“Many shall be restored that now are fallen, and many shall fall that are now in honor.”
– Horace. This is the opening quote in Benjamin Graham and David Dodd’s “Security Analysis”
Buffett & Munger
Warren Buffett started his career buying cheap stocks. These weren’t good companies, they were mediocre and bad companies that were ridiculously cheap. After the 1960s, his style evolved from buying cheap “cigar butt” stocks to finding quality companies at decent prices. “Quality” in the sense that the companies are capable of compounding wealth over long periods of time.
Buffett moved on to the new style of investing primarily as a matter of size. His wealth had advanced to a point where it was difficult to move in and out of companies when they were at 2/3 of their value and then sell when fully valued. He had to be able to park money and let it compound over long stretches of time. Another reason for the style change was via the influence of Charlie Munger. The quality companies that he purchased are now famous investments: The Washington Post, See’s Candies, Coca-Cola, Gillette, etc.
These were companies that had high returns on capital. They were also businesses with competitive moats. No one will ever be able to make a beverage that can effectively compete with Coca-Cola. Men will always shave with razors and Gillette is the most well-known brand. People will always buy candy and See’s candy is a great brand. You’re not necessarily going to play it cheap on Valentine’s Day. No other paper will displace the Washington Post as the premiere newspaper of the Washington, D.C. metroplex.
Many value investors that were small in scale were able to achieve high compounded rates of return dealing with cigar butt stocks. They normally become too wealthy to nimbly move into and out of cheap stocks at the opportune times. A notable exception is Seth Klarman. Very few been able to duplicate Buffett’s returns at his size, or even fractions of his size. Buffett admits that size matters. In fact, he says that if he were running $1 million, he could achieve a 50% rate of return.
It’s Not As Easy As It Looks
Everyone saw what Buffett did and now wants to duplicate it. In retrospect, it seems obvious that the businesses Buffett bought would go on and continue earning their high returns on capital. But was it as obvious as it seems now with the benefit of hindsight? If it is so obvious, why have so few been capable of duplicating Buffett’s results?
The answer is competition. The forces of competition in a capitalist economy are relentless. Consider this: since 1955, 88% of Fortune 500 companies have moved on in one way or another. There were countless companies that had high returns on capital in Buffett’s time that looked invincible. I’m sure most former Fortune 500 companies looked invincible in their heyday, but 88% of them weren’t. Buffett was capable of identifying the companies that would survive and acquiring them at a good price. He made it look easy but it wasn’t.
Competition is relentless. Any business that achieves high rates of return is going to attract competition. Human nature makes us extrapolate whatever is happening in the present into the future, but this is typically folly.
Let’s say I invent a widget that costs 50 cents to make and generates $1 of revenue, a 100% rate of return. Naturally, other companies are going to try to make widgets. They will undercut me in price. The supply of widgets will also continuously increase until it meets the demand. Over time, the introduction of competition will reduce the rates of return. Think of what happened to any major industry and you see the forces of competition in action. This isn’t a flaw of capitalism, it’s a feature. It’s one that benefits the consumer.
The impact on the stock prices of companies of these competitive forces is even more extreme. The widget company earning 100% returns on capital is going to attract a lot of attention on Wall Street and will likely earn insane valuations. Therefore, not only do these companies have real-world economic pressures that will bring them down, their stocks typically become overvalued as well. The introduction of competition to a company with an overheated price is an explosive combination.
You can see this in the backtesting for mechanically buying “quality” stocks with high growth and returns . The returns aren’t linear like you would expect. The “best” decile doesn’t perform the best. Unlike the backtesting for value metrics — which typically show a linear relationship where the cheapest decile has the highest stock gains and then they decline from there — quality metrics typically show lumpy returns. Typically the best returns are somewhere in the middle. The companies in the highest decile “quality” metrics don’t deliver the higher rates of return. You can see this in backtesting for return on equity, return on invested capital, return on assets, growth in earnings per share, etc. The notable exception to this is gross profits to assets, as discovered by Robert Novy-Marx. Although now that it has been discovered, it is possible that this advantage may be arbitraged away in the upcoming years.
In an attempt to duplicate Buffett and try to elevate value investing above the dirty business of buying cigar butts, value investors are constantly trying to marry “quality” with “cheap”. They’re looking for companies with amazing managers, a competitive moat, high returns on capital . . . that also sell for a good price.
This might sound easy but it’s not. As I mentioned, 88% of the Fortune 500 from 1955 is now gone. I’ll bet they all thought they had a “moat”.
General Motors used to have a moat in the 1950s and 1960s (well, it was an entrenched oligopoly, but a form of moat nonetheless). Other companies that appeared at one time or another to have a moat were Bethlehem Steel, Kodak, Standard Oil, Western Union, The American Tobacco Company, Fairchild Semiconductor, RCA. All of these companies eventually succumbed to the relentless forces of competition and were taken off their perch.
Buffett and Munger have an underappreciated genius in identifying these rare firms with strong moats and high returns on capital and then buying them at discounted prices. I don’t think this is something that can be replicated in any quantitative fashion. Joel Greenblatt attempted to do this in The Little Book That Beats the Market, with outstanding results. However, Tobias Carlisle discovered that the quality component of Greenblatt’s formula (return on invested capital) actually reduces the returns. You can read about this in Deep Value. Simply using the “cheap” component of the magic formula actually achieves better results.
My thinking is that attempts to duplicate Warren Buffett and Charlie Munger actually leads to the under performance of value managers. It’s the reason that most value managers outperform the S&P 500, but can’t beat the lowest deciles of price-to-book and price-to-earnings.
The Good News
The obsession with quality creates many of the value investing bargains that I seek. The flip side of the relentless impact of competition on high return business is that low return businesses attract little attention. Low return, bad businesses aren’t necessarily dead. They may be at the end of a waning period in their industry in which many of their competitors are dying. The decline of competition will ultimately drive returns higher. A struggling business with a low ROE is trying to turn things around, likely by reducing their costs. If their strategy doesn’t drive returns higher, at the very least there will be very little competition and the existing competition may leave the market behind.
A good example of something like this is a stock like Archer Daniels Midland. It operates in a mediocre return business (ADM has a ROE of 7.77%, compared to a Buffett stock like Coke with an ROE of 15.92%), but attracts little competition due to the mediocre returns of the business and large investments necessary to penetrate the market. No one is going to make the massive investments in scale to duplicate ADM’s results for a relatively low ROE. Simultaneously, low ROE stocks will typically be ridiculously cheap at the end of a competitive cycle because they generate an “ick” reaction in most investors. “Ick” creates bargains.
The “Ick” Factor
I’m not opposed to quality investing. I just think it is far more difficult to implement than is typically appreciated.
If one is going to go down the “quality” road, I think it’s important that the stock have some level of an “ick” factor to the investing public. If a consistently high ROE stock with a competitive moat has what appears to be an attractive price, it’s important to ask why everyone else doesn’t see the value (particularly if your insight into the attractive price is achieved with DCF analysis).
A great quality investment needs to generate an “ick” to ensure you’re getting a good price. Some of the best Buffett buys had a massive temporary “ick” factor — like the salad oil scandal, New Coke, or GEICO’s massive losses in the mid-1970s. If the stock isn’t reaching out to you with an “ick” factor, it’s probably not really a bargain. If you find one of these stocks, my suggestion would be to only go after it if there is an “ick” factor and you’ve done sufficient research to know that the “ick” is temporary.
I’ll Stick With Cigar Butts
I’m not Warren Buffett. I’m not Charlie Munger. I’m not going to achieve their rates of return over long stretches of time. The good news is that I don’t need to identify Buffett stocks to do well in the market, mainly because I’m operating with small sums of money and can behaviorally deal with temporary losses in the realm of cigar butts.
15% rates of return in the lowest value deciles of the market may not sound as sexy as the Buffett’s 19.2% returns on billions and billions of dollars in capital, but it is an excellent return to strive for and it’s one that can be obtained by operating in the lower valuation deciles with small sums of capital.
PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures. Full disclosure: my current holdings.