22 Questions With Michael Nowacki

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

When I was 19 years old I was trying to figure out what profession I wanted to pursue. A job with a sense of contribution was important to me, but I also wanted there to be an unlimited ceiling. For example, becoming a police officer, teacher or nurse is very rewarding, but the opportunity to move up the leadership ladder in those professions is very limited. I came across a biography on John D. Rockefeller, who was also from Cleveland, and was blown away by his philanthropic achievements. I knew immediately I wanted to become a philanthropist, but you need a fortune to do that. I read everything about the people on the Forbes 400 and how history’s great fortunes were created. I realized that nearly all the self-made ultrawealthy were either business owners or investors. I studied both and fell in love with investing. In investing I get my sense of contribution by helping people achieve their financial and investment goals.

I started managing about $1 million for friends, family and a few others when I was only 24 years old. I started an independent advisory firm in 2011, and it has been extremely successful. So I’ve been managing money for about 12 years now.

2. Describe your investing strategy and portfolio organization. What valuation methods do you use?

My business partner and I have two firms. One is called Thrifty Investing, which focuses on suitability, financial planning, volatility management, retirement planning and income. Unlike most firms who have minimum investments of $250,000 or greater, we not only take on small clients, but we don’t charge any fees to clients under $25,000. These are the people that need help the most, and we want them to feel welcome.

The other firm is called Forever Investing. I actually just published a book on the investment approach, "Forever Investing: The Investment Strategy of History’s Greatest Investors." We are trying to raise $200 million in capital, then we are closing it to new investors. Forever Investing is based on the idea that you should purchase companies with the intention of owning them forever. These must be outstanding businesses with exceptional management. Ben Graham’s best investment, which produced most of his excess gains, was a forever investment in GEICO. Michael Steinhardt ran one of the best hedge funds in history, but made more money off a forever investment in Wisdom Tree. Warren Buffett says his favorite holding period is “forever.” Carl Icahn (Trades, Portfolio) has held some companies for three decades. Nearly everyone on the Forbes 400 is a forever investor. Let me make this clear, though: Having a target holding period of forever doesn’t mean you will own a company forever. Companies and industries change. However, targeting companies you only want to own forever creates a highly selective and disciplined approach where you rarely lose money if you execute well.

3. What drew you to that specific strategy? If you only had three valuation metrics, what would they be?

I had a conversation with a friend of Ted Weschler, who is co-manager of investing at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Ted’s friend said something that really hit home with me. Ted has a background in private equity and PE companies usually have holding periods of three to seven years. When Ted’s friend asked him what his target holding period was for the investments in his hedge fund, Ted said, “Forever.” I went back and reverse engineered Ted’s investments. Many of the companies he owned in 2001 he still owned when he shut down his fund in 2012. Ted earned a 1,236% return in his fund, which is remarkable considering it wasn’t a great decade or so for the market. Berkshire Hathaway went up only 146% during that same time.

Valuation metrics change depending on the company and industry. Obviously, Buffett likes to use book value as a metric for Berkshire Hathaway. Fast-growing retailers like to use operating cash flow since earnings and FCF are depressed due to growth initiatives. Private equity companies like to use EV and EBITDA.

We look for companies that we are confident will increase in intrinsic value at healthy rates for a very long time. Then we try to buy them when we feel they are undervalued and can deliver us 15% annual returns over the next decade. Under Armour (UA, Financial) is a company we love and would like to own forever, but we aren’t invested yet. We hope it keeps declining.

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?

Peter Lynch wrote two of the most witty and insightful books on investing. "Common Stocks and Uncommon Profits" is my favorite book ever written on investing. "100-to-1 in Stocks" is also a great book. I’ve read everything Buffett has written, and his biographies are a great resource. Also, anything on Andrew Carnegie, who has a strong case for the greatest investor of all time.

Martin E. Franklin earlier this year, and he has had a big impact on me. He was CEO of Jarden (JAH, Financial) and a major shareholder. He is one of the best investors you’ve never heard of. From a personality and character standpoint, you can’t ask for a better person. He is kind, gracious and well-mannered. At 24 he was CEO of a company with 13,000 employees. In 1992 he bought an eye care company for $2.3 million, made acquisitions, then sold it in 1996 for $300 million, which was a twenty-threefold return.

When Martin E. Franklin took over Jarden in 2001 it was around $2 a share. It recently was sold to Newell Brands (NWL, Financial) for about $59 a share. He started two new companies, Nomad Foods (NOMD, Financial) and Platform Specialty Products (PAH, Financial). My firm made timely investments into both companies earlier this year at around $7 each.

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?

We will hold a stock forever as long as it keeps increasing in intrinsic value and the price isn’t extremely overpriced. We are okay with holding an outstanding company with exceptional management if the price is high, but sometimes they reach extremes and that is when we will sell. We will also sell if management changes and/or we don’t like the new management strategy. We will also sell if the fundamentals of the business or industry are deteriorating, and a recovery will likely be too far into the future.

Investors want immediate feedback when they make a purchase. If you buy a poor or mediocre company because it is cheap and the stock goes down, you probably don’t want to buy more because you don’t want to be overexposed to a poor or mediocre company. If you buy an outstanding company with exceptional management and the price goes down, you’ll be enthusiastic about buying more.

6. How has your investing approach changed over the years?

In 2004 Buffett was my greatest influence so I invested in great businesses at fair prices like he does. I’ve always had concentrated portfolios with a top investment sometimes reaching 20% of the portfolio. I did well and outperformed the market.

During the financial crisis I switched to buying dirt cheap businesses regardless of the quality. I also took advantage of merger arbitrage opportunities. There were mergers that were nearly certain to go through with 20% spreads, which we’ll never see again. The only time we see those spreads today is when it is almost certain the merger will not go through. In 2009 I earned a 287% return. In 2010 we were very concentrated and holding on to positions for tax purposes, which turned out to backfire.

Cumulative Performance of Michael Nowacki and Nowacki Asset Management: 353.8%

Cumulative Performance of S&P 500: 50.1%

(Notes: Performance calculated using the Modified-Deitz Method; Nowacki Asset Management’s inception date was May 2, 2011. Results are net of fees. S&P 500 returns include reinvested dividends.)

In 2014 the “bargain hunting” backfired. I was up over 20% through October, then oil crashed causing two of my large investments to tumble. Another investment in a financial company that we owned also declined around the same time, which resulted in us slightly underperforming the market after fees.

2015 was the roughest year I’ve had as an investor and was down roughly 15%. Everything that looked like a bargain was a value trap. It was widely publicized that billionaire Bill Ackman (Trades, Portfolio) was down 20% for that year. Billionaire fund manager David Einhorn (Trades, Portfolio) had only one negative year since he founded his firm in 1996, but he was down 20% in 2015 as well. Also in 2015, billionaire value investor Seth Klarman (Trades, Portfolio)’s hedge fund was reported to have had only his third negative year in 33 years. It was a tough year, and I had excellent company, but it did not excuse my poor performance and mistakes. I was embarrassed and frustrated.

In 2016 I re-read every great investment book, essay and article. I interviewed a few investors I admire, such as Martin E. Franklin. It was when I talked to Ted Weschler’s friend that I decided that having a target holding period of “forever” is the best investment approach.

7. What type of business do you want to own in a rising market? A business that increases in intrinsic value every year. What type of business do you want to own in a flat market? A business that increases in intrinsic value every year. What type of business do you want to own in a declining market? A business that increases in intrinsic value every year.

8. Name some of the things that you do or believe that other investors do not.

Most value investors want to pay a price about a certain metric, whether it is 15 times earnings, an EV/EBITDA of 8, etc. One of the things I learned from \Franklin is that you need to be flexible.

The mistake most value investors or bargain hunters make is that they think short term. They focus on poor or mediocre businesses and are looking for a multiple expansion, then they dump the company. That is not “investing into businesses” it is trading. An investor that has 100% turnover a year but invests that way for 20 years is not a long-term investor. He or she is a short-term investor for a long period.

In 2004, Google started trading at about $50 a share (adjusted for splits), which many considered a steep price at the time; Google earned roughly $30 a share in 2015. In 2004, Google looked expensive, but in reality it was dirt cheap at a forward price-earnings (P/E) of 1.7 times 2015 earnings. Compounding intrinsic value at high rates can lead to extraordinary returns if you are right about the rate of growth and don’t overpay.

9. 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?

John Malone is a brilliant CEO and investor. Martin E. Franklin. Jeff Bezos is brilliant. Management at Google is as good as it gets. Kevin Plank at Under Armour is brilliant and is only 43 so he’ll be driving the company forward for a long time.

I wrote a whole chapter on quality of management in my book. There are quantitative and qualitative measures. The quantitative tend to show you more about the business and industry, rather than quality of management, unless you compare qualitative measures versus other similar companies. Qualitative measures are much more difficult. It is like asking “How can you tell if a woman is beautiful?” You just know one when you see one.

One of the biggest mistakes I think investors have is that they are biased toward management whose personalities they like or admire. Jeff Immelt is a likable guy and has all the qualities of a CEO that MBA programs tell you that you need, but General Electric (GE, Financial) has not done well under his tenure. Donald Trump and Michael Steinhardt have personalities that turn off many people, but they get results. Bill Gates (Trades, Portfolio) and Steve Jobs had controversial personalities.

In other words, personality should not be as heavily weighted as it is. However, character should be weighted very heavily. Never invest with management that you don’t completely trust.

10. Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?

My partner uses stock screeners regularly on Fact Set. I might do it once or twice a year. We have a framework for finding ideas, show below.

11. Name some of the traits that a company must have for you to invest in it, 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.

We need bargain hunters in the markets to buy poor businesses or they’d all go to zero. There are also good returns to be made in the long term if you are a talented bargain hunter. However, we don’t want to be the ones that are buying these poor businesses.

To us, a high-quality company is one that has sustainable competitive advantages and will increase intrinsic value at healthy rates. We like businesses with niche products, such as Platform Specialty Products and Chase Corp. We also like these businesses because they have exceptional management and use FCF to make acquisitions, which fuels long-term growth.

12. What kind of checklist or homework do you utilize when investing? Do you have a specific approach, structure, process that you use? Do you have any hard cut rules? Do you talk to management?

We just read the annual and quarterly reports, conference call transcripts, investor or conference presentations and any articles we can find. Unlike many investors that automatically dismiss short sellers, we like to read articles by short sellers or people that are negative on the company because it helps us learn the risks and downside.

We don’t talk to management. We feel we get a good grasp on management from the conference calls, presentations, media interviews, etc.

13. How do you go about valuing a stock? When is a company cheap or not cheap?

Discounted FCF is the method we prefer. Valuation is not precise because you cannot precisely know the future. We get a “valuation range” when we try to determine what a company is worth. We get a low estimate and a high estimate. When the gap is too big, there is too much uncertainty, and we usually avoid the investment unless the company is (1) selling far below our low estimate or (2) there is a high level of probability it will be near the high range of our valuation and it is unbelievably cheap relative to that valuation, with virtually no long-term downside if we are wrong.

14. What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?

There are lots of businesses we avoid. We don’t invest into companies that consistently lose money. We don’t buy “asset plays.” We avoid highly cyclical companies like autos, airlines and oil, where bad timing can cause significant permanent losses. We don’t invest in companies we don’t understand well and have difficulty predicting, such as biopharmaceutical or semiconductors. We don’t like mature retailers because they can only grow through same-store sales, which is usually a low single-digit growth rate. We generally avoid turnarounds unless the turnaround is already starting to happen.

Our favorite industries are health care, medical, industrial and niche chemicals.

15. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?

We have been cautious this year and have about 30% cash, which is too high. We were hoping the election would rock the markets and create some opportunities, but stocks ended up becoming more expensive.

We don’t feel the market is overvalued. It is not cheap either. Rising interest rates and a shock to China’s economy are the two big macro concerns.

16. What are some books that you are reading now? What is the most important lesson learned from your favorite one?

I read a lot of books at a time. I’ve never read “The Art of the Deal” by Donald Trump so I recently picked that up. It is more interesting than I thought it’d be, and I wish more successful people in business would write biographies. There are valuable lessons in everyone’s biographies.

17. Any advice to a new value investor? What should they know and what habits should they develop before they start?

This is the most important thing about investing, and it never gets talked about. No matter what strategy you have, if the execution is poor, you will do poorly.

There are literally hundreds of thousands of people across the globe that call themselves value investors. How many outperform?

I admire David Tepper (Trades, Portfolio) and Stanley Druckenmiller (Trades, Portfolio) a lot, both are absolutely brilliant, but I can’t really tell you their investment strategies. They have great intuition and are cautious most of the time, then when a rare opportunity comes up, they load up.

Charlie Munger (Trades, Portfolio) said, “The key to investment success is not to do super smart things, but to avoid doing dumb things.” Tepper has a saying around his office, “There is a time to make money, and a time not to lose money.” Buffett says, “Rule No. 1 is not to lose money. Rule No. 2 is not to break rule No. 1”. Most people think these sayings are catchy but then end up making poor and undisciplined investment decisions because of the “potential” upside.

18. What are your some of your favorite value investing resources or tools? Are there any investors that you piggyback or coattail?

We don’t really use any resources. We follow some investors that we admire. We never piggyback on others' ideas, which implies you are buying it because you have faith the other person did their homework. We look for companies other investors own that might not be on our radar, then do our own analysis.

19. Describe some of the biggest mistakes you have made value investing. What are the worst investments that burned you? What did you learn and how do you avoid those mistakes today?

I’ll give you one great example: Iconix Brand (ICON, Financial). It was a stock that showed tremendous historical growth, the founder was the CEO, and he is Kenneth Cole's brother; it bought back lots of shares, and they made frequent acquisitions.

Go back and try to value the company in 2015 based on historical data up through 2014. FCF was consistently around $200 million, and it would spend roughly that amount on acquisitions a year. They went from 73 million shares in 2011 to 48 million shares in 2014.

The debt was kind of high at $1.3 billion but manageable with the $200 million they were earning a year.

Give the company's opportunities from acquisitions and historical growth, it would be fair to say it was worth 15 times FCF. If you deduct the $1.3 billion from the EV, that is a $1.7 billion market cap, or $35 per share price. It was trading at $20 when I bought it.

Even if you gave it an EV of 10x FCF, the company was worth $700 million, or $15 a share. That seemed low because it could maintain its debt and was earning $200 million a year. Certainly you’d buy a company for $700 million that was earning $200 million a year, right?

There were some warning signs I should have listened to. The COO and CFO resigned in the past year, but that could just be because they found other opportunities. They also had to revise historical annual reports, but one would expect that after the revision that they were now correct.

I bought at $20 and immediately things got worse. The new CFO resigned after only a few months on the job, which caused panic. The company was then accused of misleading investors with how they record revenue and profits on their joint ventures. As the stock was collapsing, the founder and CEO resigned.

I got out at about $14, but it was a large position because I thought it was very cheap and had consistent FCF. The stock kept going lower and went all the way to $6.

The lesson is that numbers don't tell the whole story. Quality of the business and quality of management are critical.

20. How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?

The ups and downs cannot be avoided. It is part of investing. Our Thrifty Investing business focuses on managing volatility because not everyone can tolerate the swings in the market. Our Forever Investing business has a portfolio of outstanding businesses with exceptional management so we are comfortable holding them during market turmoil.

21. How does one avoid blowups in value investing?

Leverage is responsible for most blowups. Illiquid positions are responsible for a lot of blowups. Being heavily concentrated into highly cyclical businesses causes many blowups. Being heavily concentrated in poor or mediocre companies causes some blowups.

If you are a bargain hunter and invest in poor and mediocre companies, you need to be pretty diversified. Remember you can own 100 positions and be more concentrated than someone with 30 positions. For example, if someone with 100 positions has 80% of his or her portfolio in the top 10 ideas, it is more concentrated than an evenly weighted portfolio with 30 positions.

How you allocate money to each investment impacts returns just as much as which investments you buy. Yet most investors focus 95% of their energy on which companies to buy.

22. If you are willing to share, what companies do you currently own and why?

All of our positions we purchased sometime in 2016, one in the past week. Our largest holdings are Platform Specialty Products, Stericycle (SRCL, Financial), PayPal (PYPL, Financial), Nomad Foods, Zimmer Biomet (ZBH), AmerisourceBergen (ABC) and LiLAC Group (LILA). We sold Berkshire (10% gain), Colfax (CFX)(50% gain) and WestRock (WRK.W)(plus its spinoff Ingevity, which rose 80%). We are hoping to buy Chase Corp. (CCF) and Under Armour if they decline because we love the companies and management.

Here's a fun one – What stock would Warren Buffett (Trades, Portfolio) or Benjamin Graham buy today if he were you?

Buffett invests very differently than Ben Graham, with the exception of Graham’s GEICO investment. Buffett would like Stericycle because of its moat. Ben Graham would probably like Nomad Foods but back when it was around $7 where we picked it up.

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