Whitney Tilson: Selected Published Columns

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Whitney Tilson: Selected Published Columns
Whitney Tilson

Value Investing

Why will investors wait for a better deal on a car, but not a stock? Whitney Tilson discusses the elusive but vital topic of value investing in his first Fool on the Hill column, trying to hammer down not only what it is — but what it isn’t.

By Whitney Tilson
Published on the Motley Fool web site, 11/7/00

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(http://www.fool.com/news/foth/2000/foth001107.htm)

With the suspension of the Boring Portfolio, I’ll now be writing in this space every Tuesday. Since many Fools may not have spent much time in the backwaters of the Bore Port, I’d like to use this, my first Fool on the Hill, to introduce myself. (I don’t have much space here, so I’ve included links to many of my favorite articles below; links to all 45 Motley Fool columns I’ve written over the past year are on my website.)

Unlike pretty much every other writer for the Fool, I don’t work for the Fool. I’m a money manager in New York City, though I’m about as far from the fast trading, Wall Street stereotype as you can get. I’ve been a consultant and entrepreneur (many times over), and have an MBA, but have never worked for a financial firm. In fact, not too long ago I was an individual investor just like you. I taught myself how to invest my reading voraciously, then began to manage my own money, then some for my family, and eventually started my own firm.

What is value investing?

I am a value investor, though if you looked at my portfolio, you might scratch your head and wonder. I’d like to use the rest of this column and the next one to share my thoughts on value investing, especially as it applies to the New Economy.

Very simply, value investing means attempting to buy a stock (or other financial asset) for less than it’s worth. In this case, “worth” is not what you hope someone else might pay for your stock tomorrow or next week or next month — that’s “greater fool investing.” Instead, as I wrote in Valuation Matters, “the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.”

Buying something for less than it’s worth: What a simple and obvious concept. Charlie Munger said it best at this year’s Berkshire Hathaway annual meeting: “All intelligent investing is value investing.” Bargain hunting is pretty much what everyone tries to do when buying anything, right? How many people walk into an auto dealership and say, “I want to buy your most popular car, and I don’t care about the price. In fact, if the price has doubled recently, I want it even more.”? Conversely, why would someone be deterred from buying if the dealer had recently marked down the price by 25%? And how many people would buy a car based on a stranger’s recommendation, without doing any of their own research?

So why do so many people behave like this when buying stocks? The answer lies in part, I suppose, in the realm of human psychology — the assumption that the crowd is always right, and the comfort of being part of the herd. Also, there’s the thrill of gambling and the hope of a big score. (I intend to return to the topic of behavioral economics — the subject of my first Motley Fool column, The Perils of Investor Overconfidence — in future columns.) Another factor is that valuation is tricky — it’s hard to develop scenarios and probabilities to estimate a company’s future cash flows. But that’s no excuse. As I argued in perhaps my most controversial column, The Arrogance of Stock Picking, if you don’t have the three T’s — time, training and temperament — that are the basic requirements for successful stock picking, then you’re very likely to be better off in mutual funds (or, better yet, index funds).

As I noted in my follow-up column, More on The Arrogance of Stock Picking, “I think it’s a sign of the times that this [point of view] would be considered by some to be controversial or insightful. Heck, I’d give you the same advice were you to undertake any challenging endeavor: piloting a plane, teaching a class, starting a business, building a house, whatever. But when it comes to investing, people are bombarded with messages that they should jump into the market and buy stocks, and of course there is no mention of the risks involved or the skills required to invest properly.”

I think my arguments largely fell on deaf ears during the madness earlier this year. With the unfortunate pain many unsuspecting investors have experienced since then, maybe now there will be a more receptive audience.

What value investing is NOT

Many people think that value investing means buying crummy companies at single-digit P/E ratios. Ha! While some value-oriented investment managers have fallen into this trap (the subject of my column, Should Warren Buffett Call It Quits?, which compared Warren Buffett with the Tiger Funds’ Julian Robertson), I’m skeptical that there’s much genuine value in companies trading at low multiples but with poor financials and weak future prospects. Buffett agrees. In his latest annual letter, he wrote: “If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.”

Nor does value investing rule out taking risks. If the potential payoff is high enough, even the risk of total loss is acceptable. For example, every value investor I know of would jump at the chance to invest at least a small portion of their assets in a coin toss, where heads would pay 5x, but tails would yield a total loss. (I make similar calculations when I make venture capital investments.) Unfortunately, however, as I argued last month in Perils and Prospects in Tech, many people take tremendous risks — often unknowingly — by buying high-flying stocks in the belief that they are making such a bet, when in fact the odds are far worse.

This does not mean that value investing excludes all companies with high P/E ratios (though I would argue, as I did in Cisco’s Formidable Challenge, that very few businesses of any size are likely to be undervalued if they trade above 50x earnings and certainly 100x). For example, I bought Intel early last year at approximately 25x trailing earnings. That may not sound like a bargain, but I felt that this exceptional company would generate enough cash over time to justify its price. Despite its recent hiccups, my opinion hasn’t changed and I’m still holding.

As this example shows, I don’t believe that value investing precludes buying the stocks of technology companies. While Buffett is famous for his aversion to such stocks (the subject of my column, Why Won’t Buffett Invest in Tech Stocks?), he does not deny that there can be wonderful bargains in this arena. He simply says:

“I don’t want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that’s a 7- or 8-foot bar that I can’t clear. There are people who can, but I can’t. Different people understand different businesses. The important thing is to know which ones you do understand and when you’re operating within your circle of competence.” (1998 annual meeting)

I urge you to think about your circle of competence. Understanding it — and not straying beyond it — is one of the most critical elements of successful investing. Another critical element is a firm grasp of Sustainable Competitive Advantage.

Conclusion

Value investing is very simple in concept, but very difficult in practice. The market, for all its foibles, tends to be quite efficient most of the time, so finding significantly undervalued stocks isn’t easy. But this approach, done properly, offers the best chance for substantial long-term gains in varied markets, while protecting against meaningful, permanent losses.

Next week I will continue with some thoughts about why, despite being a value investor, I embrace rather than shun the tech sector.

— Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected] To read his previous columns for the Motley Fool and other writings, click here.

Valuation Matters
How to beat the market

By Whitney Tilson ([email protected])
Published on the Motley Fool web site, 2/7/00

(http://www.fool.com/boringport/2000/boringport000207.htm)

“The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
— Warren Buffett, 1982 annual letter to shareholders

“We submit to you then, Fool, that valuation isn’t half so important as quality and the durability of the business model. At least when you’re building a Rule Maker Portfolio. In fact, we’ll go so far as to say that the quality of the company is fully 100 times more important than the immediate value of its stock price.”
— The Motley Fool (Step 7 of the 11 Steps to Rule Maker Investing)

I believe in The Motley Fool’s core investment philosophy of buying the stocks of quality companies (or index funds), holding for the long run, and ignoring the hype of Wall Street and the media. But if I were to level one general critique of the Fool, it would be that there is not enough emphasis on valuation. I agree — and I’m sure Buffett would too — that the enduring quality of a business is more important than today’s price, but 100 times more important? C’mon! The experience of the past few years notwithstanding, that “pay any price for a great business” attitude is a sure route to underperformance.

For a number of years now, we have been in a remarkable bull market where valuation hasn’t mattered. In fact, I believe that the more investors have focused on valuation in recent times, the worse their returns have been. But this hasn’t been true over longer periods historically, and I certainly don’t think it’s sustainable. While the laws of economic gravity may have been temporarily suspended, I do not believe that they have been fundamentally altered.

Don’t get me wrong — I’m a big believer in the ways that the Internet (and other technologies), improved access to capital, better management techniques, etc., have positively and permanently impacted the economy. Nor am I the type of value investor who thinks that anything trading above 20x trailing earnings is overvalued. I simply believe in the universal, fundamental truth that the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.

I find it hard to believe that this type of thinking is present in the hottest (mostly emerging, technology-related) sectors of the market today. The enormous valuations imply phenomenal growth and profitability for numerous companies in each sector. That’s a mathematical impossibility. Sure, a few of these companies might become the next Ciscos and Microsofts, but very few will. They can’t all achieve 80% market share! I believe investors in these sectors are setting themselves up for a fall, not because they’re investing in bad businesses, but because the extreme valuations create a highly unfavorable risk-reward equation. I suspect many are not investing at all, but are simply speculating in a greater fool’s game.

Well, if that doesn’t trigger a flood of hate mail, nothing will. But before you flame me, consider this: I own some of today’s hottest stocks. But I bought them at much lower (though still high, to be sure) valuations, when I felt confident that their future cash flows would justify their valuations at the time. Now, while I am not as comfortable with their valuations and am certainly not buying more, I am determined to stick to my long-term investment strategy and hang on to these stocks as long as the underlying businesses continue to prosper.

Overview of Valuation

If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard — and it’s ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It’s neither art nor science — it’s roughly equal amounts of both.

The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:

Charlie Munger (Berkshire Hathaway’s vice chairman) said, “Warren talks about these discounted cash flows. I’ve never seen him do one.”

“It’s true,” replied Buffett. “If (the value of a company) doesn’t just scream out at you, it’s too close.”

The beauty of valuation — and investing in general — is that, to use Buffett’s famous analogy, there are no called strikes. You can sit and wait until you’re as certain as you can be that you’ve not only discovered a high-quality business, but also that it is significantly undervalued. Such opportunities are rare these days, so a great deal of patience is required. To discipline myself, I use what I call the “Pinch-Me-I-Must-Be-Dreaming Test.” This means that before I’ll invest, I have to be saying to myself, “I can’t believe my incredible good fortune that the market has so misunderstood this company and mispriced its stock that I can buy it at today’s low price.”

Conclusion

Since I’ve been quoting Buffett with reckless abandon, I might as well conclude with another one of my favorites, from his 1978 annual letter to shareholders (keep in mind the context: Buffett wrote these words during a time of stock market and general malaise, only a year before Business Week’s infamous cover story, “The Death of Equities”):

“We confess considerable optimism regarding our insurance equity investments. Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense.

“We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire’s insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available — but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities — at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)

“The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pretax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pretax gains in equities for the three-year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.”

It is clear that Buffett’s unparalleled investment track record over many decades is the result of buying high-quality businesses at attractive prices. If he can’t find investments that have both characteristics, then he’ll patiently wait on the sidelines. That’s what’s happening today. As in 1971, Buffett has again largely withdrawn from the market, refusing to pay what he considers to be exorbitant prices for stocks. This is a major reason why the stock of Berkshire Hathaway (NYSE: BRK.A) has been pummeled. And Buffett himself is ridiculed as being an out-of-touch old fogey (you should read some of the e-mails I get every time I write a favorable word about him). Only time will tell who is right, but I’ve got my money on Buffett.

Next week, I will take this discussion of valuation from the theoretical to the practical by analyzing American Power Conversion’s (Nasdaq: APCC) valuation.

–Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected] To read his previous guest columns in the Boring Port and other writings, click here.

Related Links:

  • Boring Portfolio, 11/8/99: Slightly More Optimistic: Comments on Buffett’s Fortune Article
  • Boring Portfolio, 11/15/99: The Debate Over Buffett’s Fortune Article
  • Boring Portfolio, 11/22/99: Buffett’s Prescient Market Calls
  • Fool’s School:

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