Following up on his previous emphasis on simple rules for investors, Tobias Carlisle turned in chapter 12 to the basics. In the concluding chapter of "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," he codified his thinking about deep-value investing into eight simple rules.
1. “Zig when the crowd zags.”
Obviously, this refers to taking a contrarian view, but we need to know the crowd’s consensus before we can head in another direction. The crowd’s majority opinion can be found in the difference between the price of a stock and its value.
Carlisle pointed out that good prices are available only when the crowd wants to sell. Further, a “good” price should be tilted to the contrarian’s benefit with a small downside and a big upside. This tilting provides a margin for error. Further, because of reversion to the mean, stocks that seem scary, bad or boring move from undervalued to overvalued with time.
2. The bigger the discount, the better the return.
In a qualification we have not seen so far in the book, Carlisle argued that for most “industrial” companies, the Acquirer’s Multiple is the best single measure of discounted value. Previously, he had not referenced sectors in discussing the power of his metric.
He did follow up, though, by observing that for non-industrial businesses, such as finance (banks and insurance companies), book value would be a more optimal single measure. That leaves a wide swath of the market without further description.
3. Find a margin of safety.
He called margin of safety “a threefold test of the discount to the valuation, the balance sheet and the business.” Regarding valuation, a wide discount allows for mistakes and for decay in value over time. This goes against the “received wisdom of the market and academia” that assume higher returns require greater risk.
On the balance sheet issue, the Acquirer’s Multiple metric should point investors toward off-balance sheet issues such as leases and underfunded pensions, as well as hidden assets. Third, the company should be own a “real” business, with excellent operating earnings and matching cash flow. The reason for matching cash flow? To ensure the earnings are not being manipulated.
4. A share is an ownership interest, not just a ticker symbol.
According to Carlisle, this has two important implications. First, a shareholder has rights and can exercise those rights by voting at meetings. Second, an owner pays attention to all that a company owns and owes, especially its cash.
As we have noted before, too many investors focus on the profits and ignore the assets on the balance sheet. In other words, they focus on the eggs rather than the golden goose (in robust businesses, at least).
The author added, of the crowd, “They ignore cash. A seemingly poor business with a strong balance sheet could represent hidden value. The asset value offers a free call option on any recovery in the business.”
5. Too much growth and profit may not be a good thing.
Fast-growing and profitable companies attract competition, leading to erosion of margins and profits. Moats do help, but in Carlisle’s eyes, strong and sustainable moats are hard to find. In addition, we know about the strength of moats in Warren Buffett (Trades, Portfolio)’s companies in retrospect. But unlike Buffett, most of us cannot know how strong and sustainable a moat will be in the future.
And once again, it’s necessary to remind ourselves of reversion to mean; over time, high growth and profit companies will eventually become just average companies. Instead, we should look at companies that currently face difficulties and have prices reflecting those challenges.
6. Simple, concrete rules help us avoid errors.
Such rules are testable and should be both back-tested and battle-tested. Back-testing checks the rules for theoretical strength, especially when the rules are tested in different countries and different stock markets. The battle test ensures the rules work in the real world: “No strategy has ever failed in theory. Almost all have failed in reality.”
7. Be prepared for the concentration trade-off.
As noted elsewhere in the book, concentration means focusing on only the best ideas. But with a concentrated portfolio come two important trade-offs. First, it will be more volatile than the market as a whole: “Good years for the market can be great years for the portfolio. Bad years for the market can be terrible years for the portfolio.”
Second, concentrated portfolios make their own way. They don’t follow the broader market. This is known as “tracking error,” meaning that your portfolio can go down as the market is moving up, and vice versa. So, concentrate but not so much that it could lead to bad decisions when the market is making you look bad.
8. Maximize after-tax gains for the long run.
According to Carlisle, there are three implications from his after-tax, long-run statement. First, investors often misprice stocks because the companies behind them are facing tough times in the coming year. This provides an opportunity for patient investors willing to put up with below-average results in the short term. Buying and holding until a turnaround arrives is known as “time arbitrage” and is “an enduring edge” for investors focused on the longer term.
Second, compounding may be powerful, but it takes time build up steam. Eventually, though, interest and gains become significant for those willing to wait more than a year or two. Third, compounding can be reduced or killed by taxes and fees.
That winds up our review of Tobias Carlisle’s book, "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market." The book argued that a metric called the Acquirer’s Multiple — an industrial-strength price-earnings ratio — is a robust tool for deep-value investing.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
