What Happens When You Don't Buy Quality? And What Happens When You Do?

[Guest hellsten]

A presentation by Sanjay Bakshi from October 11, 2013:

https://dl.dropboxusercontent.com/u/28494399/Blog%20Links/October_Quest_2013.pdf

 

[ItsAValueTrap]

Nice article!  I think that a lot of value investors are still focused on cigar butts and turnarounds.

[gurpaul88]

Thanks! good read

[constructive]

It is a good article, but I think it undersells the difficulty of quality investing a bit. 

 

Buffett is a vocal proponent of high quality investing, but on the other hand his returns were higher earlier in his career, when he was more influenced by Graham and less by Munger.

[ItsAValueTrap]

But Buffett even states in one of his shareholders letters that Berkshire Hathaway was a mistake...

[Liberty]

Buffett is a vocal proponent of high quality investing, but on the other hand his returns were higher earlier in his career, when he was more influenced by Graham and less by Munger.

 

Careful about seeing direct causality there. There are many variables, such as the underlying market movement, the size of his investable assets, etc. Also, some of his early picks weren't cigar butts (GEICO).

[rohitc99]

you have to look at the presentation in an indian context. In india, low quality cheap stocks do not reach their fair value or the value does not get recognized, because it is close to impossible for an outsider (hedge fund, activist investor etc) to rattle the management or push for a change.

in addition bankruptcy laws are absent, so you have zombie companies holding onto and wasting capital. as a result, it is far better to buy higher quality companies than the cigar butts in india.

I think mohnish mentioned that he had similar experience with his basket of net nets in japan.

[Packer16]

Interesting observation.  It sounds like buying cheap "good enough" companies will not work in less developed marketr like Japan and India.

 

Packer

[Palantir]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

[nkp007]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

 

Agreed. You can't make ~30% compounded for an extended period of time by buying "great companies at fair prices" (I assume fair means ~10x earnings).

 

If he had only $1 or $2 million, I guarantee you he wouldn't be wasting capital by allocating it to just "fair" opportunities.

[Liberty]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

 

Agreed. You can't make ~30% compounded for an extended period of time by buying "great companies at fair prices" (I assume fair means ~10x earnings).

 

If he had only $1 or $2 million, I guarantee you he wouldn't be wasting capital by allocating it to just "fair" opportunities.

 

Good points, I agree.

 

His personal portfolio is mostly JPM afaik, though, so he's not totally against the idea of moving up even in smaller portfolios. But it's still in the 100s of mils. I guess that's the problem if you compound really fast; you rapidly reach the point where you have to look at bigger companies...

[Parsad]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

 

+1...fully agree!  Cheers!

[rohitc99]

Interesting observation.  It sounds like buying cheap "good enough" companies will not work in less developed marketr like Japan and India.

 

Packer

I ran a small experiment in india. portfolio 1 was high quality companies (with good growth) and portfolio 2 was the cigar butts. both the portfolios did better than the market, but portfolio 1 did far better than portfolio 2.

The other difference in india is that high quality companies with competitive advantage can easily grow at 15% for a long time which lets the value compound. in case of cigar butts, one needs to constantly rinse and repeat

 

in contrast, in the US generally something event happens which unlocks the value ...in india that is a rarity

[Uccmal]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

 

+1...fully agree!  Cheers!

 

So does special situations include GE, Goldman Sachs, and Bac convertibles.  How about great companies at fire sale prices? 

[Packer16]

I think buying high quality companies at fire sale prices occurs maybe once every 25 to 50 years.  If you have cash for these they are the safest investments but if you purchased less quality companies at the same time I think the upside would be greater in the US.

 

Packer

[racemize]

A presentation by Sanjay Bakshi from October 11, 2013:

https://dl.dropboxusercontent.com/u/28494399/Blog%20Links/October_Quest_2013.pdf

 

So that credit suise study he cited seems to be somewhat contradicted by this tweedy browne essay:

http://www.legend-financial.com/files/Great%2010-Year%20Record%20Great%20Future,%20Right.pdf

 

perhaps it is based on the return on invested capital rather than ROE? 

[Uccmal]

I think buying high quality companies at fire sale prices occurs maybe once every 25 to 50 years.  If you have cash for these they are the safest investments but if you purchased less quality companies at the same time I think the upside would be greater in the US.

 

Packer

 

Agreed Packer

 

I dont know about that.  Since the financial crisis we have had JPM get hammered down by the Whale,

BP get killed by the gulf leak.  These are only two examples I can think of in 5 minutes.  Buffett bought General Dynamics stock in the 90s when war was never going to happen again.  These seem to happen frequently, though perhaps not predictably, in the absence of a "global" meltdown. 

[LC]

I think great historical records are only useful as a gauge of whether management and operating structure can properly monetize favorable business/industry conditions.

 

Take two companies, both with equally favorable future business prospects. One has  a ten year track record of exceptional operations. The other has only been in existence for two years.

 

That situation is when the track record is important. But the most important thing is having favorable future prospects.

 

"If past history is all there was to the game, the richest people would be librarians"

[BG2008]

My suggestion is to do what you have a "knack" for and try to find a "niche" that you're really good at

 

In the past, I thought I would buy quality business at a fair price.  After a couple year of tinkering with my personal capital, I personally find that quality businesses are much harder to spot than the way that Grandpa Buffet explains it.  Obviously, it's easy to look at Coca Cola and say that's a heck of a business when Buffet explained it.  This is akin to looking at the answers in an Engineering problem and working backwards to figure out the 5-6 steps to get to the solution.  You also know you're right to begin with.  In real life, finding a quality business is like solving a complex engineering problem without knowing the answer.  You have to make sure that you follow the correct logic and you did not miscalculate along the way.  Then you have to load up the truck and buy with conviction.  I truly respect people who can do it well, especially those who can do it well really early on in their career (20s). 

 

I myself have dedicated my craft, for the time being, to harvesting melting ice cubes and engaging in special situations.  But I make sure a few things happen 1) The melting of the ice cube stops or slows down drastically (liquidation, asset sale, shareholder activism etc) 2) I buy an ice cube that's substantially larger than the adjusted size 3) I can put the ice cube into a freezer at some point (return of cash to shareholders)

 

I do this because I am confident in my analysis and I will know whether I was right or wrong rather quickly.  Another downfall of paying up to buy quality is that one can look like a genius for years in a bull market.  I bet there will be a few fund managers who started their fund in 2009 who will be exposed the next time we have a financial crisis.  People who bought Bear Stearnes and Lehman Brothers looked like geniuses for quite a few years until it all came crashing down

 

I was at a conference once and David Einhorn mentioned that he bought Apple when it was a net-net and he regrets not holding onto the name.  What Einhorn forgot to mention is that he compounded money at some pretty impressive double digit returns since.  Last time I check 20% compounded over 20 years is about 38x.  It's not Apple like, but it's not far off either.  But I am certain that we can spot a net net a lot easier than how Apple was going to revolutionize the electronic business, that Steve Jobs was going to create a computer masquerading as a phone and get people to pay $600 for the machines.  That's a much more difficult call to make than "I'm buying a melting ice cube at a 50% discount and I know that we're going to stop the melting very soon"

 

I personally think that Buffet started buying great businesses because it's hard to find net nets when he was managing over $100mm back in the 70s/80s.  There are less opportunities for him to rinse and repeat at that point.  Buffet also said that if he was managing $1 to $10mm today, he would look at a much different opportunity set and he can guarantee to do 50% a year.  That's a very powerful statement and one should invert that a bit.  It's a known fact that Buffet used to shoot the lights out of the Dow when he was trading in his PA.  For those of trying to "get rich quick without taking on a lot of risk", I suggest that you look at the more obscure corners for the truly asymmetrical risk/reward opportunities. 

 

As the asset base grows, I will absolutely start to look at larger market cap and higher quality businesses.  As a matter of fact, I kind of have a plan in place for when the asset base is 5x, 10x, 50x, and 100x of its size today.  In the meantime, I will learn about picking good companies as well. 

 

In short, do what you have high conviction and can honestly call yourself "the smart money."  Also, I would recommend that everyone learn to hedge or set aside cash for that 25 year storm where you can pick bargains on the cheap

 

 

 

 

[oddballstocks]

BG2008....awesome post!

[giofranchi]

I understand and agree with all that has been said in this thread! Yet, as always, I like to bring in the perspective of a businessman… As a business owner I know two things: 1) I wouldn’t start one if too unpredictable, 2) (and most important in my view) I wouldn’t start one without a partner who allocates capital reliably or, even better, shrewdly.

 

I don’t know if 1) + 2) = “high quality”… and I don’t care much about the answer either. The fact is simply I demand: predictability + good capital allocation. I don’t shift capital into any venture, if I don’t see those two prerequisites.

Instead, if I see both, then I look and wait for an entry price which would allow me to compound capital at 15% yearly for many years into the future.

 

giofranchi

 

[Guest valueInv]

I disagree...I think buffett is interested in high quality investing, not because he believes it is a superior method, but because it fits into the structure of Berkshire Hathaway better. BRK is built around the fact that he can invest low cost float into equities, and the implied leverage allows him to take businesses that will be around for decades and lever up their returns....

 

Deep down, I'm confident Buffet is a hardcore deep value/special situations guy, not this "just buy great companies at fair prices" that he talks about.

 

How do you know?

[Packer16]

I think buying high quality companies at fire sale prices occurs maybe once every 25 to 50 years.  If you have cash for these they are the safest investments but if you purchased less quality companies at the same time I think the upside would be greater in the US.

 

Packer

 

Agreed Packer

 

I dont know about that.  Since the financial crisis we have had JPM get hammered down by the Whale,

BP get killed by the gulf leak.  These are only two examples I can think of in 5 minutes.  Buffett bought General Dynamics stock in the 90s when war was never going to happen again.  These seem to happen frequently, though perhaps not predictably, in the absence of a "global" meltdown.

 

I am not saying that these bargains are not available all the time just that for large caps you need to be more careful because your competition is much higher.  For every JPM and BP there are Dells and HPs.  Smart value investors have invested in both it is just harder to outperfrom with large cos.  What advantage do any of us have over sellers of JPM, BP, Dell or HP versus the advantage we can have over sellers of Saga Communication, Salem Communications, Lin TV or Alliance Healthcare or even in the extreme some of the microcaps mentioned here.

 

As to Buffet, I think he tries to leap the 1 foot fence before the 10 foot one but as his assets have gotten larger the fence has gotten higher so he has had no choice.  In my mind these smaller situations are lower fences because the competition is less.

 

Packer

[Uccmal]

I think buying high quality companies at fire sale prices occurs maybe once every 25 to 50 years.  If you have cash for these they are the safest investments but if you purchased less quality companies at the same time I think the upside would be greater in the US.

 

Packer

 

Agreed Packer

 

I dont know about that.  Since the financial crisis we have had JPM get hammered down by the Whale,

BP get killed by the gulf leak.  These are only two examples I can think of in 5 minutes.  Buffett bought General Dynamics stock in the 90s when war was never going to happen again.  These seem to happen frequently, though perhaps not predictably, in the absence of a "global" meltdown.

 

I am not saying that these bargains are not available all the time just that for large caps you need to be more careful because your competition is much higher.  For every JPM and BP there are Dells and HPs.  Smart value investors have invested in both it is just harder to outperfrom with large cos.  What advantage do any of us have over sellers of JPM, BP, Dell or HP versus the advantage we can have over sellers of Saga Communication, Salem Communications, Lin TV or Alliance Healthcare or even in the extreme some of the microcaps mentioned here.

 

As to Buffet, I think he tries to leap the 1 foot fence before the 10 foot one but as his assets have gotten larger the fence has gotten higher so he has had no choice.  In my mind these smaller situations are lower fences because the competition is less.

 

Packer

 

I dont really have any disagreement with this.  Funny, as I wrote the above I was thinking of The HP disaster, and how difficult it really is to see quality..The greater trick is to identify decent companies not in secular decline these days.  As BG2008 mentioned above, in that great post, identifying quality is easier when reverse engineered. 

[Kraven]

My suggestion is to do what you have a "knack" for and try to find a "niche" that you're really good at

 

In the past, I thought I would buy quality business at a fair price.  After a couple year of tinkering with my personal capital, I personally find that quality businesses are much harder to spot than the way that Grandpa Buffet explains it.  Obviously, it's easy to look at Coca Cola and say that's a heck of a business when Buffet explained it.  This is akin to looking at the answers in an Engineering problem and working backwards to figure out the 5-6 steps to get to the solution.  You also know you're right to begin with.  In real life, finding a quality business is like solving a complex engineering problem without knowing the answer.  You have to make sure that you follow the correct logic and you did not miscalculate along the way.  Then you have to load up the truck and buy with conviction.  I truly respect people who can do it well, especially those who can do it well really early on in their career (20s). 

 

I myself have dedicated my craft, for the time being, to harvesting melting ice cubes and engaging in special situations.  But I make sure a few things happen 1) The melting of the ice cube stops or slows down drastically (liquidation, asset sale, shareholder activism etc) 2) I buy an ice cube that's substantially larger than the adjusted size 3) I can put the ice cube into a freezer at some point (return of cash to shareholders)

 

I do this because I am confident in my analysis and I will know whether I was right or wrong rather quickly.  Another downfall of paying up to buy quality is that one can look like a genius for years in a bull market.  I bet there will be a few fund managers who started their fund in 2009 who will be exposed the next time we have a financial crisis.  People who bought Bear Stearnes and Lehman Brothers looked like geniuses for quite a few years until it all came crashing down

 

I was at a conference once and David Einhorn mentioned that he bought Apple when it was a net-net and he regrets not holding onto the name.  What Einhorn forgot to mention is that he compounded money at some pretty impressive double digit returns since.  Last time I check 20% compounded over 20 years is about 38x.  It's not Apple like, but it's not far off either.  But I am certain that we can spot a net net a lot easier than how Apple was going to revolutionize the electronic business, that Steve Jobs was going to create a computer masquerading as a phone and get people to pay $600 for the machines.  That's a much more difficult call to make than "I'm buying a melting ice cube at a 50% discount and I know that we're going to stop the melting very soon"

 

I personally think that Buffet started buying great businesses because it's hard to find net nets when he was managing over $100mm back in the 70s/80s.  There are less opportunities for him to rinse and repeat at that point.  Buffet also said that if he was managing $1 to $10mm today, he would look at a much different opportunity set and he can guarantee to do 50% a year.  That's a very powerful statement and one should invert that a bit.  It's a known fact that Buffet used to shoot the lights out of the Dow when he was trading in his PA.  For those of trying to "get rich quick without taking on a lot of risk", I suggest that you look at the more obscure corners for the truly asymmetrical risk/reward opportunities. 

 

As the asset base grows, I will absolutely start to look at larger market cap and higher quality businesses.  As a matter of fact, I kind of have a plan in place for when the asset base is 5x, 10x, 50x, and 100x of its size today.  In the meantime, I will learn about picking good companies as well. 

 

In short, do what you have high conviction and can honestly call yourself "the smart money."  Also, I would recommend that everyone learn to hedge or set aside cash for that 25 year storm where you can pick bargains on the cheap

 

This was a very good post.  Should be required reading for new (and not so new) investors.