I received a couple questions/comments from readers lately regarding Buffett and some previous comments I made on strategy before and after the Berkshire annual meeting. I always enjoy interacting with readers. The vast majority of my days are spent researching new investment ideas, so I can’t always respond to everything, but please feel free to email me questions/comments to firstname.lastname@example.org. I read all my emails even if I don’t always have time to respond. When possible, I’ll respond individually, or when I receive numerous emails on the same topic, I’ll do a post.
As for the questions that I wanted to address on Buffett, a few have to do with his evolution from deep value to quality (an evolution that I think is very misunderstood, which I’ll comment on in the next post).
For this post, the question was on how I think about quantitative vs. qualitative analysis and specifically, what do I think about net-nets?
Here is a discussion that I'll repost from a comment I made a number of months ago:
I'm very much interested in the numbers... but I also work hard to try and understand the qualitative aspects of a business. But I generally agree with Buffett when he said the most "sure" money is made on the quantitative side, while the real big money is made when both qual and quant line up...
But to answer your question--very generally speaking--my ideal investment is a great operating business that produces consistent free cash flow and high returns on capital that for some reason trades at a low price relative to normal earnings. But those investments are relatively rare. So I'm always on the lookout for undervalued situations such as hidden or cheap assets or other special situations resulting from some corporate event like restructuring, or spinoffs, etc...
But very simply, I'm just trying to find large, low-risk gaps between price and value. I try to make everything very simple. I want obvious value...
Net-Nets: Almost Always Poor Long Term Investments
The headline above might aggravate some of my friends. So let me briefly explain: investing in net-nets can be a viable strategy, but net-nets are dubious long term investments on an individual basis. The topic of net-nets reminds me of Winston Churchill's famous words about Moscow in 1939 that I paraphrased in the title of this post... individually, they are risky and unpredictable.
Ben Graham would agree, most net-nets are inferior businesses that by their very nature lead to inferior long term investment returns. However, the overall strategy of owning a basket of them can work. The key is owning a basket of them and selling them "on the blips"--it's a strategy that I don't feel comfortable with, for reasons that I'll elaborate on below.
However, the general strategy seems to continue to work according to all of the tests, and I know investors who have done very well just mechanically buying these things (net-nets, negative EV stocks, etc...). Although I look at net-nets occasionally, I'm not very excited about them. I would prefer to own businesses that are growing intrinsic value (my experience is that most net-nets today have shrinking intrinsic values). This means that over time, your margin of safety will erode, meaning you need the investment to work out sooner rather than later. As soon as you get in, you're looking for a way out.
So despite the empirical evidence that the strategy can work and my respect for the investors I know who implement such a strategy, I typically tend to pass on most investments in this area. I have a large amount of discomfort when I know that the fate of my investments depends not only on the price that some other investor is willing to pay me for my assets, but also the timeframe in which he or she must accommodate me. In other words, these backtests tend to work because most of the holding periods are quite short (usually just 1 year).
I have done a lot of research on these tests, and just anecdotally, I’ve noticed that many of the holdings in these mock portfolios do in fact jump up in price from time to time, allowing the investor to exit at a profit. But if you look at some of the old portfolios from say 3-5 years back, you’ll find that most of the holdings (even after some occasional significant rises) ended up either in bankruptcy or continue to wallow along at low prices.
So as long term investments, they often tend to be quite mediocre. This means you have to have more of a trader’s mentality, or a liquidator’s mentality with these types of really cheap cigar butts. You need to get out of them as quickly as you can once you’re involved. That’s just not a relaxing situation to be in, and it just doesn’t suit my personality.
Net-Nets: A Different Ballgame in Graham's Day
I think Graham and Schloss had a field day with net-nets in the 30's-50's because of the opportunities available. The significance of the discounts that were widely available in the shadows of the Depression cannot be overstated. Schloss often found companies that weren't necessarily great (some might even be losing money temporarily), but they had "$35 worth of liquid assets with a stock price of $15 and a 6% dividend". It's hard to lose money with a basket filled of situations like that. Most of the net-nets today are burning cash at a rate that will erase the margin of safety you initially get in just a year or two. Some of those will work, but they have much higher risk than I think Schloss would have wanted to take on.
A&P: The Largest Retailer in America
Another example that Graham referenced: In the late 1930's, a company called A&P was the largest retailer in America, if not the world, and in 1938 it traded so cheaply that it was a net-net. (Imagine if Walmart had a bad year or two and traded below liquidation value—that’s the kind of environment Graham was working in)...
In the late 20's A&P traded close to $500 per share. By 1938, it had sunk as low as $36, thanks to a bad year and general pessimism. To put this price in perspective, A&P had net current assets $38 per share, including $24 of cash. So basically, the market was pricing A&P at liquidation levels--assigning no value to their business. But the average earnings per share of the previous 5 years (1933-1937) were about $6 per share. So A&P had a P/E based on avg 5 year earnings of about 6, and it traded below net current assets (which were largely liquid).
These might be some of the more extreme examples, but there were many opportunities to invest in good stable operating businesses that might be experiencing a temporary bad year. These were logical, low risk investment ideas.
The net-nets today (at least in the US) are not of this caliber. Some investors are quite adept at finding cheap and safe stocks, and are achieving excellent results. But on balance, I think Graham and Schloss would have not been interested in the vast majority of net-nets and so-called cheap stocks that show up today in these typical screeners and backtests.
If they were investing today, my guess is that they would have looked at and found many undervalued ideas, and as Schloss did in each decade of his career, they would have adapted to the current set of opportunities, but I doubt they'd be buying most of the net-nets in the US today.
Buffett's 1989 Shareholder Letter
The above thoughts are much more eloquently and succinctly summarized by Buffett in the '89 letter:
"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.
You might think this principle is obvious, but I had to learn it the hard way..."
To Sum It Up
So those are just some thoughts... remember to keep it simple, look for obvious value... and focus on investing in businesses that you can understand and can reasonably estimate intrinsic value. In the end, it doesn't really pay to put yourself into a rigid style box. Just try to identify the value of things and then try to pay a lot less.
I have a few more comments on a similar topic that I’ll post next week on Buffett, and specifically on his famous “guarantee” that he could make 50% per year investing small sums—a result that he in fact achieved for a number of years by using an investment strategy that I think is mostly misunderstood by most investors.
Until next time…. Have a great week!
Some posts related to this topic:
- Star Manager's Case Study of a Great Business vs. a Net-Net
- Buffett on How to Think About Stocks
- Importance of ROIC
- A Few Thoughts on Buffett and Great Banks