Below is an investment letter I wrote in February of last year. The essence of what I was trying to get at is essentially what Sanjay Bakshi was saying (though more clearly and elegantly than I did) in his recent interview with Vishal Khandelwal in this excerpt:
So, to summarize, if you are going to invest like Ben Graham, then your sources of margin of safety are different than if you invest like Warren Buffett. You just have to be aware of those sources and also of their limitations.
I also strongly feel that when it comes to moats, it makes sense to think in terms of expected returns and not fuzzy intrinsic value.
What will not work is to apply the same methodology to every business.
For example, in my view there is a way to invest conservatively in businesses which are likely to experience a great deal of uncertainty. But you simply can’t use that approach when dealing with enduring moats. And vice versa.
You need to have multiple models to deal with different situations to avoid the “to-a-man-with-a-hammer-everything-looks-like-a-nail” trap.
The key is that the quality of a business and the sustainability of its competitive advantages makes an enormous difference in how it should be valued. A P/E ratio of 10 or 20 or 30 or whatever number means little unless you have some insight into the quality of the business and the sustainability of that quality going forward.
In the letter below, I separated investments into four categories, but that is just one way of viewing things. Reality is probably more of a continuum instead of set categories and one that can change quickly when innovative competition comes along.
Filters - by Joe Koster (February 21, 2013)
Seeking Wisdom: From Darwin to Munger
Besides running screens and paying attention to stocks on our watch list, when looking for new places to invest, we also read other people's write-ups and hear other people's ideas all the time. This can be a useful thing because a lot of these ideas are great, the people are usually smart, and it is another tool to search for potential things in which capital could be put to work.
But the human mind is made to fall for stories and miscalculate the odds when a good narrative is in place, as has been usefully described by the work of Nassim Taleb and Daniel Kahneman, among others.
Filters are an important—though certainly not guaranteed—way to help limit mistakes, whether from the narrative fallacy or from other potential errors.
By not even thinking about things that don't pass certain filters, you'll probably miss plenty of good ideas, but you'll also avoid plenty of good stories that turn out to be bad investments. And as it takes a 100% gain to make up a 50% loss, for example, it is probably much more important to avoid the losing investments than it is to try and pick every winner.
Or as Howard Marks often says, if you avoid the losers the winners will take care of themselves.
So whether potential investment ideas are your own or those of others, I think the most important thing isn't necessarily the number of things you look at, but rather knowing when you should stop looking at that idea and move on to something else before your own psychology makes you see things that may not really be there.
In an interview with my friend Miguel Barbosa last year, Alice Schroeder mentioned this in regards to Warren Buffett’s filtering process:
Typically, and this is not well understood, his way of thinking is that there are disqualifying features to an investment. So he rifles through and as soon as you hit one of those it’s done. Doesn’t like the CEO, forget it. Too much tail risk, forget it. Low-margin business, forget it. Many people would try to see whether a balance of other factors made up for these things. He doesn’t analyze from A to Z; it’s a time-waster.
And to elaborate on this point, let’s return to one of my four favorite books, Peter Bevelin’s Seeking Wisdom: From Darwin to Munger. In Seeking Wisdom, Bevelin mentions a comment that Buffett made in 2001 where he described his thought process:
At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.
- Can I understand it? If it passes this filter,
- Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
- Is the management composed of able and honest people? If it passes this filter,
- Is the price right? If it passes this filter, then we write a check
I think filters are some of the most important things to spend time developing well in order to become a great investor. If your filters are good enough, you can save a lot of time and, hopefully, avoid a lot of mistakes.
I discussed some of the things we seek when looking for investments in “The 4 Gs of Investing” and by and large, they are very similar to Mr. Buffett’s.
In one area, though, our philosophy is closer to the way Buffett managed money when his capital base was much smaller, rather than the way he manages Berkshire’s much larger base of capital today.
That area occurs at the intersection of quality and price.
Though our preference is for companies with sustainable competitive advantages, we are willing to consider other businesses, at the right price.
When looking for investment ideas, I’m looking for stocks that fall into one of three different categories, with some consideration given to a fourth category.
*Featured posts photo by Drew Beamer on Unsplash