What type of value investor are you?

Geoff Gannon wrote a great article over the weekend entitled "The 4 Questions to Ask Before Buying a Stock." In the post he writes:

"I think there are really 4 questions you answer before buying any stock:

• Is it safe?
• Is it a great business?
• Am I getting a great price?
• Can I hold this stock for as long as it takes?

The ideal stock would get 4 “yes” answers."

He then goes on to and compares prominent value investor Monish Pabrai to Ben Graham in relation to their value investment styles:

"A lot of differences in style come down to how you answer these 4 questions. Someone emailed me saying he thought Mohnish Pabrai was more of a Ben Graham investor than a Warren Buffett investor.

Not really. Graham was obsessed with question #1. He wanted to know a stock was safe. Pabrai cares less about #1 and more about #3. Pabrai’s overwhelming focus is on getting a great price.

Graham wanted a great price. But safety always came first.

There are stocks Pabrai has owned that Graham wouldn’t. Nothing wrong with that. Different people invest differently.

We all rank these 4 questions a little differently. We obsess about one. And our standards are a little too loose on one of the others."

As investors in distressed debt and post re-org equities, many of the businesses we are buying into are not great businesses. Eastman Kodak, one of the topics du jour, is not a great business. In a very, very old memo from Oaktree's Howard Marks:

"We are less concerned with the absolute quality of our companies than with the price we pay for whatever it is we're getting. In short, we feel “everything is triple-A at the right price”. We have many reasons for following this approach, including the fact that relatively few people compete with us to do so. But we feel buying any asset for less than it's worth virtually assures success. Identifying top quality assets does not; the risk of overpaying for that quality still remains."

Of course, this is, on some level, a matter of personal preference and client needs. For example, I run an equity portfolio for a client whose investment mandate is quality, quality, quality. Some of the best companies in the world are in that portfolio, and luckily, I can sit on my hands for a long time before putting money to work due to the long term nature of the capital. That enables me to buy at a FAIR price; not a great price, but a FAIR price where I expect to earn mid teens return on capital.

My father-in-law loves talking about stocks. He has no conceptual understanding of free cash flow yields, tangible asset valuations, or anything to give him a semblance for a range of values a security is worth. He understands businesses (he runs one), is terrified of debt, and can hold securities for a long, long time. In essence, he has ticked off 3 of the 4 requirements mentioned above.

Does that mean he will be successful? Far from it, because price, more so than anything, is the single largest determinant of investment success. If you overpay for the best company in the world, your results will struggle. If you pay a fair price for the best company in the world, you will generate fair returns. And if you pay a remarkably low price for the best company in the world, and can sit and watch the company compound your capital many times over, you will get remarkable results.

But those situations are few and far between. The greatest investors will inevitably be the ones that find those situations and bet the truck as it were. Under that caveat, it then becomes a situation of playing to your strengths.

Some of us are better business analysts. I am often amazed when I go to small group management meetings and analysts are asking questions that floor with me an outstanding level of detail. Things not talked about in the news or analysts reports that require an intimate level of understanding of a business. While I am impressed with this skill and the level of due diligence it requires, I worry that analysts and portfolio managers lull themselves into a sense of security because they know everything there is to know about a business. Or worse, behavioral finance starts coming into play, and people become tied to / in love with their ideas and do not want to see it leave the portfolio, or worst, not enter the portfolio after hours and hours of research has been poured into the idea.

"Is it safe" is the question credit and distressed debt analysts are most likely to have an edge relative to their equity counterparts. We know capital structures. We know covenants. We can adjust EBITDA for credit agreement add-backs. We can calculate restricted payment baskets. We know what a permitted investment is and the implications of leakage of collateral. We read security and pledge and guarantee agreements. We try our best to ascertain how much we can be primed. We understand when underwriters are trying to be sleazy with change of control agreements (i.e public company carve out). Playing up in the capital structure is our best defense to maintain "safeness."

"Can I hold this stock for as long as it takes" is a tricky one. Why is locked up capital the best sort of capital? You can wait. One of my favorite investment stories is Carl Icahn's investment in The Stratosphere in Las Vegas. In 1997, he bought a controlling position in the mortgage bonds at a discount to par. He spent some money on the casino, bought a number of other casinos at a discount, and then waited. He waited 10 years until gaming multiples were through the roof and then sold the operation to Whitehall (an affiliate of Goldman Sachs). And made nearly a 10x return on his equity. Now if Carl had serious issues in the market rout of 2002, he may have had to sell the property to meet fund redemptions, and thus forgo an impressive gain.

We never really know WHEN our investments are going to work out. It's why so many funds are labeled and run with the "value with a catalyst" as a moniker. The catalyst serves as a stop gap on time and hence lowers the risk of selling out at the lows. Further, catalysts, generally speaking, create probabilistic scenarios with expected value ranges that will vary wildly among market participants. And again, generally speaking, these situations are market agnostic which dampens volatility of a portfolio which is something many fund of fund, endowment, and other large capital allocators are looking for in managers.

Finally, some are better than most at estimating intrinsic value of securities. This can be in the run of the mill S&P 500 company, or it could be the liquidation of a distressed issuer. When you read any news report or sell side research piece on Eastman Kodak, inevitably someone will be quoting or re-reporting on the valuation of an "IP Expert." Different businesses should be valued differently. One person may value XYZ company one way, while another may use a whole different set of metrics, and come up with similar valuations.

And let me be clear: I am speaking about a range of values. The conceptual underpinnings of a "price target" flabbergast me to say the least. How can you be so convinced this stock is worth $20 dollars a share? If you change any multiple, or revenue growth forecast, or margin assumption, on the order of basis points, that number is going to change. Better to be approximately right than precisely wrong. (Caveat for credit analysts: I can conceptually understand when you say a price target on a bond is par because you think it gets paid off). To me, on a vanilla company, this range will come from a conservative multiples of run rate cash flow (derived from conservative assumptions on things like margins).

Naturally, you are to buy securities at prices BELOW the low point of these range of values. That is hard to do many times, but with patience, and a terrified market, good things can happen. "What is priced" in is a question we should all be asking ourselves in every investment. If lots of future growth and margin expansion is priced in, you may want to avoid. And if you every bad aspect of a company is touted relentlessly by the buy-side and sell-side peers alike, without regards to price, well that is something you may want to get up to speed on.