A podcast listener emailed me about something I said in a Q&A episode:
“A few podcasts back, you said you read value investing books and then started making mistakes because you read them. Where were the mistakes?”
Focusing too much on statistical things like what the price-to-book ratio was and what the P/E was and those sorts of things. The stuff of back tests and academics and all that. Quantitative value investing stuff. Using less common sense.
This is a topic I tried to talk about in the net-net podcast. Returns in net-nets - both my own and any common sense back test I've run - are really excellent. And the success rate is much, much higher than anyone thinks. Like Andrew has asked a couple times "So, some of the Japanese net-nets must have worked out really well and some went to zero..." and I have to say "no, they all worked out". But, that's common sense. If you don't just buy net-nets but focus on companies with 10+ straight years of profits and cash that's 100% of the market cap or more - those work out well and remarkably consistently. But, it's easy to focus on dumb things like whether something technically is a net-net or whether you should buy at 2/3 of NCAV and whether you should sell at NCAV and all that. Common sense says that shouldn't matter much at all. If it's a decent business, it's cheap at 110% of net cash. Why would you only buy things that were 65% or less of NCAV where net current assets are mostly inventory, where the company lost money in 4 of the last 10 years, etc. You wouldn't if you hadn't read value investing books. You’d only think that way if you’d read a specific rule somewhere. Like, I would have bought George Risk whether I ever read Ben Graham or not. Now, maybe I wouldn't have bought the Japanese net-nets without getting the idea of a "net-net" from Graham. But, in general, there is way too much talking about definitions, rules, etc. in value investing and worrying about what can be tested empirically and so on and not enough talk about common sense. Net-nets and low P/B and all that work because it's a market price for a stock that's often below what a bidder would offer for the entire business. It's boring to put it that way. It's hard to write a whole book boiling it down to that one point. But, it's true. You should buy businesses you like, feel comfortable owning, etc. when they trade in the market at a price below what you'd pay for 100% of the company. Basically, you should think like an acquirer and forget the stock trades day-to-day. That's how I first approached stocks before reading about value investing. And that's the thing I most have to remind myself of every day now. I have to remind myself to only think in those terms and not to think in terms of what statistics I know about returns in stocks, not to think of stocks as "stocks", etc. Not to worry about catalysts, etc. Just to think if I was being offered 100% of Keweenaw Land at $130 million or whatever, would I take that deal. That's literally the only way I thought when I started investing as a teen. It’s the only way I knew how to invest. But, that's the easiest thing to forget once you start learning about value investing. The correct model is really just to imagine you are being offered 100% of the company at the current market cap / enterprise value / etc. and you'll be able to do whatever you want with the company. But, most everything written about value investing - except for stuff written by like Warren Buffett himself - will tend to make you drift away from that. Buffett always has the 100% buyer mindset. But, books about Buffett don’t always have that mindset.
The model that works is the one I had before I read anything about investing. If you’re going to consider whether you should buy Keweenaw Land Association you ask: 1) Do I want to be in the timber business? 2) Is the market cap a good price for all 170,000 acres? If you’re going to consider whether you should buy U.S. Lime (USLM) you ask: 1) Do I want to be in the lime business? 2) Is the market cap a good price for all these deposits? If you’re going to consider whether you should buy Vertu Motors you ask: 1) Do I want to be in the car dealership business? 2) Is the market cap a good price for these dealerships?
In those cases, a “value” price could be one times tangible book value or three times tangible book value. You just appraise the timberland, appraise the lime deposits, appraise the dealerships and ask if you’d buy the whole company on those terms. That’s what I always did before I started reading hundreds of books about investing. And many value investing books do say that’s the basic idea of what you should be doing. But, then they drift off to talking about more generic quantitative approaches and less about common sense.
The closest I came to explaining the problem caused by learning too much about value investing was when I talked about how not buying DreamWorks Animation was my biggest mistake of omission. It wasn’t that DreamWorks Animation – which I could have bought around $17 a share and was later acquired for $41 a share – was some sort of home run. The reason I say that was my worst mistake of omission is because the only reason I passed on that stock is because I had read too many value investing books, thought too much about the right multiples for a stock, wrote about value investing, talked with other value investors, etc. The free cash flow yield and the P/E and the book value of a movie studio – especially a young studio like DreamWorks Animation – is irrelevant. I knew that. I’d never use any of those figures to value the entire business. And yet I allowed myself to look at things like book value when considering the stock. I allowed myself to think of the stock as a stock instead of thinking of the stock as a business with a certain market cap. If I was a billionaire and had been offered 100% of DreamWorks Animation at the equivalent price of $17 a share – I would have bought the whole studio right then and there. So, it’s my worst mistake in terms of process rather than outcome. It’s just idiotic not to buy a stock when you’d buy the whole business at that price. And it’s the kind of idiocy you can only get from a book. A younger, less well-read me would have bought DreamWorks with no hesitation. Whether or not that one outcome would’ve been good isn’t the point. The point is that from a process perspective, passing on DreamWorks was just philosophically wrong. There should never be cases where you’d buy the business but pass on the stock. But, if you get used to thinking in terms of certain multiples, you can convince yourself to do something as dumb as that.