“Searching for companies is like looking for grubs under rocks: if you turn over 10 rocks you’ll likely find one grub; if you turn over 20 rocks you’ll find two.”
– Peter Lynch
“Somebody asked how to beat Bobby Fischer; you play him any game except chess. And so I don’t play Bobby Fischer at chess.”
– Warren Buffett
Discussions about sourcing investment ideas inevitably fall back to the tired clichés of “fishing where the fish are.” Instead, we find the quotes above to be more instructive in highlighting that finding investments that can outperform is:
- A lot of work and is largely a function of disciplined repetition of a defined process, and
- About choosing to participate in parts of the marketplace where you have better odds of success.
The beginning of the sourcing process starts with your underlying philosophy regarding the stock market. There are 2 fundamental questions you must first answer for yourself:
First – Is the Market efficient or not?
Second – Are you pursuing a value strategy or a momentum strategy?
First – Is the Market efficient or not?
What do we mean by market efficiency? In the 1960s, economists at the University of Chicago articulated a hypothesis (the efficient market hypothesis or “EMH”) that investors are rational, and that the stock markets were efficient – generally meaning that the current price for a given stock reflects all available information and, as a result, that no investor in the markets will consistently be able to achieve above-average returns, regardless of their investment strategy, over a lengthy period of time. Obviously in any given year, 50% of managers will have above average performance and 50% will be below average.
For most of the investment industry, EMH has largely been adopted as fact. Practitioners of this view structure portfolios by looking at a wide-range of asset classes, analyzing their historical returns and volatility, quantifying the correlation of each asset class to another, and then mathematically seeking to optimize a portfolio through a “mean-variance optimization” (MVO). MVO designs a portfolio that tries to create the largest possible return by blending the right amount of assets given historical volatility and correlation for an investor’s desired level of risk (using volatility as a proxy for risk).
Our view is that while markets are efficient most of the time, there are areas where / times when they become inefficient. As well, we disagree with EMH proponents in describing risk as volatility, instead we define risk as permanent capital loss. At the risk of being overly technical, we are highly skeptical that modeling volatility by assuming a normal statistical distribution (a bell curve) even begins to approximate the reality of how risk behaves in the capital markets. As humans, market participants are not always rational, and are prone to spells of greed (2000, 2007) and fear (1929, 2008) that cannot be explained by EMH.
What we saw in the recent financial crisis was that when volatility increased, all assets became highly correlated (investors sold all stocks and bonds simultaneously, without differentiating between high quality and low quality). What drove permanent loss of capital was the nature of the investment opportunity, capital structure, and initial valuation paid – so if you paid too much for a share of an over-levered mortgage lender, you lost money, whereas if the price of your Berkshire Hathaway shares fell 50%, then regained their prior level, you merely experienced volatility.
Investment risk is similar to the underwriting analysis that a bank does when determining who to give a mortgage to. In that scenario, the banker would define risk as the potential loss of initial capital given the credit quality of the borrower (i.e. will the bank get its principal back, let alone the appropriate interest rate for the risk incurred?).
Finally, there is substantial research to support that there are inefficiencies in the marketplace that certain investors can take advantage of to achieve above-average returns consistently (See ‘The Superinvestors of Graham-and-Doddsville’).
Second – Are you pursuing a value strategy or a momentum strategy?
After determining if markets are efficient or not, you have to answer the question of ‘Where do profit making opportunities fall’ or to connect to our initial quote, where is Bobby Fisher not playing chess? There are generally two basic strategies that are able to generate outperformance consistently.
‘Value’ or buying stocks that are unloved or cheap, and ‘Momentum’, or buying what has been performing well most recently. Notice that we did not highlight “growth.” While many growth stocks have high momentum, in a momentum strategy, the important approach is to invest in names where the price movement has recently been favorable. These are the only two strategies where the sources of these opportunities are persistent over time (and have been documented extensively in academia).
Third – What is your ‘edge?’
Upon choosing a strategy to invest by, you have to be able to articulate your ‘Edge’ – or ‘how is your investment process able to deliver above average results consistently over time’?
As Bill Miller of Legg Mason has observed, there are three basic categories of edge in the market: informational, behavioral and analytical.
- Informational – You have better/more information than the market regarding the investment
- Example – You speak with several hundred private equipment rental companies to get a sense for industry trends relevant to a public competitor (e.g., United Rentals)
- Pros – Higher probability of success as you know something that others don’t
- Cons – Can be expensive and / or time consuming to acquire. Pushed too far, and it can run into the realm of insider trading
- Behavioral – You have the ability to behave in a different manner than other investors
- Example – Funds with long-term capital and a long-term time horizon were able to buy General Growth Properties shares during the Credit Crisis at $0.33 (now $25+); Many funds were unable to stomach the volatility or headline risk of holding shares that had fallen from $60 and might fall further
- Pros – Helps drive non-correlated performance to the market
- Cons – You may look different (i.e., wrong) for long periods of time
- Analytical – Your analysis is better / more thorough than the rest of the market
- Example – ASCMA reports negative earnings the faster it grows due to an accounting quirk; Investors using only stock screens see unattractive metrics
- Pros – Differentiated from other participants
- Cons – Extremely challenging and time-consuming to do; difficult to manage in a portfolio with a large number of positions (30+)
Where to fish / where are the grubs?
Once the investor has determined their approach (value or momentum) and their edge, there is still the matter of finding the actual investments. Here is how we think about the process:
Globally there are ~16,000 public companies, with ~11,000 in the US. Within those 11,000, it is important to define your circle of competence – industries and types of businesses you can understand thoroughly.
Now that we’ve marked the boundaries of the proverbial fishing pond – within the pond’s waters are four areas where we believe the fish will be found. We call these areas ‘opportunity types’ and they include:
- Strategic Transitions
- Spin-outs – a large company distributes ownership of a smaller subsidiary to its existing holders (e.g., Kraft / Mondelez in 2012)
- Activists – a public shareholder advocates for strategic change
- Management transition – PWC estimates 15% of public CEOs replaced annually
- Out of Favor Grower
- Stocks become cheaper as their growth rate slows due to maturity and / or as Wall Street expectations around growth change (e.g., Berkshire Hathaway, IBM, or Microsoft)
- Cyclical Businesses
- Cyclical businesses see their valuations boom / bust as economic cycles progress and investors become fearful or greedy (e.g., United Rentals or U.S. Steel)
- Businesses are cheap due to other, company-specific circumstances which make it difficult for the market to value the stock appropriately
- Often involves litigation, mergers, restructurings (e.g., BP with Gulf of Mexico spill)
So how does this look in all practice?
The first step in implementing this is the actual narrowing of the list of potential companies. This ‘top of the funnel’ consists of a few core activities:
- Watch list – a database of companies we know quite well
- Comparable valuation databases by industry (e.g., we know BP, so Exxon & Chevron are comps)
- Corporate action databases (i.e., companies that are to be spun-off, bought, etc.)
- Analysis of portfolio holdings of other like-minded investors
- Quantitative screens (which stocks appear undervalued based solely on quantitative metrics?)
- In-depth reading of financial press
- On-going research / conversations with key contacts across our sectors of focus
These activities help us generate a list of possible investments that may be worthy of further exploration. Next we begin the process of further analysis. The tension to be managed at this stage is to put enough time into the initial analysis to not prematurely rule something out, but also to not invest too much time into an idea that ultimately is not worth pursuing further. In some cases, a quick review of the situation is quick to make a determination that something does not make sense.
Ideas that warrant additional consideration then pass through our full investment ‘underwriting’ process. Our underwriting process is structured to drive a deep understanding of the economics of the business, return profile of the company/industry, and the opportunity for investment. This process culminates in a lengthy 20+ page written analysis of the business, industry, opportunity, risks and return potential for each opportunity.
Once the write-up is complete, the idea will flow through our Devil’s Advocate process in order to make an investment decision.
My experience with fishing began as a young boy, when my grandfather would bring us along with him down to the lake. His decades of experience, like any “professional” guide, drastically improved my odds of catching a fish. As time passed, my interest in fishing has waned, largely because there are times when, guide or not, the fish simply aren’t biting.
With 800-900 potential investments to look at per year, we find investing to be much more engaging than fishing, as every day that the market is open there is a new, unique opportunity to analyze.