedrock principle of Ben Graham-style value investing is that is that you must make Mr. Market your servant rather than your master. To a value investor Mr. Market is not wise, but rather highly unpredictable and irrational. Warren Buffett minces no words here: “This imaginary person out there — Mr. Market — he’s kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed you buy from him. There’s no moral taint attached to that.”
A cornerstone to this ‘make Mr. Market your servant” viewpoint is: the price of an asset is rarely the same as the value of an asset. Price is what you pay and value is what you get. Asset prices will always fluctuate. The objective of a value investor is to profit from volatility by waiting for something to happen that is inevitable rather than trying to predict its timing. Once you reach this rather simple realization, life gets far better for an investor.
5. “A lot of people don’t have the patience or temperament to really be investors.”
“The stock market is like the weather in that if you don’t like the current conditions all you have to do is wait awhile.”
The fourth bedrock principle of Ben Graham-style value investing is that the investor must be rational to avoid mistakes which are usually caused by emotional or psychological errors. If you cannot be patient is it impossible to be a successful value investor. While being patient is a key attribute you must also be capable of being aggressive and pouncing on an opportunity when the time is right. Patience and aggressiveness as desirable qualities for an investor may seem a bit at odd to some people, but they are essential.
March of 2009 would be an example of such a time. Seth Klarman said to Charlie Rose: “I think that the analysis is actually the easy part. When I speak to business school students, I tell them investing is the intersection between economics and psychology. Economics, the valuation of a business, is not that hard. The psychology – how much do you buy? Do you buy it at this price? Do you wait for a lower price? What do you do when it looks like the world might end? Those things are harder and knowing whether you stand there and buy more or something legitimately has gone wrong and you need to sell, those are harder things and that you learn with experience and you learn by having the right psychological make-up in the first place.”
This concept of waiting vs predicting baffles many people. If you let go of the idea of predicting “when” and focus on “what” intrinsic value is and “how” to buy a partial stake in a real business, that you understand, with a margin of safety, there is some hope for you as a Graham value investor.
6. “Think independently. We try to be skeptical of conventional wisdom and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.”
“You live by the sword, you die by the sword. If you are right, you are going to add value. If you are going to add value, you are going to have to look different than the market. That means either being concentrated, or, if you are not concentrated in a number of issues, you are concentrated in types of businesses or industries.”
You can’t beat the market if you are the market. That a contrarian viewpoint and being correct about that viewpoint is necessary to outperform a market is provable mathematically. Seth Klarman has famously said: “Value investing is at its core the marriage of a contrarian streak and a calculator.” It is easy to say you are a contrarian but hard to actually be one. There are many poseurs who think they are contrarian. Getting an unusual haircut or tattoo does not by itself make you a contrarian. The warmth of the herd is comforting. In some circles not it is the tattoo owners that is the herd dweller. People who are wrong while acting conventionally are rarely shunned. To be successfully contrarian requires honesty, self-awareness, aggressiveness and bravery since it is not a natural human state.
Seth Klarman believes: “You need to balance arrogance and humility…when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.”
7. “Most investors should own no more than 10 to 20 stocks.
“Good investment ideas… are difficult to find. When we think we have found one, we make a large commitment.”
“Do not diversify excessively.”
Some Ben Graham Style investors have a diversified portfolio and some do not. Lou Simpson is a focus investor (he doesn’t diversify widely). Charlie Munger is also a focus investor. Other value investors, like Joel Greenblatt in his current fund, are diversified. Whether an investor is diversified is not a bedrock part of the Graham value investing system. In the case of Lou Simpson, he feels that the number of stocks that an investor can genuinely understand is limited. He would rather put fewer eggs in a basket and spend a lot of time understanding those eggs.
The idea that a dentist working full time in his or her profession is going to pick technology stocks better than the market after fees and expenses is unlikely. A UPS driver is hoping to beat the market by buying a health care stock or an automaker? I have said many times in this series on my blog: most people should buy a diversified portfolio of low fee index funds/ETFs. You are not Lou Simpson. You are unlikely to be like Lou Simpson. It is possible, but unlikely that you can invest like him. The fact that there is a tiny chance you might be like Lou Simpson is what gets so many people into trouble with their investing. People think: “these other people are muppets, but I am a super genius.”
8. “Dealing in a circle of competence, dealing with companies that you have the ability to understand, being able to come up with a good analysis of a company’s value and earning power, is fundamental.”
“Invest in what others don’t know.”
“I get excited when we get some insights on a business that’s not really well understood.”
The goal of a value investor is not just to buy a share in a quality business, but to find assets to purchase that represent a mispriced bet. To find a mispriced bet, someone must have made a mistake. Howard Marks points out that “active management has to be seen as the search for mistakes.” To find a mispriced bet you must know what you are doing. To raise the probability that you will know what you are doing, it is wise to stay within your circle of competence. Charlie Munger makes this point succinctly: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.”
There is this interesting idea that as more people (~38% in the US less globally) move to index investing that there will be less alpha for experts. On the margin this conclusion seems logical, but the supply of “damn fool” investors is still massive. in any event, at some point as the number of index investors increases the ability to outperform will increase, since markets will be less efficient.
9. “One lesson I have learned is to make fewer decisions. Sometimes the best thing to do is nothing. The hardest thing to do is sit with cash. It is very boring.”
People have a tendency to think that there is a benefit to hyperactivity in investing. Some activity is essential since with no activity of any kind it’s a good sign you are dead. But as a rule, making fewer decisions as an investor results in better decisions and lower fees and expenses as well. As is usual, Jason Zweig describes these issues perfectly: “Mr. Munger favors what he calls ‘sitting on your a—,’ regardless of what the investing crowd is doing, until a good investment finally materializes….Many money managers spend their days in meetings, riffling through emails, staring at stock-quote machines with financial television flickering in the background, while they obsess about beating the market. Mr. Munger and Mr. Buffett, on the other hand, ‘sit in a quiet room and read and think and talk to people on the phone,’ says Shane Parrish, a money manager who edits Farnam Street, a compelling blog about decision making. ‘By organizing their lives to tune out distractions and make fewer decisions,’ he adds, Mr. Munger and Mr. Buffett ‘have tilted their odds toward making better decisions.’”
10. “We do not have hard and fast rules on selling. We do not sell that well.”
Life is far easier for a Graham value investor if you set your holding period at forever. This is, of course, not always possible. In an upcoming blog post on Mason Hawkins I included this quote about selling: “We sell for four primary reasons: when the price reaches our appraised value; when the portfolio’s risk/return profile can be significantly improved by selling, for example, a business at 80% of its worth for an equally attractive one selling at only 40% of its value; when the future earnings power is impaired by competitive or other threats to the business; or when we were wrong on management and changing the leadership would be too costly or problematic.” That selling shares is harder than buying shares is not a technical issue. Instead, it is easier to make emotional and psychological mistakes when selling shares. Resisting the urge to try to “time” the market when putting in sell orders can be excruciating. Mistakes from tendencies like loss aversion are so easy to make. It’s a good idea to follow Charlie Munger’s advice when selling shares: “Other people are trying to act smarter. I’m just trying to be non-idiotic.”
11. “It is very important to look at your mistakes and determine why you made them.”
“When we make mistakes, we always try to do postmortems.”
The best way to learn is through feedback. Ray Dalio, the founder of the Bridgewater investment fund, has expressed this idea in a formula: “You learn so much more from the bad experiences in your life than the good ones. Make sure to take the time to reflect on them. If you don’t, a precious opportunity will have gone to waste. Remember that pain plus reflection equals progress.” And there is no better feedback than the negative results from personal mistakes and folly. Charlie Munger believes in “rubbing his nose” in his mistakes. If you do this post-mortem work, you can increase the percentage of mistakes that are new as opposed to repeated mistakes. Investment performance can be remarkably improved simply by making fewer mistakes. Sometimes what looks like a special technique or system generating success is simply the people involved being dedicated to being less stupid.
12. “I try to read at least five to eight hours a day.”
I don’t know any successful investors who don’t read a lot. As just one example, in Michael Eisner’s book Working Together: Why Great Partnerships Succeed Warren Buffett is quoted as saying: “Look, my job is essentially just corralling more and more and more facts and information, and occasionally seeing whether that leads to some action. And Charlie — his children call him a book with legs.”
Of course, reading alone is not enough. Charlie Munger puts it this way: “Neither Warren nor I are smart enough to make the decisions with no time to think. We make actual decisions very rapidly, but that’s because we’ve spent so much time preparing ourselves by quietly sitting and reading and thinking.”
Read and think. Read and think. Read and think. And don’t forget the thinking part.