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How can the market be wrong?

Investor biases: I believe that many investors exhibit behavioral biases that negatively influence their investment decisions. These biases include equating a successful company with a good investment, overreacting to short-term news or forecasts, favoring a company for irrational reasons, and extrapolating future growth from past performance.

Asset bubbles: the market tends to favor certain asset classes at a given time for mostly psychological reasons. Recent examples are the US, UK, and Spanish housing market bubbles 1995 – 2007, the private equity bubble 2002-2007, and the BRIC bubble 2002-2007, the treasuries bubble in developed nations 1980-??? (still ongoing).

What makes you think you are better than other market participants?

I try to minimize the impact of common investor biases or errors by (a) applying a consistent value approach to investing and (b) requiring a high margin of safety. I make mistakes, as everybody else. However, I aim to reduce the damage from mistakes by making conservative investment decisions. If I cannot find investment opportunities matching our investment criteria, I would rather hold cash and wait for markets to improve. Having stable, patient and unlevered capital also supports portfolio returns.

What determines a company’s fair value?

Going concern: I think a business with reasonably good prospects is fairly valued if a shareholder can expect annual returns of 10-15%. Companies that are large, stable and unlevered (or have low leverage) typically require a lower discount rate than small, volatile and highly levered companies.

Liquidations: I invest in securities trading well below their expected recovery ratio (i.e. their assets as realizable prices).

How long does it commonly take for the market to recognize fair value?

While I prefer a five-year test, I feel three years is an absolute minimum to assess performance. Shareholders can book profits either through dividends or through higher share prices. Latter are only likely if the market corrects an undervaluation (multiple expansion) or earnings grow substantially.

Do you have a favorite value metric such as free cash flow?

I use various metrics depending on the situation.

Generally speaking, I always look at a business as either a going concern or an asset/liquidation play. To assess going concern values, cash flows are more important to me than reported earnings, as they tend to be more truthful. To assess liquidation values, I look at current market prices or replacement values of a company’s assets. I also always pay close attention to a company’s leverage. For financials, I prefer a combination of equity ratio and growth of book value/share over time.

Lastly, I think it is important to remember that certain value metrics or magic formulas provide great tools for identifying opportunities and communicating investment ideas, however they always only capture a snapshot of the whole story. There are two books I found useful in helping me identify pitfalls when analyzing businesses: Quality of Earnings and Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.

What’s the very first factor or parameter you look at when you analyze a company? What’s the first for valuation purposes and what’s the first for business or accounting strength?

In my initial screens, I look at

  1. Owner earnings (OCF less capex)
  2. Balance sheet structure (type of assets, working capital, leverage)
  3. Price

I want to understand

  1. How a business is generating money
  2. What it needs to generate money
  3. How successful it is in generating money
  4. What it is doing with the money it is generating
Do you take into consideration bad quality companies at very good prices?

I would also buy a mediocre company if the price seems appealing. However, I try to avoid companies where the numbers don’t add up, I don’t understand the industry, or where management has done a terrible job in allocating capital.

When do you decide the investment was a mistake and you exit ? Is there a specific criterion?

I am constantly re-assessing my original investment theses. And if a re-assessment leads to the conclusion that a stock might actually not be trading at or below intrinsic value (as I had previously thought), I sell.

Reasons for why I might change my mind could be:

  1. I see a dramatic and unforeseen decline in earnings power or asset values
  2. Overly disappointing capital allocation (e.g. a company has lots of cash and then starts using it in a wasteful way)
  3. I discover new facts that I don’t like (e.g. better business and/or industry insights, fraudulent activities)
What diversification do you have? Do you hold cash?

I tend to go with Buffett: “Put all your eggs in one basket, and then pay very close attention to that basket”. Studies have shown that diversification into more than 20 positions actually does not improve returns.

I am highly concentrated (max 20 positions). The top 5 positions often make up 50% of the portfolio. However, I do spread my investments over geographies and currencies.

I am fully invested if I find many opportunities that I consider to be trading at or below fair value and I don’t want to risk losing out on potential gains by holding cash. I acknowledge the optional value of holding cash.

When would you consider going short?

When I buy things, I like companies that generate large amounts of cash flow relative to the price I am paying, and that invest their capital well. I would like to be short, in general, high-priced, cash-eating companies. So it is essentially the opposite of my long approach.