Investment PhilosophyInvestment QuotesWalter Schloss

Two Key Checklist Items

I am not a big fan of going through specific “checklist” items one by one when evaluating an investment idea. I know this idea has gained enormous popularity in recent years, partly due to the good book The Checklist Manifesto, and partly popularized in value investing circles by Mohnish Pabrai.

I respect Mohnish a lot, and I think his idea of evaluating previous investment mistakes (both his own mistakes and especially the mistakes of other great investors) is an excellent exercise.

One investment mistake to study would be Pabrai’s own investment in Horsehead Holdings (ZINC). This investment would be a case study that maybe I’ll put together for a separate post sometime, as it’s one that I followed during the time he owned it. There are a few reasons why I always scratched my head at why he bought ZINC, and there are a few reasons why I think it ultimately didn’t work, but one thing I’ll point out is what Buffett said in his 2004 shareholder letter (thanks to my friend Saurabh Madaan who runs the Investor Talks at Google for pointing me to this passage):

“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

“Our failure here illustrates the importance of a guideline—stay with simple propositions—that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.”

This sounds very similar to the problem that Horsehead Holdings (ZINC) had with its zinc facility in North Carolina. Without going into details, I think there were too many variables that needed to go right for ZINC to work out as an investment.

But let me just say that mistakes are part of investing. So many people are so quick to cast judgment on investors like Pabrai, David Einhorn, or Bill Ackman when they make big mistakes. I’m not apologizing for these investors, but I think that those who are criticizing these investors should look at their entire body of work to draw conclusions, not just one bad investment. These three are very good investors with outstanding long-term records that have vastly exceeded the S&P 500, and they should be judged on that record, not the underperformance of the past couple years.

But regardless of what you think of these investors, it helps to try and learn from their mistakes. I wrote a post on Valeant a while back, which is Ackman’s biggest error. I also looked at SunEdison, which was an Einhorn investment. It is infinitely easier in hindsight (the rearview mirror is always clear) to attribute reasons for why these investments didn’t work out, but nevertheless, I think it’s helpful to study these mistakes.

I don’t think a 100-point checklist would have been necessary to pass on any of these three investments (ZINC, VRX, or SunEdison). Two of the three companies were ultra-focused on growing revenue regardless of the return on capital associated with that growth, using the so-called “roll-up” approach. All three of these investments saw their losses dramatically accentuated by debt.

I think each of these investments hinged on a few key variables (in addition to debt), and I think rather than running through a generic “pre-flight” checklist, a better method is to have a few very broad checklist items, and then determine the key variables that really matter regarding the business in question.

What do I mean by “broad checklist items”? One general checklist that Buffett and Munger use:

  1. Do I understand the business?
  2. Is this a good business? (Competitive advantages, high returns on capital, etc…)
  3. Is management competent and ethical?
  4. Is the price attractive?

It doesn’t get much simpler than that, and I think this 4-point filter is a common denominator that could be used on just about every investment.

Obviously, there is a lot of thought and analysis that goes into answering those simple questions, and so there are sub-categories that might pop up.

Key Checklist/Concept #1

This isn’t really a checklist item. But it’s a takeaway I’ve had through my own experiences:

  • Whenever I find myself getting more attracted to the security than I am to the business, it’s often a good reason to pass

My mistakes have almost always come from investing in “cheap” stocks of subpar businesses. I’ve learned that I’m better off focusing on good businesses. This means missing certain opportunities, but for me, it also means reducing errors. Also, when it comes to managing other people’s money at Saber Capital Management, I don’t feel comfortable owning low-quality businesses, regardless of how attractive the valuation appears to be. I mentioned this on Twitter recently and it sparked some interesting discussions.

There are a number of investors who disagree with me on this point. Some investors make a lot of money buying crappy businesses that are beaten down to really cheap valuation levels. It’s possible to make excellent returns buying garbage that no one else wants and selling them when the extreme pessimism abates some. This is the approach that guys like Walter Schloss used to great success in the 1950’s-1970’s—the so-called “cigar butt” style of investing.

But I think one big difference between the cigar butts of yesteryear and the stocks that investors get attracted to today is the debt levels on the balance sheet. The cigar butts that I read being pitched today are often questionable businesses that are loaded with debt. If things turn around and the company survives, the equity can appreciate multiples from its current level. If not, the company goes bankrupt and the equity gets wiped out.

It’s possible to become very good at handicapping these types of situations, but it’s not my style of investing. I choose to pass on these overleveraged companies with minimal chances of success.

Low Probability, High Payoff Investment Ideas

This brings me to another point I want to make regarding estimating probabilities. I read investment pitches all the time that discuss the probability of various outcomes. This makes sense—Buffett himself has talked about assigning probabilities to various outcomes of an investment. And certain odds might tell you that even a low probability event can be a very good bet to take. For example, a bet that has a 25% chance of winning and pays out 10 to 1 is a very good bet. It is a low probability bet that has positive expectancy, and it’s a bet you should take every time.

But I generally pass on low-probability ideas for the following two reasons:

  1. Unlike cards or dice (or other games of chance where probability can be more or less accurately determined), business and investing are dynamic with ever-changing odds. Cards and dice are closed-systems with a finite set of possible outcomes. Business is fluid, and there are an infinite set of unpredictable events that can greatly impact the outcome. It’s unreasonable to assign rigid probabilities to these types of situations.
  2. Investors tend to overestimate the likelihood of success of low-probability events (to use the above example, an investor might assume a 25% odds of success and a 10 to 1 payoff; but in reality it’s just 10% odds with a 5 to 1 payoff. The investor might accurately describe all of the moving parts of the investment, and rightly understand that it is a low-probability event, but still be way off with his or her estimate of risk/reward and thus make a bad bet). It is too easy to arbitrarily assign overly optimistic probabilities to this type of investment in an effort to justify buying the stock.

A year or two ago I read numerous Dex Media write-ups (the company that published phone books), including one by Kyle Bass. DXM was an equity stub—a sliver of equity with a huge amount of debt on a dying business that was trying to make a transition to digital from print. All of the write-ups recognized the obvious struggles of the business, and all recognized that odds of success were too low. But I think those who bought the stock overestimated the odds of success and/or the amount of the potential payoff. One investor said the DXM payoff could be as high as 100-1. This reward could justify an investment even at a very low likelihood of success.

The Fannie Mae and Freddie Mac investment cases might be current examples of this type of low-probability, high-payoff type investment. Maybe these will work out, but I think many are overestimating the likelihood of success.

In my experience, it’s better to forego the low-probability investment ideas. They are too difficult to accurately judge, and they usually involve bad (or highly leveraged) businesses.

Key Checklist/Concept #2

Schloss invested in poor-quality businesses in many instances. How was he so successful? Schloss used a checklist of sorts, and the very last (but not least) item on his checklist was:

  • Be careful of leverage. It can go against you.

This seemingly oversimplified statement is really great advice. I think that while Schloss invested in businesses with subpar (or no) competitive advantages, he was able to do well because of his patience and his willingness to wait for the cycle to turn. Many of his investments were in capital intensive, cyclical businesses—but most of the companies he bought had clean balance sheets.

Today, our society is much more accepting of higher debt levels—both at the personal level and at the corporate level. Because of the availability of debt made possible in part through securitization, it is much easier for companies to gain access to credit than it was in the 1950’s. Most companies that Schloss would have looked at in his day are now saddled with debt in an attempt to improve their inherent low returns on equity through leverage. Schloss was satisfied with the low ROE’s, as he figured he wasn’t paying much for it, and eventually, the earning power would inevitably turn higher as the business cycle turned from bust back to boom.

The business cycle still has the same fluctuations of course, but leverage now magnifies the equity values. I see scores of oil and gas producers whose stocks have risen 500% or more since the February lows. Leverage has magnified the comeback in their equity values. It also would have been their death knell had oil prices not bounced in the nick of time.

Schloss said in a Forbes article in 1973—aptly titled “Making Money Out of Junk” that there are three things that can go in your favor when you buy cheap, out of favor companies:

  • Earnings turn around and the stock appreciates significantly
  • Someone buys control of the company (buyout)
  • The company begins buying its own stock

However, you need a clean balance sheet to put yourself in position to capitalize on a cyclical upturn and the corresponding rebound in earning power that could come with it.

Where the Puck is Going

Stanley Druckenmiller gave an excellent talk early last year where he mentioned one of the two key things his mentor taught him:

“Never, ever invest in the present. It doesn’t matter what a company is earning, (or) what they have earned. He taught me that you have to visualize the situation 18 months from now… Too many people tend to look at the present…”

Buffett has mentioned closing his eyes and visualizing where a company is 10 years from now, or being happy owning the stock if the exchange shut down for five years.

I don’t think it matters what the exact length of time is, but the point is that when you make an investment in a stock, you’re buying a piece of a business. When I look out to a certain point into the future, whether its 18 months or 5 years, I’d rather try to focus on a company that I think will be doing more business, have greater earning power, and be more valuable than it is today.

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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.

21 thoughts on “Two Key Checklist Items

  1. Some excellent points here John!

    I watched Pabrai’s investment in ZINC from the sidelines and scratched my own head. “Maybe” I thought to myself, but there were just too many of these “maybe” variables to make it a good business (#2 on your list)

    Your point about leverage is well taken, but with interest rates so low, is higher leverage really a bad idea?

    I can think of one “cheap” company off the top of my head that fits the bill with a 1.5 times debt to equity ratio. Yet only pays a meager 3.3% (combined) interest-rate on that debt. Operating income covers that interest expense by 10 to 20 times.

    I would have to play some very big “what if” scenarios before that kind of debt situation became a problem.

  2. Agree with everything you said in the article.

    One of the issues that gets overlooked with with higher probably bets (good companies) is that the position size can be greater. You can’t for example put a large position on Fannie Mae because of the binary nature of an uncertain outcome.

    On the topic of the GSEs, what probably would you put on success there?

  3. John- you’ve talked a lot about Wells Fargo in the past and have mentioned liking their TARP warrants. How would you assess the health of the underlying business and risk of the common stock/ warrant investments going forward?

    1. I sold my shares on the news of this settlement. I was disappointed about the management response to this fraud, and I’m concerned that the brand image that Wells Fargo has enjoyed could potentially be tarnished. It’s not as cheap as some of the other bank stocks I own, and if this results in any (even modest) attrition in checking accounts and the customer base, it could have a meaningful impact on the value of the company. Most of all though, I just don’t want to be part owner of a business that was seemingly nonchalant about the fraudulent behavior that was going on inside the retail bank. That said, this isn’t an existential risk to Wells at all. The majority of the public is unfamiliar with this story. Wells will still do business with tens of millions of customers. And the dollar amount of this mess (both in terms of the fine and the actual money that was removed via fees from customer accounts) is miniscule in the scheme of things. But I do think that the scale of this fraud (5300 employees and 2 million accounts) is big enough to indicate a problem with the culture. The culture is a main reason for the premium valuation that Wells has enjoyed over time. I still think banks are cheap, and I still own two other banks, but Wells is not nearly as cheap (even after this decline, which wasn’t that much considering the negative consequences that could possibly come to fruition).

      I think the valuation is just average, but I think if this develops into a larger issue then customer attrition comes into play, which is a problem for a bank like Wells that relies on its huge business that it does in the retail bank (57% of its income comes from the retail bank, of which a large percentage is high margin revenue that comes from cross-selling, the very practice that it will now almost certainly begin to slow). The bank has always relied on its image and reputation, which deservedly gave it a premium valuation. I’m not sure the valuation will be given as much going forward. We’ll see.

      Mostly I sold because I just don’t want to be a part of such widespread bad behavior toward customers.

      Here are a few clips from a recent letter I wrote to my investors regarding Wells Fargo:

      I have decided to sell our shares in Wells Fargo after spending more time thinking about the situation currently going on at the bank. We had a small position, but given that I recently established the position I thought you might want to know why I reversed course. Many of you might not know, but Wells Fargo has been fined for opening roughly 2 million fake accounts and around 500,000 fake credit cards under client names without the clients knowing. The company had an incentive structure that paid bonuses for selling new products, such as a new checking account, a home equity line, or a credit card.

      To achieve lofty sales goals, employees began opening fake accounts under client names, and drafting small amounts of real money from client accounts to deposit into these new “fake” bank accounts. The fees were usually labeled as some sort of small transaction fee. This didn’t really do anything profitable for the bank, but it allowed bank managers and other employees to achieve bonuses based on a certain amount of products being “sold” to customers.

      On fraud:
      I have a simple rule: I don’t want to own a company that is engaged in fraudulent behavior. There is always the possibility that this type of behavior could exist in an organization with 268,000 employees, so it’s not to say that companies have to be perfect—there will always be a few bad apples.

      But what troubles me is the extent of the fraud (2 million fake accounts involving 5300 employees), and worse, management seemed content to try and sweep this under the rug instead of addressing it head on by holding upper level managers responsible for the behavior of those in their departments. It also took a CFPB action to put an end to this practice.
      For example, we could look at Warren Buffett’s investment in Solomon Brothers back in the early 90’s as a model for how to address bad behavior within an organization. At that point, there was fraud going on within Solomon, and Buffett came in and cleaned house, saying at the time to Congress:

      “Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.”

      Here is a clip of the 1991 Senate hearing, and an example of how a management team should react to such a scandal: https://www.youtube.com/watch?v=7u7-UNSkr4o

      Buffett has also more recently stated the following:

      “Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people, and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect in minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety.”

      Ironically, WFC is one of Buffett’s largest holdings, and so it will be interesting to see how he deals with this situation. My guess is he’ll try to defend the bank somehow, and thus defend his large investment. But I’m not interested at all in owning this company at this time, regardless of the outcome.

      Those are just a few comments. Maybe I’ll do a post at some point.

        1. Well, it’s very unlikely that I’ll get to ask a question. Odds are slim among 40,000 shareholders. But yes, I would love to ask him about his thoughts on Wells, and my guess is he’ll come out publicly and defend the bank (and his large position) if this situation gains more traction. Buffett is powerful enough that he can effectively force John Stumpf out if he wanted to. I think Stumpf has done a terrible job managing this situation (both before it became public and especially in recent days by reluctantly (only after being prodded) taking responsibility for the situation). The leadership at the bank leaves a lot of question marks.

          The bank itself is still very strong, has a solid balance sheet and a great retail franchise. But this situation narrowed their moat in my view. You can’t make this type of mistake on this scale when your number one advantage has always been a Main Street, retail focused bank built on reputation and trust.

          If I have to guess, it probably turns into more or less of a non issue. But given the events that have transpired, I don’t really want to partner with this management team. My guess is they’ll stay (Stumpf at least). If this continues to get worse, then maybe the board makes a change (at the prodding of Buffett). Either way, I can’t imagine him selling his shares given the decent valuation, the huge deferred tax liability, and the history he has had with this company (not to mention the size of his position).

      1. John, thanks for the generous reply. I’ll be interested to see if Charlie Munger comments on the matter given his scathing remarks on Valeant in the last year.

  4. JOHN,
    EXCELLENT ARTICLE. I FEEL THAT VALUE INVESTORS LIKE PABRAI, BILL ACKMAN ARE VICTIMS OF THEIR OWN INTELLIGENCE. PABRAI’S INDIAN INVESTMENTS IN JAMMU AND KASHMIR BANK, SOUTH INDIAN BANK WHICH HAVE HIGH NON-PERFORMING ASSETS WAS SHOCKING AND IS A LEARNING FOR INDIVIDUAL INVESTORS.

      1. Based on his comment, Sundaram likely knows much more than I do about those Indian banks. I heard Pabrai mention the J&K bank in a talk he gave at Boston College in 2014. I think it appeared cheap, trading at very low P/E and P/B ratios. I glanced at the financials, but never thought about going further since I don’t know much about the Indian banking system, economic conditions, or lending practices.

  5. Nice writeup John. An additional key point about low-probability payoff situations is that the Kelly betting rule says to bet a smaller percentage as the probability of success gets lower. Thus, one has to size all the low-probability bets small, and even if one does that, there is always the possibility that they have some correlation (e.g. market or sector risk).

  6. John

    The bank’s practices were known about publicly as far back as 2013. Surely you saw this before your recent investment in Wells? I am trying to square that with your letter to investors.

    I appreciate your blog and am not trying to be rude. Just trying to understand what changed for you.

    Thanks

    1. Hi Ted,
      Two main reasons for selling: a) the extent of the behavior b) management’s response to it.

      I did read the LA times article, and the LA lawsuit was announced over a year ago as well. I have also read other articles that have indicated anecdotal and one-off examples of this type of behavior, but when you have an organization with 268,000 employees, this type of behavior isn’t surprising. It’s fairly easy to find a few bad apples to put together a story. I didn’t think those few bad apples indicated a culture issue (but I think I was wrong in that assumption). Buffett himself said someone at Berkshire right now is doing something that you wouldn’t be proud of. So I did read the LA times piece a few years back, and the SEC filings also disclose numerous lawsuits, which again, isn’t that surprising for a company of this size. But what really surprised me is that management has been firing 1000 people per year that were engaged in this type of behavior without altering the incentive structure. So it’s not that it was surprising that bad behavior was going on inside a company this large, but I just came to the realization that maybe I was wrong regarding management and the culture, given how extensive this was and the poor response to it (in my view).

  7. Great Post. This is such solid advice for any investor and highlights the power of simple rules.
    I must disagree with your point about Fannie and Freddie — in fact it was just this type of check list that lead me to fannie and freddie
    If you look at the GSEs they are
    1) great business with great return on capital
    2) necessary for the functioning of the mortgage system
    3) easy to understand business (outside of their portfolio business which is history)
    4) a “one problem” stock. You don’t have to have 10 things go your way here – only ONE — that the net worth sweep
    has to found unconstitutional which is not a low probability likelihood if you look at the facts of what happened here
    SO I think the GSEs are exactly the type of investment this checklist would highlight
    Joe

    1. Thanks for the comment Joe. I don’t have a strong opinion (well, strong enough to sit this one out), but I hope you’re right. I agree with the point that Fannie and Freddie are essential participants in the mortgage ecosystem. And they certainly aren’t going anywhere. There are no (and will be no) viable alternatives, and there is no political will to do anything that could harm the availability of the 30 year mortgage. That said, the government has been known to act unfairly before, and I have decided that I don’t want to take the other side of that battle. I hope for shareholders (and private property rights in general) that it works out, but I wouldn’t bet on it. One way I have chosen to think about it is this: why not just wait until (if) Fannie and Freddie are allowed to keep their profits and become quasi-independent again? Yes, the stocks will jump immediately if that happened, but at that point, all the same fundamentals (strong competitive position, attractive fundamentals, etc…) still apply. And it’s likely that the stocks would still be undervalued significantly. I’ve heard people say these stocks are 10-20 baggers (some say even more). My guess is the stocks won’t rise 10x overnight if this works out in favor of shareholders. This is a rare situation where I’d rather wait until the situation works out, because although the stocks will be much more expensive, they likely will offer much better risk/reward at that point. There is still a lot of downside currently, given the government’s ability to drag this out.

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