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:
- Protect our capital by minimizing the risk of permanent loss of principal.
- 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:
- Rule #1: Don’t Lose Money
- 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 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.
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”.
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:
- Quantitatively Undervalued Stocks (Undervalued stocks that are purchased at a discount with the intent to sell at a profit when they become fairly valued)
- 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.
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.
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:
- Systematically identify the most undervalued portion of the universe of stocks
- Apply some basic measures of quality to find the best stocks within that undervalued universe
- 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.