Investing with Both Sides of the Brain

July 18, 2017 | François Sicart
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Participants in the investment markets tend to fall into one of two categories. A growing number engages in a relative performance contest where they essentially compete against each other or against “unmanaged” indexes over relatively short periods of time: one, five or, more rarely, ten years. These short periods are convenient for consultants and marketing staffs but, in our observation, sprinters seldom win marathons. We thus prefer to ignore short- or medium-term market fluctuations and to concentrate on our goal, which is to grow the patrimonies of our client families — along with our own — over multiple cycles and several generations.

As Ben Graham, mentor to Warren Buffett and to some of modern history’s most successful investors, wrote in The Intelligent Investor (Harper & Brothers, 1949), “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

We have already explained our caution toward today’s investment markets and why we currently prefer to hold significant cash reserves — not so much as a protection against the next decline (whenever it finally comes), but rather as dry powder to use when outstanding opportunities arise. Our practice is to buy, perhaps aggressively, at lower prices and when pessimism is rampant.

Meanwhile, our research continues unabated, although it mostly feeds a wish list of purchase candidates (at lower prices) and only occasionally triggers immediate decisions. We are also using this period to constantly fine-tune our selection criteria and our strategic approach, which will be the subject of this letter.

Traditional Value Investing Was Never Truly Long-Term

We have long described our investment discipline as “value, contrarian” but we have also stressed that we are long-term investors – as opposed to shorter-term traders. The main logic behind this choice is that little usually happens in the short term to drastically change a company’s intrinsic value or its fundamental prospects. Mostly, what changes over these shorter time frames is volatility — the mood of the investing crowd and what it is willing to pay for a dollar’s worth of earnings, cash-flow or assets. As Ben Graham used to say, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We prefer weighing to counting votes.

Individually, the words value and long-term seem intuitively compatible with a conservative approach. But closer scrutiny may reveal that combining them into a single investment formula constitutes a challenge.

The discipline of a value investor is to buy businesses at a significant discount of their current intrinsic value.

Over time, the main components of a business’ intrinsic value (sales, earnings, cash-flow, net assets) may not grow in a straight line, but they usually do so on a moderately cyclical uptrend. On the other hand, the price of that same business on the stock market’s “voting machine” is largely determined by the pessimism or enthusiasm of the investing crowd, which fluctuates more rapidly and with greater volatility than the fundamentals.

Typically, a stock bought at a significant discount from intrinsic value will thus move from undervalued to fully valued and overvalued, but then, generally, back down the same valuation scale and so forth.

There have been numerous studies, including by Nobel laureate and Yale professor Robert J. Shiller, which illustrate that the higher the premiums of stock prices climb over either historical norms or various valuation criteria, the lower the future returns. It thus makes sense for value investors to sell a stock bought at a discount from its intrinsic value when it goes to a premium. The “long term” thus becomes subject to valuation levels.

Warren Buffet, Berkshire Hathaway’s chairman and perhaps today’s most famous investor, once claimed that: “Our favorite holding period is forever” (Annual Report, 1988). This is easy to say and to practice when you buy an entire company or a controlling interest in it. If you are a smaller value investor, however, the companies you bought at a discount will eventually become attractive to other companies as well. In many cases, the stock will be taken over from you more rapidly and at a profit that will be decent, but smaller than you had hoped for over time. As a result, a successful value portfolio sometimes tends to trade more often than its long-term manager would prefer.

In recent months, such takeovers have happened to us several times, but this is a mixed blessing: it helps our near-term investment results by moderate increments, but it also detracts from more sizeable gains we hoped to realize in the longer term. In addition, it requires us to find undervalued replacements for our portfolios. In periods like the present, when compellingly undervalued stocks are rare, this often winds up increasing our already large cash balance. This outcome may prove a godsend when the markets’ day of reckoning finally arrives, but in the interim it tends to unnerve the impatient, who are always afraid of missing “something.”

Narratives and Growth, Numbers and Value

Narrative and Numbers, a new book by NYU Professor Aswath Damodaran (Columbia University Press, 2017) deals with the importance of numbers but also of the narrative in business and investment decisions. Interpreting both forms of information is essential, but both can be misleading. Furthermore, the skills to decode them often belong to very different people, which makes it difficult to approach an unbiased, uniform truth.

Still, Prof. Damodaran, an expert in finance and business valuation, argues for an approach where a business narrative is favored (for understanding) but strictly contained by numbers (to avoid self-deception and wishful thinking).

Reading his book reminded me of the age-long feud between value and growth investors.

Value investing is almost entirely about numbers: figuring what a company is worth and trying to buy its shares at a discount from that value, which also implies a contrarian bias. “Value investing is at its core the marriage of a contrarian streak and a calculator,” says Seth Klarman of the Baupost Group, one of the most successful investors of recent decades.

As a numbers-based discipline, value investing deals principally with the present and carefully stays clear of forecasts and projections into the future.

The least famous of the star investors, Walter Schloss (with his son Edwin) achieved a spectacular record over 41 years, beating the market from 1956 to 1997 by 20% vs. 11% annually (*). Most of their research was done from company annual reports. Indeed, Schloss put little faith in earnings estimates or the guidance of management and avoided contacting companies before investing. The key to successful investing, he maintained, is to properly value a company’s assets, since companies can easily manipulate earnings through accounting adjustments. (*Wall Street on Sale, Timothy P. Vick, McGraw-Hill, 1998)

Qualitatively, then, traditional value investing mostly relies on the credibility of a company’s numbers.

Growth investing, at the opposite, is mostly about narrative. One looks at a company’s past record, to get an idea of the business’s strengths and weaknesses as well as of management’s skills, but also to extrapolate an estimate of future growth in sales and profits.

If the past record of growth in sales, earnings and cash flow is superior, the future for the company’s business drivers looks favorable, and the quality of management promises continued superior growth and profitability, an investor does not have to buy shares at a discount from current intrinsic value: he or she can simply wait for the intrinsic value to grow.

Dean LeBaron, a pioneer of quantitative investing explains, “Growth investing tends to be based more on qualitative judgments about the kind of companies that will offer remarkable growth rates and exceptional returns… It [is] presumed that companies with a past record of growth in revenues and earnings [have] the momentum to carry them into the future. And they have to go farther into the future or at greater rates of growth than the market had already accorded in its discounting through current prices.”

He also quotes T. Rowe Price, who first set out the principles of growth stock valuation in the 1930s: “Growth stocks can be defined as shares in business enterprises that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in the future.”  (Dean LeBaron’s Treasury of Investment Income, John Wiley & Sons, 2002)

 Self-Confidence, Dreams and Hubris

During the 1960s, Charlie Munger worked hard to convince his compadre Warren Buffett, until then a staunch practitioner of the Ben Graham school of value investing, to look for quality first rather than to seek out deep value.

Buying cheap, “cigar-butt” stocks, as advised by Graham, “was a snare and a delusion, and it would never work with the kinds of sums of money we have,” Munger recalled in the Wall Street Journal (September 2014). The conversion was sealed when Warren Buffett wrote in Berkshire Hathaway’s 1989 Chairman’s Letter: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Munger’s long-term logic is compelling: “If [a] business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.” ( 2015)

But one thing that comes across clearly from Munger’s writings and interviews is that he is extremely confident in his own intelligence and judgment. It takes a lot of both to “understand a company’s competitive advantage in every aspect — markets, trademarks, products, employees, distribution channels, position relative to trends in society and culture, etc.” (*) and to trust that it will continue to grow and prosper over 40 years. (* Poor Charlie’s Almanack, Peter Kaufman,  Donning Company Publishing 2005)

Not everyone possesses that discernment all the time. For example, many growth investors expend a lot of effort trying to evaluate the quality of a company’s management, but this can be an elusive and volatile notion, as I was taught by two personal experiences.

In 1969, my first assignment as a young analyst was to write a report on American Metal Climax (AMAX), a leading molybdenum and non-ferrous metals producer. Over several weeks, I got all the numbers I could have wanted from the company’s financial comptroller, as well as some useful insights. I also got to meet Ian MacGregor, the company’s chairman. By the time I submitted my report to the senior partners, I knew most of what there was to know about the company. In fact, when AMAX’s copper mines in Zambia were nationalized, I knew instantly how many kwachas per share this would cost the company!

When I recommended AMAX (*) as a contrarian, value investment, however, several partners objected that it did not have the reputation of a well-managed company. Then in the following couple of years the price of copper doubled and MacGregor’s leadership was widely recognized.  It is said that, for investors, genius is a bull market. It could be said that in the corporate world, it is rising product prices that turn corporate managers into “geniuses.”  * In 1993, AMAX merged into the Cyprus Minerals Company which, following subsequent mergers, is no longer listed.

Some years later, Philip Fisher, viewed by some as the “pope” of growth investing, invited me to visit a California company with him. Fisher famously paid more attention to the quality of people, products, and policies of firms than to their past financial numbers. “After reading financial reports, he gathers background information about his purchase candidate. He speaks by phone or in person with customers, suppliers, competitors, and others knowledgeable about the company. Then, if the company is worthy of further consideration, he meets with the firm’s top executives and questions them about their businesses.” (Nikki Ross, Lessons from the Legends of Wall Street, Dearborn Trade, 2000).

I certainly can vouch for Philip Fisher’s investigative thoroughness and keen understanding of the businesses he analyzed. In spite of this, however, the subsequent performance of the company we visited together was disappointing. This does not detract from Fisher’s well-deserved reputation as an outstanding analyst or from his investment record: it just goes to prove that qualitative judgments about corporate managements are iffy.

Reconciling Numbers and Narrative, Growth and Value

We live in an era when Adam Smith’s “creative destruction” has intensified. Increasingly, the way to measure productivity and success in traditional industries such as metals, chemicals, manufacturing or economic sectors such as services and retail, is becoming irrelevant to newer, more immaterial, even virtual businesses that are replacing them.

It is difficult to fathom the future value of “disruptive” businesses when they have little or no current profit and the size of the markets they can eventually capture from older competitors is still speculative. Yet it is difficult to ignore that biotechnology companies, Amazon, Google, Uber, Facebook, TripAdvisor, Netflix and the like are transforming the investment landscape. How do we adapt our research universe to include these new entrants without abandoning our value, contrarian discipline?

I think one error would be to try and apply our traditional value criteria to the new growth industries, which typically are asset-light and intellectual-property- or know-how-heavy. But another error would be relying only on these companies’ narratives and on the “alternative” accounting data they often adopt.

We have elected to treat the two universes separately: One is well-suited for traditional accounting and analytical criteria and another is more suited for the narrative and imagination, though we try to make an educated guess about credible numbers.

In both universes, we enjoy an advantage over the majority of investors: the luxury of having a longer time horizon. Most financial analysts and portfolio managers look at corporate results on a one-year horizon, two years at most. This is dictated by clients, boards, trustees and consultants, who scrutinize performance over short periods ranging from quarterly to annual. We, on the other hand, are willing to make educated but considered guesses about sales, earnings and valuation two or more years out.

For the “narrative” part of our universe, even though precise estimates would be an illusion, we make every effort to envision all possibilities five years out or more, and then weigh the risk of loss against the profit potential of our various scenarios.

As we do this, we try to keep in mind the admonition of Peter Lynch, legendary manager of the once-spectacularly successful Magellan Fund. Lynch warned that that there are two ways investors can fake themselves out of the big returns that come from great growth companies:

“The first is waiting to buy the stock when it looks cheap… The second is to underestimate how long a great growth company can keep up the pace.” Both mistakes are easy to make, but Lynch had a reliable sell signal: “If 40 Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling.” (One Up on Wall Street, Penguin Books, 1989)

This is why both our value selections and our growth ventures will continue to have a contrarian bias.

François Sicart

July 15, 2017



This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.