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:
- Do I understand the business?
- Is this a good business? (Competitive advantages, high returns on capital, etc…)
- Is management competent and ethical?
- 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:
- 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.
- 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.
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.