1. How and why did you get started investing? What is your background?
In a past life I ran the power grid for the state of California. I enrolled in UC Davis' MBA program as a working professional to keep my career options open. Through the school, I ended up winning a lottery to have lunch with Warren Buffett (Trades, Portfolio). We had a lengthy question and answer session at Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) headquarters before Buffett treated us to steaks at Gorat's. He had a well-thought-out, articulate answer to any question we lobbed at him. I was incredibly inspired. On the plane ride home, I kept asking myself one question: how had one man accumulated so much knowledge? I started reading everything about him I could get my hands on to answer that question. I had always been interested in saving and investing, but I never had a true framework until I stumbled into value investing. After years of study, I eventually transitioned careers and founded Farnam Street Investments with my then-boss at the energy company, who also happened to be a big Buffett fan. We named the company as a tip of the cap to Warren Buffett (Trades, Portfolio)'s first partnership he started out of his house on Farnam Street.
2. Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas from?
I will keep this very general as later questions get more specific. We look to always get more than we pay for. We want positive asymmetry or what Mohnish Pabrai (Trades, Portfolio) would call a "Dhandho bet"-- heads we win big, tails we do not lose much. We are almost pathological about minding the downside of an investment. This is not always a good thing. Worrying about what can break your portfolio can cause you to become blind to the major upside that might make your portfolio. I wonder if we are too risk-averse sometimes, but I believe many value investors have that same feeling during a long-in-the-tooth bull market.
3. What drew you to that specific strategy? If you only had three valuation metrics what would they be?
One thing I have realized is that I have always been a value investor at heart. I never pay retail for anything. I used to browse on Craigslist looking for a deal or an arbitrage opportunity. Here is a nice analogy of our investment process. At one point, I discovered that salvaged title vehicles often sell for absurdly low prices. The reason? You cannot get financing for a salvaged title, you have to pay cash. That eliminates a large population of credit-financed buyers. Yes, the cars have been in an accident and fixed up so you have to stomach some uncertainty, but if you take the car into the shop and make sure it is structurally sound before you buy (i.e. do your research), you can get a great car for a bargain price. I bought a salvaged title Toyota Prius for the family for about half the going price and we still drive it around today. Who does not love a good deal? And why would not that apply to partial ownership of publicly traded companies?
I am hesitant to reference specific valuation metrics because they are often a shorthand for doing the actual work of understanding an investment. I will say that I am biased toward ones like enterprise value that include debt. Unless you are following an automated low price-book, price-book, EV/EBIT quantitative approach like the Magic Formula, I find investors often use metrics as an intellectual crutch. They are not meant to be a substitute for real thought, unless you fully let go of the reigns and follow an automated system, which is actually quite smart.
4. What books or other investors changed the way you think, inspired you or mentored you? What is the most important lesson learned from them? What investors do you follow today?
As the host of the author interview series "Five Good Questions," I read a lot of great books and interact with many inspiring people. Narrowing the books down to a small number for a recommendation is difficult because they all add to your knowledge base. It is hyperbole but I feel like it would be like asking Picasso, "Which was the one brush stroke that made this painting?" He could not say-- the collection is greater than the sum of its parts.
We follow many investors through their 13Fs. Admittedly, only a small percentage of their ideas ever make sense to me. This is likely due more to limitations on my end. I am OK with that. The important thing is to not follow other investors into a position that you do not adequately grasp. Valeant (NYSE:VRX), anyone?
5. How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?
Ideally, we find a great capital allocator running a quality business and are able to buy in at a cheap price. These are the best because, as owners, we can sit on our hands and let the business' intrinsic value compound annually while we cheer them on, secure that the stock price will eventually follow the upward march of the business value.
6. How has your investing approach changed over the years?
Early on we were very quantitatively driven. Almost exclusively actually, and not by accident. This is the same evolution that Buffett followed. As he grew intellectually under Munger's influence, he started to trust the mental models and base-rate data he had accumulated in his readings. Those are the minimum requirements to generate an accurate forecast for a business. Do not get me wrong, being numerically cheap still matters a great deal to us. But I believe that after more than a decade of dedicated studying, reading and intellectual growth, I am just now on the cusp of being able to trust a qualitative insight I might have. Many of them are mirages or the cat is out of the bag already and the special nature of the business is already baked into the price. That could just be this extended bull market talking again though.
7. Name some of the things that you do or believe that other investors do not.
Sometimes I feel so contrarian, I do not even know where to start with a question like this. If there is a status quo, I am likely challenging it.
I will say that I have a fondness for Austrian economics that I do not see widely held. I had a undergrad degree in economics that was very mainstream and Keynesian. When I discovered Mises, Hayek and Rothbard, I felt that same intellectual inoculation that I felt with value investing. It just made sense and clicked for me. I believe society will one day recognize the hubris and mistakes of a top-down, centrally-planned, Keynesian economy and we will rediscover the Austrian tradition. Start with Hazlitt's "Economics in One Lesson" and see if it grabs you.
8. What are some of your favorite companies, brands or even CEOs? What do you think are some of the most well-run companies? How do you judge the quality of the management?
No surprise, I am a fan of Jeff Bezos at Amazon (NASDAQ:AMZN). I love his truly long-term approach to building businesses. Exceedingly rare. I also appreciate the culture that Reed Hastings has built at Netflix. There is a great slide deck that explains their values and is a bold stake in the ground. (As a side note, I like both of those companies but hate their current prices.) I am also impressed by the systems and culture 3G has created. They are doing the Lord's work of capitalism by stripping out the fat that builds up in a large bureaucracy. They are a vital part of the economic ecosystem and should be celebrated, not vilified.
9. Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?
Not a lot. More so during market panics when prices are changing rapidly. The 52-week low is not a bad place to start. We also do a lot of digging through the 13F filings of investors we admire and (occasionally) understand.
10. Name some of the traits that a company must have for you to invest in, such as dividends. What does a high-quality company look like to you and what does a bad investment look like? Talk about what the ideal company to invest in would look like, even if it does not exist.
A management with stellar capital allocation is quite the luxury for an investor. Knowing when to reinvest in the business, pay off debt, acquire or divest a line of business, buyback shares or simply do nothing is highly accretive to shareholders, yet surprisingly rare. I am actually working on a book right now to help CEOs become more adept at good capital allocation.
A high-quality company is one which produces high returns on invested capital and can reabsorb and compound those profits internally at a high rate with no signs of annual decay. Add to that a management who intelligently directs that flow of capital and it is pretty hard to go wrong.
There are only two ways to have an exceptional business. You have to be able to answer "yes" to one of the following questions.
1. Is your product or service differentiated enough where you can charge more than your competitors?
2. Are you the lowest cost producer?
If you answered "no" to both, you do not qualify as special. It is simple math: revenue minus expenses equals profit. You have to either win on revenue or expenses to achieve an abnormal profit. Most businesses only earn their cost of capital, and that is OK-- we need them to turn the wheels of society. But they should not be confused with exceptional businesses.
11. What kind of checklist or homework do you utilize when investing? Do you have a specific approach, structure, process that you use? Or do you have any hard cut rules?
We have an internal proprietary checklist that we have been building for years. It is currently at 84 pages. The checklist nuggets from our daily reading do not come as frequently as they once did, but we are always looking to add new insight to our manifesto. It is a good day when something new makes it into the checklist.
Obviously, no investment checks 84 pages' worth of boxes. It is designed more to slow us down and bring out what Daniel Kahneman would call our "System 2" thinking mindset.
12. Before making an investment, what kind of research do you do and where do you go for the information? Do you talk to management?
Our research scales up in line with our position size increasing. When we find something that is statistically cheap, we will often buy a little. Then as we get to know the company better, attend shareholder meetings, interact with management, etc., we develop a better understanding of what is really happening with the company and get comfortable enough to buy more. Our research gives us increased confidence to scale up the position. It is hard to really know a company before you own some. You can leverage the commitment and consistency bias against yourself to do more research. This slowly developing process usually works out in our favor as the price of what we are interested in is often trending downward. By design, we are averaging down as our understanding is averaging up. Sometimes we do not accumulate enough before the prices moves up. C'est la vie.
13. How do you go about valuing a stock and how do you decide how you are going to value a specific stock? When is cheap not cheap? If you can, give some of examples.
In a perfect world, you could measure the future cash flow coming out of a business, discount it back to today, and you would know exactly what it is worth. "Count the cash," as Bruce Berkowitz (Trades, Portfolio) would say. In practice, that level of precision is impossible. The world is too sloppy for that. But if you can get in the ball park of knowing what the business might look like in three to five years, you can get an idea of a range for intrinsic value. Then if the price you pay gives you plenty of margin versus that intrinsic value (in case you are wrong on your estimates), you can feel like you are getting a bargain. Or as Buffett has said even better, "Price is what you pay, value is what you get."
14. What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?
Sadly, few bargains. My kingdom for a net-net.
Just for fun, let's cover what a terrible business looks like. Highly cyclical, fashion-like changes in customer tastes. Rapid technological obsolescence. Long lead times between design and feedback from customers. Requires incredible amounts of "Red Queen" capital where you run faster just to stay in place. Historically low, even negative, returns on that capital. High debt loads. Dumb competitors competing away profits to zero. Labor issues. Long-tail warranty liabilities. Global supply chain risk and foreign government and currency issues. High fixed costs mean operational leverage works against you as sales slump. The market understanding these problems and never pricing at high multiples, even during the good times.
Wait, did we just describe the auto industry?
15. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
To be honest, I feel out of sync with today's market. I cannot help but wonder if there is too much complacency. The high valuations seem to neglect a lot of potential risks. There has not been a wildfire in quite sometime to clear out the undergrowth. I am a long-term optimist but I do not believe reversion to the mean has been suspended indefinitely.
16. What are some books that you are reading now? What is the most important lesson learned from your favorite one?
I will give one specific book I got a lot out of: "The ONE Thing" by Gary Keller. It is the 80:20 principle on steroids and really highlights how we harm ourselves with multitasking and confusing efficiency and effectiveness. Hint: efficiency is doing things well, effectiveness is doing the right things. The punchline of the book is this: what is the ONE thing you could work on, which if done well would make everything else you work on easier to accomplish, or not even necessary? Ruthlessly carve out four hours per day for your ONE thing and you cannot help but make a bigger impact. That takes a big commitment though. Like a lot of life, the answer is simple but not easy.
17. Any advice to a new value investor? What should they know and what habits should they develop before they start?
I am terribly biased but my only real advice is to read a lot of books. It does not matter the subject, it is almost all useful.
Allow me a bit of a tangent. Think about the return on investment a book offers. For generally $10 to $15, you get to have an in-depth (albeit one-way) conversation with a knowledgeable expert who likely dedicated at least a few years to refining and distilling an epic amount of information about a specific topic. For the cost of a mediocre dinner, you get in return what amounts to years of another human’s efforts. I did the math. If it took the author one year, you are paying about one-half of one penny per hour for that author’s effort. How much time does this half a penny per hour investment save you in culling through information? We are talking years!
I like to think of books as the “oil of information.” About 12,000 gigawatt-hours of solar energy hits the earth every day. That is a lot of energy, but the problem is it is spread out over the 197 million square miles of the Earth's surface. It is simply not very concentrated. Nearly all life on earth makes a living collecting and processing that solar energy. Sometimes large packages of that energy that we call “plants and animals” get physically trapped and subjected to extreme geological pressures. That decayed material full of potential energy becomes so compacted for so long that it eventually forms oil. In essence, oil is made up of millions of years of concentrated sunlight borne out of extreme pressure, creating immense energetic density. Likewise, books are a similarly extreme concentration of information. Oil is formed under Herculean pressures inside the Earth. To stretch the analogy, the human equivalent of a similar amount of mental pressure is applied to the information that becomes distilled into a book. Just as mankind has been able to raise living standards immensely by harnessing increasingly energetic materials (dung < wood < coal < oil), books are simply a better fuel for our brains.
18. What are your some of your favorite value investing resources or tools? Are there any investors that you piggyback or coattail?
No joke, a GuruFocus premium membership provides a ton of value. The 15 years of financial information is a fantastic resource. I should probably also put in a plug for my labor of love project, Five Good Questions.
Otherwise, I would say if you want to find original insights, you have to look where no one else is looking. Do not be afraid to wander off the intellectual reservation. The things you need to know will still find their way to you. The crowd feels safe, but there is not much of a view.
19. Describe some of the biggest mistakes you have made value investing. What are your three worst investments that burned you? What did you learn and how do you avoid those mistakes today?
Some of my biggest mistakes have come from over-betting and slowness to trade up. I will describe one specific example from my personal portfolio that contains both errors. During the Great Financial Crisis, there was a company that was in the process of liquidating. All that was left on the balance sheet was a collection of auction rate securities. To oversimplify, they were bonds that get repriced at auction at regular intervals. Everything was being sold and immediately dividended to shareholders, so there was no operational risk. Due to the turmoil, these auctions simply were not taking place. The market discounted these bonds to about 30 cents on the dollar. I bought in with a seemingly nice margin of safety. My thinking was these securities are currently frozen, but when they thaw in a few months, even if they only sell for 60 cents on the dollar, that is a nice quick double. I bet an unreasonable amount of my own net worth (20% if I recall correctly). Only it took more like two years for things to work out, dramatically reducing my annualized return. And worse, the opportunity cost of that money was enormous at that time. I passed up a lot of amazing deals sucking my thumb and holding on to these dumb ARS bonds that were not doing anything. Ouch.
20. How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?
I have always had an even-keeled demeanor. It is a great asset for an investor but it is a handicap in a lot of other domains (ask my wife-- better yet, don't). I try to keep in perspective that most of what you experience and your expectations are social constructs-- stories we tell each other. Read the book "Sapiens" for more on that topic.
This may sound like an odd extension to this answer, but I believe an underrated part of the investment game is managing your physical health and finding what Tony Robbins has described as a "peak mental state." When your body feels right and your mind is dialed in, you are capable of amazing things. The energy feels electric. Most people follow Strategy:Story:State. "Figuring out what to do will make you a better person and you'll then feel great about yourself!" This is completely backwards. You should follow State:Story:Strategy. Get your mental state dialed in. Realize the stories you tell yourself can either help or hinder you and should be carefully chosen. After that, the strategies to execute become obvious and easy once you are armed with the right mental state and empowering stories. Your brain flat-out functions differently in a peak state.
As for health, we could talk for hours, but all I will say is try skipping a meal and see how you feel. Do not be afraid to be a little hungry-- nothing bad will happen to you. By choice, I hardly ever eat breakfast. Fasting is part of almost every culture and probably more closely represents the human experience for the majority of our evolution. Perhaps we lose something important biologically when there is fast food on every corner? (Obviously, I am not a medical doctor. Do your own research.)
21. How does one avoid blowups in value investing?
One word. Ego. An over-inflated ego manifests itself in several insidious ways. Thinking your circle of competence is bigger than it is. Over-optimism creeping into greed. False confidence from avalanches of available data and the precision of models and spreadsheets. Overconfidence causing position sizing to become too large. Boiled down to a two word answer: stay humble.
22. If you are willing to share, what companies do you currently own and why? How have the last five to ten years been for you investing wise compared to the indexes?
We do not typically discuss current investments in public forums.
The last few years have been a difficult time for value investors of every stripe. We have been in a lot of cash (upwards of 70% at times), which has thankfully spared us a lot of the damage we have seen from other investors we follow and greatly respect. It was no special insight on our part, we simply had a hard time finding attractive investments. At the same time, that cash anchor means returns are going to be muted when compared to a bull market. We have given back a lot of the outperformance we had built up. We are still feeling patient, though I would be lying if I said I was not ready for some better prices to come our way. I honestly did not think it would take this long.
I am not sure what either of them would be buying today if they were in my shoes. I ask myself this exact question often. Buffett closed down his partnerships when valuations were high and he was out of sync with an exuberant market. The amount of cash currently at Berkshire headquarters is a relevant data point. He has been pretty quiet.
Graham would probably be holding a diversified basket of relatively cheap stocks (similar to the Magic Formula), though he likely would not love the aggregated metrics of the portfolio. When you are used to a portfolio with a combined 30%-plus earnings yield, how attractive does 5% look? Not very.
24. What is the most contrarian investment you've ever made? Why did you make it and how did it turn out?
I have never discussed this publicly, but in a personal account I experimented with extremely out of the money VIX call options. The thesis was simple. The person selling me this "insurance" was picking up my pennies in front of a steam roller. I carved out a certain amount of my net worth (not a lot) and dedicated it toward benefiting from extreme convexity. This approach was like intellectual catnip for me; perhaps I was reading too much Taleb and Spitznagel at the time? Extreme asymmetry producing capital just when the market was crashing-- what is not to love about chasing Black Swans? I would lose a little bit every month paying my "insurance premiums," waiting for the big pay day when the correction happened. Only that day never came. The money I was willing to lose ran out first. Pennies gone, no steam roller, lesson learned. Thankfully, I could never get comfortable enough to employ this strategy with client money, so the damage was limited to me personally.
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