The Unconventional Investor

The unconventional investor details the cumulative knowledge I have acquired during my investing quest. These are lessons that I learned from value investing greats by reading books and watching speeches of theirs. Nothing below is a reinvention of the wheel — they have existed for centuries in books and tapes and have recently shaped my philosophy.

“Wrong does not cease to be wrong because the majority share in it.” – Leo Tolstoy

Every successful investor I have come across has, in one way, shape, or form, deviated from widely held investing beliefs.

The Value Investing Phase

My call to the world of finance began on a ride to California (summer after freshman year, 2012) with my brother where we listened to the audio version of Michael Lewis’s book, The Big Short. The first part of the audiobook discussed the story of a then neurology resident at Stanford, Michael Burry, who blogged about investing during his free time and attained an extraordinary investment record with his hedge fund, Scion Capital. He became well known only after successfully shorting the subprime housing bubble. I was captivated not only by his Subprime housing short but also by his equity investment record. I read everything I could about him online. I picked up Ben Graham’s The Intelligent Investor. Sophomore year of college began, and I switched my major from Electrical Engineering to Finance.

In August 2013, I began my junior year at the University of Arizona. I initially sought out to be a triple major in Finance, Accounting, and Economics – I wanted to learn and understand everything I possibly could about finance. I wanted to be just as good an accountant as the CPAs, just as good an economist as the economic experts on TV, and just as good a financial analyst as the Wall Street financial analysts. I soon realized that the Federal Reserve, despite having all realms of economic research and the brightest minds at their disposal, missed the sub-prime bubble. Alan Greenspan, Former Federal Reserve Chairman, is seen here writing off Michael Burry as ‘lucky’ despite the fact he detailed and consistently wrote about the bubble in his letters to investor(s) years in advance. President Bush with his cabinet of prestigious economists also missed the boat as well (case 1 and case 2). Ben Bernanke, Former Federal Reserve Chair as well also publicly stated that there was no housing bubble and when it became painfully obvious that there was one, significantly understated the severity of the ensuing chaos. I finally understood why Buffett says that any company with an economist has one employee too many. I learned that the only way to truly understand finance and economics is to: (1) think independently and, (2) always question the status-quo. The outlook of the status quo always assumes that the recent past resembles the future, but the future rarely, if ever, looks like the past. That view is efficiently priced into the market, and it only leaves downside if the view is wrong.

Cognitive Bias, Rationality, and Modern Finance and Economics

My Real Estate Professor in college told my class about a friend of his (Finance Professor as well) at a different institution who quit her tenured position around 2004 to become a realtor because they were making so much money at the time. In the quest to mathematize everything, economists assume that the market participants are ‘homo economicus’ or immaculately rational. Nobel Laureate and famed economist, Eugene Fama, does not believe bubbles exist – how does one predict a bubble when they do not even believe it exists?

Economic and Finance theories run on the assumption that people are rational which is where its deficiencies become apparent. People believe they are acting rationally; but are they truly acting rationally? the divergence between perception and reality is driven by emotions and/or false information. Emotions propel irrationality and are immeasurable. I’m no economic expert but the more I read, the more I realize that to learn economics, a primer in history is imperative. As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” Most events that occur in modern times have historical parallels – reading about prior economic events and the ensuing reaction is a great way to learn.

RISK

Volatility and Risk

The prevailing view in finance is that risk can be measured by a security’s volatility relative to an index, or better known as Beta (stocks). The Efficient Market Hypothesis (EMH) states that no one can outperform the market without taking additional risk to compensate for the additional returns. So, What is ‘risk’? Moreover, does one need to take more ‘risk’ to attain higher returns?

What is Risk?

Risk is the probability that an outcome will deviate from what one expects, and so any scenario with more than one potential outcome has some element of risk. The amount of uncertainty in a situation is what determines the “scope” of the risk in the situation, and the price paid for the security determines how much risk one is actually exposed to. For example, let’s assume that the unconventional investor is about to purchase a plot of land with two identical buildings on it, Building A and Building B. Let’s assume that an identical property down the street was sold last month for $300k, meaning that each building was worth $150k. So that means that each building in this property is potentially worth $150k. Let us assume that there is a catch with this property — let’s say that Building A was constructed last year and building B was constructed two centuries ago and so investors are afraid that it may fall apart and thus have priced the property as so. Let’s take a look at three price scenarios:

A. $250k

B. $200k

C. $150k

Remember, any scenario with more than one potential outcome has some element of risk but the actual risk taken depends on the price paid. The uncertainty and thus, the scope of risk in all three scenarios, is that Building B crumbles, and the investor loses anything he/she pays over $150k. The scope of risk is defined by any price above $150k and the actual risk that is taken is defined by the price paid for the property. If the investor pays Scenario A, the risk taken becomes $100k, in Scenario B, the risk taken becomes $50k, in Scenario C, the risk taken is $0, meaning no probability of loss. The investor that pays $150k takes no risk because if building B crumbles, he loses nothing and can still sell building A for $150k whereas if the building B stands, he stands to make a lot of money.

Another example could be Company A owns a 50% stake in Company B. Company B’s market value is $500 million. Company A’s market cap is only $250 million meaning that investors have ignored the value of Company A’s operating business. The same output above applies here — there is zero risk for an investor that pays $250 million or less for Company A. Risk is introduced at any price above $250 million.

Volatility is risk only in short-term because there is a high probability of capital loss from daily market fluctuations. To a day-trader, volatility is certainly indicative of risk but for the long-term investor, the amount of risk taken is determined by the price one pays for an asset — the lower the price, the less the risk. The definition of risk, in this case, depends on the investor’s time horizon. As a long term investor, my definition of risk is the probability of permant loss of capital.

Low-Risk Investments Produce Higher Returns

Another widely held belief is that low-risk investments produce low returns/high-risk investments produce higher returns and thus, one has to take more risk in order to boost returns — I believe this is false because ‘risk’ can be subjective. Take bonds, for example, a BBB rated bond may be viewed as riskier than AAA bond of the very same company (all else equal) to the general populace and the Rating Agencies. Say the BBB bond is backed by a building which most investors are skeptical of because of a widely publicized but erroneous rumor about the strength of its foundation. The unconventional investor looks and examines the building and sees no issue with it. He asserts that the BBB bond presents a low risk/high return opportunity. To the general populace, however, the bond presents a high-risk, high return opportunity. The opposite can also be true for a AAA bond – where it could turn out to be high risk, low returns, but the general populace views it as low risk, low returns – Mortgage Backed Securities from the Financial Crisis is a quintessential example of this.  The ‘risk’ part of the equation is inherently flawed since it is subjective. The unconventional investor should seek out investments with low risk, high return characteristics. 

WACC > ROIC – The Value Destroyer

A company is said to be ‘destroying value’ if its Weighted Average Cost of Capital (WACC) exceeds its Return On Invested Capital (ROIC). WACC comprises of the weighted average of a company’s Cost of Equity (COE) and Cost of Debt (COD). The cost of debt is a substitute of the interest payments (%) a company that chooses to sell bonds would pay — this makes sense. The cost of equity, however, is calculated by using, in some way, shape or form, the market value of equity. COE can be calculated via the dividend capitalization model or the Capital Asset Pricing Model. COE  presents a reflexive/circular relationship that should not exist — why would an active manager, who believes that market prices are wrong, incorporate the volatility of market prices or market prices in general into his calculation? In an assumption that a company trades below cash, is profitable, needs not to raise debt nor equity, but has a hypothetical cost of debt or equity that exceeds its ROIC, is the company destroying value? Would a private buyer say no to such a company? probably not. The hypothetical cost of debt does not matter unless the company needs to raise debt, and the cost of equity — defined by the fluctuation of market prices or market prices in general — is inherently flawed and does not make sense under the assumption that the investor in question repudiates the Efficient Market Hypothesis. 

Crowd Psychology & Risk

If a well-known fraudster attempts to borrow money from others, those that are aware of his/her past will avoid lending to him. What would have been fraud ceases to exist because everyone expected it and thus, avoided it. If no one knew about his past and they lent him money, they would have lost their money. The risk that should have existed in the first place is eliminated before it is incepted only if the masses initially realize, and choose not to take the risk. Conventional risks – those invented and mediated by academia (Finance/Economics) – rarely ever show up because everyone expects them to occur and this, in effect, eliminates or severely diminishes their impact. It is the ‘preposterous improbabilities’ – those that academia and the general populace ignore and write off as unlikely that tend to show up and no one is ever prepared for them. Investors should be concerned less about the risks that concern the masses and more about the improbabilities that sedate them. The riskiest securities are generally the securities that the masses believe to be the safest, and vice versa.

Margin of Safety Vs Margin of Error

What’s more important than a margin of safety is minimizing one’s margin of error. A low margin of error underpins the validity of one’s supposed ‘margin of safety.’  Minimizing the margin of error entails only entertaining companies with proven, consistent cash flows. An investor that forecasts 30% compounded growth for two decades exposes oneself to a high margin of error which renders the ‘margin of safety’ obsolete. If the growth comes out to 25%, the fair value deviation is significant; the potency of compounding works both ways. The point here is that one should avoid making long-term ‘high growth’ forecasts because they rarely ever turn out as one expects. See “what is ‘risk’?” above.

The ‘No Financial Modeling’ Approach

I stopped modeling my investment ideas because I lost touch with its meaning — I found myself adjusting the discount rate or even growth rate to justify my desired price. The psychological urge to make unintelligent assumptions becomes larger when you can toggle a model to justify a new valuation because you have done so much work on the company you do not want to skip out of buying the stock. The inherent positive bias that we, as humans, possess, makes financial model dependence a looming catastrophe. So I got to a point where I said to myself: ‘If I cannot justify a value without plugging numbers into a spreadsheet, the company is not worth my time.’ I stick to companies that are extremely easy to value with high cash flow certainty but are facing some temporary issue. These are rare, so I compensate for it with a concentrated portfolio.

The Concentrated Approach

A concentrated portfolio is beneficial because you can closely track the securities you own. Also, virtually every investor that I have come across that outperformed over the long run ran concentrated portfolios. Seth Klarman’s top 5 positions make up 58% of his reported portfolio according to Baupost’s latest 13-F. Berkshire Hathaway’s market value of investments its 2015 Letter to Shareholders was $112.3 Billion and yet, Berkshire’s top 5 positions comprised of 73% of the portfolio. I do not possess the prowess of Buffett or Klarman but I have had a hard time finding more than 10 good ideas at any given time and that is my justificiation for running a portfolio with <10 securities.

 

 

PJ Q&A

  1. Describe your investing strategy and portfolio organization. Where do you get your investing ideas from? What kind of checklist do you use when investing? Do you have a specific approach, structure, process that you use?

I look for companies with proven, consistent cash flows. I make exceptions for losses caused by non-cash expenses. A company that can generate and maintain consistent cash flow probably has a competitive advantage – my goal is to find that. I buy them when their cycles have turned, and the price is depressed relative to their normalized earnings power. Only after a company passes the quantitative cycle valuation and the consistent cash-flow test will I even consider opening the company’s 10-K. I make no attempt to forecast the operating or net margins of unprofitable companies. Competitive Advantages are not always necessary as long as the risk/reward scenario is compelling.

I also like companies that exhibit some sort of shareholder return – be it paying down debt, paying dividends, repurchasing shares or perhaps re-investing in growth. So net-nets that do not exhibit any cash return do not meet the value criteria for the portfolio

  1. What drew you to that specific strategy?

Michael Burry. I studied some of his older investment theses and realized that he stuck to cheap companies with proven, consistent cash flows at very cheap valuations. In his 2001 Q4 letter to investors, one of the stocks he owned fell to ¾ TTM FCF right after the 9/11 selling rout. He bought more of it and the company was bought out by a competitor at a 700% premium from its September 30th lows in Q4 2001 – less than three months later. Although value of that sort is nearly impossible to find in today’s market, it is quite obvious that buying cheap works.

  1. What books or other investors changed the way you think, inspired you, or mentored you? What is the most important lesson learned from them? What investors do you follow today?

Tobias Carlisle. Reading his book, Deep Value, in 2014 was eye-opening for me. It was the first book I read that detailed backtests on various investing strategies. After reading the book, I re-read Michael Burry’s letter to investors as well as his older investment theses and finally understood what he was doing. The Art of Short Selling by Kathryn Staley and Financial Shenanigans by Howard Schilit are also two of my other favorites. One does not need to short-sell to benefit from them, I have avoided an innumerable amount of investing landmines on the long side because of those two books.

I learned that the amount of safety embedded within an investment is not derived from the quality of the asset, but on the price paid for it. As is so often the case, market participants are willing to pay a premium for ‘quality’ and that is what inherently makes the ‘high-quality’ security risky. At the end of the day, the value of any asset is the present value of its future cash flow and not the quality of the asset. So the price paid for the ‘quality’ asset is more important than the ‘amount of quality’ embedded within it, IMO.

  1. How has your investing approach changed over the years?

I started out trading penny stocks, then speculating on larger cap stocks and then 100% Value approach after learning some hard speculative lessons. I am still evolving and finding various risks within my process. For example, I purchased shares of a company that provides shelter services to the employees of Crude Oil (to take advantage of the depressed crude oil-linked stocks) companies in Canada earlier this year. I decided to sell it because I no longer wanted my portfolio to be tied directly to a commodity. So that is one thing that has changed this year. I will buy the stock of a company that provides sells a commodity based services or product but also has another unrelated segment that will provide cash to the company while the commodity price is depressed. I cannot predict the price of any given commodity, so stocks that are fully dependent on commodity prices are excluded from my value criteria.

  1. Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?

I use Gurufocus – it is the best price per dollar spent out there. I recently went through a very broad screen of stocks in the U.K, USA, Australia and Canada with the only requirement being >$20 million market cap and came up with a list of stocks that I’d like to purchase at the right price. What makes this extremely efficient for me is that it shows you a 15-year financial history of the company. I can tell within 10 seconds if I am interested in looking further or not. I read many theses on SeekingAlpha and GuruFocus, but I have not bought a stock based on someone else’s research just yet, but I think it is a great way to find ideas. It is also a great way to learn from other people’s mistakes.

  1. How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?

If a stock hits my price target or if I realize that I made a mistake in my analysis, I’ll sell. I do not buy the Buffett ‘forever’ holding period that most value investors love. I don’t see the point of holding a security past its intrinsic value — Buffett’s best years were during his partnership days which coincided with high portfolio turnover because he would sell something at intrinsic value and then buy something cheaper. He only started preaching ‘buy and hold forever’ after the size of his portfolio got too large. One can achieve higher returns with higher turnover and the returns should be high enough to compensate for the higher tax rate.

  1. How do you go about valuing a stock and how do you decide how you are going to value a specific stock?

The stock in question has to be both absolutely and relatively undervalued for me to buy it. If the company is cyclical, I will usually try to figure out how cyclical it is and then figure out an appropriate multiple to pay for it. It has to be the cheapest of its competitors and also trade at a reasonable valuation absent of competitor comparison.

  1. What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?

I avoid for-profit education – there is something so immoral about degree mills that irk me. Also, immoral investments eventually catch up to investors in the form of government interventions. I also generally avoid Banks and Insurance companies – valuing them is quite difficult. Distributors and supply chain servicing companies look fairly reasonable; you can get a 10% earnings yield on some of them absent of growth.

  1. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?

Markets feel overstretched and perhaps, overvalued. 25x earnings is certainly a deviation from the norm, but government bonds concern me the most. People have accepted negative rates in Europe and Japan, and it is nuts. To get the same yield on the Dow today with U.S. Government debt, you have to buy 30-year U.S. Treasuries, which is ridiculous. One only has to look at the performance of U.S. Treasury securities in the 60s when rates rose from generational lows into mid-single digits. The bondholders lost both on a nominal and a real basis while adhering to the ‘low-volatility/low-risk’ mantra. Today, rates are even lower than they were in the 60s and people are still running to government bonds for ‘safety.’ Equities may be exposed to larger drawdowns, but fixed-income Investors bear both currency and interest rate risks over the long run. In an environment with ultra low rates, fixed income investors ought to be prudent. There is also the Pension liabilities of the states and many more.

  1. Describe some of the biggest mistakes you have made value investing. What are your three worst investments? What did you learn and how do you avoid those mistakes today?

Pier 1 Imports was my biggest so far. Bought at $6.5 and sold at $4.9 – I cut my losses around 24%. I looked at the company and quickly came to the conclusion that it was ridiculously cheap. I took current assets, adjusted inventories down 20% and subtracted all liabilities. I added the derived number back to the market cap to get my version of enterprise value (EV). Normalized earnings pointed to somewhere near 5x EV. I also assumed the high inventory levels would normalize in the coming quarters and that margins would revert to the mean. I was dead wrong. I came to the conclusion that the best time to buy these uber-cyclical retail stocks is during an actual recessionary downturn. Inventory deleveraging for all companies within the industry happen at the same time, so you do not even have to time it. You just buy the cheapest one and play the waiting game. Attempting to ‘buy and hold’ a highly cyclical company would lead to buying and taking an 80% drawdown just to realize a 30% gain over a two-year span – it’s not worth it.

  1. How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections, and fluctuations?

Q1 of 2016 is the closest I have been to a ‘crash.’ I was 14 in 2008 and had no clue what was going on. There’s a quote from Peter Lynch that goes like this:

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”

And one amusing quote from one of Warren Buffett’s partnership letters:

I resurrect this “market-guessing” section only because after the DOW declined from 995 at the peak in February to about 865 in May, I received a few calls from partners suggesting that they thought stocks were going a lot lower. This always raises two questions in my mind: (1) If they knew in February that the DOW was going to 865 in may, why didn’t they let me in on it then; and, (2) If they didn’t know what was going to happen during the ensuing three months back in February, how do they know in May? There is also a voice or two after any hundred point or so decline suggesting we sell and wait until the future is clearer. Let me again suggest two points: (1) The future has never been clear to me (give us a call when the next few months are obvious to you – or, for that matter, the next few hours); and, (2) no one ever seems to call after the market has gone up 100 points to focus my attention on how unclear everything is, even though the view back in February doesn’t look so clear in retrospect.1966.07.12 Second Half Buffett Partnership Letter

Corrections and crashes are difficult to predict, so I won’t stress myself out attempting to. If it happens, then I guess it happens.