Tim du Toit is a value investor based out of Hamburg, Germany. Tim is the editor and founder of Euro Share Lab. On his website he reveals what more than 20 years of equity investment have taught him Euro Share Lab
I met Josh the first time in 2006, at the value investment seminar I attend each year in Italy. In that year Josh was finishing up his MBA at Columbia University specialising in value investing.
Since then we’ve kept in touch through e-mail and each year had long talks at the seminar in Italy where in 2010 he also started presenting.
In 2007, directly after finishing his MBA Josh started an investment partnership called Greenlea Lane Capital Partners, named after the street he grew up on.
At the seminar in 2011 all the investors were licking their wounds and discussing how the last few years of dreadful stock market performance has impacted their net worth as well as that of their clients.
Josh surprised everyone when he mentioned that from 2007 to the end of 2010 the partnership he manages returned 55% to investors compared to the 2.4% of the Russell 3000 index. On a yearly basis over four years this equals 11% compared to the 0.6% of the index.
Needless to say we were all very impressed with the performance in arguably the worst for years of market performance in the last half a century.
What you will immediately notice when meeting Josh is his soft-spoken nature. He does not boast, is not arrogant and will hardly say anything about his partnerships or its performance except if he’s asked about it.
But when you start talking to him you will immediately notice that he knows exactly what he’s doing. He has excellent investment ideas which he has researched from top to bottom. With no question about numbers, business strategy and management’s incentives he cannot answer immediately.
After hearing his presentation about pricing power at the value investing seminar in Italy in 2011 I immediately thought that you will benefit if I could convince Josh to explain his investment approach, where he gets his investment ideas and mistakes he has made in an interview.
I was really pleased when Josh agreed to the interview below (Emphasis mine).
How did you get started in investing?
After graduating college in 2001, I did sell side equity research at a large investment bank. There, I was exposed to the basics of financial analysis, but we did not have a sound framework for judging the quality of businesses or valuing them.
A lot of the recommendations we made seemed arbitrary, so I found myself searching for something that made more sense.
I was very lucky that my father pointed me in the right direction, giving me the book The Quest for Value, which is about economic value added. From there, I went onto Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond, and I started reading Warren Buffett’s letters to shareholders. Like so many value investors, I was hooked immediately.
What attracted you to value investing?
My experience on the sell side showed me how it is crucial to have a framework for decision-making that could be reduced to fundamental principles that are clear and indisputable.
Value investing is attractive because it makes sense.
The underlying logic is to buy assets for less than they are worth, because this simultaneously increases the potential for gain and decreases the potential for loss. At the same time, value investing—in large part because it is so simple—is difficult to put into practice in a disciplined manner over a long period of time.
It is human nature to muck up the works. This explains why something that is so easy to understand does not extinguish itself. It keeps working because it runs contrary to human nature.
How would you describe your investment philosophy?
My approach is to think of each investment as if it were the family business. We own 100% and our wealth is determined by the earning power of the business over time. There would be certain prices I would sell for in an instant, and certain prices that would be clearly too low.
The intrinsic value is somewhere in between.
Over the years, I would want the earning power of my business to at least keep up with nominal GDP; otherwise, it is likely that there are better stores of wealth available to me, and I would be inclined to sell my business.
This means that there must be minimal risk of competitors hurting my market position, or of technological change rendering my business model obsolete.
What is even better is if the business has the opportunity to compound at high rates of return. Most of my investments have the ability to compound intrinsic value at double-digit rates for a long time. If this is true, then there is less need for multiple expansion to produce an attractive investment return.
It is possible to make a lot of money investing in medium or worse quality assets, relying for your returns on the convergence of price and value. But if you stick with businesses that increase in value over the years, then time is your friend.
My experience strongly suggests that timing is the trickiest part of investing, so I am comfortable with an approach that minimizes the importance of getting the timing right.
How do you typically find ideas and what is your selection process before an idea gets added to your portfolio?
The basic sources that I use to generate ideas—publications, screens, talking with other investors, and so on—are probably not very different from what most investors utilize.
I have found, though, that the way I organize my process is somewhat atypical because of the narrow focus on great businesses.
My goal each day is to expand the list of companies that I would like to buy if presented with an attractive price. I do, of course, prioritize research on ideas that seem like they may be currently cheap, but most of the time I am expanding my knowledge base in order to maximize the future opportunity set.
In terms of research on individual companies, I strive to be very comprehensive and careful. One nice thing about making a small number of large investments is that you generally do not have to feel rushed during the research process.
What are your ideas concerning portfolio composition and the value of individual holdings in relation to the portfolio?
Right now we have 8 investments, and the top 5 represent about 70% of our capital.
I prefer a relatively concentrated portfolio because it complements the focus on great businesses, and because it fits with my temperament. I enjoy the research process and do not mind going for long periods of time without making a new investment.
I would find it unsatisfying to have investments that are not large enough to make a meaningful contribution to the performance of the overall portfolio. For me, having many small positions would be more stressful than having a few, high-conviction investments.
But I also believe that there are many valid approaches.The key is to know yourself and tailor your investment strategy to your own idiosyncrasies.
Do you follow any key risk-management guidelines in managing your portfolio?
I usually invest between 5% and 15% of capital in each holding. I generally avoid allowing an appreciated position to exceed 25%, or allowing aggregate investments in a single industry to exceed 1/3 of the portfolio.
I would be comfortable if any one of my investments were much larger than it actually is. Sizing positions below my ultimate comfort level and imposing concentration limits is important because things go wrong.
Describe some of your most notable investment mistakes and what did you learn from them?
One of the most significant lessons I have learned is how risky it is to invest in unproven business models. I do not have a precise definition of “unproven,” but if a company lacks a substantial history of successful operations (say, 10 years), and I find myself struggling to work through the logic of why its business model should thrive over time, then it’s likely “unproven.”
I have made two small investments in unproven businesses and was wrong both times.
One of these was a company called ZipRealty (ZIPR). ZIPR had an innovative approach to the residential real estate brokerage business, and in success mode it would have been a phenomenal company. In fact, there was a significant and growing body of evidence that ZIPR’s model was working; however, it was not conclusive, and I spent a great deal of time attempting to figure out if ZIPR’s operations were sustainable and scalable.
Unfortunately, the original business model did not work nearly as well as had been hoped, and now the company is fundamentally shifting its strategy. In retrospect, it is painfully obvious that the analysis I was undertaking with this investment was simply too difficult. I was seduced by the hope of great upside.
Now, I simply stay away from these types of investments.
Once I understand the basics of how a business works, its virtues must be fairly obvious. I also require a substantial history of successful operations for a company to be a candidate for investment.
Why and how did you set up your fund? How did you attract the first investors?
set up my fund in mid-2007 as an extension of an account I had been managing for myself
Moving to a limited partnership structure facilitated participation by friends and family. I was very fortunate to have a small group of people who were willing to invest alongside me before there was a track record.
The investor base has modestly expanded over the years, but every LP shares the truly long-term orientation that forms the basis of our investment program. We contribute money to the fund expecting to leave it there to compound indefinitely.
I have virtually all of my money in the fund and expect for that to continue for the long term.
What company do you find interesting at the moment and why?
Our largest investment is an American company called Markel Corporation (MKL). Markel is a specialty property & casualty (P&C) insurance company headquartered in Richmond, Virginia.
By and large, P&C insurance is an unattractive and opaque industry. It is also one in which the quality of management is especially important.
These factors make assessing an insurance company a particularly challenging task, which is something I try to avoid. However, there are clearly some standouts in the industry, and these companies are not just better than their peers, but are exceptional compounding machines by any standards.
Often the most worrisome issue for an insurance investor is reserving. Reserves are the liability on the balance sheet representing an estimate of future insurance claims. If the reserves are understated, then book value is overstated. There is a certain amount of quantitative analysis that one can do. To develop confidence in an insurer’s reserving, I think a long history of favorable developments (initial estimates proving conservative), underwriting profits, and declining underwriting activity in deteriorating pricing environments are pre-requisites.
But no amount of quantitative analysis can ensure that today’s reserves are adequate.
There are reasons that reserves often prove to have been too optimistic in the fullness of time. Sensible underwriting dictates that unattractively priced business will be turned away.
This sounds obvious but is actually uncommon, because underwriters risk their jobs by ceding market share to competitors and meaningfully shrinking the amount of business being conducted. There is often a certain amount of self-deception at work when companies write bad business in a tough environment. Reporting lower reserves today produces higher earnings.
Later, inadequate reserves will need to be revised upward, but this might not happen for multiple years—beyond the timeframe most people or organizations worry about.
However, these pressures can be overcome simply by addressing their causes: perverse incentives and short-termism.
At Markel, for example, the compensation of underwriters is in large part dependent on the profitability of the business they write. They have significant opportunities to earn money, but they are contingent on multi-year performance. Markel’s senior executives are compensated based on the rolling 5-year compounding of book value per share, which is a good proxy for the progression of the company’s intrinsic value.
More important, Markel’s management has its wealth heavily concentrated in Markel common stock, and employee stock ownership is pervasive. The company is run by principals, rather than hired agents. This makes short-term thinking highly irrational.
There is a deeply embedded culture of long-term orientation and discipline. Markel employees take great pride in working there, and it is an employer of choice in an otherwise unexciting industry.
As a general proposition, these qualitative factors are challenging to evaluate. I do not think I could do a good job assessing the culture or mentality of most insurance companies, and the difficulty of doing so is part of what makes investing in the industry a treacherous undertaking. However, it is also possible for presence of the desirable qualities to be obvious. I think Markel is an example of this.
Assuming one is now convinced that Markel has a quality insurance franchise that will produce underwriting profits over time, I think the best way to frame the company is not as an insurer at all, but as a holding company in the business of capital allocation.
As a capital allocator, Markel possesses competitive advantages shared by exceedingly few investors: permanent capital with recurring inflows, negative-cost perpetual leverage in the form of insurance float, and the flexibility to a make both public and private investments.
It is hard to imagine a better person to have leading the investment effort than Tom Gayner.
When superior talent, a superior vehicle, proper incentives, and a truly long-term orientation are combined in one operation, the result is likely to be very good.
Markel’s book value per share compounding from 1990 through 2010 was 19% annualized. While size is the enemy of performance, there is still only about $3 billion of shareholders’ equity, which is comparable to Berkshire Hathaway in the late 1980s. There is long runway ahead of Markel, and it is a much stronger and better positioned company than ever before.
What is also interesting about Markel right now is that in addition to being a superb compounding machine, it is an opportunistic investment.
We are in the midst of a severe, protracted “soft” insurance market. There is no sign of a turnaround, so Wall Street considers insurers “dead money” and valuations are low. Although it is impossible to tell when the market will turn, it will, because pricing cannot remain inadequate forever; the industry must earn a return on capital.
Markel has used the period of difficult conditions to prepare for the inevitable turn (and beyond). It has shrunk the top line and preserved capital so when pricing becomes attractive, it can spring into action.
The excess and surplus lines in which it participates are the hardest hit but will rebound most dramatically. In a hard market, Markel’s premiums could double or triple.
By contrast, while the typical insurance company will benefit from improved conditions, it will also be dealing with the bad business put on the books during the soft market. Markel has also opportunistically acquired attractive insurance operations and expanded its international presence.
Finally, the company recently completed a restructuring of its marketing organization to take better advantage of what is by far the broadest array of specialty insurance products in the US. The previous structure did not adequately take advantage of cross selling opportunities.
Josh, thanks for your time and insights
Your interviewing analyst