My Investment Approach by Brian Langis, Seeking Alpha
My overall approach to investments.
Recently, Bruce Greenwald carried out a virtual Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital. Greenwald and Lu covered multiple topics during the discussion, addressing everything from the value investor's approach to appraising businesses and what he had learned from his great friend Charlie Munger. The duo also discussed China's economy Read More
I share some advice.
I hope you can share your investment approach too so we can become better investors.
Being labeled as the "investment guy" to my family and friends, I often get hit with questions that go something like this: "What's your investment philosophy, approach? How do you invest? What formula do you use? Or tell me what stock to buy so I can make money". The frequency of questions and discussions grew overtime as my online persona developed due in part to my articles on Seeking Alpha and myblog. Those of you in the investment business know that you can't really answer it with a one-liner. The purpose of this article is to provide a comprehensive answer to some of the questions I occasionally receive. Another purpose is that maybe it will spark other people to share and discuss their investment approach.
When it comes to the question of what kind of investor are you? I don't like checking myself into a box but if I have to, I would have to check value investing. I don't believe that markets are efficient, I believe companies have an intrinsic value, I look for a margin of safety, I have contrarian characteristics, volatility is not a measure of risk, and I buy things when they are on sale. I don't speculate and I don't short. I guess that on paper that would make me a value investor. But I'm not a purist. I also incorporate some growth investment characteristics and I also keep an eye on special situations. I don't run an investment fund with strict investment boundaries, so my hands are not tied to a certain investment category. I'm free to go where the opportunities are. That's why I don't "categorize" my investment style.
Back to the question "what kind of investor am I?" I'm never really satisfied with the answer the "I'm a value investor" and so my questioner. The phrase "value investing" itself can be more confusing than helpful. It's like saying "I buy low and sell high". So what's a value investor? The short simplified answer is that it's an investor that buys an undervalued stock. He's looking to buy a dollar for fifty cent. Using that rationale then isn't everybody a value investor? Obviously nobody buys a stock or an asset because they think it's overvalued. Everybody thinks they are getting a bargain and it will be worth more. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. In other words, you can't be a contrarian if everybody is a contrarian. In value investing, there are many schools of thoughts and it has expanded well beyond the Benjamin Graham school of strict value investing. I'm not a disciple of any value investing tribe. I believe value and quality goes hand-in-hand. I'm not overly fixated on paying low multiples. It is rare to get a truly great business at dirt-cheap prices. Unless you get really lucky, you are not going to find a quality business with a large economic moat trading at a price earnings ratio of six.
At the base, when I buy a stock, I have a fractional ownership in the business. It might not be much, but a percentage of ownership in a company. This gives me an indirect stake in the assets and profits on the company. In today's digital age where you can buy and sell stocks all day by just swiping your mobile, it's easy to forget that shares represent ownership in a company that employs people, produces goods or services and, hopefully, generates revenue, profit and cash flow. I guess it's psychological. I see the same effect when playing online poker versus playing at a table. Online, there's a disconnect that happens in your mind that when you don't see your chips, you forget that's real money. Players are more "loose", throwing money at bad hands and chasing streaks. That same behavioral disconnect happens when people see their portfolio filled with stickers bouncing around. I feel that the stock market is a mood gauge. It tells me what mood people are in any particular day. I can tell if they are panicking, depressed, or overly optimistically greedy.
What you see bouncing around every day in your portfolio is price. It's different from value. Value doesn't bounce around. You need to develop your own opinion of value. Adding value requires one to see that the stock is mispriced. Share prices, you may have noticed, vary enormously over the course of a year. I keep seeing the same stat over and over again that the average stock moves around 80% from its peak to low during a 52-week period. I don't know how accurate the stat is, but by looking at my portfolio there's some truth to it. A business's revenue, profit and cash flow rarely change anything as much as its share price. The reason for this is that the price of a company's shares is only a reflection of what people are willing to pay for them at any given time. In other words, price doesn't tell you anything about a company's worth, but it tells you a lot about the popularity of the company with the crowd of investors. Sometimes, usually when prices are rising, they're greedy. When prices fall, they become fearful and rush for the exits. All this emotion can push the share price a long way from the intrinsic value of the underlying business.
I don't worry about volatility. And by the way, volatility does not equal risk. I'm more concerned about permanent capital impairment. If something is going to be worth a lot more in the future I'm going to buy it regardless of the volatility. I also try to take advantage of volatility. When you have strong period of volatility like we saw at the beginning of 2016, it can cause investors to sell and sometimes to do so indiscriminately. There's a Chinese proverb that goes something like "the greater the crisis, the greater the opportunity". Or if you prefer an English quote, Winston Churchill said "Never let a good crisis go to waste".
When looking at the investment merit of a company, I usually look for these four criteria:
The company needs to be profitable and a strong generator of free cash flow with a good return on capitalI'm looking for honest talented managementReinvestment opportunities (capital discipline + allocation)Valuation: I want to buy the company at a bargain but I usually I have to settle for a fair price (a dollar for 70 cents if it's an attractive company.)
You will notice that the first three criteria are dependent on others and that means management plays a key factor. You can't really have one without the other, over the long-run anyway. Good management will generate free cash flow and allocate capital in a disciplined manner. If point 1, 2, and 3 are solid, you probably wouldn't find the company in the bargain bin unless you are lucky. I mentioned that I would settle for a fair price because usually you have to pay a premium for quality. Since I tend to hold my stocks for many years, I don't really care if I buy Company X at $52 or $50. What I noticed is that the day Company X trades at $75, it's not going to matter if you bought it at $51 or $50. The primary motivation for purchases is that values are good enough and that I have enough of a margin of safety for errors of judgment. The best business in the world is one that makes a good return on its capital and can reinvest profits at the same returns. That's a compounding machine that generates great wealth over time. Time here is essential. You need patience and a cool head to ride the ups and downs. A trick is not to look at your portfolio every day. It deviates you from focusing on the long-term. It's hard to do and you can train yourself.
As to my analysis approach, I have more of a bottom-up style. I focus on the business, the fundamentals, the valuation, and look for a margin of safety. I read the filings, the presentations, conference call transcripts and related research. I talk to business people and people that are familiar with the industry. I also look at the competition to see how it's doing. I don't ignore the macro environment but I also don't spend too much time on things I can't control. Rather, I spend my time focusing on learning about the business than trying to predict the direction of interest rates or where we are in the business cycle. Besides, I already make enough mistakes. There already way too many PhDs getting burned trying. I'm very aware of the economic situation and I have my own views. However I don't let my economic opinion make investment decisions.
People often ask me what I think about this stock or that stock. Most of the times they bring up obscure companies that I have never heard of. Before they tell how Company X will revolutionize a certain industry, the first thing I do is I go right to the balance sheet. This will give me a snapshot of the health of the company to see if it will survive the next couple months. I want a clean balance sheet. Is the company financially sound? Can it pay its bills for a bit while I investigate further? Then I look at the cash flow statement and income statement last. The cash flow statement will tell me a lot about the operations of the company, its use of cash, and very importantly if it's generating free cash flow. The income statement will tell me if the company is growing and its margins. This can be done pretty quickly once I have found something I like, I roll up my sleeves and I start digging deeper.
I don't try to time the market. If you are a market timer, you need to be right twice, once when you buy and once you sell. Some people might be successful at it, but I don't have that skill. I don't know anybody who is successful at it either.
I also don't always visit the companies and meet management. If it's a big company that has analysts covering it, it would be a waste of time and they probably aren't likely to meet me. Apple has 100 analysts, what is it that I know that they don't? Tim Cook Is not going to pick up my call. In situations like researching small caps companies with no coverage, I take the time to talk to management. However I remain skeptical with what that management has to say. They will always tell you that things are ok. But it's a good way to learn more about a company. I suggest that if you want to go further, sometimes talking to employees, or ex-employees, suppliers or the competition will tell you more about the company.
A very important step that I take is that I try to put myself in the shoes of the seller. Why is this person selling their stocks? What's the motive? What is it that they know that I don't? How can this company blow up? How can I lose money? Sometimes when I find a company that I like you become too optimistic and you only want the info that validates your thoughts. The exercise forces you to think differently and to develop another perception as to the merit of the potential investment. It has prevented me from making mistakes.
Arriving at the value of a company or an asset is more an art than a science. There's no secret formula. Don't waste your time on the secret sauce du jour. There's not a single metric or formula that you can use that will make you money over and over again. Just buying low P/E or P/B stocks won't make you rich. That would be too easy. Wouldn't that be great?
Adding value is a zero-sum game. You are buying a stock because you think it's undervalued and the seller thinks it's overvalued. You can't both be right. Basically you need to be better than the person selling it. If you cannot value a business, then price has no meaning. You need to develop the ability to compare price to a certain value. That's when it makes sense. You do not want to value a Ford at BMW prices. You want to buy a BMW at Kia prices. It is all about seeking a reasonable discount on its actual worth.
When looking for investments, I focus more on the "art" side than the "science" side. The "science" side is the numbers and the valuation. If you run a screen for cheap stocks then you will have a lot of garbage to filter through. Over 90% of the companies caught in the screen are not investment worthy. And it's brutally time consuming. Sure you can run sophisticated filters but you are competing in a crowded field. There are way too many people and computers already doing that. Everybody can run the numbers and screens. I don't have an edge in that department. You won't earn market-beating returns by simply picking the quantitatively cheapest companies. Cheap companies are cheap for a reason. I've seen stocks trading at 6x P/E drop to 3x P/E. That's when the lessons really sink in.
The 'art' part of investing is the difficult part. On the art side, I focus on the character of the business, its qualities and economic moat. Instead of going through 90% of the garbage from the screen, I'm looking at the 5% of companies that might be investment worthy. I try to figure out what enables some businesses to earn outsize profits for an extended time. How strong and enduring its competitive position is? What is the nature and source of their sustainable competitive advantages? These are some of the questions that I ask and they are not easy to answers. Another advice is to ask the question "why" a lot. Why is this company earning outsized profits? And keep going and going. It's like peeling an onion.
The "art" side is very subjective. There's not a straightforward methodological approach to it. You use screens heavily, you need to screen the screen. The "art" side is refined with time and experience. I don't think you can simply start with the art side. I think everybody starts with the screen approach and you realized how time consuming and inefficient this is. You go through each company on your list and you start noticing patterns on why these companies are terrible investments. You quickly become a better decision maker. Unfortunately, I do not have a clear-cut way of valuing businesses. Usually I arrive at a value conclusion with a range of values.
I don't really rely on DCF models even though they are thing of beauty. There are too many assumptions, projections, and you can play with the discount rate all you want. How do you seriously predict with any accuracy what the long-term cash flows are for a given company? Especially a company that is young or that might be using an innovative and new business model. There are so many disparate variables. The model is so hypersensitive that if one input is off one degree you will get out of whack values. There's a joke in the industry that goes if the numbers blows-up my model, I will ignore them. Sometimes I take a stab at it but it's not my preferred valuation method. Great businesses make a good investment, not great models.
I don't do any technical analysis. I dabble around with it but I never made a transaction based on it. The cup and handle pattern just doesn't resonate with me. A friend of mine uses technical analysis pretty extensively and he gets really excited when he shows me these different chart patterns. I just don't see it. My reaction to chart patterns is pretty much the same; "this looks like a chicken leg, so what?" His reaction is the same when I talk about the investment merits of a certain company and its valuation metric. It sounds like a foreign language to him. I'm not claiming that technical analysis is not working; it's just simply not the right investment approach for me. It seems to be working for my friend. I guess the key is to incorporate it in your investment approach but it's not on "my to-do list".
I don't use a formal checklist although I probably should. There is already a lot of existing investment literature about the importance of using checklists in investing, most notably "The Checklist Manifesto" by Atul Gawande. Right now I rely on my common sense mental checklist like medical professionals operating on a patient should have clean hands. But medical professionals use checklists. I certainly think I could improve my performance if I use a practical checklist. Just relying on memory can be faulty. Reflecting back on some investment mistakes of the past, some of them could have been avoided with a checklist. However you need the right checklist. The issue is there's not one perfect checklist. You can look at different templates but you need to build your own. You also need to adjust the checklist according to the company and industry you are analyzing. Also most investing errors are not from the lack of fundamental analysis, but originate from psychological missteps. So you need a checklist that keeps your behavior in check. A checklist is not a bullet proof method of eliminating mistakes. You still will make some. But it will minimize the chance of losses.
At the end of the day, my role is to look for pricing inefficiencies. The greater the gap between price and value, the greater the margin of safety is. When calculating value, I don't try to be too precise. I expect a range of outcomes.
I'm free to invest in any asset class anywhere but I have a soft "no" list. I generally don't do pharma, mining, and 95% of the tech stocks out there, etc...But I didn't ban them from the investment universe. It's just I don't think the opportunities are worth the risk. Those sectors above usually lack an enduring competitive advantage and an economic moat. I also can't buy them with a large enough margin of safety. I prefer companies that have hard assets and I invest in companies with a really strong brand and intangibles. I find it easier to calculate the downside. It really comes down to finding that competitive advantage. Great investments are identified by finding business models that would be impossible to ruin with competition. Sometimes there's one or two abilities that make them better than their peers and that could be branding, distribution, product quality, low cost operator etc…
I find a lot of ideas through reading. I can't stress the importance of reading enough. I picked up most of my knowledge and ideas by reading. I believe that if you want to be successful in investing, it is important to be willing to learn and explore new concepts on your own. I read a lot of annual reports and I form an opinion about the companies. Usually what happens is that I end up with a list of companies on a watch list with the price I want to buy them at. It happens that the company could be on the watch list for years. So when the company hits my price target, I already know the company pretty well.
If I find an undervalued stock that generates strong free cash flow (high free cash flow yield), usually something good will happen. The company might reinvest the cash to make it compound, make an acquisition, distribute a dividend, or buyback shares.
My investment approach is a mix of value investing principles with my own twist to them. The truth is you need to develop your own investment approach. Warren Buffett is the most famous "value investor" but you can't copy him. You simply can't. You also can't copy Carl Icahn or Michael Burry. You don't have their resources or talent to influence management teams. You also don't have access to the type of deals they do.Investors shouldn't let somebody else's opinion drive their decision. You need to have the capacity to think independently and develop your own perspective. As noted investor Sir John Templeton said: "It is impossible to produce a superior performance unless you do something different from the majority." At the end of the day you need to know yourself and you need to develop your own investment style. Like I said there's no secret formula to investing. It's not supposed to be easy. That's why only a few people are great at it. And they are great at it because they do their own thing.
Like I already mentioned, there's no secret formula. You need to take a position that others shun and avoid what is popular. That's hard to do. Early on it will look wrong and it's a brutal feeling to have. Focus on quality at a bargain and be patient. It's the last part of the equation that's the most difficult. You need nerves of steel to sit through some of the roller-coasters. . Emotions are the single most important factor for investing success. If you can't control your temperament, everything else doesn't matter. If you have the best strategy but you can't hold on to it, you are doing more damage than good. If you have a solid opinion of value on your company, you will be facing the storm because you have something to focus on.
I tried to jot down most as much as possible about my investment approach. Most importantly, I hope it helps answer some of your questions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.