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Saying Goodbye to Benjamin Graham
Lessons from a decade of mistakes
The following is an updated version of a previously unpublished quarterly letter. It was deemed to be too honest regarding my evolution as an investor for clients’ consumption.
The Value Gene
My path to becoming a professional investor began the day a good friend of mine handed me a copy of The Intelligent Investor, Ben Graham’s seminal book on the philosophy of value investing. It turns out I was a value investor before I even knew what a value investor was. The idea of buying something for less than it was worth has always been appealing to me. While other teenagers were sleeping in and hanging out with friends on the weekends, I used to set up a booth to sell my baseball cards at the local mall. The average age of the other card dealers was probably 50 years old. And there I was, a seventeen-year-old trying to sell cards for more than I had bought them for. A lot of successful investors have a formative story like this. Famous real estate investor Sam Zell (right before he died) told a story on the Capital Allocators podcast about how he used to buy Playboy magazines for $.50 and then sell them to his friends for $3 an issue. Even my own grandfather had a story like that. When he was a kid, he used to show up at Yankee Stadium early to buy the best tickets at the field level. As he told the story, the Manhattan businessmen would typically show up to the games late when all of the best seats were long gone. My grandfather would then flip the seats he bought—at a markup—to the businessmen so he and his friends could watch the game in the bleachers for free. The “buy low, sell high” mentality that began with a side hustle in the Bronx eventually turned into a very successful career as a real estate developer.
All of the above stories involve a short-term arbitrage of sorts. By leveraging imperfect information or inefficient markets, there was a small profit to be made. When it comes to modern public stock markets, consistently making profits based on having better information has gotten much, much harder. In addition, inefficiencies get eliminated much faster in the internet age. When Ben Graham was in his prime, there were plenty of so-called “net-nets,” companies whose market valuation was less than their net current asset value. These days, given the fact that anyone can pull up a company’s financial statements in seconds—rather than having to wait for the company to mail them out—it is hard to find inefficiently priced securities with a large margin of safety simply based on the liquidation value of current assets. The world has changed and thus the entire value investing community has had to evolve.
Some firms develop an informational advantage by having access to data that is not available to everyone. That allows the firms to play the quarters and anticipate short-term price movements better than can most investors. So, there are still opportunities for short-term arbitrage if you have the ability to spend millions of dollars on data. The rest of us have to play a different game, namely taking advantage of other market participants’ desire for certainty or their myopic focus on next quarter’s results. In other words, think and act longer term and let the miracle of compounding work its magic in a tax-efficient manner. Put another way, buy a business that is getting more valuable every day at a modest discount to its intrinsic value and hold on for years. Simple, right?
Lessons and Learnings
The pivot away from physical asset-based valuation was the evolution that Ben Graham’s most famous student, Warren Buffett, went through, partially attributable to his partnership with Charlie Munger. Buffett learned that instead of trying to revive a struggling textile mill in New England (what Berkshire Hathaway originally was), he was more likely to be consistently successful buying shares of American Express and Coca-Cola and holding onto them for decades. When you read Buffett’s letters or listen to him and Charlie speak at the Berkshire annual meeting, the logic of what they have done to create so much value for their shareholders is inarguable. But, what trips people up, even those who subscribe to the Buffett-Munger ideology, in their pursuit of buying and holding the same stocks for years fits within a few behavioral buckets:
Too much focus on short-term concerns about how a company will fare in tough economic times. (What happens if there is a recession? Won’t I be able to buy the stock lower? What about what I just heard from a pundit on CNBC?)
An inability to hold the same companies for years because it is “boring.”
The fact that our somewhat linear minds just can’t quite grasp the power of compound interest.
The emotional pain associated with buying a stock that is up a lot, especially if you had passed on it at a much lower price. (Commonly known as anchoring.)
FOMO. When what you own ain’t going up and a certain class of stocks is (say, the Nasdaq 100), it is really hard not to pivot to invest in what is working.
The seductive thrill of finding a cheap stock that gets our contrarian juices flowing in the hope that we can make a good “trade.” (The stock market equivalent of selling $.50 Playboy magazines for $3.)
Of course, there are other decision-making tendencies that make it hard to emulate Buffett. But, it is the last one of these I want to focus on as it relates to my journey and to the topic of this letter: saying goodbye to Ben Graham. As mentioned above, I have the value bug. It was Graham’s work that really spoke to me. I didn’t grow up reading Buffett’s letters. In fact, what really attracted me was what is known today as deep value investing. In Cove Street parlance, that consists of investing in 3s and 4s on the Buffett-Graham scale: mediocre companies that trade at a very large discount to their (apparent) intrinsic value. These days, those aren’t Graham’s net-nets. Instead, they are businesses with no moat, limited pricing power, cyclical end markets and returns on capital that are either at or below their weighted average cost of capital (WACC). The deep value strategy often consists of buying these stocks when they are truly hated, and the market is implying that things will never get better. Then, if your contrarian premise is right, you sell these companies when they get to fair value. And then you move on to the next set of hated companies or industries. What could go wrong?
In my experience, a lot. I could write an entire article on why it is so hard to be consistently create value as a deep value investor but there are a few things I will highlight. First, is tax inefficiency. If you buy a stock hoping that it can be sold for 30% more in a year—and you are right—you are going to generate taxes for your taxable investors. And, depending on when you sell it, you may have to pay the higher short term capital gains rate. Over the long run, such taxes will detract meaningfully from the net returns to investors. The alternative, of course, is investing in business that can be held for years without any tax consequences.
The next is the turnover associated with such a strategy. If you have to sell each stock that eventually reaches intrinsic value—as opposed to holding them like you can with better businesses—you constantly have to find new ideas. That level of activity often comes at a cost in that a small team does not have the bandwidth to continue to perform maintenance diligence on existing ideas and turn over enough rocks to find compelling new ideas. Even a bigger team still has the issue of continually stepping into situations where the firm has no intellectual history. Many cheap stocks are cheap for a reason and having followed a company for five years gives you context for logical reasons a company is unlikely to be successful. However, if you are constantly stepping into new situations in which there is a fair amount of investor distaste or apathy, that lack of history with the company and management can lead to poor outcomes. In other words, you have to take so many swings that inevitably you run into a situation in which you are very wrong and suffer a severe impairment of capital. All you need is a few of those in a year to offset all of the good work your winners have done.
Lastly, and this is a big one for me, is the opportunity cost of time. There is a fair amount of work required before investing in any company, even something that is bought to be sold over the next two years. All of the conversations with management, expert network transcripts, and conference call notes populate the intellectual history a firm has with a company. If a diligence process is robust enough, it creates a large file that can conceptually be leveraged by other team members. The initial work also provides an incredible foundation to build off of. If that file pertains to a company that is getting more valuable over time—especially if it is run by a great management team—the return on the time spent can be quite high, even if the initial decision is to pass based on valuation. On the other hand, if that time is spent on a mediocre business that is depressed for what may or may not end up being a temporary reason, what you end up with is an intellectual dead end. Either you pass on the idea because the business is simply too awful to invest in, regardless of price; or, you invest with the intention to sell the business in short order. In both cases the time spent collecting information and getting to know management is inevitably going to be somewhat worthless at a certain point, even if you make money. There is likely to be limited ongoing value from that file.
What you learn when markets are in freefall is that the last thing you want to invest in is a below-average business. The ideal is to have created and continually updated files and models on the best businesses within your purview—and then proceed to break open the glass when the market psychology pendulum has swung from greed to fear. Doing so should be a consistent (but likely not predictable as it relates to timing) source of potential opportunity that easily overwhelms the return on spending resources on what is cheap and hated right now.
Evolution and Gratitude
When I was interviewing for the analyst role at Cove Street back in 2011, I pitched Jeff Bronchick a deep value stock that I will never forget. The company is named Sterling Infrastructure (formerly Sterling Construction) and it is still public—ticker STRL. The stock has actually done really well recently, but it took about a decade. Most money managers would have sold the stock long before the recent run—or would be out of business if they held a bunch of stocks with STRL’s performance. The company appears to have recently become more consistent with its margins and returns but when I pitched Jeff on it, the margins were all over the place and the returns on capital were below STRL’s WACC. While there are some very large and successful public construction contractors, when you start with a gross margin in the 10-15% range, there is a pretty small margin for error. As such, the stock traded well under book value and near tangible book—and that is what attracted me to it.
The reason this story is important is not based on what STRL was in 2011 or what it has become today. This example is emblematic of where I was as an investor when I got to Cove Street. I was unquestionably a Ben Graham devotee. Yes, I had gone to Omaha for the Berkshire meetings, but it would take many more years for me to appreciate the magnitude of the shift that Buffett made when he officially said goodbye to his former mentor and started focusing on better businesses.
What is absolute now is that in order for me to invest, I need to see distinct signs of internal momentum: a business that is performing well now and is getting more valuable over time. I wish I had gotten to this position without making so may mistakes. But, I am grateful for them. No more investing in Cinemark (Ticker: CNK) at $35 pre-COVID because the stock was cheap and we had a contrarian thesis that theaters were not in secular decline. No more investing in Tupperware (Ticker: TUP) at $65 because it had high returns in the past but for which further brick and mortar retail penetration in emerging markets would present a definitive secular headwind. No more investing in Qurate (Ticker: QRTEA) at $20 despite the fact that very few people under the age of 40 are actually ever going to watch TV to do their shopping. (I have already done a podcast on my absolutely terrible call on Lumen (Ticker: LUMN) so I won’t go into that one here.) And finally, no more buying value traps like Western Union (Ticker: WU) at $18 in the face of fierce competition and evidence of dwindling pricing power.
I mistakenly used to think that I could consistently outperform by taking the contrarian position that revenue growth going forward would not be negative-2 percent but actually positive-1 percent. I think the above examples would suggest that the base rate of success of stepping in front of a secular headwind because a stock is statistically cheap is not very high. In fact, all of the above mistakes would have been avoided if I had insisted on internal business momentum before investing.
So, with that, I am going to say thank you to Ben Graham for all of his wisdom and contributions to the value investing community. The margin of safety philosophy is likely to serve me well throughout my entire career. But, from here on out, if you look at a company in the portfolio, you better believe that my research indicates that the businesses are getting more valuable every day. While that does not guarantee investment success and mistakes will be made along the way, what it does is position the portfolio to benefit from the power of compounding. It should also limit both the frequency and severity of loss, at least relative to investing in companies with clear secular headwinds. I have been quoting Buffett’s first rule of investing—don’t lose money—for many years now. It just has taken more than a decade to fully understand the implications and the power of that rule.
Are there are mentors or ideas you should say goodbye to?