Investment Philosophy

Summary Thoughts on Investment Approach

One of the most common questions I get from readers as well as clients involves my overall investment philosophy. I talk about this often with clients, but I thought I’d write some comments specifically pertaining to my own investment philosophy and a few aspects of my approach that I think are of central importance.

Below are some points that help describe my investment philosophy.

Strategy

My firm has a simple investment objective: to compound our capital at high rates over the long term with minimal risk of permanent capital loss.

Our investment strategy is to make meaningful investments in high quality, predictable businesses that can be expected to compound value at high rates, and that are currently available at good prices.

One benefit to investing in undervalued high quality compounders is that investment returns can come from two possible sources:

  • The internal returns that the business generates
  • The possible increasing valuation multiple that the market “assigns” to the business

My approach involves one of Ben Graham’s fundamentals—thinking of stocks as entire businesses. This helps me to think more like a long-term business owner who thinks about things that impact the business model and not about things that impact the near term stock price.

Although each investment has unique elements, these are a few of the attributes I am looking for as an owner-minded investor:

  • Simple, predictable business models
  • Track record of consistent profitability (high returns on capital and consistent free cash flow)
  • Favorable long term prospects for retaining and reinvesting earnings (compounding machine)
  • Shareholder friendly management
  • Significant value (cheap price)

This is a well-known gameplan, but one that is not often executed well. Below are some investment tenets that help me implement my strategy.

Margin of Safety

My investment philosophy is founded on Ben Graham’s famous “margin of safety” concept, which I define as the gap between price and value. I am focused on limiting the risk of permanent capital loss, and my objective is to limit unforced errors. To do this, I look for investment ideas that I can understand, and that are clearly and significantly undervalued. I define value as my conservative estimate of either:

  • The rate that I expect the investment to compound during my holding period, or
  • The price that a private buyer would pay for the entire business.

The margin of safety is the most important concept in my philosophy, and it is one that is talked about frequently, but still underrated and misinterpreted by most market participants.

It is very important—if not somewhat obvious—to understand that I am only interested in making investments in ideas that represent large and obvious gaps between price and value. In my opinion, a larger margin of safety both reduces risk and increases future returns—which is opposite of most investment theories which preach that with lower risk comes lower returns.

So my investment approach involves patiently waiting for these significantly undervalued investment opportunities. Too many investors are in a hurry to fill their portfolio with moderately undervalued ideas in an effort to either over-diversify or get fully invested—a practice which significantly dilutes returns over time. I am not excited about a stock that trades at $25 that has “30% upside”, to use a general example that represents what I often see in the blogosphere and on investment websites. Stocks that trade at $30 that are worth an estimated $40 simply do not have enough potential return to compensate for the inevitable uncertainty that exists with each situation. More importantly—the margin of safety (by my definition—the $10 gap between price and estimated value) is too slim—one minor mistake in analysis or one adverse development in the business can cause the investment principal to become impaired.

In fact, I’m less interested in assigning static values to investments, and more interested in thinking in terms of compounding. In other words, if I buy at the current price, what will my returns look like over my holding period as the business builds value and the valuation finds a normal level? Each investment is different, and some investments are bought with the intention to sell at a certain price, but my ideal investment is a compounding machine that builds value over long periods of time.

Think Like a Business Owner

I also find it helpful to think as a business owner would, not as a stockholder. I imagine myself buying 100% of each business, and I think of each investment as if it were the family business. If I’m not willing to buy the entire business, then I’m not interested in owning the stock. This approach—although often stated—is rarely actually implemented. To truly adopt this mindset gets one thinking in longer and broader terms—less about quarterly results, P/E ratios, and current earnings, and more about the business model itself—including the long term competitive position of the business, its durability, and its long term prospects.

I find that thinking like a business owner also goes along well with the margin of safety concept, as it steers me toward higher quality companies that on balance tend to build value over time and thus increase my margin of safety as time goes on. Thinking in this manner also helps me maintain a patient, disciplined, long-term approach, which I think is a productive mindset to have when investing in the stock market—and it’s a mindset that the majority of market participants lack, thus giving our partnership an important edge.

Make Meaningful Investments

My preference for investing in easily understandable investments with large gaps between price and value along with my business owner mindset leads me to a portfolio management style that is focused. Great investment ideas are simply not available every day, and my investment approach involves waiting patiently and remaining disciplined when good ideas are not available. This leads to both infrequent investment activity and a relatively small number of investments in the portfolio—both of which I feel reduce risk and increase the probability of achieving superior returns over time.

Most mutual funds and even the majority of value oriented funds own in excess of 30-50 positions (some funds own well over 100 stocks). This makes it virtually impossible to achieve significant outperformance. It also makes for much greater maintenance involved with following so many ideas, which I find difficult. The math of portfolio management is very compelling, and worthy of an entire post itself. A variety of research states that a 10-15 stock portfolio diversifies away the vast majority of so-called “market risk”—which is not something I’m concerned about anyhow. My goal is to reduce the risk of permanent capital loss, not worry about short term price fluctuations.

I tend to feel very comfortable making meaningful investments in a select number of great businesses, and I think it is far less risky to own a relatively small number of undervalued stocks that are well-researched than it is to own a large number of stocks that are comparatively less undervalued and less understood.

To Sum It Up

I think that a conservative, disciplined, patient approach to buying significantly undervalued stocks of high quality companies that are growing shareholder value is the best way to achieve our goal of compounding our capital at high rates over the long-term with minimal risk.

I have a few more posts coming that will go into some more detail on these compounding machines that we all desire to own—specifically some more comments on the importance of reinvestment potential and return on invested capital, and how that pertains to value—which is in the end, what we are all after.

30 thoughts on “Summary Thoughts on Investment Approach

  1. I was interested in your comment on portfolio concentration. I seem to remember you preferring a “Schloss-like” approach with many smaller positions. Has your thinking changed on this topic, or is my memory serving me wrong?

    1. Hi Lukas,

      Yes I have many more thoughts on portfolio management… I think Schloss’ strategy can work well in certain situations where an investor is interested in playing a “numbers game” similar to an insurance style bet. In other words, if you are looking at Japanese net nets in 2011, or South Korean cheap stocks in 2005, or various community banks that are trading for 60% of tangible book, etc… I think the basket approach can work well.

      I think diversification generally has a much more negative impact on returns than it has a positive impact on risk mitigation. However, in some situations, diversification is necessary just to achieve the desired result. Schloss’ diversification was not necessarily to control risk, but rather to ensure that he achieved his expected result. And if you are buying stocks that are very cheap that have certain issues that are hard to predict in any individual case, then a basket approach might be necessary.

      In fact, I know numerous investors that have implemented this approach very well. And as you know, I love Schloss–more for his simplicity and his logical approach and less for his specific tactics he used.

      So it’s really a matter of what kind of strategy you desire.

      For me, I would love to own 30-50 positions that all had the same risk reward dynamics, but there are not that many ideas that I think are both safe and significantly undervalued. Owning a lot of positions also adds a less often stated problem–research and maintenance requirements. My personality is such that I desire to have a solid understanding of the investments I own–there will always be people who know more, but I don’t feel comfortable allocating capital to ideas that I haven’t researched well and feel like I have a firm understanding. And there is a direct negative correlation between the number of positions in the portfolio and the level of understanding that one can have for each business.

      Again, it’s not to say that some can’t make this work. Lots of small positions will create the desired basket effect, or “insurance underwriting” result… and this can work too, but I find it stressful to own too many things. I am much more comfortable in understanding what I own, as when the market takes a dive, I get more excited about my holdings because I have a firm understanding of the businesses.

      I am really interested in ideas that I can understand and that I think are extremely undervalued, and those ideas just aren’t that prevalent.

      So my portfolio tends to be focused more on what I consider to be my better ideas.

      But it’s an art, and yes, it’s always evolving.

  2. Nice post John. I have been reading your blog since the beginning and was drawn to it by the fact one of your investing heroes is Walter Schloss, someone I have studied carefully too and greatly admire. Your approach described above seems to be more towards the Buffett end of value investing, great businesses at great prices. Examples of your investment approach remind me of Buffett’s Disney and Washington Post purchases, i.e. a fantastic price but also a business that can compound returns at high rates, further increasing the current margin of safety to intrinsic value. Would this be a fair assessment? I also wanted to ask you why you don’t practice the Schloss/Graham style as such? I would love to hear your views as I have in recent months, become torn between the two. While I have always been drawn towards the traditional Graham & Dodd approach, my onging study of Charlie Munger and is use of Maslow’s hammer analogy to describe the development of traditional Grahamites over the years, really makes you think. I guess the approach you have can capture the best of both ends of the value investing “tent”, as Jean Marie Eveillard describes it. I have wrote this comment pretty quickly so sorry if it’s a bit jumbled. I hope I have made some sense. Thanks.

    1. Thanks Tom. Yes I think your comments are accurate. I have been really influenced by Schloss and Graham as well as Buffett, Munger, and Greenblatt and many of the other ubiquitous names in value investing lore. And yes, I think the Disney and the Post are good examples of ideal investments, but it’s hard to use specific examples. I look at many ideas, and many ideas are not necessarily the common thought of examples of large, mature businesses that everyone associates with Buffett (Coke, JNJ, P&G, etc…). I also look at ideas that are in the “special situation” category, or what I would call the “private buyer bargains” category.

      What I’m really looking for are the wide, obvious gaps between price and value–it sounds obvious and almost silly to state that way, but that’s the easiest way to summarize it. I need to understand the situation, and I need to see significant value in excess of price. And I have found that I feel more comfortable investing in predictable businesses with a history of building value and prospects that make it easy to see that the compounding will continue.

      I think it’s important to consider that each investor has to come up with a style that matches their personality and their own skill set. I personally find it easier for me to protect my capital by trying to invest in the right business, rather than trying to constantly be going from situation to situation looking for the lowest price. I feel more comfortable researching ideas and understanding what I own. I love Schloss for his simplicity, and his strategy, but I am not comfortable owning as many stocks as he did, as it creates an enormous amount of maintenance and research to keep up with the businesses the way that I like to. I also feel that businesses that are building value offer a safer investment than those whose values are static, or shrinking.

      It’s a good discussion, and one that we should continue in future posts.

      I agree with Michael Burry when he said that each investor has to have their own individual strategy–if there were a specific blueprint, it would be easy… but it’s an art, and that’s part of the fun.

  3. Have you computed statistics such as volatility of your portfolio(s) and compared with the indices? I ask because Larry Swedroe argued to me that the papers showing only 10s of positions are needed were from the 80s. With higher volatility in the 2000s, recent papers argue more positions are needed (he also had some post arguing investment concentration for mutual funds makes performance worse). In my own portfolio I have a fair amount of concentration but the volatility is only slightly higher than the market.

  4. By the way, my favorite investments are those that the Kelly betting formula says to go all in on. I size proportionally to that Kelly fraction. This is essentially another way to look at the margin of safety. I generally compute the margin of safety in terms of annualized rates.

    The psychology to me is that buying stocks is like jumping out of a window. The only safe way to jump out a window is on ground floor. And if some error could be involved, better to jump out a basement window, and climb up through the window well, even if you get dirtier.

    The margin of safety is how much of a bargain you got, I.e. expected value. But it does not account for the dispersion of the final outcome, I.e. variance. That is where Kelly betting comes in. Because it says, if you know for sure you will eventually have a positive outcome, bet big, and the less uncertainty you have, the more you should bet. Thus insurance style investing requires diversification (low Kelly fractions), even for the same margin of safety, as compared with Munger investing (high Kelly fractions).

    In essence, if I know for sure that I’m exiting through a ground floor or basement door (or window), and I haven’t confused it with a third floor window, then I should be confident to exit in haste!

    1. Thanks for the comments Connelly. As for portfolio stats, I’ve never really computed any stats for my portfolio. I think of each stock holding as its own business that is mostly uncorrelated to the other businesses I own. I’m not saying the stock prices aren’t correlated in the short term, I’m just saying that overall, I think of them as businesses and so I’m not really concerned about volatility or stock price movements in relation to the indices. That’s an interesting comment by Swedroe, and I haven’t seen any recent research on that, so it’s an interesting topic. But regardless of whether the volatility is the same or higher, my reasoning for taking meaningful positions have more to do with my definition of risk. In other words, if I could find 50 ideas that were all equally undervalued with the same risk reward profiles and the same upside potential, then that would be great. But I find it difficult to find too many investment ideas that meet my desired margin of safety–which I define as the gap between price and value.

      So I’m really just searching for really big gaps between price and value, which keeps my aggregate risk low–again, my definition of risk is losing money, not excess volatility.

      Thanks again for reading!

      1. I tend to crunch stats fairly often. Usually I just bin investments into different styles and compute summary return rates and volatilities for each, plot returns, and compare them with passive benchmarks that I consider decent. It’s not clear how useful this is yet since I am still a novice. It may be useful, or may be just an excuse to geek out with data :-).

        Thanks for the great blog John!

  5. First, congratulations on a truly excellent blog. I recently discovered it and have been going through the archives post by post.

    The debate on Buffet/Munger vs Schloss/Graham approaches is an interesting one. I personally don’t see why one has to lean exclusively either way. I have around two thirds of my portfolio in long-term compounders, and this portion is highly concentrated in 5-7 positions. The remaining third of my portfolio is spread around 10-15 Schloss-like companies which is basically a basket of very cheap statistical bets, special situations, etc. My problem here is just finding enough cheap companies to invest in. I’d happily own 20-30 but don’t see that many bargains out there today.

    Again, great job on the blog.

    1. Thanks for the nice words Dave. Yes, I completely agree. Each style is different, but the objective is the same: figure out what something is worth and pay a lot less for it.

      Michael Burry once talked about how he realized that there was no specific blueprint that one has to follow—there are certain principles that should be adhered to, but there are numerous styles, and each style has to be adapted to the personality and skill set of the practitioner. There are many things that work. And as you’ve done, styles can be combined. There aren’t rules that state you can’t buy both categories. Investing is an art form…

      Thanks for reading!

  6. John, Fantastic work.. I was recently introduced to your blog via Old School Value.

    Both you guys have some seriously amazing content! I am based out of India and relocating shortly to the US 🙂 Will continue to follow your blog and learn more about value investing.

  7. Hi John,

    First of all, superb work on the blog – I’ve learned a huge amount from your posts.

    I wondered whether I could make a request for a post, namely one that looks at methods for calculating value? I’m a novice retail investor and haven’t really come across anything that lets me know where to begin. What is value, and how does one calculate it? I’m prompted to ask because you hint at it in your article (value as the price you’d pay for the entire business, or the expected compounding rate). Clearly it’s more an art than a science, but I’d hugely welcome any pointers. (I should add at this point that I’ve read an article you posted on Schloss comparing tangible book value per share to actual share price, and another article that calculates how much a share would be worth if it returned the same rate as a US T-bill, but that’s as far as I’ve got. And I wasn’t sure whether Schloss’ method applied to shares other than banks or insurance companies.)

    Thanks again for writing such an excellent blog.

    1. Thanks Anthony. I appreciate you reading. I’ll try to work up some thoughts on valuation soon. That would be a good post topic. I’ll give you the short answer (straight from Buffett’s owners manual on page 4): intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. So just like a bond bears interest in an amount that is typically known and fixed and can be valued–a stock also has these cash flows. Only a stock’s “coupons” are not known in advance, and they can often fluctuate significantly. But in general, I think it’s very practical to value stocks this way because that’s how business owners think, and I view stocks as fractions of businesses. A business owner derives value from his business by the cash flow that he receives. The more cash flow it produces, the more valuable the business is to him.

      However, I will warn you that I’m not a fan at all of computer generated models. Many investors set up DCF models and all kinds of elaborate spreadsheets for calculating this intrinsic value. However, these models make it too easy to fall into a false sense of precision, and it’s very easy to slightly alter one variable to get the “desired” value.

      I try to think about it logically, and in very simple terms. How much cash is the business producing in normal times, how predictable and stable are the cash flows, and how much is that worth to me? I’ll try to follow up with some more thoughts in the future. Obviously, there are other ways to look at this, but I think an approach based on cash flow makes the most sense, even in businesses whose values are often anchored to book value. But it is an art, and there are a few things to look at.

      To simplify it, try to remember that the discounted value of the future cash represents value, and the simplest thing to do is to look for businesses that produce consistent and predictable cash flows. Try to figure out the amount of cash the business produces in a normal year and decide what that normalized stream of cash is worth to you.

      Buffett once said he likes to pay around 10 times pretax earnings for good businesses. Other people often use an average market multiple of 15, or in other words an average earnings yield of around 6% to value stocks that are of average to slightly above average quality. So if a stock is worth 15 times earnings, buying it at 10 times earnings is great, etc…

      I’ve never really tried to do this, but I think it probably works fine over time. I try to think more in terms of compounding–the internal rate that the business is compounding at–i.e. how much can the business retain and reinvest from what it earns, and what kind of return can the business get from that incremental investment? In other words, I’ve mentioned before that an enterprise’s compounding rate is the simple product of two factors: ROIC and reinvestment rate. I like to look at the cash flow yield I currently get, and my conservative estimate for what the business is compounding at, and that helps me get an overall idea of what my investment compounding rate might be over time.

      So I try to find businesses that are producing cash flow, but whose cash flow can also be reinvested at high rates to produce even more cash flow. So I try to get a big picture handle on the current cash flow and the possible compounding rate, and then of course I’m trying to buy at a price that allows me to experience an investment return that at least equals and hopefully exceeds the compounding rate.

      Check out Buffett’s article on GEICO from 1951. http://basehitinvesting.com/wp-content/uploads/2013/05/The-Security-I-Like-Best.pdf That’s a compounder that traded at around 8 times earnings. He spent most of the time discussing the advantages the business had, the current earnings that the business was producing and the high levels of reinvestment opportunities that the business had, and then simply stated that 8 times earnings seems much too cheap for such a business.

      He didn’t come up with some exact value, but he figured it was probably worth twice what is was trading at. He figured the stock would reach 80-90 over the next 5 years (it traded around 40 when he bought it).

      I’ll try to write some more thoughts in the future. I have a few comments on the topic of compounders in the next few posts, which might help you. I also have some posts drafted up on banks which might help you with financial stock valuations. One thing to do to practice is to pick an area that is simple for you to understand, and begin reading about each of the companies in that industry. This helps you begin to learn what metrics matter in each industry, and thus will help you come up with inputs that are important to consider when valuing the businesses in that particular industry.

      Anyhow, these are some random and meandering thoughts, but I’ll try to formalize it at some point later.

      1. John, very many thanks for putting together such a detailed reply and for the GEICO article. I read it with interest. Look forward to the post in due course!

        1. Hi Anthony —

          Here is how I do investing. As a prelude, read all the value investing books.

          Then follow 4 steps: (1) find an obscure store of value, (2) understand the business or asset well, (3) price the asset, (4) enter a position if there is a substantial mis-pricing.

          First step: let’s choose a store of value that is obscure. I know nothing about watches. But for fun, let’s check out a manufacturer of luxury watches, Vacheron Constantin, which I arbitrarily pulled up because I searched for expensive goods. Check out their merchandise and in particular watch their videos for some of their collections:

          http://www.vacheron-constantin.com/en/watches/patrimony

          Second step: let’s start to understand the business. We can’t expect to make lots of progress in one day but let’s start learning.

          I note how the merchandise is extremely high quality and manufactured in Switzerland. The business has been around for 259 years. I read carefully about the company on Wikipedia and note that its most expensive watch was sold for $5 million but subsequently increased in price on auctions to $11 million. That watch took 6,000 hours to assemble. Thus, labor costs should be high. I refresh my basic economic knowledge by re-reading about the economics of Veblen goods such as luxury watches where demand increases as price increases.

          Now I determine whether the company is public or private. It is part of a public holding company Compagnie Financière Richemont (“Richemont”) which owns lots of Swiss luxury goods businesses. I note the founder is worth $8 billion. I pull up the annual reports and note sales have skyrocketed in recent years, in particular in Asia due to the increasing wealth there. The net profit margins are 15-20%. Clearly the company has pricing power and a moat due to its retail customers who are not price sensitive. I note there are only two articles on SeekingAlpha about this company, which I read (this is good for us, because a mis-pricing is more likely).

          Next, I price the company. I compute some basic financial ratios that private buyers such as LBOs might use: 2013 EV/EBIT is 14.5. Using the average of the last two years EBIT the ratio is 15.8. I check out the financials for previous years and note the share price has increased at +16% annualized since 2001 (if I invested I would go back further).

          Depending on the return rate that you want, we should expect this business to be purchasable below a ratio of around 10. Because if earnings stay constant, the business should be yielding earnings of around 10%. And this business possesses competitive advantages, so the intrinsic value will grow over time, and realized returns will be a bit higher. The price isn’t currently interesting to me but if it was then I would keep learning more.

          Now I possess no substantial advantage in pricing this company, because despite being obscure it is still fairly large, and I know nothing about luxury watches. I can occasionally expect to detect a mis-pricing here but that should be rare.

          So let’s try and be creative. We could price their smaller competitors or options chains if listed, where we should find more mis-pricings.

          But let’s price the watches themselves. Let’s choose the “Prix des Vacheron Constantin”:

          https://www.collectorsquare.com/luxprice-index-montres/prix-montres-vacheron-constantin-gerard-mercator-43050.html

          We can see that the sell prices for collectors fluctuate between 10.4 k Euros and 88.1 k Euros, with most in a range from 15 to 30k Euros. Suppose there was no difference in condition between these watches. If we bought at the low end and sold at the high end three years later we should realize +100% cumulative or around +20-30% annualized after modest transaction fees. We could potentially also loan the watch to a highly trusted family member and gain an additional yield. This starts to get interesting.

          I note in approval that the website is in French and buying and selling these is going to require quite a lot of specialist knowledge — meaning more potential mis-pricings. There are extra risks though because these watches don’t throw off cash flow, and we have to store them safely. We could read up on how to determine condition for this particular luxury watch, figure out how to minimize sales and transactions costs, and start bidding on them online.

          But realistically, how many investors are going to be buying obscure luxury watches versus GOOG? You can probably tell tons of people how to invest in situations like this and still few people would do it because it would be a pain. Just like Buffett’s cocoa bean arbitrage. Who wants to exchange securities for beans?

          In summary you can see that this process requires quite a lot of research. After each deep dive we calculate a price, and if we’re sufficiently discriminating on prices then we can achieve a good return rate.

        2. Note in my previous comment I over-estimated the potential for mis-pricings for that watch, because the prices vary by the particular make and condition. This just indicates that I am a watch novice :-). But I’m confident that if you become an expert and start looking through collectable watches you will eventually find a mis-pricing!

  8. John:

    This is my first visit to your blog (through Feedly), and I commend you for your eloquent description of your investment process. It reinforces the way I and my partner (long-time Graham desciples) have thought about investing for the past 35 years.

    One notable example is our ownership of Markel Corp., which we bought when we opened our firm’s doors over 20 years ago. It’s one of the best compounding machines we’ve ever run across. We’re anxious to reconnect with Gayner, Markel, and associates in Omaha this weekend.

    Keep up the great work. I’m a new fan!

    1. Thanks for the nice words Steve. Keep in touch. Thanks for reading. I will be in Omaha this weekend, and I’ll be at the MKL breakfast as well. Looking forward to it.

  9. Hi John,

    When it comes to evaluate the management team, I find it very difficult as this is the only part that can’t be quantified(profitability, compounding machine, valuation can all be assessed using a few figures).

    When I read companies’ report or shareholders letters, I find it’s very difficult to conclude whether it’s a shareholder friendly management. They talk about their business strategies, how to implement into the practices, they expanding their business, initiate a number of programs to reduce cost and improve efficiency. They talk about culture, people,etc. It looks like they are doing the right things. But if evry management is doing the right thing, how I can determine whether one is superior to others?

    Coming back to business expansion, I know Buffet mentioned before that acquisition is not always good for the shareholders. And I can see some companies, for example, spend substantial amount of money to buy other companies to broaden their customer base or to expand to Asia market, etc. obviously, the acquisition sometimes deteriorate their margins or the ROIC in the new market is not as good as that in their base market, etc. But can these facts be convincing that the management ‘ acquisition or business expansion is not wise, not thinking from shareholder’ view? One may argue that you need to be patient, the benefits from the aquisition may not be seen immediately from financial figures. The management may also argue that this is for long-term development of the company, though in the near term it may drag the overall performance. To me, this argument also make sense. Then how can I evaluate a management?

    Thanks, John.

    Ruthy

    1. Hi Ruthy,

      Those are some great questions you raise. It is difficult to assess management quality sometimes. But I’m a big believer in track records. One thing I’ll do is to look back at old 10-K’s and old shareholder letters to see if management has done what they said they would do 10 years ago.

      There are some quantitative things you can look at. One is simply looking at the numbers on how they allocate capital. You can look at the balance sheet to see the retained earnings over a certain period and you can determine if those retained earnings in fact created at least as much market value. You can also look at the treasury stock and the amount of shares that they’ve bought back over time and determine the exact average price that those buybacks have occurred at on balance. This helps you find out if they have created value by buying back stock at good prices. Each industry is different. You might look at returns on equity relative to competitors.

      A simple thing that I sometimes like to look at for some businesses is how their net worth has grown over time (book value). You need to adjust consider dividends and buybacks when looking at per share book value numbers as well.

      Judging management, like judging value, is an art. There are many things that go into the mosaic.

      One last and maybe most important thing to consider: Figure out how management is incentivized. Do you own a lot of stock? Are they buying stock? Are they compensated with a lot of options? Is the pay linked to metrics that are important factors to value (like ROE, book value, stock price, etc…) Sometimes more revenue is good, but sometimes it can be bad if it destroys value. All of this matters. Incentives are very important.

      Hope this helps.

      You’ll learn more as you study more companies. Over time, you’ll naturally become better at handicapping these various things and determining the proper weight to put on each piece of information.

      The best thing I can say is look and see how they’ve acted in the past (track records matter).

      1. Hi John,

        Thanks for your reply which is very thorough.

        I have questions regarding the quantitative things you mentioned. First, you said comparing the RE for a chosen period with the change in market value. As market value is influenced by the Mr Market, why do we compare the accumulated RE with market value? I.e. Why does this a good indictor for management team?

        Second, you said working out the average price for share buyback. Why does the buyback price matter? What is a “good price”? I just don’t understand the relationship between the price the company pay the buyback and value created from this action.

        I appreciate if you can shed light on these stuff. Please forgive me if this is too simple and silly questions.

        Thanks,
        Ruthy

        1. Hi Ruthy. Good questions. The thing that might help is to think about the big picture view: If you own a business and retain earnings (as opposed to paying yourself or your shareholders out all the earnings as dividends), what is your objective by retaining earnings? Your objective when you retain earnings is to be able to invest those earnings to create more value for your business.

          You could do a number of things: you could use that capital to grow your current business (if you own a chain of shops, maybe you invest in opening up another shop), you could use it to maintain your business (capital expenditures that are unrelated to growth, aka “maintenance capex”), you could use it to acquire another competitor who owns similar shops (acquisitions), or you could use it to maybe buy out some of your partners that want to sell, thus increasing the ownership of the remaining partners (share buybacks).

          So at a very basic level, your objective when you retain earnings is to increase (or at least maintain) the value of your business. If the earnings you retain are destroying value, then you should be returning those earnings to shareholders rather than investing them.

          So the natural way to look at it is to determine if over a long period of time, these retained earnings have in fact created value. Your point about the market price is a good one… I don’t think you can look at this on a short term year to year basis. I think you have to make this judgment over a long period of time.

          As for buybacks… it is very important to understand that just like any other investment, it can be value creating or value destroying. Buybacks only create value if they are done at prices that are below the intrinsic value of the business. So you want to look at the average prices that management has bought back shares to determine if they have purchased them at prices that are below intrinsic value.

          If buybacks are done at prices that exceed fair value, then they destroy value and those dollars would have been better off in some other investment (or returned via dividends).

          Hope this helps…

          1. Hi John,

            Thanks for your explanation. Using common sense makes it much easier to understand.

            Can I ask for the calculation of the book value. You mentioned to adjust dividends and share buyback. I think stock split should also be adjusted. What do you reckon? Btw, do you usually calculate BV per share yourself? Morningstar has the data. But do you know if it has adjusted dividends and share buyback? I don’t know how they get the figure.

            Many thanks, John.

            Ruthy

          2. Hi Ruthy,

            Book value is a balance sheet number that is based on a specific moment in time. In other words, a balance sheet is a snapshot summary of a company’s assets and liabilities on that particular day (12/31/13 for example). So book value is a measurement (assets less liabilities) on that day.

            There are no adjustments needed for splits, dividends, etc… to calculate the current book value. I don’t rely on data sources to calculate it, I just look at the most recent balance sheet that is filed in the latest 10-K or 10-Q. Book value is another term for shareholders equity, net worth, etc… It’s simply the assets minus the liabilities. Book value per share is just the shareholder equity divided by the number of current shares outstanding.

            I think the question you raise refers to a comment I made regarding the GROWTH of book value over time. If you want to judge a company’s growth in equity, you can look at the book value growth, but it helps to also remember the dividends that have been paid out, or the money used to buy back shares (both of which reduce shareholder equity). So just keep that in mind if you are looking at the change in shareholder equity over say a 10-year period or so.

  10. You mentioned three ways to get a return as a value investor. higher valuation or multiple expansion, internal returns and capital allocation by management. I understand the first and last but the second.

    How does one make money in a business that generates more earnings, when you hold the stock?
    You have mentioned that the multiple can stay the same but if the business keeps on generating more cash it will eventually be reflected in the stock price. Why is this so?

    1. Hi Yuan,

      Sure… the internal returns are based on the ROIC and the reinvestment rate. But let’s just keep it simple and call it growth of earnings. I actually just had a similar question on a different post. Think of it like this very simply: Businesses can become more valuable in the market in two main ways: Earnings grow and/or multiple expands (I’m being simple and not including capital allocation).

      So if you think about a P/E ratio… if the P/E ratio stays the same but the “E” doubles, then the stock doubles. A stock with EPS of $1 and a P/E of 20 is a $20 stock. If the earnings go from $1 to $2, and the P/E stays at 20, the stock goes from $20 to $40 per share.

      A multiple could always stay the same, but as long as the business continues to have reinvestment opportunities and generates more earnings, the stock price will increase (assuming same multiple).

  11. I’ve been thinking about this post some more after a Eureka moment I had at a meeting at work this week. I work for a large investment company. A guy who manages hundreds of millions in a large fund was saying he didn’t want to own the largest company in the index he is tracking because he hates its fundamentals. But he added “it’s definitely very risky to underweight this one too much.”

    In other words, the thing this guy was MOST worried about is not buying enough of a company he hates, because of the risk that it could keep going up, leading him to underperform the index and the other funds he is benchmarked against. In my experience this kind of behavior/thinking is pervasive in the industry. It’s all about relative performance — and speaks to your point that it’s virtually impossible for big value funds to hit the ball out of the park.

    This is why those of us who don’t care about what is in the index (or what the rest of the herd is doing) — and instead think about investing as owning a fractional share of a business — have a huge advantage over many of the biggest so called professionals.

    1. Dave, that’s very interesting feedback regarding the fund manager you know. And I agree, there are many comments that I hear like that and it reiterates the importance (and the huge advantage) of thinking differently.

      Great comment.

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