Developing an Investing Philosophy - 2020 Edition
From starting my investing journey with Buffett to Graham and Fisher, I reflected on the past 5-6 years to pull out what my investment philosophy looked like.
A long-only, public equity investing strategy that finds and invests in businesses that:
Are operated by owners (i.e. skin in the game) who are/could be intelligent fanatics/iconoclasts I want to partner with
Builds a moat around investing in people to generate high return on capital
Dominates their market
Ability to expand dominance through reinvestment with healthy financials
I can sleep well holding for 10+ years
I can own in a concentrated portfolio of 4 to 8 businesses
I have an edge in either analysis, psychology, insight, and/or structure
I don’t know if this is the ‘win-all’ strategy and I’m not saying it is. It’s just mine and it fits why I invest, and my general style. Of which I explain in detail below as I comb through my mind to come to conclude on the above.
Initial Reflection.
Since then, my views have been influenced by very many businesses, entrepreneurs and investors alike. Though, I’ve found a gravitational pull towards the concentrated investors like Munger and Greenblatt.
I also found a pull to smaller and less liquid companies after realizing the great investors of now began with small companies. Ian Cassel of Intelligent Fanatics Capital has been a major influence here.
From investing my own money, working at a fund managing other’s money, and reflecting on what truly interests and excites me…. I found a pull towards the weird, unconventional companies. The so-called “boring”. Given this site’s homage paying respect to my own “boring-ness”, this makes sense.
On top of the weird companies that interest me… the other points of fascination have been on people. Human performance was what brought me to investing in the first place as I sought for a job similar to powerlifting. This may also be the reason why I gravitated to reading books like Thorndike’s The Outsiders and Cassel's Intelligent Fanatics and why I continuously put more weight on management.
This could also explain my attraction to angel/seed venture investing given a desire to put greater focus on management. But alas, I once again needed to find something unconventional and weird and that brought me into the realm of bootstrapped, remote companies like Basecamp…. VCs who invested in such companies like Indie.vc… and for small companies that dominated niches per Burlingham’s book: Small Giants.
When I left the institutional investing world in 2018, I knew investing would continue to play a major part of my life. The decision a few years ago was to not raise money to manage other people’s money but to remain a private investor who constructed an engine that could generate cashflow for me to increase my own investment float… but who knows.. maybe I’ll manage money for the brave, patient, and weird that believes in all that I stand for below.
So it’s in the light of the 2 year anniversary of my departure from employment, 6 years after my foray into investing, and in the midst of my first major bear market (COVID-19 Pandemic as I may tell the youths of the future) that I thought I’d sit down in the quarantine of my home to write down my current philosophy/affinity towards investing in the public markets… at least until new facts dictate I change my mind.
Copying Existing Frameworks
What I’ve noticed is that many investors/funds follow a kind of 3-point framework. The fund I was at looked at great businesses, run by competent management at a fair valuation. This is very similar to what Charlie Munger’s frequently said in his interviews as well. Simple. Chuck Akre uses the “Three-legged Stool” framework of business model, management, and the business’ opportunity to reinvest cashflow.
When I consider the other investors I mentioned above and the ‘crowd’ I’ve been attracted to, their checklists/frameworks are relatively all similar with:
A concentrated investing style
With a long-term time horizon
In great businesses (i.e. compounders)
Run by exceptional management
That can reinvest to grow the business at a high return on capital
Purchased at a fair price to intrinsic value
So what is my framework?
I daresay, I do not have a need for originality.. but I guess one of independence where it’s a framework that fits my belief…
As I continue to quote cliche’s, I truly do believe investing to be more art than science. Some may argue it’s more science than art when looking at amazing quant firms like Simon’s Renaissance Technologies but I view it merely as a different style. There are so many ways to make money after all.
To be frank, I much more believe that qualitative factors will be the differentiating factor for investing success than quantitative analysis. At least for me…
"Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess—I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight.” This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” - Warren Buffett
I guess I’m more in the camp of big money over sure money? Though I’m hoping to have a bit of both.
But as much as I may blabber on about my beliefs and my frameworks… for the time being…. I’ll be stitching together things other people believe and have done. As Picasso says, “Good artists borrow, great artists steal”… and with investing being an art… I daresay I must steal to make it my own. Monish Pabrai, another investor I admire, frequently speaks about the value of cloning other great investors as he had done. Not to mention the many writers I follow who talk about how you end up following the writing styles of your favourite authors until you develop your own style.
My “Style"
It may be blasphemous to not follow Jeff Bezos’ view on customers first but I think that becomes the second order effect of employees first.
"In business school, they'd say, ‘This is a real conundrum: Who comes first, your employees, your shareholders, or your customers?' My mother taught me that your employees come first. If you treat them well, then they treat the customers well, and that means your customers come back and your shareholders are happy.” - Herb Kelleher, Founder of Southwest Airlines.
I believe Southwest’s financial results can speak for themselves when they’re practically the only airline to have achieved 20 years of profitability in a capital-intensive industry that is not known for great returns on capital.
As fitting with what I set out to do with OMD Ventures, I believe a great business builds a moat through its people first. The skeptics and “data-oriented” may chirp and croak about the need to prove how one would measure performance and the fact is, one only needs to look at the long term financial results of the business to see if it’s working or not. Some businesses will achieve top financial results without investing in their people but to me, that’s been the result despite the negligence. Not because of it.
I do hold the view that as a business becomes larger, the importance of the management team and the system surrounding the business’ people may have lesser weight as the business model picks up steam. This may guide my focus to smaller businesses but some large companies who can continue to not lose sight of investing in people will probably do exceptionally well compared to large peers who do not.
The close-minded may believe the idea of culture is ‘woo-woo’ and mistake investing in people as merely culture. That is not so. Whatever the term is, it’s like what Justice Stewart said in regards to pornography: “I know it when I see it."
Investing in people does not mean making sure everyone is happy. That could be a result but that is not a requirement. Like Nietzsche, I believe some folks are more capable than others and those more capable need to be supported to make a great contribution to the world than those that are lesser able. Much like knowing your circle of competence as an investor.
The more entrepreneurs I’ve had a chance to meet, the more I’ve gotten to study, the more I believe they have something special. I know that’s why I don’t ever want to run a 100+ people organization. It’s not my place. But I’d very much like to find those people and support them. Organizations that build a moat around people recognize this and create an environment to bring out the best from the best.
This focus on investing in people gives rise to numerous amazing companies I love like Basecamp, Patagonia, Constellation Software, Berkshire Hathaway, Semco etc…
I empirically understand the value of investing in great businesses. If Munger, Fisher and many other great investors believe in it… it’s good enough for me. To be frank, it plays well to the kind of investment I want: One that’ll let me sleep at night.
I’ve also learned from my experience of buying “traditional” Graham-style net-net investments that it doesn’t excite me. Especially if it’s a commodity-related business… as my experience is that sometimes factories can be written down from $500M in value to $0 to result in immediate bankruptcy.
Hence, my framework will include investing in great businesses. A great business would include the ability to generate high returns on capital.
"Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.” - Charlie Munger
But a great business that is also weird, unconventional, unusual…. That is interesting to me. The fact is that, if I’m not interested in a business then I will not want to learn more about it and that’s probably the end. Of all this, a key criteria would be that the business has built its moat by investing in its people.
This would lead to the framework of management. Though I would prefer founder-led businesses, I’ve seen how professional operators can turn an entire business around (i.e. Satya at Microsoft or Howely at Transdigm) so this has broadened the focus to owner-operators. To say the least, it’s an aligned management team. If I’m going to own a part of the business, I want to do it with leaders who have skin in the game. Simple enough. Preferably, large insider ownership with less silliness with warrants/options that dilute shares.
The framework of management is a broad term that intertwines with the people and the overall culture of the organization. Whether it’s management’s compensation being tight to return on capital metrics over 5 year periods or a requirement for a majority of senior management’s bonuses to be reinvested into buying the company’s stock on the public market… This could also trickle to the makeup of the business where there are many decentralized units or an M&A tactic that doesn’t result in centralizing operations to cut costs to maintain the culture at operating units or only acquiring 80% of a company so the existing management team has an incentive for profit from the 20% they retain.
Now, a clear fact of moats is that they either expand or contract. Either by function of the market growing or shrinking and/or because the business loses or gains share in the markets it operates in. This could be an expansion in an existing market, entering a new market or creating a new market. Either way, stagnation is no good. The value of investing in public equities is to have a chance of investing in organizations that will continuously grow and succeed as a result of investing in human capital. That’s what I’d like to see from my investments.
I believe that my reward as a shareholder will be an outsized business performance result and that will only be the result of investment in people by its leaders. What I’d learned from speaking with 100s of business leaders has been that such a tone for investing in people needs to be set by the leaders and that’s what makes the management so crucial.
No matter how much analysis I do bottom-up and no matter how much I believe a business needs to be built bottom-up, the general tone and belief in that view must be set by the management at the top. That means creating a system that is continuously altered from bottom-up feedback but still executed from the top-down.
This is why management is so important. Management is what sets the tone for the future and what the business has done up to this point is a reflection of what the management stands for now.
Ever-increasingly so, I find my search starts with Outsider-type management who are iconoclasts in their industry. Then I’ll look at the business and see if I get interested further in.
This means the business needs to be able to (or at least have a high chance of) reinvest all its free cash flow at higher rates of return. This could mean a large addressable market where the pie is growing at a rapid rate and/or it isn’t fully saturated with incumbents. Either way, paying away all the FCF in dividends or share buybacks with no strategic reason is not interesting.
At What Price?
How much is a business that generates 80% return on capital, grows free cash flow at 20%, has a dominant position that only results in 5% of the total market with the next biggest competitor at 2%, with free cash flow margins at 40%, gross margins of 70%, operated by a founder who owns 25% of the business etc….. worth?
Anyone who is remotely familiar with Buffett and Munger knows they err to the view of “great business at a fair price over a fair business at a great price”. But what is fair?
It’s quite subjective is it not? I would be the determinant of the business’s value and the idea is that I would pay a lower price than what it is valued at. I really don’t care if people think this is a cop-out answer but I don’t think anyone knows the value of companies. At least not the ones that are truly great businesses. Financials show the past but when investing in compounding businesses, you are looking at the future… which is so hard to predict. I would’ve never been able to tell you that Amazon would be a $1tn business in 2004.
Price obviously matters. But it’s probably a place I spend the least amount of time on. Prices of goods are quite relative aren’t they? If I have 10 great businesses, I’d probably compare the current prices between the 10 and that’ll be a factor to consider. And that would also be relative to everything else that represents the business and its management team.
I might be willing to pay more for a business that has an amazing operator with an amazingly aligned business culture than one that doesn’t have one but is an amazing business only.
If I were to use a discount rate for simple DCF calculations, I'd use a range from 10% to 15% because I consider that to be my own internal hurdle and my opportunity cost. Another approach it consider is to look at the FCF yield the business is priced at and consider the implied growth of the business given my discount rates. I can make a judgment of whether the price is reasonable or not from that.
Reasonability is another word for how much margin of safety do I think I have and am I comfortable with that? Sometimes, a business will be priced in with no growth. Sometimes, it will be really low growth and given the characteristics of the business, I may find the margin of safety to be great. Sometimes, the margin of safety may not appear to be great and I may not purchase it but I may be willing to forgo that given how much I love everything else about it. But my portfolio will have to reflect that.
It almost feels like I haven’t been definitive in my answer and maybe that’s because that’s what valuing a business is actually like. It’s never definitive. At least, the kind of businesses I’m attracted to and want to find. If I am consistently looking for 10x, 20x, 60x or even 100x potential businesses… I should be rather fine with paying a price I think is reasonable given the facts I have at the moment. But the work will continue from reassessing the management and business annually.
Does Size Matter?
I’m sure it does. But we can’t ignore liquidity. What I learned from working at a fund is that one of our greatest restrictions on whether we could buy a share of a business was related to its liquidity. Liquidity truly restricted the size of our investable universe. There are regulatory restrictions that require your ability to have a certain amount of liquidity, not to mention some mandates have risk policies requiring a certain amount of liquidity for client redemptions. The bigger the fund's AUM, the harder stricter such liquidity restrictions are.
There is also the ROI on time where funds don’t want to dedicate research time to companies that will never become a major holding in the portfolio. If the portfolio has 80 companies and the max size per holding is 3% per stock, the fund probably doesn’t want to bother on small/illiquid stocks that will only be 0.3% holdings.
There is also literature from Roger Ibbotson of Yale and Zebra Capital that shows how illiquid companies, especially the small and illiquid companies, tend to have higher outperformance than liquid names over some 20 year time period.
This allows small investors to get into illiquid names and ride up the increasing liquidity that larger funds bring in as the company grows in enough size and liquidity for them to invest in.
But size also matters. A $100M company that becomes $10bn has 1000x but if you get in when it is $1bn it has 10x….
But the business at $100M may be much different than when it is at $1bn. It may require greater gambles of forecasting at an earlier stage. Sometimes it may not.
It could also be that a $100M company may not be able to become a $50bn company but a $1bn company might be able to. Because it might be in different businesses and it may have a different kind of management and it may result in a different incentive and purpose.
Like I mentioned before, I love small businesses that dominate small niches. And there will be a place in my life to work with founders of those businesses. I thought that would be the case for public companies too but my mindset has changed around that.
I previously thought I’d only stick to the small and illiquid because I would have an edge over the larger funds. It’s also the place with less competition as many companies are not covered by research analysts of investment banks and many are under the radar.
But I’ve decided I wouldn’t restrict myself to size. Though I’ll be honest, I find smaller companies to be weirder and more unconventional because they aren’t well known yet… just like how software roll-up businesses were rare when Constellation was a $400M company than now when it is a $25bn company.
I do like companies that are less liquid than others. I also do like companies that have minimal institutional ownership. However, I would much prefer to own a company that I could see dominating for another 10+ years. This may be in small companies but it may also be in larger companies.
With many more companies choosing to stay private, a $1bn company may not really be a mid-cap company either… It could even be considered that a $1bn could be an illiquid small-cap company as well.
This also places into consideration my own time commitment. The fact is that I am continuously trying to build a business in OMDV where management of a public equity fund is not the core focus. Rather, the core focus is invest in human potential but that is not limited to public equity. With that consideration, I have to consider looking at companies that provide the trade-off of widely available information sets, some establishment of a moat etc…
But if I had to pick an area I like to look at, it would probably be SMID-cap. A cross of small and mid-cap names with the hopes of finding ones that will becoming prominent large caps in the future. This group of companies still fit under a some-what earlier and illiquid camp but doesn’t require as much hand-holding as a micro-cap will. Though, I’m hoping to focus a lot of the work for OMDV on even earlier stage companies so I think I’ll be able to get everything I want and be able to assimilate mental models between the two.
The OMDV Operations
This brings on the POV of portfolio construction.
A big one is on diversification. Simply put:
“Two things should be remembered, after purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and overall market risk will not be eliminated merely by adding more stocks to your portfolio.” - Joel Greenblatt
"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally." - Warren Buffett
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” - Warren Buffett
“A well-diversified portfolio needs just four stocks.” - Charlie Munger
I could go all day but the logic resides in concentration of my holdings. I think the goal is to get to 4 holdings. But given how I’m starting in a position of ignorance and need some defense on that, I’ll probably lean to be a little higher with an investment in 4 to 8 businesses.
The view is to think of each business in the portfolio as a segment of OMDV and each management team as a set of partners for the overall OMDV business. This is the approach I’d take to each investment. To look at it and see if this is a business I would like to have as part of OMDV.
As time passes, I do believe the better businesses will make up a larger function of the portfolio and the weaker ones, in business and conviction, will make up a lesser part of the portfolio.
Given how I would approach the portfolio as a full operation of various companies, I would consider looking at leverage from the holistic point of view as well. I typically prefer low debt businesses. My general view on debt is that it’s preferable not to use borrowed money. Equity financing is no better either and greatest preference is for businesses to grow by reinvesting their cash flows.
But I cannot deny that there are some managers who can masterfully use leverage like John Malone of TCI/Liberty fame. Hence, to enable flexibility of management who can prudently navigate the use of leverage, I think looking at leverage from the point of view of my entire portfolio instead of only at an individual company basis may be important as well.
This all boils down to controlling the downside to limit the permanent impairment of capital you see.
“If you are going to be a very concentrated investor, you should not use leverage. You can’t leverage because you need to live through the downturns and that is incredibly important.” - Joel Greenblatt
Big swings and drawdowns of 50% don’t bother me as much, if it’s in businesses I have conviction in. I’ve had it happen to some other businesses and the worry and loss of sleep revealed how little conviction I actually had and it was a position I should not have initiated. Lesson learned I hope. Concentrated portfolios will inevitably experience this and it is up to me to control the worst-case exposures. Leverage plays into effect as a result.
My Edge
Every investor needs an edge. Investors tout the virtue of competitive advantages and moats in businesses but an investor too needs his own competitive advantage as investing is a business in itself. Business may just be a loaded term for the act of doing something worth doing where one should be able to generate high returns on investment. Then one may look at one spends her time on in a different light. The investment being time/effort/capital and return being financial/emotional/material/biological etc..
Alas, what do I consider my edge as an investor to be?
Many investor presentations present the following as the broad ‘edge’ categories.
Informational
Analytical
Behavioural
Usually, the first one is illegal in public markets but is very much an edge in private markets. Which may also be why many gravitate to the private side because of another pillar of ‘edge’ being available.
Analytical is often touted to be the one for the quant funds but the qualitative shops view that as their edge as well.
Behavioural…well Buffett says temperament.. the ability to truly think long term, to be patient is an edge. Bezos calls it the ability to be misunderstood for a long time. On that note, I recommend finding his interview with Charlie Rose in 2010 when people were still making fun of Amazon and they looked at AWS as some weird venture.
For a while, I felt many forgot about another pillar that should be put into the ‘edge’ categorization: Structural.
The structural advantage an investor has for not having to deal with short-term minded clients (i.e. 90% of people who invest in funds). The structural advantage of having small amounts of capital under management so that they can have concentrated positions in less liquid names. The structural advantage that comes with a longer time horizon as someone in their 20s vs. Someone in their 40s.
I believe structure is the system that drives whatever behavioural adaptation. The structure can also incorporate a relatively frugal and low cost lifestyle as well. Consequently, this is what I also like to see in management I invest in. I am quite turned off by large compensation packages for CEOs and the abuse of company capital for lavish expenditures. This behaviour breeds into company culture you see.
As far as public markets are concerned, I probably have no informational advantage. What I have are analytical and structural.
Analytically, I’ve learned about very few management teams that focus on an investment in people as a driver for their investment thesis. I’ve met one fund that ignores financial data and invests on people data. For me, I believe the analytical advantage exists in an ability to connect the people side and the financial side. I don’t have a set formula but rather a focus.
For this kind of analytical advantage to persist, I will most likely have to seek out companies that are earlier on in their growth cycle. This could mean a micro-cap or a mid-cap company. As long as I perceive the company to have enough runway for growth for the next 10, 20 years. I cannot forecast the next 10 years but the conviction will result from seeing the systems the management has put in place and how that execution has translated to outcome in financial terms. I admit, sometimes it may not be as clear and for that I may need to wait longer or invest in small chunks as I follow the execution pattern.
Structurally, I will have an advantage in less liquid names. Though, I may be deviating from this here as I believe the focus is to find great businesses that succeed as a result of an investment in human performance. This may bring me to invest in companies that are not necessarily illiquid but in fact, very liquid. Though I may be throwing away my advantage of managing a little big of capital, I can still utilize my structural advantage of being able to hold onto an investment for 20+ years with distraction limited to myself.
Simply put. My edge is psychological in who I am, what I’m naturally attracted to, my ability to suffer, the systems I create for myself to obtain various mental models, and the view that a business is a commune of people building something. I do not believe my edge is distinct. Yet. It’ll take continuous work and time to sharpen it but this is the one I plan to sharpen.
A Philosophy That Serves Me.
Naturally… an investment philosophy should serve me. It’s like a training program to get stronger or a diet to stay healthy. The one you can stick with is best. That requires a deeper understanding of who you are, what you are hoping to achieve and even more so, why you are doing anything.
Investing, for me, is fun. But what about it is fun you may ask? I would be lying to you if I said wealth didn’t matter. Of course it matters. However, wealth is not what I’d use in a piss contest.
The fun part comes in the intellectual process of learning. For me, the most excitement in the learning results from finding other businesses that challenge social conventions in lieu of the rational, logical and commonsensical.
It’s the kind of feeling I get when I read Mark Leonard’s shareholder letters for the first time. It’s the giddiness I feel when I hear about the frugality of AB Inbev’s HQ. The excitement learning that Atlassian has no sales team. It’s about finding these weird businesses run by intelligent fanatics. Usually, the business becomes interesting as a result…. Preferably, the business too is weird and misunderstood so I can like it more.
Investing is finding such partners that I want to align myself with because we share similar values on life and core beliefs. Sometimes it could be because the business is just so fascinating. As I reserve every right to change my mind. But investing is how I stand by what I believe in by deploying my hard-earned capital.
In one way, it’s the belief in the prosperity of humanity and especially that the unsexy, unconventional ways I believe in are right and everyone else is wrong.
Compilation.
A long-only, public equity investing strategy that finds and invests in businesses that:
Are operated by owners (i.e. skin in the game) who are/could be intelligent fanatics/iconoclasts I want to partner with
Builds a moat around investing in people to generate high return on capital
Dominates their market
Ability to expand dominance through reinvestment with healthy financials
I can sleep well holding for 10+ years
I can own in a concentrated portfolio of 4 to 8 businesses
I have an edge in either analysis, psychology, insight, and/or structure
Until it all changes as I make more mistakes.
Disclaimer - I’m writing this for myself. For my past, present and future self. Much of what I write is my opinion. If it somehow ignites agreement in you then great, I’d love to hear about it. If it sparks disagreement in you, don’t reach out because I don’t care for it. There always are obvious exceptions and the flawed person in me hasn’t considered them all.