While evaluating an investment manager’s historical track record is important, it is even more important to understand his or her investment philosophy. Understanding the investment philosophy helps both to evaluate how the past record was achieved and to assess the likelihood of future success. To help current and future clients understand my investment approach, I intend to include the following section in each investor letter.
In a nutshell, my investment philosophy can be broken into four parts: 1) Find Great Companies, 2) Avoid Investing Traps, 3) Don’t Overpay, and 4) Take a Long-Term Owner Mentality. Let me explain what each part means.
1) Find Great Companies
First, notice that I said great companies, not average companies and not merely decent companies. While it is possible to make money buying average companies at bargain prices, the truly phenomenal returns (3x, 5x, 10x your money) are made by buying great companies that can compound value at a high rate for decades.
Buying great businesses is by no means a controversial statement and you won’t find many investment managers that claim they buy bad businesses. However, greatness is subjective. How should we measure it for a business? I propose that while a high growth rate or a high profit margin are nice to have, they are not the most important characteristics of a great business. A fast-growing business aggressively juicing growth with bad economics is a recipe for disaster. And a business with low profit margins, such as Costco, can still be a great business.
In my view, the most important characteristic of a good business is a track record of maintaining a high return on invested capital. This metric measures the efficiency over which a company deploys capital. It captures the profitability and capital efficiency of a company’s operations and the management’s capital allocation decisions. Over the long term, the returns a company’s shareholders enjoy will approximate the returns on the business’s invested capital.
Another reason to require an established record of high returns on capital is that it implies the business has a certain moat or competitive advantage. Almost by definition, the very fact a business is able to sustain a high return on capital suggests it is able to successfully defend against competition. Of course, the investor still must do the work to understand the nature of the competitive advantage and its persistence, but it is a great starting point.
2) Avoid Investing Traps
When faced with a difficult problem, Charlie Munger’s advice is to “invert, always invert.” Inverting the question of which companies to invest in would result in asking which companies to avoid. By studying history, we can identify situations which often end poorly. If we can avoid the common investing landmines, our probability of success goes up significantly. In general, I tend to avoid the following situations.
- High Leverage: Warren Buffett is quoted as saying that Rule #1 of investing is to not lose money and Rule #2 is to not forget Rule #1. Leverage can boost returns, but it introduces fragility and greatly increases the risk of permanent loss in a down market. While high leverage isn’t the only reason a company goes bankrupt, it sure seems to be a key contributor in many situations. We prefer our companies to have little to no leverage. We also never use margin (borrowed money) in making our investments.
- Initial Public Offerings (IPOs): IPOs are often exciting, but their performance is quite lousy. After a day-one pop, academic research has shown that most IPOs underperform in the subsequent years. There are key reasons why this is the case. First, there is significant information asymmetry as the sellers in an IPO are the company insiders. Second, the sellers control the timing of the IPO. If the price is too low, the IPO is delayed or cancelled. As a result, the only IPOs that actually happen tend to be those priced dearly with high valuations. For these reasons, the odds are stacked against the buyer in the IPO.
- Significant M&A (Mergers & Acquisitions): Whether it is due to integration issues, culture clashes, or hidden problems, the history of major M&A is poor. Deals often look good on paper but fall far short of promise. It is no coincidence that the AOL-Time Warner Merger, one of the largest M&A deals in history, is also one of the worst.
- Turnarounds: Though the allure of turning around a struggling business might be tempting, statistically most turnarounds fail. Buffett has a great piece of advice that investors should take to heart. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
3) Don’t Overpay
The key takeaway here is that valuation matters. Even a great business can turn into a poor investment if purchased at too high a price.
The performance of Microsoft stock between 1999 and 2014 is a great example. Microsoft sold for 60 PE in 1999. The cost of such nosebleed valuations was a decline of nearly 70% at the lows. Microsoft stock would not return to its 1999 high until 2014, almost 15 years later.
The poor performance of Microsoft stock occurred despite the solid performance of the business. In fact, Microsoft remained a great business and continued to compound earnings at a double-digit rate during this period. The problem was that the PE ratio declined 75% from 60x to 15x. Simple math shows that for the stock to remain unchanged, the earnings actually quadrupled during this period! Microsoft was so overvalued in 1999 that it took 15 years for the company to grow into its valuation.
We strive to be patient, disciplined investors who only swing at the pitch when the price is right.
4) Take a Long-Term Owner Mentality
If we are so lucky as to have acquired a great business at a good price, our ideal holding period is forever. To quote Charlie again, “The first rule of compounding is never to interrupt it unnecessarily.”
We will sell a great business only for two reasons. 1) Something has changed about our original investment thesis. The initial assessment of business quality may have been wrong or sometimes a technological innovation comes along and disrupts an existing business. Newspapers and yellow pages were great local monopolies until the age of the Internet. 2) The stock becomes clearly overvalued. Notice that I did not say fairly valued or slightly overvalued, but clearly overvalued. Since great businesses are rare and valuation is an imprecise art, it is best not to sell unless the overvaluation is extreme.
Over the long-term, our low turnover strategy also has the added benefit of reduced transaction costs and capital gains taxes. Even in the age of zero trading commissions, there are real transaction costs in the form of bid-ask spreads. The more frequently an investor trades, the more significant the drag from transaction costs becomes.
Finally, for taxable accounts, the benefit of tax deferral of capital gains is generally underappreciated. An example will illustrate the significant benefits of tax deferral. Let’s assume there are two strategies that each start with $1,000 and earn 10% per year. Strategy A defers all capital gains until the end and ultimately pays a favorable long-term capital gains tax rate of 20%. Strategy B has frequent trading and recognizes short-term capital gains that are taxed yearly at the ordinary income rate of 32%. Over 40 years, Strategy A will have grown to $45,259. After paying 20% of its gains in taxes, Strategy A will realize after-tax profits of $36,407. Strategy B, which pays taxes annually, will have grown only to $13,895. The proceeds from Strategy A are nearly 3x the proceeds from Strategy B, with the only difference being the tax efficiency of the strategy. Of course, if you had invested through a Roth IRA, you get to keep the entire $45k. If you are not maxing out your Roth IRA each year, you should be!
In a world where average holding periods are measured in days, weeks, and months, being able to own stocks for years is a behavioral competitive advantage. Taking a long-term mentality allows us to avoid overreacting to short-term factors and not miss the forest for the trees.
In closing, I believe that if we follow these key investment principles, the chances are good that our long-term investment results will be more than satisfactory.
