Part 1 in a series of tutorials on value investing, the mispriced markets way.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The 5 Year P:E
Part 4: Hitting The Books
Part 5: How To Find Winning Stocks
Part 6: When To Sell
An Introduction To Value Investing
You can approach investing from many different angles. Some investors focus on dividends. Others are drawn to growth companies. Adherents of technical analysis spend their time looking for patterns on stock charts while fundamental analysts pore over financial statements. There are passive investors and momentum investors. Day traders and “buy and hold” investors. Even amongst the community that label themselves value investors there are a variety of approaches. Here, some focus on earnings while others emphasize book value or free cash flow. Warren Buffett devotees spend their time looking for moats while Peter Lynch disciples search for growth at a reasonable price. Followers of Joel Greenblatt and his magic formula will spend their time calculating returns on capital and enterprise values.
I’m not going to talk about all of these competing ideologies. I’m going to talk about the way I invest. With some relatively minor refinements and enhancements along the way, I’ve been investing essentially the same way for close to 30 years. And my track record suggests that my approach is as good a one as any and, in fact, far, far better than most.
Bargain Hunting
I’m a value investor at heart. That means I love a good bargain. I spend my time scouring the market looking for undervalued gems the same way a savvy shopper might hunt through the clearance rack of sale items at their favourite clothing store or a car buyer might make the rounds of the local used car lots looking for the best deal.
In order to find those value opportunities I need to know what I’m looking for. I need to know what the characteristics are that make a good investment in the first place. The used car buyer will have a list of features that are important to them. They’ll look for low mileage. They’ll look for any sign of rust on the underbody. They may want leather seats or a sun roof or favour a certain car make and model with a history of good reliability. They probably won’t get everything on their wish list. They’ll have to make compromises, balancing the price they’re paying against their list of nice to haves. Ultimately, they’ll want to get the most car for the least amount of money.
That’s exactly how value investing works. When I’m looking to add a new company to my portfolio, there are a variety of characteristics that I like to see. Ideally, I’d like a company with a number of different avenues for future expansion. I’d like them to be in a strong financial position with a limited amount of debt. A big pile of cash sitting in their bank account would be even better. A good track record of past performance is a definite plus. A lack of strong competitors, a diversified set of customers, a proprietary product that no one else can copy; these are all nice things to have. But just like the used car buyer, I probably won’t get everything on my wish list. I’ll have to balance the price I have to pay with the features that I get to find the best deal I can.
I don’t need to own the biggest companies or the best. Instead, I’m looking for the best bargains. The stocks whose prices don’t accurately reflect the full value of the company.
When I find such a stock, I buy it. And then I wait. I may be waiting for 6 months or a year or two or three. But more often than not, if I wait long enough, other investors begin to see the value that I saw and they bid the share price up until it reaches a more reasonable level. At that point, I sell my position and move on to the next opportunity. Wash, rinse and repeat. Do this over and over again and your portfolio will grow and prosper.
Buying Companies, Not Stocks
I use some mental tricks to help me frame my investment decisions in the right way. When I buy a stock, I like to think of myself as buying the entire company. I often talk about the companies I own, not the stocks I’ve bought. While I may not have the wherewithal to take over entire companies, when I buy a stock I am nonetheless buying a part ownership stake in the company and I make my investment decisions accordingly.
To me, the stock market has always seemed almost too good to be true. With the simple push of a button, I can buy a piece of a profitable, growing company. With that little twitch of my index finger, I instantly become a part owner of the enterprise. From that time onward, everyone from the CEO on down to the mail room clerk is now essentially working for me. While I’m out skiing or having a coffee at the local coffee shop, there is some Harvard trained MBA working their fingers to the bone to make my company the most successful it can be. And it gets better. I can pick and choose out of a smorgasbord of thousands of different companies. If I don’t like the look of one, I can move on to the next. If I’ve done my research well, I can buy stakes in profitable, well run companies with lots of potential and I can buy these stakes at fire sale prices! If things don’t turn out as well as hoped, I don’t have to lose sleep worrying about how I will keep the lights on at my factories or how I will meet next week’s payroll. With another click of a button, I can sell my stake as easily as I bought it and move my money into a more promising situation.
After all these years, I still can’t believe that this is how the system works. It doesn’t seem fair. It seems too easy. There are pitfalls to be sure. Investing is no walk in the park. But it’s not rocket science either. Successful investing, in my opinion, starts with this core concept: when you buy a stock you are not buying a piece of paper or a ticker symbol or a lottery ticket, you are buying a piece of a very real business. You are becoming a part owner of that business, and if you treat your investment this way, paying the same care and attention into it as you would if you were the sole proprietor, you stand an excellent chance of coming out ahead.
Buying For The Long-Term
I take this thought process a step further and generally consider myself to be buying a more or less permanent ownership stake in that business. I like to buy with the idea that I am prepared to own this business for the next 10 or 20 years, through boom periods and through busts. If I am not comfortable owning a company for the long haul then I don’t buy it. If something goes wrong, I don’t assume that I will be able to “get out in time”; I assume that I am riding this puppy all the way down to zero. (And, in fact, I’ve done just that on a number of occasions.)
This way of framing your investment decisions naturally leads you to make healthy choices. You’re much less likely to take a “flyer” on some hot start up company. You’ll be paying keen attention to the risks associated with an investment and the financial strength of the companies you are buying. And if you’re focused on the long-term prospects of a business, you won’t be relying on a “greater fool” to come along and bail you out of an ill conceived investment.
This approach ensures that my portfolio is built on a solid foundation. While most of my money has been made from opportunistically buying low and selling high, when I buy stocks with the idea that I am prepared to be in it for the long haul, it means that I don’t get shaken out of the tree when things go south. (As they have very dramatically on more than one occasion over the last 30 years.) I could hole up in a fishing hut on the beach, Rip Van Winkle style, for the next year and be confidant that my portfolio would still be in good shape a year later when I returned from my sojourn. This confidence is what lets me sleep well at night and what lets me make the bold, contrarian choices that have fueled my superior stock market returns.
One of the greatest advantages that a small, private investor has (and there are many) is this ability to adopt a long-term outlook. So many investors and so much of the Wall Street machine is geared towards immediate gratification and short-term results. If you can take the long view, you can find incredible opportunities that the myopic masses have missed.
It’s All About The Price You Pay
But at the same time, I am not a buy and hold kind of investor. There is a perfectly legitimate style of investing where you simply accumulate a portfolio of successful companies and then hold them forever. Every so often you’ll hear stories of grandpa’s heirs uncovering a fortune in General Motors and IBM stock that had been quietly growing and compounding for decades and that no one knew about.
I’m a good deal more opportunistic. While I like to be prepared to hold for the long haul, I’d much rather score a win as quickly as possible and move on to the next undervalued opportunity. It’s the repeated cycling from undervalued to fairly valued (ie buying low and selling high) done over and over again that has allowed me to post such impressive rates of return.
In order to enjoy this repeated elevator ride you need to learn how to identify those undervalued opportunities. It’s not so much about how good the company is that you are buying, it’s how good a deal you’re getting when you buy the company.
I typically run a small, concentrated portfolio of a dozen or so stocks. Apart from my house, my entire net worth is tied up in this handful of companies. Given this, the price I’m paying for these businesses becomes crucially important. Overpaying for even a few of these holdings can put a significant dent in my long-term results.
To a value investor, the price you pay is more important than the company you are buying. There are thousands of companies out there (tens of thousands if you’re willing to venture further afield). There are great companies, good companies, mediocre companies and to be honest, quite a few pretty crap companies. All of these companies have a price. The great company will obviously be worth a good deal more than the mediocre one, but both have value. The great company can be a terrible investment if the price is too high (something we see again and again in the markets) and the mediocre company can be a wonderful investment if the price is low enough. I have bought great companies. I have bought mediocre ones and on a few occasions I have even bought the crappy ones. (Although in those cases, I typically have good reason to think that they aren’t quite as crappy as the market believes.)
In each case, The price I was paying initially was low enough, relative to the value of the company I was acquiring, that I stacked the odds heavily in my favour.
Great Companies Don’t Always Make Great Investments
This is the key concept that many investors miss. They find great companies and think that will make them great investments, but it doesn’t. The two are very different things. Imagine you are a successful businessman looking to add a new business to your growing empire.
You spend months kicking the tires of various businesses and finally find one that you like. Would you then go to the owner and say “I love your business and I’d like to buy it. Here’s a blank cheque. Just write whatever you feel like on there.”? Of course not! And yet, this is exactly how many investors approach the market. They find a company they like or that their broker recommended or that they read an article about and they buy the stock without any consideration of whether the price they are paying is proportionate to the company they are buying.
A more value-oriented approach would be to find a business you like. Research both the business and the market carefully so you have a good sense of what similar businesses are selling for and then make the owner a lowball offer. If he refuses, move on to another business and try again. Maybe try to search out a business where the owner is incentivized to sell and see if you can wrangle yourself a deal.
Be Selective
One of the biggest keys to my success over the years has been my selectivity. As a small investor you have the advantage of running a concentrated portfolio. You don’t have to own hundreds of different stocks from every sector of the market. You don’t have angry investors breathing down your neck asking why you don’t own any shares in whatever the popular “it” stock of the moment is. You can take your time looking for the best bargains. The perfect combination of price and features that will set you up for success. The key is to be choosy. Learn how to walk away from a deal if it doesn’t look quite right. There are many times when I have abandoned a potential investment after spending hours researching it because I came across some item in the small print at the back of a financial report that just didn’t sit right. No one is holding a gun to your head and demanding that you buy a stock. Learn how to say “no” and say it often. You are looking for the very best deals that you can find. 10 or 15 well chosen stocks are enough to provide broad diversification. Out of a market of hundreds or thousands of stocks there are likely to be a handful of exceptionally good deals to be found. Try to own those and only those.
If I wasn’t buying at a discount then, over time, I should expect to simply match whatever the overall market is doing. This is known as the efficient market hypothesis. The idea is that any piece of news about a company, both good and bad, is already priced into the stock. A great company will naturally be worth more than a crappy company but that will already be fully reflected in the stock price if the market is functioning properly. The result is that the future stock price performance of the two different companies is likely to be quite similar even if the underlying performance of the companies themselves is very different.
In other words, you get what you pay for. You can buy a top of the line appliance that will last you 30 years and pay dearly for it or a piece of crap made to wear out after 5 years and pay much less for it. In the final accounting, if the free market is functioning properly, both items should be priced for a similar end result. ie the 30 year appliance should cost about 6 times as much as the 5 year one. You could buy 6 different 5 year appliances in succession or one 30 year appliance and spend the same amount of money in the end.
Likewise, in the stock market you could fill a portfolio with high quality, blue chip stocks or a bunch of poorly performing dogs and you should expect roughly similar outcomes in the end. The popular companies will likely perform better, but you’ll have to pay dearly to own them. The laggards may be less successful, but you can buy them for a song.
For the most part, this is indeed how the stock market operates. It is mostly efficient. But only mostly. Thankfully, there are times when prices do get out of whack. The 30 year appliance may be priced as if it will last only 15 years or the 5 year appliance might be priced as if it will break down tomorrow. A value investor spends all his time looking for those mispricings.
The value discount is the secret sauce; that is what drives superior returns. Most stocks are not heavily discounted. After running all the numbers, you’ll usually come to the conclusion that the company you’re looking at is priced fairly, more or less. The market is not perfectly efficient by any means. It does make mistakes. But the collected wisdom of thousands of investors, all acting independently, does a reasonably good job at keeping stock prices relatively coherent.
If you look long and hard enough, though, you can occasionally find stocks whose share prices are severely out of whack. People will tell you that value investing is dead. That there is no point in trying to hunt down bargains because the Wall Street professionals will have beaten you to the punch. Or that AI has made old-fashioned human brainpower obsolete. None of this is true.
There are still mispriced opportunities out there. I’ve been at this game for many years and I see just as many mispriced stocks out there now as I did 20 years ago. They are not common. They are not easy to find. They never have been. But they do exist.
Learning how to identify those mispriced opportunities and get those market beating returns you’ve been looking for, is what the rest of this series is all about.
In the next post in this series, Part 2: The General Store, I’ll elaborate more on how I begin to assess the value of a company.