The Philosophy of Value Investing

I have a BSc in Economics and have worked as an investment analyst at one of Europe's top venture funds.
I have decided to Taaalk anonymously. I am a global investment manager at a long-only investment fund which closely follows the value investing practices and beliefs set out by Warren Buffett, Charlie Munger (who taught me!) and Benjamin Graham. I'm here to Taaalk about the strong set of principles and techniques that guide investments within my fund from both high-level and granular perspectives.
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Admin
13:24, 06 May 20 (edit: 13:25, 13 May 20)
This Taaalk was written on the first version of Taaalk in 2016.
The archive.org version is available here.
Joshua Summers
14:21, 07 May 20
Is there one main philosophy that guides your approach to investing? And if so, what is it?
Value Investor
14:23, 07 May 20
The value investing philosophy laid out by Benjamin Graham is the most fundamental guide to the way I think about investing. But as with a compass, everyone uses their guide in different directions and to different lengths. To continue with that analogy, Graham's principles usually boil down to 3 pillars, but I'll add a fourth.
  1. Stocks represent ownership in a business
  2. Buy stocks at a price that offers a large margin of safety
  3. In the short term, the market is an [often irrational] voting machine, but in the long term it is a weighing machine [measured in accumulated cash profits]
  4. "The fault, dear investor, is not in our stars -- and not in our stocks -- but in ourselves." -Ben Graham
If you study Warren Buffett then you may recognize the 4th as his insistence that one stays within their own circle of competence. Otherwise, it nullifies your ability to make any judgement of 1, 2, or 3.
The flipside of that seemingly narrow confinement is it allows you to concentrate long enough within that circle and eventually understand it better than anyone else. It's easy to think of a circle as something flat, as if competence is measured by the width of your scope. But I think a sphere would be more appropriate -- I am most concerned with the depth of understanding. A very wide circle can still be as flat as it is on a piece of paper, but if it takes you 4,000 miles to get to the center of the Earth, invariably it would have an even wider equator.
Bringing this back to pillar #4 and the original question, I am guided by a continuous process of self-improvement and a ferocious curiosity to discover truth at its core. It is backed by my temperament to patiently drill down until I hit the golden nuggets of insight and unmistakeable value that happens to be mistaken due to prevailing views of the surface. To me, investing is about discovering that the world is not flat nor round, but spherical.
Joshua Summers
14:25, 07 May 20
That is a beautiful answer.
In terms of the four pillars, does the following ring true [I'm sure we'll get onto each of these in a lot more depth down the road, but just to get a sense that my thinking is in the right place]:
1) If you think about stocks as something you own, the perspective should be one of contentment with the asset. Say, for example, I was going to buy a picture to hang in my house (to own) - I would want it to be one I could look at every day and enjoy, do you view a stock the same way? It has to be something you're truely happy with - as opposed to an asset you don't like very much, but hope to sell on for a profit at a later date.
2) In terms of a margin of safty, you want to have a figure of the true value of a business in your head - and buy stocks when it is well below this? 
3) In the long run, truth wins out - and the ultimate truth of any business is the sum of the cash profits it can generate? In the short term, people's hearts and minds win out (and their irrationality leads to situations where point '2)' works and when it doesn't)
4) It's down to you to do the work, in the long run the market is not wrong, you were. You have to do your research properly, turn over every stone.
It feels like a lot of the above points to that ferocious desire to make truth appear - and the more you understand about a specific world, the easier it is to see the underlying truth. How does one, or did you, go about picking your sphere? And do you think of spheres as verticals (for example, the automotive industry) or as something more conceptual?
Value Investor
14:34, 07 May 20
1) It feels great to own a great business that continues to grow. It's not the same as owning it wholly though, as stock ownership is usually fractional. You only get to hang this picture in your house maybe one day out of the year. I don't feel as happy if my great business is trading at a dangerously overvalued price, it can be tempting to sell because you no longer have the same margin of safety compared to other more reasonably valued assets.
Buffett solved this by owning 100% of his most favorite businesses, so that he can extract FCF directly rather than cash out his ownership. The most recent example is where he extracted Duracell from his P&G; stake in a stock for stock transaction that had tax advantages as well. Since Duracell produces steady, albeit slightly declining, FCF -- he will collect the cash value over time rather than sell it all at once and trigger tax consequences -- and still retain 100% ownership of a great brand. It is also important that this is complementary to his insurance float, which alleviates the trade off of receiving a lump sum today versus a prolonged payback period. Who knew that 15 minutes could save you quite a bit on cost of capital?
Going back to your art metaphor, this is more like owning a museum and collecting an entrance fee. And all the expensive artwork is donated by people who can't find a safe place to store them, and they even help you pay for the security guards.
2) Everyone thinks they are buying below intrinsic value, otherwise there wouldn't be any buyers. Margin of safety is about buying far below even the worst case scenario. It is about finding tangible value that you can hold on to even when everything else gets wiped out by the worst storm imaginable.
You have to be creative in destroying the value that you think is there, intrinsic value is not a constant. Capitalism is very destructive, which is the nature of creation. CEO's get overly creative all the time and the true value of your business changes. Knowing your margin of safety well allows you to buy more during a disaster.
3) The FCF of an enduring franchise may go on for a long time. But due to the time value of money, the NPV of this perpetuity portion is not very significant once you go past about 10 years and assume growth converges toward 0 as the business matures.
This is where dividends really matter, because it sets a floor for recovering your cost basis and escaping from the trap of discounted cash from the far future. Companies can also buyback shares today, which increases the dividends per share that you receive in the now. Therefore, the more cash that piles up to the shareholder, the more provable that the value is actually secured rather than subject to destructive spending or time inflation.
Some may argue that you can sell your entire stake and therefore prove your value calculations based on the cash in and cash out of your trades, but that profit is actually earned from the secondary market rather than the primary business. Be careful not to confuse secondary market profits from the underlying business. A stock going up doesn't prove that you are right, it just means that the market agrees with you for a certain period of time. Cash generation is a permanent fact stemming from the reality of business competition. I am laser focused on trying to ascertain the durability of cash generation rather than market fluctuations.
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."  
- Warren Buffett
4) Intellectual honesty doesn't require a lot of intellect, but a lot of honesty. The first step toward being honest to others is to first be honest with yourself.
I enjoy great value investors not because they are great at investing, but because they are great at being honest humans. Doing proper research involves seeing through to the core of the issue and moving past all the noise. If you think noise is important, then you are being dishonest to yourself. Reaching clarity is an iterative process. Underlying every complicated problem is uncomplicated, common sense.
Once I built some competence in avoiding inherently unpredictable or non-durable businesses, and recognizing these issues as soon as possible, it contributed to a larger pool of time to focus on the next layer of the sphere. Even a predictable, durable business may be trading at a price that makes the investment unpredictable in terms of offering enough downside protection.
Once you are in this zone of predictable and attractively priced, which is predicated on your sensitivity to accounting tricks and adjustment toward economic realities, only then is it worthwhile to spend a lot more time on the qualitative business, industry, and management factors -- beyond what your gut instincts might have already suggested.
I would say that I've picked a deep focus on deconstructing corporate history and company culture. You'll notice that companies with 10-20 year histories give you a lot more insight and you can study each turning point to see how they've adapted. Companies with less than 10 years history are too hard to extrapolate anything meaningful.
I would avoid generalizing industry biases and most often it is the exception to the rule that has the most hidden value. Company culture will tell you how they overcame the industry hurdles. It's still about the ratio of price versus quality, and you don't always get to choose which quadrant Mr. Market is hanging out in, but extremely low price is always a great starting point.
Joshua Summers
14:37, 07 May 20
Going over your last paragraph, there are a few things that really stand out.
So for you, the first thing was building up a solid understanding of what a non-durable business looked like so you could eliminate them from your radar as quickly as possible. For you is that a qualitative or a quantitate analysis that takes place, and what do you look at?
The idea that being able to do this quickly frees up your time to look in depth at companies that meet this basic requirement makes a lot of sense. What made you choose corporate history and company culture as the thing to focus on next?
Value Investor
17:09, 07 May 20
I usually benchmark an idea with the top player in an industry to see what qualities each contender has that is more durable than the other. Many businesses will be around for a long time, but not necessarily their profit margins.
The first thing to figure out is how does this industry make money, and how does it set its prices? How much reinvestment is necessary to maintain prices? If an ideal business requires very little reinvestment and consistently raises prices -- then how far from this ideal is the business in question? If it's anywhere close, it should jump out at you -- otherwise it's likely to be farther away from predictably durable.
While most experienced investors can figure this out, they may under-appreciate the weight of this factor. A lot of people thought Buffett overpaid for the BNSF railroad. Even paying up $35bn, he doubled its value in 4 years. Recently he admitted that more capital needs to be reinvested, so it is more capital-intensive than many people would prefer, but it's more important that he thinks BNSF will be around in 100 years. So long as reinvestment does improve pricing power, then it is actually a great situation to have a way to automatically redeploy the massive amounts of profits within the same regional monopoly and earn a compounded return on the incremental capital. Geography can play a big role in durability because it does not change easily.
No matter how great a business, it will be forced to adapt over time. History will show how they faced previous challenges. Businesses are truly tested during tough times. That is when the company culture will show its true colors.
As value investors, our foremost focus is on downside protection. You have to see if a company's moral fibers will break down during crisis -- the good times will take care of itself.
One of Buffett's favorite companies See's Candy had such a demonstrated resilience during World War II when butter, sugar, and cream were in short supply and subject to rationing. Instead of diluting their products like many others did, they insisted on "quality without compromise" and limited their production while using the same original recipe.
History does not change easily, so it is important to do things right when you are writing your own history. You have to keep earning your reputation tirelessly.
Admirable companies have demonstrated this over long periods. They have to past the historical test of behaving properly toward customers, suppliers, employees, and shareholders during tough challenges and despite temptations to do otherwise. If so, they will have the healthy habit of turning crisis into opportunity -- which is hugely important for improving their market position throughout multiple cycles.
Knowing how hard it is to behave this way makes me comfortable that their competitors will likely fail the same tests and crumble over time.
Joshua Summers
17:10, 07 May 20
Have you noticed any common traits in businesses that are able to sustain long term profits? And are you effectively looking for monopolistic companies? For example, the BNSF example you give makes a lot of sense. It's hard for there to be a great deal of competition on a rail road, so 'owning' geography seems like a sensible trait to look for. The same could be said with Coke in a way, as the space the brand owns in people's minds is so large. 
The story about See's Candy make me feel like the companies you're looking for have the strength of character to not be destroyed by greed or being foolishly generous. Is this right? It feels like running a company successfully is very much about finding a balance between pleasing your customers, suppliers, employees and shareholders, which takes sensible levels of both greed and generosity - you have to treat yourself well (make a profit) and you must treat those you serve well too (who you make the profit from). 
If you're out of kilter either way for too long the results will inevitably fall apart. Is your view that if you are able to find a company that can generate long term sustainable profits and it is run with a suitably long term perspective, then you're onto something very good?
Value Investor
17:16, 07 May 20
Charlie Munger has said "Almost all good businesses engage in 'pain today, gain tomorrow' activities." Not only do you have to resist temptations of short-term profits and foolish decisions, but you have to survive painful decisions that may be extremely painful for extended periods.
Value investors are tested this same way when they experience a prolonged bull market -- all kinds of speculators will make huge profits while you miss out on the party. You have to be willing to look stupid for a long time.
The insurance business also requires this propensity to avoid huge temptations of underwriting risk for gain today, pain tomorrow.
Doing nothing can be more painful than it looks! Most of the time, your stakeholders won't even allow you to survive this competition -- it is counter-intuitive to pay someone to do nothing even if it is the best decision. On the other hand, sometimes you have to actively do something painful -- such as massive capital expenditures or sweeping transformations like IBM did in the 90's.
The latter inside-out campaigns are rarities but have out-sized implications -- as in the case of China, which underwent constant revolution and reform for the past century with no end in sight -- they are now attempting an unprecedented anti-corruption campaign. The leader of this effort has compared it to performing surgery on one's self. Berkshire Hathaway also grew out of a 23-year battle with its ailing textile business, as well as frustrating episodes with Buffalo News, Geico, National Indemnity, etc. Through this, Buffett has proven to be a rather skilled surgeon. Of course, he'd still prefer companies that have superb immune systems to begin with.
Monopoly is a strong word and there aren't too many just laying around -- though it's worthwhile to study all the ones that are. But even fragmented industries can have certain players that command a large portion of the profits.
Some industries may still be waiting for this profit-consolidator to emerge. Most of the time you can't predict the winner, but once in a while you can. A lot of people think it's too late by the time the dust has settled, but it might just be a mature company in a young industry, or even the industry is mature but the country is young.
In relation to history, all of our modern forms of economies are still very young. If you always use a long-term perspective then you can easily weed out companies that engage in short-term thinking. If you keep avoiding things that are too difficult to predict or are simply nonsense, then eventually you will stumble upon something suitable. You have to keep learning and revisiting things because the dynamics may have changed.
There's a balance there between preparing too far in advance and researching actionable ideas -- the former can sometimes prove to be one of those painful undertakings that don't payoff until much later. Luckily, if your actionable ideas are long-term holdings then eventually you will find enough to be fully invested, which frees up your time to pursue more difficult research.
Being highly aware of your own process helps you recognize companies that are process-oriented as well. Certain processes are more sustainable than others. As you've mentioned, treating stakeholders well is an important process that you have to maintain day by day and through all your actions. Treating stakeholders poorly would be an unsustainable process.
I think there are safe assets you can predict with more certainty and then there are exceptional businesses that have greater growth potential that is discounted by uncertainty. Ultimately you have to fall back to the price you're willing to pay at the time the market is offering these choices to you. The right price can make a growth business be a more certainly profitable investment, and a bad price can make a safe asset become a risky investment.
I prefer to set the bar high for the level of certainty required, and only when it passes that test will I proceed to consider growth upside. In aggregate, a series of low risk / high reward bets will do better than medium risk / very high reward bets -- even if the ratio and expected value is exactly the same. The reason is because you cannot control the order in which these outcomes occur.
In the latter case of elevated risk you may be out of business before you are even able to reap the rewards if they are weighted in the tail end of the series. But of course, you can also be out of business if your returns are too modest while your competitors are front-loading high returns. In the first case, however, the capital has not suffered any permanent losses.
For most people, however, preservation of wealth is likely the priority if investing isn't their professional career. The adverse impact to your lifestyle of losing a substantial part of your net worth is likely to outweigh the benefits of a couple incremental percentage points. This is especially true if the risk-averse approach actually ends up earning even higher rates of return because the market eventually does reward these 'safe bets' quite handsomely.
Joshua Summers
17:17, 07 May 20 (edit: 17:18, 07 May 20)
I don't know if you're familiar with the marshmallow experiment [where one of the strongest predictors of future success was the ability for a child to postpone eating one marshmallow now in order to receive two fifteen minutes later - http://jamesclear.com/delayed-gratification], but it sounds like the internal strength needed to pass it is something that every value investor and long term thinking CEO needs to train. It feels like this ability to resist short term temptations combined with a close to correct underlying view of reality are the important combination (and I'd imagine that there is a strong correlation between the former and those that spend time trying to work out the latter). Do you feel you are a naturally a two marshmallow person or have you ever had to train your long term focus?
You talk a lot about research, both for more instantly actionable ideas and for longer term views. Do you think you could give me an example or two of what that practically is like? What is the process like of investigating, say, the exceptional business with greater growth potential than is discounted by uncertainty? And what does a more complicated / less instantly actionable piece of research involve?
Value Investor
17:19, 07 May 20
I think the long-term focus comes with studying overwhelming examples of failure caused by short-term thinking.
I grew up playing music and sports, which take years to master and has been an importantly long journey for me. Then there's the realization that life and investing are inherently long-term. Everything from your reputation, to the purchasing power of your net worth, and your relationships need to be preserved for a long time.
I have a natural tendency to care about the things I value, I don't want them to disappear. Pairing this perspective with the patience to see it through eases the pressure of time and I find life more enjoyable this way. I was elated to find out that this attitude works well for investing because so few people are this way.
Research is something that you have to experience for yourself. It's a useful exercise to go back 15 or 30 years and try to make a case for why certain companies eventually became winners.
Look at Coke in 1988, IBM in 1992, Priceline in 2002, and any other stock that took at least 20 years to get to mega-cap today. They all faced massive uncertainties, the key is to figure out which obstacles were fatal and which ones were temporary. And how their competitors dealt with the same industry headwinds differently.
You'll have to ask a lot of questions based on all the available information at that time, and then rank those in terms of significance to the long-term outcome. You'll find that it's actually very difficult to tell even with the benefit of hindsight. Instantly actionable ideas can be as simple as looking at a balance sheet and realizing that the market price is 1/5 of its reported net worth, preferably in cash or liquid securities, or a reasonable appraisal of its real estate assets.
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