Importance of ROIC Part 2: Compounders and Cheap Stocks

Posted on Posted in Case Studies, Investment Philosophy

This is part 2 of my follow up thoughts on compounders, cheap stocks, and the importance of returns on capital. Part 1 is here. Also, some previous posts before that are relevant to this post as well:

To recap last post, I basically wanted to convey that valuation and quality are not mutually exclusive. There seems to be two factions within the large value investing community. It sometimes feels like a presidential primary race. We’re all on the same team at the end of the day, but these two factions seem to always disagree on numerous points. The factions I’m referring to are the Graham deep value followers and the Buffett quality company followers, for lack of a better way to put it.

I espouse that there really isn’t as much of a difference between the two that everyone seems to think. The end game is that we are all trying to locate low risk 50 cent dollars.

In the last post, I made a comment about Fastenal, and that the stock has been one of the best performers in the US Stock market in the last 25 years, averaging better than 20% annual returns since the late 1980’s. Of course, many will say: “sure, it’s easy to use FAST as an example”. That’s true, it is…

And I agree that even though paying 50 times earnings would have worked very well for FAST shareholders in 1989, I’m not interested in going anywhere near that type of valuation, because I don’t want to rely on my dubious ability to predict the future that far in advance. However, this does not mean that I want to abandon my effort to study some of the most successful businesses of years past. Improving pattern recognition skills increases the probability of successfully identifying these types of quality firms going forward.

I want to find good businesses and I want to own them. I just am not willing to pay the prices they typically trade at. So I wait for opportunities for good operating businesses at cheap prices, occasionally investing in some special situations, hidden asset situations, or other undervalued safe ideas. Often enough, I’ll locate an idea where I can buy into a quality company at a very cheap price. In the last post, I referenced a very low risk, low cost bank that I own that has grown book value at 9.3% annually over the past 15 years without a single down year, has paid a sizable dividend every year since 1926, and yet could be purchased at 7 times earnings and 60% of book value. Those are the types of compounders that I like to own. If I’m wrong about the quality, I didn’t pay much for it. If I’m right about quality, my returns will be significantly better than a similarly valued lower quality stock.

As Pabrai says, “Heads I win, tails I don’t lose much”.

Return on Invested Capital is Most Important Over Time

The following is a collection of some comments that I made following one of the previous posts. I thought it would be interesting to demonstrate the importance of quality (return on capital) when it comes to long term ownership of equities. Again, this doesn’t mean that buying at 70% of book value and selling at 100% is a bad idea (on the contrary, it’s one that I will participate in under certain circumstances) it just means that over time, companies that can consistently produce returns of 15% on their capital are going to create far more wealth for their owners than companies that only produce 5% on their capital.

As I mentioned, I’ve done some rudimentary studies of this ROIC vs Value topic previously. A good way to demonstrate the importance of high returns on capital is to look at long term shareholder returns (over 15-20 years or more). For example, I just picked up my Value Line and flipped to the steel section, and industry that is known for their low returns on capital over time. Note: the steel industry is cyclical, which leads to very volatile results. The companies will produce periods of very high returns followed by periods of very low/negative returns. But over the full cycle, the economics of the steel business inevitably lead to very mediocre returns on capital of 4-6% in most cases.

We could do this exercise on a number of stocks, but take US Steel for example. This company has reorganized a couple times in the past few decades and so a glance at the chart doesn’t reflect the entire story, but it still provides a Keynes style “roughly right” look at the results a long term owner would have achieved. Pulling up a long term chart we see that the stock (X) traded around $30 per share in the early 1990’s.

X Long Term Chart

USX earned around $3 per share in the early 1990’s, followed by a few years of losses, and then a period of excellent profits in the early 2000’s, and then back to losses.

But just taking a snapshot in time in the early 1990’s, one could have bought the stock at $30 or so at around 10 times earnings. Today, the stock trades at $25, leaving long term shareholders with a loss of principal after 20 years or so.  Interestingly, even if we paid 3 times earnings for X in the early 1990’s—which would have been around $9 per share—our returns over the next couple decades would have only amounted to around 5% per year, which equates roughly to the company’s average return on capital.

Now, you might notice that we could have paid 3 times earnings and then sold out at a profit a few years later, reaping a nice IRR. But this relies on buying low and selling high in a shorter period of time–a feat that is much easier said than done. In retrospect, it seems like a cinch: just buy in 2003 and sell in 2007, right? Some can practice this type of investing, but I find that timing is the most difficult aspect of executing an investment approach, so I try to minimize the importance of getting the timing right.

But the point here is that paying low prices to earnings is more important if your holding period is a shorter period of time and you have confidence in your ability to know when to unload your shares at a higher price at some point in the future—a necessary skill when trying to buy and sell mediocre businesses that produce unexciting returns on capital.

Some Other Examples in Steel

Flipping through the steel section of Value Line, this example holds true with many other steel stocks—subpar ROICs over time leading to subpar investment returns over time. Gilbraltar (ROCK) traded at $7 in 1994 (20 years ago), and it trades at $15 now, an annualized return of just 3.5%.

ROCK Long Term Chart

ROCK paid dividends in some years, but they weren’t large dividends, and even if we add 2-3% to those returns, they are still mediocre.

One more example: Ampco-Pittsburgh Corp (AP) traded at $8 in 1994, and it trades at $21 today, a 4.9% annualized return before dividends, which again might add 2% or so to those returns.

AP Long Term Chart

An interesting note with AP, if we go back even further to 1984 (30 years ago), the stock traded at $22 per share. So 30 years later, our poor long term shareholder has roughly the same principal that he started with 3 decades ago, albeit at a much lower real value! It is likely that a buyer of AP stock in the mid 1980’s could have paid far less than 1 times earnings for AP, and still be left with very mediocre long term returns.

I’m not trying to pick on steel stocks. They are just an example of an industry that is burdened by miserable economic headwinds that has left most companies struggling to earn adequate returns over time. Of course, not every steel company produces low returns. The low cost producer might be able to sustainably create above average returns on capital over time. But in a business like steel or any other commodity business, it’s tough.

The exercise is really about any company that produces low ROIC vs any company that produces high ROIC over long periods of time.

High ROIC always wins in the end, given a long enough time horizon.

Compare Long Term Results from High ROIC Companies

One of the best performing stocks of the past quarter century is Fastenal (FAST). FAST sells nuts and bolts, sounds basic enough… but the returns are far from basic. The company averages around 20% returns on capital and produces very consistent results. 25 years ago, the stock traded for a split adjusted $0.32. Today it trades at $44, or 138 times the price in 1989. A $10,000 investment in FAST in 1989 would be worth just shy of $1.4 million today and it would be throwing of $30,000 per year in dividend income to boot—the annual income from the dividend alone is three times the total initial investment! The stock has averaged 21.8% annualized returns not including dividends. This outstanding long term investment result nearly matches the company’s average return on capital over that time.

FAST Long Term Chart

Fastenal earned roughly $3 million in 1988, and a buyer of FAST paid somewhere around 25 times earnings for FAST in 1989. But a buyer could have paid 50 times earnings for FAST in 1989 (or roughly $0.65 per share) and the compounded annual return would have only decreased from 21.8% to 18.4%…. a big difference over time, but certainly still a splendid result.

This is just one simple example, but a similar long term result could be observed with Walmart, McDonalds, Starbucks, The Gap, Wells Fargo, M&T Bank, Eaton Vance, and many other well-known examples of high ROIC companies that have correspondingly high stock CAGR’s over time.

Valuation and Quality: “Joined at the Hip”

The idea here is not to attempt to push long term compounders. And these comments above will agitate deep value guys. But, I certainly am NOT recommending paying 50x earnings—even for great businesses. Capitalism is too competitive and the future is too uncertain (at least for me) to be able to consistently pick out the next Fastenal.

But it does demonstrate that a business that can sustainably produce high returns on incremental investments over long periods of time (a good business) is far more important for long term shareholders than the price they initially pay for that business.

Again, I cannot emphasize enough that valuation is more important over shorter time periods, quality is more important over long time periods (10-15 years or longer). The longer you hold a stock, the more important the quality of that company is, as your long term returns will approximate the company’s business results–and their internal returns on capital over time.

In the shorter term (1-3 years), valuation is key. You can buy a steel company at 5 times earnings and will likely have the chance to sell it at 10 times earnings at some point. Same goes for low P/B stocks, net-nets, etc…

It seems that the two factions I referenced above always want to put their style into a box. I try to think about it more simply, more logically. If my goal is to locate and own a group of businesses, I want those businesses to be of high quality, conservatively financed, predictably stable, well managed, and cheap.

Forget about the metrics, the style boxes, the value leader you follow, etc… just try to think about what kind of business you want to own, and what kind of long term rate of return you demand, and then search out ideas that match those things. Look for the simple, the understandable, and the obvious—large gaps between price and value.

The objective is the same: figuring out what something is worth and paying a lot less for it.

_____________________________________________________________________________

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

33 thoughts on “Importance of ROIC Part 2: Compounders and Cheap Stocks

  1. This is great analysis. So what stocks do you believe currently match your high ROIC criteria and are trading at attractive values? Thanks.

  2. great post. but i think your analysis has a lot of selection biase. There are many high ROIC companies that fared far worse than FAST. These companies are typically in secularly declining industries (think about the newspaper industry). Best Buy had pretty good ROEs prior to AMZN coming along and eating their lunch. For every FAST, there are 10 companies with high ROIC that have done much worse than the market. Investing is not as simple as finding high ROIC companies…

    1. AA,

      Yes, I agree completely. And of course, FAST is chosen with bias–I simply looked for stocks that have produced great returns over the past 25 years, and FAST is at the top of that list. I knew going in that there was bias.

      The idea is basically to understand the math. A business that produces high returns on incremental investments is going to grow intrinsic value over time. It’s that simple.

      But you’re absolutely right: a business that HAS grown intrinsic value in the past doesn’t necessarily mean it’s a business that WILL grow intrinsic value in the future.

      That’s where the skill level of the investor come in. You have to analyze the durability of the business and consider its future prospects and competitive position. You have to think about the business and come to a conclusion that it will be able to produce good returns on its investments going forward, and you have to decide how much those streams of cash are worth.

      You’re right: it’s not easy. But my basic point was that the math and the logic is simple. A business that can produce high returns on incremental investments will increase value much faster than a business that produces low returns on incremental investments.

      Simple, but not easy…

      1. I’ve been reading the McKinsey Valuation guide which focuses on the importance of ROIC when it comes to value, and there’s a section that mentions a study regarding how companies with high ROIC tend to maintain their high ROIC over long periods of time (i.e. competitive advantage) and much more sustainable than growth rates, especially those that have a proven business model. The one’s a like in this area besides FAST are TJX and UHAL.

  3. This is a great post, John. One area where I think “value investors” blend the style and it hurts them is selling. If you are investing in a cheap company, you need to sell it when it is less cheap. Because Buffett started investing in cheap companies and now invests in compounders, I honestly, think there is this mixing of ideas and people invest in bad ROIC companies when they are cheap. Sometimes (though not always) they will get “re-valued” and that is when you need to sell, like the steel companies you mention. Horsehead Holding Corp. (ZINC) is a good current example of this. It was cheap, now it is more fully-valued. But, it was never and will never be a great compounder. If you are going to invest in both “styles” (although I hate that word), it helps to know which bucket the company falls into.

    1. Yes, all good points Matt. And I agree regarding the “styles”… Each investment is different and some remain “undervalued” over a long period of time (the very rare ones stay perpetually undervalued–i.e. BRK: I’d argue BRK was always undervalued at any price in the 70’s and 80’s). Some, like the one you mentioned, might reach fair value sooner and warrant a sale in a much shorter period.

      Thanks for the comment.

  4. Hi John, great post. Have you looked at all into Tobias Carlisle’s research and his strategy at Eyquem? He subscribes to deep value and cheap as the only factor, and he downplays quality (high ROIC), saying it’s actually a hindrance to returns. His studies show high ROIC companies don’t persist because they are dependent on favorable business conditions, which change, and inevitably the companies mean revert (obviously FAST would be an exception). Value and quality win, but value alone wins bigger and quality alone actually loses. I think the key here is his holding period, which is three years, but wondering if you had other thoughts. Thanks.

    1. Are you saying that Carlisle backtested the return contribution of the 2 Magic Formula selection criteria, EV/EBIT and ROIC, for a static holding period of 3 years, or have longer holding periods also been tested? 10 years would be interesting…

      1. Yeah the Greenblatt tests were all 1 year from what I know. I think the Carlisle tests were also relatively short term (1-2 years I believe). The only long term test I’ve ever seen regarding this is a Fortune article that Buffett mentioned. It was a 10-year test showing that high ROE stocks outperformed. I did a post on this a few months ago (it’s one of the links at the beginning of this post).

    2. Hi Josh, yep–in general I agree with the basic idea that mean reversion is more powerful in the short term. In other words, low P/E stocks tend to revert to their mean over 1-2 years. And in that short of a period, the quality doesn’t necessarily matter. How many times have we seen crappy companies double in price because they were “cheap” only to fall back down to the same level a few years later. But over time, just about any long term winner in the stock market has come from quality businesses.

      I think I mentioned this in another comment on this post, but basically I think that over a short period of time, valuation is the most important, and over a longer period of time, the internal results of the business are most important.

      Of course, we’d ideally like the great operating companies at low prices relative to their earnings!

  5. John – thanks for the insightful post. I feel like Buffet has mentioned on several occasions this very same point: an investors return approximates the unlevered return on the business he/she buys if held for a long period. This is just (for me) another example of hearing the words, but not really thinking about it clearly. This post helped me internalize this point better, so thanks for that.

  6. This post is basically presenting the same message that Charlie Munger did when he said “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns.” It’s well worth restating; when I read Munger’s remark, the idea blew my mind fully as much as the concept of brands versus commodities. I’m still staggered by it.

    On that note– a business that produces nuts and bolts sounds like the ultimate commodity, like the steel they’re often made from. It sounds like even more of a commodity than insurance. I know why Buffett and Munger did well in insurance. Why on earth did Fastenal do so well in such a business?

    1. Yep, that Munger quote was from one of my all time favorite lectures he did. I’ll have to make some more comments on it at some point, but yes, that simple logic holds true.

      As for Fastenal, I wouldn’t describe them as a commodity company. They are a distributor of nuts and bolts, not a manufacturer. I think around 95% of their revenue comes from selling products that other companies have manufactured. They do manufacturer some of their products, but its very small relative to their overall sales volume.

      As for their success, they’ve succeeded for a variety of reasons. They started out in a small niche in one location selling just fastener products, and slowly expanded and as they achieved greater economies of scale. But a big reason for their success is outstanding long term oriented management. They have grown steadily over time, but they haven’t been in a hurry. Their product base has expanded over the years, but fasteners still represent close to have their revenue, and so they’ve never strayed too far from their niche that made them successful.

      They have 2600 stores, and feel they can reach 3500, so they likely have a lot more room for growth, but management has never been in a hurry, and importantly, they’ve always been extremely focused on keeping costs in check.

      Frugal management is a rare thing, and when combined with a high margin business with a long runway for growth to reinvest earnings, it can create splendid results for management.

      1. OK, and thanks for answering, but my main question still stands. Why was Fastenal not undercut on price by competitors for something so simple as nuts and bolts?

        1. Well I haven’t studied Fastenal closely, I’ve only read through the 10-K casually. But I have a few thoughts. Again, I’d have to really study the business to provide a better answer, but there are few initial things to think about. I like to consider price, selection, and convenience when trying to understand these types of general questions (three big reasons to consider why customers would choose one retailer/wholesaler/distributor, etc.. over another). FAST’s margins are high, so the natural question is why couldn’t a competitor undercut them, as you suggest. (One brief thought is the WD-40 case study… if you go Walmart to buy a can of WD-40 for $3.50, and you notice a competitor on the shelf selling at $3.00 or $3.25, are you really going to switch from a brand that you know works well to a brand you’ve never tried for 25 or 50 cents? Now I’m not sure the same logic applies to fasteners, but it’s something to look into. Basically, the thought is that the cost of the individual unit is very low, so sometimes the cost/hassle of switching outweighs the marginal savings a customer might achieve by changing their account to a different distributor).

          Fastenal has 632,000 stock items in their fastener product line, so they have a wide selection, and their store base makes it very convenient for their 405,000 different manufacturing and construction customer accounts (in some cases Fastenal has a setup right in the customer’s plant). So there are some key factors in the selection and convenience categories I think….

          The other thing to consider is scale. 42% of Fastenal’s revenues come from just the fastener product line, so we are talking about sales of somewhere around $1.4 billion annually just from the fasteners. This logically means good buying power and that likely results in much lower costs than a smaller competitor would have for the same or similar product. So a smaller competitor would likely have much lower gross margins even at the same product price just because they can’t buy as much, and if they tried to undercut Fastenal’s price, their margins would be lower still, and on top of that, the smaller scale means that their operating costs are likely a higher percentage of revenue, making the bottom line margin quite slim. It might be harder than it looks to attack Fastenal’s margins (at least it has for the past few decades).

          So I think it will be tough for smaller competitors (Mom and Pops) to underprice Fastenal. In fact, I wouldn’t be surprised if the smaller competitor’s prices might be higher because of the above fundamentals (again, I’m not sure as I haven’t investigated this at all–these are all just theories based on a quick read of the annual report).

          As for the larger competitors, that might be different. They have the scale to compete. But one other thing to consider is the customer service aspect. Fastenal has a very efficient distribution model. They also have a large number of stores (about 2,700 stores), and a large variety of products, and so location and selection combined with the customer service (delivery or on-site availability and very knowledgeable, well-trained employees in the stores) gives it some advantages over some competitors as well.

          These things are hard to replicate, and I think are a few of the factors that might contribute to FAST’s wide moat.

          Anyhow, there are probably other reasons, but those are a few theories that come to the surface initially. Would be interesting to investigate further if FAST became a pressing investment idea.

  7. Hey John, thanks for sharing and I learned a lot. I think high ROIC business can attract entrant and competition to lower down the ROIC, so monitor the change in ROIC and understand why is critical for value investor. Maybe the consumer products industry is easier to find great compounders such as FAST/Coke.

    Cheers!

  8. John,

    Long time reader, first time poster. Your blog is fantastic and I think your analysis of ROIC compounders vs. deep value companies in all of the articles above is really your best work yet. Okay, enough with the compliments…

    If you haven’t read it, I think you will find this piece, “Profits for the Long Run: Affirming the Case for Quality”, by GMO to be quite interesting. http://amourtan.com/wp-content/uploads/2013/06/quality.pdf The authors discuss risk, quality, and persistence of ROE.

    In the end, if you have the option (and we do), why not buy something that’s both cheap AND good? If you can buy a good company at a price that gives you a reasonable-to-good return on the company’s normalized current earnings, then you get any future growth for free. Then, the focus shifts to the durability of those current earnings. Sure there are not as many of these investments opportunities out there, but that only means that the investor needs to sift through a lot of dirt, sit on his hands until he finds a gem, and then make a bigger bet when he does find something.

    1. Thanks for the nice words Jake. I appreciate you reading.

      I agree with your points. In the end, the way I explain things to my investors and other friends who ask me generally about investing is Greenblatt’s succinct line: “We’re just trying to figure out what something is worth and pay a lot less”. I think quality is an inherent aspect of value, and thus good companies have more value, generally speaking, than poor companies. But yes, we need to find cheap and good ideas, and we need investments to be significantly undervalued in order to create the results that we want.

      Thanks for the comment, and the link. I haven’t read that report, but put it on my list.

  9. Josh and Fabian — What you might be referring to is this article by Greenbackd:

    http://greenbackd.com/2013/03/19/performance-of-the-decile-approach-to-magic-formula-alternative-quality-and-price/

    Josh — Nice article as always. I might suggest rather than just ROIC you use a more general term like ‘quality’. In my readings and experience if one is to try to numerically predict good businesses this requires using many different factors. For example, ROIC is good but a lot of cyclical companies like those in ore mining can have artificially inflated returns at their cyclical tops.

    1. Thanks for the comments Connelly. Yep, that’s a nice piece by Toby. And I think that is the piece that is referred to. I’ve long believed (although I’ve never seen any backtests) that high quality (specifically, high ROIC) firms will do much better over the long term. In other words, it is far less of a factor (some might say no factor) in short term (1-2 years) results. But over 10 years, a company that produces high returns on its capital invested will create more value than a company that produces low returns on capital, and the stock price itself should correlate to that over time.

      I think that mean reversion is a powerful force, and that’s why I think that short term strategies that rely on mean reversion (or low P/E stocks reverting back to fair prices) is more effective in the short term (at least in the backtests it appears that way).

      I’m trying to think more holistically from a business owner’s perspective. We’d like to own the gumball machine that produces lots of cash flow relative to the cost of acquiring the gumball machine, and we want to have an ample amount of barber shops available where we can install more gumball machines that create similar returns on investment. Over time, assuming we can continue to generate these high returns from the gumball machines, our partner who put up the capital will do well without the necessity of buying into our company at a bargain valuation.

      Of course, buying in at a bargain valuation can provide a nice added kicker, but if our partner intends to own a stake in our gumball business over a long period of time, then he better have a good handle on our future ability to generate adequate free cash flow in relation to the capital required to operate and grow our business.

    1. Yes, it’s a good observation. Just like the steel stocks in the mid 2000’s (or housing stocks… how many housing stocks had high growth rates, excellent ROICs, and were trading at single digit P/E’s in 2007?)

      The key is normalized ROIC, not peak ROICs. Be careful with cyclicals.

      1. Yes, I would suggest looking at several measures, such as averaged 3 year, 10 year ROIC, profit margins, volatility of margins, predicted increase or decrease in competitors (this would identify WFM as being in more trouble than the historically trailing ROIC of 10% would suggest), worst case predicted operating margins, etc.

        The main trouble I would have with buying and holding high quality companies for a long time is I really don’t trust Wall Street, MBAs, executives, and so forth. From what I’ve read of the psychology of most of these people they tend to be sociopaths, greedy, issue themselves stock options in a way that divorces interests from shareholders, ignore minority shareholders, boards are generally subject to heavy conflicts of interest, and they generally tend to be exploitive of the poor (McDonalds was getting some bad press regarding that recently). The volatility in the stock market has increased in recent years and my belief is it is due to all these factors.

        The textbook case of a quality company growing is you have a great company that grows earnings for many years, shareholders are enriched, employees are happy, and there is great morale. But in the modern market I wonder how long that company would last before some corrupt executives install themselves and all the earnings mysteriously evaporate due to nepotism, bad employee satisfaction, and vast quantities of issued stock options.

        I saw my Dad work in Hewlett Packard and I worked for 2 years in a technology company (Adobe) where I was told at the outset that despite my Ph.D. research at Princeton becoming a headline feature for their Photoshop product they had no interest in hiring me for longer. In both cases the people in charge didn’t make good opportunities for their workers. In my opinion leadership should be all about making those opportunities.

        Perhaps I’m just reading my life experience too much into other people but I generally have a sort of paranoid skepticism towards corporations. Sure I’d like everyone’s interests to be aligned but in practice I expect a bunch of political operatives to be causing trouble by selfish rent seeking.

        1. Yep, this all boils down to incentives. As Munger says “incentives matter”. The Federal Express case is an example of one he uses to demonstrate the power of human incentives.

          I do believe that there is a lot of waste and a lot of excess compensation that stems from greed in corporate boardrooms, but I also think there are a number of high quality management teams that truly do have shareholder interests in mind (mostly because they themselves are shareholders–this is a very key point). Although insider ownership and aligned incentives are often discussed, I actually think their importance is underappreciated.

          1. I’d agree about incentives to an extent, but I don’t think that explanation goes far enough — it should also incorporate trust.

            Look at EBIX which we both own. In the Goldman Sachs takeover deal Raina arranged to significantly increase his stake in the private company with a buyout price of ~$20 that undervalued that company. Minority shareholders had no such option. This was analyzed here:

            http://seekingalpha.com/article/1418841-ebix-shareholders-are-getting-a-raw-deal

            Why would Raina do that? Well obviously because the equity was significantly undervalued and he could put that cash in his own pocket. So incentives explain this situation — if you take the Raina view that the situation was a non-repeated game like the Prisoner’s Dilemma. The rational choice for Raina given that assumption was to not be an angel and just take all the money. In conclusion we can say there was significant insider ownership, but it was actually too concentrated, because one agent was in a position to take advantage of all those minority shareholders.

            But any discussion about incentives is premised on the point that managers can only be trusted so long as they are already “corrupted” to act in your interests. So yes incentives are good and all, but if you fundamentally have no reason to trust someone, they incentives will serve as a band-aid but they won’t fix the underlying problem. That’s actually why I have a skepticism of MBAs in general — because when I talk to them they are often obsessed with money. Not operating businesses excellently, or learning every day, or giving a fantastic customer experience, or living a life they are proud of, but frequently, it’s just dollars.

            Now to go back to Buffett and Munger, I think where they really diverged from Graham, was they talked a lot to executives. And I think in doing so they didn’t just learn about incentives, they learned about which people were really trustworthy, and which people were going to just default in the first round and take all the money. I believe the whole operation of Berkshire is based heavily on trust of really good people. They afford wide latitude to the management of each of their sub-companies, and trust those management:

            http://dealbook.nytimes.com/2014/05/05/berkshires-radical-strategy-trust/?_php=true&_type=blogs&_r=0

            I think trust is also apparent in how Berkshire has treated acquired companies. Sure they have had to cut jobs. But generally speaking the way they trust people is fantastic as compared with much of the corporate world.

            And Buffett/Munger are models of trustworthiness themselves. Certainly the management fee they charged for running Berkshire has been low since it first became public. Buffett certainly could have charged a higher fee (i.e. salary). And I admire that Buffett didn’t become wasteful of money like many who are wealthy. I noted he fired one of his investment managers for purchasing a position in a private portfolio against Berkshire policy (can’t remember which one now).

            I currently haven’t talked to managers to learn which ones are trustworthy. I’m not sure I would enjoy that. But that might be required to get better at investing at some point.

  10. Some value investors focus more on price than quality, but I think every value investor should be looking at getting as much quality as possible for the price they are willing to pay.
    Since there is often lots of irrational behaviors reflected in stock prices, prices do move in the opposite direction of business quality from time to time. That’s why forming our own idea about the quality of our investments is very helpful. It unlocks us the ability to use prices as a servant rather than as a guide.

  11. Hi John,
    I m a newcomer to your website and I am really enjoying it. Very clear ideas, structured and instructional. Thanks.
    Only now after reading several of your posts that I finally got to understand all those years of disagreements with my father. He is a typical growth investor while I ve always been a 100% value guy, thought I did not know there was an exact name for it…
    But to the point. I am curious about your bank you mentioned.I obviously study several years back annual reports before investing and always ask myself if I would have bought the stock in those years. So my question is. Did your banks numbers look just as exciting say 5 years ago? And if so, why does it take so long for the market to price the stock “correctly” as we understand it?

    1. Hi Dave,

      Actually for a few of the banks I’ve recently invested in, the numbers probably look better now than they did five years ago. Many banks have significantly improved their capital ratios. Some of the banks have very liquid balance sheets and very low loan to deposit ratios, suggesting opportunity awaits when interest rates eventually rise. The strong balance sheets combined with the low stock price (in some cases–most of these stocks have been picked over at this point) creates what I consider to be a splendid opportunity for safe, consistent compounding in the years ahead.

      Some of the banks had lower stock prices 5 years ago, and so you could make an argument they were better investments then. It all depends on each individual situation. The large banks have dramatically improved their balance sheets. It’s incredible to compare precrisis balance sheets to current balance sheets at companies like C, BAC, and some other large financials like AIG. Much less leverage, and much more simplified.

      The small banks (or at least the ones I like) don’t look that much different than they were 5-10 years ago, although many of the small banks have just built up capital and are even safer than they were before. Some I consider to be too conservative, but probably better that than the opposite.

      The small community banks operate using a much different model… most are sleepy old banks with historic roots in their communities (some have operating histories back to the 19th century). And their business models are much simpler–basically they accept deposits, make loans, and invest in short term liquid securities. I’ve gone through a list of around 1000 or so. There are only a few that interest me, as the vast majority (probably 19 out of 20) produce mediocre to poor returns on their capital. But a select few are well managed and profitable, and have been for years. I prefer investing in these types of banks, as their intrinsic value tends to grow over time, providing me with a margin of safety (time is my friend). Some investors have done quite well in recent years buying mediocre banks at dirt cheap prices. I suppose at some price, this might be okay as long as the bank is safe. I prefer cheap for sure… but I try to locate banks that can compound net worth, as this allows me to rely less on the market’s timing of the valuation since I can rest easy knowing that the value is growing.

      Anyhow, not sure if that answers your question, but feel free to follow up. As for the market valuing the company at its fair value, that’s one question I’ll never know. I echo Graham’s response when he was asked the similar question in a Congressional hearing when he said he didn’t know when or why the market eventually valued the companies at intrinsic value, but it always seems to do so eventually.

      Part of the reason value investing works is because it takes a healthy portion of both discipline and patience, and many investors lose one or both of those at times, which ensures that the strategy will always work over time. It’s simple, but not easy!

  12. Hi John,

    Nice article, I really enjoyed this and part one. Seeing that you touched on steel companies here, I was interested to see if you had ever done any work on SCHN or TKR? I feel that they are businesses that are in, or related to, the steel industry that could begin to start earning larger returns on capital, and it’s not yet reflected in the price. A quick summary of the ideas: SCHN is a recycler of ferrous and nonferrous metal. In recent years, though, it has seen exceptional growth of its Auto Parts Business (self service yards that I think could see operating margins of at least 10%) and Steel Manufacturing Business (slight value add can bring operating margins to maybe 5-10%), which are higher margin than the Metals Recycling Business. I wonder if the earnings power of these “moatier” businesses could start to overpower the low returns on the MRB. As for TKR, it is a company that makes bearings, transmission, gearboxes, etc. It recently spun off its steel manufacturing business, which I think could provide an exceptional boost to ROIC. Just wondering if you happened to have looked at either of these ideas. Thanks.

    1. Hi Bryan,
      Thanks for reading and thanks for the comment/ideas. I haven’t looked at those companies, but will put them on the list.

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