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Investment Philosophy |
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I view my principal job as an investment manager in relatively simplistic terms. Above all else, it is my job to properly appraise the intrinsic value of the business or asset under analysis. I look for businesses that are worth $100 million that can be purchased for $65 million (or less, of course). That’s the majority of my expertise: valuation analysis. I can’t predict, with much accuracy, when the asset will rise to its intrinsic value, or whether or not the cash bid will actually decline over some period of time. Given enough time, however, a business worth $100 million will eventually trade at fair value.
If I do my valuation analysis well and spread out the bets in case I make the occasional mistake, then I don’t have to worry when I buy a $100 million business for $65 million and the price subsequently drops to $55 million. The principal issue here is patience. Most stock market investors are extremely impatient. The average mutual fund manager, for example,
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……………...holds a stock for an average of less than 1 year. Such impatience often leads to a significant mispricing of a business or asset. If I exercise greater patience and judgment than the average investor then I have an overwhelming advantage in generating long-term returns for my investors.
Each time I evaluate an asset or business, I assume I will ultimately be proven wrong about some aspect of the analysis. I regularly imagine developments evolving contrary to my expectations. Consequently, roughly 80% of my research efforts are devoted to examining the downside of a particular investment. Success, after all, takes care of itself. It is the manner in which an investment manager handles adversity that is the true test of his or her mettle.
In order to reduce the probability of loss resulting from an adverse outcome, I typically look for businesses trading at prices that already reflect bad news. Legendary value investor Benjamin Graham termed this concept margin of safety. If I buy a business at a price that imputes a large enough margin of safety, then all is not lost if something goes wrong. If the price already reflects bad news, after all, then additional bad news will have a muted affect on its value. And if anything at all goes right, the business should eventually increase in value.
Which brings me to the concept of reversion to the mean. I tend to focus on “out of favor” assets and businesses because, at the end of the day, I believe that the concept of reversion to the mean is a dominant characteristic of asset markets over extended periods of time, and there have been volumes of research produced to support this contention. The earnings growth rates of companies and industries tend to mean revert quickly because of the nature of capital markets. Industries which are experiencing high growth rates tend to attract competition and capital investment by other firms. This competitive process eventually results in lower returns on equity and lower earnings growth rates. Conversely, industries with low growth rates do not attract much new capital investment and managements are capable of achieving higher earnings by operating more efficiently. Thus, the earnings growth rates of both high and low growth companies tend to revert to the mean. As a result, acquiring out of favor businesses at low prices tends to generate much higher returns over the long term than buying popular businesses at rich prices, as valuations afforded to the former tend to rise over time and valuations on the latter tend to decline. The difference between a good business and a good investment, after all, is the price one pays.
In addition to concentrating on out of favor businesses, I also tend to focus on illiquid securities. The capital markets place a considerable premium on liquidity or, conversely, assign a considerable discount to illiquid securities. Because my investment style is long term in nature, I actively seek out illiquid situations in which I am highly confident that I can eventually capture the marketability discount through a “liquidity event” (e.g., a sale of the business, repurchase of my position by the company or a refinancing in the case of a debt obligation). Clearly, however, patience is critical in such situations.
In summary, I typically seek out unusual investment opportunities that are shunned by others as a result of their small size, poor recent financial results, illiquidity, complexity or general level of unpopularity. Over the long term, a portfolio of such investments, if properly managed, should meaningfully outperform all relevant benchmarks on both an absolute and risk-adjusted basis. |
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