“The definition of value investor is flexible. But it should always rest on the basis of buying an asset at a discount to its intrinsic value.” -Thomas Macpherson
Over the past 11 months, I have written some 85 articles about mutual and hedge fund managers; disappointingly, about two-thirds of them have underperformed the S&P 500 over the past 10 years.
At the same time, there is a guru among us, one who belongs in the pantheon of value investors: Thomas Macpherson, a fund manager and steady contributor of excellent ideas to GuruFocus readers.
Macpherson has taken those good ideas and compiled them into a book, “Seeking Wisdom: Thoughts on Value Investing.” Until recently, he was the managing director and chief investment officer at Nintai Partners; since then, he has been an investment manager at Dorfman Value Investments.
The following table (plus fine print) shows his outperformance at Nintai, through the end of the second quarter of 2016:
Note Macpherson has nearly doubled the S&P 500 benchmark—after fees—since Nintai’s inception. That 14.3% return would put him on most top 10 or top 20 lists of guru investors, had this been a conventional mutual fund.
When it comes to his book, Macpherson’s great strength is his focus on the human side of investing. With his performance record, he might well have written articles or a book about the mechanical side of topics such as stock picking or valuation metrics. Instead, he writes mainly about human factors.
For example, the first sentence of the book reads: “One of the particular defects of many investors is focusing on what they should invest in rather than how they invest” [author’s emphasis].
Macpherson points out he began as many of us do, looking for a “Peter Lynch ten-bagger,” but says his thinking has inverted over time. He now believes returns will look after themselves if he properly manages the factors within his control: trading costs, turnover and stock selection.
Indeed, he argues 30% to 40% of your lifetime returns will never get to your pocket because of failure to manage costs, turnover and stock selection. To invert that idea (Macpherson likes inversions) is encouraging news for those of us who are not professional investors. It means we can generate respectable results by not doing anything foolish. Let’s review the big three issues that can make the difference between success and failure:
- Trading costs: Start with the fees you pay to managers. For example, Macpherson offers the case of two investors; one invests in a low-cost index fund at a cost of 0.25% per year, and another who invests in a standard mutual fund at a cost of 1.50% per year. They both invest $100,000 for 30 years and both enjoy an average annual return of 6%. At the end of the term, the investor who paid 0.25% per year has $532,899 in her pocket, while the investor who paid 1.50% per year has $374,532 in his pocket. That’s a difference of $160,539, attributable to only a lower management fee.
- Turnover: Each time we buy shares, we pay a fee we never get back. And each time we sell a stock, we pay another fee we never get back. Perhaps more importantly, the investment will never have time to compound. Obviously, the market does not offer many free lunches, but letting time do the work is one of them.
- Stock selection: Don’t pay too much. Like Seth Klarman (Trades, Portfolio), Macpherson says he has two key descriptors: great companies and great prices. In a broader context, he often refers to established processes by which an investor can identify and value the right companies. However, he concedes it can be hard to establish great prices: “I use a proprietary hybrid discounted free cash flow (DCF) method to get to a value per share, but generally defining what is a great price is relatively subjective.”
In a chapter devoted to pricing, he argues that identifying the right price depends on asking the right questions. They include: what is the company worth, do I fully understand how the company makes money, will the company be as successful 20 years from now and is my data set valid and reasonable?
To test his answers to those questions, Macpherson uses another process he calls "Getting to Zero." In other words, he tries to break the investment case. His method revolves around halving the one-, five- and 10-year free cash flow growth estimates. He does this twice (quartering free cash flow growth in the second iteration). He says this creates scenarios that test the financial limits of a potential holding.
“Seeking Wisdom” also tackles a number of other issues. One I was curious about was dividends. Macpherson considers dividends crucially important, but not in the way many investors would. For him, it is not just the dividends, but reinvesting dividends. Following an idea developed by Michael Mauboussin (who is frequently cited in this book), he observes dividends do not provide excess returns for investors. Instead, dividend reinvestment and price appreciation on the reinvested capital provide the extra return. To that Macpherson adds another reason for reinvesting dividends: the companies in which he invests have extremely high returns on invested capital (ROIC). That means he can increasingly benefit from management's skill in deploying or redeploying a company's capital.
Investors who have suffered bouts of bad years in their investing lives will welcome Macpherson’s thinking about this subject. He says, “What’s particularly difficult to understand is that it takes times of underperformance to achieve long-term outperformance.” He adds "The Super Investors of Graham and Doddsville" underperformed the markets about one-third of the time they spent in the market (The super investors he refers to are the subject of a 1984 article by Warren Buffett (Trades, Portfolio), in which he discusses the records of Graham and Dodd alumni).
Macpherson notes times of underperformance are necessary to achieve long-term outperformance. Why? Underperformance drives out investors who do not have the right temperament to hold on during bearish times. Second, non-value investors and the market will eventually recognize the value but will not know when to buy. Third, at times, investors prefer lower-quality, higher-risk stocks that have the potential for high returns (and reduce demand for higher-quality companies).
One of Macpherson's ideas that continues to intrigue me is the possibility of large pharmaceuticals as substitutes for bonds. Once upon a time, bonds provided decent yields, and not just for widows and orphans. Since quantitative easing (QE) appeared after the 2008 financial crisis, however, interest rates have been historically low, and bond yields have stayed down, too.
As a result, many erstwhile bond investors are going outside their comfort zones to find decent yields. That includes investments in equities, and not just safe, boring equities.
Macpherson points out pharmaceuticals may provide a medium risk-reward play for those investors. While many would argue pharma is high risk, he says that is not necessarily true because of dividends and pharmaceutical pricing. The big companies in the space, he says, have a long history of "generous and increasing dividends" over the past 10 years. As for pricing, he says U.S. drug pricing is unique in the world, allowing companies to charge higher prices; they get long patent (moat) protection; and it's hard and costly to get approval for both new drugs and generics.
In this review, I have touched on just a fraction of what he covers; I encourage you to read “Seeking Wisdom: Thoughts on Value Investing.” I hope to see much more of Macpherson’s thinking in both articles and books.
I have a few minor gripes, the most important of them being a long list of subjects were covered in the book; perhaps Macpherson can take some of them and develop them into longer articles or mini-books. For example, I read both chapters on selling and definitely wanted more (although his experience on selling is somewhat limited—he says he continued to hold, until the book was published, about half of the stocks he started out with in 2004).
There are many things I liked, beyond those listed above. Macpherson brings a wealth of quotations and anecdotes to his writing. They help us understand the subject material that follows and provide a richness to his writing. He is an excellent writer, able to bring life to what are often difficult subjects.
But most of all, I appreciate his message that we do not need to be geniuses to succeed at investing. Just keep your costs under control, as any good business would, and let time compound your capital. With those measures, many of us can chalk up respectable investing returns.
Macpherson has not just been seeking wisdom—he has been finding it, too.
Disclosure: Macpherson is a fellow GuruFocus contributor, and we have exchanged a few messages. I have deeply appreciated his encouragement of my amateur analyses and have complimented him on his expert insights.
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