In “Returns and Lessons Learned”, which was published when the TSOH Investment Research service launched in April 2021, I discussed some of the most notable investment blunders that I’d made over the course of the past 10+ years. But the reason why I wrote that article wasn’t self-flagellation; instead, my objective was to highlight how these mistakes planted the seeds for an evolution in my investment philosophy and research process.

Today, I want to share additional detail on my investment philosophy.

The reasons why are two-fold: First, it’s pertinent information for current and prospective subscribers; I want you to have a clear understanding of the kind of investment ideas that I’m looking for, which may or may not align with your own approach. Second, it’s a useful exercise for me personally: I have evolved as an investor over the years, and it might be worthwhile to take a step back and clearly define who I am and what I’m trying to accomplish.

So, with that, here are the key tenants of my investment philosophy (as a reminder, I discussed asset allocation in "Mo' Money, Mo' Problems"; revisit that post for my views on structural vs tactical allocations, holding cash, etc.).

1) Long-Term Holdings

“One thing every investor needs to think about is identifying their edge… We think the biggest edge any investor can have, and the biggest edge we do have, is a long-term orientation. It’s easy for people to say they have a long-term orientation, but it’s harder to actually have one.”

- Seth Klarman, March 2009

My typical holding period is measured in years, or even decades.

I’ve owned Microsoft and Berkshire Hathaway, my two largest positions, for more than ten years. Of the remaining companies currently in my portfolio, I’ve owned most of them for at least three years (the more recent additions are Bank of America, Liberty Broadband, Spotify, and Dollar General).

The reasons why I’ve chosen this approach are three-fold: (1) Short-term investing / trading is a competitive game where one’s advantage may be dependent upon access to third-party data (credit card spending, web traffic, etc.) or even insider information, which is a clear disadvantage for an individual investor like myself; (2) Short-term investing / trading is more influenced by luck and market timing (over the long run, the outcome for an investment will converge with the underlying results of the business); and (3) A long-term investment time horizon has a number of important advantages over trading, some of which are obvious (preferential tax treatment by Uncle Sam), while others are less tangible (for example, I believe a long-term “relationship” with a company lends itself to a perspective that may be more nuanced and level-headed than somebody who has only been following a company or industry for a short time, resulting in better decision-making).

2) High-Quality Businesses

“If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

- Charlie Munger

This is a natural extension of point number one: if you plan on holding an investment for years, it’s logical to search for companies where per share intrinsic value is expected to increase at higher than average rates over a comparable time horizon (“Time is the friend of the wonderful business, the enemy of the mediocre.”). When you own a stock for 5-10 years, the temporary fluctuations in Mr. Market’s perception of the business, as expressed through changes in its P/S, P/E, or EV/EBITDA multiple, will have a much smaller impact on the outcome than it would over a holding period measured in months (in the latter example, the vast majority of gains or losses on the investment will be attributable to changes in sentiment).

But what is a “high-quality business”?

Personally, these are the four main criteria I’m looking for: (1) Operates in an industry with structural tailwinds that will support (organic) top-line growth for the business; (2) With attractive normalized unit economics and high ROIIC as a result of sustainable competitive advantages (strengthening economic moats); (3) With a thoughtfully financed balance sheet; and (4) Run by individuals with a long-term time horizon, integrity, and managerial skill (in terms of operating the business and in making capital allocation decisions).

This section comes with an important disclaimer: in all honestly, I don’t believe each of my investments currently meet all of these criteria.

My explanation for that inconsistency is two-fold: (1) The application of these criteria isn’t always black or white and requires the ability to make sensible exceptions. For example, Spotify doesn’t pass the second criteria on its current economics largely due to where it’s at in its lifecycle; that said, I expect that to be resolved over the course of the next 5-10 years. As that example suggests, these criteria cannot always be rigidly applied or taken at face value. (2) It’s a fair critique of some of my portfolio positions, and I need to be more demanding as an analyst; if I own companies that are not on a path to meeting each of these four criteria, change is required.

I do want to highlight one notable downside of a strictly applied “quality first” investment approach: by definition, it will eliminate a large percentage of the investable universe from our opportunity set. This comment from Chuck Akre’s Q3 2007 partner (investor) letter is worth thinking about:

“The majority of the time, we are allocating our dollars to better than average businesses at ‘fair’ prices, and only occasionally do we get an opportunity to buy these businesses at ‘bargain’ prices.”

Akre has narrowed his opportunity set to a single bucket (“better than average businesses”). And as his team has noted subsequently, it’s quite a restrictive definition: “Of thousands of publicly traded companies, there are probably fewer than 100 that meet our criteria”. Personally, I accept the trade-offs associated with this approach: Anything that does not pass the quality filter is no longer under consideration as a potential investment, no matter how attractive the valuation appears, or actually is. (As Buffett put it, “I don’t have to make money in every game.”) I’ve chosen the sand box I want to play in, and I’m focused on finding the best investments available to me within that clearly defined opportunity set. Given that I’m only likely to own about 5-15 companies at any given time (more on this below), I’ve found there is still ample room to find attractive investments despite this constraint.

3) A Concentrated Portfolio

“If you look at all the great investors, and they’re as different as Warren Buffett, Carl Icahn, and Ken Langone, they tend to make very, very concentrated bets. They see something, they bet it, and they bet the ranch. And that’s the way my philosophy evolved… there may be only one or two times a year that you see something that really, really excites you… The mistake 98% of money managers and individuals make is they feel like they’ve got to be playing in a bunch of stuff. If you really see it, put all your eggs in one basket and watch that basket very carefully.”

- Stan Druckenmiller

My views on position sizing have been influenced by my investment approach (the long-term ownership of high-quality businesses). And, somewhat counterintuitively, my preference for concentrated bets has also been influenced by my belief that investing is a highly competitive endeavor with intelligent and hard-working participants (particularly in the fight for short-term gains). Given that reality, how can we give ourselves a good shot at long-term success? (Defined as better than average returns over the course of one’s investment career.) Personally, I think the answer is a balance of patience and conviction. Notably, I think the incentive structure in finance limits the ability of some market participants, such as investment advisors and fund managers, to truly be patient or to act aggressively, even when they have good reason to believe said action is warranted (those rare, truly great ideas). The upside is outweighed by the downside (career risk); for what it’s worth, I spent 10 years on the buyside and witnessed this reality firsthand.

The adoption of a truly long-term mindset, along with the willingness to act aggressively (and the patience / perspective to think long-term and stay aggressive) when those opportunities present themselves, is where my best chance at long-term outperformance lies (from “The Long-Term Crutch”):

“In those rare instances when you find yourself aboard a one-of-a-kind vessel with an exceptional captain, I’ve come to believe you should significantly loosen conventional valuation metrics that typically cause great consternation for traditional value investors (where they’re willing to trade a great business at a “high” price for a poor business at a “bargain” price).

This is where I think it truly pays to have a long-term mindset – not as an excuse for inadequate analysis or as a justification for continuing to ride a broken down nag with a low probability of meaningful long-term improvement, but in support of continued ownership of a truly great business with a best-in-class management team (of which there are very few in this world).”

This is probably the most significant change that I’ve made to my process over the past decade. I used to think about aggressiveness in terms of doubling down on (what often proved to be, in hindsight) a struggling thesis / busted story but where the discount to fair value appeared to be widening (intrinsic value declined ~10%, but the stock price fell ~20%).

Today, I tend to approach it from the opposite side: I’m much more willing to make a position larger when the thesis is working (the business is delivering strong results), which is achieved through additional open market purchases or letting the position grow in size as the stock delivers outsized returns.

In summary, I believe competitive markets demand meaningful action when rare opportunities appear. Charlie Munger put it best when he spoke about the few successful bettors at the track (from “A Lesson on Elementary, Worldly Wisdom As It Relates to Investment Management & Business”):

“I had dinner last night with the president of Santa Anita [horse racing track]. He says there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house… They are that shrewd about something with as much unpredictability as horse racing. And the one thing that all those winning bettors in the whole history of people who have beaten the pari-mutuel system have is quite simple: they bet very seldom... It is not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a mispriced bet - that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet heavily when the world offers them that opportunity… And the rest of the time, they don’t. It’s just that simple.”

4) Valuations and Modeling

This is where it gets a bit trickier: Even when we find one of those elusive “high-quality businesses”, how does a thoughtful, long-term investor think about the price that they’re being asked to pay to buy (or continue owning) it? At what point is greatness fully reflected in the stock price?

Personally, I can live with valuations that get “a little silly” on conventional metrics (as discussed in “I Don’t Defend This Logic”). 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). In addition, I have more appreciation for right tails and Einstein’s “eighth wonder of the world” than I used to. As someone who aspires to be a long-term owner of great businesses, here’s what I’ve concluded: cutting off the right tail solely because the valuation appears “a little silly” is a bad idea. Over time, the opportunity cost is too high (identifying truly great long-term businesses isn’t easy). On those rare occasions where you find yourself invested in a great business with a long reinvestment runway being operated by an honest and able manager, you should demand a similarly rare valuation to part ways with your equity interest. In terms of a multiple of current (or normalized) EPS or FCF, it deserves something significantly higher than the average company.

But I don’t think that’s a sufficient conclusion.

I think this idea becomes more useful if we attempt to quantify greatness through financial modeling; it’s a useful exercise for roughly valuing and ranking our opportunity set to make well-reasoned investment decisions (I find it particularly useful for similar businesses, as I’ve outlined in the past with decisions like Facebook vs Twitter, Costco vs Dollar General, etc.).

A model requires you to explicitly define - to quantify - greatness; it also provides perspective on how Mr. Market views a business relative to its future normalized earnings power. For a detailed (numerical) example of how I work through this exercise as part of my equity research process (my attempt at quantifying greatness), please review my deep dives on Spotify and Airbnb.

What  you’ll see is that I’m focused on identifying and quantifying the key drivers of long-term value creation; I’m not trying to out model the Street on FY22e or FY23e EPS. My goal is to generate a rough estimate of long-term normalized per share earnings power, and to see how that compares to today’s valuation (I think of it as being somewhere between a traditional DCF and a reverse DCF). As part of this exercise, I frequently remind myself to remain cognizant of the risks presented by a false sense of precision; if you become consumed by the outputs of a model, that’s a perilous situation.

Conclusion

Much of the investment philosophy that I picked as a young investor, primarily from sources like the Berkshire Hathaway shareholder letters, remains fundamental to what I believe and practice today. But real-world experience over the past 10+ years has also provided its own insights. The biggest lesson I’ve had to relearn is that equities represent a minority interest in a business. At times, I let the balance between being a market participant and a business owner get out of whack; I think I became overly focused on short-term valuation metrics, which blinded me to some opportunities that were well within my circle of competence (DG is a notable example).

This has served as reminder to emphasize the importance of owning high-quality businesses with sustainable competitive advantages operating in attractive end markets with strong balance sheets and best-in-class management teams, in addition to ensuring that the equity trades at a reasonable valuation (likely to deliver attractive long-term returns).

As Gayner says, focus on the movie, not the snapshot. As an investor, that’s my north star - and if I can maintain my focus on the right opportunity set, I believe I have the analytical ability to find some attractive ideas over time.

 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 is 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.