Bruce Berkowitz (Trades, Portfolio) is a well-known investor whose Fairholme Fund (Trades, Portfolio) enjoyed a long period of success in the early 21st century. As a value investor steeped in the lessons of Graham and Dodd, as well as Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), Berkowitz applies a strict value methodology in his investing practice. Two factors that he considers to be especially important to the creation of shareholder value are cash flows and management.
Cash flows
Berkowitz believes that value investors should pay close attention to a company’s cash flows. If a cheaply-valued company is generating a lot of cash, that is usually a definitive sign that it is undervalued. You may think that this is obvious and not a particularly profound statement, but consider the fact that the majority of the coverage of company financial reporting tends to look at earnings (ie. the income statement) rather than cash flows.
In my opinion, cash flows are a much better representation of the true financial position of a business because it is a lot easier to game earnings than it is to game cash flows. Money goes in, money goes out - it’s hard to muddy the waters much on this. Of course, the income statement is still very important; my point is simply that investors are doing themselves a disservice by only looking at earnings. All financial reports must be used together to form a coherent picture of the business in question.
Management
The second factor that Berkowitz believes investors should be paying closer attention to is the quality of management. In an interview, Berkowitz tied this idea in with his views on the importance of cash flows:
“It is always nice to own a company that your idiot relative could run...Bad management or a bad person can really screw up a good company so the management factor has become more and more a part of how to kill a business. Once you ascertain the free cash flow of a company, one of the ways that you can try to kill a business is through poor capital allocation”.
How does the average investor go about evaluating management? As a non-institutional investor, you are at a disadvantage when it comes to getting good information. It is unlikely that you will get a face-to-face meeting with management or otherwise be in a position to evaluate managers one-on-one. The public record, however, is very much open for anyone to peruse.
Berkowitz’s quote reminds me of something that Buffett once said: “Invest in companies that even an idiot can run, because sooner or later, somebody will”. I think that both of these statements strike at the core of what it means to invest in a durable business: it should be easy to understand and have an ability to generate large amounts of cash on autopilot, meaning that managers would have to actively try in order to run the company into the ground.
Perhaps this is the real lesson here: rather than trying to handpick the best managers, focus your efforts on finding companies that don’t need the best managers to succeed, which may be easier to do for the individual investor.
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