I’ve stuck fairly close to that approach. And, yet, that’s sometimes caused me to be clearly in value territory and sometimes caused me to get emails asking if I’m really a value investor at all. The fact that I’ll happily buy a company with negative tangible book value still shocks some true Grahamites.
I’ll get to the idea in a minute – the very simple and very good idea – of buying consistently profitable companies at low EV/EBITDA ratios. First, I’d like to tackle the issue of investment style. Can you have a clear style of your own – and yet sometimes appear to be a value investor, sometimes a quality investor, sometimes a contrarian investor, sometimes a net-net investor…
In my experience, you can.
Warren Buffett once said that all investing is value investing. And most quantitative attempts to shove Buffett into a style box conclude he is a high-quality investor rather than a low price investor. Since he is a buy-and-hold investor, his portfolio is full of stocks that are no longer cheap. A wonderful blog called “Value and Opportunity” – it’s one of my absolute favorites, you should be reading it – demonstrated this quite clearly in this post.
I get a lot of emails from people who are confused about what kind of investor I am. It depends on which articles of mine they’ve read first and which they’ve read most recently. First impressions are hard to shake. And for some readers my “establishing character moment” was a micro cap – like George Risk (RSKIA) or Ark Restaurants (ARKR) – two stocks I own now.
Others “met” me in print when I was writing about Japanese net-nets. Or when I was writing GuruFocus’s Ben Graham Net-Net Newsletter. They naturally think of me as a net-net investor. Someone who will buy any stock so long as it is cheap.
Then there was the time I bought Barnes & Noble (BKS). If you read that article, you probably thought I was a contrarian investor.
Finally, if you’ve been reading my articles for a really, really long time – like way back in early 2009 – you’ll remember me owning stocks like Omnicom (OMC) and IMS Health. These never qualified as value stocks on a price-to-book basis. About the only justification a value investor could find for buying them was a low price-to-free-cash-flow.
So what kind of investor am I? Do I simply change styles from year-to-year?
I have changed as an investor. But I haven’t changed much – if at all – since the 2008 crash. What has changed is where the opportunities are.
In 2009, a lot of stocks were cheap. I bought the stocks I liked best. They were stocks like Omnicom and IMS Health and Berkshire. Some of them were quite big. My usual diet is pretty micro cap heavy. But if big cap stocks sell at low prices, I’m willing to buy them too. Usually, they don’t. In early 2009, some did and I bought them.
Am I a value investor?
Am I a micro cap investor?
Am I a domestic investor or a foreign investor?
Well, right now, I own two stocks: George Risk and Ark Restaurants. They are both American stocks. They are both micro cap stocks. And – on an EV/EBITDA basis – they both qualify as value stocks.
So we could say I’m a U.S. micro cap value investor. I think that’s misleading.
I’ve used this analogy before, so forgive the repeat. Here’s my idea on “investing styles.” I don’t think you can look at any investor’s portfolio at a single moment in time – and you certainly can’t look at just one position – and say what their style is. That doesn’t mean they don’t have a style.
Basically, I think two investors – with different styles – can own the same stock at the same time, for different reasons.
And I think a stock can fit more than one style.
The analogy I trotted out before – and am bringing out again – is an author’s style. One of the best known works of George Orwell is “Animal Farm.” It’s a fairy tale. Yes, it’s also an allegory. And, yes, it’s also a political book. But it’s undeniably written as a fairy tale. One of Charles Dickens’s best knows works is “A Christmas Carol.” It’s a ghost story.
Now, if you sat down each night for a year and read a fairy tale a day and near the end of that year you picked up “Animal Farm” – I think you’d find the flavor of that book kind of odd. Likewise, if you read a ghost story a day for a year and near the end of that year you picked up “A Christmas Carol” – I think it would jump out at you as distinctive.
Well, that happens in investing all the time. Net-nets are a great example. Everyone has an idea of what the net-net genre is like – just as we’ve all got an exemplary fairy tale or ghost story in mind – and a lot of what net-net investors come across out there in the investing wilds match that image you’ve got in mind.
But a lot doesn’t.
There are many different flavors of net-nets. And some net-nets are every bit as genre busting as “Animal Farm” or “A Christmas Carol.” They tick all the boxes that cause them to qualify as a net-net. But they have other attributes that we’d consider odd.
Most net-nets are money losers – or at least lousy businesses. However, there are actually a few net-nets (in fact, quite a few in Japan) that earn money every year. Many net-nets face technological change, legal problems, etc. Some seem perfectly normal. Some – like Paradise (PARF) – are in businesses that have been around a long-time and will be around a long-time. There is almost no risk of technological obsolescence there.
Most net-nets are micro caps. But every so often something like Ingram Micro (IM) ventures into net-net territory.
You can see this clearly if you follow blogs – like Oddball Stocks and Whopper Investments – that cover net-nets. There are some genre busting net-nets out there.
I think this happens with all stock genres. I just think it gets noticed with net-nets because they have a clear technical definition. Something either is or is not a net-net. If it is a net-net and it has been profitable for 12 straight years, that’s strange and we notice it because we can’t deny it’s a net-net but it just tastes wrong to us. It tastes too good to be a net-net.
Well, I think that happens with a lot of stock genres that have squishier defining lines. And I think investors like Warren Buffett operate in those spaces.
What works in investing?
Studies show momentum works – but I know nothing about that. So let’s leave momentum aside. What else works in investing?
I can think of three things: quality, safety, and cheapness.
For me, these are the three corners of the stock style map. Most stocks probably end up somewhere in the middle of that triangle. A few are extreme examples that end up totally at one end. The classic net-net tends to be an extreme example. A net-net is cheap but it’s not much else. It’s usually not very safe or very good. It’s just cheap.
Cheapness is easy to define quantitatively. Academics like – or liked, there may be some change over time here – the price-to-book ratio. I’m not a big fan of price-to-book. I’ve always thought enterprise value to EBITDA made much more sense. First of all, only tangible book ever made sense to me. And, secondly, price-to-book always included a rather unfortunate leverage aspect. I’m not saying that an unleveraged stock that trades below its tangible book value isn’t cheap. I am, however, saying that while EBITDA always matters – I’m not sure book value does. In fact, I’m sure in many cases it does not.
For example, here are three stocks I think look kind of interesting right now:
Weight Watchers (WTW)
John Wiley (JW.A)
Dun & Bradstreet (DNB)
I think cash flow ratios show them for what they are – a bit cheap on a leveraged (FCF basis) but just reasonably priced on an unleveraged (EV/EBITDA) basis. I think price-to-book ratios for these – and frankly, any stock with substantial internally generated economic goodwill – is meaningless. And that’s kind of important because some of Warren Buffett’s favorite stocks (Coca-Cola, Moody’s, Gillette, etc.) are stocks where price-to-book is meaningless.
I mentioned that I own two American micro caps right now: George Risk and Ark Restaurants. In neither case would I ever make a decision to buy, sell, or hold those stocks using book value as a reference point.
With some other stocks – DreamWorks Animation (DWA), Carnival (CCL), International Speedway (ISCA), and Berkshire Hathaway (BRK.B) – I would use price-to-(tangible)-book as a reference point. But that is only because in each case I believe the company has some value not shown on the books. In other words, I’d be willing to use price-to-book precisely because I think I know it’s wrong.
This is a big problem in defining value investing. Some value investors will tend to have high – possibly even “no meaningful figure” – price-to-book ratio portfolios. Meanwhile, some other value investors may have high EV/EBITDA portfolios but low price-to-book portfolios. These are the guys who focus on asset values.
I think it’s value investing either way. I believe in something called asset-earnings equivalence. Physics has mass-energy equivalence. And I believe business has asset-earnings equivalence. I think that unless you really believe in asset-earnings equivalence you’ll be baffled by half the investment universe. If you don’t make asset-earnings equivalence the foundation of all your thinking when you analyze businesses – you’re going to end up stuck entirely in an earnings value mindset or an asset value mindset. And you’ll think what the other guy is doing isn’t real value investing.
Finally, I think there’s a third part to the story. The two things that matter most are assets and earnings. We can measure them both in value. But to do that we need to think in terms of time. We want durable assets. We want stable and recurring earnings. We want the future to be as good as the past – or better.
This is where the DCF usually comes in. I don’t believe you need to use discounted cash flows to figure out whether or not to buy a stock. And I’m sure you are better off not using discounted cash flows.
I’ve always found DCFs to be indeterminate. They lay out the equation exactly as it must be. By definition, no one can argue with a DCF. But they hinge on precisely those things that could turn out either way. If your assumptions are correct, the value is correct. But the assumptions can reasonably vary and in either direction.
That part is key. It separates most DCFs from something like a price-to-tangible-book approach to DreamWorks, Carnival, International Speedway, and Berkshire Hathaway. In those cases, I can’t know the correct price-to-book ratio (because I don’t know the “normal” return on tangible equity going forward) but I can determine the likely direction of my error.
At a price-to-book ratio of 1, the likelihood of undervaluing any of those companies – DreamWorks, Carnival, International Speedway, and Berkshire Hathaway – is much higher than the likelihood of overvaluing them. So I can’t come up with a number. But I can determine an action. If they trade below book, I’m justified in buying them.
There is a cheat here. And I think it’s the one Warren Buffett uses. Buffett just bought Heinz. Yes, he lent some money as part of the deal. But he still bought half the company – and while the preferred is part of the story, there’s no getting around the fact he paid a high overall price for Heinz. Buffett said: “We hope to own Heinz 100 years from now…If you own great brands and you take care of them, they're terrific assets."
Here, the margin of safety is non-numerical. The business is inherently safe. But he has no margin for error. If he is wrong in his assessment of Heinz’s future, there is no discount to absorb the blow.
You have to be completely certain about a business’s future to pay a price like Warren Buffett did for Heinz.
I think most purchase decisions are better restated in these terms than presented as an intrinsic value. If I was certain of this business’s future I would pay “x.” I am certain this business is better than most businesses and most businesses trade for “x” times EBITDA – therefore, I can pay…
I think that kind of approach makes more sense in the real world than a DCF does. And it’s that approach – of trying to find an above average business at a below average price – that I’ve used when picking stocks.
Back to Buffett, and some simple arithmetic. If you were completely certain of a business’s future from now until the end of time you could pay 12 times EBITDA.
That price – without using leverage – will tend to get you an after-tax earnings yield greater than 4%. Historically, public companies (if we use the Dow as a proxy) have been able to grow around 6% a year. If you were a true buy-and-hold forever investor buying a business with zero future uncertainty you could pay 12 times EBITDA and still make 10% a year.
That’s the definition of a pure “safety” investor in stocks. It would be someone who only bought a business like Heinz.
I’ve never been able to do that. And I’ve never had much success as a pure “cheapness” investor either.
Where I have had success is buying the highest quality net-nets and highest quality low EV/EBITDA stocks I could find. What would you call this? Value at a reasonable quality investor?
I don’t have a word for it. But I know it works.
There are many measures of quality and safety. My preferred metric is simply the number of losses going back as far as possible in the company’s history.
In other words, if you ever find a company trading at five times EBITDA with 20 straight years of profits – you have my permission to buy it sight unseen. A basket of ten such stocks will always work out. Of course, in the U.S., there’s probably only about ten such stocks at any one moment in time.
Those criteria are probably a little too tough. But you can generate a list of 100 to 200 stocks – at almost any time in the U.S. – simply by limiting your shopping list to stocks with ten straight years of profits trading at less than eight times EBITDA.
I think most investors would benefit from that simple blending of genres – good enough and cheap enough.
A cheap business is one that trades for a low EV/EBITDA. A good business is one that tends to always make money.
That’s a simple definition of good and cheap. But in my experience, it works much better than trying to maximize the goodness (at any price) or cheapness (at any quality) of the stocks you buy.
I don’t have a name for buying an above average business at a below average price. And considering how quickly dogma can attach to a name – I’m not real eager to slap a label on the approach.
But if you want to know whether I’m a value investor or not – all I can say is:
Is buying an above average business at a below average price value investing?
If so, I’m a value investor. If not, I’m not sure what I am. But I’m sure I like it better than when I knew I was a value investor.
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