15 Questions With Brian Grosso

Today, we talk to international value investor Brian Grosso. We touch on Walter Schloss, his Japanese stock find, his favorite stock screens as well as the U.S. stock market

1. How did you get started investing? What is your background?

PJ, thank you for doing this interview with me and giving me an outlet to share my story and ideas.

In my youth, I didn’t read or use my brain much. I spent a lot of time playing football through high school and worked part time. I always did well in school with an aptitude for math and science, but I wasn’t engaged in my schooling. In my junior and senior years of high school I was at risk of going down the wrong path because I was losing my sense of self-identity after sports ended and I didn’t know what I wanted to do with my life. My guidance counselor and mom pushed me toward engineering, but my heart wasn’t really in it.

Fortunately, two things happened then. First, I got a girlfriend! And second, I discovered investing. After my high school graduation, I had more time on my hands. I had a few thousand dollars saved up from work and started looking for things to do with it. I vividly recall doing a Google search for “best investing strategy” and reading those first articles, I knew I’d jumped down the rabbit hole and that I wanted to do this for the rest of my life.

The first day of engineering classes, I went to my new guidance counselor and told her I didn’t think I wanted to do engineering. She looked at me like I was crazy. Shortly thereafter I started an investing group on Facebook (FB, Financial) and started writing for Seeking Alpha.

I continued to write throughout college and had a few finance internships, but my plan from the early days was to manage money eventually. Originally, I thought I’d work as an analyst for a few years after college and then set off on my own, but speaking with a mentor, he encouraged me that the sooner I started building a track record the better. I also realized that it would be easier to start a business right out of college while I had a lower cost of living, no kids and fewer commitments.

So I began the process of starting my investment management firm at the end of my last internship last August. I was up and running and managing outside accounts in January 2016. I graduated with my bachelor's in accounting this past May and am now focused exclusively on the business and investing.

2. Describe your investing strategy.

My firm's investment approach can be summarized in the same four, one-syllable words that Walter Schloss famously used: "We Buy Cheap Stocks." Alternatively, you could say I am a quantitative deep value investor. I also invest globally, scouring many markets in search of cheap stocks.

If you take a look at most of my postings or the stocks I own, you will agree. Most of the securities that interest me trade below tangible book value and at single-digit multiples of profits and cash flows. With the U.S. market setting record highs and its proxy, the Standard & Poor's 500, trading at nearly 3x book value and 25x earnings, you may be wondering where I find such bargains. That’s where microcaps and other markets like Japan come in. There are riches in niches and because I am such a small manager, I can invest in them.

Here's some more detail on how I invest with nice marketing words:

We buy 30 to 40 cheap, low-risk stocks of businesses that we understand and hold them for years. We will go anywhere to hunt for value. We are systematic and patient in following stocks and waiting for Mr. Market to offer them at the price we want. We invest on our terms, not his. We invest in great numbers, not great stories.

3. What drew you to that specific strategy?

Personality and mental wiring. I’ve always been very quantitative and while I don’t have a long attention span, I am good at doing the same thing over and over and over. I also am a perfectionist which leads me to develop processes and systems like checklists to handle all the numbers in an efficient and organized way. This is why I’ve moved toward a diversified portfolio where I turn over a lot of rocks (I will routinely go through a screen of 1,000 stocks, starting with the A’s). And I invest in numbers (quantitatively cheap stuff), not stories because I don’t think qualitatively. I think more statistically like a casino operator than like a businessman assessing competitive advantage and such.

4. What books or other investors influenced you?

There are many ways I could answer this question but what I want to focus on here is the literature that specifically led me to the investment approach I have adopted.

One of my pet sayings lately has been that to have a compelling thesis, you need logic and data. Theory and evidence. That’s how I break down the mass of literature that led me to this.

I first encountered the swell of data.

First, the evidence that most investment approaches haven’t worked in practice:

• "A Random Walk Down Wall Street."
• "The Behavior Gap" concept.
• "Investor's Manifesto."

Then, evidence of the efficacy of a different kind of approach that isn’t commonly practiced – buying cheap stocks:

• Anything on Walter Schloss; here’s a good place to start.
• "Quantitative Value."
• "What Works on Wall Street."
• "The Little Book That Beats the Market."
• "What Has Worked in Investing."

And finally, the theory of it all:

• "Security Analysis."
• "The Little Book of Behavioral Investing."

The evidence that cheap stocks outperform is remarkable. You really must look at these backtest results and Schloss’ track record. And the reason buying cheap stocks works is a psychological disconnect from reality. We are wired to expect the thing that is unlikely to happen. When a business has performed well in the past, we are wired to expect that performance to continue. We naturally extrapolate performance and bid these stocks up to expensive levels. When a business is performing poorly we do the exact opposite, selling and expecting continued deterioration. But in free market economies where resource allocation is pretty efficient and dynamic, the opposite of extrapolation tends to be what actually occurs: mean reversion. Business performance is more likely to be cyclical. So if you follow your natural expectations, you will do poorly. But if you can override all of that and not even try to really predict business performance, just buy cheap stocks and avoid land mines like fraud, you will do better, and doing better is the name of the game.

5. How has your investing changed over the years?

I’ve already provided a lot of detail on how I invest today. So it’s interesting that two to three years ago I was 100% invested in a single stock, Express Scripts (ESRX, Financial), and my investment thesis was highly qualitative.

My explanation is that in the beginning I did what any new investor should do: experiment, discover yourself and then discover an approach that matches your personality and mental wiring. I feel that I’ve found my approach today, but it’s not as if I started investing and immediately knew what worked for me.

6. Name some of the things that you do that other investors do not.

I don’t think I’m particularly special or entitled, but I do think I’m weird. For some reason, my brain works in weird ways. There are a lot of negative externalities to that. I must admit I’m not the most social person in the world. But it does help me think and invest unconventionally. I am weirdly obsessive about designing the minutest aspects of my investment process to reduce the impact of emotions and intuition on my investment decisions. I wrote an article recently detailing all these efforts.

7. Where do you get your investing ideas? Do you use any stock screeners?

Initially, I exclusively use screens. My default is to focus in on one market and screen for stocks trading under:

• 1x book value.
• 1x sales.
• 10x earnings.
• 10x cash flow.

I start with the A’s, looking at the 10-year financials computing enterprise value in my head and comparing that to average operating income and free cash flows over the 10 years. If after this glance I’ve established that the stock looks very cheap and interesting, I go from there.

I also maintain a watchlist of all the stocks I own and those I would be interested in owning at a slightly cheaper price. Right now there are over 200 stocks on this list. The prices update automatically so I check it periodically to see if any names have gotten to the price I want them at. If any get there, I re-evaluate them.

9. Name some of the traits that a company must have for you to invest.

• Cheap stock.

That is obviously the big one and I actually think I’d do well even if that was the only thing, but there’s empirical evidence of some other criteria being predictive of outperformance such as:

• At or near multiyear lows.
• Strong balance sheet, low bankruptcy risk.
• Small market capitalization.

And beyond that I think it’s crucial to avoid land mines by attempting to identify risks in a very systematic way. I have a checklist that I use to look for fraud, self-dealing or significant idiosyncratic risks like customer concentration.

10. What kind of checklist do you use when investing?

I have a checklist with 34 items currently. They are grouped into categories by importance with the following titles:

• First and foremost, We Buy Cheap Stocks.
• Core (other stuff I know works).
• Risk.
• Psychology.
• Other.

Initially I am looking to see if the stock is cheap relative to both earnings and assets. Then I look for the other predictive criteria mentioned above. Then the majority of the items on the list focus on risk. Stuff like whether the business has ties to China, there’s been an auditor resignation, executive compensation is unreasonably high, related-party transactions, etc. The Psychology section is stuff that helps me personally. For example, I find that I make better investment decisions on stocks that I’ve followed for awhile than ones that I just found that are new and shiny, so I have a checklist item “Slow?” which is basically telling myself to be wary if this is one of those new discoveries. Other is stuff that I like to look for that doesn’t seem as important and doesn’t have empirical backing.

11. Before making an investment, what kind of research do you do?

I like to look at 10-plus years of financials and calculate average ROE, ROA, FCF margins, etc. Then I build a back-of-the-envelope valuation to see what my total return expectations are over a few years and if that meets my hurdle. Then I like to fill out as many checklist items as I can. If everything still looks good, then I go to the financials and start with an annual report three to five years ago and read forward from there. Somewhere along the way I look for research on sites like Seeking Alpha, Value Investors Club and Corner of Berkshire and Fairfax. Finally, I do a variety of things to see if the stock satisfies my other checklist items. I usually prepare a write-up gathering my thoughts into something coherent and then make a decision as I’m writing that.

12. What kind of bargains are you finding in this market?

I think U.S. stocks in general, large caps in particular, are very expensive. I’ve looked to microcaps in the U.S. and international developed markets like Japan to find value. Right now I own stocks in the U.S., Japan, Singapore, Hong Kong, Australia and France. Japan in particular strikes me as cheap. I think the cheapest stocks on the planet are domestic demand, nonfinancial microcaps in Japan.

Some of these companies have been around for 50-plus years and been consistently profitable and cash generative over at least the last 10, but the stocks are available today at less than half of the net cash on the companies’ books. Right now one-third of my portfolio is in a large basket of these Japanese stocks and I’ve written several articles about them:

• "Investing in Japan."
• "Investing in Japan, Part 2."
• "Nichiwa Sangyo At 41% Of NCAV – Any Takers?"
• "Taisei Oncho: Profitable Japanese Gem Under 50% NCAV And 2/3 Net Cash"

13. How do you feel about the market today? Do you see it as overvalued?

As I said, I have thought large U.S. stocks have been expensive for over a year. I have a variety of theories for why this is:

• Unrealistic extrapolation of superior U.S. equity returns of the past century.
• Trends toward passive vehicles (indexing, smart beta, robo-advisers) which can't invest in the small and illiquid.
• Low interest rates inflating valuations among all asset classes including stocks.
• We're due for a market crash.

Regardless of reasons and causality, though, if you look at the data, the U.S. is expensive.

That doesn’t mean hold cash though. I subscribe to Peter Cundill’s maxim: there’s always something to do. Look to Japan and other cheap markets and hunt ruthlessly for cheap stocks. They can still be found today.

14. What are some books that you are reading now?

I have been on a philosophy binge lately. I recently finished Thoreau’s "Walden" and am now nearly through Bertrand Russell’s "A History of Western Philosophy." I am also fiddling around with "Securities Markets in Japan" by the Japan Securities Research Institute, a rare English resource on Japan. Next up I will probably read "Deerslayer" because I will be camping on Cooper’s Glimmerglass (Otsego Lake) in a few weeks, as well as Christopher Browne’s "The Little Book of Value Investing."Not sure if it counts, but I’ve also been reading everything and anything by Dr. Seuss with my nephews recently. Here’s my favorite!

15. Any advice to a new investor?

Experiment in life and with different investment approaches, discover yourself and find a way of living, people and an investment philosophy and approach that match the self you discover. Don’t listen to the naysayers and work your butt off. Be excellent. Maintain a strong support network of mentors and friends and leverage them when it is most difficult – when you are in a rough patch. Follow your passion and optimize that, not money or recognition. Live by an inner scorecard. Make decisions scientifically. Have the right sense of perspective. In a universe of a billion trillion stars just like our sun, you can feel tiny and insignificant. But also remember that a person’s a person, no matter how small. OK, that’s enough preaching!

Thank you again, PJ. For anyone reading this, I can be reached at the links below:

Seeking Alpha | Website | Email | LinkedIn | Twitter | Harvest

Disclosure: No position in the stock mentioned.

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