How to Be a Value Investor in Software

Dec 29, 2016 by Jon Hook in  Featured

Travis Cocke is a featured instructor at Best Ideas 2017.

Is it possible to be a value investor in software companies?  Traditionally, growth investors have ruled the space.  If you are not growing revenues (hopefully accelerating), the narrative you get is your company is a broken story that is likely on its way to irrelevance and is most likely a value trap or eventual take under…so the conventional thinking goes.  However, over the years I have noticed commonalities amongst the software winners I’ve held and ones that did not pan out or became value traps.  In the article below, I’d like to share with you how I think about software companies using a value oriented framework.  These are tools and tricks that I’ve stolen from other people but I think are still underutilized and representative more of software investing than in other industries.  The four core topics are:

  • Intro: Understanding the Software Business Model
  • A Framework for Margin of Safety in Software Stocks
  • Underused Valuation Metrics
  • The “Voss Sauce” of Software Value Investing

Intro: Understanding the Business Model

Software companies generally fall into one of two buckets when defining how they sell their software:

  • Perpetual Licenses: The customer owns that version of the software, permanently. The key term here is “that version.”  The strategy here is to release a new version of the software with so many important features that every 3-5 years that customers buys a new perpetual license.  When I bought Microsoft Office, for instance, I owned that software forever, until I wanted to upgrade to a new version.   As a general rule of thumb, software companies will sell a license that includes the first year of maintenance/support.  After that, the customer often pays ~20% of the license as part of a recurring maintenance revenue.  Generally in an enterprise setting maintenance is a required part of the perpetual contract.
  • Subscription/Term Licenses: The customer is renting, not owning, the software, hence the buzzword SaaS, or Software as a Service. Usually a customer pays a fixed monthly or annual (or sometimes multi-year) subscription fee. Think of this type of service as “Netflix style.”  You didn’t buy the DVD, you are paying for the right to view it over your subscription period.  The big difference is that, embedded within the subscription fee is both the license and maintenance revenue, all rolled into one.

So which is better from an investor standpoint?  If all things are equal (a huge if, discussed further below), I would prefer my company sell exclusively monthly or annual subscription services.  There are two reasons for this:

  • Modeling uncertainty: Licensing revenue is going to be lumpier and harder to predict, hence you will get more surprises and of greater magnitude. You will have to make more assumptions about how many old customers will upgrade to the newer version and replenish licenses.  In my view it is harder to value perpetual license revenue, which would, all things equal, raise the cost of equity and lower intrinsic value.
  • Lifetime value of customer is higher This is much more debatable, but again, all things equal, the NPV of a customer will be higher under a subscription model.
  • Renewal costs lower This may sound counter-intuitive since you need more frequent renewals, but from my experience the bigger the upfront purchase (e.g. a new license), the more sales people and more expense that is involved, and often with monthly or annual subscriptions closing a renewal is rather simple and uncostly (and preferably won’t involve another sales commission).

Let’s take an example where we assume that a company can either buy the software as a perpetual license for $100 and then pay $20/month in maintenance, or they can pay $50/year via subscription, which includes maintenance.  As you can see, the cumulative lifetime revenue starts out higher with perpetual but by year 3 the subscription has cumulatively added more revenue:

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Now those astute in finance know that cash in year one is actually more valuable than cash in year five.  If we apply a 10% discount rate to all revenues, here is what we get:

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The picture is basically the same, but the spread tightens so that in year 3 it is equal and it’s only in year 4 that a real advantage to subscription occurs.  Another way of looking at this analysis is that the two models, ceteris paribus, are basically equal if you assume that every three 3-4 years the customer will buy a new perpetual license.

In addition to license/subscription, there are basically two different ways to deploy the software:

  • Cloud: This means all the information is being stored somewhere in a big data center, away from the company. If we are thinking in email terms, Gmail is a cloud email service.  Cloud connotes that if you have a browser and internet, you can have access to the software (e.g. it doesn’t have to be installed on your laptop or desktop).  From a cost/benefit analysis perspective, the cost of running the software (those big computers called servers) are generally paid for by the company selling the Cloud software.
  • On Premise: This means the software is installed, stored, and run locally with on-premise hardware.

A common confusion point is that people equate SaaS/Subscription software with Cloud software.  While most Cloud software does run on a subscription model, in reality there are plenty of companies that sell On Premise software via Subscription (e.g. Quorum, QIS CN. The opposite is rarer, it is hard to find many Cloud vendors who sell perpetual licenses).

A Framework for Margin of Safety in Software Stocks

I have a screen that immediately gets me interested in a software name:

  • FCF positive/neutral
  • Annual Customer retention >90%
  • EV/ (Maintenance/SaaS Revenues) = < 2.0x

If the company is larger (e.g. $1 billion market cap and up), I’ll raise the EV/Maintenance Revenue ratio to 3.0x.

This is broad brush stuff. There are dozens of important caveats to this basic premise, but the general idea is that maintenance revenues are very high margin and relatively predictable in a run-off scenario.  If the company is also FCF positive you know it at least has enough scale to likely be sustainable. You can use a modified annuity formula to come up with the implied value of each dollar of recurring revenue, as illustrated below:

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If you buy a company that has shown itself capable of scale and being somewhat cost conscious (ergo FCF positive), at 2x recurring revenues, and 90%+ customer retention, in my view the bet starts to become asymmetric to the upside because a) often times the assumptions above prove to be conservative, especially 10% customer declines perpetually and a 35% tax rate b) additional unforeseen bad things will have less negative impact on the price than unforeseen good things having a positive impact c) there is greater likelihood the company will get bought out as the strategic EBIT margins will be higher from a buyer’s perspective.  The incremental EBIT margin of high quality maintenance revenue is higher than 65%, generally (sometimes 85-90%) and thus attractive to an acquirer who could cut costs and fold the revenue into their existing support structure.  It is very rare for a software company to get bought out for under 2x maintenance or SaaS revenues unless it’s hemorrhaging cash or has some other major problem (e.g. accounting or major customer concentration issues).

The above general equation is just a starting framework and each company is obviously unique.  If the company’s long term effective tax rate is 30% and they can maintain a 65% run off margin and only lose 5% of their customers a year, you get this:

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If the company needs to sacrifice some margin to maintain a 0% growth (more spent on renewals), it can result in a higher multiple as shown below:

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Cost Structures and Run-Off Margins

As a Value analyst, a critical element is what an eventual runoff margin could be if the company chose that path.  Running this exercise in nauseating detail is helpful because a) it helps you get a deeper understanding of the cost structure and b) it helps inform not only a downside but also how a Strategic (or Financial) acquirer might value the maintenance revenues.  For each area, I am trying to get an idea of what is currently in the “growth” bucket and what is in the “maintenance” bucket as this can inform my eventual goal of figuring out run-off margins.

Cost of Goods Sold (COGS)

There are two very important things to figure out here: 1) what goes into the COGS line (on a cash basis, separate out any depreciation/amortization) and 2) what is the gross margin on maintenance/recurring.

You will want to find out what the company is putting into their COGS line.  Ask specifically, “what costs go into your COGS line?” to find out, if it’s not explicitly laid out in the Q/K.  What I would expect to find is the following:

  • Hosting costs for cloud products
  • Maintenance costs (e.g. support center plus other salaries geared towards support)
  • Implementation costs
  • Training costs
  • Depreciation of capex, specifically if the company built server farms themselves

Ideally the company will break out their COGS by source, e.g. COGS for support, COGS for implementation.  If not, this is a great question to ask.  Specifically, you want to get a sense for the COGS on the recurring revenue.  This gives you the underlying gross margin on the renewal business, and it should be quite high, ranging from 70%-90% for a good software company (rising higher as scale rises).

Gross margins (as an aggregate percentage) can be quite misleading.  For instance, a company must often front lower margin implementation/training costs to get a customer up and running.  Thus, a company that is doing gangbuster business may see a material decline in gross margins (again, as a percentage, not necessarily gross profit dollars unless implementations are a loss leader).

Sales & Marketing (S&M)

S&M might be the most challenging as there are so many elements to it.  There is a fixed element to it (sales salaries), variable element (commissions), discretionary (marketing budget).  Ideally you would like to get from management/IR the following:

  • Breakout of Sales and marketing expense– sometimes never disclosed, sometimes only disclosed in the K. If management won’t give you exact data go back through the last few Ks to see if it’s disclosed, to get a sense of how consistent it is.
  • Commission rates and structures– ask the company how they incentive their salespeople specifically. If it’s a perpetual license, do they get some percentage of that license and then some percentage of maintenance?  Walk through a typical client buying the typical software first to understand what a salesperson receives.
  • Renewals vs. new sales- especially important for subscription and term license deals is what the salesperson gets on an ongoing basis. I’ve heard vastly different things here.  Some companies simply give the salesperson a piece of the original license sale, or a percentage of the first year’s subscription.  Others get nice healthy checks simply by resigning a renewal or even for auto-renewals.  This is actually critically important when considering runoff margins.  If the company is paying the salesperson for renewals, it implies the renewal takes some effort and that retention is more challenging.  Or, alternatively, the company is being run more for the employees than the shareholders.  All things equal I prefer a divided sales structure, e.g. some part that focuses on new sales and a point where that client transfers over to a centralized renewal center.  This structure gives me more clarity on what I could cut in a run-off scenario, plus seems more efficient.
  • Non-direct channels- it’s important to know how sales made outside of direct, company owned sales people are handled. For instance, if you sell some of your software through a computer OEM sales team, how does that work its way through income statement?  If the indirect channel gets a 30% cut of the license, is the revenue recorded as a net sale (meaning it will be higher margin because the cost of the OEM take is already accounted for) or a gross sale (meaning additional sales expense will be added).

You may hear many in the industry talk about Customer Acquisition Cost, or CAC, which is mostly some derivation of comparing S&M costs to new customer additions.  This is then compared with the Lifetime Value of the Customer as a ratio to see if acquisition costs are used effectively, with the general school of thought being the LTV needs to be at least 3x as a high as the CAC for a healthy SaaS company.  There are some good references on this here and here.  While I think analyzing a company’s marketing spend and how it drives new sales is important, I find these metrics can suffer from false precision, as generally you are working with limited data and doing some guesswork, and the CAC can be distorted easily.  For instance, a CAC could temporarily decline if the company is launching new products it intends to upsell and ramps S&M ahead of demand.  I also view it as more relevant for growth investments than value investments.  Nevertheless, this is an industry standard metric one should be familiar with when thinking about Sales and Marketing spend.

Growth bucket: new sales salaries/commissions, discretionary marketing dollars for new business

Maintenance bucket: sales salaries focused on retention, commissions on existing clients, mission critical marketing dollars designed for brand retention/renewals.

Research & Development (R&D)

R&D is the real “invested capital” when we are thinking about ROIC for most software companies.  It is challenging in the sense that growth/maintenance/one-time is often not disclosed like an industrial might disclose maintenance vs. growth capex.  It’s also a mistake to believe R&D can be hacked down in a run-off scenario too much.

  • Capitalized R&D– the most common way I know of to manipulate EBITDA is to capitalize R&D vs. expensing it (well, that and stock comp). When comparing any two companies, it’s critical to normalize this factor when looking at EBITDA metrics.  Also, if the company is reporting FCF but excluding capitalized R&D that is a red flag.
  • Maintenance vs. Growth R&D– this is challenging to figure out, and usually not reported, but in some cases you can get a sense for the developer base that is covering current products vs. those covering new products. There may also be “one off” development work, particularly if the software company does customizations to their software, or if there is integration work being done to outside software parties

Growth bucket: new modules/projects to existing software meant to be cross-sold, one-off integration projects

Maintenance bucket: salaries for developers working on maintaining primary software

General & Administrative (G&A)

Unlike companies in other industries, software companies tend to separate Sales & Marketing from General & Administration, as opposed to the broader SG&A that most companies report.  This can make screening on strictly G&A levels more challenging.

I view G&A at a good software company as the most fixed cost and the one that benefits the most from scale.  A tiny software company may spend 20-30% of sales on G&A while a more mature midcap to large cap should probably target closer to 5%.  Ultimately these costs include things like: upper management salaries, legal, accounting, human resources, travel, corporate development/treasury, and potentially rent for leased office space.  Since this can cover a broad spectrum of things, it’s important to get an idea of what is there.  For companies that grew a lot early and then slowed, there can often be a lot of fat here that could be cut in a run off situation.

  • Management salaries and total comp- generally the most egregious spending will be management paying themselves, so try and bucket this off. In a runoff situation or acquisitions by a strategic buyer a lot of these costs can be cut down.
  • Historical analysis- one thing I like to do is look at the absolute level of G&A over time. As mentioned, most of these costs are fixed and should be growing much more slowly than the company is growing, and can serve as a reference point as to what the company could get back to if it needed.
  • Takeout analysis- this is one place where takeout analysis diverges from run-off analysis. In a runoff, most G&A costs may need to be kept.  However, in a takeout, this is where the largest redundancies are located.  Therefore, in a runoff analysis you want to be a bit more conservative in what you can cut from G&A (especially if it’s at or above comps for its size), while in a takeout scenario analysis you can probably safely cut a bit more.

Growth bucket: HR additions, senior level management salaries, some rent expenses

Maintenance bucket: Most rent, some management expense, technology (ERP) expenses

Free Cash Flow

There’s been times someone has come to me with a software idea claiming it is growing 30% and trades at 3x recurring revenues.  Upon inspection, while the person is not making the numbers up, a murkier story emerges when I see the cash burn and numerous equity raises over the years. A company that is FCF positive (or at least has been FCF positive in its recent, current state) shows me that they not only can achieve scale and that the they have a real business, but also that management is acting responsibly and managing the company’s money like it’s their own and not engaging in the RGAAC (Revenue Growth At All Costs) strategy or Empire Building strategy.

We can have intelligent debates about cash burn.  If the company’s market opportunity set is available it may in fact be the right call for them to burn cash in the short run to acquire customers, build new products, and expand operations.  The problem is, I need to know so much more about the growth opportunities and visibility of said opportunities to get comfortable with the cash burn, or trust management so intrinsically (very rare), that I generally dismiss a company from my value investor universe that is actively burning cash and wants to continue to “invest in growth” (code for burn cash).  I prefer companies that can self-fund their own growth and have shown a history of at least breaking even.  I may miss out on some true home runs by sticking with this methodology, but I also feel more secure about the Enterprise Value I am working with and can more reliably get a sense for true downside.

Questions to ask yourself:

  • Has this company ever been cash flow positive? Go back and check their history since inception and see.
  • If it was before and is not now, what changed? Did R&D go up (maybe salvageable, possibly more discretionary in nature) or are they spending more on sales & marketing (less compelling, potentially trying to throw more money at the problem to keep revenue up)? Have gross margins declined (indicative of price cuts)?
  • Cash flow quality questions:
    • Is the company generating FCF simply by signing longer term contracts and getting cash upfront? While this does have some positive attributes, check to make sure the long term deferred revenue balance is not spiking relative to overall deferred revenues.  It may mean they are signing longer term contracts at worse terms just to show strong billings that will not be sustainable.
      1. Billings equals revenue+ change in deferred revenues.
    • Is the company hiding any cash costs in traditional FCF calculation? Make sure there aren’t any funny items in the Cash Flow from Investing items (like R&D capitalization that they are excluding from their capex, or “intangible acquisition”) or Cash Flow from Financing (lease payments).  Capitalized R&D is by far the most common “trick” to show a higher EBITDA and really needs to be normalized across companies (or just use EV/EBIT).  Sometimes capitalized R&D is legit, as it really is more like “growth capex” rather than maintenance capex, but some companies capitalize practically all their R&D.
    • Is the company generating FCF simply by doling out excessive stock comp? If stock comp expense is above 5% of sales I start dinging the company on any cash it’s actually generating.   To be conservative, I ex-out normalized stock comp grants from the FCF.
Customer Retention

It is important for me to understand the long term historical churn of customers, the primary reasons for churn, and the steps/costs needed to maintain current churn.  A company that does not explicitly report its retention numbers (both customer and dollar retention) or at least verbally give updates on a retention framework is generally crossed off my list.  If the retention was great, they would probably report it.

It’s also very important to understand the most common reasons for churn.  Know that management will almost never admit to any competitive losses or people just leaving their product.  Instead they will blame the following:  sales team reorganization causing renewal delays, industry consolidation, and customers going out of business.

Even when reported, churn can be a very tricky number to interpret and get confidence in, as there are numerous ways to distort it.  For instance, you can maintain a customer by charging them 50% less.  Or, maybe you have 95% customer retention but you lose a customer that represents 20% of revenues.

Generally, I’m willing to award a higher “g” value (growth in DCF/run-off analysis) if I can see a history of customer churn, along with revenue retention (e.g. or average revenue per user, or ARPU).  Ideally, I get a history going back to the last recession, as I want to understand how recessions hit the company, but sometimes this simply is not possible.

Customer concentration is trickier, as there are two (inherently contradicting) rules of thumb:

  • High concentration in a few customers is riskier, obviously, but probably less costly to renew and support (unless those customers are mega cap behemoths that demand excess resources).
  • Extremely low concentration is less risky, but likely will result in greater costs to maintain.

The perfect company is somewhere in the middle, selling to businesses (rather than to consumers), where no company is more than 10% of revenues, but the number of customers is manageable and supportable at a reasonable cost.  For consumer facing businesses I will be inclined to lower my run off EBIT margin assumptions, all things equal.

It’s important to get a thorough understanding of the costs that go into maintaining and keeping a customer.  Some questions to get a handle on:

  • How does support work? Is there a centralized support center, or does support staff need to go to the customer’s site on occasion?  What is the current capacity utilization of the support staff?  In an ideal world, there is a very low rate of calling by customers needing support, but the support is critical enough that customers will still pay for it.  It’s important to understand the fixed versus variable cost element here. If the customer base drops 10%, do you still need pay the same number of workers to support, or can you slim down and keep the margin?
  • How does contract renewal work? Is there a sales process or is it automatically renewed until canceled?  If there is a new “bake off” every time a renewal comes up, costs to maintain the customer will be higher.  Do salespeople get commissioned on renewals (preferably not)? I prefer shorter contracts that automatically renew unless the customer steps in and cancels (assuming high switching costs and the software is mission critical), preferably with automatic price escalators over time (e.g. tied to CPI).
  • What are the switching costs? Obviously if the software is complicated and employees use it all the time, there is major pain in switching to a new platform (e.g. call it the Excel Effect for us financial analysts).
  • How mission critical is the software? If it goes down can the company function?  ERP is critical.  Data analytics maybe less so.
  • How much does the software cost compared to the competition? If it’s priced at a premium, potential churn is higher.  If it’s 50% cheaper than competitors already, that threat is mitigated somewhat.

All these questions can help you answer what a good churn value can be, and also help assist in getting to a reasonable runoff margin on maintenance revenues.

A Note on Recurring Revenues

“Recurring revenues” seems to be the new buzzword any company (not just software/tech) likes to throw into their investor presentations.  Recurring revenues are theoretically attractive because they should provide more revenue stability, but the first thing I do when I hear that a company is “70% recurring” is find out exactly what they mean by that.  Every dollar of “recurring” revenue is not equal.

The two biggest games people play with recurring revenues are:

  • Classifying lower margin contracted revenues as “recurring” (e.g. hardware maintenance or other contracts).
  • Classifying non-fixed revenue as recurring.

For #1, I don’t have any issue with this type of recurring revenue.  It is generally stable, and usually somewhat profitable, but it simply won’t have the 60%+ run off EBIT margins that higher margin software maintenance or SaaS revenue will have.  Generally, I have seen this type of revenue come in closer at 25-30% gross margin.  Thus, while the consistency may be there, it needs to be valued differently since the peak operating margin will be so much lower. Using our original framework, it could look something like this:

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For #2, the biggest potential issue is if the customer is being charged based on usage or transactions.  For example, outside of the tech arena, a company I spoke with that collects garbage for corporations considered that revenue recurring because they had signed a two-year contract that was volume based.  However, a lot of the revenue was also based on the price of metals (e.g. scrap steel) and could deviate significantly.  Some Health Care IT names and Payment Processors have a transaction charging model.  One of my favorite business models, fund administration companies (e.g. stocks like SSNC), charge based on Assets Under Administration, which can fluctuate with asset prices while still being contractually recurring.

Neither of these two issues are deal breakers, it’s just important to understand the quality and volatility of the “recurring revenue” before giving them high run off margins and low churn.

Valuation Multiples for Software Stocks

I employ three different valuation techniques that I believe are beyond the mainstream stock screening criteria.  Some stocks are less prone to be valued in this way than others, and some benefit from using all three:

  • EV/Software Recurring
  • EV/Gross Profit
  • EV/(Funds from Operations-Capex)

EV/Software Recurring

As discussed, I think this can be more effective than simply using EV/Sales as a baseline.  This valuation method is best employed when either the company has most of its revenue as software recurring (either maintenance or SaaS), or to derive a margin of safety.  As described above, even smaller companies should at least maintain a 2.0x ratio here if they have shown some level of profitability and have a reasonably stable customer base.

Sell side analysts do use this on occasion, but tend to stick with EV/Sales.

One notable exception is John Difucci from Jefferies.  Every Friday he publishes a comp table showing his estimate of what software stocks are trading at, EV/Software Recurring wise.  In his opinion, a company should trade closer to at least 4-5x its maintenance/SaaS revenues, although he is generally dealing with larger companies with superior scale.  I find this analysis helpful as he has gone through the 90+ companies in his universe and pinpointed their maintenance revenue base.  Of these 90 companies, the median EV/Software Recurring is 6.6x and the average 7.8x.  Only six are below 2x and a quick scan of those reveals they have some major structural challenges.

EV/Gross Profit

Gross profit is a nice way to normalize companies that have a mix of software, hardware, and service revenues.  A lot of vertical niche software companies will also sell hardware with the software package, usually at lower margins, which can make using an EV/Sales ratio challenging since a lot of those sales are of lower quality.   A company with a lot of hardware and service revenue may look expensive on an EV/Software Recurring because one has not given any value to the other revenue streams.

EV/Gross Profit is a nice middle ground between EV/Sales and EV/EBITDA, assuming the company is categorizing its COGS correctly.  This can be problematic, as some companies put amortization of intangibles into their COGS, or depreciation, while others do not.  Some companies dump some of their R&D and S&M into COGS, while others do not.  This needs to be normalized when comparing relative EV/Gross Profit valuations.  Scanning the entire United States Technology landscape, the median EV/Gross Profit is about 6x, so when I look at this metric I look for any company below 3x as “interesting.”       

EV/(Funds from Operations-Capex+Normalized Cash Interest +-Normalized Taxes)

This is fundamentally the same as EV/unlevered FCF except it is adding back changes in working capital and then applying the long-term tax rate to the company.  I find it to be slightly more telling than traditional unlevered FCF as a measure, as it removes what are sometimes volatile swings in working capital and sometimes normalizes a company that has pronounced seasonality in its Account Receivables and Deferred Revenues.

It’s important to note here that you want to monitor normal working capital ratios like DSO (Days Sales Outstanding) and DSDR (Days Sales of Deferred Revenues).  If A/Rs are swelling or Deferred Revenues are collapsing there could be other problems going on with the company that this metric will not catch.

I would note this ratio is also less important for faster growing SaaS companies, as the true business momentum of the company needs to include growth in deferred revenues (e.g. Billings which is revenue+ change in deferred revenues).  For a company with low to no growth that is focusing on profitability and cost cutting, however, this is a solid way to capture true improvements.  It can be compared to Adjusted EBITDA and Adjusted EBITDA-Capex and if there are large directional discrepancies (e.g. Adjusted EBITDA is improving much faster than this metric) it is a potential flag that EBITDA is being distorted.

The Voss Sauce of Software Value Investing

The dream of any value oriented software investor is that ultimately fundamentals improve enough that growth and more neutral investors begin to pile in.  This is a rare occurrence, but when it does happen it can result in incredible returns.  The largest outsized returns occur when both revenue growth accelerates (sometimes from negative to positive) along with rising margins.  While it’s hard for me to empirically prove this, I believe there is something very psychologically pleasing to hold a stock that is improving both revenue growth and overall margins.  People, rightly or wrongly, begin to extrapolate these improvements into the future (just like they were extrapolating the negative trends previously).  Even if it’s simple optics and perhaps not sustainable, these two things in concert will rarely result in material underperformance.

The way I look for these situations is primarily asset divestitures combined with management/board changes.  This signals to me that there is a change in thinking, and rather than going down the route of Empire Building the company is attempting to maximize shareholder value.

Once you spot a struggling value software company divesting assets, two additional criteria are important to note:

  • Make sure the asset being divested is the worse asset, not the better one, as when one sells the better asset it signals more desperation to me than a sustainable change in value creation thinking (HHS as a recent example)
  • Make sure the company is reasonably financially healthy (as in not about to go bankrupt) without the asset sale. Sometimes a company will “burn the furniture to heat the house” and that’s not what we are looking for here.

A divestiture does a couple things that I find attractive.  One, it simplifies the story.  Ideally the company moves from a multi-segment business to a “pure play” which almost always garners a higher multiple in the public market. Two, it temporarily makes the optics look worse for the company while setting it up to look a lot better in 12-18 months.   A casual glance of that company will show revenue declines and sometimes lower profitability (depending on how much of an albatross the divested asset is, there will sometimes be unallocated corporate costs that the asset was sucking up, or perhaps some severance costs), causing almost all screens/investors to overlook it.   However, once the noise clears up, in theory you should have a better asset (hopefully growing), stronger management focus on that single asset, and improved profitability (assuming the divestiture was weighing on profitability).

If the company is holding a “gem” asset that is growing materially, the divestiture can result in the Voss Sauce of technology investing: accelerating revenue growth and rising margins concurrently.  I believe this improvement in fundamentals will also increase the likelihood that the company gets bought out, as it’s now “cleaner” and easier to analyze for a potential strategic acquirer.

Example 1: QHR Corporation (QHR.v, Canada)

QHR Corporation is a leading provider of Electronic Medical Records (EMR) in Canada.  90% of its revenue are “recurring” and we assessed them as very high quality recurring as they were monthly subscription fees charged to doctors who used them as mission critical software.  They reported churn of 2% of less, were growing their doctor base, and the gross margins on recurring revenue were about 90%.

They popped onto our radar in mid-2015 when we noticed they were trading in around 2.25x recurring revenues (3.5x gross profit), had forced their CEO out, were marginally cash flow positive, and had made a major divestiture in late 2013.  The stock had stagnated from being a high flying growth stock into more core/value territory.  However, we did not immediately buy the name because profitability was still being plagued by another problem asset, a Revenue Cycle Management business in the United States that was hurting their cash flow numbers.

In mid-2015 they began to suggest being open to selling that problem asset, and we got very interested in the company in July, 2015, when they formally announced they had sold the RCM division.  At that point they were a full-fledged EMR pure play in a consolidating industry with strong underlying characteristics.

After digging in on the company, we believed margin improvement was imminent (given management’s focus on improving margins and guidance on cash flow improvements) given the noise surrounding the divestitures and a slight dent in profitability from a tuck in acquisition related to the EMR business.  We also estimated that at the very least revenue growth could stay in the 15-20% range for the next few years and could potentially accelerate.

What is interesting in observing the stock chart below is that the market did not immediately react to this.  Profitability still looked stunted, and there was some hand waving about the new CEO and how large the growth runway really was.  In our minds, management (along with an activist investor, Pender Funds, who had board seats) had realized that slimming down and focusing on their EMR opportunity in Canada was the way to go, and we approved.  We felt buying the stock at close to 2x the annual recurring revenue run rate, with recurring revenues growing 20% and profitability forecasted to improve, made the bet asymmetric.  We also believed, although it was not a part of the core thesis, that this evolution to a pure play made it materially more likely a strategic would get interested in the company.

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This stock hit nearly all our check boxes:

  • 25x Recurring Revenue and 3.5x Gross profits
  • FCF positive
  • Asset divestitures fully completed, with new management team
  • High quality business with low churn
  • Material chance to accelerate both revenue growth and profitability concurrently

Example 2: Merge (MRGE)

Merge is another Healthcare IT stock that sells a mix of software, hardware, and services but focuses on radiology as a niche.  It had a series of negative fundamental and idiosyncratic developments that pushed it to 1.7x sales, 3x maintenance, and 3.5x gross profit in the beginning of the 2014 when we began to get interested.  License and hardware sales went into negative growth as the adoption of ICD-10 (new billing coding) slowed down sales cycles.  The company had an incident where a rogue company falsified a few million in billings, they removed the CEO, and the company’s debt got dangerously close to breaking covenants.

New management with a track record for operational turnarounds was brought in and we were immediately impressed with their new focus on paying down debt and improving margins (nothing like a brush with breaking covenants to inspire focus).  While they did not specifically divest businesses, they did get out of selling certain types of hardware which were money losing for them, and seemed to take a holistic view towards cost cutting while still recognizing and investing in their best assets.  In addition, we felt they had two “gem” call option assets (one was a clinical trial software platform that competes with Medidata, and one was an imaging interoperability initiative to drive availability of radiology exams between hospitals).  We believed, based on the slight cyclicality of the business and clear reasons for slowdown, that both growth would return in time and that margins could improve material, making the bet asymmetric.  We also believed the optics would improve materially as much of the revenue declines were coming from getting out of the low margin hardware business.

It was pretty clear that if the company just executed marginally, there would be a 3-4 quarter period of the Voss Magic Formula for technology stocks, rising margins concurrent with improving revenue growth, which is what happened (shown below):

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From Q1, 2014, to Q4, 2014, EBITDA margins improved over 200 bps while growth went from -20% to flat.

What is interesting, and perhaps encouraging for future investments, is that there was plenty of time to get into the stock even though fundamentals clearly improved materially in Q2, 2014 (with margins improving even before that).  For a few frustrating months, we felt the thesis was playing out but the stock was not reacting.   A lesson for these value based forgotten stocks, though, is that sometimes it will take a few quarters of sustained execution before the market regains trust in the company.  Once that happens, outperformance can commence.

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Meet Travis Cocke, Managing Partner of Voss Capital.

Better Business Minds Make Better Investors

Feb 11, 2015

One of the most frequently asked questions among aspiring value investors and seasoned fund managers is, “What’s the most effective way to become a better investor?” This is of course, is a vastly broad question, with answers all over the map. Yet, there’s a fundamental common thread among the top practitioners of the value investing philosophy, that’s worth highlighting here.

The clip below is from our interview with Robert Hagstrom, Chief Investment Strategist and Managing Director of Legg Mason Investment Counsel, and author of several notable value investing books, including: Investing: The Last Liberal Art and The Warren Buffett Way. In the interview, Hagstrom attributes some of Buffett’s titanic success to him being a “great business historian”. That is, researching, reading, and understanding the nuances of the companies he buys to a degree of prodigious fluency.

“There is an art side to it,” says Hagstrom. And, like any skill that gets refined into an art, you get better the more you practice. Take for example the story about the British cycling coach, Dave Brailsford. In 2010, Dave was tasked with the job of coaching the British Cycling Team in the Tour de France, a race no British cyclist had yet won. In only two years, Brailsford team achieved victory in 2012, again in 2013, and once again 2015. The secret? Dedication to marginal improvement.

In making daily 1% improvements to the performance and strategies of his riders, the British team compounded a significant advantage over their competition. In just one year, consistent 1% daily improvements creates a 37X result. This is a calculation Buffett no doubt knows all too well, and one he’s applied throughout his business career. How exactly did Buffett develop his business thinking prowess?

Developing the Business Mind

On this subject, Buffett often says, “I’m a better businessman because I’m an investor, and being an investor, makes me a better businessman.” If you’ve read Alice Schroeder’s biography of Buffett, The Snowball, then you might already be familiar with this concept and some of the entertaining stories that exemplify Buffett’s business acumen.

From a very early age, Buffett’s business prowess was off the charts. Look back at the newspaper routes, the pinball machines, collecting and cashing in discarded ticket stubs from betting tracks, and his golf ball recycling business–all of which are evidence of Warren’s unusually sharp eye for profit.

Perhaps the best example of Buffett’s love and appreciation for business fundamentals is his decision in 1966 to acquire Associated Cotton Shops, then owned by retailer Ben Rosner. As the story goes, upon hearing Ben once counted out all 500 sheets of toilet paper to ensure he wasn’t being short-changed from his suppliers, Buffett knew he wanted to work with him. You could also argue, Buffett’s decision to acquire Rose Blumkin’s Nebraska Furniture Mart was made on similar principles.

Creating a Latticework of Mental Models

The name for this blog, comes from one of Charlie Munger’s recommendations to become a better investor, which is, to create for yourself a latticework of mental models. If you’re already familiar with this concept, then you might enjoy taking this as an opportunity to perform a new assessment of your models. If you’re just discovering this idea for the first time, than you’re in for a treat.

In the world, you have a broad array of disciplines: Physics, Biology, Psychology, Mathematics, Philosophy, etc. Mastering one such discipline in your life would be worthy of recognition. What Charlie points out however, is that you can learn the 20% of the core concepts that provide 80% of the value, without dedicating your life to the field. In his brilliant 2007 commencement speech to USC, Munger says the following:

“You have to learn these things in such a way that they’re in a mental latticework in your head and you automatically use them for the rest of your life. If you do that I solemnly promise you that one day you’ll be walking down the street and look to your right and left and think, “my heavenly days! I’m now one of the few most competent people of my whole age forward. If you don’t do it, many of the brightest of you will live in the middle ranks or in the shallows.”

In a followup interview with Robert, he discusses how you can become a better investor via the latticework of mental models.

You don’t have to see the markets as an equilibrium-based system, says Hagstrom. You can look at markets from a biological perspective, which explains some of the non-linear behavior, that would otherwise be unexplainable. Essentially, what Robert is getting at, is that understanding the principle ideas from different mental models will help you be a more prepared investor. Instead of panicking when things start behaving in an unusual manner, you have a different way of thinking about investing that restores rationality.

Summary

There’s a tremendous amount of quality knowledge resources and recommendations on how you can become a better investor. Yet, the underlying thread among the most brilliant investing minds like Buffett and Munger, is an understanding and fluency of business fundamentals. No matter if you’re just beginning your investing career or are already an experienced portfolio manager, you don’t need to be a world class investor to grasp business fundamentals, but you must understand business to be a world class investor.

Resources Mentioned:

The Snowball by Alice Schroeder

Robert Hagstrom

7 Steps To Becoming A Great Stock Investor by Earl Jordan Yaokasin, CFA

Also See:

Simon Caufield on The Genius of Warren Buffett

An Introduction of Mental Models by Farnam Street Blog

Idea Generation for Intelligent Investors

Apr 10, 2017

Idea generation is both art and science. In investing, various quantitative methods can throw up many “names” for consideration, based on criteria such as price to earnings, enterprise value to sales, or price to tangible book value. On the surface, the companies with the lowest ratios will be the cheapest publicly traded companies at the moment. However, if investing was as simple as picking the quantitatively cheapest companies and earning a market-beating return, then investment success might not be as elusive as it is actually.

Several issues arise with the use of purely quantitative methods. First, quantitative screens suffer from a version of the “garbage in, garbage out” problem: One-time items, such as a non-recurring gain on the sale of subsidiary, can inflate reported income, making a company seems cheaper on a the basis of P/E than it would be if the one-time gain was excluded. Second, even in the absence of one-time items, a cyclical business will report the highest earnings at the top of a cycle, right before income is about to decline. Third, cheap companies are often “cheap for a reason”, with the most obvious reason being that the company in question is a terrible business with low returns on capital. If a company trades at a low P/E multiple but retains earnings and reinvests them at a low rate of return, long-term shareholders are unlikely to earn a high return. Over time, shareholder returns converge with the return on capital at companies that retain the vast majority of earnings.

Every investor faces a practical constraint: limited time. If an investor had no time constraints, idea generation strategies would be much less important, as we could analyze every available idea. Time limitations force us to prioritize. Quantitative screens are one way of prioritizing companies for further research. Conversely, David Einhorn, founder of Greenlight Capital, has talked about looking not for statistically cheap companies but scouting for situations in which non-fundamental reasons may lead to the mispricing of a security.

Over the past seven years, The Manual of Ideas has queried a number of thought-leading investment managers about their idea generation strategies. We highlight some of their insights below.

stipple-portrait-allan-mechamAllan Mecham, founder of Arlington Value Management [source]:

[I generate ideas] mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know. That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

stipple-portrait-charles-de-vaulxCharles de Vaulx, chief investment officer of International Value Advisers [source]:

Compared to many of our peers, it would be fair to say that we may rely a lot less on screens. It would be easy every week to run screens globally about stocks that trade at low price to book, high dividend yield, low enterprise value to sales, enterprise value to operating income, and so forth. Generally speaking, a lot of our value competitors begin the investment process —by that I mean the search for ideas—by trying to identify cheap-looking stocks. Sometimes using screen devices they look for cheap-looking stocks and once they have identified a list of cheap-looking stocks, then they decide to, one at a time, do the work and investigate each of these companies. The pitfall with that approach is typically those cheap looking stocks that you’ve identified will typically fall in two categories. Either stocks that are of companies that operate in overly competitive industries or overly regulated industries where the regulator may not always be a friendly regulator. So you may find steel companies, or some retail companies, or the insurance industry in many parts of the world is notorious for its overcapacity and lack of barriers to entry. So, either you’ll find companies in overly competitive businesses where it’s hard, or even worse, you’ll find typically some of the lousiest competitors in their respective industry. If you had run a screen a day before a company went bankrupt, the stock probably looked cheap on maybe a practical basis or probably enterprise value to sales basis. The problem with these cheap-looking stocks of both categories is that it’s going to be hard for these stocks to see their intrinsic value go up over time. If anything, especially in the second category, the worst competitor type category, some of these companies may actually see intrinsic value go down over time.

Conversely, what piques our curiosity, what makes us want to investigate an investment idea is not that it looks cheap at first sight. It’s rather that the business looks neat or that the company seems uniquely good and well positioned in what they do, and then we hope and pray that, for one reason or another, the stock happens to be cheap. I’ll give you an example which goes back many years. Maybe 15 years ago, I was reading briefly about a company I had never heard of – Thomas Nelson, a U.S.-based company. They were the leading publisher of bibles in America, maybe in the world. They were also a leading publisher of inspirational books and I said, well, book publishing used to be a great business. It changed from being a great business to a good business. Margins went from being obscenely high to just high because authors asked to be paid more over time. I said, gee, a bible publisher… There’s not much in the way of author rights. That’s pretty neat. Next to that brief description of the business was a P/E ratio that did not look low- it was15 times earnings, a P/B that did not seem low and a dividend yield that did not look enticing. So the stock did not look cheap, but I said maybe there’s something hidden. Maybe the earnings are temporarily depressed, and so maybe the stock is cheap even though it does not look so at first blush. I was intrigued by the business, and I took a look at it and realized that the company had, for the five years just prior, started to come up with five new bibles – bibles for children, bibles for the elderly and so forth – and they had capitalized the costs of creating these new products. Now that those bibles were available for sale in bookstores, the company was amortizing over five years, or maybe three years, that cost. So now the company’s earnings per share were after a pretty big amortization of capitalized costs, which was not a cash charge. What looked like a high price to earnings ratio of 15 times was only a 10 times price to earnings before amortization of capitalized costs. So the price to cash earnings was much more reasonable. I was intrigued by the fact that the company, two years prior, had misbehaved. Since they had a good business, they had decided to diversify and buy into a difficult business. They had bought a printing business in the UK. They had borrowed money for that, but to their credit, a year later they realized their mistake and had sold that business at a loss, but they had sold it and the proceeds were high enough to pay down debt. The bottom line is that for the few people who knew that company in the past, who owned it, they were disappointed in management because of that one time mistake. I felt that, hopefully, management would have learned from their mistake.

Oftentimes, we will study over the years great businesses, whether it’s a Google, an Expeditors International [EXPD], 3M [MMM], and we keep them in mind and we have a tentative intrinsic value estimate, and sometimes there could be a crash. There can be a crisis like ’08, something happens and sometimes these stocks fall enough that we revisit them. I talked about these great businesses that are cyclical, the temporary staffing companies, most of the time they’re too expensive for us to catch, but once in a while, especially during an economic downturn, we’re able to buy them. Even L’Oreal [Paris: OR], the French-based yet global cosmetics company, a few times in the past during an economic downturn, sales slowed down and the growth guys that typically own the stock don’t want to own it, because the growth rate is not there. So they dump it. It still optically looks too expensive for the deep value guys. In other words, instead of staying at six, seven, eight times EBIT, it may still trade at nine, ten, eleven times EBIT. So the growth guys don’t want it, the deep value guys don’t want it. It sits in limbo, and that’s when we’re able to get those things. So it’s not much in the way of screening. It’s just the analysts, based on the sector they follow, and because some of us have been in this business for a long time – myself, over 25 years and Chuck [de Lardemelle] and Simon [Fenwick] and Thibault [Pizenberg] for many years – and because we’ve looked at tiny companies and huge ones, we have a pretty good idea of what the best businesses and companies are out there in the world, and we keep them in mind and try to revisit them when there’s a crisis or a big economic downturn.

stipple-portrait-bryan-lawrenceBryan Lawrence, founder of Oakcliff Capital [source]:

Voracious reading, talking to other investors, and looking for areas of disturbance in the markets that may create opportunities. It has been interesting to study the records of the great investors, and see how they generated ideas. Often the great investor works alone much of the time, which makes sense given the difficulty that two people will have agreeing on which are the best ten stocks to own. But it is very smart to find a small number of other investors whom you respect, and with whom you can share ideas. You do not have to agree on everything, and their different perspectives can enhance your own thinking. Oakcliff shares space with two other firms run by first-class people. I enjoy having a collegial environment in which to kick around an idea, but also the freedom to make my own decisions.

stipple-portrait-john-lambertJohn Lambert, investment manager at GAM [source]:

The principal method of idea generation is through the use of very long-term performance charts, which help to identify areas of currently depressed sentiment and hence probable low valuations. Ideas also come through more quantitative screening, subscription to quality newsletters like the MOI and general reading. It is best described as eclectic, and there are no hard criteria for qualification as a potential idea or inclusion in the portfolio.

stipple-portrait-larry-sarbitLarry Sarbit, chief investment officer of Sarbit Advisory Services [source]:

There are many ways of generating them. It’s called searching. It’s just a long-term search process of opening yourself up to different ideas, don’t be closed off. Ideas come in many forms and many types of businesses, and even the way you evaluate them can be different on a case-by-case basis. There’s no perfect template that you can use to be successful.

Mark Cooper, portfolio manager of First Eagle Investment Management [source]:

My number one thing I do for generating investment ideas is reading. And different people learn differently and different people process information differently. And as students of mine have heard in the past, I don’t hear very well so I don’t process things audibly very well. I don’t spend a lot of time talking on the phone to people, having conversations with other investors as smart as they may be, and often smarter than me or who have very good ideas. But sharing ideas is not something that I spend time doing. I want to look for ideas and read various sources of information, and try to have an idea of what’s going on in the world. How do I see things? Where do I see opportunities? Reading probably is the number one thing. I will use screens as well, and the reason I do that—I didn’t use it as much in the past when I was focused really exclusively on one sector and one industry—but as I’ve become more of a generalist and I have positions in companies in pretty much every sector around the world, in many different countries, I find it harder and harder to filter out from 6,000 or 7,000 maybe possible equity securities that trade above $1 billion [in] U.S. market cap. I want to filter that list down to a more manageable list, which we can watch. And we do use a quantitative approach to do that, to narrow down the universe. But the idea being it’s all about saving time, improving our search process and focusing on those ideas that might be potentially interesting at the right price.

stipple-portrait-sahm-adrangiSahm Adrangi, founder of Kerrisdale Capital Management [source]:

We’ve made some of our best investments by becoming experts in weird and unusual areas of the public markets, and using that deep understanding to our advantage. For instance, we generated strong returns on SPAC warrants in the second half of 2009, and accomplished that by becoming experts on how SPACs operated. Aside from that, we probably rely on Sumzero.com more than anything else. People post some great ideas on Sumzero, and by doing our own diligence on those ideas, we can typically build an attractive portfolio.

Mark Massey, fund manager of AltaRock Partners [source]:

It’s all qualitative stuff. We really don’t do screens. In fact, the only screen that I find useful is one that spits out companies that have been buying back a high percentage of shares. This MAY be indicative of a well-aligned management team that has great conviction in the durability of its competitive moat… but it could be the opposite, too… so you always have to do a lot of work to get to the truth. I really think the key to our success has to do with our love for the game. We absolutely love coming to work every day. I literally spend almost all of my time reading. And while it, no doubt, makes me a bit of an oddball, my greatest pleasure is to be constantly searching for wonderful businesses that, for whatever reason, are mispriced. Having done this for nearly thirty years, I have built up a lot of knowledge and understanding about many different businesses, moats and business models. The result is a long list of companies that we would like to own at the right price. And we know from experience that if we continue to be patient and disciplined, a few mouth-watering opportunities will eventually come our way.

Fernando del Pino, private investor [source]:

I run value screens mainly focused on valuation rather than on business quality-oriented measures. For instance, high ROE is nice, but statistically high ROE stocks have not proved to perform better than the market. I also avoid extremely indebted businesses, except when the market is pricing a bankruptcy that I see improbable, making the risk-reward ratio extremely asymmetric and, therefore, attractive. I try to read as few newspapers as possible. Maybe 80% of what you read is just entertainment, 10% is pure propaganda and 10% is information, some true, some false. Therefore, I think that reading daily news is a terrible waste of time and a dangerous source of noise and distraction. I follow a few outstanding investors (partly through MOI) and a few selected newsletter writers from around the world whom I’ve followed for many, many years. I also keep reading a lot of books on anything from religion (I’m Roman Catholic), psychology or history to investment, economics or medicine. Apart from enjoying reading from the point of view of culture, I hope (and believe) that it builds the right mental model overtime. Information is the lowest use of man’s intellectual capabilities; then higher up you find knowledge; and at the summit, there is wisdom. You have to aim at the latter. Too much information hinders knowledge, and very often, too much knowledge hinders wisdom – because of hubris. Today we live in a world with overwhelming loads of stupid information and very little wisdom, I’m afraid.

stipple-portrait-christian-olesenChristian Olesen, portfolio manager of Olesen Value Fund [source]:

stipple-portrait-josh-tarasofJosh Tarasoff, general partner of Greenlea Lane Capital [source]:

I have a routine that I repeat on roughly a monthly basis, which includes many of the same things that a lot of investors do. This routine generates a list of companies that are worth more work. I prioritize the companies that seem to be attractively priced, but a lot of the time I find myself researching companies in order to be prepared if the price becomes attractive in the future. Because of the very narrow focus on great businesses, I do not find as many interesting situations as many other investors do. A great deal of the work I do is simply expanding my knowledge base.

stipple-portrait-don-fitzgeraldDon Fitzgerald, fund manager of Tocqueville Finance [source]:

Investment ideas come from a number of sources, such as regular quantitative screenings, tracking of Tocqueville investments which have been portfolio holdings in the past, monitoring of the financial press, management meetings and conferences. Opportunities caused by disappointments of short-term market expectations are good targets. Also spin-offs and de-mergers where existing investors often sell without doing their homework on the new company’s real value or situations where you have a forced seller pushing down the stock price are good hunting grounds for fundamental investors.

stipple-portrait-simon-denison-smithSimon Denison-Smith, co-founder of Metropolis Capital [source]:

We get our ideas from two sources: 1. A proprietary screen that we have built with assistance from Thomson Reuters which works off their Reuters Knowledge platform. This model processes over 80 historic financial variables and uses these to calculate a first-cut intrinsic value, from which we derive a first-cut margin of safety for each company that we run through the screen. We use cash flow and debt filters to further refine the screen. 2. Reading widely in business magazines (e.g., Investors Chronicle), newspapers (e.g., the FT) and various online sources – to see if there are any companies that we have missed, which we then analyze.

stipple-portrait-ori-eyalOri Eyal, founder of Emerging Value Capital Management [source]:

The short answer is I read everything and talk to everyone. I subscribe to about 20 different publications: Forbes, Fortune, Barron’s, The Economist, Value Investor Insight, Capital and Crisis, Complete Growth Investor, etc. I also surf the leading investing websites: Value Investors Club, SumZero, Market Folly, etc. I attend great investing conferences: The Value Investor Congress, IRA Sohn Investment Conference, The Rodman & Renshaw Global Investment Conference, etc. And perhaps most importantly, I regularly talk with other smart fund managers and discuss ideas.

stipple-portrait-jack-rosserJake Rosser, managing partner of Coho Capital Management [source]:

The great thing about investing is you get to cultivate your curiosity about the world at large. I once described my job as sitting between four walls reading and thinking. That truly represents the majority of my day. At its heart, investing is a multi-disciplinary endeavor. Thus, one has to know a little about everything to make informed decisions. I often joke that one can become a real Cliff Claven in this business. Our reading diet consists of The New York Times, The Wall Street Journal, Forbes, Fortune, Business Week, Bloomberg, Barron’s and various value-oriented investment blogs. We subscribe to two newsletters, The Manual of Ideas and Value Investor Insight. In vacuuming up large quantities of information, we keep our antenna alert for informational inefficiencies. […] Apart from reading, we utilize a number of sources as a starting point to sift through ideas. These include Value Investors Club submissions and SEC filings of investors we admire. We also find that informational inefficiencies are often present in spin-off situations, busted IPOs or post re-org opportunities. Last, we keep an “On Deck” portfolio of companies on Yahoo! Finance that are worthy of further research and a “Punch Card” portfolio of what we consider the world’s best businesses. This allows us to keep tabs on the world’s best companies and position ourselves quickly should opportunities materialize.

Zeke Ashton, portfolio manager of Centaur Capital Partners [source]:

We get ideas from all sorts of places. We used to get a sizable number of leads from statistical screening, and we still use screens, but we have found them in recent years to be more productive in sourcing short ideas rather than long ideas. Nevertheless, we still scan through lists of stocks that appear to be cheap from a statistical basis and occasionally we find a good one. One of our major idea sources these days is from the inventory of the many ideas we’ve owned or researched at some point in the past – many times, after we’ve sold those stocks, the price will come back down to a level that makes them very interesting again. Since we generally already know the company, it is just a matter of getting quickly up to speed with the latest developments to determine if it is actionable. We also find occasional ideas by doing industry overviews to get to know a number of players in a specific sector or niche that we think may be out of favor or neglected for some reason. Often we will find a gem or two. Finally, we get some ideas through our network of value investing contacts, and through a number of specialized research publications that we have found are compatible with our approach, of which your own publication would be one example. But no matter the source, the ideas are merely candidates until we’ve actually produced a piece of internal research that covers the bases and gives us confidence that we understand the business, can reasonably value it and also gauge the risks factors involved.  And of course, the stock has to be cheap.

stipple-portrait-charles-de-lardemelleCharles de Lardemelle, portfolio manager at International Value Advisers [source]:

I have found over my career as an investor that the best ideas often do not screen very well. Basically, you are spotting something that doesn’t show in the numbers yet and will show over time. That happens from time to time, those tend to be larger positions or we would build them over time. But unfortunately, we don’t find enough of those. These situations are few and far between, require judgment and a vision. Those inflection points, however, can be sources of great gains or losses in any industry.

stipple-portrait-barry-pasikovBarry Pasikov, managing member of Hazelton Capital Partners [source]:

Originally, a majority of my ideas were generated by a screening tool using metrics like price/sales, revenue growth, margin expansion, cash on the balance sheet, debt reduction, 52-week lows, etc. The results were as you would expect: names of companies that met my criteria but frequently did not have the long-term results or earnings power that I was looking for. My searches then began to progress from quantitative to qualitative valuations. Unfortunately, I don’t know of any screening tools that can search for a company with a sustainable competitive edge, operating in a niche industry with high barriers to entry, requiring little to no capital expenditure, and of course, is cheaply priced when you fully understand their business model. I found that the trick to finding these companies is not to search for them. Instead, study the types of industries where investment opportunities may be hiding; an industry that could conceal an unloved, abandoned, sometimes vilified company lacking sex appeal. I also do a fair amount of reading and two of my favorite magazines are BusinessWeek and Fortune. I am not reading them for investment recommendations; I read them because both magazines do a great job of giving a quick and concise overview of different companies and their industries. Knowing which facts and metrics to focus on is extremely helpful when researching a new company. This has helped me to invest in a few companies I would definitely have overlooked simply because they would not have popped up on a screening tool. […] Ultimately, there are a number of ways to generate ideas, and like strategies, an investor should pick the ones that best suit his investment style. The one common thread is that doing your own homework is mandatory. Even though I get a good amount of information flow coming in from very trusted sources, I still find it necessary to do my own research. More importantly, when you do your own research, it makes a big difference in truly understanding whether the swoon in the price of a company’s stock is an opportunity to add at a more attractive level or whether your valuation of the company was misunderstood.

stipple-portrait-lisa-rapuanoLisa Rapuano, founder of Lane Five Capital Management [source]:

Idea generation is fairly idiosyncratic, frankly. We run screens of high-return, low-multiple names (the so-called Magic Formula) and of low-multiple names and of things that have recently moved down in price aggressively. My favorite screen is the New Low list – at least it tells me what is truly out of favor. From there, it’s a fairly labor-intensive process of going through the names and seeing if any of them look like they would be down for temporary reasons and that there are decent business models on the other side of what is causing the controversy. More often than not, we come up with ideas from much more random sources than screens: magazine articles, talking with other managers, randomly typing the wrong ticker in Bloomberg, sell-side downgrades that might signal capitulation, looking at spin-offs or recapitalizations, tracking management changes and turnarounds. In my experience, the nice neat little funnel of screening to portfolio doesn’t really work. Undervalued things are sometimes hiding under expensive-looking or very complicated rocks.

stipple-portrait-brian-baresBrian Bares, founder of Bares Capital Management [source]:

We do exactly one computer screen on market cap that identifies our constituent investment universe. From that point it is old-fashioned hard work. Our research analysts are free to follow their intellectual curiosities. I want to foster a collegial environment where people are constantly exchanging ideas. If I constrain people to specific sectors, or task them to write up a specific idea, they may not go the extra mile to get an idea as polished as it can be. We have had ideas come to the table from researching competitors. Others have materialized by visiting management simply because we are in the area. And some have come to our attention through shared board members or founders. Anytime one of our research analysts comes up with an idea, it is presented in a formal process internally. The idea needs to meet our qualitative criteria for competitiveness and management capability. We also have a very important discussion about what our advantage is in researching a specific idea. We love it when there are behavioral reasons for pervasive contrary opinions. We also take pride in knowing that our research is better than what is out there, both from the sell and buy sides.

stipple-portrait-max-otteProfessor Dr. Max Otte, founder of IFVE Institut für Vermögensentwicklung [source]:

I’m generally a man of too many ideas. So my challenge is rather how to narrow down my ideas systematically. My discipline is to stick to a rather limited universe of stocks — 200 German, Swiss and Austrian, maybe 100 international stocks — which I follow intermittingly and which change only slowly over time. I’d rather profit from price fluctuations in the securities I know than try to find new ones all the time. I read papers. I read annual reports. I have an excel-database with approximately 150 stocks. Over time, you develop expertise in certain markets. You acquire a “feel” for those stocks, when a sector or stock might become interesting and when its price is getting too high. I am also looking at a list of relative losers over five years to find interesting cheap stocks. And sometimes I take home an interesting idea from value conferences or a publication like yours. That’s not forbidden by law! Success is what counts.

stipple-portrait-adam-steinerAdam Steiner, head of research of SVG Capital [source]:

A mixture of customized valuation screens, industry contacts, and by monitoring private equity transactional activity. It’s quite hard to get the sell side to understand what we are looking for, except for a few exceptional brokers.

Philip Best, founding partner of Argos Managers [source]:

One of the things we really believe in is that there is too much investment that goes on from people who are basically just sitting behind a Bloomberg screen and who are doing arm chair investing. They are sitting there and they are waiting for ideas to come to them. And Marc and I believe a great deal in getting out there. In getting out there and meeting companies and talking with managers and we spend a lot of time traveling around France. And “A” we like that and “B” that is what we think brings the most to the job…We try and read as much of the local press as we can. Whether it’s in France or the UK, Switzerland or whatever and also a bit of the trade press. Plus, it is classic value investor stuff. A lot of the ideas have come from this idea of “idea clumping.” You know you find one cheap software company in Germany and suddenly you find a bunch of others.

stipple-portrait-jeroen-bosJeroen Bos, investment director of Church House Investment Management [source]:

The funny thing is that it is often said that finding these so-called net-nets is very difficult, but I find that if that is the only area that I look for in a relatively small market like the U.K., if you look hard enough, you’ll find them. And that is exactly what I do. By looking at companies that I think look attractive but are at levels that I find too expensive, I’m already in a much better position because I’m only having to wait for the price to drop to the level that I’m willing to pay for them and make up my mind instantly to buy them. I have done the process beforehand. By just sitting there and watching, there are always stocks that can be bought at these extreme levels. And that is all that I do. If I can’t find them, then we’ll just wait in cash until the period comes that they are available.

stipple-portrait-massimo-fugguettaMassimo Fuggetta, portfolio manager of Bayes Fund [source]:

I do unconstrained screens…unconstrained from a geographical and from a sectoral point of view. And what I look at is situations where the valuation metrics, P/E or price to book or price to cash flow, things like that, are in sharp contradiction with the history of profitability…when I can relate that undervaluation to a particular situation to a change in management, to a scandal, or to something that has happened around the company, not necessarily that particular company but in a more general context that becomes an opportunity…Greece has come down for obvious reasons, but that’s a huge hunting ground for cheap bargains…of course the dangers are very high, you have to be very, very careful but the opportunities are certainly there. Same I would say for Spain and for Italy.

stipple-portrait-david-baranDavid Baran, chief executive officer of Symphony Financial Partners [source]:

We visit every company. So if we’re interested in a particular company usually it’s not because we’ve done a screen and we found it’s cheap. Finding what’s cheap is easy because that algorithm is very well-known. But unless you can go and meet management and understand why is the company cheap then your investment process hasn’t even started. So I would actually tell most investors to throw away your screens…we visit companies year after year after year and they’re still cheap. But until you can identify what’s going to cause them not to be cheap, there’s no point in investing.

stipple-portrait-drew-edwardsDrew Edwards, Managing Director, Advisory Research [source]:

The majority of our ideas come to us through screens. We run lots of different screens based upon different industries and so forth. But what we’re looking for are the same core criteria. We’re looking for companies that trade at attractive levels relative to their net asset value or their tangible book value. Companies that have strong balance sheets, limited leverage and have shown an ability to generate consistent operating profit through cycles. Those are the basic criteria whether it’s a bank or a manufacturing company… At a tactical level, the way we handle this is: I run screens on a daily basis, I take the output of my screens and I drop the tickers into an internal database that we maintain. And we’re looking for situations where the company is triggering new criteria. So in our database we will, as I mentioned before, there could be a company that’s trading—we like the business fundamentals, we like the valuation but we have concerns about the management team or the debt levels are maybe a little bit higher or whatever the case may be, we’re looking for, in our internal database, for that criterion to be triggered and at that point we go on and do additional research. Or alternatively, if the company has never populated our internal database, that’s an exciting situation to us because it’s a new idea that we haven’t researched before and we very quickly go and meet with management.

stipple-portrait-tim-mcelvaineTim McElvaine, president of McElvaine Investment Management [source]:

…we don’t really have any market cap constraint. Obviously, North American or Anglo-Saxon markets as you might typically define them would be preferred because of familiarity and governance. But the bigger the population you can select from, the better ideas you can have. I’d like to give you an example. We’ve had investments for the better part of certainly since I’ve worked with Peter or since I had my own fund I’ve always invested in and out of Japan – quite different culture, its own peculiarities but we’ve always had very good experience there. Mostly because we were disciplined about the price we’re paying. That’s a market where a lot of people have negative comments, but it’s a good example of—as a recent book on Peter, There’s Always Something to Do, and even within a market like that—we’re able to find stuff to do.

stipple-portrait-rahul-saraogiRahul Saraogi, managing director of the Atyant Capital India Fund [source]:

I use multiple methods to generate ideas. I do not, however, aspire to know every single thing about every single listed company, it is just not possible. Even if one’s analyst team does it, it doesn’t help the fund manager because he or she cannot internalize that much information effectively. The beauty of the investment business is that you don’t have to kiss all the girls. If one can find a few investment ideas that meet one’s investment criteria, one can do very well over time.

stipple-portrait-amitabh-singhiAmitabh Singhi, managing director of Surefin [source]:

It is a combination of reading newspapers, screening, talking to friends, looking at investments made in the past, reading annual reports, etc. The process of getting ideas is often lumped together so long periods of inactivity are (fortunately) interrupted by brief periods of hyper-activity.

Igor Lotsvin, portfolio manager of Soma Asset Management [source]:

All of our ideas our internally generated – we never use the sell side to come up with investment ideas. We frequently listen to conference calls or meet with management of companies.

Paul Sonkin, former portfolio manager of the Hummingbird Value Funds [source]:

I’ve seen a lot of companies [in the micro cap space]. There are companies that I’ll look at for five or ten years before I even own a share. I got an email from one of my former students who said, have you looked at such and such company? It’s been on the periphery of my radar for ten years. We do look at them, and I keep track of their progress. I read through their press releases, and if the stock price falls to a level that becomes extremely attractive, or there is some corporate event, then it moves to the top of the inbox. I have a very big inbox, but you have to do triage or prioritize. Then there is also maintenance research on existing companies. Sometimes we have to go back and do a lot of research if there is something that has changed, but a lot of the times nothing has really changed. And again, a lot of these companies take very long-term views in terms of their business plans, so we just want to see if they are executing against their plan.

Paul Johnson, professor at Columbia Business School [source]:

We are always on the lookout for new opportunities. We source many of our investments from screens and sometimes we get ideas from the Street. We are also constantly reading the news and investment forums. We run a low-turnover, concentrated fund with approximately 12 core positions. As such, we only need to find a few great ideas a year. We have a clear sense of our target investment and can filter ideas quickly. Few make it past the initial screening, but those that do get intense scrutiny.

stipple-portrait-brian-gainesBrian Gaines, founder of Springhouse Capital Management [source]:

For the most part, we keep our eyes open and use past experience to quickly identify what could be interesting. If you follow stocks as actively as we do, you really find yourself in the flow of many different potentially interesting names and using past experience prevents you from wasting time on ideas that have a low likelihood of securing a place in the portfolio. We also look for ideas in many of the areas that Joel has written about, as well as some of the more standard channels for value investments, such as insider buys and new low lists. But we have found that most of our ideas have come from simply following many stocks over a long period of time. Our experience has been that good ideas don’t come in perfectly spaced installments—they tend to ebb and flow. It is always more fun to have a long list of great new ideas, but when the ideas are sparse you have to continue doing company research and wait patiently for opportunities that meet your criteria. We find ourselves in the latter situation today. As I mentioned earlier, the environment for new ideas can change rapidly. The only thing we can do in the meantime is learn about more companies so that we are better prepared when the tide changes.

Scott Barbee, portfolio manager of the Aegis Value Fund [source]:

We generate ideas in a multitude of different ways. Our primary methodology is a simple stock screen looking for companies trading at discounts to tangible book value. Additionally, we run screens in search of companies trading at low multiples of leverage-adjusted cash flow. Speaking with other similarly oriented fund managers, examining their regulatory filings, and reading industry-specific research are other channels through which good investments can be found. Additionally, we are all voracious consumers of business news and we occasionally find gems through this general reading.

stipple-portrait-ciccio-azzoliniCiccio Azzollini, chief executive officer of Cattolica Partecipazioni [source]:

I’m always checking the new low list, not just stock prices but also lows based on P/E, P/S, etc. I also find ideas by reading constantly — I regularly read the Wall Street Journal, Financial Times, New York Times, Barron’s, Fortune, Forbes, Value Line, SPACAnalytics, Gemfinder, Value Investor Insight, Superinvestor Insight, The Manual of Ideas, Outstanding Investor Digest, Value Investors Club, SumZero, Distressed Debt Investing, Merger Arbitrage Investing, Magic Formula, and Grant’s Publishing. I’m always eager to read shareholders’ letters, news and interviews with some of my favorite investors, including Whitney Tilson, Bill Ackman, Lloyd Khaner, Seth Klarman, Joel Greenblatt, Mohnish Pabrai, Rich Pzena, David Einhorn, John Paulson, Marty Whitman, Howard Marks, Bill Miller, Bob Olstein, Francisco Parames, Eddie Lampert, Jeremy Grantham, and of course Munger and Buffett. Finally, I always attend the Value Investing Congress in New York and Los Angeles, which is a great place to find new ideas.

Scott Callon, partner of Ichigo Asset Management [source]:

We invest only in Japanese small caps, so we need to build our understanding of our portfolio companies directly. The sell-side is a business, and Japanese equities have underperformed for so long that the sell-side has retreated (along with a good chunk of the buy-side), so our investment universe has no research coverage to speak of. If one is investing in Toyota, there are plenty of folks out there expressing a view, but our universe is under-researched, under-known, and under-owned.

stipple-portrait-mattew-millerMike Pruitt, Matt Miller, and Joe Koster. former principals of Chanticleer Holdings [source]:

We read a lot, pay attention to what other people we respect are buying, follow stock idea websites, watch for insider purchases, but we generate most of our ideas by running screens in Capital IQ. Even though it is a pricey service for a small fund, we realized in the beginning that we could get a big edge with a powerful screening tool and the ability to quickly filter results to try and find attractive things. What we have found is that especially in the small and micro-cap space, you have to turn over a great number of rocks to find something truly interesting and Capital IQ helps in that regard.

Eileen Segall, former portfolio manager of Tildenrow Partners [source]:

The majority of Tildenrow’s ideas are generated from a quantitative screen based on free cash flow as a percentage of enterprise value, and on the metric return on invested capital (ROIC). The remainder of ideas I find through reading value investment publications like The Manual of Ideas, talking to other stock pickers, investment websites, blogs, and conferences. Every now and then, an idea that doesn’t make it into the portfolio will lead to a better investment in that same industry.

Adam Weinrich, portfolio manager of Pala Fund [source]:

For me generating ideas in Asia is no different than in the US (you see, I have this big dartboard…). I look for changes, events, and disruptions leading to mis-valuations. The changes may apply at the company level, to an industry, or to an entire country. So I read a lot of news and company reports. I talk with friends at other funds. I listen to what insightful people on the sell-side have to say. Part of the appeal, and challenge, of investing in Asia is that each market and economy is unique. Each country is at a different stage of development and has different trading dynamics. The Hong Kong market is quite speculative with a lot of fast money and small caps that go up 3x in two months. Korea has some similarities. But in both markets there are terrific opportunities if you do your own work and are careful. Japan has a plethora of liquid stocks, a wide range of industries and is relatively transparent. But one has to understand how corporate decision making there differs from other countries. Taiwan, Australia and Malaysia are very different economies, but each has stable equity markets supported by big domestic institutional buyers.

Doug Barnett, president of Quest Management [source]:

We screen for stocks with high growth using Bloomberg, then go and visit the companies and construct our own financial models. We read broker research to see what companies are doing, but we never rely on broker earnings estimates as they are usually wrong. We also read the newspapers, The Economist, Fortune, Forbes and Marc Faber’s Doom, Boom and Gloom newsletter.

stipple-portrait-sid-chorariaSid Choraria, investment manager at APS Asset Management [source]:

I concentrate my idea generation efforts within the under-researched areas of the market, typically small and mid-cap companies in Asia Pacific, which tend to be ignored, misunderstood and provide the most interesting opportunities. I like generating original ideas, companies that are off the beaten path and with potential to grow but the underlying theme is always finding value. I look to source ideas constantly, through a variety of sources that keep me intellectually curious. Some of my ideas can come from just paying attention to companies in Asia in day to day life. I developed an exhaustive screening database that assists me mine for key factors I look for in a forensic way, quantitative and qualitative. These can include return on invested capital, quality of earnings and free cash flow, significant share repurchases, insider buying, brand, customer captivity and pricing power. I also generate leads by asking companies “Which of your competitors do you fear the most?”. Finally, I regularly read value oriented publications. Once I narrow it down to a certain set of opportunities, my investment process is driven by a bottom-up, fundamental research approach. I like to spend a substantial amount of time understanding the business, specifically its competitive position (i.e. pricing power, economies of scale, customer captivity). Then I look for an alignment with and incentives of management with shareholders (i.e. capital allocation, compensation, sticking to core competency, etc.). Finally, I look for opportunities to purchase companies at a substantial discount to the price a rational private owner would pay for the business. I keep a watch list and add companies when they pass the first two criteria but do not meet the price. Accumulated knowledge about the business, industry and management often lead to additional opportunities. I also follow some prominent value and private equity investors to see if they might be shareholders in the business. While their presence is not necessary, if the value discrepancy is large, it can be an advantage to have an informed investor engage in value creation and invest alongside them.

stipple-portrait-peter-kennanPeter Kennan, managing partner of Black Crane Capital [source]:

Our universe of companies is in Hong Kong, Singapore, Southeast Asia, Australia, New Zealand. That includes Taiwan. We look at enterprise value above $200 million. We don’t care how small the market cap is, so they can have a small market cap. That generates a screen and then we scan out financials because we can’t get really comfortable with what assets are inside financial organizations. That results in about 1,800 companies in our universe and we then sort through those looking at various criteria. One of the key criteria for us actually is a big fall in share price, so we take a look at any company that has fallen more than 50% versus a 52-week high. It might be five minutes, it might be five hours, but we take a look at all of them almost without exception. We have some screening based on we might do a small cap company in the private development space, for instance, so we get used to screening things that are relatively lower quality businesses. We’re really looking for a quality business at the heart of it, but it can be pretty ugly in terms of leverage, corporate governance concerns, cyclical issues, etc., etc., etc. It can have lots of problems, but at the heart of it, it must be a core, good quality asset, which could be cash, could be properties, could be infrastructure, could be a very strong cash flow business, for instance, with a solid market position. That’s how we scan, so the share price fall is one of the key ones. The problem is really cheap stocks get scanned over and over and most cheap stocks, even in Asia, unless you’re in 2009 territory or 2011 after the big selloff, most cheap stocks are cheap for a reason. Then we also look at things like bigger portion of minority interests, which would be indicative of a large conglomerate, which might have a sum of the parts discount and might have some activity to unlock that value. Big associate earnings, so again, this is another thing the market will miss is that a lot of the earnings are coming through associates and are not in consolidated form. These are the things we look at.

Wong Yu Liang and Victor Khoo, managers of Lumiere Capital [source]:

Our primary source of ideas is from reading corporate announcements and annual reports, especially during the earnings results season, because this will allow us to pick up ideas that may not be found using valuation screens or from the media or broker reports. We look primarily at the Singapore and Hong Kong markets which have similarly high standards of corporate disclosure hence the approach is pretty similar. For other markets like Indonesia and Malaysia, we will scrutinize corporate governance and management motivations a lot more closely.

John Burbank, chief investment officer of Passport Capital [source]:

Looking at China or looking at Silicon Valley, it’s [about] understanding what is the leading edge of change as well as what is being hurt by change — either part. Anything moving quickly will have those two things happening. It’s generally most useful if you can figure out what is changing that’s different than people understand. Anything that’s changing differently than it happened before – it’s an important point – is inherently not understood very well, because most things regress to a mean. Most thinking regresses to a mean. It expects things to go back to a level [they were] before. The things that change market prices, more broadly — it’s the signal that diverges from reversion to the mean, at least for long periods of time. That is where you should put your attention. The problem with “value” is that, relative to growth, it often can keep you stuck in a lack of change, unless it’s value for positive change reasons, but that’s rarer than just “value”. Markets are probably smarter about rating growth relative to value, but there’s so many affecting things going on — globalization, technology change, Fed policy, although that’s really not most important from a secular, long-term reason — that need to go into a probabilistic weighting [in] your investment analysis. Most Americas are trained [in] bottom-up stock picking — that’s the direction they go in markets. The issue is, you need to learn a different way of approaching it, and it’s accretive. You have to learn a lot more things, and it gets accretive with time. It can probably be discouraging at first. I think about how is the world changing or industry changing, and then I look to understand companies. Companies that are changing in ways I did not expect make me then go up to try and understand what are the broader things going on, so I can see a pattern emerge. Then try to take advantage to that.

stipple-portrait-aaron-edelheitAaron Edelheit, founder of Sabre Value Asset Management [source]:

Insider buying, spin-offs, turnarounds, restructurings and reading what other really smart money managers are doing.

stipple-portrait-brian-boyleBrian Boyle, chief investment officer of Boyle Capital [source]:

We really don’t have a rigid process or use screens to generate ideas. However, there is usually a common linkage among our investments. For example, Fairfax Financial has been a major holding for years, which led us to Sandridge Energy. We owned Canadian Oil Sands Trust in the past because of Seymour Schulich. Likewise, when he became a significant investor in Birchcliff Energy we took notice. We also study the investments of other great investors. I have files on over 50 other investors that we respect, so we look at what others have been doing to see if anything might be interesting. At the end of the day, you must do your own homework though.

stipple-portrait-john-heldmanJohn Heldman, president of Triad Investment Management [source]:

We annually review thousands of companies by reading corporate annual reports, SEC filings, and reviewing Value Line reports. In addition, we subscribe to an extensive number of newspapers, magazines, periodicals, etc. We read extensively including general publications to understand broad economic trends and specific periodicals to deepen our understanding of certain industries. We are always looking for businesses that meet our criteria with the understanding that one day we will likely get an opportunity to invest in the business. So we have accumulated a body of knowledge about a wide range of businesses. If we can understand the business, it demonstrates growth and durability, has above-average profitability and shareholder-oriented management, it becomes part of our roughly 250 company universe. Once a business makes the qualitative cut, then we focus on valuation.

Vitaliy Katsenelson, chief investment officer of Investment Management Associates [source]:

Number one, I have a watch list — a few hundred stocks that I researched at some point in time, some of which I owned in the past, and which I want to own when they hit my price target. I look at the list weekly. I screen. I learn what other investors I admire own. I have a good circle of friends who are value investors; we share ideas. I look at stocks that are making 52-week lows. None of these things are earth-shattering. Before I buy a stock I need to figure out what the street is missing. With very few exceptions, I find little value in street research. I read it on occasion but mostly to find out the consensus.

Robert Vinall, founder and managing director of RV Capital [source]:

I generate ideas by speaking with like-minded investors, screening (in particular for 52-week lows) and reading newspapers. I am particularly keen also on referrals from competitors and suppliers of investee companies. I do not view my circle of competence as static. I am permanently trying to expand the edges of my circle of competence to encompass new companies, sectors and countries. For example, I have felt for a long time that China is beyond my circle of competence as I am unfamiliar with the culture and frankly the issue of property rights scares me. But Buffett has made a few investments there and stated categorically that all investors should have it on their radar screen. You ignore Buffett’s advice at your peril, so I have started ordering annual reports for some Chinese companies. I hope that one day I can claim that certain Chinese companies are within my circle of competence.

Richard Cook and Dowe Bynum, principals of Cook & Bynum Capital Management [source]:

Idea generation is a fairly eclectic process for us. We read a variety of domestic and international publications, travel internationally to expose ourselves to new markets and ideas (for example, we have developed some competency in Latin America), and ask executives and managers we meet with who is the best competitor in their industry or what is the overall best business in their geographic region. Because we run a concentrated portfolio and have low turnover, we are only looking for a handful of great ideas each year (which is a good thing because only a few ideas typically survive our iterative process of trying to think of all the ways that a company may “die”).

Paul Malcolm, portfolio manager of Wilshire Capital Allocation [source]:

For me investment ideas are pretty hard to come by and I am not looking to gain any competition. That is why I do not tell anyone about The Manual of Ideas. It is too valuable of a resource.

The Biggest Mistakes Investors Make

Apr 27, 2016

Joel Greenblatt once observed that learning from past investment mistakes is crucial but also extremely difficult to implement in practice. I don’t remember the exact quote but Greenblatt said something to the effect that past mistakes dress up in new clothes and come back to haunt us in the future.

This resonated with me because I have made the same type of mistake multiple times as the situation was somewhat different in each case. We seem to be prone to thinking that old mistakes do not apply because we are on guard against them. Then, the market teaches us a lesson. Still, even as learning from past mistakes is easier said than done, there is no path toward improvement unless we attempt to learn from our mistakes — and those of others.

At The Manual of Ideas, we ask most fund managers we interview about investment mistakes, so we have a repository of hundreds of answers.  I’ll highlight just a few:

Howard Marks, co-chairman of Oaktree Capital Management:

“…people tend to get in trouble in investing when they have unrealistic expectations, especially when they have the expectation that higher returns can be earned without an increase of risk. That is a very dangerous expectation. Which is the thing which is most dangerous to omit? I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it. The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years. That is one of the reasons why we have to think of great investing in terms of a long time span. Short-term performance is an imposter. The investment business is full of people who got famous for being right once in a row. If you read Fooled by Randomness by [Nassim] Taleb, you understand that being right once proves nothing. You can be right once through nothing but luck. The law of large numbers says that if you have more results, you tend to drive out random error. The sample mean tends to converge with the universe mean. In other words, the apparent reality tends to converge with the real underlying reality. The great investors are the people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it. […]”

Watch Paul Lountzis comment on three mistakes investors make:

John Lambert, investment manager at GAM:

“Compared to most professions, investors suffer a distinct lack of useful information and feedback that would enable them to improve their processes and, ultimately, results. Knowing where and how to make small improvements across the range of skills required to deliver better returns is difficult to do, and consequently it is often put to one side and forgotten. This would be a mistake. A greater effort to understand one’s strengths and weaknesses as an investor, by deconstructing and measuring your process as thoroughly as possible, is something the thoughtful individual should constantly be striving for. Process analytics and improvement should be a core part of any investment process! […]”

Mariko Gordon, chief investment officer of Daruma Capital Management:

“It’s very important not to be prejudiced and stubborn. You have to be open-minded but you also have to be very disciplined, and grounded, and firm too. […]”

Jean-Marie Eveillard, senior adviser to First Eagle Funds:

“[The single biggest mistake] is not being value investors. Admittedly, it’s difficult not to pay attention to—everybody has a Bloomberg machine or something—not to pay attention to daily changes in stock prices. If you’re an investor in real estate, if you own a few buildings or if you own even one building, you don’t worry about the price of your building on a daily basis because there is no daily transaction. It’s less difficult to be a long-term owner if you own real estate, or in general illiquid assets, than it is with equities that trade daily. It’s not for nothing that Buffett is one of the richest men in the world. It’s because he has a very sound approach to investing. It’s not a recipe, it’s not a formula. Of course, his enormous success is due to a large extent to his own extraordinary skills. But when he wrote that article in 1984 it was in an attempt, which was a very humble attempt in a way, to say that his own success which was already obvious in the mid-1980s was due not just to his own skills, but also due to how sound his investment approach was. Most investors, including professional investors, have an investment approach—and maybe they cannot avoid it, because there is what Jeremy Grantham calls career risk, which is nothing to be ashamed of. The mistake they make is to pay too much attention to the short term. Ben Graham was right, short term, [the market] is a voting machine. You’re in the hands of market psychology if you invest in the short term. If you invest in the long term, it’s a weighing machine that weighs the realities of the business. The Frenchman who told me, hey, if we the French, we don’t buy that small stock, which you own, it will never go up. Well, no. That’s not true. It may go up after a long period of time, but it will go up if it deserves to go up. […]”

Larry Sarbit, chief investment officer of Sarbit Advisory Services:

“[Investors] allow emotion take over their investment decisions. That is undoubtedly the biggest problem. They don’t think very much at all. There’s not a lot of thought going on and so therefore don’t be surprised if things don’t work out well. They’re their own worst enemy. Investors do more damage to themselves than anybody else could do to them. If they would just think like they were going to the grocery store, again that’s Ben Graham, if you think about buying stocks, like he said, like groceries instead perfume, you’ll do a lot better. But people don’t and there’s not a heck of a lot you can do for them. The truth is that most people are not going to make money in the stock market. The vast majority of people don’t make money. It’s unfortunate but it’s almost a law that that’s the way it is. The money comes in at the wrong time and it goes out at the wrong time. I can tell you right now we’re seeing the market turn south because of rising interest rates. If the markets keep going down or if they go nowhere for the next three years, I can see exactly what investors are going to do. They’re going to get out, they’re going to stop investing, and they’re going to get out.
They keep doing this over and over and over again, generation after generation, decade after decade, century after century. The behavior just repeats over and over and over again. Not much you can do about it. But that’s what creates the incredible opportunities to buy things. It creates it for us – it’s that people don’t think. […]”

Watch Chris Karlin opine on the biggest mistakes investors make:

Bryan Lawrence, founder of Oakcliff Capital:

“[The single biggest mistake is] not having the right temperament or sufficient balance in their lives, to manage through the humbling experience of the markets. The Great Crisis found the cracks in a lot of relationships and the demons in a lot of personalities. Buffett talks about the financial consequences of a receding tide, but we should also think about the psychological consequences. Certainly the brokers don’t have to push too hard to get the clients to change managers after a bad streak. […]”

Mark Cooper, portfolio manager at First Eagle:

“…it’s really about investors not being comfortable in their own skin, and they tend to chase things that are maybe the latest fad or whatever is hot today. And you have to have patience and stay the course of your investing philosophy, but you also can’t be afraid that you’re going to miss something. And as investors become more experienced, hopefully they become more comfortable with what they know and what their circle of competence is. Don’t worry so much about what’s outside that but you just want to narrow down the investible universe or what you can possibly follow and what you can know, and focus on that. And if the opportunities present themselves take advantage of it. But if you’re always worried about what somebody else is doing or what might work the next three months or what’s going to work between now and year end, changing your roadmap gets people in trouble. […]”

Watch Robert Deaton of Fat Pitch Capital on the biggest mistake investors make — and how not to make it:

Brian Boyle, chief investment officer of Boyle Capital:

“The biggest [mistake] I see is overconfidence. The markets have a way of taking care of that though. This can be a very humbling business and it is important to remember that. […]”

Lisa Rapuano, portfolio manager of Lane Five Capital Management:

“[The single biggest mistake is] being human? Seriously. The most important thing to do is to understand your own temperament and skills, to develop a plan and to stick with it. But human nature is to go with what feels good, to look for social proof and to act out of fear and greed in times of stress. Developing an understanding of how you personally react to things and creating a structure around yourself that helps you optimize your strengths and minimize your tendency toward error is a huge advantage. Unfortunately, everything seems stacked to work against us. Even as professionals, the structure of the industry creates pressures to conform to stupid ways of investing because either they gather assets or they at least don’t get you fired. For individuals it’s even worse. It takes a lot of work to remove yourself from all the noise and the pressure and you still make mistakes. On the other hand, this is what makes our business so wonderful: you can always get better, you can always learn more and it’s never, ever boring. […]”

Listen to investor and author Stephen Weiss highlight two mistakes to avoid on the path to investment success:

Barry Pasikov, managing member of Hazelton Capital Partners:

“[The single biggest mistake is the absence of] discipline. Investing is easy to understand, but challenging to execute and that challenge comes in the form of remaining disciplined. All investors begin their journey with only the best of intentions, but frustration, and temptation, mixed in with a little self-doubt can lead anyone astray. There are four disciplines that I rely on to guide me down the value investing path: 1) stay true to your strategy; 2) recognize overconfidence; 3) control your emotions; and 4) patience. […]”

Richard Cook and Dowe Bynum, principals of Cook & Bynum Capital Management:

“While we would typically list a few (e.g., having a short-term perspective, overestimating the strength and longevity of competitive entrenchment/advantages, investing with inadequate information), the single biggest mistake has to be investing without a margin of safety (i.e. not buying a company at a large discount to a conservative appraisal of its intrinsic value). By the way, full credit for this idea goes to Ben Graham, who once wrote: ‘Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, ‘Margin of Safety.’’ There is a great quote that is generally attributable to the physicist Niels Bohr: ‘Prediction is very difficult, especially about the future.’ At its core, investing is about predicting the future cash flows of a business, which means that investors like us are inevitably going to make mistakes in their evaluation of the quality of a business or the people running it. An appropriate margin of safety serves to prevent permanent capital losses when an investor is wrong and provide outsized returns when he is correct. We only like to play the game when we know the odds are in our favor.[…]”

Simon Denison-Smith, co-founder of Metropolis Capital:

“…investors who are not undertaking sufficient analysis and due diligence in each position they invest are taking significant risks. A lack of deep understanding of a position leads to two specific challenges: 1. It is much more difficult to have a conviction of what the fundamental value of the stock is without this, which makes it psychologically more difficult to buy when the market delivers a compelling price and to have the discipline to sell when the market is over-exuberant. 2. It makes risk management much more difficult, particularly spotting when something fundamental has changed within the business. In the last 3.5 years, we have exited three positions at a loss, where the share price fall subsequent to our exit was between 70-90%. In all three cases, we were close enough to the businesses, to fully appreciate the impact of news flow that was in the public domain but had not been fully appreciated by the market. […]”

Watch Jonathan Mills and Simon Denison-Smith expound on the issue of mistakes:

Brian Bares, portfolio manager of Bares Capital Management:

“My experience tells me that individual investors run into the most trouble with the simple things: saving habits, proper diversification, and sticking to their investment policies. My peers in institutional investing probably run into the most trouble when they mistake familiarity with excellence. You may know everything there is to know about an idea, but that doesn’t necessarily make it a good idea. Also knowing when you have an edge is very difficult, but in my experience it is the critical factor that allows us to stand out in the ultra competitive world of institutional money management. […]”

Amitabh Singhi, managing director of Surefin:

“…most people enjoy the process of creating wealth but not the process of managing it, which leads to reckless behavior in investing. Most people who do not apply the same rules of wealth creation to wealth management don’t take the latter seriously enough. For instance, rarely would one start a business that one doesn’t understand. So why invest in situations that one doesn’t fully understand?”

Watch Dominic Fisher of Thistledown Investment Management share his thoughts on learning from investment mistakes:

Ori Eyal, founder of Emerging Value Capital Management:

“The key to long-term wealth creation is not earning high returns. Rather, it is earning good returns while avoiding (or minimizing) the blow-ups. The biggest mistake that investors make is not investing in a conservative enough manner. The world is a dangerous place for capital. Inflation, expropriation, revolution, currency devaluation, industry declines, wars, natural disasters, depressions, market meltdowns, black swans, theft, fraud, and taxes all pose a constant and lurking threat to growing (or even just maintaining) wealth over time. In any given year, the probability of disaster is small. But over many years and decades anything that can go wrong eventually will. […]”

Listen to Glenn Surowiec, founder of GDS Investments, share his insights:

Alan Zafran, partner of Luminous Capital:

“Investors fail to adopt a personal investment philosophy and stick with it, through thick and thin. We’re all human, right? It’s just too easy to succumb to emotion and let ‘fear and greed’ drive your asset allocation and investment decisions. Of course, nothing could be farther from rational from an investment perspective.”

Aaron Edelheit, founder of Sabre Value Asset Management:

“[The single biggest mistake that keeps investors from reaching their goals is] themselves. For investors, the combination of emotion, fear of loss, greed for gain, how your brain works are all so important and few pay attention to it. I think knowing yourself—what are your weaknesses and your strengths—is critical to being a good investor. I work on it every day. […]”

Watch Olivier Combastet of Pergam share insights into learning from mistakes:

Zeke Ashton, portfolio manager of Centaur Capital Partners:

“There are a probably an infinite number of ways one can screw things up. But I think one can capture a very large percentage of the possible mistakes under one broad roof by saying that a lack of a coherent investment strategy that makes sense and can be followed with discipline and perseverance is the biggest mistake investors make. Without an intelligent framework for making decisions, it’s awfully hard to succeed. […]”

Ken Shubin Stein, founder of Spencer Capital Management:

“…all investors can benefit by keeping an investment journal and using checklists in doing their research. These two very simple tools not only will help keep people focused on their goals and sticking with their strategy, but they will also help them avoid mistakes out of impulse. They will also protect investors from some of the cognitive biases to which we are all subject. In the checklist, it’s possible to put not only the steps necessary to do the research as well as lists of mistakes or problems that occurred in the past and should be avoided, but also a list of cognitive biases. This allows the investor to check with him or herself and to think about whether there are forces at play that may be activating some cognitive biases, and if so, to consider those. […]”

Watch Ken Shubin Stein elaborate on the issue of investment mistakes:

Guy Spier, chief executive officer of Aquamarine Capital Management:

“The biggest mistake is when we as investors stop thinking like principals. I think that when we think as principals, when we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective. Most of the answers flow from having that perspective. While thinking like that is not easy, and most of the time the answers are not to invest and to do nothing, the kind of decision-making that flows from that perspective tends to be good investment decision-making. […]”

Igor Lotsvin, portfolio manager of Soma Asset Management:

“[The single biggest mistake is] reacting to noise in the market and becoming emotional. Markets are often highly irrational over short periods of time – investors need to have their own assessment of a given situation and not be slaves to the market. […]”

Don Yacktman, president of Yacktman Asset Management, on how to deal with investment mistakes:

“When one makes a mistake, admit it, learn from it, move on, and try to improve on what the mistake was so that we don’t repeat it over and over again. […]”

Mark Massey, fund manager of AltaRock Partners:

“Several things come to mind as I think about it… making emotional decisions… short-term thinking instead of long… a lack of thoroughness in due diligence… These are all issues, but I think the best answer to the question is a little more subtle… and it’s that most investors fail to properly weigh and adequately take into account that they are players in a pari-mutuel betting game. So you probably know what I mean by that, but let me elaborate. So most people know how horse betting works, right? So before the race begins, all the bets are tallied up, and based upon all the bets, the odds are calculated… and so what ends up happening is that the top horses – the ones with the best pedigrees, the best jockeys, and the best track records – end up paying out very little profit when they win, which is most of the time. And while the payoff can be great when the worst horses win, the fact is, they rarely do. Investing is very much the same. Great businesses – the ones that have demonstrated competitive advantages and which have enjoyed long records of success – are almost always priced very expensively, while poor businesses are almost always correctly cheap. Consequently, it is hard to do better than average betting on either. The secret to winning in horses and in securities is the same. You need to study like mad and be really patient. Every now and then you will come across a really great business (or horse) that for one reason or another is mispriced, sometimes severely so, and this is when you invest (make a bet). The rest of the time you just keep working hard and waiting. You only bet when you are convinced that you have a near cinch. […]”

Watch Jon Heller comment on the topic of investment mistakes:

Pat Dorsey, chief investment officer of Dorsey Asset Management, on the mistake of confusing growth for competitive advantage:

“…people mistake growth for having a moat. Anyone can grow. Anyone can grow by building new stores, by underpricing a product. That doesn’t mean it’s sustainable and as investors, we’re buying a future and so that’s sustainability that really matters. There’s a competitor to Aggreko, a company that we’ve been doing a lot of work on now called APR Energy, which is UK-listed, but based in Jacksonville, Florida, and they have been winning some deals from Aggreko – we’re pretty sure – by underpricing. […]”

David Steinberg, managing Partner of DLS Capital Management, on mistakes in deep value investing:

“You cannot be in denial, you have to be pragmatic. It’s pragmatism and recognizing that we are all human in our judgment, and we do make mistakes. Recognizing mistakes and being able to act on those mistakes to change course, which we would call basically flexibility, flexibility in thinking. As much as we need discipline and be able to maintain, we need to be able to identify when we need to change directions and have the flexibility to recognize that something has changed and be able to appropriately act on it. It’s a function of a different type of discipline. It’s discipline in recognizing a change in the winds. […]”

Watch Karim Taleb of Robust Methods discuss investors’ biggest mistakes:

Martin Conder, director of Novum Capital, on mistakes investing in retailers:

“I have most often made mistakes over moats in retail. A retailer with strong physical presence in good locations might seem well defended but, in addition to these moats being eliminated by online competition, the retail market is very fluid with tastes and shop formats always changing and footfall very agile. In the UK for example Jessops and Woolworths seemed to be very well established and much loved brands, but now gone. […]”

Peter Kennan, managing partner of Black Crane Capital, on mistakes investors make in Asia:

“The biggest thing about Asia is that this is almost a paradox in that people come here because of growth and because of diversification. New opportunities give the diversification and there is growth, there’s no doubt about that. The problem in China—and I’m bullish on the growth of China. I don’t mean it’s going to go back to ten-plus percent, but will it be six, seven percent and be growing year on year on year on year. However, that doesn’t necessarily translate to shareholder returns and a lot of investors come out here with too short a time horizon. The volatility can just swamp them. If you look at the P/E ratings at the moment in China on average, they’re very low and it’s good value. Then at different times those ratings have been much higher and they own individual stocks that everybody gets conviction and excitement about because they feel it’s safe for whatever reason. A P/E of 30x is quite common amongst more popular stocks in China. The average is 11x, so if you’ve got a stock that’s 30x and it doesn’t work out so well, you’ve got a long way to fall. […]”

Watch John Gilbert of GR-NEAM comment on the mistakes insurance investors make:

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