"The Evolution Of A Value Investor"

In late 2021, I published a post titled “My Investment Philosophy”.

The goal of that write-up was to clearly outline the long-term approach that drives my decision-making. In the section on valuation and modeling, I wrote about how I approach the balancing act faced by long-term investors when they find themselves holding businesses at higher than average valuations:

“Personally, I can live with valuations that get ‘a little silly’ on conventional metrics [a nod to Munger]. Much like the restrictive decision I’ve made to only focus on ‘high quality businesses’, I’ve concluded that this approach presents the least bad option for me (the kind of risk that I’m willing to incur).”

I specifically used that language - “for me” - to make a distinction between a personal choice and a decision that can be labeled as right or wrong. Said differently, while I recognize that there are other (logical) thought-processes for how to navigate this, I’ve selected the approach that I believe is best suited to my mindset, abilities, and time horizon / cash flow considerations.

Honestly, that’s a more lenient view than I would’ve accepted as a younger investor. At the time, despite limited experience / knowledge, I held some strong opinions (a dangerous combination). I was generally dismissive of investment approaches that didn’t look like traditional value investing, or at least my interpretation of value investing - for example, paying ~25x earnings for just about anything. I probably would’ve looked at an investor like Herbert Wertheim and concluded that his long-term success was largely attributable to a single, and probably lucky, outcome (a $5 million investment in Heico that is now worth >$1 billion). That conclusion may not have held up in light of some pertinent facts – i.e. the scuttlebutt and earned conviction that led to his huge winner – but I surely could’ve made up some passable explanation for why my way of doing things was right and his was of doing things was wrong.

What I’ve slowly learned is that my thoughts about the proper way to play the game were far too rigid. While certain approaches may not align with my idea of what it means to be an investor, there’s clearly more than one way to get to heaven (with someone like Stan Druckenmiller, I still don’t truly understand what game he’s playing). An inability or an unwillingness to accept that speaks more to the views of the individual than to reality. Instead of thinking about whether various approaches are right or wrong, I now tend think about them in terms of trade-offs. Consider the distinction between growth and value (as both are traditionally defined). My good friend Bill Brewster has articulated a useful way of thinking about the puts and takes of either approach: value investors understand the role of price / low valuations in mitigating the left tail risks, while growth investors understand that the right tail can be longer than the value investors appreciate (or more appropriately, may be longer than they’re willing to continue staking their capital against).

As opposed to distinguishing between right and wrong, this shifts the question to finding the framework that is best suited to your desires and abilities (the risk you’re willing to incur). In doing so, it becomes useful.

As we think through the trade-offs we must consider as investors, I think these two statements do a good job of summarizing the primary issues:

“I want to be in position to outperform the market... but I also want to avoid any sustained periods of significant underperformance (despite clear evidence that this is all but unavoidable, even for the great investors).”

“I want to buy and own great businesses... but I also want to be price conscious to ensure I own stocks currently offering the highest IRR's (typically with a time horizon of five years or shorter, with the return estimates derived by comparing today’s price to the output of a financial model).”

At a high level, I think that those two statements capture the large majority of the (unavoidable) stress and concern that we face over time as investors.

At some level, they ultimately demand that we make a choice.

The first one is straightforward: do you truly want to be an active investor? While the answer doesn’t have to be binary (you can run a mix of active and passive allocations), there are clear implications as you differentiate between those approaches. If you choose to be active, the follow on question is tied to the second statement: what is the (long-term) path to the promised land?

Personally, while fully recognizing that there are alternative ways to intelligently play the game, one of my biggest learnings over the past decade is the importance of clearly establishing an investment philosophy (a clearly outlined vision beyond “I want to make money”).

This seemingly small step alters your perspective on what companies or investment ideas to include in your opportunity set, as well as your approach to portfolio decision-making (position sizing, holding periods, etc.). As an example of a firm who shares a similar philosophy to my own, consider this comment from the team at Akre Capital: “Of the thousands of publicly traded companies, there are probably fewer than one hundred that meet our criteria.” That is a big statement. The Akre team is saying that the vast majority of all publicly traded companies are not a candidate for inclusion in their portfolio, regardless of how attractive or cheap they may appear (be). Will that lead to missed opportunities? Of course it will. But what they’re implicitly saying is that they accept this cost because they believe it will be more than offset by the resulting benefits - keeping a clear eye on the dozens of public companies that they would truly want to own at the right price. (“Of our most costly mistakes over the years, almost all have been sell decisions. The mistake, in virtually every instance, has been selling too soon.”)

As outlined in “My Investment Philosophy”, I’ve chosen a similar approach. I ended up in that camp over time because I think it is aligned with my mindset and my long-term time horizon (it also helps that certain investors who I greatly respect have shown how fruitful it can be when well implemented). I accept the cost of being exposed to valuation risk as a condition of playing a game that is focused on business quality as the first filter (to be 100% clear, my job as an analyst is to sift through the opportunity set to minimize the valuation risk while focusing on / maximizing business quality).

This is a “business first” approach to investing. While the quality of the underlying business has always been part of my analysis / investment process, this seemingly subtle shift has led to a meaningful change in how I approach the game - most notably in terms of how I think about when to trim or add, which has a significant impact on position sizing over time. (To pick a specific example, it’s a big part of why Microsoft is still my largest position after 10+ years as a top holding; under an alternative approach, it’s quite likely it would’ve been cut to a much smaller weighting over time - if it would still be in the portfolio at all). What I find particularly interesting is how many “valuation first” investors seem to ultimately come around to that way of thinking. For example, consider this comment from Steve Romick of the FPA Crescent Fund in a recent speech titled “The Evolution Of A Value Investor”:

“I remained anchored for longer than I should have to a narrow focus on the importance of balance sheets, book value, and current cash flow or earnings. My continuing education in the real world fostered a more nuanced understanding of value… Today, when considering similar companies, I rarely regret paying an extra multiple or two of earnings to partner with capable and shareholder-centric management teams. While I had focused on the price paid compared to balance sheet metrics as the essential arbiter of downside protection, I’ve since come to appreciate the substance of a business - such as its competitive position, profit margins, and growth rate - has greater importance… I evolved and embraced the idea of buying great businesses at reasonable prices, not just good ones at great prices. Continuing to invest with a margin of safety did not change, but it came from a different place, more from a business’s quality than its balance sheet.”

Maybe Romick hasn’t moved all the way to “buy and almost never sell” like Wertheim, but it sounds like decades of experience has led him to the conclusion that there’s something to be said for an approach that leans in that direction (in practice, I’d bet that “extra multiple or two” is likely much higher).

The evolution of my investment philosophy has followed a similar trajectory.

Conclusion

Believing that there’s a right way to invest strikes me as similar to believing that there’s a right way to run a restaurant. One restaurateur might argue that the variable to optimize for is pricing, with the quality of the food and the dining experience as a secondary concern; another may argue the primary considerations are high-quality food and a compelling experience, with price secondary (a “high” price doesn’t necessarily equate to a poor value).

When framed that way, nobody would reasonably argue either approach is without merit (there are plenty of successful restaurants in each of those buckets); in my mind, that same conclusion applies to the world of investing.

That said, I’ve become convinced that there are advantages in clearly deciding which type of investor you want to be, and then doing everything in your control to focus on playing that game to the best of your ability. Or, as Romick puts it, “Determine what strategy works best for you and stick with it… Find a style that synchs with your personality so that when tested during stress, you are not getting pushback from the person in the mirror. There isn’t one right way, but there’s probably one way for you.”

For me, I eventually came to the conclusion that there were disadvantages with a “go anywhere” / “there’s a price for every asset” approach to investing, particularly in terms of where it drew my attention. That lesson has informed the more restrictive approach I operate with today (and for what it’s worth, I’d still call myself a value investor). If you look at the portfolio activity that I’ve shared with you since the launch of this service in April 2021, I think you can clearly see how that way of thinking has materialized in my decision-making.

I’ll close with something that Charlie Munger said at the 2000 Berkshire Hathaway annual meeting about the different styles of value investing: “Well, I agree that all intelligent investing is value investing. You have to acquire more than you pay for, and that’s a value judgment. But you can look for more than you’re paying for in a lot of different ways. You can use filters to sift the investment universe. And if you stick with stocks that can’t possibly be wonderful enough to put away in your safe deposit box for 40 years, but which are underpriced, then you have to keep moving around all the time; as they get closer to what you think the real value is, you have to sell them and find others. And so, it’s an active kind of investing. The investing where you find a few great companies and just sit on your ass because you’ve correctly predicted the future, that is what it’s very nice to be good at.”

NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty, or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions, and estimates expressed in this report constitute my judgment as of the date thereof and are subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. The TSOH Investment Research Service is not acting as your financial advisor or in any fiduciary capacity.