“(My) strategy is very simply to make meaningful investments in good companies when their stocks are undervalued.
This is obviously what most investors are trying to do…”
Like John, I used to think that this is what most investors were trying to do. However, the thousands of email exchanges I’ve had over the 12 years I’ve been writing this blog have taught me that most investors are not trying to “make meaningful investments in good companies when their stocks are undervalued.”
Let’s break this statement down to see what I mean:
1. Make meaningful investments
2. In good companies
3. When their stocks are undervalued
We have 3 key words there:
Make Meaningful Investments
What is a meaningful investment?
“Meaningful Investments” According to Me
My minimum position size is around 20%. My maximum position size is around 50%. I usually own 3-5 stocks. I often have some cash.
At the start of this quarter, my portfolio was more concentrated than usual. I had 50% of my portfolio in my top stock alone, 78% in my top 2 stocks combined, and 92% in my top 3 stocks combined.
“Meaningful Investments” According to Joel Greenblatt
Quote: “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to reduce risk is small.”
Answer: A meaningful investment is 13% to 17% of your portfolio (1/8 = 12.5%; 1/6 = 16.67%).
“Meaningful Investments” According to Warren Buffett
Quote: “Charlie and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.”
Answer: A meaningful investment is 16% to 25% (80%/5 = 16%).
“Meaningful Investments” According to Charlie Munger
Quote: “If you are going to operate for 30 years and only own 3 securities but you had an expectancy of outperforming averages of say 4 points a year or something like that on each of those 3 securities, how much of a chance are you taking when you get a wildly worse result on the average? I’d work that out mathematically, and assuming you’d stay for 30 years, you’d have a more volatile record but the long-term expectancy was, in terms of disaster prevention, plenty good enough for 3 securities.”
Answer: A meaningful investment is 33% (1/3 = 33.33%).
So, the above value investors (jointly) define a “meaningful investment” to be in the range of 13% to 33% of your total portfolio.
Over the last 12 years, I’ve discussed position size with dozens of individual investors. Maybe five of them take “normal” positions of 13% to 33% of their portfolio. I would estimate that at least 85% of investors do not try to make meaningful investments.
In Good Companies
What is a good company?
Good Companies According to Me
Quote: “A business with market power is a good business. A business without market power is a bad business…Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”
Answer: A good company is a player in markets (both those it buys from and those it sells into) where competition is extraordinarily imperfect.
Good Companies According to Warren Buffett
Quote: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
Answer: A good company faces extraordinarily mild price competition.
Do Most Investors Look for Good Companies?
Most public companies don’t have highly persistent profitability. They experience mean reversion. This is because either: 1) They operate in markets (both those they buy from and those they sell into) where competition is not extraordinarily imperfect and therefore tends toward the “mean reversion” of profitability common in more perfectly competitive markets or 2) They expand the corporation by taking the profits earned in an extraordinarily imperfectly competitive market (one in which they have a “moat”) and re-invest them in a more perfectly competitive market (where they don’t have a moat).
Is it possible to identify imperfectly competitive industries ahead of time?
They’re less cyclical.
Let me explain.
A perfectly competitive market is made up of a large number of price takers. An imperfectly competitive market is made up of a small number of price setters. A large number of price takers – each believing they have no influence on the market they operate in – act irresponsibly in the literal sense of believing their individual actions are not responsible for the outcome the group experiences. A small number of price setters – each believing they have some influence on the market they operate in – act responsibly in the literal sense of believing their individual actions are responsible for the outcome the group experiences.
In other words…
Players in a perfectly competitive market act like humans do when wearing masks, among strangers, etc.
Players in an imperfectly competitive market act like humans do when showing their face, among peers, etc.
As a result, perfectly competitive markets are driven by more self-destructive decision making. Self-destructive decision-making leads to cyclicality.
This is because a cycle is only possible if a decision is made now that is regretted later. An industry free of regrets would be an industry free of cyclicality.
A decision may be regretted later because it was based on information that proved to be false or…
A decision may be regretted later, because – despite having the correct information – a player in the market made a decision they knew was against the group’s long-term interest because they believed it might be in their own short-term interest.
Economists, investors, etc. tend to focus on bad information as an explanation for behavior that is later regretted. However, anecdotally, I think many of us would have to say that the regrets we observe in our day-to-day lives are at least as frequently due to the decision maker having all the necessary information to make a correct decision but still giving into a short-term impulse simply because the ill effects of the decision were known to be felt only in the long-term.
The classic quote here is, of course, from Citigroup CEO Chuck Prince in July 2007:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Note the focus on time as opposed to risk. This is something you hear in cyclical industries but never in non-cyclical industries. He said: “in terms of liquidity, things will be complicated.” That’s all you need to know to know you shouldn’t be dancing. That’s the risk. But, he prefaced the bit about risk with “When the music stops” and added the afterword: “But as long as the music is playing…” This kind of quote is common – though rarely as direct – in cyclical industries. The justification for self-destructive behavior is that “yes, we’re doing something risky” but “no, now’s not the time we’ll have to pay for the risks we’re taking”.
Credit Suisse did a study of how persistent profitability was by industry. (You can Google the title “Do Wonderful Companies Stay Wonderful” to find a discussion of this report).
The extreme results – the industries listed as those where firms had the most persistent profitability and the industries listed as those where the firms had the least persistent profitability – were not surprising.
The 3 industries where firms had the most persistent profitability were: 1) Household and Personal Products, 2) Food and Beverage, and 3) Hotels and Restaurants. All non-cyclical industries.
The 3 industries where firms had the least persistent profitability were: 1) Insurance, 2) Semiconductors, and 3) Real Estate. All cyclical industries.
Let’s take a look at Berkshire Hathaway’s 5 largest stock positions shown in the 2009 shareholder letter:
(This is the last year where Warren Buffett was the only person at Berkshire making investment decisions.)
#1) Coca-Cola (KO): Soft drinks
#2) Wells Fargo (WFC): Banking
#3) American Express (AXP): Credit cards
#4) Procter & Gamble (PG): Toiletries
#5) Kraft (KFT): Food
Coke and Kraft are in the food and beverage industry. That’s the #2 industry in terms of most persistent profitability among firms. Procter & Gamble is in the household and personal products industry. That’s the #1 industry in terms of most persistent profitability among firms. There were 24 industries listed in that Credit Suisse report. So, 60% of Buffett’s top 5 stocks in 2009 were in the top 8% of industries by persistence of profitability at the firm level. Almost without exception, Buffett’s 2009 stock investments were in companies that were either in non-cyclical industries or in financial services.
(The exceptions are Posco and ConocoPhillips. Berkshire also owned BYD; however, this investment was probably made by Charlie Munger – not Warren Buffett).
Berkshire’s investment portfolio skews heavily towards the very least cyclical industries around.
Do most investors look for good companies?
When I put out a call for readers to request I research specific stocks for them (I’ve since cancelled this project), I got as many requests for companies in cyclical industries as in non-cyclical industries.
In fact, after getting a flood of requests from readers – I wrote this on the blog:
“Finally, a suggestion. I will certainly try to do my best to research any stock you ask about. However, I have gotten a lot of requests to research companies that are speculative in the sense that:
· They are in bankruptcy right now
· They are losing money right now
· They have never made money in the past
· Statistical measures like Z-Score and F-Score suggest they are very poor credit risks
I can research these stocks. But, common stock is junior to the company’s obligations. So, in cases like this, my write-up is likely to focus on the company’s weak financial position and the possibility that the stock will be worthless.”
These requests were not for good companies.
Conclusion: I would estimate that investors spend about 50% of their time looking at good, non-cyclical companies and about 50% of their time looking at bad, cyclical companies. Except among a very small subset of readers I exchange emails with – I have not detected any tendency for investors to focus on good, non-cyclical companies to the exclusion of bad, cyclical companies.
When the Stocks are Undervalued
I write a value investing blog. And I have to say that my readers do tend to ask about cheap stocks. They tend to own the stock that has the lowest P/E, EV/EBITDA, etc. in an industry. They are much more interested in stocks hitting 52-week lows than 52-week highs.
Conclusion: In my experience, value investors really do like to buy stocks that have fallen in price, stocks that are cheaper than peers, and stocks with low price-to-book ratios, price-to-earnings ratios, and especially low EV/EBITDA ratios.
One Out of Three
My experience is limited to talking with readers of the blog over the last 12 years. These readers (or at least the ones who email me) are maybe 40% American and 60% from other countries. They almost all identify as value investors. A very slight majority are individual investors who don’t work in the investment industry. Most of the remaining minority are professionals in the sense they work in the investment industry – often as analysts – but do not have ultimate responsibility for a portfolio. A much smaller minority – probably no more than 5% – are fund managers. The funds they are running are usually small: anywhere from tens of millions to hundreds of millions of dollars – not billions.
So, the population I’ve interacted with skews entirely to the “value” side. It is more individual investors than institutional. A lot of money is run by big institutions which may not be value oriented. I can’t talk about them.
For those investors I can talk about: how do they score on John Huber’s 3-point strategy?
#1: Make Meaningful Investments
False. Overwhelmingly, the investors I know prefer to make non-meaningful investments. They prefer taking a 5% position over a 15% position and a 3% position over a 33% position.
#2: In Good Companies
Neither true nor false. At the same price, I get the impression they’d prefer investing in a good, non-cyclical company over a bad, cyclical company. But – give the prices at which stocks typically trade – they seem as interested in bad, cyclical companies as good, non-cyclical companies. When a reader asks me about a stock unprompted – that stock is as likely to be a bad, cyclical company as a good, non-cyclical company.
#3: When Their Stocks are Undervalued
True. The value investors who read my blog like stocks that have dropped in price. They like stocks with low EV/EBITDA multiples, low P/E ratios, and sometimes even low price-to-book ratios. They like stocks that are cheaper than their peers.
Conclusion: The value investors who read my blog don’t really follow John Huber’s approach of seeking to “make meaningful investments in good companies when their shares are undervalued”. Instead, they seek to make less than meaningful investments in companies regardless of their quality when those stocks are cheap.