Kill the Company

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The Science of Hitting
Apr 05, 2012
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Bruce Berkowitz is famously known among value investors for his kill the company strategy, which is part of his investment process; here is what he has said in the past on the topic:

We try to kill the company. We think of all the ways the company can die, whether its stupid management or overleveraged balance sheets. If we cant figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.

This is similar to what Alice Schroeder noted about Warren Buffett (BRK.A, Financial)(BRK.B) at the Value Investing Congress in 2008; when discussing a potential investment that Warren had turned down in the 1950s, here is what she had to say about his analysis:

He said no because he went through the first step in his investing process, and this is where I think what he does that is very automatic [to him] but isnt very well understood: he acted like a horse handicapper. And the first step in Warrens investing process is always to say, 'What are the odds that this business could be subject to any kind of catastrophe risk that could make it just fail?' and if there is any chance that any significant amount of his capital could be subject to catastrophe risk, he just stops thinking. No. And he wont go there.

As Alice notes, this is backwards from the way that most individuals approach their investments. For many people, the process starts with an interesting idea, whether that comes from a GuruFocus article, Jim Cramer, or a friend at a cocktail party. At that point, the investor will likely look at the financials and the valuation, and attempt to estimate some range of intrinsic value (Im probably giving the average CNBC viewers investment process WAY to much credit); only at the end will the individual likely stop to think about the potential risks that are hiding around the corner.

There are a couple of concerns about this approach: The first is that Warren Buffett disciples (likely many of the people reading this article) believe that a wonderful business at a fair price is preferred over a fair business at a wonderful price; with that as a condition, the sequence discussed above appears backwards, and will result in a significant amount of wasted time and effort if the wonderful business aspect is an imperative for potential investment. By flipping the approach, we can zero in on the most fundamental condition for the preservation of capital: a sustainable competitive advantage.

Another issue is the perverse effect of human emotions, which may cause us to act irrationally. As many readers have likely experienced, finding an undervalued security ignites a fire in the belly, and begs for immediate action (with the justification being that the opportunity may be gone tomorrow). While its easy to say that we wont let this excitement affect our objectivity, my personal opinion is that this is a recipe for trouble; suddenly, your definition of a competitive advantage becomes a bit more lenient, such that your hours of hard spent research dont go to waste

But flipping the order on its head is a much more attractive (and logical) approach. With thousands of securities to choose from, you have the luxury of simply following those that fall into your circle of competence, and choosing from that shortened list the few that hold a truly sustainable competitive advantage. From that point, you can estimate each securities intrinsic value, and then twiddle your thumbs until the market price on any individual stock hits a level that offers an adequate (estimated ex-ante) return.

This seems like common sense, and is ideal for individual investors who dont have clients to report to; if you sit in cash for a year and dont make one trade, no one will have any idea (if you must, you can lie to your friends and neighbors about your recent investments in the high-flying tech stocks of the day). By focusing on catastrophe risk and attempting to kill the company, you kind generate a list of stocks worthy of your precious capital; with a bit of patience, this is a strategy that all but guarantees attractive long term returns.

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High-quality businesses for the long-term. In the words of Charlie Munger, my approach is \"patience followed by pretty aggressive conduct.\" I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.