A common misconception among many individual investors, financial market commentators, and investment professionals is to refer to any individual or institution who purchases common stock as an “investor”. Seemingly nowhere in this accepted definition is there any regards to the price paid, purpose of the purchase, or level of due-diligence conducted.
My observation, however, is that most stock market participants, even the so-called “smart money” (i.e., fund managers and other professional investors), are in fact speculators who are seeking to profit from short-term price fluctuations. Given that short-term price fluctuations largely represent factors other than changes in underlying business values, speculation is largely an attempt to deduce the perceptions and actions of other market participants – a game seemingly few (if any) can win. Investors, on the other hand, are those who view stocks not as pieces of paper to be traded back and forth, but rather as pro-rata shares in companies. An investor recognizes that the benefit of stock ownership lies in the proportional claim that a stock owner has on the earnings and net asset value of a company, and seeks to profit from the reflection of the company’s fundamentals in the stock price.
The distinction between investment and speculation can at times be unclear. The best definition in my opinion of investing as distinct from speculation comes from Benjamin Graham, who is considered the father of “value” investing – an investing philosophy which we religiously follow at Tortuga Capital – in his 1934 book Security Analysis (co-authored with David Dodd):
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”1
I will devote the rest of this essay to how we at Tortuga Capital apply the Graham and Dodd framework in our investment approach.
Criterion 1: Thorough Analysis
Graham and Dodd’s “thorough analysis” criterion is a reference to the level of due-diligence which an investor must conduct prior to purchasing a security for investment. At Tortuga Capital we seek to thoroughly understand a company’s financial position, earnings generation, management and governance structure, competitive position, and industry. Although the research process changes somewhat company-to-company, we do follow a general blueprint in conducting company due-diligence.
We start by reading at least the last three years of the company’s annual reports (possibly more for cyclical companies). While reading through the annual reports, we want to get an understanding of the company’s various business and product / service lines. We also spend a substantial amount of time on the company’s financial statements, accompanying footnotes, and Management’s Discussion and Analysis (MD&A) section, trying specifically to understand (1) what a company owns and owes (assets and liabilities) at approximate market values, (2) a company’s “free cash flow”2 for the period, and (3) management’s record in allocating the company’s cash flows and managing its financial resources. We make a number of analytical adjustments to the company’s financial statements to aid us in assessing the above considerations.
We then read the proxy statements and shareholder letters for the corresponding period of time. With the proxy statements, we particularly pay attention to management’s compensation, overall corporate governance (for example, does the company have a truly independent board of directors), and related-party transactions. With the shareholder letters, we want to get a feel for how management is communicating with shareholders and to see how management’s claims reconcile with the company’s operating performance as derived from the financial statements.
We also try to identify the company’s most relevant competitors to see how the company compares, and we also read a number of earnings call transcripts and investor presentations. We spend a great deal of time on the company’s website, trying to further understand the business, and we may make phone calls to a few of the company’s competitors, customers, and suppliers in an effort to gain further insight.
All of the above efforts culminate in an attempt to value the company, so we can compare our valuation estimates to the company’s current stock price.
Criterion 2: Safety of Principal
For Graham, safety in an equity investment came primarily from paying a price that is significantly below appraised business value. Graham referred to this discrepancy as the equity security’s “margin of safety”, stating, “The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”3 Insisting on a margin-of-safety on individual securities greatly decreases the probability of a large and permanent loss of capital in an investment portfolio.
I have discussed Tortuga Capital’s approach to business valuation at length in another essay. To abridge here, we employ several valuation methodologies and use various scenarios in our input assumption in each valuation model. We thus come up with a range of values, rather than a single figure. We perform the valuation only after studying the business extensively.
Our preferred valuation method is to capitalize normalized current free cash flow. In other words, we attempt to estimate the amount of free cash flow a business can produce in a steady state on an unlevered basis. We then divide this figure by an appropriate discount rate (capitalization rate), add any non-operating assets, subtract out any non-equity liabilities, and divide by the number of shares outstanding. We supplement this approach with other valuation approaches, such as the comparable companies approach (widely used by investment banks and private equity acquirers). We will buy the stock only if the current stock price is significantly below our conservative estimates of per-share business value.
Adding to Graham’s margin-of-safety concept, we also try to assess a firm’s debt-service capacity, relying on traditional approaches of corporate credit analysis. If we feel that a company can satisfactorily service its debt under adverse conditions and raise more debt capital if needed, then we feel we have an additional layer of safety in our investment.
Valuation is an inherently subjective undertaking, involving many assumptions regarding the future performance of a company’s earnings and other fundamental factors. Circumstances may change that greatly impact a company’s valuation, or an analyst could simply be wrong in her assumptions. Having the discipline to only purchase a stock at a discount from appraised business value, using conservative assumptions, decreases the probability that an error in the analysis will adversely affect an investment portfolio. Thus, insisting on a margin-of-safety is central to the investment approach of a risk-averse investor.
Also important, although secondary, in managing risk is diversification. However, our views on diversification differ from conventional views.4 In the lexicon of modern finance theory, diversification generally means an attempt to maximize returns for a given level of “risk”, an approach generally referred to as “portfolio optimization”. This portfolio approach requires an investor to find securities or asset classes whose past price returns are uncorrelated with those of other securities or asset classes in her portfolio. In our estimation, there are several major flaws in this approach: 1) risk is viewed solely in statistical terms as the extent to which past stock prices movements have deviated from the average, 2) expected future returns are viewed as the simple arithmetical average of past stock price returns, and 3) correlations are mathematically derived from past stock price fluctuations. In other words, the modern mathematical approach to diversification is fully reliant on past market price movements, the assumptions that such statistical relationships properly capture the risks of business ownership, and that such statistical relationships will persist into the future. We at Tortuga Capital do not accept these premises, nor is this approach consistent with Graham’s view of how an intelligent investor should view market prices.5
We at Tortuga Capital do prefer to find companies which are uncorrelated with other companies in our portfolios in the sense that the companies may perform differently in different economic environments. However, we prefer to take a much more qualitative approach to thinking about correlations in business fundamentals, rather than taking the more mathematical, market-price-centric approach of so many modern investment managers and academics.
Criterion 3: Satisfactory Return
The third criterion of Graham’s definition of investment partially follows from the second criterion (safety of principal). A margin-of-safety centric approach to risk minimization offers an opportunity for satisfactory returns (i.e. average returns), if not superior returns with less possibility of permanent capital loss.
The possibility of excess return on a security comes from the bargain purchase price. The Graham and Dodd approach, in other words, is predicated upon not only identifying a bargain purchase, but also that the market, within a reasonable time period, will correct the mispricing. Of course this assumes that the valuation approximated the actual business value to begin with. Security prices in a functioning capital market should reflect underlying business value in the long-run. In the short-run, however, such dislocations between price and value can be exploited by a prudent investor, assuming the investor has the patience to hold the security until the value has been realized in a much higher security price.
So what are the means by which security mispricing corrects? Underlying value can be realized by either a) market participants coming to the realization that the security is mispriced and purchasing the stock, thus forcing up the price, or b) some specific event occurs to unlock the underlying value. Value-unlocking events are numerous, and include the company being acquired or the company engaging in a share buyback or recapitalization. In any event, our experience – and the experience of other Graham and Dodd practitioners – shows that markets do correct mispricing, generally within several years but sometimes much sooner, allowing Graham and Dodd practitioners the opportunity for above-average long-term investment returns.
In 1934, Benjamin Graham and David Dodd laid a path followed by some of the most successful investors in history. Central to their approach is the delineation between investing and speculating. The allure of speculation brought on by a 24-hour news cycle, the temptation of short-term trading profits, and the innate desire for instant gratification embedded in the human psyche can make adhering to investment principles difficult. However, we believe that the odds of long-term investment success will be greatly enhanced by a patient, risk-averse, and analytically rigorous approach to security selection.