CHAPTER 7
Investing in Stocks (I): Foundations and Principles

We know that we have to invest in real assets and that shares are the best option. We also know that we can invest in shares through index funds, semi-passive or fundamental funds, and actively managed funds. And finally, there's also the option of investing directly in stocks.

It's a risky business trying to systematically outperform the indexes; history says as much. Yet some of us are either sufficiently arrogant, deluded, or audacious to take on the challenge. After all, we all think we are better drivers than the rest.

This part of the book is aimed at those daring enthusiasts or professionals prepared to take on the indexes at their own game. Flying in the face of history and current trends as they remorselessly shift towards passive management.

Investing in stocks is not easy. You have to buy what nobody else wants and sell what everyone else is trying to buy. It's a fight against our very nature. An endeavour that can be hugely rewarding in the long term, if things work out, but that will test our wits on a daily basis. But we are not powerless, as I will try to explain. Indeed, it is an art to which some of us have dedicated our professional life and where I may add most value.

FOUNDATIONS AND EXPERIENCE

Graham

Although they might not know it, nearly all value investors started out life investing like Benjamin Graham, Columbia University professor and ‘creator’ of value investing. Until Graham arrived on the scene, stock market investment amounted to little more than blundering around with speculative gambles. Thanks to Graham's teaching, based on an extensive analysis of the forces at work in the markets, it has now become a serious and demanding craft.

His biggest contribution came in the form of two now classic books: Security Analysis and The Intelligent Investor.1 In the first book, he provided a detailed analysis of the tools needed for scrutinising a company and investing properly; in the second, he describes the investment process, developing concepts which have gone on to be crucial for many of us.

Perhaps the most important of them all is the idea of the margin of safety. It's a simple but crucial concept: we should maximise our safety by investing in shares whose intrinsic value is significantly above their market price. A 50% discount is preferable to 30%. This margin of safety affords us protection against inevitable valuation errors.

Specifically, his main recommendation for maximising the margin of safety is to buy shares in companies whose price is below the company's liquidation value, excluding fixed assets. In other words: the value of the company's current assets (stock, account receivables, and treasury), less all liabilities, should be above its market price.

It is a very demanding condition, which made sense 80 years ago. The stock market had been decimated by the Great Depression and many companies were cheap enough to fulfil this criterion. For Graham it was of little concern what the company did, it just needed to be cheap.

The legendary Warren Buffett started out investing by following in his maestro's footsteps, and most good investors started the same way. I guess when you are starting out you want to rapidly prove yourself and you trawl the markets for anything cheap, without pausing to think, convinced that this path will enable you to make money as quickly as possible.

However, experience ultimately teaches us that many of these cheap stocks are to be found in challenging sectors or subject to major competitiveness challenges, and in the long term can remain eternal duds. Time is not on our side with such stocks, since the returns on capital are low and the potential upside is slow to materialise and uncertain. The balance sheet isn't everything.

Philip Fisher/Joel Greenblatt

I have oversimplified Graham, who also took account of other factors, such as growth or stable results, although he didn't put as much emphasis on them. Either way, from this point on, most investors began to pay attention to other drivers, such as growth or business quality, assigning increasing weight to them over time.

Phil Fisher played a pivotal role in the transformation undergone by many investors. It was under the influence of his partner, Charlie Munger, that Buffett first became attracted to Fisher's philosophy. Fisher was another successful long-term investor, who wrote at least two superb books: Common Stocks and Uncommon Profits and Conservative Investors Sleep Well.2 He put his money on investing in long-term growth stocks, with very robust competitive advantages that were capable of being sustained and increased over time. The price paid for them was not as important, since if the company performed well, it would be able to sustain a high multiple. This idea is less intuitive and therefore harder to digest than simply buying something cheap; it means paying seemingly expensive prices for something that will only yield results after a period of time.

This is ultimately the road that Buffett has gone down. Thus, most value investors are also indirectly indebted to Fisher to some degree or another. For us, the shift towards quality was a slow one, perhaps too slow, all the while trying to pay as little as possible for it.

Up until that point I had maintained a certain unshakeable bias towards investing in cheap assets, whose quality was not always proven. It was a mix that had produced good results and it was a challenge to change my ways.

Every investor develops at their own pace. The trigger to ultimately revolutionise my approach once and for all was Joel Gleenblatt, who convinced me that we had to make a decisive shift towards quality, without looking back.

I came across Greenblatt's short book, The Little Book That Beats the Market,3 in a bookshop in New York in December 2008 by accident, without searching for it and almost reluctantly. I had heard of him in a book given to me by Mohnish Pabrai: The Dhandoo Investor.4 Mohnish is an excellent investor, who we had got to know the year before at Ciccio Azzollini's always interesting and enjoyable investment conference, organised each July in Trani, southern Italy.

Mohnish is also something of a maverick; every year he gives his friends and acquaintances a book. Giving books as presents can be a double-edged sword, you are asking the recipient to devote some of their time to something that may or may not interest them. I generally don't like being given books, because I always have interesting books lined up to read and I have the vice – for better or worse – of reading every book that is given to me, almost without fail. As I don't have endless time for reading, these books can end up becoming a poisoned chalice.

However, you gradually discover that books which are dropped into your lap have the major benefit of shaking you out of your comfort zone, which tends to be limited to what you already know and authors whose opinions you share. Mohnish's books open up new worlds, from Atul Gawande's recent book Being Mortal,5 which gives an excellent insight into care for terminal illnesses, to Pavithra K. Mehta and Suchira Shenoy's Infinite Vision,6 on Aravind, the Indian organisation specialised in low-cost treatment of eye diseases. The topics are diverse and take you into lives and situations that you didn't even know existed, let alone believed could interest you.

The end of 2008 was an apt moment to ring the changes. Although we were convinced that we had taken the right approach to preparing for the crisis, investing at reasonable prices, there was scope to keep improving. It is crucial to have one's own set of sound principles (preferably the right ones!), but they need to be flexible enough to adapt to potential refinements along the way. It's not an easy balance: robust but not stubborn; flexible but not indecisive; it's all perfectly possible in theory, but very hard to implement in practice.

Getting back to Greenblatt. What he does in his invaluable book is give empirical proof that quality shares bought at a good price will always outperform other stocks. To do so, he classifies each stock according to two criteria: quality, measured by ROCE (return on capital employed) and price, measured by the inverse P/E ratio (price to earnings, the price that we pay for each unit of earnings), the free cash flow yield.

He uses a numerical classification for both return and price: 1, 2, 3, 4,…, with 1 being the stock with the highest ROCE under the return criteria and 1 the highest free cash flow under the price criteria. He then adds the points obtained by each share in both rankings to produce a definitive classification, which he calls the ‘magic formula’. It's simple but effective: the companies with the lowest sum of both factors deliver the best long-term returns. Furthermore, the same is true throughout the ranking; companies situated in the lowest 10% post a better return than the second 10%, the second decile outperforms the third, and so on until the last 10%.

Mark Spitznagel reaches similar conclusions by analysing companies with a high ROCE and low price. In contrast to Greenblatt, he proxies low price through the relationship between stock market capitalisation and capital employed net of cash or debt. As can be seen in the chart on the following page, the stocks with the best combination of both – which he refers to as Sigfrieds – obtain exceptional long-term results.

This is because these companies are facing short-run P&L problems, which are resolved over the medium term. His approach delivers better results than Greenblatt, which he attributes to Greenblatt's use of price/free cash flow, which means that the formula is excessively growth sensitive.

Magic Formula Results

Magic Formula (%) Market Average (%) S&P 500 (%)
1988 27.1 24.8 16.6
1989 44.6 18.0 31.7
1990  1.7 (16.1)  (3.1)
1991 70.6 45.6 30.5
1992 32.4 11.4  7.6
1993 17.2 15.9 10.1
1994 22.0  (4.5)  1.3
1995 34.0 29.1 37.6
1996 17.3 14.9 23.0
1997 40.4 16.8 33.4
1998 25.5  (2.0) 28.6
1999 53.0 36.1 21.0
2000  7.9 (16.8)  (9.1)
2001 69.6 11.5 (11.9)
2002  (4.0) (24.2) (22.1)
2003 79.9 68.8 28.7
2004 19.3 17.8 10.9
30.8 12.3 12.4

Note: The return on the ‘market average’ is an index with weights that are identical to an investment universe of 3,500 stocks. Each share in the index contributes an identical amount to the return. The S&P 500 is an index with market weights of the 500 largest stocks. The largest stocks (those with the largest stock market capitalisation) are assigned a higher weight than smaller stocks.

Source: Greenblatt (2006).

Spitznagel is the only investor I know who applies strictly ‘Austrian’ criteria to investment.

The exceptional results obtained by both Greenblatt and Spitznagel are surprising, but logical: good companies bought at reasonable prices should obtain better returns on the markets. As ever, the problem with applying these approaches is that the formulas deliver over the long term, but they can also underperform for relatively long periods, for example three years. This makes it tough for both professional and enthusiast investors to keep faith when things aren't working.

Graphical illustration of Siegfrieds vs. Average Johanns of the S&P.
Siegfrieds vs. ‘Average Johanns’ of the S&P

Source: Spitznagel (2013).

However, Greenblatt's simple experiment persuaded me, and it inspired me to make the definitive leap to quality. We had already been tentatively moving in that direction, but without the necessary conviction and consistency. We needed to go all in.

Those readers who don't want to continue can stop here and apply the formulas, either through a fund which uses them or by themselves. Various funds take this approach and it's essentially another very appealing form of semi-passive management.

The more adventurous can keep reading.

SETTLING ON QUALITY

With Greenblatt as a catalyst, the pieces began to fall into place and from then on we stuck to quality companies. There is no scientific way of finding the perfect combination of price and quality. Should we pay dearly for high quality? And anything for moderate quality? Obviously, paying little for quality would be ideal, but practically impossible. Uncovering real gems at an attractive price.

I think over time we ended up finding the right balance at Bestinver. Through applying Greenblatt's criteria, by September 2014, our portfolio had an average ROCE (the companies forming the portfolio) of over 40%, with a free cash flow yield of over 10%. A good set of businesses at an attractive price.

In order to reach this point we progressively sold off stocks that didn't meet the new philosophy and bought only those meeting the quality requirements. It was slow work, requiring us to sell off cheap companies and fight against out attachment to them, but we were convinced that it was the right way to go and we went all in.

However, searching for quality is not about blindly following formulas. While these are a good starting point, they remove the essential human element which is of such importance to those of us who work in this field. It is not enough to find a high ROCE and low P/E ratio. I have to understand where the profits are coming from and, above all, where they are headed. This is the essence of my work and what I spend most of my time doing. The possible purchase price can be readily found in the daily newspaper or in real time on Bloomberg, but analysing a specific sector and the company's competitive position is what enables us to determine the intrinsic value, which is neither as obvious nor as easy to identify. In fact, it's the great enigma of investment. However, there is a way to begin deciphering it.

COMPETITIVE ADVANTAGES

Few companies can sustain exceptional profits over the long run. The market works, and it goes after such businesses from all angles, usually getting what it wants. The key point is to distinguish between businesses able to withstand the passage of time – even if it's only 25 years – from those which are enjoying a more typical short-term profitability spike.

There are a lot of ways to perform this type of competitive analysis, which MBAs go into in some depth. Some of the clearest and most interesting explanations come from Bruce Greenwald, professor at Columbia University and Pat Dorsey, from Morningstar, who also focuses his analysis from a similar perspective.

Greenwald develops Michael Porter's classic work, which looked at the intensity of competition according to various factors: rivalry among competitors, the existence of substitutes and barriers to entry, and the negotiating power of suppliers and customers. Porter was the first to explain the interaction between companies and the outside world, but Greenwald simplifies the analysis, singling out barriers to entry as being the critical factor. ‘One of them [factors] is clearly much more important than the others. It is so dominant that leaders seeking to develop and pursue winning strategies should begin by ignoring the others and focus only on it. That factor is barriers to entry – the force that underlies Porter's “Potential Entrants”’.13

A high ROCE and stable market share are both a consequence and a necessary signal of barriers to entry. A low ROCE of around 6–8% is consistent with barrier-free markets, where any competitor can enter and obtain a position, with repeated fluctuations in the market shares of the different actors.

Illustration of Industry characteristics determine the sustainability (duration) of the return.
Industry characteristics determine the sustainability (duration) of the return

Source: Compustat. McKinsey Corporate Performance Centre analysis.

Once a company has been identified as having high profitability in a stable market, the next step is to identify the underlying reasons why there are barriers to entry allowing an exceptional profit to be earned. It's almost impossible for high profits to be maintained over the very long term, but barriers to entry can keep the wolves at bay for a period of time.

If we know and clearly understand these barriers to entry, then we will be able to predict when they might disappear and put in jeopardy the company's advantage and profits. This helps us keep errors to a minimum and enables us to take a stake in this exceptional profit.

Barriers to entry can appear in different forms.

(1) Through having a cost advantage. This can arise in various ways. The first is due to the characteristics of production. For example, a mine with access to raw materials: Saudi Arabia and its oil; or the final consumer: quarries or cement plans are small natural monopolies.

The second way cost advantages can arise is from process advantages, both patentable and otherwise. Some companies continually improve their processes, enabling them to maintain an advantage over time. But these are weaker forms of barrier.

Thirdly, the biggest players will be able to enjoy cost advantages over long periods whenever size or scale is essential to watering down fixed costs. These costs can come from manufacturing, advertising, or distribution (an extensive distribution network is very hard to replicate). But it's important to realise that size in itself is not as important as size relative to other competitors; and it's the distance to them, together with the presence of high fixed costs, which constitutes this advantage.

(2) Through the existence of switching costs. Companies can get away with charging above-market prices when the client finds it onerous or uncomfortable to change and buy the product or service from a competitor. This might be because they have grown accustomed to it and don't want to change. This is typical of some consumer products, such as Coca-Cola or tobacco.

It might also arise because it involves a cost which doesn't compensate the effort expended, be it in time or possible new risks. This also typically applies to certain products which are essential, but only have a relatively low value in terms of the final product, such as the lubricants manufactured by specialists like Fuchs Petrolub. The cost of shutting down a machine due to a lubrication defect is enormous, especially in relation to the cost of the lubricant. Another example is software which is highly embedded into a company's operations. This is an advantage enjoyed by one of our old favourites, Wolters Kluwer.

Switching costs can also be enhanced by difficulties in finding alternatives. While the Internet has made life a lot easier, it's not always straightforward to make comparisons between products due to differing specifications or a lack of transparency.

(3) Intangible assets, through the existence of true brand distinction, enabling a mark-up to be charged on the competition. This happens when you compare Apple with Sony: the latter is well known but lacks the same pull factor, or Coca-Cola compared with other cola brands or tap water.

Patents are also a form of intangible asset (such as pharmaceuticals) or licences (for telephony), which temporarily authorise legal monopolies. Patents suffer the risk of being contested, while licences can be revoked by the granting authority.

(4) Through ‘network effects’. The more people use a product, the more valuable it is to the client. This makes it harder for new competitors to emerge, who will need to build up this network. An example is Facebook or credit card payment companies, such as Visa, etc.

Companies in such sectors can obtain exceptional profits, with the added benefit of not necessarily requiring excellent management. Nearly anyone can manage such companies in the short run, while in the long run the goal is to continue building on these advantages.

By contrast, for a company which finds itself in a more challenging sector, facing fierce competition, management competence can be the deciding factor. In these cases, a good manager can make all the difference, putting in train ongoing improvement processes which keep the company ahead of its competitors.

Greenwald14 provides a very good summary of the analysis that needs to be carried out, which he divides into three stages:

  1. Developing an industry map.
  2. Determining whether the market is protected by barriers to entry.
  3. Identifying the sources of these barriers.

Using this approach we can build a full picture of the competitive advantages enjoyed by the company we are analysing.

Scheme for Analysing competitive advantages in three steps.
Analysing competitive advantages in three steps

What about when there are no advantages or barriers to entry?

Sometimes we may be deceived into thinking that there are barriers, which do not stand up to deeper scrutiny. This can lead to significant errors, meaning it's important to be very cautious:

  • A differentiation in itself does not automatically lead to exceptional profits. It is important that it also includes some of the previously mentioned factors; being different from the rest is not enough.
  • Sector or company growth is not synonymous with high profitability, but rather a potential sign of problems to come. Growth will attract capital, capping profitability at moderate levels. We know that the market works and, if there are no legal restrictions on competition, that it will manifest itself in one way or another, despite companies' best attempts to aggressively defend their patch.

Another second negative implication of growth is that it can reduce the relative importance of fixed costs, lowering this barrier to entry and stimulating competition.

  • It's not enough to have a good new product. It should be the start of something sustainable over time. Hot iPad apps or high-grossing films are examples of ‘perishable’ products. The advantage will last longer if a franchise can be created around the product, which reduces the risk of the second or third part being a flop, such as Superman 2, 3,… Otherwise, the lack of continuity will mean that it is little more than a flash in the pan.
  • Nor is advanced technology the be-all and end-all, since unless it creates unbreachable barriers, it will tend to favour users, but not shareholders. It is worth emphasising that both good products and good technology will be immediately copied by the competition. If a new type of restaurant proves successful, it will be surrounded by imitators within the space of a few months.
  • Size in itself is no guarantee of profitability, and can even be counterproductive. Context and, particularly, relative size are crucial to determining its relevance.

Finally, executives' management ability is not a competitive advantage per se, although it's clearly preferable for the management to support the company's development, rather than getting in its way, as can sometimes happen. This is the ‘halo effect’ explained by Phil Rosenzweig: it's easy to identify good managers based on past results, but the difficult job is predicting which of these managers will continue being successful in the future (the same is also true for mutual fund managers).

THE POSSIBILITY OF REINVESTING

If some of these companies in attractive sectors also offer a certain amount of growth, facilitating reinvestment of capital, then we are looking at a gem, with the added benefit of being coherent with our long-term investment philosophy.

If a company can reinvest with a 20% return on investment over the next 20 years and we are able to buy the stock at a reasonable price, then the return on our investment will be close to this annual 20% over 20 years.

However, bear in mind that the potential for companies with high returns on capital to reinvest a lot of capital are limited, since they tend not to be very capital intensive.

Furthermore, the market will probably be correctly pricing such gems which are capable of obtaining high returns over time, meaning we must wait for the right moment to acquire them at a reasonable price, because they are rarely going to come cheap. We will go into this in the next chapter.

NOTES

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.227.252.87