“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.” – Charlie Munger (Trades, Portfolio)
As a value investor and a serious Charlie Munger (Trades, Portfolio) groupie, I often remind myself of the above quote from Munger. For me, value investing has been an amazing journey of learning, ignorance removal and gradual wise-up.
This journey has been both challenging and gratifying. In some ways it is like playing a game in which once you have accumulated enough credentials you will advance to the next level. The move from one level below to one level above takes both time and effort, but it's an integral part of the fun. In this article, I’d like to share my view of different levels of value investing based on observations, thinking and personal experiences.
Before going into the discussion, I’d like to make a few general observations:
- You can beat the market regardless of your level. There is no need to discriminate among different levels. What’s most important is to find the style and strategy that fits your own personality and life.
- No matter what level you are at, you have to understand behavioral biases.
- A sound investment philosophy based on “margin of safety” is required on all levels as is the willingness to work hard.
With the above points in mind, now let me move to the eight different levels of value investing in my opinion.
This level is where most value investors begin their journeys. In this level, a value investor would read most of the value investing classics such as “The Intelligent Investor” and “Common Stock and Uncommon Profits.” He acquires familiarity with the most important concepts in value investing such as margin of safety, intrinsic value, moat, etc. Most likely, he would start to “spot” value based on definitive quantitative metrics such as net net, low price-earnings (P/E), low price-book (P/B) and historically low multiples. If he can buy a basket of these cheap stocks, he would have a statistical advantage to beat the market in the long run by 1% to 2%. This level can be summarized as the “cigar butt” level. At this level, investors often fall into the so-called “value traps.”
At this level, a value investor starts to care more about the quality of the underlying business. He is likely to be attracted to high-quality businesses with a wide moat and often characterized by high return on capital. He prefers to buy a great company at a fair price than to buy a fair company at a great price.
At this level, a value investor can recite most of the famous Warren Buffett (Trades, Portfolio) and Munger quotes. He knows most of the important concepts within the value investing framework. He can discern possible wide moats without knowing why and won’t spend much time on the long-term sustainability of the moat. He is also likely to analyze one company at a time without considering the whole value chain.
Quantitatively, value investors at this level usually collect enough historical financial and valuation data and perform a good amount of quantitative analysis to come out with some sort of projections.
One common mistake investors make at this level is to miss out on real great compounders because they may appear expensive.
Once a value investor has acquired a good understanding of the value investing framework and learned some different business models and different competitive advantages, he can go deeper on both qualitative analysis and quantitative analysis. He collects as much data as possible in order to perform in-depth fundamental research.
At this level, an investor pays detailed attention to segment financials, underlying growth drivers, operating metrics, comparative analysis, etc., in addition to detailed historical annual and quarterly financial data. Essentially the investor can tie numeracy to literacy about a business on a detail level. It is at this level that an investor figures out mathematically why American Express (AXP, Financial) could not renew the deal with Costco (COST, Financial) if it has to match Visa (V, Financial) and Citi’s (C, Financial) offers, or why ESPN is a double-edged sword for Disney (DIS, Financial).
At this level, an investor usually can come up with detailed numerical projections about the business for the next few years. He can express the qualitative analysis in detailed quantitative terms.
One peril of which an investor needs to be keenly aware at this level is the false security offered by the vast amount of data as well as the detailed analysis. The numbers may tell you one thing, but you may start to develop a gut feeling that the numbers might be misleading even though you don’t know why.
Based on my observations, most investors get stuck in one of the previous three levels. Very few make it to Level IV and above.
At Level IV, an investor knows well how to play both the classic value investing game as well as the high quality game. He can increase his odds of outperformance by intentionally only playing in less efficient markets such as distressed debts, emerging markets or special situations. He is also religious about implementing the right process and designing an environment that encourages doing the right thing.
Superior thinking and superior analysis are the markers of achieving Level V.
Here are 10 signs that an investor has achieved Level V:
- He knows the difference between knowing the name of something and knowing something.
- He understands circle of competency and knows his circle of competency.
- He achieves ecolacy by going an extra step to ask the questions so what and then what.
- He can quickly filter out irrelevant data and focus on the most important, relevant and knowable data.
- He knows the history and the culture of the business well, and he studies the past extreme successes and failures in the industry in which the business operates.
- He knows the businesses within a company’s ecosystem as well as the company.
- He sees risks others don’t see, and he sees risks before most people see them.
- He asks questions about the businesses that may not have definitive answers but are important to think about.
- He can tell whether management is lying or not.
- He has a super long term investment horizon and can often tell where we are in different cycles.
At this level, an investor will rely less on precise numbers produced by detailed models. He knows being roughly right is much better than being precisely wrong. This leads to minimum use of detailed financial models and the habit of focusing on big picture numbers and deep simplicity.
At this level, an investor has a holistic view of the business. He can incorporate macroeconomics into microeconomic analysis. Let me use an analogy to make this point: At this level, a business can be thought of as a tree. Most people see the tree as it is. However, an investor on this level can not only see the tree, he can also see the forest in which the tree grows, the park in which the forest resides and what the park, the forest and the tree will mostly look like in 10 years.
Another way to put this is the following quote from the book "101 things I Learned From Architecture School" – “when designing a stair, window, column, roof, lobby, elevator core or any other aspect of a building, always consider how its design can express and reinforce the essential idea of the building.”
At this level, an investor also sees the interactions and connections among different industries and different countries – most things are linked one way or another.
I think Li Lu at Himalaya is perfect example of Level V and Level VI.
At this level, an investor takes investing up a notch by mastering what has worked in one market and transferring that knowledge and experiences to a less developed market. He is also actively engaged in the cultivation of the business in which he invests by providing capital and bringing together different parties that may all benefit from a win- win situation.
Tom Russo (Trades, Portfolio) and Zhang Lei from Hillhouse Capital Management are the very few investors at this level. The Blue Moon example perfectly illustrates this level of investing:
Blue Moon is in a traditional liquid laundry detergent business in China. Formidable and established players such as Procter & Gamble (PG, Financial) and Unilever (UN, Financial)(UL, Financial) both play in this field and have great established brand equity already. Not only did Zhang Lei provided capital to Blue Moon, he also arranged for Blue Moon’s executives to meet with executives from China’s ecommerce giant JD.com (JD, Financial) so Blue Moon’s executives could learn about ecommerce from JD while JD’s executives could learn more about merchandising from Blue Moon. Zhang Lei didn’t care about the capital spending needed to build the business, which burdens short-term financials.
This is not a zero-sum game but a win-win situation in which Hillhouse, Blue Moon and JD can all benefit from each other’s success. Subsequently, Blue Moon redesigned its detergent packs so that they could fit into JD’s distribution networks. Zhang Lei also applied his knowledge in the social media world and pushed for an aggressive social media strategy. Blue Moon now is the largest liquid detergent brand in China.
I can only think of Buffett and Munger at this level. Not only do Buffett and Munger possess all the capabilities needed in the previous seven levels, they also have many competitive advantages that are unique to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), to name a few:
- People from all over the world bring special deals only to Berkshire Hathaway. Companies like Goldman Sachs (GS, Financial) and GE (GE, Financial) only turn to Berkshire in stressful times for capital and grant Berkshire extremely favorable terms.
- Almost every business Berkshire bought widens its moat.
- Buffett and Munger are perfect partners for each other and arguably only for each other.
- Berkshire has maximum flexibility in terms of asset class and security class. They can invest in common stocks, preferred stocks, convertible bonds, equity puts, derivatives and all types of securities in all types of businesses.
- Negative borrowing cost and constant flow in of permanent capital.
Let me end with another Mungerism with which we are all familiar:
Investing is not supposed to be easy. Anyone who finds it easy is stupid.
Disclosure: Long JD.com and Berkshire Hathaway.
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