Thursday, October 29, 2015

The Limits of the Outsider approach to investing

Often great books, even business books, do not directly translate into actionable investing concepts. "The Outsiders" by William Thorndike is one of the best business books I have read. It details the exploits of John Malone, Henry Singleton, Buffett and others, and how they built incredibly successful businesses.

Its a series of stories that elaborate on inspiring vision and execution, but there is one problem - for sure, these outsiders were wildly successful, but how can an outside individual investor recognize these companies and managers a priori to join them on their ride? Ay, there's the rub.

The exact tactics that John Malone and many others used to build their companies - massive amount of debt, continuous M&A, buybacks, and eschewing earnings - look like many of the exact things that a defensive investor seeks to avoid.

Interestingly enough one of the questions that came up when the book came out was, nautrally, so we know the historic examples of Outsider CEOs, but what current CEOs embody that approach? One of the main examples given was Michael Pearson the Outsider CEO of Valeant.

Valeant seemed to tick all the Outsider boxes - a new CEO with an unconventional approach, shaking up a staid industry, massive debt, 9x revenue growth in the last five years, a Debt/Equity ratio of 4.8,  and one acquisition after another, each one larger than the last. Most people(*) including Thorndike tabbed this as the next Outsider.

But when I tried to apply The Outsider theory in investing, as an outside, individual, non-professional investor, I found that its not so easy. Again, the very metrics I look to avoid are the hallmarks of many Outsider approaches. In fact, John Malone even mocks the lower risk approaches

“Their philosophy is low leverage, low risk and high cash payout to their shareholders,” Malone said of Vodafone. “I prefer to grow equity value.”

Who am I to argue with Malone's approach? Of course, Malone can say that with confidence, his track record speaks for itself, but what about lesser skilled CEOs of which there are many? And again, how should we recognize a Malone up front? So what works for Malone and Singleton is probably not going to work as well for an individual investor, because the difference between Malone versus Leo Apotheker and Carly Fiorina is not always obvious at the time in terms of tactics.

Now Valeant shareholders are having to wrestle with these questions. Is this a great buying opportunity, because Philidor is totally copacetic, should they back up the truck? Or is it time to run for the exits? Either way, its potentially very expensive to find out.

Sanjay Bakshi's excellent lecture on Klein vs Kahneman distills decision making down to Klein's expert insights versus Kahneman's mistake avoidance. Individual investors already have major implicit advantages - time and patience, not sure they need more, because they can harvest satisfying returns simply from time and patience assuming they can avoid mistakes.  In my view, bravery is required to capitalize on your view of what scenario Valeant is in at present. Bravery can yield great results when you are right, but patient quality offers a better margin of safety the rest of the time.

* Well, one person did not: "Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time." - Charlie Munger (March 2015)

Saturday, October 24, 2015

Dwelling on Quality

In an oped in the FT two years back, Nick Train asks a great question - "what is the right price for quality shares?" That's a deceptively important and potentially difficult problem actually.

Its important because of Munger's three laws of investing

Its a potentially difficult problem because while most intermediate investors can recognize a bargain price and they can recognize high quality, the intersection of the two is problematic. Take a company like Diageo, its P/E is 20 right now. For a cheapskate like myself that is a bit on the high side. On the other hand, its a high quality franchise. For one example its Return On Equity has ranged between 32-48% for the last decade. But because the market is not generally stupid, it never gets classically cheap. The last time it was in bargain territory was 2008 (when everything was) when the P/E was down to 14.

So what to do? Sit on cash for a decade or two waiting for that one opportunity? Or pay up a bit for higher quality.

Nick Train: "...should Diageo’s shares really be trading at 20 times historic earnings? 

Any discussion of these issues has to begin with an acknowledgment of the fundamental investment attractions of these shares – which are self-evidently great. I would contend that more investment weight should be placed on the excellence of a business than its valuation. 

It is easier to be certain that Diageo is a great business than it is to decide whether or not it is overpriced on 20 times earnings, or still cheap on 15 times. The excellence is not debatable; the valuation discussion is worryingly arbitrary. So, I tend not to worry about valuation unless truly egregious levels are struck – say a price/earnings ratio of 30 times or more. "

Morgan Housel did some digging on this topic, he went back to 1995 and looked at what P/E would you pay for an 8% return. Interestingly enough, many of the higher priced companies (on a P/E basis) had excellent returns, and many apparently cheap companies just stayed cheap or outright floundered.

In the Adventure of the Copper Beeches, Sherlock Holmes said, "Crime is common. Logic is rare. Therefore, it is upon logic rather than upon the crime that you should dwell." There are plenty of cheap stocks, even today, however the number of great companies that can compound over decades is very small. That kind of quality is rare, but it is knowable with investigation. Therefore, in the case of price and quality, the investor should dwell on quality.