CHAPTER 2
Circle of Competence
In a 1989 Fortune article profiling 10 young money managers—under the title “Are These the New Warren Buffetts?”—Marshall Weinberg, of the brokerage firm Gruntal & Co., recalls a dinner in Manhattan he had with Buffett himself: “He had an exceptional ham-and-cheese sandwich. A few days later, we were going out again and he said, ‘Let's go back to that restaurant.' I said, ‘But we were just there,' and he said, ‘Precisely. Why take a risk with another place? We know exactly what we're going to get.' And that is what Warren looks for in stocks too. He only invests in companies where the odds are great that they will not disappoint.”
This anecdote says a great deal about a core tenet of successful investing: combining an understanding of what Buffett calls your “circle of competence” with the discipline to remain within its boundaries. There's certainly no one right circle of competence to have, nor should it remain static over time. But when successful investors talk about ideas that have gone awry, one key reason often cited has been venturing into an industry, company, or market situation with which they don't have experience or don't yet have a full command. Enough can go wrong even when you're in the center of your circle of competence, why increase the chance of mishap by operating outside of it?
Regardless of how broad or narrow their field of play, the best equity investors are able to articulate clearly where they expect to find investing opportunity and why. This circle-of-competence definition includes the characteristics of companies of interest, with respect to such things as their size, where they operate geographically, their business models, and the industry or industries in which they compete. It also includes the situations that the investor has found can lead to potential share mispricing, such as where a company is in its evolution, where an industry is in its cycle, and when a company or industry is likely to be neglected or misunderstood. All of this informs where the investor will—and won't—look for ideas, and the tactics he or she uses to generate them.
In an interview in 2009 we asked Julian Robertson, the founder of Tiger Management and one of the most successful hedge fund managers of all time, what advice he might have for students interested in pursuing an investing career. He spoke about them getting experience working with the best investors possible, and about learning to focus:
A baseball player never really gets paid, no matter how many homeruns he hits or what his batting average is, unless he gets to the big leagues. Then he's guaranteed to make a lot of money. But in the fund business you can find a minor league where you can hit for a better average, because that's what you're paid on.
I remember one of our guys taking us into Korea in the early 1990s, and the market was so inefficient that it was a gold mine if you knew what you were doing. One of our Tiger funds today focuses on gold—a league that is inhabited by some of the crazier investors out there—and it just has a phenomenal record. They know more about gold than anyone else in the world and they just kill all the rest.
My point is that to be successful in this business, you don't have to be better than everybody everywhere, just better than everybody in the league in which you play. It's maybe today more difficult to find those inefficient areas, but it's not impossible.
This section assembles the myriad answers the best investors give when asked to explain where they look for opportunity and to justify why they've chosen the focus they have. Again, it's important to keep in mind that there is no narrow set of right answers here. What matters is that some level of clear focus exists and that the rationale behind it is sound. From there, it's all about execution.
THE RIGHT SIZE
One of the most basic distinctions investors make in defining their field of play concerns company size. How big a company is can say a lot about its complexity, the sustainability of its business model, how actively followed it is, the volatility of its stock price, and why it might be mispriced. Practical concerns can obviously come into play: A manager with $5 billion in assets will find it much more difficult to invest in microcap stocks—where he or she might have to own 100 percent of the company in order to take a position size that is material to his portfolio—than will someone managing $50 million. But managers typically can identify their sweet spot in terms of market cap, or, alternatively, should be able to explain why they're agnostic on the point.
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Our strategy from the beginning has been to focus on areas where we believe we can have some advantage, where there is a greater prevalence of irrationality and higher likelihood of mispriced assets. For us, that's not going to be investing in Microsoft or in some quantitative strategy against a room full of Goldman Sachs' PhD's with Cray supercomputers. We have to be guerrilla investors, lying in the weeds and picking off opportunities among the obscure and mundane.
That usually means small, ignored companies that no one else is talking about. We'll invest in companies with up to $1 billion or so in market cap, but have been most successful in ideas that start out in the $50 million to $300 million range. Fewer people are looking at them and the industries the companies are in can be quite stable. Given that, if you find a company doing well, it's more likely it can sustain that advantage over time. We can also take a significant-enough stake in any company that, if necessary, we can have an impact on how it's run.
—James Vanasek, VN Capital
My basic premise is that the efficient markets hypothesis breaks down when there is inconsistent, imperfect dissemination of information. Therefore it makes sense to direct our attention towards the 14,000 or so publicly traded companies in the U.S. for which there is little or no investment sponsorship by Wall Street, meaning three or fewer sell-side analysts who publish research. Money is made in the dark, not the light.
You'd be amazed how little competition we have in this neglected universe. It is just not in the best interest of the vast majority of the investing ecosphere to spend 10 minutes on the companies we spend our lives looking at.
I consider myself better off buying an index fund or an ETF rather than trying to figure out how to own Johnson & Johnson or Coca-Cola or Exxon, very high-quality companies with dozens of analysts fine-tuning their estimates by the penny every week. I love Coca-Cola and find its financial characteristics to be outstanding, but how can I have an edge in buying and selling its stock? How can something like that ever be a fat pitch?
I would point out that most ignored companies are not investable, either because they're not really public or are just complete garbage. But within that flea market is where you find the greatest bargains, so we troll through it to find the small percentage of companies that are ignored for improper reasons.
—Carlo Cannell, Cannell Capital
I accept the proposition that public markets are most of the time efficient in pricing large-cap companies, but I've never believed there was sufficient trading volume or research coverage of very small companies to make their prices similarly efficient. So it ought to at least be theoretically possible for an investor in microcaps to have an informational advantage. We focus on companies with an average market cap of $400 million, which either don't have Wall Street coverage or the value-added of that coverage is, shall I say, modest. It can turn your stomach, but we also see it as an opportunity that frequent imbalances of supply and demand in the stocks we follow are capable of producing enormous price swings.
We found Roger Ibbotson's recent study of the impact of investors' preference for liquidity to be quite consistent with our experience. He's done seminal research on the superior performance over time of small-caps over large-caps and of value investing over growth investing, but in this case he found going back over 40 years that investors overpay so much for the perceived safety and lower frictional costs of liquid stocks that the opportunities to earn gains in the less-liquid stocks they neglect are significant. One could certainly argue that the extreme increase in market volatility that started in 2008 has exacerbated this inefficiency.
—David Nierenberg, D3 Family Funds
The potential value added by the research into a microcap company is substantially greater. I have a lot less competition. I'm also much more able to speak directly with the CFO or CEO, who may not be as polished in the ways of Wall Street and might be more open and forthcoming about their business. All of that makes it easier to uncover new and previously unknown facts, which can be an important edge.
—Paul Sonkin, Hummingbird Value Fund
We focus on smaller-cap companies that are largely ignored by Wall Street and face some sort of distress, of their own making or due to an industry cycle. These companies are more likely to be inefficiently priced and if you have conviction and a long-term view they can produce not 20 to 30 percent returns, but multiples of that.
—Robert Robotti, Robotti & Co.
Our process is meant to identify where short-term fears have created inefficiencies in pricing, and as you go down in market cap, the market reactions get more extreme. Because so many people are looking at large caps, when a stock gets even a little undervalued the market tends to take advantage of that. If you're investing on bad news, it's best to look where the overreaction on the downside is the biggest, and that's more often in small caps.
—Canon Coleman, Invesco
I'm also not going to spend any time trying to figure out what a conglomerate like General Electric is worth. Too many moving parts, and there are so many other people who have to own it that it's very unlikely it will be dramatically mispriced anyway.
—Zeke Ashton, Centaur Capital
In the same year I started my firm, 2000, I read David Swensen's Pioneering Portfolio Management. He talked a lot about how institutions using a multi-manager approach ought to find managers who concentrate capital in their best ideas and who look off the beaten path to produce above-average results. That dovetailed perfectly with what we thought made sense anyway: The market gets less efficient as you go down the market-cap spectrum, so running a concentrated portfolio of around 12 stocks in the least-efficient segments would offer the best opportunity to produce above-average returns. We started out primarily in microcaps, which we define as $300 million in market value or less, and have since started a small-cap strategy as well, investing in companies with up to $2 billion in market cap.
—Brian Bares, Bares Capital
We believe we can generate alpha in smaller companies in part because the market overemphasizes the income statement and underemphasizes the balance sheet in valuing them. We try by focusing first on the balance sheet to take out some of the risk that comes with relying so heavily on inherently unpredictable future prospects.
—Bruce Zessar, Advisory Research, Inc.
Maybe the biggest reason small companies outperform is just their entrepreneurial nature. We're almost always more comfortable investing behind management with significant ownership in the business than in big companies where that's rarely the case.
—William Nasgovitz, Heartland Advisors
We stick primarily to smaller companies because if we can't speak with senior management on a regular basis, we aren't interested. Otherwise we're just playing with numbers. We've always focused on small caps, but what makes them even more interesting today is that sell-side Wall Street research has never been worse. Everyone has cut back on research staff, which means more and more companies are ignored or getting very superficial work done on them. I was reading an analyst report over the weekend where the price target on the company had gone from $6 to $16, but as far as I could tell nothing at all had changed. The worse the research, the better the chance we find something that's being overlooked.
—Candace Weir, Paradigm Capital
Multiples tend to contract further when small companies mess up than when large ones do, so there's more room on the upside when a small company grows out of a turnaround. I'd also argue that it's generally quicker and easier for a small company to be turned around, which improves your chances of investment success.
—Kevin O'Boyle, Presidio Fund
In my second year at Columbia I took Bruce Greenwald's value investing class, and on the first day he showed us a table from Eugene Fama and Kenneth French's famous Journal of Finance paper called “The Cross-Section of Expected Stock Returns.” The table showed how low-price-to-book stocks and small caps tended over long periods of time to outperform the market as a whole. The whole idea made so much sense to me that I decided that was the basic direction I wanted to go.
—Paul Sonkin, Hummingbird Value Fund
I'm never going to run $1 billion while sticking with these teeny-weeny companies. That suits me, because I much prefer managing a portfolio to managing the staff I'd need with a lot more assets. Most important, though, is that I just love the thrill of the hunt involved with these types of companies. Why give that up?
—Paul Sonkin, Hummingbird Value Fund
Small-cap investing can be more labor intensive due to the sheer number of companies, but at the same time you can more quickly know just about everything you need to know about a company to make an investment judgment. I can't say that in looking at a company like AIG, for example.
—Philip Tasho, TAMRO Capital
We're looking for the prospect of an accelerating rate of positive change. That means we're naturally drawn to management changes, turnarounds, or, more generally, to situations in which changes in the macroeconomic, competitive or regulatory landscape require a company to remake what it does or how it does it.
That strategy is particularly tailored to small caps. Simpler business models are easier to analyze and cross-check, while at the same time change happens faster in small companies, making for more investable inflection points. One or two people can also make a big difference, quickly.
—Mariko Gordon, Daruma Capital Management
The traditional reason for looking at a small-cap stock, which is less liquid, less known, and therefore theoretically riskier, is because it can grow faster. What happens as a result is that people crowd into the same 200 names that are rock-star growers, leaving aside a large number of smaller companies that may still have excellent prospects but fall between the cracks. We have always been about finding those types of companies and learned through experience early on that (1) you want to invest in companies with great balance sheets; (2) you want to take a long-term view; (3) the price you pay matters a lot; and (4) you have to be diversified. To be good at it you have to focus on it, so we believe our edge is in bringing a formidable amount of knowledge and experience to a part of the stock market that is not always well understood or effectively followed.
—Whitney George, Royce & Associates
For quality-of-business reasons, we now focus on companies with between roughly $1 billion and $8 billion in market cap. The $500 million company is unlikely to have as global a footprint and as diversified a customer base as we want, and the business generally is less mature and more volatile. We've invested successfully in smaller companies over the years, but it can be more hair-raising than I'm comfortable with at our current asset size.
We avoid the biggest companies because we want to eliminate the “what you don't know” risk. With bigger companies there can be many different business units with distinctly different trajectories, making it harder to identify the core engine that truly drives the bottom line. There's also just a greater possibility that you miss something important, like environmental liabilities, or underfunded multi-employer pension plans, or work rules in a region that limit your ability to sell businesses.
—Jeffrey Ubben, ValueAct Capital
I do believe mid caps to some extent offer the best of both worlds. They're usually not as well followed as large caps and by the rule of large numbers can have longer growth runways. At the same time, they're broader-based and therefore less volatile than small caps, with better liquidity. I also think it's been an advantage that the investing world seems more focused on small-cap or large-cap exposure, leaving mid-caps relatively neglected.
—Tom Perkins, Perkins Investment Management
Our sweet spot tends to be in small and mid-size companies that often aren't particularly well followed by Wall Street. It would be illogical for us to know or uncover something about Procter & Gamble or Texas Instruments before 100 smart analysts did. I'd add that as brokerage firms have gone out of business or cut back on the number of companies they follow, it's not as if we need to focus on tiny or new companies to find those that are relatively ignored. You can find plenty of established, decent-sized companies that just don't get the attention from Wall Street that they once did.
—Dennis Delafield, Delafield Fund
We try to be cap-agnostic, but we do want businesses that are easier to understand, and smaller to mid-size companies are generally easier to understand. They have fewer divisions and we can usually get more of our questions answered. Our median market cap in the fund is around $5 billion.
—Steven Romick, First Pacific Advisors
We generally want to own only those things that can be bought out. That number keeps getting bigger, but it does tend to keep us out of the very biggest names.
—Christopher Browne, Tweedy, Browne Co.
Our sweet spot tends to be in companies with market caps from $1 billion to $5 billion. Illiquidity in smaller-cap companies is fine for a portion of your book, but it's nice to have the ability to change your mind and more easily sell if things don't develop as you hoped. The largest companies can certainly be mispriced, but our ability to create an analytical edge given the number of people looking at them is more limited.
—Brian Feltzin, Sheffield Asset Management
The high-quality characteristics we look for in companies to own at the right price tend more often to be in large-caps than small-caps. We agree with all the arguments that small-caps may benefit from persistent market imperfections that can lead to them being mispriced—which is one reason we like them—but the fact is that large-caps meeting our criteria get mispriced from time to time as well. Maybe the inefficiency has a different trigger, but whatever the reason, we're glad it exists.
—C.T. Fitzpatrick, Vulcan Value Partners
It is hard for us to have an edge in analyzing Microsoft's or Intel's business, but we do believe it's possible through understanding macro trends and market psychology—and through the use of a clear valuation discipline—to buy even the most widely followed companies when they're out of favor and sell them when they're too highly regarded. If Intel's historical valuation range is between 12 and 25 times earnings, with discipline and patience there should be opportunities to buy at the low end of that range and to sell at the high end, making good money along the way.
—Ralph Shive, Wasatch Advisors
We gravitate toward larger, diversified companies where the inefficient pricing comes from an excessive focus on short-term issues that we expect to mean-revert. If we're wrong, in a big company our downside risk is limited because there are other parts of the business that can hold up value or even increase overall value if we bought cheaply enough. In my experience, if we're wrong with a smaller company focused on one product or one geography, there's too much risk it's going to zero.
—Daniel Bubis, Tetrem Capital
I build an earnings model from scratch for every material position in the fund, which is the best way to understand the key drivers of the business and its profitability. I'm looking for opportunities in which I have a differentiated view on forward earnings, preferably revenue-driven. By focusing on better-followed mid-cap and large-cap stocks, I can have a much better understanding of what constitutes consensus, and specifically how and where my view varies from it. In smaller companies that attract little attention, it's harder to know the expectations embedded in the share price.
—Jed Nussdorf, Soapstone Capital
It's much easier to find large-cap stocks that are out-of-favor—they're on the front page of The Wall Street Journal and the folks at CNBC are all over them. But in addition to looking for what others don't like, we also look for what is relatively neglected, which are almost always smaller to mid-cap names. In these cases our anticonsensus view is that the quality of the business and its prospects are just being missed by the market.
—Robert Kleinschmidt, Tocqueville Asset Management
We want to maintain the discipline that we will invest in a company, regardless of size, if it meets our criteria. Part of that is because we learn from all the companies we own. Part of that is because it keeps us fresh and engaged and not stuck in the rut of looking at the same 100 companies everyone else is. We also take the position that a penny more in return for our shareholders than we would have had otherwise is a penny worth having. If smaller-cap companies can give us that, we'll buy them.
—Clyde McGregor, Harris Associates
[The SEC's] Regulation FD, for better or worse, is used by many bigger companies to restrict access to senior management and limit communication to the canned presentation. We learn a lot from sitting down with management at smaller companies and really talking about their businesses, competitors, and opportunities.
—Edward Studzinski, Harris Associates
The information-inefficiency tale commonly told about the small-cap universe is over-hyped. In a diversified institutional portfolio, with 50-plus names, you're deluding yourself if you think you can have some unique inside scoop on more than a handful of the names you own. That's all the more true in recent years, with all the concentrated hedge funds out there selling themselves as small-cap experts.
—James Kieffer, Artisan Partners
INDUSTRY PREFERENCE
Central to any accomplished investor's definition of his or her circle of competence is a description of the industries—or more generally, the types of businesses—on which he or she focuses. Hard-earned experience would appear to be the most impactful teacher here—the emphasis is usually more on where they will not invest, rather than on where they will.
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Stepping outside your areas of competence is often a seductive siren song, but I've learned from experience not to listen anymore. Without the confidence that comes from experience and the ability to recognize patterns, the risk is higher that you'll overpay or sell too soon in a panic. If you're a value investor, it's pretty easy to explain to yourself or your investors why a deep-value idea hasn't worked out yet. But if you bought JDS Uniphase at $100, which was down from $200 but on the way to $2, that's tougher to explain.
—Shawn Kravetz, Esplanade Capital
The more specialized the knowledge necessary to understand a business, the less likely we'll invest in it. Who's going to be the better biotech investor, the person who ran drug trials for Merck for 25 years or us? We do little in pharmaceuticals, healthcare, and computer technology.
—James Vanasek, VN Capital
We've struggled to underwrite moats based on intellectual capital, say in a company like Qualcomm, where its earnings power is enormous if all its patents hold up. That's another reason we're not active in things like pharmaceutical or biotech companies.
—James Crichton, Scout Capital
In general, the best thing for us is to find companies that have really stumbled, but where you can look at their past and understand why they are going to earn something much better in the future. That's opposed to looking at a company like Amazon.com, for example, which might be a great business, but where understanding exactly what the model is going to be in the future isn't easy. It's a lot easier to look at the prospects for a rail-car manufacturer, whose business has been the same for decades.
—Steven Romick, First Pacific Advisors
We don't typically bet on scientific innovation, so we rarely find things we'll consider in healthcare. We avoid many areas in technology because of the speed of the product cycles and the magnitude of change from cycle to cycle.
—Adam Weiss, Scout Capital
Successful technologies change something, creating an efficiency or demand that wasn't there before. But the very fact that the change happens means that somebody else can come along and change it again. If because of the threat of technological obsolescence I'm uncertain about a company's cash flows several years out, I'll put a big discount on those cash flows and conclude they're not worth much. Because Wall Street tends to put a large value on the future cash flows of technology companies, we rarely find one that we consider very attractive.
—Ed Wachenheim, Greenhaven Associates
Back in the late 1990s we invested in a few too many “concept” stocks—earlier-stage companies with developing technologies where the stories were compelling and indicated that there would be considerable future value. The problem is that without a real underpinning of asset value or earnings, these types of companies can run into big trouble when the thesis doesn't pan out as quickly as expected or new competition disrupts the story.
—Randall Abramson, Trapeze Asset Management
We're drawn to companies with long product lifecycles, in which the product or service will be more or less the same five years from now. If that's not the case, we don't believe we can with adequate confidence make reliable long-term earnings forecasts.
—Murray Stahl, Horizon Asset Management
We'd like to believe any business is analyzable, but when you have product cycles of only twelve months, as an investor you're very reliant on the company hitting that window exactly right. If they don't and somebody else does, you can buy low all you want, but you find out pretty quickly that you were buying a future income stream that was a mirage.
We haven't sworn off technology entirely, but we've essentially sworn off investing in short-product-cycle technology. We look for technology companies where the business cycles are glacial in comparison.
—Larry Robbins, Glenview Capital
We're typically not attracted to most technology businesses because of cut-throat competition, potential technology obsolescence, short product cycles, and the excessive use of stock options. The return on time is also a problem—you spend so many hours analyzing new products and technology trends that 50 percent of your time gets spent on 5 to 10 percent of your portfolio.
At the same time, technology is an important driver of economic growth and grows at above-GDP rates, so we want to have exposure to it. We like to attack difficult industries through the side door, so to speak. With Arrow Electronics, for example, we can own a leading distributor of technology products—including semiconductors, software and electronic components—that supplies mostly small and medium-sized companies. That allows it to benefit from the growth in high tech without the typical risks associated with tech stocks.
—Pat English, Fiduciary Management, Inc.
I first got interested in technology stocks after watching things like Micron Technology go from $20 to $40 to $20 to $40 to $20 to $40. The cyclicality in many of these businesses can be more regular than is often believed, so it's possible to buy on the down leg of a cycle because there will inevitably be an up leg. We've had considerable success, in particular, in buying technology companies that also have great balance sheets. Companies like this have the flexibility to invest in new initiatives, buy new technology and invest in R&D. Even if they aren't profitable today, you have the potential for a goldmine if the business turns around.
—John Buckingham, Al Frank Asset Management
From the beginning we have occasionally come across products or technologies that we thought were too compelling to ignore by sticking rigidly to our playbook. These ideas are higher risk and so they won't make up a big part of the portfolio, but we make room for them when the potential is as high as we think it is.
—Charles Mackall, Avenir Corp.
Circle of competence essentially comes down to whether we understand the business. There are several sub-questions under that: Do we know the right people in the industry? How well do we understand the products and the customer decision-making process? Are there unanalyzable things that could have a big impact? No matter how well you understand the steel industry, for example, there's tremendous volatility and variability in the business that may not be susceptible to prediction, which makes it difficult for us to underwrite the business with adequate confidence.
—James Crichton, Scout Capital
We tend to find more special situations in industries with higher cyclicality, which most often aren't the most glamorous sectors of the economy. How companies both prepare for and respond to industry capacity utilization rates going from 100 percent to 30 percent and earnings falling off a cliff has a dramatic impact on their future prospects. If the down cycle makes entry points attractive, that can create excellent opportunities.
—Vincent Sellecchia, Delafield Fund
We find that at times companies—or even industries—can trade at big discounts to their inherent growth rates because of the perception that the earnings are highly cyclical.
—Jon Jacobson, Highfields Capital
We're far more interested in cyclical companies that are well capitalized, that don't lose money at the bottom of the cycle, and whose peaks and troughs are both higher over time. We'd be less apt to buy into something like a capital-intensive pulp and paper manufacturer, which bleeds money at the trough and, when they do generate some cash flow, needs to spend much of it on new or upgraded plant and equipment.
—Charles de Lardemelle, International Value Advisers
Cyclical industries don't scare us if we understand the long-term supply and demand dynamics of the industry and believe that the company we're interested in is on the right side of that. We think, for instance, that insurance is a lousy business. There's way too much capital, too little differentiation and way too many managements doing the same dumb things. That's all contributed to there being a generally soft pricing market for six or seven years. That said, we're happy to own insurance companies that don't think like everyone else and zig when the others zag.
—Steve Morrow, NewSouth Capital
We don't have a problem with cyclicality. Wall Street still looks for certainty in areas that are uncertain. We feel good about lumpiness. We just try to be cash counters—if you can buy something at 5× free cash with limited chance of permanent impairment, even if it earns only half of what we thought, that's okay.
—Bruce Berkowitz, Fairholme Capital
The downside of an industry cycle is a consistent reason why things get cheap. We'll put a reasonable multiple on the normalized earnings power of the business over three to four years—knowing it can take five or six—and, given the types of things we look at, often come up with intrinsic values that are three to five times where the stock is trading today. Which is not to say the wait can't sometimes be painful.
—Robert Robotti, Robotti & Co.
Cyclicals by their nature repeatedly experience boom and bust periods that create opportunities for investors like us who pay careful attention to supply/demand economics and believe in mean-reversion.
If you look at the average equity holding period over the last 15 to 20 years, it's clear that there are a lot of people out there just renting stocks. The primary inefficiency we're trying to exploit is that investors don't like it when things aren't going well and a company is under-earning its potential or what's normal, so our focus on the long side is to identify overreactions in the stock when that happens. Companies can get put in the penalty box if they stumble. It doesn't happen all the time, but reliably enough that we're rarely at a loss for ideas by focusing on cyclical but temporary issues in a company's business.
—Brian Feltzin, Sheffield Asset Management
High-quality businesses tend to be characterized by things like strong brand names, customer loyalty, pricing control, some cost advantage and growing long-term markets. Low-quality businesses, which don't have much control over their futures, exhibit the opposite characteristics. We generally consider cyclical, commodity businesses to fit this more negative profile and so are less invested there.
—Bill Nygren, Harris Associates
There can certainly be a cyclical component [to what we find interesting], but the more salient observation is that there is variability over time in how the market looks at the company or industry. Perceptions don't vary much for things like electric utilities or even a stable blue-chip business like Coca-Cola. In those cases it's difficult for us to find the valuation dispersion and reflexive selling at nonsensical prices that we look for.
—Brian Barish, Cambiar Investors
We're unlikely to invest in a pure cyclical like a steel company, where the returns are governed primarily by macro forces.
—Boykin Curry, Eagle Capital
In areas like basic materials and other commodity businesses, there usually just isn't enough of a moat, which makes it hard for us to get interested on a fundamental basis.
—Adam Weiss, Scout Capital
I'm very leery of any business that is so cyclical that it burns cash at or near the bottom. I've concluded there are enough alternatives out there that I don't need to accept that kind of risk.
—Chris Mittleman, Mittleman Brothers, LLC
One of the lessons I took from Warren Buffett years ago was to define the areas you're comfortable with and stick to them. I generally stay focused on food, beverage and tobacco companies. Branded consumer businesses are those for which I have a natural affinity and that I think I understand. While I would have a hard time on the weekend observing what DRAM chip is in the cellphone of the person walking next to me, I pay a lot of attention to—and think I learn a lot from—what people are wearing, or eating, or smoking or drinking. Of course these are also all businesses that lend themselves to the types of global growth opportunities I most value.
I'm always tempted to look in other areas, but I come back to asking whether my ability to gather information and develop insights about a business are substantive enough to justify a position I want to own for a very long time. That happens very rarely.
—Thomas Russo, Gardner Russo & Gardner
There is something inevitable to me about positional goods. Once you've provided for your basic needs, you start to march up the consumption curve and it is often the more traditional brands that attract the consumer as he reaches a new position in life. The more you prosper, the more narrow the universe of items through which you can express your prosperity.
—Thomas Russo, Gardner Russo & Gardner
We prefer companies without heavy reinvestment needs. The average company has to pour more than half its earnings every year back into the business to maintain itself. If you don't have to do that—like most consumer products companies, for example—you have more to invest in new businesses, to give back to shareholders, or to keep on hand for a rainy day. That's a huge advantage that we don't think people are correctly evaluating.
—Stephen Yacktman, Yacktman Asset Management
I like to invest in consumer brands in areas like chocolate, whiskey, beer and wine. These are products that have been around for thousands of years, that people like, and I don't think that's going to change. Changes in technology or the trend toward outsourcing don't diminish the fact that people like to have a drink at the end of the day, or that they enjoy chocolate.
—Thomas Gayner, Markel Corp.
I've always had an affinity for companies that actually make things. We favor companies with transparent businesses that we can understand fairly quickly and those that have large and recurring maintenance, repair, and overhaul revenues from an installed base, such as elevator companies or aerospace-parts firms.
—Alexander Roepers, Atlantic Investment Management
We're focused on four sectors that have exhibited unvarying demand regardless of economic activity and that have key fundamental strengths that help explain why they've been around for hundreds of years. The inherent demand of people to smoke, drink and gamble and of nations to arm themselves is clearly strong and long-lasting.
—Charles Norton, The Vice Fund
I'm biased more towards industrial and capital-goods businesses, which I find more rational than those that are tied primarily to consumer demand. I'm not much of a consumer myself, so I don't have a great feel for what makes a lasting consumer business. Why do people like Coach bags? How do you predict the extent to which they'll like them tomorrow? I just don't know. When Motorola was doing so well with the Razr phones, I didn't recognize what a fad that was and got hurt in the stock as a result.
—Ralph Shive, Wasatch Advisors
I have often made the mistake of investing in businesses that needed and used more capital to operate than I thought they would. That's one reason I tend to avoid heavy industrial companies. Some very smart people own General Motors now—I hope they make money and it's probably good for the country if GM survives, but I can't figure out how to make that work as an investment. We just don't own those types of companies.
—Thomas Gayner, Markel Corp.
One thing about being an investor for 20 years is that experience leads you to write off big chunks of the market. I don't do retail because you have to recreate the demand every day. I don't do financial services because it's a spread business with no real free cash in it—you have to grow equity to grow assets to make more spread. I don't do much in industrials because the capital demands are high and, long term, the cost structure—particularly with labor and energy prices—is challenging in a global economy. I don't do commodities—we like price-makers that set prices based on value added, as opposed to price takers.
If you buy a high-quality business, you only have to be right once—buying at the right price. The sale is fairly easy to execute. In cyclical or commodity areas, you have to be right twice, on the buy and the sell. If you miss the exit, it might be awhile before it comes back around.
—Jeffrey Ubben, ValueAct Capital
It's easier to describe what we don't do: oil and gas, commodities, utilities and biotech. We fundamentally believe that energy and commodities have been value-destroying businesses over time. At the same time, their value tends to be driven by the price of a commodity that we have no ability to predict. With utilities, they don't tend to be businesses that can create excess value. They might be nice surrogates for bonds, but not much more. In biotech, we just have no illusions that we know how to analyze the business. Outside of these few areas, just about anything else is fair game.
—Ricky Sandler, Eminence Capital
As long as it's a good-quality business selling at an attractive price, I don't care much about what the company makes or sells. One thing we are very conscious of is the degree of leverage in a business. That can be financial leverage, which is reflected on the balance sheet. It can be operational leverage, where you look at how much of the cost base is fixed or variable. It can also be the degree of leverage to a particular industry or geography. In general, I'm uncomfortable with companies that are vulnerable to more than one of those kinds of leverage going against them at the same time. A cyclical business that has a lot of fixed costs, for example, should not have a lot of financial leverage or be too levered to one geography or industry. If things go the wrong way, management has its hands tied in trying to get out of trouble. This is a big reason we rarely find opportunity in more commodity-type businesses.
—David Herro, Harris Associates
We avoid industries in which information arbitrage is extremely important to stock prices. I don't think we'd buy a single-product biotechnology firm, for example. The same holds true in a crisis situation like Bear Stearns [in 2008]. I had no idea whether it was a zero or if it was going to be fine. In cases like that, our time-horizon advantage is dwarfed by our competitors' short-term information advantage.
—Boykin Curry, Eagle Capital
We believe in reversion to the mean, so it can make a lot of sense to invest in a distressed sector when you find good businesses whose public shares trade inexpensively relative to their earnings in a more normal environment. But that strategy [in 2008] helped lead many excellent investors to put capital to work too early in financials. Our basic feeling is that margins and returns on capital generated by financial institutions in the decade through 2006 were unrealistically high. “Normal” profitability and valuation multiples are not going to be what they were during that time, given more regulatory oversight, less leverage (and thus capital to lend), higher funding costs, stricter underwriting standards, less demand and less esoteric and excessively profitable products.
—Steven Romick, First Pacific Advisors
One way of dealing with information being more available is to stop playing the game and seek out securities or asset classes where there's less information or competition.
—Seth Klarman, The Baupost Group
We tend to be less invested in areas in which there's less differentiation between the winners and the losers and in which results are more macro-driven than company-specific. We typically do not have significant investments in utilities or REITs, for example.
—Lee Ainslie, Maverick Capital
We don't like businesses that are completely reliant on human capital that can walk out the door. We have no rule against it, but you generally won't find us investing in things like investment banks or consulting firms.
—Don Noone, VN Capital
Because five or six unique holdings make up 60 to 70 percent of each of my portfolios, I exclude companies with idiosyncratic risk profiles that I consider unacceptable in such a concentrated portfolio. That means I exclude high-tech and biotech companies with technological-obsolescence risk, tobacco or pharmaceutical companies with big product-liability risks, utilities and other regulated companies where the government can change the rules of the game, and companies that lack sufficient transparency, like banks, brokerages and insurance companies.
—Alexander Roepers, Atlantic Investment Management
We have not done well in fashion-related businesses, which I'd extend to retail, where our record is almost unblemished by success. We tend to be susceptible to value traps in these businesses. One example was our investment years ago in Bombay Company, a home-furnishings specialty retailer. We were attracted by an enthusiasm for the CEO, combined with the apparent financial anomaly of a company trading at only 30 percent of its $700 million in revenues. We would still be awaiting the turnaround had we not decided to sell out at a modest loss and move on.
—David Nierenberg, D3 Family Funds
We've never been that fond of the hotel business because the tenants move out every night. That makes the business susceptible to economic swings in a way that office buildings with long-term leases to credit-worthy tenants aren't. We prefer to see more predictable streams of cash flow than lodging companies typically have.
—Michael Winer, Third Avenue Management
Some areas lend themselves better to our types of analysis than others. It's very hard for us to figure out what brands are worth, for example. It's also hard for us to figure out what future scientific developments are worth. We tend to stay away from those kinds of things. But at the right price, we'll consider anything.
—David Einhorn, Greenlight Capital
Most people say they want to stay within their circle of competence, and that's smart. But there's no reason to say “Here's my circle of competence and, guess what, it's never getting any bigger because I'm not going to learn anything new.” We're trying to understand new things if we can.
—Bill Miller, Legg Mason Funds
There's a real premium in this business on innovation. That doesn't mean chasing the latest fad, but it does mean recognizing new opportunities and taking advantage of them even if they don't fit exactly into your historical playbook.
—Jeffrey Tannenbaum, Fir Tree Partners
I have a problem with the concept of circle of competence as defined by many value investors, who won't invest in energy, won't invest in commodities, won't invest outside the U.S. This business requires constant learning, even sometimes abandoning precepts about industries and geographies that no longer apply. If you're not willing or able to do that, I think the environment ahead means you're in for a very tough time.
—John Burbank, Passport Capital
WHERE IN THE WORLD?
When we first started interviewing highly accomplished investors for Value Investor Insight in early 2005, a U.S.-centric focus was more the norm than the exception. For any number of legitimate reasons—language barriers, accounting-principle differences, limited research capacity—value-investing orthodoxy still argued for geographic focus rather than expansiveness. While this stance remains prevalent, in clear ascendance is the argument that as industries and companies have become ever more global in scope, so must the investors who follow them. Regardless of the position taken, all investors today must think carefully about their geographic field of play and how they expect to cover it.
* * *
It has become increasingly clear to me that the best opportunities in coming years are going to be outside the U.S. That wasn't the case when I started out, when buying a stock in Canada seemed awfully unusual to people.
Over the past five years we've more than doubled our international exposure, to the point where 65 to 70 percent of our portfolio on a look-through basis is invested outside the U.S. Companies able to tap into growing affluence and people's innate desire to improve what they eat, what they wear and how they live will have decided advantages over those focused on mature economies like the U.S. and Europe, where deleveraging will take a long time to work out.
—David Winters, Wintergreen Fund
From day one we've had a significant portion of our assets invested outside the U.S.—it's currently about 30 percent of our gross exposure. This is probably too broad a generalization, but in our view non-U.S. markets tend to be less efficient than the U.S. market. If you look at our core opportunity set, which we define as the 3,000 or so stocks that trade more than $10 million a day, on average we took advantage [in 2005] of about 12 percent of the available opportunities in the U.S., 6 percent in Europe and 3 percent in Asia. In an ideal world, I'd like to be more selective in the U.S. and take advantage of more opportunities outside the U.S.
—Lee Ainslie, Maverick Capital
I'd argue that literally every investor today has to be a global investor to understand what's going on—certainly in markets like energy and commodities, but also to take advantage of where we think the best opportunities are going to be.
—John Burbank, Passport Capital
We believe it's prudent for long-term investors to have a significant and growing portion of their portfolios allocated to equities in foreign countries that are growing faster than the U.S. and whose currencies will likely appreciate against ours.
—David Nierenberg, D3 Family Funds
In general, you still see less long-term commitment to owning equities by investors outside the U.S. When markets run into trouble, you'll see more wholesale selling of equities by big non-U.S. institutional holders. There may be some historical precedent to that, but we hope it continues.
—Will Browne, Tweedy, Browne Co.
We probably held 35 to 40 percent in non-U.S. stocks five years ago and that number today is closer to 70 percent. Most of that is a result of company-by-company assessment, but I will admit to casting an eye toward history and wondering if today's U.S.-centric investor isn't like the similarly positioned British investor in the early 1900s who would have left a lot of money unearned as a result of his nation losing economic relevance due to progress elsewhere while he or she stayed invested only domestically.
—Thomas Russo, Gardner Russo & Gardner
There's increasingly a distinction without a difference. Nestlé is Swiss, Diageo is British, Johnson & Johnson is American and Philip Morris International is headquartered down the street from us but no longer has any business in the U.S. We own all of them and in most of the ways that matter to investors, the analysis and valuation of their businesses is very similar.
Businesses are dynamic entities, moving capital and assets to maximize opportunity. They increasingly operate on a worldwide basis, so we have to as well. We've found that knowledge of businesses and companies is quite transferable and have often applied our experience in one market to another. For example, we've had success over the past several years in buying Coca-Cola bottlers at different times and in different markets.
—Will Browne, Tweedy, Browne Co.
Another reason it's important to be more international in your outlook: If you're not paying attention to what competitors in emerging markets can do, you're likely taking on risk with U.S.-company investments that you shouldn't.
—Robert Williamson, Williamson McAree Investment Partners
For our type of investing, which involves buying big stakes in companies and investing for the long term, we need transparency and a firmly established rule of law. If we can't believe the financial statements or we see too much risk of the rules being changed after the game starts, the whole exercise is pointless. As a result, we won't invest in Russia. We've also never owned a mainland Chinese company, because most of them are controlled by the state and there's too much potential conflict between shareholder and state interests.
—David Herro, Harris Associates
The foundation of our process is the ability to arrive at a reasonable estimate of intrinsic value, which is often undermined in emerging markets by a variety of reporting, governance, legal and regulatory obstacles. In South Korea, for example, consolidated financial statements aren't always available. In Russia, the government hasn't kicked the habit of controlling companies that are supposed to be owned and controlled by shareholders. Even in countries where government is less intrusive, regulation can be inconsistently and unfairly applied, adding uncertainty to business models that makes forecasting very difficult.
At a low enough valuation, of course, the incremental uncertainty can be worth taking on. But valuations have only rarely gotten low enough in emerging markets relative to the developed world for us to step over the border. It's not for lack of effort—we're always looking—but so far we've found plenty of opportunity elsewhere to keep us busy.
—Dan O'Keefe, Artisan Partners
For better or worse, the Anglo-Saxon business model puts the interests of shareholders first. We are less comfortable in markets where loyalties are more divided.
—Jeffrey Schwarz, Metropolitan Capital
There are still language barriers, particularly in Japan, but that's gotten better over the years as English has become firmly entrenched as the international language of business. Culturally, in some parts of the world we're up against a kind of social-democracy attitude, that says shareholders are equal constituents with employees and customers and suppliers and banks. I don't ascribe to that at all, so in some cases we have some convincing to do. Most often, if that attitude is too prevalent we just won't be very active.
—David Herro, Harris Associates
We like to operate under the illusion that if we see something that is out-and-out unacceptable being done, that there's a clear rulebook and well-defined avenue to complain about it. It's not clear that's yet the case in China.
—Will Browne, Tweedy, Browne Co.
In general, there aren't many countries in which we wouldn't invest. But if a country is too economically or politically troubled or the rule of law doesn't really prevail, we pass. The main country in which we won't invest today is Russia. There's still too much risk for foreign (or even local) investors that you'll think you own an asset and then Mr. Putin decides you don't.
—Jean-Marie Eveillard, First Eagle Funds
We do very little direct investing in Eastern Europe, where the level of disclosure and the quality of corporate governance is still poor. Many leading companies are controlled by government-related entities or majority shareholders who couldn't care less about the interests of minority shareholders. We also aren't very active in the U.K. London has its own well-established and well-capitalized investment community, so we find value there is arbitraged out quicker than it is in continental Europe.
—Richard Vogel, Alatus Capital
For the types of companies I generally invest in—sophisticated global companies like Diageo, Nestlé, Pernod Ricard—the information is generally accessible and complete, so I don't require a greater margin of safety or lower multiples because they're international. Also, partly because the field hasn't been as crowded, I've had as good, if not better, access to senior management at non-U.S. companies.
—Thomas Russo, Gardner Russo & Gardner
We're not afraid of political risks, which we generally think are exaggerated. We invested in Thailand after the coup. We're investing in Turkey in the face of political uncertainty. It's not a big component of what we do, but there are always small pockets of mispriced risk and political uncertainty can create very nice bargains.
—Oliver Kratz, Deutsche Asset Management
Over the next 10 years it's far more likely that the huge amount of capital owned by the rest of the world will grow by investing somewhere other than the U.S., whether it's in infrastructure in China or the Middle East, or to develop consumer markets in places like India.
—John Burbank, Passport Capital
We haven't been traditional emerging-markets investors because we do not chase growth or glamour, but we like nothing better than to invest in emerging markets on a contrarian basis. Strong economic growth is never steady, so you can find nice opportunities to invest after booms have gone temporarily bust.
—Charles de Vaulx, International Value Advisers
One of the keys to Warren Buffett's early success was investing in high return on capital consumer businesses that were relatively immature when he bought them and that grew enormously along with the U.S., the largest economy in the world. He owned companies like Gillette, Wells Fargo, and Washington Post Co. over a period in which consumer products, financial, and media companies grew from being a relatively small part of the S&P 500 to a very large part of it. That's a natural evolution in any large, developing economy and we expect that dynamic to create considerable value in places like India for a long time.
—John Burbank, Passport Capital
We keep heading more toward direct international investing, but worry that we're going to be the patsy. We looked at South Korea, but kept asking ourselves what edge we really had there. How do we understand the culture, the management?
The U.S. is going through the same decline faced by all past great civilizations. It's in the nature of things. It takes a very long time and happens in 10,000 different ways. All smart companies and investors need to respond to that. We actually look at our energy bets as more of a global play on the fact that 3 billion new capitalists in Asia are going to have a significant impact on future energy demand.
The good thing about investing is that you don't have to do everything to be successful. There are plenty of different ways to make money.
—Bruce Berkowitz, Fairholme Capital
Because we put such a strong emphasis on companies based in close proximity to us—two-thirds of our portfolio companies are in the upper Midwest, with 50 percent very nearby in Minneapolis/St. Paul—we commit ourselves to knowing all the public companies in that limited universe very well.
Our initial research is very qualitative, focused on getting to know management and letting them explain what their markets are, how they're addressing them, where they're investing and how they make those investment decisions. From that, we also want to learn from various other constituencies, from suppliers to customers to current and former employees. All of that is considerably easier when you're close to where these people are.
—William Frels, Mairs & Power, Inc.
My feeling is that it's beyond my skill set to try to buy local companies outside the U.S. Some people will make a lot of money doing that, but not me. What I am doing is buying companies like GE and Citigroup and Diageo, who already have tremendous expertise and operations outside the U.S. to take advantage of international growth and development opportunities.
—Thomas Gayner, Markel Corp.
I once heard someone say that every time you double the distance from where you are to where you are investing, you should divide the quality of your assessment in half.
—Francisco Garcia Parames, Bestinver Asset Management
I did have the good fortune in the 1980s and into the 1990s to have our style of value investing not be widely practiced, particularly in continental Europe. Value stocks were largely neglected and it was possible, if one was willing to be patient, to often buy them for a song. That's no longer true—many of the more secular inefficiencies are gone.
But the fundamentals of value investing—which to my mind are based on common sense—still work, and work equally well across borders. We look at stocks exactly the same way, whether in Hong Kong or Japan or Paris. People always ask, “But don't you want to invest like the locals, understanding the local idiosyncrasies?” and my answer is simply no. We never buy stocks based on what we think other investors are going to do.
—Jean-Marie Eveillard, First Eagle Funds
People tend to lump international investing into this general bucket of opportunity, which to us is kind of silly. We expect a closing of the relative GDP-per-capita gap between the developed world and many emerging markets, but as that happens we believe you're still going to have stocks be cheap or expensive based on cyclical ups and downs and on valuations that overshoot and under- shoot. Unless you're smart about picking your spots, you're not going to be successful no matter where you invest.
—David Samra, Artisan Partners