Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.
1. Are you a value investor?
No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.
2. What is value investing?
Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.
3. What is your approach to investing?
I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.
4. How do you evaluate a stock?
I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going to be worth 3 or 4 years out? I’m willing to hold something for 5 or 10 years, absolutely, but only if there is a compensatory reward, and little downside. If the business passes my first two filters, I’m reading everything I can on the business. I’m evaluating the strength of the business, the strength of their balance sheet, their performance versus competitors, the words coming from the mouth of management, the price of the shares, everything. I’m either going to value the company based on the salable assets it has today, or the present value of its future cash flows. Something selling for a 20% sustainable free cash flow yield is as cheap as something selling for half of liquidation value. I just want to know all I can know about this business from an outside perspective, given the limited resources at my disposal. It’s necessary if you’re going to have 80% of your portfolio in 5 holdings, or even 4 holdings.
5. Why do you buy a stock?
I’ve figured out that I don’t have the time or intelligence to evaluate every security, so I’m only buying the companies I’ve taken the time to understand. Did Sam Walton care that Bill Gates got rich building Microsoft? I doubt it, because he was too busy getting rich building Wal-Mart. When I’ve strayed from this mentality, I’ve bought into the wrong companies, trust me. I don’t want to see a small price disconnect, either. I’m looking for a price that’s way off considering the value and economics of the business. GARP is a good term, except not the way it’s traditionally used. I like Growth at a Ridiculous Price. My early experiences losing money helped me develop that sort of thinking. Lastly, though I’m thinking like a 100% owner, I don’t have the money to actually do it, so I have to have faith that management won’t kill my company and cause me to lose money. In some cases, management is a key part of the thesis. At minimum, I’m just betting that they’ll maintain the value that is already there. I’m running a very concentrated portfolio, so I can’t afford to be wrong very often. One big mistake could do some serious damage, so I keep that in mind before I buy anything.
6. Why do you sell a stock?
I’ll sell something for a couple of reasons. Number one, I was wrong. Either I didn’t understand the business well enough, or my analysis was off. Unless there is a compelling new reason to hold on, say the business is now selling for less than net cash or something, I’ll sell. Number 2, the business becomes overvalued. I don’t want to risk permanent capital loss at the point. Lastly, if I have a much better opportunity to invest in, I’ll sell. However, the burden of proof is on the new idea, as Eddie Lampert has said.
7. What investment decision are you most proud of?
I’m proud of my decision to hold off on buying Delta Financial last year. I’d already gotten killed on another, similar, company, and I started analyzing DFC in a similar way. I’m looking at this company, saying to myself “OK, here’s a better than average mortgage originator, they’ve done a great job securitizing…” I mean I almost rationalized buying this company after losing my shirt on American Home Mortgage.
