In The Intelligent Investor, Benjamin Graham famously wrote “an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”. Why then have so many investors deviated from these wise words by the father of value investing in exchange for instant gratification?
With software fundamentally changing industries, venture capitalists being forced to pay outrageous valuations just to get in on the action, workforce talent moving into high-paying technology companies, and capital in the public markets being reallocated towards growth, value investors have struggled mightily. Some, either threatened by or envious of their peers’ returns, have abandoned the sound concepts of value investing and fallen prey to temptation. “The value investing of yesterday is dead,” they claim as they jump ship. No longer do they want to hit singles and doubles consistently. With greed and impatience as their fuel, they are going for the home runs.
These investors fail to realize that periods of underperformance are the key to successful value investing. In fact, Seth Klarman has called underperformance the price investors pay for longer-term outperformance. The key is to remain disciplined while underperforming, and wait for the storm to pass. After all, while volatile in the short-term, the stock market is efficient in the long-term. In this essay, I attempt to humbly reintroduce investors to the “great companies at good prices” subset of value investing, which seems to have been forgotten, and apply it to the current market.
Discussion on Moats:
Charles Darwin’s theory of evolution states that the species which survive are the ones that are most adaptive to change. This very same law of nature governs capitalism. Capitalism allows for emerging technologies to disrupt mundane industries, and nimble start-ups to replace bureaucratic corporations. It is only the companies that are adaptive to this change which survive. These companies are able to adapt to change either because 1) they have such durable competitive advantages – or “moats around the castle” – that they are able to remain the exact same or 2) as core business growth slows, they begin throwing sharks and gators into their moat to further strengthen their competitive position. When analyzing moats, many investors utilize frameworks such as Michael Porter’s five (or six) forces model. However, companies that survive and continue to grow amongst increased change beg the question – “ is adaptability the final force which we missed?” Perhaps it is. Perhaps we should also credit Phillip Fisher for the second question of his renowned scuttlebutt strategy: “Does the management team have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?”
Moats in Technology:
These moats can be formed in technology, especially with “software eating the world” (credit for this phrase goes to Marc Andreessen). Buffett never claimed that moats couldn’t exist in technology; rather, his hesitation from investing in technology stemmed from the fact that “economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise”. The intrinsic value of any business is the sum of its future cash flows discounted by an appropriate rate; Buffett is simply saying that in a constantly changing industry it is very difficult to predict the winners, and their future cash flows. Regardless, Berkshire Hathaway recently invested in Apple Inc.
Why? Perhaps it is because Apple has been able to build a fortress-like business franchise even while operating within the rapidly changing technology sector. In his 1991 letter to shareholders, Warren Buffett humbly accepted that he feels no guilt for missing out on investment opportunities that require foresight into high-technology such as Apple. At that time Apple was a company whose success was reliant on the constant innovation of products superior to their competitors. Now, 25 years later, Apple is a much different investment.
Apple is now a cash cow due to its ecosystem with strong mental models at work; network effects (iOS), economies of scale, intellectual property and tremendous brand strength through social proof and positive advertising. One can assume that Apple will maintain their leading 40% share of the smartphone market by continuing to successfully release new iterations of its core products with minimal upgrades. In his 1991 letter cited earlier, Buffett also defines a “franchise” (as opposed to “a business”) as providing a product or service that is 1) desired or needed; 2) is thought of by its customers to have no close substitute; and 3) is not subject to price regulation; arguably, Apple checks these boxes. Buffett continues by stating that this company will demonstrate these conditions through their ability to price their product/service aggressively and earn such high rates of return on capital that even mismanagement cannot ruin them; check again!
While on the topic of franchises earning high rates of return, it is important to highlight the Fortune study cited in Buffett’s 1987 letter: out of the 500 largest industrial and 500 largest service businesses analyzed, only 25 averaged a return on equity of over 20% with no year below 15% for the decade prior to the study. According to Buffett, these companies were also stock market superstars (during the decade, 24 of 25 companies outperformed the S&P). He goes on to state that these companies achieved their stellar returns while employing minimal leverage and offering rather mundane products/services in “much the same manner as they did ten years ago”.
Some may believe that the key to investment success is to identify the companies that will begin to achieve these outstanding results for the next decade. I am even less certain about my ability to identify these companies that may dominate in the future than Buffett was in 1987 – even if they do not involve esoteric inventions, high-technology, or brilliant merchandising. While history may not be the ideal indicator of the future, it is the best one we have. And so, if a company has achieved stellar results over the past decade due to some distinct competitive advantage, it does not seem far-fetched to assume that the next ten years will look quite similar. And, if Mr. Market’s uncertainty regarding the ability for future growth temporarily depresses the price of this particular company, it makes for a very attractive purchase price to a value investor. Of course, it is up to the investor to analyze whether a company’s competitive advantage is durable enough to allow for similar returns going forward (this requires taking a step back from financials as outstanding quantitative material is the result of the qualitative strengths in a business). Caveat Emptor.
Is the company’s core competitive position still so strong that they may achieve stellar returns for many decades to come, and why? Is the core business finally being threatened yet the company will still thrive for the next decade because of proactive actions taken to adapt to this inevitable change by widening its moat? Or none of the above – has the company’s reign come to an end? These are the questions that a rational investor must ask. Of course, due to the rate of technological change, the probability that the future will look like the past, even for wonderful companies, is much higher for those operating outside of technology.
While smartphones may not be as mundane as industrial equipment, neither iPhones, Macs, or the App Store remain the sexiest technological innovation in today’s rapidly changing world. As stated before, Apple has become a consumer franchise that releases annual products with minimal changes compared to their prior models, and yet consumers remain loyal. Furthermore, if a new paradigm such as virtual reality begins to take off, Apple can choose between acquiring a leading player or copying successful products rather than spending on research and development themselves. Therefore, chances are that the next decade for Apple will look similar to the last decade.
The numbers validate the assertion that Apple is no longer a risky, high-technology play. After decades of significant fluctuations in their return on equity due to product cycles of new innovations, the decade of 2005-2015 saw Apple average a ROE of around 33% without a single year below 20% (as we all know, from 2005-2015 Apple was a stock market superstar and significantly outperformed major indexes). It was not until after these outstanding financial results labeled Apple as a mature, valuable “franchise” and shares somehow still fell to a depressed LTM EV/EBITDA multiple range of 6-10x that Berkshire Hathaway jumped in headfirst. At that valuation, all possible growth came free (whether from emerging markets, new product offerings, etc.).
Note – Apple’s focus on building out a complete ecosystem (Mac, iPhone, iPad, Apple TV, Apple Watch, Apple Music, Beats, etc.) proves that they are exactly the type of adaptive company that we described earlier. Although hardware sales are declining, Apple is expected to earn recurring revenue from its services business equivalent to that of a Fortune 100 company by 2017. Unsatisfied with their initial, vulnerable competitive-advantage of sexy technology products, Apple decided to throw sharks and gators into the water and further strengthen their castle’s defense. Before moving on from Apple, it is important to bring light to the major risk in this investment (which their ecosystem strategy should mitigate): the risk that some smartphone product which consumers deem superior begins to compete with Apple, or some new technology replaces smartphones in general.
I believe that Alphabet fits the same mold of technology companies with a defensive market position that has been further strengthened through adaptive processes. One does not need to understand technology to understand the value of Google’s core search engine. Simply ask yourself how many times you and your close friends use Google versus other search engines. In fact, I urge you to count the total amount of times that you use Google.com this coming week. The number will shock you. This was, and remains, Alphabet’s initial moat.
While the barriers to entry for a start-up to replace Google as the go-to search engine are extremely high, the very nature of capitalism described earlier puts Google at risk. So, the company has branched out and built an ecosystem similar to Apple. Besides owning Youtube and their dominant advertising business, the company’s Android system operates in a near duopoly with Apple’s iOS and has many of the same mental models at work. Furthermore, from 2003-2013 Google averaged a return on equity slightly above 20% without a single year below 16%, and it was understandably a stock market superstar. If one was to invest in this company after these results, and once the stock was trading at a LTM EV/EBITDA multiple of 9-10x in early 2013, their investment would have approximately doubled by now. And how did I confirm this you might ask? I “Googled” it.
A curious reader may ask why I left out such pertinent players as Amazon and Facebook from my discussion of defensive technology companies that continue to adapt. Amazon first widened its moat by transforming from the leading online bookstore to the leading online retailer in general. Amazon then continued to adapt by expanding into cloud services, consumer electronics, digital video streaming, grocery deliveries, and more all while continuing to build out its impressive distribution infrastructure. Meanwhile, Facebook leveraged its competitive position as the world’s most popular social networking site to add valuable assets to its arsenal and gain more presence in mobile and emerging markets (WhatsApp, Instagram, Oculus VR, etc.). The company even plans on bringing internet access to the entire world in their quest to get every human online – and presumably on Facebook as well (lucky guess?). So why did I leave them out? It is reflected in their financials. Unlike the stable decade of financials for Google and Apple, both Amazon and Facebook have had wildly fluctuating returns on equity during their public lives.
Furthermore, in my investment lifetime, these two companies have always traded at premium multiples. And now my extremely engrossed readers (I admit that perhaps I am being too optimistic by pluralizing readers) might use my own statement from earlier against me and exclaim, “The value of a company is the present value of its future cash flows discounted by an appropriate rate… therefore, high trading multiples do not necessarily reflect that a company is overvalued!” I agree. However, due to their fluctuating past financials and software focus, I am unable to predict the future cash flows of these two companies. Unfortunately, trading multiples are my only proxy.
Moats Outside of Technology:
Moats are easiest to analyze, value, and maintain outside of technology. Let us take Coca-Cola for example. Buffett invested in Coca-Cola between 1988 and 1991, during a period of increased globalization. Coca-Cola already had a durable competitive advantage due to its branding, market leading position, and economies of scale; future success was simply a function of how much more syrup it could sell to bottlers as the world population grew and as it entered new geographies. In his 1993 shareholder letter, Buffett explained that “though the $40 invested in 1919 in one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca-Cola stock would have grown to $25,000 by yearend 1993”. This company is the perfect example of a franchise whose future continues to look similar to the past, albeit at slower growth rates, with minimal risk for technological disruption. In fact, even Buffett’s rather “late” investment in Coca-Cola has grown around 16x over the last 28 or so years when accounting for dividends and two of the most severe market crashes of all time.
Much like Google and Apple, Coca-Cola adapted to changing environments. Coca-Cola adapted by creating new soft-drink product lines (i.e. Fanta & Sprite) and new Coca-Cola flavors/types (i.e. cherry), acquiring other beverage manufacturers (i.e. Minute Maid), focusing on health and fitness related headwinds (i.e. Dasani, Powerade, Diet/Zero), and partnering with energy drinks (Monster). One could say that Coca-Cola developed the consumer-goods equivalent of an ecosystem – a complete, non-alcoholic product offering. Meanwhile, Coca-Cola’s main competitor, PepsiCo, which has maintained similarly wonderful returns on equity during its public life, has widened its moat by expanding into the snack business.
The issue is that this information is common knowledge. With more capital in the markets than ever before, more analysts following these easy-to-value companies, and more quant models programmed to identify stocks with specific characteristics (wonderful ROE and margins for over a decade), these companies will continue to trade at premium valuations compared to their intrinsic value, depressing future returns. Due to stable future growth expectations and at times even a solid dividend yield, inordinate selling is unlikely to ever occur; therefore, these stocks will most likely never trade at attractive prices until some secular decline forces them to rerate, and justifiably so.
Many also argue that the fortress businesses of Buffett’s day are under siege, proving that these secular declines may be coming sooner than later; American Express, MasterCard, & Visa are being threatened by the emergence of Bitcoin; Geico is facing the troubling reality of a future with autonomous vehicles, decreasing the need for auto insurance; Walmart is engaged in a resource consuming, no-holds-barred contest with Amazon. It is an investor’s prerogative to decide whether or not these threats will fundamentally affect these companies’ economics during his/her expected holding period.
For illustrative purposes, let us assume that many of these mature moats will not present attractive returns going forward; where then should value investors allocate capital, outside of technology? Simple. They should invest in less mature companies with similarly wonderful characteristics (moats) whose stocks have been driven down to good prices due to irrational investor sentiment. While Wall Street exuberance coupled with computer-driven investing can inflate the price of a stock rather quickly, Wall Street apathy coupled with computer-driven investing can depress stock prices at an even more rapid rate.
Of course, a sharp decline in share price does not justify a great value investment candidate on its own (even for a wonderful company); as stated before, it is important to identify variant perception. Have things fundamentally changed for the company being analyzed or is the market overreacting? This is the question that must be answered.
When identifying these situations, it is my personal preference to focus on businesses that I am familiar with and can understand; after all, Benjamin Graham, did say that “investing is most intelligent when it is most businesslike”. Purchasing common stock in a public corporation makes me their part owner, and there is no rationale behind owning any portion of a company that I cannot appreciate fully. In fact, I have little interest purchasing stock in a company whose products I cannot analyze as a customer and whose economics I cannot understand as an owner; in my humble opinion, doing so would be classified as pure speculation; there is also no way I can beat industry experts at their own game. To further simplify the increasingly difficult task of picking stocks, I heed the great Peter Lynch’s advice and attempt to focus on companies whose product a child can illustrate with a crayon.
Take Chipotle for example. Chipotle is a truly wonderful franchise that was once a Wall Street darling before its stock was driven down close to 50% after an E. coli outbreak landed 21 customers in the hospital. Chipotle originally became a household name and hot stock by satisfying growing consumer preference for healthy offerings, fast casual dining, & customization. As a recent college graduate, I am part of the demographic that Chipotle appeals most to. As a customer, I can assure you that while analysts might comp Chipotle to Mcdonalds, Yum! Brands, & even Panera, Chipotle’s product has no real competition when it comes to the combination of quality, taste, price, and experience. One of Warren Buffett’s favorite qualitative assessments of a company is to ask whether or not a well-capitalized competitor could harm it. With the strong brand and share of its customers’ mind that Chipotle enjoys, this is extremely unlikely.
Along with understanding Chipotle’s value as a customer, I can understand Chipotle’s economics as an owner; because of this, its future cash flows are much easier to predict, the company is much easier to value, and the high multiple it trades at is of little concern to me. Chipotle has some of the most impressive economics in food retail history, with 70% pre-tax returns on investment within a few years of new store openings. Furthermore, any conservative back-of-the-envelope DCF values Chipotle’s equity anywhere in the range of $600-$800 (resulting in a margin of safety anywhere between 30% and 50%); after all, the celebrated economist John Keynes famously said, “It is better to be roughly right than precisely wrong”.
And, as with all franchises, Chipotle’s success translates into the ability to compound its equity at very high rates. Since 2005, Chipotle has averaged a return on equity of approximately 20% without a single year below 10%. Even with the current issues it is facing, Chipotle’s LTM financials result in an ROE of above 11%. What is most impressive is how Chipotle has been able to achieve these results with minimal debt (no debt at all since 2012).
Understandably, Chipotle has had to increase marketing spend & implement costly new food safety procedures in order to bring customers back to its stores, which experienced negative sales growth for the first time in history earlier this year. Indubitably, this will, and already has, impacted their short-term economics. But, as history has shown with other food-borne illnesses at restaurant chains, customers will return. If customers returned to Jack in the Box after children were hospitalized in the early 1990s, they will definitely return to a brand known for food safety (I must acknowledge that investors on the other side of the table from me use the food safety image that Chipotle boasts as the reason customers feel betrayed and have boycotted the brand). Furthermore, if social media was the reason that news regarding the illnesses spread so far and quick, it will play the same role in gradually bringing customers back into Chipotle’s doors. After all, social proof is a powerful force.
After spending countless hours gaging customer traffic at multiple Chipotle restaurants in my neighboring cities, I can attest to the fact that the infamous Chipotle waiting lines have begun to return – slowly but surely. I am confident that most readers need not be reminded of the “slow but steady” adage from their childhoods. Let us all collectively pause and take a moment to appreciate the sweet smell of nostalgia in the air.
As another personal aside, I was recently able to broker my close friend’s first visit to Chipotle and experience her very first bite. Unfortunately, there is no Chipotle in the town she is from. Fortunately, she has now found a fast-casual meal that is affordable, addictive, and can be consumed in good conscience. And oh boy is she hooked. In the last two weeks since her first visit, she estimates that 70% of her meals have been Chipotle. If only we can get her to stop “accidentally” walking out of Chipotle with their Tabasco sauce in her take out bag. Cost controls, people. Cost controls.
Critics have called into question the response to these outbreaks by Chipotle’s management team. Many of these same individuals argue that when the going gets tough, concept founders should be replaced with experienced executives. Fair enough. Enter the mental model of a catalyst: activist investor William Ackman. As a 10% owner of this valuable asset, with his reputation on the line, and a history of value creation in food retail, it seems foolish to bet against his involvement.
Note – Identifying companies with high-quality management is an important aspect of value investing. However, because many high-profile activist investors target valuable franchises trading at discounts due to mismanagement, they can serve as white knights for value investors who follow the strategy discussed in this essay but unfortunately misjudge the quality of management. Sometimes, even the threat of an activist is enough to startle complacent but competent management teams. As Louis D. Brandeis, the former associate justice on the United States Supreme Court, wisely said, “Sunshine is said to be the best of disinfectants”.
Note – I cannot proceed in good conscience without referring interested readers to the following article, which includes an extremely intelligent debate by two investors with opposing views on Chipotle – Nick Mazing for the bears and Andrew Tseng for the bulls: https://sumzero.com/headlines/food_beverage_and_tobacco/CMG/322-chipotle-stock-safe-for-consumption. I would like to thank both individuals for the clarity their perspectives provided me during my due diligence process.
Structuring a Portfolio Around this Strategy:
After decades of experience investing in good businesses trading at great prices, Buffett came to the conclusion that investing in great businesses at good prices is the key to creating wealth while remaining sane. I see no need to deviate from this philosophy. And how do we define a “great business”? As one that is able to invest its capital at very high rates of return over an extended period of time due to some enduring competitive advantage. In his 1991 letter to shareholders, Buffett quotes a letter written by the distinguished economist John Maynard Keynes, “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence . . . One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence”. I concur.
Interestingly enough, an individual does not need to find many of these quality investments over a lifetime to accumulate wealth. In fact, Buffett has said that he could increase the future net worth of all MBA students if he provided them with one punch card consisting of 20 possible punches for their entire lifetime, with each financial decision they ever make using up a punch. With this constraint, each student would be much more objective and thorough when analyzing possible financial decisions – rather than emotional and brash. Buffett’s partner, Charlie Munger, also agrees with this notion; during a speech he gave to USC business school students in 1994, Charlie explained that the top ten insights of Buffett’s career resulted in the majority of Berkshire’s massive net worth.
So how can a fiduciary structure their portfolio around this philosophy? For starters, while Buffett and Munger may be satisfied with only one new idea per year, our capital base is much smaller and therefore our investable universe is much larger. Being market cap agnostic, it is plausible to assume that we can make at least four of these investments during a bear market and two during a bull market. After all, within this essay we have identified three companies that fit our framework within a two and a half year time frame. While Google’s returns since 2013 confirm that it was a wonderful investment, Apple and Chipotle have yet to prove us right; however, perhaps Berkshire Hathaway and Pershing Square’s respective involvements in these companies do confirm that they are valuable assets trading cheap. Somehow, during an all-time high market in the 21st century, Mr.Market undervalued the stock prices of arguably the three companies most recognized by consumers and followed by analysts; imagine just how many hidden gems there may be below the surface.
As we all know, patience is imperative in value investing. When opportunities are difficult to identify, many investors following the strategy discussed in this essay will chose to fill their portfolio with short-term, catalyst driven investments that are arguably market-neutral and maintain asymmetric risk-reward profiles: liquidations, spinoffs, arbitrage, etc. Other investors may view these special-situations as distractions and choose to sit on cash instead. When the market inevitably corrects, one crowd will sell out of their short-term positions in order to invest while the other will come out of their cash position; to each his own.
Because attractive investment opportunities may appear both randomly and briefly, it may be prudent for value investors following this strategy to sit down and identify/list 25-50 publicly traded companies that they believe have durable competitive advantages. That way, when and if the stocks of these companies fall meaningfully below their intrinsic value, an investor will be prepared to take action; of course, I must repeat that analyzing whether or not the decline in share price was justified is the responsibility of the investor – blindly investing in an asset previously deemed attractive is never a recipe for success. Why 25-50 companies? This is a rough estimate; I figure that out of the 4000 listed public stocks in the U.S., perhaps 400 (10%) lie within an investor’s circle of competence and 40 or so are truly quality assets.
Some claim that this strategy always involves investing in a great company when Mr. Market bakes in to the current price a very bleak view of the future, when, in reality, that future will come much later than expected – if ever. While this may be true for the most part, some of the companies identified by an investor may be reaching new highs and yet still be trading below their intrinsic value. Therein lies the value of a list – to help an investor be prepared at all times. Let us analyze Autozone in 2006 as an example.
Autozone, the largest DIY retailer of auto parts, is an advantaged company that performs well throughout any economic environment but performs especially well during a weak economy. During a recession, people hold on to their cars instead of renting/purchasing new ones, and fix them by themselves. Furthermore, the company’s behavior is best classified as cannibalistic because it eats away its float at an unprecedented rate. From 1996 until 2006, Autozone averaged an outstanding return on equity of approximately 75% with no year below 18%; in the same period, the company repurchased 50% of its shares outstanding. In late 2006, Autozone traded at an all-time high of $110 (LTM EV/EBITDA of 8.5x) with an intrinsic value between $200-$300; the company reached $272 by December 2010. Allan Mechum’s (Arlington Value) sound investment in Autozone around this time period resulted in a portfolio that outperformed during the 2008 recession.
As for holding periods, “time is the friend of a good business, and the enemy of a bad business”. In my humble opinion, an investor should only practice the methodology discussed in this essay if he/she is comfortable with maintaining at least a ten-year forward outlook. However, outlooks and holding periods do not have to match. In theory the holding period for a quality asset is a function of how long the company’s competitive advantage endures, whether or not the company adapts by expanding its moat, and whether liquidity is needed once a much more attractive opportunity appears.
In conclusion, investing in understandable, great businesses at good prices is a sound philosophy that has, and should continue to, compound investors’ wealth, even in today’s market.
I would like to thank each and every one of you for taking time out of your day to read this essay. I would also like to extend my deepest gratitude to Benjamin Graham, Warren Buffett, Charlie Munger, Peter Lynch, and Phillip Fisher, for it is the marriage of their investment philosophies that served as the foundation for this piece. My sincerest appreciation also goes out to Seth Klarman, William Ackman, Mohnish Pabrai, Joel Greenblatt, Eric Khrom, Allan Mecham, Nick Mazing, and Andrew Tseng, among others, whose original thoughts on investing have strongly influenced my perspective over the years.
Lastly, I would like to share my respect and admiration for Alex Bossert and Ryan Morris, both of whom have selflessly served as my mentors over the past year and played a transformative part early in my education as a value investor. I genuinely relish the opportunity to connect with my readers; please feel free to contact me at firstname.lastname@example.org with any thoughts, feedback, or questions.
Note – If serendipity somehow lands this essay in front of Mr. Warren Buffett, please know that me catching a flight out to Omaha can easily be arranged. How does dinner – on me – at Gorat’s Steak House sound? (Hey, you can’t knock me for trying…)