On value investing...

I had the pleasure of getting together with two other value investors in Pittsburgh this evening.  We had a great time discussing a wide variety of topics.  Our conversation drifted from international investments, to nano cap stocks, to how crazy the real estate market is in Pittsburgh.  After I left I was thinking about how great it is to get together with like minded people and speak the same investing language.

To other investors we often make sense, something at "5x EBITDA and below book" is worth looking at, whereas to the non-investing population it doesn't even sound like English.  Maybe it was Munger or some other famous investor who said if you can't explain a concept to a 12 yr old you might not understand it.  In the spirit of that I want to share some analogies I've used to explain investing and how I invest to non-investors.  In all the times I've used my analogy I haven't encountered anyone who didn't have the lightbulb moment and say "oh I get it now."

How I invest

Imagine an area of town with an industrial area, the area is fairly well worn, but not in total disrepair.  There are a number of companies with names no one remembers doing somewhat specialized activities.  The owners of these businesses appear to do well for themselves raising their families in a solid middle class environment.

An owner of one of these businesses decides he's had enough of the stress and daily grind and he wants to sell.  He knows how to make widgets, and isn't much of an investor himself.  He lists his business on a public market.

Investors in town know that the area the business is located is grimy, and when they look at the accounts they see the company isn't all that profitable.  It seems like a lot of work is involved to make such a tiny profit.

I come along and examine the business, I agree with the other investors that they aren't that profitable, but I notice something different.  While they aren't turning a profit they do have a valuable building and the owner has undervalued his warehouse of old inventory.  I purchase the company for less than the property and machinery cost alone.  Once I visit my new purchase I realize what the owner thought was old rusty inventory in the warehouse is actually recently purchased inventory.  The owner was a bit of a pack rat and I start to find envelopes full of cash around the facility he'd stashed for rainy days.  When all is said and done my purchase price for the business is less than the inventory, receivables and cash net of liabilities, I get the building and aging machinery thrown in for free.  The company is marginally profitable, but it's not a big concern considering the discount I already received on my purchase.

To me that's the essence of asset based value investing.  When I've told this story people marvel that these sort of deals actually exist.  I explain they exist in the markets the same place they exist in real cities and towns, not on the main streets, or in the central business district.  Rather these deals are found on the back roads, sometimes far away from town, neglected by everyone often even their owners.

How Buffett invests

Warren Buffett used to invest as I described above but he's changed as he's become more successful.  Buffett buys that restaurant in town that everyone goes to, there are always two hour waits no matter what day of the week or time of the year.  Buffett prefers when these businesses are run conservatively and have strong staying power.  He isn't interested in buying the hottest restaurant this month, he's buying the restaurant that's been hot for a decade.

Buffett will then go on and buy the bank in town, and then the local gas station, and the grocery store, and whatever else is for sale.  Eventually it will be hard for anyone in town to go a day without using one of his products, or services.

How most investors invest

Imagine yourself at a cookout in the summer.  You're standing by the grill and your brother-in-law comes and starts chatting.  He starts talking about how this guy he works with is onto a really great investment.  It's some new technology he doesn't really understand, but it doesn't matter, it's going to sell really well.  Not many people know about it yet so you have to keep quiet.  He thinks it's going to be big, almost everyone in the world needs this product, if they can only capture 1% of that market they'll be billionaires.  It's a good thing you found out about this early so you can get in on the ground floor.  Just imagine being able to pay off the house and pay for the kids college all while sitting on the beach drinking mai tai's.

Final thoughts

I find it fascinating that most non-investors can spot a good local business without a problem.  People instinctively know when someone has a model that's minting money.  Yet a disconnect happens between a local tangible market and the public markets.  Most people wouldn't invest with the wacky science-y guy promoting some new fusion technology down the street, yet they'll pour money into high tech startups.  People are also able to identify when a company has a strong brand and staying power verses a company without it.

I love when people say things like "how did that restaurant go under, it was always crowded?" because it exposes that while people understand a good brand, they don't understand the finances behind a business.  I always say that companies go under for two reasons, too much debt, and mispriced products.  Those two go hand in hand, products priced too low eventually lead to debt problems.  Maybe the restaurant is packed because the prices aren't high enough.

Talk to Nate

8 comments:

  1. Fantastic post Nate - you make it look so easy. For a long time, I used to invest with my heart and my pants came out sooner than later ! Now I have realized that any business that is in the pink dailies or is the flavour of the season which draws your heart to it is, in all probability, the worst to invest into for the long term. The best businesses I have seen are those in which the owner identified a medium sized, profitable niche (think waste compaction, think crucibles for steel plants, think oil soaked bolts for tractors) which is small enough for no large conglomerate/Fortune 500 to be interested in and dirty enough for the space age cowboys to keep off. By virtue, these guys also tend to be a lot more conservative - do not diversify unnecessarily or overpay for acquisitions, focus on profit and revenue growth together and view themselves as subservient to the company and hence the shareholder's needs.

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  2. Great article as always, Nate. I have been torn between which method of value investing is most suitable for the individual investor with a small amount of capital. Whilst the net-net deep value approach has always been the most intriguing to me and the methods used by Walter & Edwin Schloss have fascinated me, I worry that with the amount of capital currently at my disposal, I would not be able to justify the transaction costs on the size of trades I would place. My first question is in your experience, how diverse does a net net portfolio need to be? The alternative is the Buffett/Munger approach who wait for that perfect pitch and have used the 20 hole punchcard analogy to illustrate their style. To do this you would need to identify sustainable competitive advantages that will keep a company generating high returns on capital into the future. My second question is have you invested in micro cap companies that have Buffett/Munger characterisitcs? The kind of company that springs to mind would be a small specialist magazine publisher who has pricing power and a "local" competitive advantage (niche) that Bruce Greenwald describes. Thanks in advance for any advice you may have. P.S. I live in the UK but I would look for opportunities abroad too.

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  3. Great work as always Nate. I always enjoy your thoughts.

    At the risk of being "That Guy" in class who asks a question about your by-the-way comment -- what exactly strikes you as crazy about "the real estate market in Pittsburgh?"

    Recent price increases?
    How cheap real estate is there?
    How cheap loans are from local banks to buy property?
    Residential or commercial?

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    1. Good question,

      A few things, first is how quickly houses are selling. Friends sold their house in a day, they listed it for $30k more than they expected to sell it for and it sold for list price. A realtor friend said this has been happening so often it's almost scary. He said at least once a week he'll show a house the day it lists, and that evening he gets a call from the seller's realtor asking if the people he walked through want to make an offer because they've already received one or two others.

      Secondly how high prices have gone. We never had much of a RE crash here, one of the guys mentioned he went to an open house two doors down from where he lives and the place was listed for $380k. These were houses that would have been lucky to fetch $110k four years ago.

      Another guy there was talking about how he purchased a place in a semi-dumpy area and fixed it up, they had it appraised at an insane valuation.

      Lastly an area of town where I used to work had houses selling for $30-50k five years ago, now they're $150-200k and when a house in that area comes onto the market it's gone in a day or two.

      Maybe our prices are finally resetting to what normal house prices should be after being in the dumps for years. I know the shale gas has been fueling an economic boom in Western PA, it's like the oil boom again. People are moving into the region instead of out of the region, and a lot of neighborhoods that were junk have been gentrified in the last five years.

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  4. Pittsburgh is a popular city these days:
    http://www.bizjournals.com/pittsburgh/news/2013/04/12/pittsburgh-tops-u-hauls-moving-study.html

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  5. I think it's very telling that your analogies refer to actual businesses rather than stocks. Good stuff.

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  6. Dear Nate,

    Tom's question resonated with me, could you care to answer it if you may?

    "I have been torn between which method of value investing is most suitable for the individual investor with a small amount of capital. Whilst the net-net deep value approach has always been the most intriguing to me and the methods used by Walter & Edwin Schloss have fascinated me, I worry that with the amount of capital currently at my disposal, I would not be able to justify the transaction costs on the size of trades I would place. My first question is in your experience, how diverse does a net net portfolio need to be? The alternative is the Buffett/Munger approach who wait for that perfect pitch and have used the 20 hole punchcard analogy to illustrate their style. To do this you would need to identify sustainable competitive advantages that will keep a company generating high returns on capital into the future. My second question is have you invested in micro cap companies that have Buffett/Munger characterisitcs? The kind of company that springs to mind would be a small specialist magazine publisher who has pricing power and a "local" competitive advantage (niche) that Bruce Greenwald describes."

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    1. Hi,

      This is an old post, but since you asked..

      I don't think the size of a capital base should be a problem. You don't need a ton of stocks, maybe 30-50 to implement a Graham/Schloss strategy. If each position is $500 that means a portfolio of $15k will do. Presume turnover of about 25% a year, that's what I run close to, that's about eight positions, and at $8 a trade ($16 round trip), expenses run around $128 a year, not a problem at all.

      I would much rather have a portfolio of these cheap companies rather than a few companies I think are winners. Often the companies I think will win don't do as well as expected, and expected laggards do very well, one never knows the future!

      To your second question there are companies that fit the hidden champion or moat definition for sure. A few names come to mind, Computer Services Inc, Detrex, Bonal,Pardee etc. Many companies that have a very profitable niche that they are just working the profit out of.

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