While the value investing community remains a small part of the overall investment landscape, it has grown. A key reason is the long-term success of investors like Warren Buffett, Prem Watsa, and Tom Gayner. Buffett is not only the most highly regarded value investor, but also the most successful investor overall. Many investment managers have taken to copying Buffett’s approach, but is it really possible to become a value investor by reading a few books and desiring to make money? In a letter to investors several years ago, Seth Klarman of The Baupost Group warned of value pretenders, investors who brand themselves as value investors but actually miss the essence of value investing.
How do you determine if you are a value investor or a pretender? The easiest way might be to follow Charlie Munger’s advice: Invert. By considering what would make you a value pretender, you may find out if you are a value investor.
Top 10 Reasons You May NOT Be a Value Investor
Reason #10: You invest based on chart patterns, especially when they point up and to the right. If things like 50-day moving averages, chart breakouts or relative strength are part of your lexicon, you may not be a value investor. Value investing is not about where a stock price has been and what lines it might be likely to cross, but rather about the relationship between price and value.
Reason #9: You assume multiple expansion in your investment theses. If you base your purchase decisions on the likelihood that the market will assign a higher P/E or other multiple to a stock in the future, you may not be a value investor. You may instead be engaging in John Maynard Keynes’s “beauty contest”, an exercise centered on guessing the behavior of others. Value investors independently appraise the value of businesses in order to make an informed investment decision.
Reason #8: You try to figure out how a company will do vis-à-vis quarterly EPS estimates. If you shrink from buying an undervalued company solely because it might miss consensus estimates for the next quarter, you may not be a value investor. Value investors do not play the expectations game, at least not when it involves the market as a whole. It is fine to set your own estimates and base your decisions on whether businesses meet your expectations for value creation. The key is to focus on the margin of safety, i.e., the difference between price and value.
Reason #7: You base your decisions on analyst recommendations or subscribe to newsletters promising big returns. If you seek out information on the stock ratings of Wall Street analysts prior to making an investment decision, you may not be a value investor. Analyst ratings are highly skewed toward buy recommendations and are tainted by a desire to win investment banking business. Moreover, most analysts are anything but true value investors, issuing buy ratings after stocks have already run up and downgrading stocks after their prices have collapsed.
Reason #6: You use P/E to Growth (PEG) as a key valuation metric. If you are willing to pay a high multiple of earnings for a fast-growing company, you might be a growth investor or a momentum investor, but you are almost certainly not a value investor. True value investors try to get growth for free. They pay for the free cash flow a company throws off today, with future growth a bonus rather than a requirement.
Reason #5: You use EBITDA as a measure of cash flow. If you have convinced yourself that EBITDA is an appropriate measure of cash flow, you may not be a value investor. EBITDA has the advantage of normalizing for leverage and taxes, but it also “normalizes” for depreciation and amortization. The latter is an expense that not only varies widely among businesses, but also has a big impact on intrinsic value. If D&A is high, a company likely has to spend a large portion of operating cash flow on capex. This decreases the amount of cash available to be returned to the owners of the business.
Reason #4: You would worry about your portfolio if the market closed for a year. If you need a market price in order to feel like your stock investments are worth something, you may not be a value investor. Equity markets do not bestow value upon stocks. Markets provide an opportunity to buy or sell at prices that may or may not have much to do with intrinsic value. Just like you do not seek a quote on your home every day, you should not view the liquidity of stock markets as a key feature of equity investing. Value investors look to the business rather than the market for their investment return.
Reason #3: You make investment decisions based on the activity or tips of others. If you buy an equity simply because an investor you respect or, worse, a friend has made the same investment, you may make money, but you are not a fundamental value investor. Value investors make decisions on the basis of price versus value. How can you estimate the value of a business if you have not done the fundamental work to understand it?
Reason #2: Your investment process centers on the market opportunity. If you view the growth of a market or a country as the primary reason for buying a stock, you may not be a value investor. Warren Buffett has said that the key to investment success is not how quickly an industry or a company may grow. Rather, the key is the magnitude and sustainability of a company’s competitive advantage. The latter allows for pricing power, a key determinant of profitability and returns on capital.
Reason #1: Your investment theses do not reference the stock price. If you use arguments like “this company is gaining market share” or “this is a low-quality business” without referencing the market price, you may not be a value investor. Value investors do not make investment decisions without accounting for the market quotation of a business. While a value investor may prefer to buy an above-average business at a below-average price, he would also consider buying an average business at a “way-below” average price. There is a price for everything.
Still a Value Investor?
If you are feeling a bit shaken in your beliefs or consider the above list too restrictive, don’t worry. All of us have thought or acted like value pretenders at times. The temptation to succumb to the approach of least resistance is too great to ignore completely. What matters is that we are aware of the things to avoid, and that we view investing as a never-ending learning process. Buffett continues to learn well into his 80s, so why should we feel that we’ve already achieved perfection?
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.
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.
The Snowball by Alice Schroeder
7 Steps To Becoming A Great Stock Investor by Earl Jordan Yaokasin, CFA
Simon Caufield on The Genius of Warren Buffett
An Introduction of Mental Models by Farnam Street Blog
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.
Allan 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.
Charles 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.
Bryan 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.
John 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.
Larry 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.
Sahm 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.
Christian Olesen, portfolio manager of Olesen Value Fund [source]:
Josh 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.
Don 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.
Simon 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.
Ori 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.
Jake 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.
Charles 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.
Barry 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.
Lisa 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.
Brian 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.
Professor 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.
Adam 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.
Jeroen 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.
Massimo 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.
David 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.
Drew 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.
Tim 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.
Rahul 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.
Amitabh 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.
Brian 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.
Ciccio 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.
Mike 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.
Sid 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.
Peter 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.
Aaron Edelheit, founder of Sabre Value Asset Management [source]:
Insider buying, spin-offs, turnarounds, restructurings and reading what other really smart money managers are doing.
Brian 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.
John 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.
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: