Someone emailed me this question:
“Many investors seem to be characterized by a single distinctive style throughout their careers. How can we train to be good at all the following — great-businesses-at-fair-prices-type, special-situation-type, net-net-type — depending on the opportunities that the market presents at any point in time so that we can outperform the market most of the time?”
What you’re describing here are sort of what I’d call “sub-genres” of value investing. Just like there are mystery writers who are best when writing hardboiled stuff and there are mystery writers who are best when writing “cozies,” there are value investors who are best when they are buying great businesses, and there are value investors who are best when they are buying into special situations. There is cross-over. Investors can progress over their career so they are focused mainly on a different sub-genre. Elmore Leonard started the 1960s by writing Westerns. Warren Buffett (Trades, Portfolio) started the 1960s by investing in “cigar butt” type deep value stocks. By the end of the 1980s, Leonard was writing crime novels and Buffett was buying great businesses. So, they switched genres. But did they change their styles?
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Not as much as you’d think. You have a style that’s all your own. Genre isn’t important. The “style box” that Morningstar puts your portfolio into isn’t important. I bought George Risk (RSKIA) when it was a micro-cap net-net with no catalyst. I bought Babcock & Wilcox (NYSE:BW) when it was a big cap with a catalyst (a spin-off) ahead of it. But, I think both purchases fit the same style. George Risk had a core business that I thought was a solid one. That operating business was generating after-tax returns on tangible net assets of close to 30%. If that was all you were getting, it wouldn’t be a cheap stock. But you were also getting a pile of cash, bonds, mutual funds, etc. The combination of these two things – the good operating business and the random pile of surplus funds – was worth more than the stock was selling for. To me, it was clearly a value stock. But it was also a high-quality business. It wasn’t a melting ice cube, but it was a net-net.
Now, what about Babcock & Wilcox? To me, it looked very much the same. If you just screened for a cheap stock, you wouldn’t turn up Babcock & Wilcox. I thought the business that is now BWX Technologies (NYSE:BWXT) was very high quality. It had a wide moat. It should have traded at a very, very high P/E ratio year after year. And then I thought the business that is now B&W Enterprises was fine. It might have been cyclically cheap. It had a good competitive position and it had fine economics. But the industry it was serving might shrink in the future.
Then there was also a business called mPower that had lost money in recent years – it was an experimental moonshot type project (modular nuclear reactors – so very, very small power plants you could deliver by railroad to a job site and run for years without refueling). Quan and I were convinced that Babcock would shut this business down and not lose much money on it. So, you had three parts here. You had mPower, which had some slightly negative value in our view. Then you had B&W Enterprises, which was a solid business but probably going to shrink in the future. And then you had BWX Technologies (NYSE:BWXT), which was a fine business that we thought would grow sales and earnings consistently for decades to come. The combination of these three businesses – a money pit, a solid but shrinking business and a great and growing business – added up to a stock price that we thought was well below the value of those three businesses if they’d been auctioned off to three separate control buyers.
Honestly, that’s how I looked at the situation, and it's the same way I looked at George Risk. When I bought George Risk, I think it was trading for about $4.50 a share. It had a little over $4.50 a share in financial assets – cash, bonds, mutual funds, etc. – and it had a business I thought could earn close to 40 cents a share pre-tax in normal times. What if you auctioned those two things off? Let’s say there was close to $5 in investment assets. Well, why wouldn’t a purely financial buyer – someone who could liquidate the portfolio – pay between $4 and $5 for that stuff? You might not be able to unload the entire portfolio at the market value shown on the most recent 10-Q. But, you could certainly unload any group of liquid, plain vanilla assets for 80 cents on the dollar given a little time. That’s a very, very conservative way of looking at it.
Likewise, a very conservative way of looking at an operating business that I thought could make 40 cents a share pre-tax in normal times would be to say a control buyer would certainly pay $2 to $4 a share for such a business. Who wouldn’t pay five to 10 times pre-tax earnings (about eight to 15 times after-tax earnings) for a solid business. This business seemed solid to me. Small and not fast growing at all. But, solid. It deserved a P/E of 8 to 15. So, there you have a valuation of $6 ($4 plus $2 a share) to maybe $9 ($5 plus $4 a share) on a stock that was selling for around $4.50 a share. Super conservatively, I thought it was worth 30% more than it was selling for. And then not very conservatively at all (but still honestly), I thought it might be worth 100% more than it was selling for.
Many investors define value investing according to the established sub-genres. So, they would see George Risk and Babcock & Wilcox as being two totally different kinds of investments. George Risk was family controlled, illiquid, tiny (a sub $100 million market cap), and a net-net. Babcock & Wilcox was not family controlled, was very liquid, was a big stock (well over $1 billion market cap), and not really a value stock on a purely quantitative basis (it wasn’t a net-net, low P/E, low P/B, etc.) I mean, Babcock wasn’t expensive by any measure. But it wasn’t the kind of thing that would show up on a screen because it had a single-digit P/E or qualified as a net-net or was trading below book value.
That’s why I think both these picks – George Risk and Babcock – were actually made in the same style. My style. My style is basically to look at a stock as it exists today and then decide to ignore the next five years. What do I think the business – the corporation – will look like in five years? And then what do I think a control buyer – not the market – would pay for the entire business?
In the case of George Risk, it was 2010 and the stock was housing-related. I figured that the housing market in 2015 would be fine. It wouldn’t be 2005 fine. But it might be 1990s fine. I had data on George Risk going back to the 1990s. So, I never thought about what George Risk would earn in 2011. I only thought about how much cash and securities it would have per share in 2015 and what the operating business would be earning in 2015. Like I said, I figured 40 cents pre-tax would be normal. There’s stuff I didn’t know. Would they buy back stock (I doubted it, the stock was incredibly illiquid). Would they take the company private? Maybe. Would they pay a special dividend? Would they raise the regular dividend? Would they pile up actual cash? Or would they add to bonds, mutual funds, etc.? And then what would the value of marketable securities rise by just in terms of stock market gains and losses. But, basically, that’s what I did. I made my best guess as to what the business would look like in 2015.
I did the same thing with Babcock. I knew they were planning a spin-off. I figured mPower wouldn’t exist anymore, BWX Technologies and B&W Enterprises would be separate, emerging markets might be better in five years (investors were a little uneasy about them around the time Babcock was splitting up) and then I thought competitors to coal – basically natural gas – would probably be a lot more expensive in five years. But, also, that electricity demand might be a little higher but the installed base of coal in the U.S. would be lower (since smaller, inefficient plants would shut down rather than do any cap-ex spending to meet environmental regulations). Then once you have that picture, you ask what another defense contractor might pay to own something like BWX Technologies. You ask what some engineering company doing a lot of business in the U.S. but also around the rest of the world would want to pay for B&W Enterprises. Again, in both the case of Babcock and George Risk, I didn’t ask how much I thought the stock market would value these businesses at.
Those are the two parts of my style that I think separate me from most investors. I don’t care what the company earned last year or expects to earn next year. I only care what I think it’ll be earning five years down the road. The other part of my style is I don’t ask what I think the market as a whole would value the company for. I only think about what an acquirer would pay for the whole thing if it was shopped around a bit. Sometimes there is style drift in my investing. I own Frost (NYSE:CFR), and it’s hard to do much in the way of calculating what someone else would pay for a bank. Banks mostly just merge with each other. You can’t go after them in a hostile way for regulatory reasons. I think the banks I like best – Frost and Bank of Hawaii (NYSE:BOH) are good examples – would be pretty valuable to a nationwide bank without much of a presence in Texas or any presence in Hawaii (actually, no nationwide bank has a meaningful presence in Hawaii – so buying a Hawaiian bank would be the only way to enter that market).
Therefore, you could say there was some style drift there, but only with the “what would an acquirer pay” part of the process. The “what will the business look like” part of the analysis was exactly the same. I just wrote an issue about Bank of Hawaii a couple months ago. So, we’re talking fall of 2016. Yet my discussion of that bank’s earning power was all about what I thought it’d make in 2021 when I figured the Fed funds rate would be around 3%.
Now, these are huge “genre” moves. George Risk, Babcock and Frost are all in completely different buckets in terms of how most value investors think about what types of investments you can make. George Risk was a net-net, Babcock was a spin-off and Frost is a cyclical “reversion to the mean” normal earnings type financial stock. In fact, many value investors consider financial stocks separate from non-financial stocks. But, I think of all three of these investments as being in the same style. They all fit my personal style of asking what the business will look like in five years and what a control buyer would bid for such a business at that time.
Can you learn to change your style? Yes. I think you can. And I think the way to do that is just to ape someone else’s style. I mentioned Elmore Leonard before, who intentionally aped Ernest Hemingway’s style. But if you read Elmore Leonard and you read Ernest Hemingway, you’ll notice that Leonard is funny and Hemingway isn’t. Likewise, Warren Buffett (Trades, Portfolio) says he learned by trying to incorporate as much of Ben Graham’s approach and then Phil Fisher’s approach into his investment process. But, if you read the books by either Graham or Fisher, you’ll notice Buffett’s approach is actually really different from those two.
For example, Buffett has invested a lot in branded businesses that serve households. Even his biggest financial investments are Wells Fargo (NYSE:WFC), American Express (NYSE:AXP) and Bank of America (NYSE:BAC). Those are businesses that make plenty of money from households instead of serving big corporations. They have well recognized brands and aren’t exclusively consumer finance companies. But they’re closer to being focused on consumers than on big businesses.
If you look overall at Buffett’s biggest investments, you’ll see Kraft-Heinz (NASDAQ:KHC) and Coca-Cola (NYSE:KO) at the top of the list. One of his earliest, most famous purchases of an entire business was See’s Candy. That’s a branded, heavily gifted product. Buffett’s own example of his best ever investment – because he made it three times – was GEICO. GEICO is entirely focused on households. Yes, it’s an insurance company. But, it’s about as famous a brand as an insurance company can ever have. And it’s about as “consumer” focused as a financial services company can get. Neither Ben Graham nor Phil Fisher was particularly attracted to brands or consumer focused businesses. Many people think Buffett just moved from being a Ben Graham type investor to becoming a Phil Fisher investor. Really, that’s not true. If you mean he moved from low price to high quality – that’s true. But, Buffett’s definition of high quality isn’t that close to what Phil Fisher focused on.
For example, Buffett looks a lot more at brands, competitive economics, etc. Fisher focused much more on the caliber of top management and the overall organization strength. He was much more a corporate culture investor than Buffett is. Buffett bought Coca-Cola in part because of the capital allocation of Goziueta and Keough. But he also bought it for the Coca-Cola brand name rather than the Coca-Cola organization. Likewise, he definitely bought Moody’s because it was part of an oligopoly rather than because he loved top management. I don’t think Buffett knew much or cared much about the corporate culture at Moody’s. What he cared about was the market power – the ability to raise prices – that Moody’s had over its clients. That is a huge part of Buffett’s approach. You’ll notice that it’s neither a feature of Graham or Fisher’s approach.
Is there really a value style box and a quality style box? Or is it more complicated than that? Buffett is more of a quality investor than a value investor these days. But, he’s not a quality investor in the same way Phil Fisher was. Buffett is much more focused on industry structure than either Fisher or Graham ever was. You could say that it’s possible to learn as much about Buffett’s approach by reading Michael Porter as by reading Ben Graham or Phil Fisher.
That’s why I think we need to think in terms of personal style instead of wider genres. You can learn how to do things you don’t yet do by studying up on the investors you admire most who do something you can’t yet do. So, if you really admire long-term investors but aren’t a long-term investor yourself – learn everything you can from studying Tom Russo (Trades, Portfolio)’s portfolio, his speeches, etc. If you are a buy and hold type investor who doesn’t make big, concentrated contrarian and cyclical type bets, you might want to learn as much as possible about Mohnish Pabrai (Trades, Portfolio). His style is totally different from my style. So, I could learn a lot more from studying Pabrai than I could from studying Tom Russo (Trades, Portfolio). That’s what Elmore Leonard did with Ernest Hemingway. It’s what Warren Buffett (Trades, Portfolio) did with Ben Graham and then Phil Fisher. He soaked up everything he could about their approaches. He tried to ape them as best he could. But then he also noticed the places where they were lacking. Leonard noticed Hemingway wasn’t funny. He learned what he could from him, but he also looked for other people he could study who could help him expand his style in ways he wanted to.
Buffett greatly admired Ben Graham. But he saw the limitations of Graham’s approach when he realized you could buy and hold some companies for the long-term and then you’d only need to make one right decision that would pay off for a long time. Some other investors – like Walter Schloss – never learned that lesson. They didn’t have to. Because it’s a matter of style.
So, know your own style. Be honest about it. Then find those investors you admire most. The true investing masters out there, not just the guys with good records, but the guys you personally have admiration for. The guys you want to learn from. Then study up on all the ways they are different from you. Look for those places where their beliefs challenge your beliefs. Then start trying to ape their style. At first, it will be awkward. You’ll be copying someone else. It’ll be unoriginal. But, eventually you may be able to fuse some aspects of their style with aspects of your style. You’ll never become them; don’t try to be. And don’t ever try to be a master of all trades. That’s kind of the question you’re asking. How do I become equally good at everything?
Answer: You don’t. You shouldn’t want to be good at everything. You don’t need to do everything well. All you need to do is find those little edges of your circle of competence that bumped up against the edges of the circle of competence of some investor you admire. Look for those borders where you can expand your circle of competence by actively aping what the other guy is doing. Learn by studying him first. But then be humble enough – and unoriginal enough – to simply copy that guy’s ideas when they seem good to you. Eventually, you can fuse some of your style with his style. You’ll never become the other guy. But you’ll eventually become maybe 15% less you and 15% more him. If you keep doing that, your style will keep evolving without ever stopping being your style.
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