Investing Strategy: "Don't Forget What You're Trying to Do"

There are lots of bargains in small stocks currently; I believe it's risky if you limit yourself to a specific, rigid style box; Remember Munger's words about not forgetting what we're trying to do

I recently wrote a Saber investor note about three new investments we made recently and how I’m finding a lot of opportunities in smaller stocks (more notes below, and more to come on some of these as well). A number of these less-followed stocks look quite compelling. A few clients have asked me if these investments represent a strategy shift, because for many years, we’ve owned a few larger companies with dominant competitive positions. To me, it’s no shift at all: we are simply doing what we’ve always tried to do, which is attempt to find great value in companies I can understand.

Value can come in a variety of shapes: in the early part of the 2000’s, I was investing in my personal account and there were countless numbers of small cap bargains. This seemed to persist through the downturn in 2008-09, but then, in the early to middle of last decade, some of the world’s best businesses got cheap: Microsoft traded near 10 P/E, Visa traded at 15 P/E in 2011. Google traded under 14 P/E ex cash, and Apple got dipped under 10 P/E last decade (to be clear, I’m using these as examples of how cheap the best businesses were in some cases; sadly, not all of these were Saber investments!) Given that the multi-century average earnings yield for American stocks is around 6% (or around 16 P/E) and that these companies were much, much better than average, that was obviously some great value.

But more recently, I think the landscape once again has shifted to where there might be better opportunities outside of the largest companies. Apple is one of the world’s greatest businesses ever created and for years it was a core holding for us, but there is a price where the stock is very safe and another price where it is less safe or even risky (I’m not saying Apple is risky here; I’m simply stating the obvious, which is Apple at 10 P/E is a much less risky investment than Apple at 30 P/E).

The third engine in the three drivers of value (the P/E multiple) has gone from a huge tailwind to a potential headwind. It’s worth mentioning:

• A stock that goes from 10 to 20 P/E even over a decade enjoys a 7% annual CAGR just from the P/E expansion, which adds a nice chunk above and beyond whatever earnings CAGR the stock produces

• Conversely, a stock that goes from 30 to 20 P/E over a decade has to overcome a 4% per year headwind

• And this is over a decade; if these changes occur over a 5 year period, the 10 to 20 P/E stock’s tailwind becomes 15%/year and the 30 to 20 P/E headwind becomes 8%/year

  • Note that 5 years is still a long time for an average holding period (a portfolio with an avg hold period this long implies many stocks are held much longer than 5 years). Few funds have a turnover rate of 20%, which implies a 5 year holding avg holding period;

  • So, what this means is even for low turnover funds with an avg hold time of 5 years, the P/E engine is a significant and meaningful part of the portfolio’s results

While it’s true that over the very long term (20-30+ years), the P/E engine becomes less of a factor (although even then it’s a factor!), it remains a sizable factor over periods as long as 10-15 years, and perhaps more than many people realize. I heard Bill Nygren recently say on a recent podcast that almost every stock that he buys is underwritten with the idea that the multiple is going to rise (and Bill tends to own stocks for many years). It’s because Bill of course understands this tailwind (or headwind) is meaningful even over a long period of time.

There are some large stocks that still offer great value in my view, but the quantity of bargains in small/mid cap stocks is the most I’ve seen in many years. Saber’s watchlist has all kinds of businesses, and while there are commonalities I’m looking for (durable free cash flow, a business I can understand, rational capital allocation, good returns on capital), size is not one of them. There are highly predictable, durable companies that are small, just as there are risky, unpredictable companies that are large. All we want is value, which means paying less than something is worth with a large margin of safety. Right now, I think this value happens to be in smaller stocks that are somewhat off the beaten path.

“A majority of life's errors are caused by forgetting what one is really trying to do.” - Charlie Munger

Munger warns us to not forget what our main objective is. First let’s state what we aren’t trying to do: our goal of investing isn’t to invest in companies of a certain size, or in stocks that meet certain metrics, or in conventionally defined “value stocks”, or even in “quality companies”; our goal compound our capital at the highest rate we can at a minimum of risk. We might use any of the above as a means of achieving our goal, but let’s keep our eyes on the ball and not forget what our goal really is here. Simply put: while finding great businesses can be (and often is) a means of achieving our goal, our goal is to make great investments (a key distinction).

I think a lot of investors become obsessed with bucketing their investments or their style into one specific, neatly defined category. But sometimes this can lead to a rigid process that can easily slip into to a dogmatic approach that not only leads to suboptimal returns, but sometimes even excess risk (and future losses) if it means paying far too much for a great company. I have more thoughts on this latter topic for an upcoming post, including some of the math on the probability of accurately identifying a top 1% business and the practical constraints and pitfalls to be mindful of.

Please note that these thoughts are written by an investor (yours truly) who loves investing in quality companies. I seek out durable businesses that pass the “10-year test”, companies that are building value and producing strong cash returns for owners, run by rational people who allocate capital in a way that I can understand. The small and mid-sized companies I’m focusing on all pass these quality tests. But the goal is great value; specifically: low risk, high quality investment returns for my partners. Writing these notes helps remind me to keep focused on that goal and not let secondary objectives be taken to the point where high quality leads to fragility, because fragility is introduced when the price paid is too expensive.

For this post, I intended to share some thoughts on a recent book I read about John Neff, who warns of “growth traps”. Since this post is getting long, I’ll save those thoughts for part 2 in a follow up post.

For now, I want to share some notes below which come from a recent Saber Capital investor note. These are not stock recommendations, but they do describe the valuation I see in three recent investments (without naming them yet). I plan to share more details of these investments with clients and readers at a later date, but this is a sampling of the types of ideas I find compelling today, with numerous others in the works: