Value Investing Strategy and Unlisted Securities - Part 1
|Jan 22, 2013|
Note: What follows is the first entry in a multi-part essay on my basic investment philosophy. If you're here mostly for individual stock commentary, let me save you some time by telling you to come back next time you see a post with a ticker in the title. As always, thanks for reading!
I have come to believe there are only two basic strategies for succeeding in long-term value investing, and a third strategy that is a combination of the two. By "long-term value investing" I mean attempting to buy companies for significantly less than their intrinsic value, then holding until the market recognizes this value or until it becomes apparent that actual intrinsic value is far less than the investor's original estimation.
Strategy One: I'll refer to this strategy as "Quality Compounding." The idea is to buy excellent companies at a fair price and let compounding work for you. The best-known advocate of this strategy is one Warren Buffett, who has created billions in value for himself and his shareholders by buying excellent companies and then simply letting them run. A truly excellent business has characteristics like high gross and operating margins, sustainable pricing power, high returns on capital, little or no need for financial leverage and the ability to retain and reinvest earnings at high rates.
For example, let's imagine a fictional "Widgets 'R Us Company" that produces a variety of specialized industrial components. "WRU" is known for the high quality and reliability of its products and so they command premium prices. These products are also essential components that must be replaced regularly for factories and facilities to function, so WRU enjoys the ability to raise prices at least as quickly as inflation. WRU's efficient operations and proximity to customers make it the low-cost producer and allow it to produce a return on equity of 20% without using any debt. Furthermore, let's assume WRU's small size and penchant for innovation will allow it to maintain this 20% return on equity for many years to come while retaining all profits.
Clearly, this fictional company is exceptional. How many companies possess all these characteristics at once? Companies that possess at least some of these characteristics are often identified as having a "moat," a set of unique properties that (much like a castle's water feature) will allow them to fend off competition and continue to reap substantial excess profits. True economic moats are rare, and investors have a tendency to see them where they aren't actually present. Many once-dominant companies have seen their empires crumble. Investors should be cautious when assessing the presence of a moat, remembering perceived moats have a distressing tendency to evaporate nearly overnight. (Although in a way, every profitable company has at least a small moat. Every dollar of profit a company makes is a dollar another company is not making. A business's sheer existence provides some momentum.)
Back to WRU. If the company truly does have a moat and can maintain its return on equity over the long run, returns for shareholders will be exceptional. Let's say WRU has a book value of $100 million. At a return on equity of 20%, WRU will earn $20 million this year. Let's also assume the market recognizes WRU's exceptional prospects and currently values WRU at 5 times book value, or 25 times forward earnings.
If WRU can maintain a 20% return on equity while retaining all earnings for the next two decades, book value will grow to $3,834 million. At this point, WRU's market valuation will depend on the market's assessment of its future prospects. If WRU seems likely to maintain all the original characteristics that lead to its success, the market may award a valuation similar to the original of 5.0 times book value. If on the other hand WRU's prospects now seem more limited, perhaps the market will value the company at only 2.0 times book value. The chart below illustrates various valuation multiples and the 20 year compounded returns for each scenario.
Clearly, investors will do spectacularly if the market's perception and valuation of WRU is unchanged after twenty years. On the other hand, investors will still do impressively well if the market is only willing to pay twice book value in 20 years, a 60% reduction from the present valuation. The lesson is this: long-term investment returns are driven primarily by business performance, not by market opinion. This is Buffett's famous "the market is a short-term voting machine, long-term weighing machine" analogy. And it's not just folk wisdom, it's math.
Another important observation pertains to WRU's initial valuation. At 5 times book value and 25 times forward earnings, many "value" investors would not give WRU a second glance. However, in WRU's case, 25 times forward earnings was actually far too cheap! Even if WRU's valuation declines to 2.0 times book value over the twenty years, an investor at the beginning could pay 57 times forward earnings and still earn a 10% compounded annual return.
Could successful investing really be this simple? Identify an excellent company, pay almost any price and enjoy eye-popping returns over the next several decades? The answer, of course, is no. Part of the problem is the difficulty of identifying ex-ante which companies will be capable of earning a high return on equity and reinvesting these profits at high rates over the long run. Companies enjoying high returns on equity in the present have a sad tendency to experience mean reversion as competitors enter the fray or as customer needs and tastes change or as rising input prices cannot be passed on to customers. In short, moats tend to be temporary and illusory.
Another problem is the tendency of companies to run short of reinvestment opportunities with size. As companies near the end of their high growth phases, they tend to behave either wisely or stupidly. Wisely often means paying dividends, making prudent share repurchases or small, accretive acquisitions that add pricing power and growth potential. Stupidly often means engaging in reckless, wildly optimistic mergers, attempting to enter new lines of business where management has no expertise or advantage or simply engaging in empire building. (For an example of all three, see Hewlett-Packard.)
Yet another issue is the fact that companies displaying all of these qualities are exceedingly rare, and the best are unlikely to ever go public in the first place. As the owner of an exceptional business, why would you ever sell a portion to the public if your returns from other investments are unlikely to outperform the shares you are selling? And on the other hand, if you are a CEO of a large company that has identified a smaller company with all these characteristics, why would you not buy the smaller company outright and reap all the rewards?
So then, how does one go about finding these rare jewels? Very carefully, and with a skeptical eye. The qualities of a true compounding champion have been explained far better than I can by people much brighter than I am, so I'll refer you to the writings of investors like Warren Buffett or Murray Stahl of Horizon Kinetics for a the broad view.
I look at history. I like to see a long history of increasing revenues and profits. But not profit at any cost; I want to see growth in revenues and profits at least equaling and preferably exceeding growth in assets and equity. Declining turnover indicates declining profitability and declining return on equity. And, I want to see management substantially invested in the company, their own fortunes riding on the company's successes. I think investors substantially underestimate the effects of principal-agent conflicts. I don't want to see management betting the firm in hopes of a big year-end bonus, but nor do I want to see management lounging around, content to collect fat paychecks while the company languishes. Knowing the management's net worth is substantially determined by the company's net worth eases my mind. Lastly, I want to see some structural advantage that greatly enhances a company's profitability and is highly unlikely to go away. Like the Jones Act for shipbuilding companies like Conrad Industries. Or the sheer impossibility of building another major rail line in the US for railroad companies. Engrained structural advantages, whether the result of law, geography or human nature are a great help in achieving sustainable excess profits.
All this discussion leads to the question: are there any unlisted companies that embody all these qualities? I'm not sure, but I have written about multiple companies that embody many if not most of them: Computer Services Inc., Armanino Foods of Distiction Inc., AutoInfo. The OTC market operator itself, OTC Markets Group looks promising and has been written up by other bloggers.
To find other unlisted securities that exhibit the qualities of an excellent business, I would start by thinking of business models that are resistant to competition and price wars and go from there. What about smaller banks that exhibit healthy ROEs, conservative lending practices, growing deposit bases and a willingness to make smart acquisitions? Or small software companies earning large margins with low client turnover? Even among cyclical businesses there are some manufacturers that consistently manager to profit handsomely during upswings and buy up distressed competitors at the cycle's nadir. And of course there are numerous, numerous unlisted companies controlled by insiders with every motivation to increase their company's value.The advantage to finding these companies now, while they are small, is the possibility of enjoying years and years of compounded growth before any of these companies is large enough to be included in some sort of market index or even catch a mutual fund manager's eye.
But of course, if you're more Benjamin Graham and less Warren Buffett, I'll have more soon on another investing style: Asset-Based/Low Expectations investing.
If you have thoughts to share on the "Quality Compounding" (or whatever you may call it) style of investing, please feel free to share them in the comments or drop me a line at firstname.lastname@example.org
Disclosure: I own shares of Conrad Industries, Computer Services, Inc. and AutoInfo.