I’ve been spending some time updating my thoughts on Markel (MKL, Financial) and have been rereading old interviews with Tom Gayner (Trades, Portfolio), the firm’s co-CEO (previously he was the chief investment officer at Markel). In a 2016 interview with Value Investor Insight, Gayner said the following about his approach to equity investing (bold added for emphasis):
“I wouldn’t change a word in describing the four investment principles we follow. We’re looking for profitable businesses with good returns on capital at modest leverage, that have honest and talented management, that have reinvestment opportunities and capital discipline, and that have shares trading at fair prices.
One thing that has changed is a point of emphasis. I’m an accountant by training. When I first started, I was most comfortable looking at financial statements and arriving at a point-in-time assessment of what I thought something was worth today relative to what it was selling for. That’s what card-carrying members of the value investing union do. But what has become more important to me is not the snapshot, but the movie. What do the characteristics of the business say about what happens next?
That’s caused me to put primary emphasis on item #3 [reinvestment opportunities and capital discipline]. Business is so dynamic today that you’re either getting better or you’re getting worse. I’ve learned through painful experience that without ample reinvestment prospects, you’re generally looking at a rotting asset. Of course, it’s much more fun to buy great companies with bright prospects, so the main reason not to would be because they often cost too much. I am still very attuned to that, but at the margin I have become more willing to pay up for the good stuff.”
This hit close to home. As I think about the past decade, I’ve learned some painful lessons when I’ve invested in businesses that appeared cheap on a traditional basis but with questionable future prospects. I’m thinking of companies like International Business Machines (IBM, Financial), JC Penney (JCP, Financial) and office supply retailer Staples (now owned by private equity firm Sycamore). In each of those cases, the business was already showing signs of distress, did not have realistic plans to reinvest at attractive rates of return to become better over the long run, or both.
On the other hand, I’ve experienced some success buying high-quality businesses, even when their valuation did not appear inexpensive at first glance. An interesting example that I’ve discussed previously is Moody’s (MCO, Financial). I bought the stock in June 2016 following the Brexit vote (it fell by roughly 15% in two days to $85 to $90 per share). At the time, management expected earnings per share (EPS) for fiscal 2016 of roughly $4.6 per share, leaving the stock with a forward price-to-earnings (P/E) multiple around 20. I think most of us would say that kind of multiple is reasonable for a high-quality business, but hardly a screaming bargain.
But what happened over the past three years shows why that elementary analysis is insufficient.
For fiscal 2019, Moody’s management now expects EPS of roughly $8.0 per share – a cumulative increase of 75% from what they expected to earn back in 2016. That works out to a compounded annual growth rate of 20%. Think about that relative to the companies I mentioned earlier (or the endless list of companies like them). IBM and JCP both would have been lucky to report 20% cumulative EPS growth over the same period (by the way, they didn’t).
Now, you could correctly point out (as an example) that Moody’s disproportionally benefited from the tax cut. But that just speaks to the true value of great businesses: They were able to retain a larger percentage of the benefits as opposed to passing them on to customers or other stakeholders.
This tremendous growth in earnings per share has translated into solid results for shareholders. Moody’s stock price is currently north of $190 per share; it has more than doubled since June 2016 (before dividends). There has been some help from multiple expansion (it climbed from 20x forward to 23x forward), but the overwhelming driver of returns has been growth in earnings power.
Conclusion
I’ll bring it back to what Gayner said in the Value Investor Insight interview:
“What has become more important to me is not the snapshot, but the movie.”
The snapshot is a valuation metric (like the forward P/E). The movie is where the company will be able to take its business – and earnings power – over the next five, ten and twenty years.
I’ve had to learn this (painful) lesson a few times, but it’s a mistake to let valuation take the lead in the investment decision. For the long-term investor, business quality should be the primary consideration. The ability of a high-quality business to reinvest at attractive rates of return is tremendously valuable over time. In a few short years, it greatly outweighs the fruits from buying cheap and hoping to capture some upside on a re-rating (and as I saw with IBM and JC Penney, that’s a difficult way to win anyways).
This doesn’t mean that you should invest in great businesses at any price. Instead, I think the lesson here is that you can help yourself by making the first filter business quality – then thinking about the relationship between price and value. If a potential investment idea doesn’t make it past the first filter, your best bet is to just move on.
Looking back, it’s pretty clear that I should have come to that conclusion on JC Penney (IBM, in addition to having questionable future prospects, should’ve probably been in my “too hard” pile). But instead of focusing on the business, I let what I thought was a cheap price sway my decision (in the case of JC Penney, that conclusion was based on an estimate of earnings power that proved woefully incorrect in the years that followed). In the future, I’m going to try to avoid similar mistakes by following Gayner’s advice and changing my point of emphasis.
Disclosure: Long Markel and Moody's.
Read more here:
Another Lesson on the Perils of Market Timing
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