John Huber practices a disciplined value investment style in the tradition of Graham and Dodd. His investment approach has been influenced most by Ben Graham, Warren Buffett, Walter Schloss, and Joel Greenblatt. Read more about his investment philosophy below…

At Base Hit Investing, we have two primary investment goals:

  1. Protect our capital by minimizing the risk of permanent loss of principal.
  2. Compound our capital at rates of return that are far superior to the average result measured on both absolute levels and relative to the market averages

I believe that a sound investment operation is one that achieves both of these goals in that order. Lest we forget, the greatest investor in the world repeatedly said that there are only two rules of investing:

  1. Rule #1: Don’t Lose Money
  2. Rules #2: Don’t Forget Rule #1

Rules to invest by, indeed. It is absolutely crucial that we focus on protecting our capital first and foremost. To achieve these goals, we need to have a concept that is logical and proven to be successful, and then we need to create a strategy to capitalize on this concept, and a process to execute our strategy. This is what we intend to work on consistently at BHI. Investing is an art, science, and always an exciting work in progress.

BHI Investment Philosophy

I am a value investor. My own investment philosophy has been formed after years of studying what works in the market. My thinking has been influenced by numerous investors, but mostly by Ben Graham, Warren Buffett, Joel Greenblatt, and Walter Schloss. Graham was the teacher that influenced the other three, who all went on to create legendary track records (Greenblatt made 50% per year from 1985-1994 during the time he ran public money, and Schloss made 21% per year for nearly 5 decades; Graham and Buffett have results that need no explanation). These investors all used slightly different strategies, but they all had the same basic philosophy of buying stocks for less than their intrinsic value.

After studying, reading, learning, and observing, there is one thing that has remained clear: Value investing works. It has been backtested and researched for decades and more importantly, it has been successfully practiced by many great investors. It is a persistent anomaly in markets that cannot be arbitraged away. Human nature does not change, and human nature consistently provides us with a menu of both undervalued and overvalued stocks at almost all times.

Our Edge:

Our basic philosophy is that on balance, the market systematically and consistently overvalues companies with great outlooks and strong recent results. Conversely, the market undervalues companies with poor outlooks and weak recent results. This has been proven through research and practice. This is how we make money as value investors. Value stocks (unloved, rejected stocks with low P/E, P/B, P/S and other valuation ratios) have consistently and significantly outperformed their much more popular growth counterparts over long periods of time.

Some key concepts to remember:

  • Stocks are living breathing assets (not pieces of paper). They represent fractions of ownership in businesses that have real assets that produce cash flow. A stock certificate gives the owner a share of that cash flow.
  • The stock market fluctuates. This creates opportunity to buy good companies occasionally for far less than their intrinsic value (as measured by the value of their assets and/or their cash flow).
  • Stocks should be bought at low multiples to earnings, cash flow, dividends, asset values, etc…
  • Stocks should be bought with a margin of safety (large discount to intrinsic value)
  • Value investing works. History has proven this, research has repeatedly concluded this, and most importantly, some of the best investors in the world have built fortunes using these concepts.

Investment Strategy

I run two separate strategies at Saber Capital Management. In the Graham tradition, I call one strategy the “Enterprising Strategy” and the other I call the “Defensive Strategy”.

Enterprising Strategy:

My investment strategy has been built on the conceptual foundation of Graham, and refined through the latticework of investment tenets adapted from Buffett, Schloss, and Greenblatt, along with a number of others as well. I will provide an overview of my strategy here, and discuss in much more detail in later posts. I divide my strategy into two main buckets:

  1. Quantitatively Undervalued Stocks (Undervalued stocks that are purchased at a discount with the intent to sell at a profit when they become fairly valued)
  2. Compounders (Great companies purchased at fair prices that can be held for a long time as they continue to compound book value, sales, and cash flows)

Quantitatively Undervalued Stocks

My basic strategy is to own a basket of quantitatively undervalued stocks. As I will discuss more on this blog, a lot of thought has gone into the selection process. There are ways to systematically build a portfolio of stocks that collectively have lower risk and above average potential for return. As mentioned above in the concepts, the market consistently and systematically undervalues certain stocks, and we have devised methods to determine which of these stocks should be bought. I think of this basket of stocks like an insurance actuary thinks about life insurance statistics. Some of these stocks won’t work, but an adequately diversified basket as a whole will significantly outperform the market if properly selected. The basket approach to this part of my strategy provides me with three key things:

  • Margin of Safety: it provides a built-in risk management function, allowing the group of stocks to decline in value but still be safely above the investment cost
  • Diversification: Like the insurance actuary, the basket approach further decreases the overall risk of the portfolio. Insurance companies might estimate that say 4% of the people they insure for life insurance will end up dying sooner than expected, so they price their insurance accordingly. To make this business model work they need to insure as many people as possible and let the law of large numbers to work in their favor. For example, if they only insure 25 people and 2 or 3 of them die, it could have a significantly negative impact. If they insure 100 people, or 1000 people, or 10,000 people, they become much more likely, almost certain, to be close to their expected value. So although diversification decreases the ceiling for returns, and over-diversification is not what we strive for, some diversification is absolutely crucial to our risk management strategy.
  • Multiplicity of Transactions: Like a casino operator that has a mathematical edge over his customers, he wants as many people as possible to sit at the tables. The casino knows that the more people play, the more likely the casino is to achieve their expected return. We want to make as many investments in these undervalued stocks as possible, because we know that we have a casino-type edge in these transactions, and the more undervalued stocks we find, the more predictable and consistent our long term returns will be over time.

Compounders

The basket of undervalued stocks is the engine that drives my investment vehicle. However, I am always looking for great companies that are growing (compounding) their book values, sales, and cash flows over the last 10 years or more. I call these great companies compounders. One of my main routines is to flip through the pages of Value Line always on the lookout for compounders. These are good quality companies usually with exemplary returns on equity, assets, and capital. They should have good margins, and preferably little to no debt. I keep a list of these stocks at all times. I also track stocks that compound their dividends (many are on both lists) and I look for market corrections to give me an opportunity to buy these stocks at a discount to their fair value. More often than not, these stocks sell at prices that are often higher than what I can find in my undervalued basket, and thus do not create as much return for the portfolio as the undervalued stocks do. However, occasionally there is an opportunity to buy a compounder at a price that will create above average returns for that invested capital for a long time.

The allocation between Quantitatively Undervalued Stocks and Compounders will fluctuate depending on opportunities and market conditions.

Defensive Strategy:

The first priority in both strategies is to protect capital. The second priority is to compound the capital at a better than average rate of return. The Defensive Strategy is very simple… My objective is to build a portfolio of 25-30 dividend paying stocks that have a history of being quality companies that grow their dividends over time. These stocks all basically fall in the “Compounder” category (see below). These are all quality companies that provide passive income to their owners through ever increasing dividends. My objective is not to find the highest yielding stocks, but the combination of yield and dividend growth. In the end, growth of dividends will provide higher total income and total returns over time. I attempt to buy these quality stocks at reasonable valuations with a margin of safety built into the purchase price. This strategy is more passive and more defensive than my Enterprising Strategy. I’ll have more details and thoughts on this strategy on the blog, but the basic summary of investment principles in this strategy are:

  • Long history of steady and increasing dividends
  • Current yield over 2% with historical long-term dividend growth of 7%/yr
  • Payout ratios preferably below 60%
  • Modest amounts of debt (preferably less than 50% of the equity)
  • Above average returns on equity and capital
  • Good valuations (P/E ratios under 20, and preferably below historical averages)

BHI Investment Process

At BHI, we believe the investment process can be simplified down to this:

  1. Systematically identify the most undervalued portion of the universe of stocks
  2. Apply some basic measures of quality to find the best stocks within that undervalued universe
  3. Buy a basket of the stocks that fit #1 and #2, always insisting on a margin of safety.

It’s a simple as that. It can be done using simple data and publicly available information. It does not involve predicting or forecasting business trends, stock market trends, or macroeconomic trends. It doesn’t matter to us where the market goes in the short term because we know that over time, buying $1 worth of assets for 50 cents is a sound, low-risk business and investment strategy that is very likely to pay large rewards. 

I will be discussing my thoughts regarding my investment process in much more detail on this blog. Feel free to browse the categories for my thoughts on concepts, strategies, and the investing process, as well as links to research and studies on value investing and how/why it works.

7 Responses to Investment Philosophy

  1. Simari says:

    Dear John,

    I am an Italian investor and I follow the value principles to invest.
    I read your website and first of all my compliments for the great work.

    I would like to ask some questions if possible,
    first of all, the conceit behind the ROA or ROIC it’s the best way to select companies, from my point of view, at same time the price we pay it’s probably most important than that.
    How we can determine the right price or the “true” intrinsic value of a company?
    I use a Free Cash Flow model but the problem with that is hat I cannot know if the company will be living in 20 years from now.

    Kind Regards and thank in advance for the answer.

    G. Simari

    • John Huber says:

      Hi G. Simari,
      Thanks for the comment. I’ll have some further discussion on the topic of Compounders, Return on Capital, and Intrinsic Value and how those relate to each other in a 2 or 3 part post series soon.

      But very briefly, the process of determining the intrinsic value of a business is an art form. There are no rigid rules that you can use to plug data into a spreadsheet and hope that it spits out the value for you. I’ve looked at a lot of different models over the years, including many DCF’s, and I’m usually skeptical of most of these types of models. On page 4 of his owner’s manual, Buffett says that the value of a business is the “discounted value of the cash that can be taken out of a business during its remaining life.” This implies that a DCF model is the proper method of determining value. However, he goes on to say on page 5 that “the calculation of intrinsic value, though, is not so simple”, and that “two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures”

      He implies that it’s an art form, and determining the present value of all the future cash flows of a business involves looking at all different aspects of a business’s DNA including its historical financials, its profitability, the stability of its operating history, the balance sheet, evaluating its competitive position, and its management team, among other factors–all weighted and compared to the current price.

      So it’s an art form, and it takes practice.

      One thing to keep in mind–some businesses are much easier to value than others. As Greenblatt says, start with the businesses you know how to value. For practice, read a book called Analyzing and Investing in Community Banks and then go out and read a few annual reports of tiny community banks–which are fairly transparent and relatively easy to value. Or pick an industry that you have some expertise in and begin reading some annual reports of businesses in those industries. Pick simple things–I recently read a 10-K on a business that sells hot dogs and has a nice competitive position in that niche. It’s easier to understand–and value–a business that has been selling hot dogs for the past 96 years than it is to value a business that sells pharmaceuticals (at least for me–others might have an advantage with drug companies, or software, or oil and gas, etc…).

      So if you’re going to value individual businesses, you have to understand that business. As Greenblatt says, if you don’t understand it, move on to the next one. There are 10,000 stocks in the US, and probably over 50,000 world wide in developed markets. You only need to find a minuscule percentage of them to allocate a portfolio to.

      Also, value investing comes in many different shapes and sizes, and if you choose not to value individual businesses, there are alternative measures such as quantitative investing in the Graham or Schloss tradition, or even Greenblatt’s “formula”. This quantitative approach values the basket as whole, removing the need to value each individual business. It relies on the law of large numbers, similar to the insurance underwriting business. I personally enjoy reading about those types of strategies, and the results from Schloss are absolutely phenomenal, but I prefer to think of the stocks in my portfolio as fractions of businesses, and thus I endeavor to understand them and value them individually.

      Anyhow, valuation is an art form, and it takes practice. Just like practicing the piano, you’ll get better the more you practice. And the best way to practice is to just start reading reports. Over time, you’ll begin to understand the different metrics that are important for each business, and you’ll be less inclined to use hard and fast rules (ROIC above X, P/E below X, etc…) and more inclined to think inquisitively about the business and its operations.

      The last thing I’ll mention: over time, as business owners our results are tied to the internal results of the businesses we own. A business that is growing intrinsic value over time will reward us as owners. Over the longer term, quality is the most important determinant of our results as equity owners. A business that can compound value over time at 12-15% annually will create fabulous amounts of wealth for the owners of that business.

      So quality is crucial for long term owners. BUT, valuation is the most important determinant (or at least as important) over the shorter term (say 1-3 years). If you overpay–even for great businesses–you’ll have to wait a long time for your investment returns to “catch up” to the internal compounding returns of the business. Conversely, if you buy a great business that compounds value at 12% per year–if you can buy it at a discount to its fair value, then your returns will generally exceed the business’s results in the early years of the investment.

      The market is a weighing machine, and over 3-5 years, it tends to weigh things properly. So valuation is an absolutely crucial factor over the near term.

      This turned into somewhat of an impromptu essay, but I hope this helps…

  2. steven davis says:

    I don’t go hunt companies. I hunt for industries. And from there I go pick companies using these 3 criteria.

    1. P/E ratio – must be less than 10. Normally, I prefer P/E ratio of less than 5.
    2. EPS for the last 2 quarters must be positive.
    3. I don’t care about the book value. But prefer the book value to be less than 1.

  3. Simari says:

    Hi,

    first of all, thanks for the answers.

    I have been studying to find the right compromise in the value search,and as you know it’s a tough task.
    Waiting for the post series in the near future as you wrote at the beginning of your reply I would like to ask you if there are past posts or you have any thoughts about the internal compounding returns, as to compute it, if it’s released from the company etc…
    I always thought it was more important to consider the ROIC.

    Thanks a lot

    Giannicola Simari

    • John Huber says:

      Hi Giannicola,

      Feel free to search through old posts. I discuss the concepts fairly often.

      As for intrinsic value compounding, I think the following generally explains how I like to think about compounding: if we use earnings power as a proxy for gauging intrinsic value, a business will grow (or compound) its earning power at the product of two factors: the amount of capital the company can retain and reinvest, and the rate of return it achieves on that incremental investment.

      It’s simply: the incremental ROIC multiplied by the reinvestment rate. In other words, a business that retain and reinvest 50% of its earnings, and can achieve 20% return on the incremental capital it invests will compound its earnings power at a rate of 10% annually (50% x 20%). Similarly, a business that achieves 10% ROIC and can reinvest 100% of its earnings will also compound earning power at 10% annually.

      The first situation is more desirable simply because 50% of the earnings (the part that isn’t reinvested in the business) can be distributed to shareholders via buybacks or dividends, or potentially used for acquisitions. So capital allocation is a very important factor when considering the overall company. But the enterprise itself will compound value at a rate that depends on the ROIC and the reinvestment rate.

      I view this very general measure as a proxy for intrinsic value growth. It’s a back of the envelope way to determine how a company is growing the value of its business. And again, capital allocation can add or subtract from the overall intrinsic value of the company depending on how adept management is at allocating the capital that isn’t reinvested in the business at the given ROIC.

  4. Simari says:

    Hi John,

    Thanks for the answer.
    I understand your metric for the future, but how to evaluate if the price now it’s right or under/overvalued ?

    I mean, there are metrics as P/E, P/B and model as DCF but in your experience is there an objective and reliable method to compute the intrinsic value of a company?

    Thanks in advance

    Regards,

    Giannicola

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