Saturday 26 January 2019

Fishing where the cod is, and Munger's stunning rebuke of many 'value' investors

I've been thinking a lot over the past few years about some of the things I seem to be doing differently to the vast majority of self-described value investors. I just look at companies all day and try to value them, and I buy the ones I think are the cheapest. Presumably, most other value investors are doing the same thing. And yet, for years I have seen many self-described value investors complain incessantly that they can't find anything to buy - often organisations stocked with large teams of people. Some of them have closed shop as a result.

By contrast, for some reason, as a 'one man band', I seem to always find myself completely inundated with ideas. I literally can't keep up. If I work in a diligent and focused fashion, I can usually find about one new cheap stock a day. I actually have to stop myself from doing it, as I quickly run into the problem of having far too many ideas and not enough capital. I already have 150 stocks in my portfolio, and I can't really accommodate too many more. So I've really struggled to understand how so many value investors can be saying they are struggling to find anything worth buying.

So what's going on here? To be sure, some of it is a higher tolerance for illiquidity, as a small manager, but that's not the main reason. I own plenty of large liquid companies as well. It could mean my 'bar' is too low, but I don't think so. Nearly all of the stocks in my portfolio are much cheaper and have much better risk-reward prospects than the average stock I see end up with large portfolio weightings in many of the above-mentioned 'value' investors' portfolios, in my assessment. And my performance over the past three years, since I've started investing full time, would tend to indicate that has been the case as well. Something else is going on.

In the past I have spoken about how investors - including many value investors - seem to think about risk in the wrong way, and seek to avoid it rather than get well paid for bearing it. And they seem to obsess over quality to the point where they prioritise it over cheapness. I have a half-written article on the evolution (and mutation) of value investing that I have been planning to publish for a while, and may try to come around to finishing in the not too distant future, which discusses the issues in more detail.

However, perhaps in summary, what I've realised is that a lot of value investors seem to adhere to what might best be described as a 'qualitative checklist' style of investing. Borrowing heavily from the list of traits Warren Buffett has said in the past he seeks in a good investment, they will say something like "we are looking for companies in highly profitable industries with sustainable competitive advantages, a long history of high returns on capital, and capable and shareholder-friendly management. We also want companies that generate stable free cash flows through the cycle (i.e. aren't cyclical), and have strong balance sheets. And we want to invest in countries where we are comfortable with the macro, politics, rule of law, and currency. And finally, we want to own it at a reasonable price".

So what they do is they screen for stocks meeting all their strict qualitative criteria, and settle on a small list that represents a tiny subset of the total investable universe - generally a fraction of 1%. They then set about doing copious research on those names, relying on large, expensive teams of analysts. And then finally, they look at the price. After all this effort, most of the time, they find the stocks are fully priced, because their various merits are already well understood by the market. So what they do is put them on the watch list, in the hope that some day they might become cheap. And they wait, and sit on large amounts of cash in the meantime, hoping for a bear market.

Worse, they are often inclined to buy such stocks if they decline by say 20%. 'Finally Mr Market has given us an opportunity to buy such a wonderful business at a more reasonable price of 17x vs 22x', they reason. But what they overlook is that such well picked over stocks seldom decline like that unless there are new, and potentially not yet apparent, negative developments (unless the whole market has gone down). So they often find themselves ensnared by value traps, as significant unanticipated degradation in the economics of the business subsequently emerges. They find out they were buying the stock off other value managers who had better information and were exiting. They often subsequently sell at a loss, saying 'the fundamentals have changed'.

At best, they compromise their price discipline. When most of the stocks on your watch list trade at 20x earnings, and you're short of investment ideas and are holding too much cash, you might be inclined to believe 17x is cheap.

Now, there is nothing necessarily wrong with the list of attributes they are looking for, if it yields a sufficient number of great ideas. But there is no inevitability it will, because markets are adaptive, and prices reflect how other people behave, and if too many people try to implement the same strategy, the opportunities will migrate elsewhere. And it is precisely because Buffett's dictum about what he looks for in a good investment has become so well subscribed, that most 'value' investors are looking at the same tiny set of stocks, and as a result, bargains in that space have become vanishingly rare. Steve Johnson of Forager Funds once said he attended Berkshire's annual meeting, and found it amusing to see 40,000 people turn up that all believed they were going against the crowd. This irony has been completely lost on most value investors.

Buffett and Munger have already described the types of 'value' investors I am talking about as "swarming imitators" in the past, because that is exactly what they are. Unlike many, these days when I hear someone say "we look for companies we can understand, with a sustainable competitive advantage, and shareholder-friendly management", etc, almost quoting Buffett verbatim, I don't see that as a sign of sophistication. What I see is mindless imitation, and a lack of differentiated, second-level thinking. I see somebody I expect to probably underperform over time. And because all these investors are doing the same thing, and are all looking at the same tiny group of overpriced, quality companies, it is perhaps unsurprising they are having a hard time finding ideas.

I, by contrast, don't work by fixed qualitative checklists. I instead try to look at as many stocks as I can, spanning across all sorts of different countries and industries, and all up and down the quality spectrum, and I try to value them. Instead of looking at 1% of the world's investment universe, I try to look at as close to 100% of it as I practically can (of course this is a vastly unmet aspiration on account of time constraints).

Now, I am looking for exactly the same attributes in a good business as anyone else - I don't take issue with any of the Buffett criteria, or dispute they are not highly desirable. And I also do not deny that quantitatively cheap multiples don't, in and of themselves, indicate somethings is genuinely cheap, because factors such as capital allocation and competitive advantage genuinely matter. However, what I do when a company falls short of the perfect ideal, is I put a price on that shortfall. I say, ok, the governance is ok but not great; I'll take 30% off what I'm prepared to pay for it. Or the business' competitive position is ok, but not great, so I'll take another 30% off for that. Or there is some long term disruption risk, so maybe I'll take 50% off for that, etc. So I don't automatically disqualify stocks because they aren't pristine, regardless of price. I instead try to price risk and value companies.

Basically what I'm doing is not insisting on only buying companies that are 10s (out of 10), for 8, which is what most value investors are trying to do these days. I am happy to own an 8 and 5, or a 5 and 2. or even a 3 at 1. I don't care that the business is not a 10. I care that it's undervalued. And generally, the only time you get a chance to buy a 10 at 5, is when the 5s are priced at 1 (i.e. a recession), and so even then, they are often not the best investments on offer. And what you learn over time is that there is a tonne of money to be made owning 7s, 5s, and even 3s, as long as you can buy them cheap enough.

Don't like the corporate governance? Apply a discount. How much do you think is enough? 10%? 50%? 80%? 99%? 99.999%? Gazprom has probably a 90% discount for corporate governance at present, and trades at 2-3x earnings. And yet the vast majority of the global value investing community won't buy it. A 90% discount isn't enough? How much is enough then? 99%? What happens if current efforts in Russia to improve SOE corporate governance bear fruit? Most value investors would prefer to wait until after corporate governance reforms have happened and the price is 5 times as high. By that point in time it might stand a better chance of making it on to their checklist.

In my view, it is a mistake to exclude 99% of the world's listed businesses at any price (or at least, if you're going to do it, quit pretending like you are a value investor, and admit you're in the business of buying quality). Every business that is not structurally unprofitable has a price at which they are a good bet, and the goal is to figure out what that price is as accurately as possible, and to buy it for less. This is the true essence of value investing, and many people have lost sight of it. What it means to be a value investor is to optimise the equation price < value, not price < 10. It's the wrong optimisation equation.

The only stocks I exclude off the bat are pre-revenue companies, such as med-tech start-ups and resource exploration companies (that haven't found any resources yet), most of which are destined for zero (I don't deny there are opportunities there; it's just that sifting the wheat from the chaff is better suited to focused sector experts, so I leave that area to others - particularly because the base rate returns on the group overall are poor). It is this differing approach, I believe, that accounts for the wide disparity between the number of ideas I seem to be able to find, and many other value investors.

Enter Munger: Fish where the cod is

Sitting here and criticising those subscribing, unquestioningly, to Buffett mantra, has been a bit uncomfortable. It opened me up to the easy criticism, 'who are you to say you know more about how to invest than the master?' But that missed my point. I never said Buffett didn't know what he was talking about - only that imitators were taking what he said out of context (including the fact Buffett is in the market for private acquisitions he promises to never sell; has a surfeit of cash; and also concurrently emphasises the importance of a margin of safety), and that these investors were not adapting to a changing market environment. My view was that people were following Buffett's dictum with a sort of religious zeal, rather than thinking for themselves. And successful investors are independent thinkers, not followers.

Given the above, it was interesting to read in this morning's WSJ, an article which discussed Munger having called Farnam Street Investments author Jacob Taylor about his new book, The Rebel Allocator, of which Munger has been highly complementary. The article included many direct quotes from Munger that confirmed a lot the arguments I have been making. Calling these value investors (discussed further above) "fanboys", he said:

"[they are] like a bunch of cod fishermen after all the cod's been overfished... They don't catch a lot of cod, but they keep on fishing in the same waters. That's what's happened to all these value investors. Maybe they should move to where the fish are".

The WSJ author notes, "by that, he presumably means not the bargain companies that have become almost an endangered species, but rather the great companies at fair prices that Mr. Buffett has been favouring for the past couple of decades under Mr. Munger's influence". I agree with the second part of this comment, but I completely disagree with the former part. Bargain companies are to be found everywhere, if one is willing to entertain buying stocks that aren't 10s.

I see this as straight-from-the-horse's-mouth vindication that I'm on to something here. Munger seems to agree with me. He is essentially saying that the 'high quality business checklist' pond has now been overfished, and that's why these fisherman can't catch any fish. I, by contrast, seem to be fishing where the cod is, because I'm having no problem finding opportunities everywhere, and that's not because I'm particularly brilliant; it's because I'm simply willing to look. When the fish are abundant, it's pretty easy to catch them.

Additional advantages 

Aside from the fact that there seem to be more cod in the other 99% of the pond than the 1%, quality portion of the pond at present, I see a number of other advantages to looking at a wide variety of companies, in all corners of the market, spanning the full quality spectrum.

For one, you simply get a lot more practice valuing businesses of all stripes, and handicapping the odds. I get more 'outside view' data points stamped into my memory, which enhances judgement over time. For instance, I keep a list of stocks I've looked at, at what price, and what my rough valuation was and how I expect the stock to perform. I'll then come back every three months or so and see what's happened. If it played out mostly as I expected, and nothing much looks to have changed, I move on. However, if it's done much better or much worse than I expected, I go and take a closer look. What's changed? What did I miss? And what is my view now? This way I get to scrutinize my own biases (by focusing specifically on instances where my judgement has been disconfirmed), and over time I refine my mental framework to incorporate new experience/insights, so it gets slowly better and more accurate over time.

It's like shooting baskets all day, and if you do it for long enough with enough stocks, you get pretty good at valuing companies right across the 1-10 quality spectrum, and handicapping the odds on both the upside and downside. You can buy companies that are quite possibly going bankrupt, because you can say 'yeah it could go bankrupt but the risk is only about 50% and it's priced like its 90%'. You can't do that if you have no experience looking at such companies, because you've stayed with 'safe' stocks.

You also get pretty fast at doing it, because you have to, because there are so many stocks to look at. And you need to get fast if you want to have a wide peripheral vision, instead of focusing on a very narrow group of quality stocks. Like I've blogged about in the past on 'blink' investing, if you're skilled and experienced at your craft, you should be able to come up with a rough estimate of what a stock is worth within 15 minutes, and it should be approximately right about 9 times out of 10.

It takes Buffett less than 10 minutes, typically, according to him. Of course, if something looks good, you'll want to check that snap judgment to make sure you haven't missed anything - especially if you're going to take a big swing. I liken it to how Magnus Carlsen (the world's #1 chess player) describes his thought process - he says he usually knows what move he wants to make within a few seconds, but he will nevertheless sometimes think for 10-15 minutes before making a move. When quizzed on the inconsistency, he said well of course I have to check that I haven't missed anything and my initial judgment was right. The majority of the time it is, but sometimes it's not.

This is what Buffett means, I believe, when he says he knows, within 10 minutes, whether something is potentially interesting, or is a pass. He only does more work on stocks that look immediately cheap, because it's a waste of time to do more work on it otherwise. You might find something, but you probably won't, so your return on time will more than likely be suboptimal.

Furthermore, this is also why Buffett says he will not look at any private business buyout proposal unless a price is on the table. Buffett does not want to waste time researching a great business if he doesn't know what the price is, because he is looking to optimising the equation price < value, not merely compile a list of good businesses he knows a lot about. He needs to know what the price is so he can compare it to his rough estimate of value after 10 minutes, and determine whether it justifies doing more work on or not. This is the opposite of what most value investors these days do. They do lots of research on 10s, and often take months to render final judgments about what they think they are worth, before they even look at the price.

Another benefit of this approach is that because you are looking at far more companies, all up and down the quality spectrum, you are much more likely to stumble onto areas where the really significant opportunities lie: potentially wonderful companies masquerading as poor companies, because they are misunderstood, or because there is real, favourable change happening that is underappreciated. You won't find these stocks if you're only focusing on the 1% of well-known 10s, because they won't make it past your initial quality screen.

A really great example of this was the airline industry 5 years ago (I totally missed this trade as well). Buffett taught a generation of value investors to never buy airlines, period (myself included). So we didn't even either bother to look. We just declared airlines, always and everywhere, uninvestable, regardless of price. However, for those that did look, they would have discovered that the industry had consolidated down to a small number of players, and management incentives had also changed to ones focused on returns on capital, rather than growth. The global aircraft fleet was also hitting record high levels of utilisation and seat density, while Boeing and Airbus' order backlogs were 10 years long, so global capacity could not be added quickly (particularly given P&W's engine issues, which were delaying deliveries). This was a very real and important change vis-a-vis the past. Returns on capital were likely to structurally improve.

The companies started to make good money. But they still sat there at 4-5x earnings, and started buying back stock. In 2016, US airline stocks screened at the very top of Joel Greenblatt's 'magic formula' list, with a combination of high returns on capital and very low multiples. I saw them, and thought to myself, you know what; I bet they probably are a buy, because everyone hates airlines, but it might also be distorted by the recent drop in oil prices; everyone knows airlines are terrible businesses, so perhaps the formula is a bit skewed in this instance. So I quickly passed and didn't look any deeper, just like everyone else, even though I already knew the magic formula to be a great way to cut through my own biases. And I'm usually pretty good at recognising this bias when I see/feel it, and forcing myself to take a closer look. But even my biases in this case were too strong.

If people had bothered to look, what they would have discovered was that not only was there a good case to be made that profitability was set to structurally improve, but it was already evident in results. But no one looked (except Bill Miller, who made a lot of money), until - to everyone's shock - Berkshire Hathaway turned up on the register. Value investors were catatonic, and were like "b.. b... but.... but you said to never buy airlines".

What happened? Buffett and Munger adapted to changing conditions and started fishing where the cod were. They are independent thinkers that thought for themselves, and were not bound by their own rules, which were elucidated at a different time in a set of different market conditions. When Buffett bought Coke, the stock traded at 11x depressed earnings, and new management had taken over which was working to improve efficiency and accelerate growth, including internationally. Today Coke trades at 22x earnings on maximised profits, and growth has significantly slowed on global market saturation and rising competition, and declining consumption in developed markets.

Conditions have changed. Investors no longer fail to appreciate the value of consumer franchises, and undervalue good quality businesses. Buffett and Mungers' willingness to take a fresh look and buy airlines, while everyone else remained committed, with religious devotion, to the idea airlines were uninvestable, says a lot about why Buffett and Munger have been so successful. They are independent thinkers.

But here is the kicker: I am willing to bet Buffet and Munger were able to find airlines, because unlike most value investors, they look at lots of different companies, all up and down the quality spectrum, and are focused on maximising the equation price < value, not price < 10. Indeed, I have heard Buffett say in an interview, "I look at everything". So why is it that most value investors discard most of the market then? It seems like a lot of the time, people selectively choose which Buffettisms to follow, and which to discard, in much the same way religious folk selectively read the Bible. And they choose the parts to follow that conform with their own biases and justify them making investments in stocks that feel safe/comfortable.

The age of the traditional Buffett copycatism is over. The cod have swum elsewhere.