“…I’m cheap, and I really hate losing money.” —Tom Gayner, Talks at Google, June 22nd, 2015
This is the second post about Tom Gayner’s talk at Google. See here for the first one. In this post we’ll learn some more about Tom’s evolvement as an investor, four-point view of what he looks for in a business before making an investment.
Tom Gayner’s Evolution as a Value Investor: From Quantitiative Bias to the Four-Point View
In the first part of the talk Tom discusses how he started out and evolved as an investor, how his investment approach has developed through the experience he’s gotten through the years (emphasis added).
“And similar to, I think, many people as they begin go down the path of trying to become an investor, I had a very strong quantitative bias in selecting investments. And one of the ways I would describe that, and 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. And one of the reasons that would be the case is when you’re starting out and you haven’t done this a whole lot, you’d really like to have some confidence supplied by something external that you’re on the right path. And if you can do some well-established, well-trod paths of disciplines of things that have worked—boy that seems like a pretty good basis to make a decision and to think about what’s going to happen in the future. And there is absolutely nothing in the world wrong with that. I encourage that. That’s really the best way to start, but I think that is only a partial step along the journey of becoming an accomplished investor. That worked spectacularly well for Ben Graham in the 1930s, who’s the grandfather of all investing and the professor who really taught Warren Buffett the disciplines of investing. But that was a period of time when we were just coming out of the Depression, and there were a lot of securities that were mathematically and quantitatively cheap. So it was a great technique, a great discipline. It had not been practiced, but that pond has gotten a little over-fished.
So today, while it’s important to know the technical skills, to know the accounting, to know things like the net working capital, and to think about price earnings ratios and price to book value ratios, and have the series of quantitative metrics that would tell you that something is cheap, that’s good as far as it goes. But is doesn’t tell you enough. There are more things. And I call the notion of doing that sort of work, which is the first step, and you really should do it—that’s the idea of spotting value. So it’s a picture of time stands still. When you’re looking at a picture of something that you think is worth this, and it’s selling for this. So there’s a price gap there. And you want to buy it at this, and you think it will get to that. And that’s great if it works, but that’s a picture. What I have evolved to, and the path that I’ve been on for a long time—and the reason I got on that path is because I found that that notion of spotting value and thinking that there’s value gaps would close right after I showed up to buy some stock, it didn’t work. So it’s not as if I found that technique, and I learned that, and it worked, and produced great wealth. It didn’t.
So you gotta take the next step and try to figure something else out. So I moved from spotting value to spotting the creation of value, value creators as opposed to value spotters. So instead of a snapshot, instead of a picture, how about a movie. What’s this movie going to look like? How’s this reel going to unfurl over time? So instead of saying that I firmly believe that something is worth this, 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 find and spot. And I think this has applications, not just for 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 though as to how my life is unfurling.
So with that sort of thought in mind, I came up with a four-point view of what it is that I’m specifically looking for, and how I specifically think about things that I might investing in. So the first thing that I look to invest in is a profitable business with good returns on capital, that doesn’t use too much leverage to do it. And again, each and every one of those words came about because I made a mistake somewhere along the line. Things did not work and as a consequence, it was a hard, searing lesson where I lost some of my own money. […] I’m cheap, and I really hate losing money.”
A Four-Point View to Business Analysis and Investing
The four-point view is Tom’s framework for how to analyze a business and consists of the things that he wants to see in a certain business before committing his money and making an investment. The four points, or lenses as he also calls them, are:
- Profitable business that earns good returns on capital with not too much leverage
- Reinvestment dynamics
The First Lens: Profitable business that earns good returns on capital with not too much leverage
The starting point is to look for a demonstrated record of profitability. Since the purpose of a business is to serve others, to create value for its customers. The mark of a business doing that well, is a profit. In this case, an unprofitable business means one of two things: 1) the products or services are not needed or wanted (lack of demand), or 2) not very good at what they do (lack of skills).
If we take a look at the factors of leverage we have 1) the refinancing risk (risk of no refinancing of debt during times when the market doesn’t want to supply any), and 2) character of the people responsible for any decisions about leverage.
The second factor of leverage about character, and why character is important when thinking about debt and leverage goes back to the time when Markel started to buy non-insurance business. Back then Tom got some “spectacularly good piece of advice” from an elderly gentleman he once talked to who said:
“If you’re looking to buy businesses, don’t buy businesses where they use a lot of debt. And I wondered why. And he said, well, if you want to make sure that you’re dealing with high-quality, high-integrity people, generally speaking, high-quality, high-integrity people don’t use a lot of debt. Or not so much that, but if you’re a bad person, if you were sort of a little bit of a crook or had a little bit of larceny in your heart, it’s unlikely that you would use 100% equity finance. Because when it’s equity financed it means it’s your own money. When it’s debt, you’re running your business on other people’s money. He says crooks don’t steal their own money, they steal 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 have to think about, that you don’t have to do if you look at a business that just doesn’t use much debt. So it’s a margin of safety. That’s a word and a phrase that Ben Graham used quite a bit in thinking about investing, by looking at companies that don’t use much debt. That really protects your downside and protects you from bad things happening.”
The Second Lens: Management
This second point is about the management team that runs a business. The two attributes(“…one without the other is worthless. “) to look for when assessing management are :
“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 as their outside, silent, non-controlling partner are not. That will not end well.”
The Third Lens: The Reinvestment Dynamics of a Business
The third principle is about the reinvestment dynamics of the business, and here it’s all about the power of compound interest. Tom quotes Einstein and says:
“Einstein said it was the most powerful force in the universe, compound interest. Einstein further went on to say, that those who understand compound interest earn it and those who do not understand it pay it.”
This third point is addressed by answering the question: What is the reinvestment dynamics of the business, that is, what’s the compounding feature?
One example Tom discusses to show how to think about the reinvestment dynamics of a business is the restaurant business and the spectacular five-star, gourmet, lovely restaurant typically owned by the people who are there every day compared to McDonald’s.
“They’re not chains of the best restaurants in the world, from sort of a gourmet perspective. Usually the owner is the chef, or right there in the front of the house. And he’s there all the time. So that business, that restaurant can be very successful. But typically, that is not a model that is set up to be able to replicate it again and again and again and again and again. It may provide a very nice living for the owner and their family, and employ their family, and great service to the world, great food, great prices, all that sort of stuff, but it’s not replicable. So there are some businesses that you’ll see that are like that, that are boutiques in some form or fashion. It’s a limiting factor to really be able to apply capital and see it grow.
But go back in time 50 years, and at the start of McDonald’s. And then another McDonald’s and another McDonald’s and another McDonald’s. One right after the other. That’s a perfect example of where that reinvestment dynamic kicks in.
So what I’m looking at something, 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.”
Tom encourages people to always think about things in more than one dimension and in a spectrum (maybe you could call it something like a business quality 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 its capital, and can take that capital that it makes and then reinvest that and keep compounding at the same sort of a rate year after year after year. That’s the North Star. That would be the absolute perfection.
The worst kind of business is the one that doesn’t earn very good returns on capital, and yet seems to need gobs of it all the time. And again, this might be old data because the world seems to change, but I used to joke that airlines fit that category. So there were all these airlines, and they realize what was coming and going. And people seem to want to always get in the business, but they never really make good returns on capital. These days they are. Whether they will continue to do so or not, I don’t know. But that’s kind of the spectrum of business, so I just try to get as close to this end of the spectrum as possible.
Now in the real world, this does not really exist very often or very frequently and oftentimes it’s very richly priced when you see it. But how close can you get to it? Because the second-best business in the world, is one that earns very good returns on capital. It can’t reinvest it, but the management knows that. They’re intellectually honest that they have to do something else with the money. And what are their choices? Well, they can make acquisitions, they can pay dividends, they can buy their own stock. But they are thoughtful and they know that. And Berkshire really is the best example of a company that had that in place, where you had the genius at the top who knew that the original business, which was a textile business—whatever money that made, it was best to invest that somewhere else. And that’s what Buffett has done for 50 years, is to reinvest the cash flows of the various businesses that come feed into Berkshire in other places, so that is the maestro-like effect that he has had.
So that’s a legitimate way of handling the notion that you can’t reinvest in the business that you have, but you can be thoughtful about what you do to that money when it comes in it.”
The Fourth Lens: Price/Valuation
The fourth principle is about price and valuation. As Tom says, this is the fourth lens, but a lot of people start out with this one:
“And that’s really where a lot of people start in 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 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. They go into the thinking. They go into the thought process of whether this is a good investment or not, but the mistake that I see—there’s two types of mistakes you could make when you’re doing your valuation work.”
The two mistakes that Tom mentions are, number one, that you pay too much for something, more than it’s worth. But this is not the worst thing, it’s more of an error you can recover from. Mistake number two, even worse than mistake number one, is according to Tom, the hidden cost that comes from having thought about the value of a business, but you never buying into it, and where the business itself keeps on compounding over time.
“As human beings we tend to have very vivid memories of things that we did, 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 firsthand experience with it. So we probably all have stories about something and the older you get, the more stories you’ll have like this, where you thought about something or you thought something might have been a good idea, or you though that might have been a good business, or you thought that would have been a good stock. In a certain point in time. But for whatever reason, pricing or whatever, you did’t buy it at that time, and then you 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 the things that you did buy that perhaps did not work as well as you hoped it would.”
The up-coming third post, the last one about Tom Gayner’s talk at Google, is going to be about the Q&A session.
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.