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Thomas Macpherson
Thomas Macpherson
Articles (134)  | Author's Website |

Criteria Creep

In the heady times, do you allow your investment standards to float or do you hold firm?

October 11, 2018 | About:

As markets continue to sit near all-time highs, you can almost hear the stretching sound as individual investors (and professional money managers) push outwards on all their valuation techniques that help them define “value.”

An article by Grahamites (“Charlie Munger (Trades, Portfolio) on Berkshire’s Rationale for Investment in Salomon Brothers,” July 18) cited Charlie Munger (Trades, Portfolio)’s statement about their Salomon investment: Compared to things available, we thought that it was a good thing to do at the time.” I refer to this problem as “criteria creep.”

We all fall prey to it. As markets hit near continual highs, it isn’t that difficult to start thinking that maybe it really is different this time. Maybe that 15-20% cash position really is detrimental to returns. So, we begin to make decisions that – under different circumstances – we might not even consider.

Criteria creep: a working example

Here is a real-time example of this dilemma. I recently reviewed all my stock purchases since 2010 with a focus on the price-earnings ratio at the time of purchase. In 2015, I joined the team at Dorfman Value Investments (I left the firm on Sept. 28). From 2015 to 2018, I spent an awful lot of time building portfolios while carefully looking to avoid criteria creep. Looking out over the past 10 years, the purchases I made at my former firm, Nintai Partners, and Dorfman Value show a distinct creep in pricing. The average price-earnings ratio had increased from 19.6 to 22.7 (a gain of nearly 16%!).

P/E Ratio at Time of Purchase

2010 – 2014

2015 - Present



Until joining Dorfman Value, I rarely placed much credence on the price-earnings ratio. But my former partner John Dorfman drilled into me the importance of this number and its potential impact on long-term returns. That said, there was almost no movement in any other measure I used when assessing a potential investment. For instance, return on capital, equity and assets remained within 2-3% of each other from 2010 to 2018. The same goes for cash positions, short and long-term debt and free cash flow conversion rates.

A second and larger difference has been the difference of projected growth in free cash flow from the period 2016 to 2021 and 2018 to 2023. In 2014 – my last full-time year managing Nintai Partners Fund – the estimated five-year free cash flow growth was 16.8%. In 2018 this number had dropped to just 13.3% in my portfolios.

There is a chicken-and-egg issue here. As growth slows you would expect the price-earnings ratio to rise as long as prices remain steady or growing. The quandary has left me the choice to pay more for future growth or to hold cash.

Projected Free Cash Flow Growth

2016 – 2021

2018 – 2023



Buying in or getting out

This criteria creep – both in the price-earnings ratio as well as projected free cash flow growth has forced me to deeply consider whether to abide by my historical investment parameters or fudge a bit and overpay for any new investments. As usual, the answer wasn’t cut and dry. While my overall strategy remains to purchase assets below my estimated intrinsic value, I found myself in Charlie Munger (Trades, Portfolio)’s position where, compared to things available, some purchases might be a good thing to do at the time.

As I made these decisions in real time, two questions were at the core of my own personal criteria creep. First, are the underlying market conditions part of a new market reality? (The answer to this seems to be no as we’ve seen the Federal Reserve raise rates from near zero to over 2.0% over the past several years.) Second, did the opportunity cost of holding cash and staying true to my traditional standards force my investors to seek greener pastures elsewhere? Time will tell the answer.

I am currently in the process of joining the Hayashi Foundation Trust and watching the team rebuild the investment portfolio[1] and find them in the criteria creep dilemma once again. With markets reaching all-time highs as of late September 2018, the ability to find 15 to 20 stocks at my traditional standards is nearly impossible.(I don't directly manage the fund nor make stock selections).

One stock they are looking at is Paychex (NASDAQ:PAYX). In the past year the stock has risen by 22%. Its price-earnings ratio has risen to 29.3 from 19.8 in May 2012. In addition, its price-book ratio has increased tp 13.4 from 6.7 in May 2012. In nearly every valuation measurement tool, the stock is standing at all-time highs. Conversely, free cash flow has grown by 11.8% in the past five years and 30.4% in the past year. The stock yields a little over 3%.

Everything about this company’s stock meets what would be my investment criteria – with the exception of those related to valuation. So the dilemma is whether the opportunity cost (and risk) is greater than simply holding cash. To help make a more educated decision, I find there are two questions or conditions that can drive your decision making.

Does your client have strong feelings on cash?

Some investors believe cash has no place in their investment portfolio. They see it as an inflation-based money loser whereby the lost opportunity costs far exceed any potential gains. If that’s the case, then you are pretty much locked out of holding cash, and the consequences be damned. I have been fortunate that over my investing career every investment partner has seen cash as a placeholder or option to take advantage of undervalued opportunities. When I can’t find value in the marketplace, they support me in building up a significant cash position.

You believe the relationship between price-earnings and price-sales ratios has fundamentally changed

There really people out there who believe it truly is different this time, that the relationship between price and earnings really has changed. Some of these individuals believe that permanently low interest rates mean fundamental stock valuations have increased by 20-30% on a permanent basis (thereby making cash a loser’s game). Frankly, I don’t think the relationship between a dollar in earnings and the share price has permanently changed. With the Fed funds rate since remarkably low (from a historical perspective), rates are slowly rising to more normalized levels every month.


With all my pontificating, what did I do as portfolio manager at Dorfman Value? In some cases, I took Munger’s view that “Compared to things available, we thought that it was a good thing to do at the time.”

In those cases, I made several smaller purchases to fill out the portfolio. The vast majority of time in my previous investment management days, I have held firm against criteria creep and allowed cash to continue to build. When I left Dorfman Value Investments, cash was near 25% in October 2018. There is a famous story that during negotiations between Tip O’Neill (the Democratic speaker of the U.S. House) and Ronald Reagan (Republican president), O’Neill was pushing hard on a particular set of spending measures. Reagan blurted out, “You can make crap a watermelon, but you can’t get me to crap a pineapple.” The decision whether these lofty valuations represent a watermelon or pineapple is all yours.

As always, I look forward to your thoughts and comments.

[1] After serving on the board of the organization, I took a more active role as Chief Financial Officer and Co-Chairman of the Board on Oct. 1, 2018. The previous week, I resigned my position as investment manager at Dorfman Value investments.

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

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