Investment process
Cigar butts and value traps
The issue for discussion today is whether a bad company is worth buying if the price is cheap enough. We learn better when we see both sides of a story. I’ll present both and offer my own conclusion.
Howard Marks is co-chairman and a co-founder of Oaktree Capital, a Los Angeles based investment firm which specializes in distressed debt and has more than $200 billion of assets under management.
In an interview on
with Christoph Gisiger, this exchange took place:
Q: “In other words, a good company is not necessarily a good investment?”
A: Marks “That’s the key lesson. Investing is not about buying good things, but about buying things well – and if you don’t understand the difference, you shouldn’t be an investor. The next step in my career led me to high-yield bonds. Now, I invested in the worst public companies in America, but I made money steadily and safely because I was buying them so well. This shows what is at the heart of a bubble: there is nothing so good that it can’t become overpriced and dangerous. Conversely, there’s almost nothing so bad that it can’t be a good buy at a low enough price.”
Q: “But what about the risk of running into a value trap?”
A: Marks “Of course, not everything on pile B should be bought. Some of these assets are value traps. But this is where your potential is the best.” (Emphasis added)
When you read the entire interview, it is clear that Marks is talking about stocks as well as bonds. When I read this, I thought, this is wrong. On reflection, I had three thoughts. First, I thought there is more than one way to skin a cat. That is, there are different styles of investing and in different hands they can be made to work. In a way, what Marks is suggesting is what Warren Buffet describes as investing in cigar butts someone has thrown away. Second, I thought that his expertise was in distress bonds and that you can’t just invest in stocks using the same investment process that works with bonds. Third, I thought he was plain wrong as far as stocks are concerned.
Let’s take a look at some things Warren Buffett has said and written:
Looking for wonderful businesses
The following is taken from Warren Buffett’s Meeting with University of Maryland MBA Students – November 15, 2013, with notes taken by Professor David Kass.
“Q. – In the past you said you attribute 85% of your investing to Benjamin Graham and 15% to Philip Fisher. Has that percentage changed?
WB: I developed my investment strategy under Graham. I went to Columbia and learned from Graham. With Graham’s approach, you cannot lose money over time. It’s very quantitative in nature, and you have to do reasonably well. On the other hand, it has less and less application as you get into bigger and bigger companies with larger sums of money. It’s better to buy wonderful businesses at fair prices than so-so businesses at low prices.
With the “cigar approach” [Ben Graham’s approach], you can find a nasty cigar on the ground, with one puff left, can pick it up, light it and you get a free puff. You can keep doing this and get many free puffs. That’s one approach, that’s what I did. I looked for very cheap stocks quantitatively. After exposure to [Philip] Fisher and Charlie [Munger], I started looking for better companies. Previously I was doing both. Now we are looking for good companies, not just cheap companies.” (Emphasis added)
Buffett’s investment style in a nutshell
So, what is Buffett’s investment style today? I will try to describe it using, as far as possible, his own words. His style reflects his investing aims, which are, very simply to: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham 1998) p93
So, the first requirement is to buy only superb companies, i.e. companies whose earnings will march upwards. These are the wonderful businesses.
His style is thus to identify companies that achieve that end and buy them at ‘an attractive price’. (Buffett, 1998) p85
Note, he does not require that they march steadily upward. There is a normal lumpiness to the earnings of even the best companies. The only earnings that grow steadily are those that are ‘managed’ by the CEO and CFO. The ‘attractive price’ is to provide a margin of safety.
As the size of Berkshire Hathaway has increased, Buffett has had to reduce his standards on margin of safety which has, in turn, impacted his investment returns. As he puts it: “We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998) p85
Of course, most investors are not hampered by Bershire Hathaway’s size and can stick with the ‘very attractive price’ requirement.
Choosing common stocks
We only want to invest in wonderful businesses. Not in bad businesses. In a sense, it’s that simple. Choosing them can be relatively simple. There are a few basic requirements: first, they must make lots of cash (rather than reported earnings) without needing a lot of tangible assets to do so. Investors should learn to understand the company’s cash flow statement. The cash should be more than they need to maintain their existing assets and position in their market; second, they must have opportunities to invest that cash at high rates of return in growth opportunities. To read more see a series of posts on cash flow. here.
Third, they must have minimal debt. If they could pay it all off in a couple or three years from the extra cash the business generates the debt is ok. For more on debt see here.
Fourth, management and the board must have tens of millions or hundreds of millions of dollars personally invested in the common stock of the company. This will make them much more careful with the company’s capital. To read more about management see here.
Lastly, investors make sure they understand the business. What is it they do or make? Do you have a good sense as to how they make their money? Try to be a business analyst. Look deeper here.
Bottom line is the company must be a great company. Just because a company is a household name doesn’t make it a great company. In fact, many of those with old boys’ club management are quite mediocre.
Conclusion
Howard Marks says about stocks that there’s almost nothing so bad that it can’t be a good buy at a low enough price. This idea is completely alien to my own approach to investing. I will only invest in superb companies whose earnings I believe will march upwards over the years. I will only buy them if I can do so at a very attractive price. Then it’s a matter of monitoring and watching their earnings march upwards over the years. And if a company in the portfolio loses its way, it is sold.
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For readers wishing to dig a bit deeper into this topic, you might take a look at these posts:
How Warren Buffett was influenced by Philip Fisher
Misconceptions about Warren Buffett’s approach to investing
And to read up on how to identify superb businesses:
The tenets of companies Buffett invests in
How to distinguish a superb value creator from an also ran
And finally, to learn what makes for a superb company, check out these lists of posts:
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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