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Hugo Roque
Hugo Roque
Articles (32) 

Interview: 'Holding Stocks Forever' With Professor Kenneth Jeffrey Marshall

A strong, quality investing framework for long-term investors

September 19, 2019 | About:

Kenneth Jeffrey Marshall is an author, professor and value investor. His book, "Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance," was published in 2017 by McGraw-Hill. He teaches value investing at the Stockholm School of Economics in Sweden and at Stanford University. He also teaches business at the University of California, Berkeley. He holds a bachelor's degree in Economics, International Area Studies from the University of California, Los Angeles, and an MBA from Harvard University. Marshall splits his time between California and Sweden, and has found the time to kindly share his value investing framework and long-term-focusing philosophy.

Roque: What led you to adopt and teach the value investing philosophy and your "Value Investing Model," when academia is dominated by the complete opposite theory of markets: the efficient market hypothesis?

Professor Marshall: Well, academia ain’t really my papa. The market is. I started investing in 1990, but didn't start teaching until 2013. So the real world had a decade-plus head start on shaping me. That was useful. I came up as an empiricist, not as a theorist. So I think like an owner, not like a space cadet.

Come to think of it, I did get exposed to the efficient market hypothesis earlier. It was at UCLA. I was an undergraduate in the economics department there in the late 1980s. Back then professors called it the efficient market theory. But as I say in the book, the October 1987 stock market crash put that term under review. And rightly so. Eventually "theory" got downgraded to "hypothesis." Since then great work has been done to show how folks are rarely at their rational best. Professors Cialdini, Kahneman and others did that. They've done a real public service, I think.

Incidentally, only in the short term is the efficient market hypothesis silly. Over time, it’s okay. In a fair market with substantial volume, the average price of an asset over years really does come close to the average worth of that asset. But in the short term they can be wildly different.

Roque: Value investing has been underperforming growth investing and market indexes since the financial crisis. What gives you confidence that the long-term outperformance of value investing will persist?

Marshall: Let's explore that. What's value investing? It's paying less than worth. What's the opposite? It's paying more than worth. So if I may please invert the question, what gives me confidence that overpaying will underperform?

Everything.

Overpaying doesn't make sense. I trust that that’s obvious. But overpaying can only be expressed relative to worth. So the whole issue revolves around worth.

Sometimes worth is easy to gauge. Consider a low-growth American manufacturer, conservatively capitalized, and facing no real changes in its market, its costs or anything. The proper EV/OI is going to be 8, or 10, or 12 — something like that. There would be debate on the right multiple. But most would agree that it’s somewhere in there.

Now think about a very different business. For example, an online ad network in an emerging market. How many real changes does that company face?

Heaps. And folks on the buy side will come up with different conclusions about those changes. They’ll have different thoughts on the future size of the emerging market, the speed of the shift from traditional to online media, cost-per-click, regulation — everything. And the worth estimates will come from those conclusions. So the worth figures will be all over the map.

Lately, the conclusions on companies like that seem to be optimistic. Not dopey, just optimistic. So prices have been high. And to be sure, many of these companies should be fully priced. What they’ve accomplished operationally is remarkable.

But there always comes a time when glamorous businesses stop getting priced like religions, and start getting priced like businesses. That transition is never gentle. And it is inevitable. It never does not happen.

Roque: Do you find any reasons for value investing's long underperformance?

Marshall: I find three.

First is regulation. From a historical perspective, internet media companies have been regulated quite lightly in the United States. So in their home market — which is huge, conveniently — they've thrived more or less unchecked. They’ve essentially gotten a laissez-faire launch subsidy.

Contrast this with earlier media industries, like motion pictures. By the 1940s that industry had became very powerful. Single companies like Paramount were vertically integrated. They owned the studios that made movies, the distributors that shipped movies and the theaters that showed movies. This gave them a huge hand in shaping public opinion. And that came to be viewed as alarming. So eventually the judiciary made them divest themselves of their theaters, as a means of checking their power.

We've seen nothing like that in internet media. Nothing. So it remains a mega-cap growth story.

I should note that in some ways this light regulation has advantaged the U.S. American social networks and search engines took their domestic success and applied it overseas. And it largely worked. I spend considerable time in Europe. There are plenty of talented engineers and entrepreneurs over there. But when Europeans connect or search online, they do so mostly on platforms from California.

A second reason for the underperformance is the composition of the indexes. Many are market-weighted. So as a company's market cap grows, it comes to constitute a bigger and bigger percentage of the index. So index funds start to act a bit like momentum funds. And momentum funds work great, until they don't.

Third is the bull market. Value underperforms in bull markets. This is not new.

Roque: In your book "Good Stocks Cheap," you provide investors a framework to identify sound investment opportunities: "Do I understand it?"->"Is it good"->"Is it inexpensive?" On the "value investing scale," are you much closer to Buffett and Munger than Graham? Why?

Marshall: I’m very qualitative. I’m into things like sustainable competitive advantage, related party transactions, supplier breadth and so forth. Most would argue that that's more new school than old.

I do plenty of calculations too, of course. But those are relatively simple. Where there’s a real opportunity to outperform over the long term, in my view, is with some clarity on qualitative issues. Are new entrants likely to take meaningful market share? Is the customer base likely to consolidate? Is management likely to behave responsibly?

Roque: For "generating ideas,” you suggest that investors look in areas like spinoffs, reorganizations and small caps, which usually aren't categories associated with quality investing. What cautionary steps do you apply for investing within these categories?

Marshall: Are they not sources of quality ideas? I'd respectfully disagree with that. For example, this week I’m looking at a small cap that would meet any reasonable definition of quality. It has high ROCE, market leadership, tons of management ownership -- it’s almost perfect.

Please remember that just because I see spinoffs, reorganizations and small caps as promising sources of ideas doesn’t mean that I give them some sort of pass through the Value Investing Model. Each idea has to stand on its own. And few do. But on balance I find spinoffs, reorganizations and small caps to be just as promising as the four other idea sources that I outline in the book.

Roque: You say that you aim to buy these exceptional companies at a big discount, pointing out a maximum buy level of 7x EV/Ebit. How hard is it to get these kinds of opportunities? For example, Kone and Nike, which are examples of excellent companies that you present, are right now trading at close to 20x EV/Ebit. What generally has to happen to these companies for them to enter the buy zone?

Marshall: You're right: Great stocks shouldn’t get cheap. But sometimes they do.

Some bad news about a region sinks the price of a company that happens to be headquartered there. A clothing producer has a fashion miss, and its price drops as if the design department was just found to be staffed with antelopes. A regulator puts out some indecipherable missive and the price of a company under its jurisdiction nosedives.

Such drops can be overdone. But many equity analysts can’t help themselves. They previously used a discount rate of 10%, and now they use 20%. It’s nuts.

And remember, these unjustified stock price drops don’t have to happen often. They just need to happen sometimes. That’s one of the virtues of a concentrated portfolio with an infinite target holding period. When there’s a real opportunity, you have no problem making a serious commitment to it.

Roque: The second part of your framework it about behavior: "Know what you do."->"Do it."->"Don't do anything else." How important is behavior for the success of the model?

Marshall: Very. Folks often do great analyses, and then botch things by either not buying when they should, or buying when they shouldn’t, or some other gaffe occasioned by not having mastered the wacky gear between their ears. And all of us have wacky gear between our ears. We’re human.

What confers advantage in this area is simply recognizing that our gear is wacky, and having some sort of checklist that keeps misjudgment or misaction from hijacking our behavior. Chapter 16 of the book offers one. But you could derive an equally good checklist from Cialdini’s book "Influence," or from Munger’s talk on human misjudgment.

Roque: The objective of The Value Investing Model is to hold investments forever. What would be the right reasons to sell an investment?

Marshall: I don’t sell. What I buy I fully intend to hang on to. I’ve had some holdings bought out, of course, like the old Anheuser-Busch, and like BNSF. There I had to sell. But not actively. It just happened. One day there’s stock in the portfolio, and the next day there’s cash.

One advantage of my no-sell policy is that it forces me to buy well. I wind up with solid companies, and I like solid companies. It makes for a portfolio that’s robust out of necessity.

I’ve really only been hurt once by not selling. It was in 1998, when Coke (NYSE:KO) shares hit $80. As I say in the book, that price suggested that every man, woman and child on earth had just pledged to drink a bathtub full of soda a week for life. But like a goofball I held, and enjoyed a ringside seat to a slow-motion stock price pummeling.

But selling has hurt me more. For example, I sold Nike early (NYSE:NKE). Profitably, but early. That company continued to excel, and its dividends and share price shot up accordingly. But by then I was off the shareholder register. That mistake cost me a sizable sum. And that’s a real cost. Just because a loss didn’t register on a brokerage statement doesn’t mean that it didn’t happen.

I should add that a sound no-sell policy requires being ready for the price of one’s portfolio to halve. And halvings can last for years. In such a circumstance, I would hope to be even-keeled. Even-keeled and buying.

Roque: Can you give us a book or article reference that most value investors don't mention but that you find to be particularly enlightening?

Professor Marshall: A few years ago Jean-Marie Eveillard wrote a book in his native French called "En Bourse, Investissez Dans la Valeur!"  The publisher had it translated into English, and put it out as "Value Investing Makes Sense." But not many copies were printed. A few thousand, maybe.

Anyway, Jean-Marie sent me a copy last spring. I had reached out to him on behalf of a student of mine from France. Not only did Jean-Marie help the student, but he sent me a copy of his book. And remember, this dude owed me nada. I held the keys to nothing for him. He was just very gracious.

The book is fun. It’s personal, unvarnished and teems with style that I admire. Not writing style, personal style. For example, he liberally credits subordinates by name. He doesn’t pretend that he made it alone. He also echoes some nontraditional sentiments that I happen to share, like a distaste for being bought out.

So I guess I’m fond of the book both because of its contents, and because it was Jean-Marie’s good nature that landed it on my desk. He’s a good example of how to behave.

That’s a nice thing about value investing. It has people like Jean-Marie in it: unambiguously successful, polite, well-read and inquisitive.

Remember osmosis? From chemistry class? You have two saline solutions of different concentrations, separated by a semipermeable membrane, and before you know it, they each have the same saline concentration. They’ve influenced each other.

Osmosis is powerful in chemistry. But it's really powerful socially. We become who we're around. So if you want to be successful, polite, well-read, and inquisitive, expose yourself to people like Jean-Marie. Read what they write. Listen to what they say. Watch what they do.

Soon that will be you.

Read more here: 

Interview: Xavier Brun on Dealing With Uncertainty

Interview: The Long-Term Vision of Horos Asset Management

Interview: The True Value of Research

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