My Fundamental Process

In Friday's post Fundamentals Vs. Indicators I attempted to explain how I use both fundamentals and  indicators (sentiment and technical) in my investment process. A reader asked me to elaborate further on my fundamental process and I will attempt to do so in the next few posts.  Most value investors fall into one of two categories. There are value investors whose main  focus is the balance sheet and there are those whose main focus is the cash flow.

Seth Klarman is probably the best value investor right now and he is what I refer to as a "balance sheet"  investor.  He looks for situations where he can buy $1 of assets for 50 cents, even if its uncertain how or when that value will be unlocked.

The other type of value investor is a "cash flow" investor, the most famous being Warren Buffet. Warren Buffet is more interested in buying companies that generate and will likely continue to generate good cash flow at a reasonable multiple than buying assets on the cheap. In his earlier years Buffet was more like Klarman but he slowly shifted to a cash flow investor. That might be because it gets more difficult with size to be a "balance sheet" investor as many of the assets are illiquid and hard to accumulate in Buffett size quantities. Also, reinvestment of assets is much more of an issue as well.

I fall into the category of a "cash flow" investor. Balance sheet investing makes perfect sense to me but requires a greater leap of faith. The assets are usually less liquid and the how and when value will be recognized is often an unknown. Taking that leap of faith is why investors like Seth Klarman get paid but there is money to be be made in value investing based on "cash flow" as well.



Applesaucer said...

Here's my untested hypothesis: the time to buy "garbage" stocks is when everyone is afraid of them -- i.e., when you're closer to a market bottom than a top. I would classify "balance sheet stocks" with poor free cash flows as "garbage stocks."

The time to buy "quality" stocks is when everyone is looking under rocks for "bargains" because quality is too expensive -- i.e., when you're closer to a market top (if you have to be in equities at all; cash is better in such situations). I would classify good businesses with strong free cash flows and low capital requirements as "quality stocks." They will rarely, if ever, trade at a discount to book value because of their low capital requirements, among other things.

In either case, I would prefer safe and simple balance sheets, but if you are fortunate enough to get into risky balance sheet situations after the bear market is over -- again, when everyone is afraid of risk and is fleeing to quality stocks -- then you can get multi-baggers.

For an investor that is ready, willing and able to go to cash, it looks like there's never a great time to buy quality stocks. The point in buying them, I believe, is that you don't have to worry as much about timing the cycle right. Plus every now and then quality stocks go on sale. They've been on sale since late 2008 (after being expensive for a decade+) and they were on sale from the mid '70s to the mid '80s (after being overvalued during the "Nifty Fifty" Era). And I'm sure that if you go back to the '40 and '50s you'd find that they were on sale for a while back then, too.

I suspect that over the next 5-10 years quality stocks will remain on sale and when you look back, the rewards to owning them will have been in the forms of dividends and avoiding zeros. And over the next 5-10 years you can get in and out of them as the market oscillates around a trading range.


Tsachy Mishal said...

Klarman has managed to make money through thick and thin. That is why he is the greatest.

Applesaucer said...

Yeah, you're right. I wonder how he does in years like 2000, 2006, etc. vs., say, years like '03 and '09. Plus, he aint afraid to go to a fat cash position.

I think I saw a portion of his track record a few years back and I should probably check before I say this, but if I had to guess, it would be that he does spectacularly well coming out of bear market bottoms, maybe underperforms in cyclical peak years and sidesteps a lot of the trouble when bear markets hit.

Just a guess. Someone will probably show me I'm wrong.


Applesaucer said...

One more thing: my guess is that Klarman's timing is a by-product of process rather than prediction. Like he gets knocked out positions as they hit his targets and he can't find something to do with the cash.

Obvious things, of course, but hard to apply in practice when you feel like you've got to be finding new ideas and doing something with cash all the time.


Tsachy Mishal said...

Funny you should say that. Value investors tend to hate market timers. But a trader using sentiment measures and a value investor will often be buying and selling at the same time. When everybody is pessimistic is when values become available and vice versa. So value investors and sentiment based market timers are more alike than most people think.