As I was driving home the other day and listening to Howard Marks (Trades, Portfolio)’ fantastic book “The Most Important Thing” on Audible, I heard a great line that I think is relevant to today’s environment:
“It’s important to bear in mind that in addition to times when the errors are of commission (buying) and times when they are of omission (failing to buy), there are times when there’s no glaring error. When investor psychology is at an equilibrium, and fear and greed are balanced, asset prices are likely to be fair relative to value. In that case, there may be no compelling action – and it’s important to know that too. When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.”
I just got finished researching a company trading at 10X earnings that was the largest position in the portfolio of a value investor that I respect; he put forward a simple case for why the stock should trade 50% higher than its current valuation in a few years – a solid return backed by a pretty good argument. Suddenly, I found myself getting excited – not only at the prospect of making money, but of actually finding somewhere to invest a growing pile of cash.
But as I started to look at the company more closely, a few things caught my attention:
(1) The company was dependent upon a handful of customers for the majority of its sales (with a single customers accounting for ~25% of the business) – and had only become more dependent on a small number in the years since the financial crisis; during the crisis, their dependence on these customers severely affected their business (sales declined more than 20% in 2009).
(2) Key metrics (like net margins, return on assets and return on equity) were all well above their historic averages in the past 2-3 years, without any clear explanation as to why this new state was sustainable long term.
(3) Some commentary in the 10-K left me with the impression that management made cosmetic changes in order to avoid a non-cash accounting (impairment) charge in the most recent year.
(4) Management has once again become comfortable with leverage, despite the fact that it caused them serious pain in the depths of the financial crisis (culminating in an equity issuance at levels equal to ~20% of the current price); while likely to juice results in the short term, I’m not a fan.
The list goes on from there.
But here’s the funny thing: even after building a pretty robust list of concerns, I still wanted to buy the stock; I was no longer trying to “kill the company”, as Bruce Berkowitz (Trades, Portfolio) would say (here). I kept circling back to two simple points: largest position of a respected investor and only 10X earnings. I was determined that I should be buying because this investor was, even when my analysis suggested I couldn’t see what he saw – that it was best to look for greener pastures.
After days of consideration and internal struggle, Howard’s quote nicely captures what I needed to hear. My conclusion differed from the aforementioned investor, and that’s alright; I ultimately decided that 10X was only part of the story – and it wasn’t a good enough reason on its own.
Picturing a beach ball being submerged under water nicely captures this idea (an idea I’ve shamelessly stolen from Don Yacktman - here): I want to own companies where, even if the ball stays submerged – if the stock continues to trade at a discount to intrinsic value – the water keeps on rising at a sufficient rate over time. I’m okay with the gap, and even if it widens – as long as the water – intrinsic value - keeps rising.
My desire to be clever in this situation was likely a sign of fatigue more than anything else: I’ve looked at dozens of companies in the past few quarters, with little to show for it. I’ve made a single purchase, with a short list of prospects hoping to get some help from Mr. Market; he hasn’t been too interested in bringing many of them closer to my buy prices as of late.
But that can’t drive irrational behavior. The decision here – between being clever and being patient – can be tough if you let your emotions take control. Some people can’t stand watching investments they’ve passed on rise 10%, 20%, or 50% in the ensuing months – even if those gains wildly outpace increases in intrinsic value. And there’s a good chance many of the stocks you’ve looked at lately are up pretty nicely in the past 18 months.
When this happens, what can you do? Some people start to let Mr. Market dictate their actions – and when he’s saying I’ll pay crazier prices today than I would six months, that’s all the reason they need to act. If you think of stocks as partial ownership in a business, and have a timeframe of years as opposed to weeks or months, it all starts to seem a bit irrational.
At the end of the day, discipline must be non-negotiable – regardless of how optimistic Mr. Market may be in the short term. When he starts getting clever and finds a way to justify insane valuations that imply years (or decades) of perfection, there’s one answer - don’t join him.
To update readers, I remain pretty significantly invested (take a look at my year end portfolio review for an idea of what that means), only because my holdings have performed well as of late (offsetting cash additions to my portfolio); I purchased Weight Watchers (WTW) as discussed previously, but otherwise I’ve been inactive. Besides reducing one of my larger positions by a third this past week, I haven’t sold a single share of stock since the Leucadia disposition I discussed last November.
That will start changing if we keep moving higher, slowly but surely. Until then, I don’t see anything particularly clever to do.
About the author:
I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.