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

[oddballstocks]

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

 

When starting a business, yes quality is desired, you have a great point.  But I don't think it's required when making an investment.  Imagine your business is offered an opportunity to invest in a gas station in town.  It's not what your company does, but the opportunity is to invest at 50% of book value and 4x FCF, would you take it?  What if the manager is lazy and could double FCF if he advertised more?

 

I'm guessing you'd probably take the investment, it's not a long term compounder, and doesn't have a great manager, but it's a decent asset at an excellent price.  If they paid the cash as a dividend you could re-allocate it where you like.

 

We often have the choice, invest in someone who's a great allocator, or play the role ourselves.

[oddballstocks]

One other counter point to quality when you have control.  There are hoards of very rich people who got that way on the backs of crappy businesses.  They didn't all own insurance companies, or asset management firms.  They owned things many on this board would never even consider touching, carpet cleaning companies, landscaping companies, restaurant chains etc.

[giofranchi]

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"

 

Maybe, I just like history too much… And surely I don’t want to sound too cerebral and too much of a senseless scholar here… I am not, and what I do in life is running businesses.

Yet, before talking about history, its usefulness, or lack of a real purpose, I strongly advice to read:

[amazonsearch]The Historian's Craft: Reflections on the Nature and Uses of History and the Techniques and Methods of Those Who Write It.[/amazonsearch]

By March Bloch

It is a wonderful essay about history and about those who write it. And of course one of the best tool I know of to answer the following question: what’s the true role of history in our life?

Highly recommended!

 

giofranchi

 

[SharperDingaan]

Keep in mind that quality from a business perspective is very different than that from an investment perspective.

 

Generally speaking, the higher the quality of the business, the easier it is to run - so quality matters. Whereas in the value world a fallen angel (ie: sh1te business), dirt cheap, is nirvana. And after a while .... you learn that putting up with the sh1te while you are waiting for changes -  is not worth it.

 

Looking at quality vs metrics is just evolution. You have begun to look at the businesses that you own - as an actual businessman. You don't need the metrics as a substitute for experience any more.

 

SD

[SharperDingaan]

"The greater trick is to identify decent companies not in secular decline these days"

 

Look at those with a high DOL & demographic/economic trend  ... there are at least one/two in Canada that you wouldn't expect  ;)

 

SD

[giofranchi]

When starting a business, yes quality is desired, you have a great point.  But I don't think it's required when making an investment.  Imagine your business is offered an opportunity to invest in a gas station in town.  It's not what your company does, but the opportunity is to invest at 50% of book value and 4x FCF, would you take it?  What if the manager is lazy and could double FCF if he advertised more?

 

I'm guessing you'd probably take the investment, it's not a long term compounder, and doesn't have a great manager, but it's a decent asset at an excellent price.  If they paid the cash as a dividend you could re-allocate it where you like.

 

We often have the choice, invest in someone who's a great allocator, or play the role ourselves.

 

I agree, if you are able to think about “trading the stock market” as “a business of its own”. As a trader, you are able to employ a basket approach to investing, let’s say that you are able to invest 1% of your capital in 100 different stocks. And I wouldn’t mind investing 1% of my firm’s capital in “a gas station run by a lazy manager and selling for 50% of book value or 4 x FCF”. I wouldn’t mind it at all!

 

But entrepreneurs usually deal with only a few businesses at a time… And I would never invest in a “a gas station run by a lazy manager and selling for 50% of book value or 4 x FCF” 30% of my firm’s capital…

 

What I still have a lot of trouble doing is putting on the hat of the entrepreneur at 7.00 am, switching to the hat of the trader at 11.00 am, becoming once again an entrepreneur at 2.00 pm, and ending my working day as a trader at 7.00 pm.

 

That’s why I still have a lot of room to improve! For now, my firm’s equity is up 17.5% YTD… with a lot of cash and hedges… not really much to complain about that! :)

 

giofranchi

 

[cayale]

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

 

Dead on. Do what will enable you to make the right decisions at the right time. It's a little bit different for everybody, but there are examples of superiority across the value investing continuum (cigar butts to GARP).

[Palantir]

If WEB can't find special situations above 100M then how can Seth klarman? I do not believe his shift to quality is solely dependent on size.

[jay21]

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

 

When starting a business, yes quality is desired, you have a great point.  But I don't think it's required when making an investment.  Imagine your business is offered an opportunity to invest in a gas station in town.  It's not what your company does, but the opportunity is to invest at 50% of book value and 4x FCF, would you take it?  What if the manager is lazy and could double FCF if he advertised more?

 

I'm guessing you'd probably take the investment, it's not a long term compounder, and doesn't have a great manager, but it's a decent asset at an excellent price.  If they paid the cash as a dividend you could re-allocate it where you like.

 

We often have the choice, invest in someone who's a great allocator, or play the role ourselves.

 

Obviously you would take that investment. 

 

The reason why I prefer to invest in great/moated businesses is because usually the fact pattern is not as obvious as the example laid out.  Let's take a different example:

 

You notice that most hardware stores in your state/region sell for 10x FCF.  You find one put up for sale for 6x and that interests you.  What I worry about is Lowe's or Home Depot or someone with a competitive advantage coming into your region and destroying your sales.  In other words, you invest in a quantitatively cheap situation, but you are out competed by a moated company or good manager, which leads to significant value impairment.

 

That's not to say this can never be a good investment, like I said your fact pattern looks like a slam dunk.  But, I would prefer to align myself with a company that can withstand competitive pressures, which imo provides a little more margin of safety.  If I go further down the quality spectrum, I will want the margin of safety to be made up for in different ways such as a lower price, special sit factors, control, etc.

[matjone]

The thing to do is to do what makes sense to you.  That could be indexing, buying net nets,  buying great businesses,  real estate investing, putting everything into a business that you run, buying distressed debt, or any one of a hundred other possibilities.  There isn't any one right answer for everyone, but I believe there is a right answer for each of us.  And there is no rule that that answer can't change over time as you increase your knowledge.

 

What makes sense for me is following Graham.  I like to think that I am fairly smart, but I am no genius, so the thing that makes sense for me is to buy balance sheet bargains and stay diversified.  It has worked in the past and it has a logical basis.  I probably won't ever be rich, but hopefully I can keep from losing money, earn decent returns, and sleep well.

 

 

[jay21]

If WEB can't find special situations above 100M then how can Seth klarman? I do not believe his shift to quality is solely dependent on size.

 

He can find special sits occasionally. 

 

By buying quality, he relieves himself of allocating more capital because it can just be reinvested into the businesses and not returned to him.  I also think WEB thinks of BRK as a "forever fund" as outlined by Dave Merkel.  BNSF/KO/WFC/Geico/Mid American will all still be alive and kicking even when WEB is not.

[Kraven]

The thing to do is to do what makes sense to you.  That could be indexing, buying net nets,  buying great businesses,  real estate investing, putting everything into a business that you run, buying distressed debt, or any one of a hundred other possibilities.  There isn't any one right answer for everyone, but I believe there is a right answer for each of us.  And there is no rule that that answer can't change over time as you increase your knowledge.

 

What makes sense for me is following Graham.  I like to think that I am fairly smart, but I am no genius, so the thing that makes sense for me is to buy balance sheet bargains and stay diversified.  It has worked in the past and it has a logical basis.  I probably won't ever be rich, but hopefully I can keep from losing money, earn decent returns, and sleep well.

 

Good post. I agree. The key is to know thyself. Graham talks about this. He doesn't say that his method is the only way. I'm paraphrasing, but he says something to the effect that if you can invest because you are good at predicting the future, do that. If technical indicators lead you to the promised land, more power to you. He just says that it doesn't work for him and his way does.

 

Mike Burry also talks about this. He said that as much as everyone wants to be Buffett they have to do what works for them. He also says for all the time spent on attempting to copy Buffett that there aren't any mini Buffetts running around, but there are many successful Grahamites.

 

What I find interesting is the dichotomy if you will between the Graham/Schloss crowd and the Buffett crowd. The former usually seem to say people should do whatever works for them while the latter are highly critical of anyone not beating the bushes for moats.

[racemize]

Good post. I agree. The key is to know thyself. Graham talks about this. He doesn't say that his method is the only way. I'm paraphrasing, but he says something to the effect that if you can invest because you are good at predicting the future, do that. If technical indicators lead you to the promised land, more power to you. He just says that it doesn't work for him and his way does.

 

Mike Burry also talks about this. He said that as much as everyone wants to be Buffett they have to do what works for them. He also says for all the time spent on attempting to copy Buffett that there aren't any mini Buffetts running around, but there are many successful Grahamites.

 

What I find interesting is the dichotomy if you will between the Graham/Schloss crowd and the Buffett crowd. The former usually seem to say people should do whatever works for them while the latter are highly critical of anyone not beating the bushes for moats.

 

Well, personally, I'm probably 80% in the "Buffett" crowd as you put it, but I say do whatever works!  I actually think the Graham/Schloss way is probably better, especially for individuals, but I can't get myself to do it, so I guess it doesn't work for me...

[BG2008]

http://vimeo.com/32333102

 

Some good nuggets of information from a Seth Klarman Interview with Charlie Rose.  Starting from 25:25, he talks about buying cigar butts versus good businesses.  Seth talks about how Warren has moved to the third stage and he's got "stunted growth".  Klarman at one point mentioned that he himself can't find too many businesses that are great.  If Seth is being honest, that speaks volumes about others in the business.  I thought his comments about management quality of cigar butts is invaluable.  He mentioned that Ben Graham overlooked that aspect.  This is why I pay a lot of attention to whether the melting of the ice cube can be slowed or stopped.  If it does not come internally, there better be an external factor forcing that ice cube to stop melting. 

 

Seth is managing $30 billion of assets and Warren is managing about 15X that (Total assets).  So Seth has a bit more wiggle room. 

 

How does Seth make money?  He's got a few areas that he sticks to.  In short, he's the provider of liquidity during distressed times, i.e. bonds/claims against Lehman Brothers etc. Claims against Madoff lawsuits.  Interestingly enough, distressed debt is an area where size helps to a certain extent.  When a company files, one can buy up a large chunk of the distressed debt and utilize their bankruptcy/legal know how to push for maximum recovery for that class.  Small investors can't really touch that space.  I also know of a friend who is partnered with Baupost on some RE development projects.  He had mentioned that they are really long term focused and use very little leverage.  If one looks at Baupost's equity portfolio, it consist of obscure securities that are quite hard to understand.  Oh yeah, let's not forget about the quarry mines in Canada.  A lot of time, you need a specialist to understand why they bought certain stock.  Admittedly, their equity portfolio is not where they outperform the market.  In short, Baupost can be think of a X bn distressed debt fund, x bn real estate, x bn complex/complicated securities bet, x bn equity.   

 

Seth also routinely returns cash to investors.  I get the sense that Baupost today almost wait for a storm to come along and then buy really undervalued securities that will drive returns for 3-5 years.  Then they rinse and repeat. 

 

Again, I think you should stick to you what you know you're good at.  I don't think it's wrong for people to switch styles as they scale up.  The key is to be honest with yourself and understand that your out performance is due to a good investment process rather than a bull market i.e. late 90s, 2002 to 2007.  Admittedly, it is quite hard to self assess in reality

[Bagehot]

The thing to do is to do what makes sense to you.  That could be indexing, buying net nets,  buying great businesses,  real estate investing, putting everything into a business that you run, buying distressed debt, or any one of a hundred other possibilities.  There isn't any one right answer for everyone, but I believe there is a right answer for each of us.  And there is no rule that that answer can't change over time as you increase your knowledge.

 

What makes sense for me is following Graham.  I like to think that I am fairly smart, but I am no genius, so the thing that makes sense for me is to buy balance sheet bargains and stay diversified.  It has worked in the past and it has a logical basis.  I probably won't ever be rich, but hopefully I can keep from losing money, earn decent returns, and sleep well.

 

Good post. I agree. The key is to know thyself. Graham talks about this. He doesn't say that his method is the only way. I'm paraphrasing, but he says something to the effect that if you can invest because you are good at predicting the future, do that. If technical indicators lead you to the promised land, more power to you. He just says that it doesn't work for him and his way does.

 

Mike Burry also talks about this. He said that as much as everyone wants to be Buffett they have to do what works for them. He also says for all the time spent on attempting to copy Buffett that there aren't any mini Buffetts running around, but there are many successful Grahamites.

 

What I find interesting is the dichotomy if you will between the Graham/Schloss crowd and the Buffett crowd. The former usually seem to say people should do whatever works for them while the latter are highly critical of anyone not beating the bushes for moats.

 

My main concern with Graham/Schloss in the modern day is the advent of cheap computing and the quantitative firepower it unleashes. By definition, there will always be a cheapest decile of the market unless we are in Lake Wobegon where all of the kids are above average. But that doesn't mean that the cheapest decile is underpriced! I can pretty easily concoct a scenario in which the rise of value ETFs and fairly naive quantitative strategies such as those employed by DFA, LSV, and even AQR and a host of other quant funds, systematically buy the cheapest stuff in the market to the point where any excess return to value no longer exists. That wasn't an issue for Graham.

 

Stated more succinctly, the ability to fairly easily arbitrage the historical value premium is much greater now than it was in Graham's day or even 20 years ago. Now its true that this isn't as much of a problem in the microcaps where a lot of board members play, due primarily to liquidity constraints. But it is an issue for larger funds that practice value investing and I think its shown up in a big way for firms like Longleaf over the past 10 years or so.

 

If you buy this argument, then how does one confront the rise of the machines? My view is that bargains now require greater 'judgment,' the special asset which quant strategies completely lack. The judgment stocks are in the quality businesses. And that means being able to distinguish between fundamentals and expectations for stocks that are priced closer to the market. Look at a stock like Ecolab. You could have purchased Ecolab for about 20x earnings towards the end of the tech bubble in 2000. Anyone on this board could spend half a day with Ecolab's financials, conference calls, and an investor day presentation or two, and know that it is a great business with a very long growth runway. Even though you paid 20x earnings, you would have compounded at 16.5% annually over the last 13 years in a very tax-efficient manner (this is the other huge advantage of quality v value, the tax benefit of lower turnover) while the S&P returned 2%. But it isn't so easy for a computer to distinguish between, say, an Ecolab and something else that was selling at 20x in mid 2000, say pets.com or whatever.

 

Now you could rightly say that it's harder or requires more work to become good at developing such judgment v just buying 'cheap' stocks, and I wouldn't argue. But after having a strong value bent for many years, I now believe that it isn't heretical to question whether Graham's strategies are as effective today due to the explosion of data and computational efficiency we've seen over the past 10-15 years. And if that's true, then those who manage institutional capital don't have a choice but to 'adapt or die' as the saying goes.

[Kraven]

The thing to do is to do what makes sense to you.  That could be indexing, buying net nets,  buying great businesses,  real estate investing, putting everything into a business that you run, buying distressed debt, or any one of a hundred other possibilities.  There isn't any one right answer for everyone, but I believe there is a right answer for each of us.  And there is no rule that that answer can't change over time as you increase your knowledge.

 

What makes sense for me is following Graham.  I like to think that I am fairly smart, but I am no genius, so the thing that makes sense for me is to buy balance sheet bargains and stay diversified.  It has worked in the past and it has a logical basis.  I probably won't ever be rich, but hopefully I can keep from losing money, earn decent returns, and sleep well.

 

Good post. I agree. The key is to know thyself. Graham talks about this. He doesn't say that his method is the only way. I'm paraphrasing, but he says something to the effect that if you can invest because you are good at predicting the future, do that. If technical indicators lead you to the promised land, more power to you. He just says that it doesn't work for him and his way does.

 

Mike Burry also talks about this. He said that as much as everyone wants to be Buffett they have to do what works for them. He also says for all the time spent on attempting to copy Buffett that there aren't any mini Buffetts running around, but there are many successful Grahamites.

 

What I find interesting is the dichotomy if you will between the Graham/Schloss crowd and the Buffett crowd. The former usually seem to say people should do whatever works for them while the latter are highly critical of anyone not beating the bushes for moats.

 

My main concern with Graham/Schloss in the modern day is the advent of cheap computing and the quantitative firepower it unleashes. By definition, there will always be a cheapest decile of the market unless we are in Lake Wobegon where all of the kids are above average. But that doesn't mean that the cheapest decile is underpriced! I can pretty easily concoct a scenario in which the rise of value ETFs and fairly naive quantitative strategies such as those employed by DFA, LSV, and even AQR and a host of other quant funds, systematically buy the cheapest stuff in the market to the point where any excess return to value no longer exists. That wasn't an issue for Graham.

 

Stated more succinctly, the ability to fairly easily arbitrage the historical value premium is much greater now than it was in Graham's day or even 20 years ago. Now its true that this isn't as much of a problem in the microcaps where a lot of board members play, due primarily to liquidity constraints. But it is an issue for larger funds that practice value investing and I think its shown up in a big way for firms like Longleaf over the past 10 years or so.

 

If you buy this argument, then how does one confront the rise of the machines? My view is that bargains now require greater 'judgment,' the special asset which quant strategies completely lack. The judgment stocks are in the quality businesses. And that means being able to distinguish between fundamentals and expectations for stocks that are priced closer to the market. Look at a stock like Ecolab. You could have purchased Ecolab for about 20x earnings towards the end of the tech bubble in 2000. Anyone on this board could spend half a day with Ecolab's financials, conference calls, and an investor day presentation or two, and know that it is a great business with a very long growth runway. Even though you paid 20x earnings, you would have compounded at 16.5% annually over the last 13 years in a very tax-efficient manner (this is the other huge advantage of quality v value, the tax benefit of lower turnover) while the S&P returned 2%. But it isn't so easy for a computer to distinguish between, say, an Ecolab and something else that was selling at 20x in mid 2000, say pets.com or whatever.

 

Now you could rightly say that it's harder or requires more work to become good at developing such judgment v just buying 'cheap' stocks, and I wouldn't argue. But after having a strong value bent for many years, I now believe that it isn't heretical to question whether Graham's strategies are as effective today due to the explosion of data and computational efficiency we've seen over the past 10-15 years. And if that's true, then those who manage institutional capital don't have a choice but to 'adapt or die' as the saying goes.

 

You make some good points.  However, I think you are confusing a Graham/Schloss methodology with buying anything and everything that shows up in a screen.  I am not sure why there is a supposition that investing a la Graham and Schloss does not require judgment.  Also, there needs to be a distinction between early Graham and later Graham where he did change his stripes, or evolve or whatever you want to call it to essentially be a proponent of investing on the basis of screens. 

 

This goes back to what I was saying though.  It's fine to be critical (in the sense of asking questions, etc), but there is a overriding sense that it's fine to be a nice little Graham/Schloss guy when you're little, but when you grow up you realize you need to be a big Buffett guy.  I would fully reject that argument.  I would say that it depends on the capital one has.  Graham/Schloss works in my view until somewhere in the $50-100 mil mark, so no, it won't work for institutional funds.  But for most individuals, that should work just fine.

 

I don't think the machines take the bat out of my hands at least.  I am not fishing with a net, I fish with a pole.  I fish primarily in certain ponds however and that is the difference.