We have devoted a great deal of time in the last year to clarifying and standardizing our investment strategies. To those of you who perked up at his reference to the “great technical detail” with which I would be discussing our process, I hope you find the following pages thoroughly informative.
At Mayar, we assign all of our investments to one of two categories: Generals and Specials. The Generals are essentially good quality companies that trade at a discount to their intrinsic values. Of course, a smart investor must always consider the balance between quality and value. A low-quality company might be a good investment because the valuation is so attractive; by the same token, a very high-quality company with excellent prospects may make a great investment despite having too high a valuation. In other words, Generals adhere to a pattern in which low risk is the corollary of high quality.
The chart below illustrates the way both risk and reward affect possible return rates and provides a great visualization of how we like to invest.
The red area shows situations where the risk/reward does not justify investing, although that is not to say all “non-red” investments are good ones; a stock falling outside of the red area might seem justifiable in terms of the risk/reward, but this quality alone does not necessarily make it an attractive investment. Those investments in the blue area do not offer sufficient reward for us to consider investing, even if the risk is very low. Alternatively, stocks in the brown region might appear to have good value, but their quality is too low and their risk too high for us to consider investing. It may seem strange that we also tend to avoid stocks in the yellow area. Intuition would tell us the top left is the very place where we will find the best investments. However, the maxim “if something is too good to be true…” often applies here.
Thus it is the green area where we find our “sweet spot” for investing. This region is the source of our Generals, the bread and butter where we expect to consistently generate the bulk of our returns.
Of course, there are always exceptions to the rule. Should we find a very high quality stock that offers enormous upside for seemingly little risk (i.e. in the yellow area) the most likely explanation is that our analysis is wrong. However, on rare occasions, we do discover a low-risk, high quality stock. In these cases – and only after triple-checking our analysis – we keep very quiet and buy.
Attractive stocks that we find outside of the green area are known as “Specials.” There are a number of ways a stock could qualify as a Special. Those rare opportunities in the yellow region that I just discussed are a prime example. In another case, perhaps the quality of the business is lower that what we would typically pursue, but some specific other unique circumstance exists that lowers the risk considerably.
We might also classify a particular stock as a Special because the company’s net cash balance is greater than its market cap, or because we believe we can exert control over the stock in order to realize value, or because we have an excellent understanding of the business and can see an earnings delta of which the mainstream market is completely unaware. But regardless of the reason, all Specials have one thing in common: they are exceedingly rare, and we do not expect to find them consistently. And yet we continue to look, because when we do identify them, we expect them to drive significant outperformance.
Overall, our investment strategies for Generals and Specials have much overlap; however, by their very nature, Specials require us to step outside our typical investment process. For example, a stock that we might consider ‘uninvestable’ due to weak management might not be a relevant consideration in a Special where we would be seeking to liquidate all assets.
Checks and Balances
In the remaining pages of this report, I map out the specific steps we take when analyzing Generals. This process is rigorous and thorough; before a stock even makes it into our portfolio, it must successfully pass through three phases. The first is designed to kill the idea quickly, the second to form our wish list of high quality stocks, and the third to assess when the stocks in our wish list are attractive enough for us to put in the portfolio.
As Aziz mentioned in his letter, our checklist is intrinsic to our investment strategy. In fact, the framework for the entire process is inspired by this checklist, although we have expanded upon each point to aid in our decision-making First, we compartmentalized the checklist (and our process) into discreet parts. One purpose of this is to help try to overcome inherent human biases, which psychologist and behavioral economist Daniel Kahneman has expertly shown to have a significant effect on decision-making in business. We need to recognize that when thinking about a company as a whole, emotions and stories may influence our research. But when we focus specifically on the organization as it relates to management stewardship and ask ourselves whether incentives and pay are reasonable, we can safely avoid such biases.
The other important feature of our checklist is the scoring system, which runs from 0-3 (3 being the best). This system enables us to ask qualitative questions that result in quantitative answers, which then facilitate direct comparison with other potential investments. Scoring potential investments in discreet sections also helps us to separate ourselves from the story, further protecting our decision making from bias. And in doing so, we often find that we are surprised by the outcome.
Phase I: The Kill List
There are around 9,000 companies that are within our circle of competence and trading in Western Europe, North America, and Developed Asia. Even a fund with resources 10 times that of our own would struggle to continuously monitor that number of securities. Therefore, it is out of simple necessity that we have developed a process in which we attempt to quickly “kill” investment ideas. The idea is to eliminate as many stocks as possible, as objectively as possible by identifying those that have a greater risk of causing a permanent impairment of capital. By the end of Phase 1, our goal is to weed out all poor quality companies, potential frauds, fads, and failures. In this approach, we use “short-selling” techniques to eliminate stocks based on fundamentals as opposed to price. This process looks like the inverted pyramid pictured below; we start with our entire known universe of stocks and end what we call the “investible universe.”
Stocks that do not meet our criteria are moved to the “Junk Yard.” Of course, we may salvage them down the road if and when management, the business, or some other major factor has changed. But first and foremost, this methodology provides us with a quick way of efficiently eliminating investment ideas.
Quantitative Health Check
There are several accounting red flags which many short sellers utilise to try to uncover companies that are manipulating their earnings. According to one survey, as many as 20% of all companies in any given period manipulate their earnings to misrepresent financial performance1. Hence, there is a keen need to avoid investing is such companies. There are several good books that I would recommend on this topic2. But in case you are short on reading time, I will outline a few of the core concepts in our approach.
The easiest figure to manipulate is revenue, and a shrewd eye can almost always recognize these adjustments in the balance sheet. For example, pulling next year’s revenue through to this year often highlights a trade receivable. Thus, we look at receivables (and other assets) in relation to sales, with the goal of identifying significant moves in the balance sheet, i.e. those that rank within the top two deciles of their universe). Each move of this size earns the company a red flag. Whilst this practice in and of itself may not kick the company to the Kill List, it does provide useful insight regarding potential “health concerns” for the stock. The table below provides an example of a health check we conducted on Valeant.
The table clearly shows that there have been several large moves in receivables as well as “Other Assets,” which would prompt us to raise a big red flag. Incidentally, Valeant has been one of the lowest scoring companies that we have assessed using this method!
As I mentioned, poor performance on the Quantitative Health Check isn’t necessarily sufficient to kill an investment. There are plenty of other ways a company can earn a red flag, including:
- Tax Charged vs. Tax Paid: a discrepancy between the income tax charged on the P&L and the Cash Flow statement can sometimes be indicative of earnings manipulation.
- Depreciation & Gross Assets: changes in depreciation and amortisation policy is another sign that earnings manipulation has occurred.
- Net Change in Cash from Operations & Sales: when we reverse free cash flow and look at a company’s net debt/cash position from year to year (after adjusting for financing), we should see a positive outcome – if the business is cash generative.
It can be surprising how many businesses fail at least one of the above tests; the chart below provides an example of one company that earned a serious red flag for posting negative net cash-to debt ratios several years in a row.
In addition to these quantitative red-flags, there are a few behaviors that serve as warning signs at this stage of the process. These activities can be subtle, such as a change in auditors or related party transactions. Another important sign is also the use of redline, i.e. comparing the annual report of one year against another to search for changes. In particular, we look for changes in revenue recognition policy. Sam Antar, admitted and convicted fraudster and former CEO of Crazy Eddies, posted this on his Twitter account:
This simple one-word change was all an astute investor needed to realise that something was not right with the company.
In all of these examples, one red flag doesn’t automatically render the company “uninvestible.” But if a company triggers a few quantitative concerns and we also find that it recently changed auditors, these red flags effectively morph into a flashing red emergency light. When this happens, it becomes easy for us to move that stock to the “junk yard.”
Management: Capital Stewardship
Even if a company passes our initial analysis without raising many (or any) red flags, that doesn’t guarantee it will make it out of Phase I alive. First, it must pass our management test. In assessing an organization’s management, we consider two categories: Capital stewardship and Capital allocation. The purpose looking at Capital stewardship is to ascertain whether or not management is running the business for the benefit of shareholders; in other words, whether or not they are good stewards of our capital. Questions we often ask during this part of the process include:
- How much are managers paid relative to their peer group?
- Does management sufficiently and clearly disclose information to shareholders?
- What incentivizes management?
It is particularly important to look at the metrics that management use for incentive targets. To quote Charlie Munger, “Show me the incentive and I will show you the outcome.”
One bête-noire of many a money manager is Non-GAAP EPS. When this forms the basis of incentives, one must be very careful to look for any and all adjustments a company might make to bolster the Non-GAAP numbers. Even companies that choose what we would normally consider good metrics should not escape careful analysis. In the example below, the company uses CFROI (Cash Flow Return on Investment) as a key performance indicator. Normally, this is an excellent metric that accurately represents how efficiently management is utilizing assets and allocating capital. However, this company has modified its CFROI in a peculiar way:
The problem here is that the company has great flexibility in what it classifies as invested capital. This is most apparent in paragraph (v), but also note management’s use of “Recurring Cash Flow,” which enables them to ignore the effects of acquisitions and divestitures. What this indicates to us is that management is not necessarily incentivized to allocate capital as efficiently as possible.
But Capital stewardship is more than merely having the right incentives to allocate capital effectively. Just as important is the issue of integrity. Many managers have a tendency to be over-promotional; they talk up their prospects – and thus their stock price – right up until the moment after their fortune turn. At Mayar, we would rather invest alongside brutally honest managers – even if it means preparing for a bumpier ride – than enjoy the smooth sailing of a “stock-promoter” who is blindly steering his vessel. The latter case all too often leads to severe impairment of capital…and a sunken ship.
This philosophy extends to our general approach in Phase I. Yes, we will undoubtedly suffer many Type II errors; we will watch a stock soar and kick ourselves for not buying in when we had the chance. However, avoiding losers can be more effective in generating outperformance than finding winners. In fact, losses have a disproportionate effect on the portfolio compared to similar sized gains due to the compounding of median future returns. But most of all, investing in risky stocks leads to restless nights, and we firmly believe that good investments are better than sleeping pills.
Phase II: The Wish List
Once we have identified an investible universe, we seek to form a Wish List of high quality stocks that we would like to own. At this point, the conversation turns from largely quantitative analysis to more subjective issues. Of course, the problem with qualitative assessments is that it is often difficult to make comparisons. As we look over our candidates for the Wish List, all of which we believe to be great, we must determine a way to differentiate the better buy. We do this by breaking down the elements that make these companies great into small, well-defined parts, asking a multitude of questions about each component, and assigning points at each step. During this process, we start to tease out a clearer picture of each organization. The goal at this stage is to make us better able to compare stocks so that by the end of Phase II, we have narrowed our selection to 20-30 of the best available investments.
Management: Capital Allocation
In Capital allocation, we question whether management has, and will, deploy capital effectively. This doesn’t just mean considering whether or not they are good stewards of our capital – it means considering whether they will be able to deliver superior returns on capital in the future. Questions we often ask during this part of the process include:
- Have acquisitions helped enhance return on capital in the past?
- Has management been able to invest contra-cyclically?
We also assess whether or not the company uses its balance sheet correctly by buying back stock, or if they tend to over-leverage themselves. Ideally, we want businesses with management teams that add value, but more generally we seek to avoid companies in which management habitually overpays for assets and destroys value, as this could lead to a permanent impairment of investors’ capital.
Business Quality Analysis
Here we try to determine the actual quality of the organization, for example, whether it has high and sustainable returns on capital and whether the incremental returns on capital are sufficient to fund the company’s growth. One could easily fill a book on this topic, but for now, I will refer you to a great one by a portfolio manager at AKO Capital called Quality Investing3. However, there are three subjects worth discussing now in greater length.
Elements that confer quality
We have a non-exhaustive list of questions that we ask ourselves when analysing a business. As I have stressed throughout, a negative answer does not necessarily indicate low quality, but a positive score provides strong evidence of high quality. The more positive-scoring elements we can find in a business, the higher the likelihood that the business is one of high quality. Of course, our ideal businesses are ones that possess many such elements. Questions we often ask during this part of the process include:
- Does the business have recurring revenue?
- Are there high switching costs?
- Has the company proven its ability to roll out globally?
- Has the company taken market share?
- Does the product confer significant customer economics?
- Is the product a need or a want?
- Is purchasing through OpEx, COGS, or CapEx?
Taken together, the answers to these questions can paint a vivid picture of the company’s quality and potential return on investment. For example, recurring revenue makes a business more stable and resilient, while switching costs make it harder for customers to leave and creates pricing power. A company that has successfully expanded sales internationally gains credibility in its ability to sustain future growth. Similarly, a company that has taken market share proves its ability to outperform competitors and fosters confidence that it will continue to do so. It is also important to view the company from the perspective of the customer, even when that customer is another business. Products that save the customer a significant amount of money are able to generate demand and confer pricing power to the company. But even better than demand is predictable demand; desires often go unfulfilled, but needs are generally more stable – as are the businesses that fulfill them. In a B2B context, this requires looking at the way products are purchased; companies generally cut CapEx before OpEx, and COGS are variable with volumes whereas OpEx is consistent.
In conducting a thorough analysis, it is not sufficient to assess that quality of the business or product today; we must ask ourselves what performance will look like 10 years from now. And making a prediction a decade into the future can require quite a bit of nuance. On the one hand, we are fairly convinced that 10 years from now, high-end jewelry, such as Cartier, will still be as much in demand as it is today because we know that trying to replicate a brand with over 100 years of history is very difficult –and time-consuming!. We are also very confident that 10 years from now people will still use the same top brands to brush their teeth and wash their hair. However, we are not as convinced that low-end jewelry retailing will still be sold on the high-street using financing, nor do we have any idea what clothing brands will be considered fashionable.
Disruption can happen quickly and can lead to severe and permanent losses of capital. Within six years of its peak, HMV had lost 90% of its value. But stocks like this can become very dangerous to the value investor because while they might look optically cheap, they lack durability and their earnings continue to plummet – and the price follows. The durability of new technologies is equally uncertain. Horace Rackham once advised people not to invest in Ford, saying, “The horse is here to stay but the automobile is only a novelty.” Of course ,he was notoriously wrong on Ford and the car, but not on the investment prospects of the automotive industry at the time. This proves just how easy it would have been to lose money investing in automobiles at the turn of the century. During the crash of 1919 to 1921, the Dow fell by 45% and the Auto Index fell by 70%.20% of manufacturers went bust, followed by 60% a mere ten years later.
For a more recent example, consider Nokia. We all had a Nokia mobile telephone, and they once had a dominant market share of circa 65% in smartphones. Many value investors were lured in by a great free cash flow yield but were soon disappointed when Apple disrupted the industry. While investors were right to say that mobile telephones would be big, betting on a new technology through a single stock (even a market leader) is often just that – betting.
We don’t know when the next bubble will form, and by its nature, we may not even know we are in a bubble. However, experience has taught us that by sticking to our process and investing in businesses that give us a reasonable degree of confidence in how their product/technology/service will perform in ten years’ time, we should manage to avoid permanent loss of capital.
One of the most useful tools here is “Porter’s Five Forces,” often explained with the above diagram. The key test here is whether, given a multitude of billions of dollars, we could compete effectively as entrepreneurs. Ideally, you do not want to buy from or sell into a concentrated base. If you only have one supplier, they will be able to charge monopoly pricing and will erode your returns on capital. Equally, if you are selling to only one customer then they have a very strong bargaining position and will be able to pressure your pricing. And if you are one of many competitors, the other businesses will eat away at your returns by paying more to your suppliers and charging less to your customers.
One question we always ask is,” What is the delta?” In other words, what change is occurring? A company may well buy from a fragmented marketplace, but if that marketplace is in the process of consolidating then the company’s margins will soon start to feel the pressure. Fortunately, we can measure the likelihood of this occurring through the HHI (Herfindahl-Hirschman Index), which is a score that shows market concentration. It enables us to track the state of concentration of an industry and any changes to that.
The concept of an Economic Moat has been defined many times and I will not try to reproduce that work here. For those who are interested, Morningstar has a particularly good book on the subject. Instead, I will briefly mention a few of the points we look for in our investment process.
Proof of Moat
First and foremost, we need to find evidence that there is a moat. This is usually exhibited by abnormally high returns on capital, high gross margins, and/or pricing power. With the exception of pricing power (and even pricing power can often be worked out from the annual reports), these are easy to find. (and And whilst a moat can exist without these attributes (maybe in the case of Amazon) we can’t necessarily be certain that we are right.
Type of Moat
The big question here is, “From where is the source of the economic moat is derived?” It could be from Intellectual Property, Scale, Brand, Network Effect, Distribution, or Switching Costs, and it is essential that we understand how the moat is formed so that we know how durable it actually is.
Benefit of Moat
There are generally three benefits that a moat provides:
- Greater ability to take market share
- Pricing Power
- Economic rent
The first two are fairly obvious, however, economic rent is less obvious. This is where a business may set pricing at the same level as competitors (possibly even at commodity spot pricing) but is able to deliver superior returns through a cost advantage.
In the case of LyondellBasell, the company had access to cheap gas from Shale. Whilst the oil price was greater than $100, competitors produced ethylene at a much higher cost. Thus the difference between Lyondell (the low-cost producer) and the high-cost producers that set the price was the economic rent. The economic moat Lyondell enjoyed was primarily due to its geographic positioning. On top of this, it takes five years to build a world-scale cracker and is very difficult to obtain planning permission in the right geographic area, giving Lyondell a distinct advantage.
Expeditors International offers another great example of economic rent, although this is a slightly harder one to spot. This company provides freight forwarding services, but by buying transportation in bulk they are able to achieve superior pricing to other small operators, and much better than individual companies get. Thus, the cost savings they achieve are their rent, and their moat is the scale that prevents anyone else from achieving said savings
Phase III: The Wait List
When we have our Wish List, we have companies which we are keen to buy. However, there may well be very good reasons not to invest at this moment in time. For example, in the short-term a great company may fall into the category of too high risk, requiring us to put our desire to buy on hold. Alternatively, short-term risks might simply mean we “average-in,” starting small but building up so as to take advantage of resultant volatility.
The point is, we do not try to time the market nor use technical analysis in order to achieve a better entry price. We will leave “head and shoulders” to Procter & Gamble. Instead, and as I have mentioned, our focus is on finding a balance between quality and return. Even the highest quality companies will produce a poor return if over-valued. Furthermore, a company may face cyclical or secular risks that we do not believe to be “in the price.” So if we are to invest for the long-term, we must take our time, analyze our opportunities fully, and be cognizant of both short-term and long-term risks.
Whilst we tend to avoid deeply cyclical stocks such as commodities, which usually possess little to no economic moat, every company is exposed to some form of business, capital, or replacement cycle. Admittedly, it can be difficult to estimate where exactly on the cycle we are at the time of analysis, but it is crucial that we make every effort to assess whether we are closer to peak or to trough. Value Investors too often get induced into optically cheap investments only to discover that they are at the top of a cycle. When the cycle turns, the investment can become very painful indeed.
Although there are many cycles that investors need to follow, including the credit cycle, the business cycle, and the replacement cycle, the capital cycle is unique in that it is faced by all businesses alike. It is also the easiest cycle to analyse. Essentially, this cycle is concerned with the capital that is invested into the company’s sector. In contrast to other cycles, which are demand driven, the capital cycle is supply driven. There is an excellent book written on the subject from Marathon Asset Management that I highly recommend to anyone who would like to explore further4.
In assessing where a business is in the capital cycle, we track the CapEx of pertinent sectors and plot out the asset growth as well. These practices help us understand whether or not capacity is being added to a sector. When capacity is added it becomes very likely that returns will subsequently be depressed. Thus, we can establish a general understanding of where we are on the cycle without trying to be too precise. The goal here is to avoid investing close to peak cyclicality in order to avoid permanent losses. An example from our portfolio is Nordstrom (JWN US). We have heard what a terrible time the retailers are having, and it might seem intuitive to conclude that this makes for a bad investment. However, we believe that a good business and a well-run company can actually benefit from times that put stress on the industry as a whole. Now if we look at overall spending in retail, as depicted in the following charts, it is apparent that competition has been steadily withdrawing from the market.
An example from our portfolio is Nordstrom (JWN US). We have heard what a terrible time the retailers are having, and it might seem intuitive to conclude that this makes for a bad investment. However, we believe that a good business and a well-run company can actually benefit from times that put stress on the industry as a whole. Now if we look at overall spending in retail, as depicted in the following charts, it is apparent that competition has been steadily withdrawing from the market.
When an industry suffers declines and loses capacity, this often creates space for a “category killer,” or a business that is so well-run that it is able to take advantage of a downturn and actually improve its position in the industry. We believe that Nordstrom could be one such company.
I want to say upfront that any attempt to predict growth is a very dangerous path to tread. Although it can be done, it is quite difficult and, given the time it takes to get a comprehensive read on quarterly numbers, often comes at the expense of breadth of investment (Not to mention, beating estimates does not always lead to a profitable trade because the market may not agree with the street.
At Mayar, we do not try to beat quarterly numbers. However, we do take the time to conduct an assessment of what long term growth could be. Undeniably, growth is one of the key determinants of valuation – and it is difficult to escape its consequences. Even a careful investor who buys a security at a valuation where they believe growth not to be relevant could face considerable capital loss if growth is sufficiently negative. The most effective strategy here is to understand the drivers of growth and their various layers. Below is a very rough example of how we can simplistically model a total return from growth in Visa and/or MasterCard:
This demonstrates how important it is to factor in all the different layers. Even with an anemic GDP figure, we might be surprised – after we account for inflation and added in all the various layers – to end up with a very powerful number.
Whilst we do not try and get cute with timing nor like to trade (as that would be speculation), we do like to be conscious of short-term effects. Despite our long-term thinking, there are always short term risks that can lead to a capital impairment or simply to a better buying price. There are many factors we could conceivably look at – too many to name here and many which will be individual to the company – but I will quickly mention a few issues that are particularly common.
Evidence shows that stocks that have been upwardly revised tend to outperform. For us, this is not a reason to buy, but rather a reason to prioritize. If a company is having its earnings consistently downwardly revised, then it is less likely to outperform in the near term than a company whose earnings are being strongly revised up. It follows that we should prioritize companies whose outperformance might be imminent, and also that we should size our positions accordingly.
Pending Litigation and other one off binary outcomes
Often, we find situations where shares are depressed due to an impending binary event. The key question here is to determine whether or not it is “in the price.” To estimate this, we calculate the implied probability.
As an example, consider a security with two possible outcomes, which we will call Scenario A and Scenario B. In Scenario A earnings will be 12, and we estimate the multiple would also be 12. By comparison, Scenario B would see earnings of 7 and a multiple of around 10. Therefore A has a target price of 144, whilst the target for B is 70. Given the binary outcome, the price for the security should be set by multiplying the price at A by the probability of A happening, plus the price at B multiplied by the probability of A not happening.
This formula can be rewritten so that (Current Price – B) / (A – B) = the implied probability of A happening. In this scenario, if the stock were trading at 125 then there would be an implied probability of around 74% that Scenario A would unfold. Whilst we typically do not like to trade on such outcomes, we do try to avoid scenarios where the risk/reward does not favour an astute investor. So in the above example, we would only invest if the possibility of B happening was very remote indeed.
Currency and/or Commodity
Whilst movements in currencies and commodities are often reflect in the price of any given security, there are plenty of occasions where this is not the case. We adderss this issue by carefully assessing the impact, because whilst a 5% FX swing may be harmful to a one-year return, it might make little difference to a 5-year investment that doubles its earnings during that time. On the other hand, if there is a mismatch in FX and a 5% swing leads to a 25% fall in earnings, the impact could be more meaningful. Often this is due to some hidden element, such as a mismatch between revenues and costs in a certain currency that leads to an outsized effect on earnings, or a commodity in the feedstock that has recently taken greater prominence.
Take, for example, a stock with a 20% margin that suffers a 10% headwind to 50% of its revenues (5% to total revenues). If all the costs remain equal, that 5% has a 100% drop through to the bottom line and we see a 25% fall in profitability. It is true that most of our analyses of short-term factors give us reasons to avoid or delay buying, but occasionally they present cheap optionality. If these factors are not “in the price” and it is a great company with a fair valuation, the situations can prove rewarding indeed.
Valuation is neither and art nor a science; it is a craft. Whilst every stock has an intrinsic value – and that figure is an exact number – it is impossible to accurately calculate that value with 100% certainty. To illustrate, take the three factors that affect valuation: free cash flow, growth, and discount rate. If you are 100% certain of the FCF and the growth rate, then this means that there is no risk to the security (given that you are 100% certain) and the discount rate should be equal to the risk free rate.. However, using the risk free rate as the discount rate might mean that you never achieve a return greater than the risk free rate. Clearly we seek to achieve something substantially better than that!
It may be impossible to calculate an absolute and accurate valuation is impossible, but we can safely estimate a range of valuation based on an investor’s required return. If we seek a 10% rate of return, then that can be our discount rate; and if we apply a significant margin of safety then we have adjusted for the risk. As the great investor Benjamin Graham wisely noted:
“The purpose of the margin of safety is to render the forecast unnecessary.”
However, just because we believe that we need a 10% return on investment does not mean to say that we will achieve it. And if we do achieve it, we might have to wait more than ten years to do so. We never want to lose sight of our long-term horizon, but given an option between an almost guaranteed return of 12% over 20 years and an almost guaranteed return over five years, we would prefer the latter. This is not just because of the investor’s preference, but also because extending our forecasts too far ahead into the future inevitably exposes us to greater uncertainty.
Historic & Relative
We are acutely aware of our own failings as analysts and appreciate that in many instances the market might actually be right. To quote Benjamin Graham once more:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Whilst we certainly believe that there are market inefficiencies, we do not believe that they can last forever, nor would we want them too as at some point we might want to realise our value. Thus, we look at what multiples a stock has traded on historically and assess relative multiples to comparative companies. This serves as a check against our estimates of intrinsic value; should there be a wild discrepancy between our estimates and the relative and historic multiples, then we must consider the possibility that our assumptions are incorrect.
Lastly, we try not to base valuations off a simple growth assumption and multiple (or even a DCF). Rather, we run three scenarios (Bull, Bear, and Base) and then imagine what valuations each scenario could achieve. In doing so, we can ascribe probabilities to each scenario and thus achieve a range of target prices.
What’s in the Price
Even after we have completed all of our lists and exit Phase III, we like to perform one final check. As Michael Mauboussin says:
“Perhaps the single most important question an investor can ask is: ‘What’s priced in?’”5
This is where we invert the problem of investing by asking, “What’s in the price?” I have already mentioned the idea of something being “in the price” of a stock, but now I will elaborate further on how at Mayar Capital like to think about what is priced into a stock.
We know what the current price of a stock is. We can roughly gauge what the multiple and margin should be. From that, we can then ascertain the revenue growth necessary to justify the current price. And from that, we may even be able to calculate how many units a company must sell and what market share the company must gain.
The above is a simple example of how we think about what is “in the price.” Here we look at Tesla, which is hardly a typical value investment, and not one that we own. Again, we know what the current price is and what the required return is, and we have a rough idea as to what sort of multiple and margin the company could achieve five years from now. However, what is much harder to judge is how many cars they will sell. Fortunately, we do not need to guess how many cars they will sell. We only need to know how many cars they need to sell in order to justify their current price.
Taking our rough idea of the margins and multiples, we can employ a range of scenarios to help us answer the question, “What’s in the price?”
As indicated in our upper bound scenario, the company only needs a run rate of just under 400k cars. Given that they are guiding to produce 500k cars per year, this does not seem implausible. However, it nonetheless relies on beating industry margins and it requires an elevated multiple. Our “lower bound scenario” has more conservative assumptions, and whilst. I believe these numbers are likely too pessimistic, they do provide a certain “margin of safety.” Ultimately, the problem is that Tesla needs to produce 1.3m cars. This might be possible to do five years from now; the queues of people waiting to reserve a Model 3 before it has officially been unveiled certainly lends confidence to the possibility. However, “possible” is not good enough for us. It involves us having to make too many assumptions to consider it a worthwhile investment, at least from a value investor’s perspective. I will say, however, that given the plausibility of the upper bound scenario, the short sellers need more to their thesis than simple over-valuation.
Remember, we only require 20 – 30 stocks. We have no problem waiting for the “fat pitch,” for stocks that provide a high degree of certainty. For my final reading recommendation, I encourage anyone with an interest in finance to read the excellent article that Aziz wrote on the subject explaining why patience is a virtue in investing and how it is actually not all that difficult6. The essence of the argument is that if an investor wants to compound her returns at 10%, she can spend much longer than she might think out of the market and sitting on cash. The table below shows what the required return is over a ten year period, assuming several of those years are spent out of the market.
The moral of the story is that if someone spends three years waiting for an investment that will yield 15% over seven years, they still will have done better than if they settled for a 10% return over a 10-year period.
While we have a long-term investment horizon of more than five years, we do not often find ourselves needing to sit on large cash balances because this is a rolling process, and when “vintages” mature we are able to swiftly redeploy assets into new investment ideas; thus, we only really need to find four new ideas each year. Furthermore, given that we are not (yet) managing $4 billion of assets, we have the advantage of reacting very quickly when great opportunities present themselves.
The Final List
Once we have completed our analysis of a security using this process and have scored each question, we then need to review our options. We review firstly the security in and of itself and secondly the security in comparison with other investments. The individual security review is where we consolidate our learning. We discuss our findings and challenge areas where we are uncertain in our accuracy. Once we are satisfied with our work, we compare the stock to other potential opportunities on our Wish List.
As I have mentioned, our goal is to build a portfolio of 20—30 stocks. Because our analysis includes multiple scenarios, we have a firm understanding of what the downside to an investment might be. Armed with target prices and knowledgeable of potential downsides and risks we can build a robust portfolio of stocks that will complement each other.
Once we have our Final List, the last remaining task is to create an investment plan. In creating this plan, we visualise the scenarios that might unfold and ask ourselves what events would make us buy more and what events would make us sell. It is very important to try to imagine these factors before they happen so that we are able to act quickly and without emotion when circumstances change.
In all of our talk about investment procedures and list-making strategies, we have yet to mention two key elements of our process: Business Understanding and Ethicality. In part, this is because we referenced them briefly in our discussion of the initial building of a universe that is within our circle of competence. But we also see these elements as part of a continuous process, ones that cannot be confined to a particular phase of investing.
Throughout the investment process, we constantly ask ourselves if we understand a security. We may begin the process thinking that we understand it, only to realize later that we don’t. Conversely, we frequently find that the process itself adds greatly to our understanding of a business. However, we also remind each other that if at any point we fear we are straying into territory which is too difficult to navigate, we are happy to move on to another investment.
And while I do not want to opine on moral grounds too much, we are an ethical fund, and we do not want to own businesses that we would not wish our children to own. But there is also a more practical side to ethics when it comes to investments. Speaking frankly, unethical companies can make for very bad investments. Be it regulatory, public opinion, labor relations, or supply chain conflicts, unethical businesses can find themselves in trouble overnight.
Our notion of ethical encompasses more than simple sector screening and ESG reports. One example of a business that comes to mind that I, personally, deem to be unethical is a company which is probably in the FTSE4Good Index. I see it as a business that has created a monopoly on credibility within a certain industry, although I am not going to “name names”, as this is a personal opinion. The business does not pay its suppliers, and in fact on many occasions it charges them for the privilege of supplying their business. What’s worse, they effectively rearrange the product they have been supplied and sell it to their customers (who also happen to be their suppliers) at monopoly pricing! Everyone in the supply chain hates this business, yet they have to use it. There are competing models that are in their early stages, but so far nothing has significantly disrupted this business.
In many ways this is a testament to a fantastic economic moat and a very impressive business. However, I believe that it is unethical to abuse a monopolist position whilst providing such little value-add. But the real reason that a value investor should be incredibly wary of an investment like this is that there has to be a question as to the durability of this model. At some point the supply chain may well win and one of the competing business models might win. It could happen quickly, and an investor may easily miss it. As such, from a purely practical point I think this illustrates why poor ethics make a poor investment.
PS. Whilst this provides a good summary of our methodology, it is by no means exhaustive, for that you will have to wait for us to write the book. Stay tuned!
1 – Dichev, Ilia D. and Graham, John R. and Harvey, Campbell R. and Rajgopal, Shivaram, Earnings Quality: Evidence from the Field (May 7, 2013). Available at SSRN: http://ssrn.com/abstract=2103384 or http://dx.doi.org/10.2139/ssrn.2103384
2 – Some of my favourites include Financial Shennanigans by: Howard Schilit, What’s Behind the Numbers by: John Del Vecchio & Tom Jacobs, and Accounting Ffor Growth by: Terry Smith.
3 – Quality Investing: Owning the best companies for the long term: Torkell T Eide, Lawrence A Cunningham, Patrick Hargreaves: https://www.amazon.co.uk/Quality-Investing-Owning-best-companies-ebook/dp/B017BI3V9A
4 – Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15; Edward Chancellor
5 – Animating Mr Market: Micahel J. Mauboussin, Credit Suisse: https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&source_id=em&document_id=806553770&serialid=gKFZkitZvbzsLDj6TpgBXsL3759mXiVzyrfUEbIBg6Y%3d
6 – How Long Should You Wait for a Bargain? Abdulaziz A Alnaim; September 2004 Saudi Commerce & Economic Review
This post has been excerpted from the Mayar Fund June 2016 Letter.
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