Eminent value investor Tom Gayner says achieving long-term investment success is indeed a challenge, as it requires both skill and wisdom that are difficult to attain easily. And a large part of it involves managing egos and temperament!
Successful investing requires one to constantly change, learn and adapt to new techniques and technological forces, and know what not to change. It also involves the acceptance of personal responsibility for outcomes that cannot be controlled, which is often not an attractive position to accept, he says.
“Successful investing requires the management of your own ego and temperament and usually that of your clients as well. It is a challenge to master the unusual feedback loop, where doing the right thing sometimes looks stupid for what seems like an eternity, and requires second guessing both from your clients and yourself. Also, sometimes the opposite is true, where doing the wrong thing looks intelligent at the moment and you need to contend with false praise, and an incorrect sense of certainty about the decisions you are making,” Gayner said in a presentation at [email protected]
Tom Gayner is the president and Chief Investment Officer Markel Corp, where he manages the company’s investment portfolio.
Gayner graduated from the University of Virginia in 1983 and started his career in accounting and began working at PriceWaterhouseCoopers (PWC) as a certified public accountant. He worked as a stockbroker and an equity analyst before joining Markel in 1990.
The idea of spotting value
Gayner started off as a quantitative analyst where he looked at company financials and used to analyse stocks trading at 52-week lows to identify value opportunities. However, as he gained more experience in the investment world, he understood that there involve qualitative aspects which need to be considered for identifying value while making an investment decision.
He says later he changed his approach and started looking at stocks trading at 52-week highs to figure out the reasons behind their performance and to identify potential compounders.
“I had a very strong quantitative bias in selecting investments. And one of the ways or one of the tendencies that we all have, especially when we’re starting out for a variety of reasons, is to have quantitative metrics that you can rely on. So today, it’s important to know technical skills, to know the accounting, to know things like net working capital, and to think about price-to-earnings ratios and price-to-book value ratios and have a series of quantitative metrics that would tell you that something is cheap; that’s good as far as it goes. But it doesn’t tell you enough. There are more things. Doing that sort of work – which is the first step, and you really should do it — is the idea of spotting value,” he says.
Gayner says if he finds a stock attractive, he invests a small amount in it just to have a position, and then tries to learn more about the stock.
The first step towards ‘spotting’ value can be achieved by following the value investing principles. The basic concept behind value investing is that if an investor buys a stock at a price significantly below its intrinsic value, sooner or later, the price catches up with the value.
But at times, the price may not catch up with the value and so investors need to look at other ways of value discovery, he says and advises investors to look at progressive value creation rather than looking at a static picture of value.
“You got to take the next step and try and figure out something else. So I moved from spotting value to spotting value creation; value creators as opposed to value spotters. So instead of saying that I firmly believe that something is worth it, I’m now asking myself, well, what will it be worth next year? And the year after that? And the decade after that? And to have some sense of something that is increasing in value over time at an appropriate rate. Well, that’s what I’m really hunting for and that’s what I’m really trying to spot. And this has applications, not just in investing, but for leadership, for management, for relationships that you would have on a social as well as a professional basis. So it’s an integrated thought as to how my life is unfurling,” he says.
Gayner lists out a four-point approach to identify companies for investment:-
- Companies with capability to create profitability
Investors should look for profitable businesses with good returns on capital, which do not use a lot of leverage. “Continuous profitability is a sign that a company is doing something that adds to customers’ value. There are two reasons why a company may not be making profits: one, the company may not be interested in making profits or two, it may not be good at making profits,” he says.
Regarding the use of leverage, he feels businesses that use a lot of it should be avoided, as they may not have a lot of integrity. The need to regularly pay financial charges generally indicates that all is not going well for the business.
“If you’re looking to buy a business, don’t buy it if it’s using a lot of debt. When it’s debt, you’re running your business on other people’s money. So when you see a business that sort of relies on a bunch of debt to operate and be successful, that adds a layer of concern or diligence that you have to do. You don’t have to do it if you look at a business that just doesn’t use much debt. So it’s a margin of safety which really protects your downside and protects you from bad things happening,” says he.
- Look for companies having good managements
Investors should look for companies having a good management team. While assessing the management of attractive businesses, investors should look at some key attributes like:
- Character/integrity of the management team
- Ability of the management team
“If you have people that are talented, who are whip-smart, who are very skilled at what they do, but yet have a character or integrity flaw of some sort — well, they may do well, but you as their outsider, silent, non-controlling partner are not. That will not end well,” says he.
- Look at reinvestment dynamics of a business
The third thing one should look at before making an investment decision is the ‘reinvestment dynamics’ of a business. Investors should see whether the business model can be replicated successfully many times, says Gayner.
A perfect business is one that earns very good returns on capital and reinvests it again and again, thus compounding investors’ wealth. “When I’m looking at a business I’m thinking, how big can this be? How scalable is it? How replicable is it? Because in order for you to really apply a bunch of capital to it, it has to be something that you can keep reinvesting in,” he says.
Gayner further encourages investors to always think about things in more than one dimension and in a spectrum.
“Things, generally speaking, are not binary. They’re not yes or no. They’re not white or black. They’re shades of gray all the way along the line. So a perfect business is one that earns very good returns on capital, and can take the capital that it makes and then reinvests that and keeps compounding at the same sort of a rate year after year after year. That’s the North Star. That would be the absolute perfection,” says he.
The fourth criteria to look at before making an investment is the price (valuation) of a business. Gayner feels this is where most investors start and end their analyses.
“That’s really where a lot of people start investing because there are books you can read. There are spreadsheets that you can do. There are well-trod paths you can follow that talk about what’s a reasonable price-to-earnings ratio, what’s a reasonable price-to-book ratio, or what’s a reasonable dividend — all these quantitative factors. And those are all good, but as I said, they’re not enough,” he says.
“When one is looking at prices, she usually makes two mistakes: first, paying too much for what the company is worth and second, and the more costly mistake, is that one thinks the stock is overvalued and waits for the price to come to a reasonable level when all the time the stock is compounding at a rapid rate and one is not able to invest.
“As human beings we tend to have very vivid memory of things that we did and that happened recently. We tend to not have vivid memories and not do well about thinking about the things that didn’t happen to us or things that we didn’t do. And we can brush away those experiences relatively easily, because we don’t have first-hand experience with it. So, we probably have stories where we thought about something that might have been a good idea, or we thought that might have been a good business, or we thought that it would have been a good stock at a certain point in time. But for whatever reason, we didn’t buy it at that time, and then we never got around to buying it. Those are the things that really hurt. That money that you didn’t make will end up being a far bigger subtraction from your theoretical end net worth than things that you did buy that perhaps did not work as well as you hoped for,” he says.
Secret to success in investing
Gayner says the secret to success in investing is to last the first 30 years in the investment world and learn the lessons from the various ups and downs of the market. Over a span of 30 years, an investor witnesses everything that can happen in a market as it keeps on getting repeated all over again in cycles.
“The bull market, the bubble, the correction, the depression, the recession… everything will repeat again and again. You will become successful only if you last 30 years and learn the right lessons from what is happening in the market,” says he.
(Disclaimer: This article is based on Tom Gayner’s presentation at [email protected]).