The genesis of this post is couple of documents that I rediscovered on the ValueWalk Scribd page. The first is a speech given in 1981 by Dean Williams of Batterymarch Financial Management entitled, “Trying Too Hard”. The second is a research publication written by James Montier called, “Seven Sins of Fund Management”. Ironically, one of the main points made in both pieces is that investors (me included) spend too much time exposing themselves to all the informational noise that is distributed over the internet in the hope of boosting confidence enough to be comfortable with our investment decisions. As my co-founder Gregg constantly points out, over the long-run you will probably do better building a portfolio of companies that makes you uncomfortable than building one that makes you comfortable. In this article I am going to discuss why your investment process should be focused simply on understanding and valuing businesses, and being better at it than other investors. Trying to increase your confidence by gathering information that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.
“There are no answers in this business. There’s just a hell of a lot of questions.”-George Russell Jr. of Frank Russell Co.
Relative to the last ten to fifteen years, there has been a significant increase in the amount of investment-oriented information available to investors. In trying to provide investors with information that “is not in the current stock price” and therefore giving them an “edge”, many Wall Street, and independent investment research providers have begun focusing on such areas as “forensic” accounting, “channel checking”, public policy analysis, “lie detection” on conference calls, data mining and “expert” networking. Investors can find a diversity of opinion on a company because professionals and non-professionals alike publish and share their investment ideas on sites such as Seeking Alpha, Motley Fool, GuruFocus, Value Investors Club and SumZero. There are numerous investor conferences where attendees can hear ideas from “gurus”, portfolio managers, activist investors and contest winners. There are bloggers who aggregate news stories and analysis. Investors can set up RSS feeds and use websites like Reddit to keep abreast of all the investment news they deem important. But do we really need to be doing all of this? How much information is enough and how much is too much? Let’s just say that the signal-to-noise ratio for investors has degraded substantially over the yearsIn spite of the large increase in investment information relative to the past, there is little evidence that active managers in aggregate have improved their performance relative to passive strategies. In addition, assets in passive investing strategies continue to increase as a percentage of total invested assets. Instead of lengthening investing horizons because investors have more information to make supposedly better long-term decisions, the obsession with trying to utilize all of this information has actually shortened them. Average holding periods of stock in mutual funds is under 11 months and the SPY turns over its assets once a week (investment periods which are too short for fundamental oriented investment returns to manifest themselves). It appears as though trading a stock on “the new news” has replaced investing in a real business for the long-term as an acceptable investment strategy.
In spite of the large increase in investment information relative to the past, there is little evidence that active managers in aggregate have improved their performance relative to passive strategies. In addition, assets in passive investing strategies continue to increase as a percentage of total invested assets. Instead of lengthening investing horizons because investors have more information to make supposedly better long-term decisions, the obsession with trying to utilize all of this information has actually shortened them. Average holding periods of stock in mutual funds is under 11 months and the SPY turns over its assets once a week (investment periods which are too short for fundamental oriented investment returns to manifest themselves). It appears as though trading a stock on “the new news” has replaced investing in a real business for the long-term as an acceptable investment strategy.
Knowledge vs. Wisdom
“All mankind’s troubles are caused by one thing, which is their inability to sit quietly in a room.” -Pascal
This huge increase in information available to investors has helped them increase their investment knowledge (acquaintance with facts, truths or principles) about companies and their confidence (faith or belief that one will act in a right, proper or effective way) about their actions, but not their investment wisdom (making sensible decisions and giving good advice because of the experience and knowledge that you have) or the ability to process that information. Investors have become better than ever before at describing in detail the knowable facts about a company. Yet their ability to turn that knowledge into superior investment performance seems to have not improved at all. This is classic human behavior. Studies have shown that as we increase the amount of information available to us on a subject our confidence increases. However, those same studies show the accuracy of our forecasts and analysis doesn’t improve as the amount of information increases. This seems counter-intuitive. If some information is good, shouldn’t more information be even better? Think of your brain processing information the way your body processes vitamins. After a point, your body cannot absorb any additional vitamins no matter how much you ingest and in some cases over dosing on vitamins can be harmful to your health. Your brain can only process so much information and after a point it begins to self-edit; so more information adds little to nothing to your understanding.
Constantly pursuing all of this information and acting or reacting to “new information” (over trading) as it arrives gives investors what behaviorists call, the “Illusion of Control.” The illusion of control is the tendency for people to overestimate their ability to control events that they, in fact, have little or no control over. A classic example comes from the world of gambling. A study observed that craps players tend to throw the dice with less force when they want a low number to be rolled and throw the same dice with more force when they want a high number to be rolled. Since the outcome of successful investing is more wealth, the desire to control the outcome of one’s investment decisions to insure positive outcomes is extremely strong. After all, would clients pay an investment manager “2 and 20” if they really thought (or knew) that luck or randomness was driving the investment results? The good news is that while it has been shown that individuals tend to overestimate what they can control in terms of influencing the outcome of their investment, it has also been shown that they also tend to underestimate what they actually can control. To quote from the book, The Art of Thinking Clearly, “focus on the few things of importance that you can really influence. For everything else: que sera, sera.”
You cannot know more than everyone else and tomorrow (or next year) something you didn’t or couldn’t know today might impact your stock anyway. So what is something of importance that you can really influence? Understanding how a business works and how to value it is a big one. Gregg and I have found that your investment process should be focused on becoming better than others at measuring and understanding value and not on trying to generate superior information. 100% of the information we use to make our investment decisions is usually well-known by the investment community. However, we never use anywhere near 100% of the information that is knowable about a company.
“Wisdom is not a product of schooling but of the lifelong attempt to acquire it”-Albert Einstein
It is a cliché, but there is no substitute for experience. Experience exposes you to all kinds of situations and gives you a chance to feel your emotional state and understand how you react to that and learn from it. It is one thing to read about how to defend yourself against a shark attack (supposedly punching it in the nose) and another thing to actually do it for real. As generalists, Gregg and I have exposed ourselves to a large number of different industries and companies and it has helped us understand and recognize what characteristics of a company or management tend to suggest the potential for success or failure. It also has helped us transfer things that we have learned in one industry to others and to recognize when we might not really understand something about a company. Experience also helps you know “what you do not know” as much as it helps you know “what you know”. It also helps you set limits on the type and amount of information you find you need to come to a conclusion about the merits of an investment idea. In a future post I will discuss an exercise to help you figure this out.
Our experience has led us to conclude that the old “80-20 Rule” works pretty well for us when it comes to doing investment research. 80% of what we need to know to make an investment decision comes in the first 20% of the time we spend on the idea. This is why we recommend the “one-hour” analysis approach. After assembling the basic historical information about a company like annual reports, 10Ks and 10Qs, investor presentations, news stories, someone else’s analysis and conference calls, an investor should be able to draw a conclusion about the initial investment merits of the company. The investor should also be able to decide what he feels he needs to know (as opposed to would like to know) to finalize the process. I will expand on this in a future post. Hint: it is probably less than you think you need right now.
Growth is great, but pay as little as possible for it and stop looking for it.
“Stocks are bought on expectations, not facts.” —Gerald M. Loeb
While there are many reasons why a stock could be priced cheaply (liquidity risk, legal risk, poor performance, lack of visible growth prospects, bad management, etc.) there is generally only one reason why a stock is priced dearly-the expectation for growth. Since we have pointed out that we are notoriously bad forecasters, we would rather place our money on a company where investors are forecasting (and therefore not valuing) a company as if it will never grow faster than it currently is compared to paying up on the hope that a company’s current growth rate is either sustainable or due to “surpise to the upside.” If you look at the performance of stocks that have had substantial gains over time, you tend to notice a few things. One is that there is a strong correlation between earnings growth and stock appreciation (obvious). Two, the correlation between past and future growth is low (not so obvious). And third, a change in the valuation multiple (expansion or contraction) accounts for a large proportion of the change in valuation. So how can we use this in our process?
Starting with companies that are valued cheaply (relatively or absolutely) is a great place to start. After all, if you are reading this you are a “value investor”, right? As I mentioned before, I think investors do understand that multiple expansion drives a significant portion of the total return on an investment. They also understand that “positive surprises” eventually manifest themselves into higher multiples (at least for a while). Many times, investors drive up those multiples much faster than the earnings and revenues actually increase, which means that a company whose earnings are growing at 15% a year can have stock price gains of multiples of that within a year, boosting the investor’s short-term performance. What investors seem to be really trying to accomplish with all of this effort to absorb as much “new” information as possible is they are looking for signs of changes in earnings growth rates that aren’t visible to others at the time. This would seem to explain the obsession with things like “whisper earnings numbers”, channel checking at retailers, networking with experts in the field to glean changes in sales trends or competitive balance or reactions to government economic figures. But we have a better idea.
Your analysis should be focused on verifying that the current valuation is what it appears to be (for example, book value really is what it appears to be, free cash flow is sustainable, or sales are real) or that it is not (real estate, inventory, receivables, or liabilities). Since there is usually something obviously wrong with the company you are analyzing, understanding liquidity risk (or the lack thereof) is also extremely important. Understanding margins in a historical context and investigating the opportunity for mean reversion is also very important. In other words, spend time understanding the company’s ability to survive until the eventual turnaround and what the downside (margin of safety) is if your analysis proves wrong. What is not important is spending a lot of time looking for evidence that the current state of the company is about to turn imminently or identifying “catalysts” that could initiate that turnaround. Doing so is succumbing to the illusion of control. You can control what you pay for a company’s stock today, not what others may or may not pay for it in the future. As I will show shortly, even if you had perfect knowledge of a company’s earnings 10 years out, that knowledge alone cannot guarantee a satisfactory investment return. But if you buy companies with low valuations (you pick your preferred metric) that have sufficient liquidity, are patient (time arbitrage) and can “sit quietly in a room”, then you will increase your chances for success.
Changes in a valuation multiple is really just a manifestation of changes in investors’ confidence in the future growth rate of a company. That confidence can change based on company-specific events (earnings beats or misses) or competitor-specific events or macro-specific events among others. We believe that reversion to the mean is one of the most powerful concepts in investing. Since investors tend to overestimate the future growth rate of companies with high past and present growth rates and underestimate the future growth rate of companies with low past and present growth rates, we prefer to invest in companies exhibiting the latter. Investors also tend to suffer from “recency bias”. Valuations of poorly performing companies tend to be low because investors usually extend the recent trend well into the future. If future valuation multiples are going to change based on changes in investors’ confidence in future growth rates (or actual growth rates) we want to benefit from a positive revision in that confidence, not a negative one. Let’s look at why one company’s stock was flat over the course of earnings tripling and another’s stock tripled while earnings remained flat.
In 2001, Wal-Mart was the largest company by market cap in the United States. Annual revenue and earnings growth was in the low double digits and expected to continue for the foreseeable future. Return on equity was in excess of 20%. Over the subsequent 10 years, ROE remained over 20%, revenue and earnings growth remained in double digits and earnings per share tripled from $1.50 to $4.45!!!! Yet for most of that period Wal-Mart’s stock traded between $40 and $60 a share. Even though revenue and earnings growth generally met or exceeded expectations of those investors in 2001, the stock lagged because the PE ratio declined from 34X to 13X, negating the earnings growth. Even if an investor in 2001 knew exactly what the earnings were going to be in 2011 (perfect knowledge), unless he knew what investors were going to pay for those earnings 10 years out he received no benefit. He would have had the “illusion of control” over his investment because he knew the future earnings with 100% certainty!!! Had investors paid only 13X earnings in 2001, the stock would have tripled as earnings tripled and may have done even better due to multiple expansion attributed to relative stability of sales and earnings growth.
Many readers of this article would respond that it was obvious that the stock was overvalued and just like the PE ratios of the Nifty Fifty from the 60’s, the PE had to eventually contract. Fair point, but in 2001, investors seemed to be paying up for the comfort they received knowing that the company had no financial risk, was a visible “double-digit” revenue and earnings grower, and was “taking share” from retailers and grocers alike.
A few years ago, the investment case for Gannett was nowhere near as promising at Wal-Mart’s was in 2001. Since 2006, revenue had declined by one-third and earnings by approximately 50%. The stock price, which was has high as $90 in 2004, would trade as low as $8.30 in 2011. In 2010, expectations were for earnings of $2.00 a share for the foreseeable future. Newspapers were dying and websites like Craig’s List and others were “stealing market share.” Buying shares of Gannett in 2011 would have made an investor very uncomfortable. There was no storyline that was apparent at the time that an investor could point to as justification for his investment. It has been said that “hope is not an investment strategy” and at the time, it appeared as though anyone investing in Gannett was speculating, hoping for the best and not really investing. However, since its low in 2011, the price of Gannett’s stock has tripled.
Templeton Funds has an advertising slogan, “Seeing today what others see eventually.” We do not think that investors have to be able to definitively “see” the future. In fact, just focusing on the present is usually good enough. In the case of Gannett, if an investor took the time to look at the company’s balance sheet and cash flow statements available at the time, he would have found a company that was paying down debt, generating substantial free cash flow and owned many valuable assets that were demonstrably not being reflected in the enterprise value of the firm. Using private market valuations that were available at the time for Gannett’s high quality TV stations and marking to market the company’s investments in CareerBuilder and other internet companies, an investor could have concluded that those assets alone where worth north of $11 a share at the time. In other words, at $8.30 per share, investors appeared to be assigning a negative value to the newspapers. If an investor could bring himself to become more comfortable than the market (not necessarily “bullish” or very comfortable) on the future of their newspapers, which include USA TODAY, and buy the stock, there was a chance of significant gains in the future. As it turned out in hindsight, the value of those assets have been recognized by the market and investors are now putting a 12X PE on the very same earnings that two years earlier they were only willing to pay 5X for. So even with VIRTUALLY NO EARNINGS GROWTH for three years, Gannett’s stock price has tripled. Of course, looking at Wall Street research, there is a significantly higher amount of “comfort” in an investment in Gannett at $25 a share than there was at $8 a share. As Mr. Buffett said, “investors do pay a high price for certainty.”
“We have met the enemy… and he is us.” Pogo
I recognize the irony of posting an article on the internet that implores the reader to stop reading so many articles posted on the internet by directing you to other articles posted on the internet. But if you follow the suggestions in this article, hopefully you will have more time to read articles about how to improve your investment process. I think you will find that you will look at stock prices less frequently and read fewer articles that try to explain the proximate cause of the changes in those prices and prognostications of what those stock prices will be in the future. You will focus more on what you can really understand, (the present) and less on what you can’t, (the future).