In this episode of The Acquirers Podcast, Tobias chats with Gary Mishuris, the Managing Partner of Silver Ring Value Partners. During the interview Gary provided some great insights into:
- Methodical Value Investing
- Lessons From Joel Tillinghast
- You Don’t Need To Be A Good Stock-Picker
- Invest In Predictability
- The Thesis Tracker
- Four Streams For Finding Investments
- The Kill-Step
- A 5 Step Research Process
- When To Sell
- Margin Of Safety
- Concentrated Portfolio
- Uneconomic Selling
- Finding Ugly Ducklings
- Rookie Investing Mistake
- Don’t Clone
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Gary Mishuris of Silver Ring Value Partners. He’s an MIT grad with a methodical logical approach to value investing. It’s a fascinating discussion and it’s coming up right after this.
I love the story about the name, Silver Ring Partners. How did you come to name the firm Silver Ring Partners?
Gary: Sure. Basically, what happened was we were immigrants, my family is Jewish. We grew up in the former Soviet Union, and came over here when I was 10. In the process, we lived in Italy in a little town called Ladispoli. We didn’t have a lot of money. The Russians took pretty much everything we had in order to let us go. So, people, immigrants would sell things on the bazaar to the Italians. One of the things I had to leave behind was this little silver ring, because– I’m sorry, a little gold ring, misspoke there. That was a present my mom gave me that she had when she was little. But we had only one ring per person that we could bring out, so we got to bring more valuable jewelry. I had to leave that ring behind.
In Italy, when I finally made some money selling things to the Italians, I was passing by this jewelry store on the way to the bazaar where the market was, and there was the same exact gold ring that I left behind, not exactly. This is before the euro. So, they had the lire. The lire was so devalued, they talked in thousands. A mille was 1000 lire. A mille was maybe 70 cents at the time or something like that equivalent. I found this gold ring for about five mille.
So, I very proudly– I was this 10-year-old urchin from the bazaar, walked into the store, clutching this 5-mille note. The guy, the store owner, looked at me kind of weird and saw that I had some money. So, okay, he’s not here to sell me something or something like that. I looked at the display, and there was the gold ring for 5 mille and all the rings near it were 30, 40, 50 mille.
So, not only was I going to restore the ring I’d lost in the immigration process, but I was also going to get a bargain. So, I probably gave him my 5 mille, he gave me the ring, and then two weeks later, I found out why it was so cheap. The gold polish wore off, gold plating wore off, and it was just a silver ring. Now, I don’t think he cheated me. I just didn’t understand Italian, and so I think it was meant to be a silver ring that was gold plated.
But I think it taught me two things. One is that, I think you want to do your own deep research, and two, that sometimes things are cheap for a reason. Because as value investors, we frequently are attracted to things that are inexpensive, and I think that was a good reminder to not just blindly follow that, and also do your own thinking about why something is potentially inexpensive.
Tobias: How did you get started in investing. I see that you’re an MIT grad. What did you study at MIT?
Gary: Yeah, so that’s a good question. It’s funny how I started. I was studying economics and computer science. I was a dork, still am. I did a double major– still have nightmares about not finishing one elective to get enough credits for both majors, which now obviously, I clearly understand that it’s completely irrelevant, which boxes you check, but at that time seemed really important. This was during the tech bubble, and I was fortunate to buy, I think, the only tech stock that went down in early 2000. I say fortunate, because my family as I mentioned, we were immigrants, I was poor, I was working a summer job, and then had two jobs during the school year in addition to the two majors, and so may be had $1,000 or so in the bank.
Rookie Investing Mistake
So, I went into Fidelity broker site, and I read a report about this company. And Cisco was supposed to be a natural acquirer for them. I’m like, “Great. Double my money. It’s better than working. So, all the other tech stocks are going up. I’m smart. I’m studying the subjects at MIT. I’m going to go, and I’m going to make some easy money.” I buy the stock and it goes down. I’m sitting there, I’m watching the stock like a hawk. I’m doing all the things I know now not to do, but I’m like– I’m not even going to mention places I looked up the stock quotations, and I’ll leave that to your imagination. But I was obsessed and it was just kept going down.
Investing Or Speculating
So, I was saying like, “What’s going on? why?” Just around the time, Warren Buffett came, and he spoke at Sloan, the business school at MIT. I wanted to listen to him speak. I didn’t know much about him, and thought wealthy, successful investor. Let’s just learn. And it immediately resonated. He was talking about the long term, intrinsic value, competitive advantage, all the things that now I take for granted and are second nature, but they were new at the time and made me realize that I was speculating, I wasn’t investing, and that I basically needed to just throw what I was doing away I start from scratch. So, I started reading everything I could about value investing, and yeah, that’s the story.
Tobias: So, your first job out of MIT, where did you go?
Gary: Yes, I was lucky. I ended up with Fidelity in equity research, which I have no idea why they hired me. Literally, I’m not being falsely modest. I was kind of a tech geek. I was probably more focused on computer science. I had an internship with JP Morgan in their internal consulting services, but I had no finance background. I was probably overly quantitative for them, but I actually think the reason they hired me is because I was pretty sure I wasn’t going to take the job. My father passed away at an early age. My mother lives in New Jersey, and I had plans to go back to there to live near her when I graduated to be around to help out. So, I interviewed at Fidelity, to be honest, for fun, I don’t want to sound [unintelligible [00:06:40]. I guess it was a chance I could take the job, which I guess there was because I did take it eventually then.
But I basically went into this with such a carefree attitude, because I had a job offer from JPMorgan to work in their Investment Management Division. I felt like, “Hey, I can just be myself, interview, and just chat with these famous investors and maybe learn a little bit and it’ll be cool.” Which, by the way, I know now is totally the perfect attitude to exude confidence and actually impress people, as opposed to like, “Please, please hire me. I promise I’ll do it.” That doesn’t work. It’s a behavioral thing. The more you are desperate to get something, the less people are likely to give it to you.
I came in and I kept talking to them through multiple rounds until Director of Research calls me, and I’m like, “That’s very strange.” Usually, rejection letters come in the mail from HR. He calls me up, and he’s like, “Well, Gary, we’d like to make you an offer to work for us.” There were seven associates that year out of 3000 resumes, something like that. I’m like, “Well, can I work from New York?” [laughs] He was like, “No, but we’ll pay you enough so you can fly to New York.” I’m like, “Hmm, all right. I’ll think about it.” My mother was insistent. I was actually going to pass on the offer, but she thought that was the best thing for my career, and I think she was right.
Lessons From Joel Tillinghast
Now, I would say I was very lucky. When I talk to young people, or young– I’m not that old, younger people or people earlier in their career, I really stress investing, specifically mentorship, because if you think about great investors, a lot of them had a really important formative mentor early on, and they wouldn’t be who they are as an investor if they didn’t have that mentoring relationship. So, I was lucky that I got a chance to work with someone [unintelligible [00:08:29] considered the exceptional, a gentleman by the name of Joel Tillinghast, who manages the low-price stock funds at Fidelity.
He’s beating the market by 4% per year over a quarter century across tens of billions of dollars in assets, mostly in small stocks. Imagine running over $10 billion of assets in small stocks, and having a portfolio of 800 plus securities, if I gave you that profile without the outcome, you would say, absolutely zero chance he’s beating the market at all, maybe by 50 basis points.
But he is incredible, and he had a very logical, rational process, because I’m a very linear thinker. I know myself. I’m a systems engineer by training. I like building a process, slowly evolving it, and then think of as modules– You build a module, you tinker, improve it, test it. That’s how I was trained. It’s one thing to read about Buffett or listen to him speak once, then be on your own. It’s a completely different setup if you have an actual mentor that you can talk to and say, “Hey, why is this?” More importantly, to tell you when you being stupid. By the way, Joel– I’m one of the more verbose people out there, as you probably are learning, but Joel was one of the more laconic people out there, and he’d rarely say much.
I remember one morning, I showed up to my cube and Fidelity had a rating system. One was a strong buy, two was a buy, three is a hold, four is a sell, five was a strong self, so one through five. Joel left me a note on my desk and had my stocks, my tickers, and my coverage, my ratings in order of best rating to low, buys to sells, and then ROE next to each one. I think I got his point, and I was vehement and I ran into his office, and I’m like, “But Joel, I get what you’re saying, you’re recommending the cheap stocks that have low ROE, but we’re value investors. It’s not just ROE. It’s whether it’s mispriced–.” And he glanced up to me, he was looking as 10K or annual report, stopped and said, “Mm-hmm,” and he went back [laughs].
So, it’s not like he spent hours talking to me, but it’s these little nudges and this shortening the learning cycle, which on the [unintelligible [00:10:49] investing is super long, but really helped me and I was very lucky to be working with a living investing legend, which I consider Joel to be.
Tobias: What’s his process, and what did you take from that process that you include in your own?
You Don’t Need To Be A Good Stock-Picker
Gary: Yeah, I remember having lunch with Joel once, and I said, “How did you develop your process?” I was maybe in my second year of being an associate at Fidelity. Because Peter Lynch actually hired Joel, and he had a chance to work with Peter earlier in his career, and Joel said something that really stuck with me. He said, “Well, Gary, I didn’t really think I could be a good stock picker. So, I wanted to have a process that really didn’t rely on that.” At first, I was like, “What does that mean? Aren’t we all picking stocks?” But then, I think I understood what he means. What he means is that, he didn’t trust himself to really predict which business was going to have an outstanding bright future that was far and beyond, above everyone else. So, he invested in a way to minimize error, and that led him to search for predictable businesses.
So, when I think about Joel, and I think this is a big part of my process, even though this is 20 years ago, so I have grown as an investor, and I certainly evolved based on my own strengths and weaknesses, which is something I recommend, and I teach a value investing seminar. I always tell people, “Don’t clone. Don’t copy people blindly. Try to learn what you can from people and then adapt it to your own circumstances, strengths, and weaknesses.”
Because you know Warren Buffett, and you don’t have his situation, his strengths and weaknesses. So, be yourself, but just learn from them. I was able to learn that what we’re doing is predicting businesses. In investing, you’re making this arrogant statement when you buy a stock, let’s say, and you saying that the price is wrong, as the market participants… currently in agreement of the stock is a 10th… completely off, not by a little bit, but by a lot, presumably as a fundamental value investor.
The question is how predictive– because you’re trying to predict usually a range of values, and you’re trying to find situations where, based on your range, the stock is an incredible bargain, at least that’s what I’m trying to do. The problem comes when you’re trying to predict the unpredictable. So, I’ll give you an example from one that of the early in my career. There was a company called Ferro, the ticker is FOE, like friend or foe. And it was some specialty chemical company did some ceramic glazes, a hodgepodge of things. It’s five divisions. So, I was very happy. I read security analysis, I was very Ben Grahamian.
I said, “Okay, their return on invested capital has been 11%. Based on that approximately midcycle normalized earnings should be $2.50, voila. I think $40 are approximately reasonable intrinsic value for that, and the stock is at low 20s, so I’m getting $1 for 50, 55 cents on the dollar.” Very standard, and a beginner value investing process I would say. Ten years later, I had a chance to look back, and it’s really humbling, because I wasn’t off by 10% or 20%. The actual midcycle earnings over the next cycle ended up being 25 cents.
You have something like that happen to you, and you ask why? Not like, why and you are crying under the table, it also happens but that’s different. I’m not going to talk about those moments. But why did I make such a big mistake? I think you can say, well, maybe I need to improve my estimating techniques. Maybe the lesson you draw is that, well, if only I followed this and this and this methodology,
I would be so much better and I could narrow the range. I think the right lesson is a different lesson, which is some businesses are inherently more predictable than others, and they will remain so beyond the next year or two. They’re just endemic to the business they are, the industry dynamics, that competitive advantage or the lack thereof, and so forth.
Invest In Predictability
I think that searching for that predictability, and therefore eliminating a pretty good majority of the universe from consideration is something that I learned from Joel, and that’s from Joel and frankly from a number of humbling experiences, which is how I think a lot of good investors learn, is that they realize that this is a humbling endeavor, and anyone who comes in think, I’m like, “Awesome, amazing, rarely make mistakes,” they’re either too inexperienced, or delusional. What I’ve got from Joel is focus on predictable, stable businesses run by honest people.
The second thing I think I learned from Joel is, I asked him like, “As value investors, how can we maintain a long-term horizon? How does that work?” He’s said, “Well, I think it only makes sense to have a long-time horizon if the value of what you’re buying is growing.” Then, I’m stuck, I’m like, “Hmm.” I think it took me maybe a couple of years to fully understand that.
I think about the standard mental model that investors have. There’s a price or range of prices. Well, I just say we just represent the range by the midpoint just for simplicity, but there is a prior value, and then there’s a price and the gap will close. Well, I think there are lot of people focus on that price to value gap, and fewer people have focused on– maybe less so now, but in general among value investors and what’s happening to the value.
I think what Joel’s point is that if the value is increasing at reasonable rates, then even if it takes five years to close the gap or something very long, you’ll still get a very competitive rate of return on your investment. On the other hand, if you’re buying a melting ice cube and the value is really dropping, you really can’t afford to have a long-time horizon. You need the price to value gap to close right now this year, because if you wait another couple of years, yeah, it’s going to close, but maybe it’s going to close the other way. So, I think the other thing that I got from Joel from this is how do you structure investment process to have time truly on your side.
Tobias: One of the ways that you deviate from Joel though is you say that he had 800 securities, whereas you run a much more concentrated portfolio than that. So, why do that, and what was the reason for the departure?
Gary: Yeah. I don’t want to speak for Joel, because I’m not qualified. But my guess is, and this is an educated guess, but I’ll leave it at that, is that if you were in the wild, he wouldn’t necessarily have 800 securities. I think it may be discipline built in a little bit, why did I leave the big firms, and kind of bring out on my own is, when you have a lot of assets, and you have various parameters, and frankly, let’s say you’re a small cap manager and you have billions of dollars, you can become that concentrated mathematically. You just will cross the threshold of ownership on the securities, and you have to have more, it’s just math.
But let’s see how [unintelligible [00:18:08] stylistically. I think that Joel had this cartoon once that really stuck with me. A guy walks into the store, and he asks the storekeeper, he says, “I want high quality in low price.” The storekeeper says, “Sure, I have both. Which one do you want?” The punchline here is that, well, if you want it– We talked earlier about quality and predictability and having honest management and having value that’s hopefully at least not declining, but maybe growing over time. It doesn’t have to be rapid growth, I’m not saying that at all, but at least, it’s not a melting ice cube. That eliminates a huge portion of the universe. Too many businesses just don’t have the track record that I would need to assess them. They don’t have the economic characteristics. They might not have the management, and so forth. Then, if you really want a big margin of safety component on the price side, that’s infrequent.
By the way, it should be infrequent, because think about– the purpose of secondary markets isn’t for guys like me to make money for my partners. The point of secondary markets is to support the primary market, which is where you connect users of capital with companies. So, if the secondary markets were vastly inefficient and most of the time the price was wildly off, that would really damage the primary market, and essentially increase the cost of capital for companies. So, you want as a society, fairly efficient markets most of the time. The deviations, when they do happen, are infrequent.
Margin Of Safety
So, you overlay a smaller universe of potential things to consider that passes the quality filter, and then with a big margin of safety, going back to the idea that you really can’t tell if a stock is 10%, 15%, even 20% value– maybe you can. I don’t want to speak for you, but I can’t. So, you really want a big enough gap so that it’s crystal clear, like Ben Graham parable of looking at a man across the street and not having to measure him to determine that he is tall. You just want to see, “That’s a pretty tall, dude.” He could be on the basketball team. That’s good, but it’s like, “Is he really a 6’1”, or is he 5’12”? I can’t really know that.” That’s not what you want.
So, I think it naturally leads into concentration, and I think that the other thing to think about, I read an article on this, is diversification and concentration is not an input. It’s an output of both your process and then your environment. Think about it this way. What’s the cost of diversification? The cost of diversification is that– there’s two costs. One is a cost in terms of time. It takes you more time to underwrite additional investments.
Maybe [unintelligible [00:21:03] with having an army of analysts, but chances are you still want to do your own underwriting of some sort, even if you have an army of analysts. So, there is time. But there’s also the fact that there is a slope to that line, meaning the N+1th investment is likely to be less undervalued or less attractive than the Nth investment, and so forth, and so on. So, their market environments, when the slope of that line is very steep and down meaning, then the next investment after the current investments you have would be much less than undervalued than your current bunch. Then, there’s time in the market where that line is very flat, or almost flat, meaning that the next N+1th investment is almost as undervalued or just as undervalued as your worst current investment.
So, you don’t want to be dogmatic about concentration, and say, I have to own exactly 12 stocks, because I don’t know, I put it in a PowerPoint slide somewhere. That’s stupid. I think you have to think about why are you doing the things you’re doing, and what are you trying to accomplish. In my case, I want at least decent quality. I’m not requiring the highest quality, but decent quality. I want a really undervalued price that naturally leads to concentration, but then how concentrated is also a function of the environment, because I would much rather have 20 great investments than 10 if I’m not giving anything up, but if I’m giving up expected return just to say I’m more diversified, beyond a certain point, I don’t want to diversify.
Part of it, I know a lot of investors talk about there is this threshold where– people call it to sleep at night threshold. I sleep just fine at least based on stocks. What I find– I like to hike, and I like to think about stocks. I’ll hike in the middle of the day. I’ve actually stopped looking at stock prices in the middle of the day, which has been a blessing because it’s a bad habit. If you’re doing it, stop. You, the viewer– [crosstalk]
Tobias: No, I’m with you. I’m with you. I 100% agree. It’s freeing to not look until after the close and even then, I wouldn’t look until the end of the week.
Gary: Yeah, I put all my orders now outside of market hours based on limits, based on my values. Because if I’m going to miss something low, fine. That’s not the game. But back to my point, I like to hike to dwell and see what thoughts– almost like a meditation, see what thoughts bubble up. If a stock keeps bubbling up not in a positive way, not in like, “Oh, I wish I could buy more shares,” but like, I’m like, “Hmm. Just a bigger position, hmm, do I really believe that the businesses as decent as I think it is?”, that’s a sign that you probably should reduce the position to mean. I have very mathematical guidelines for position size. I have small as 5%, medium as 10, large is 15, and to get to the higher end that gets you 10 or 15, you can’t just be a cheap stock, you also have to be a pretty good business.
So, I make sure that the quality bar rises as the position size increases as one way to manage risk. But even though within that context, I listen to my mindset. If this stock keeps bothering me, maybe it shouldn’t be a 15% position. This usually doesn’t happen of about 5% positions. This happens when something is 15% plus, and I’m struggling with it. That’s a sign– Let’s just make it slightly less, because it taxes my mind, that means I’m uncomfortable there somewhere, I don’t want to rely on gut feel too much, but it’s important to– maybe it’s my process telling me something in a way that I need to listen to.
Tobias: Given that these opportunities that are high quality and undervalued are rare, why do these opportunities exist in the market on occasion?
Gary: Yeah. I’m a big believer in behavioral finance. Frankly, probably that’s the only explanation for mispricing that makes sense. The question is why– Like you said, why do they exist? Most of them, they don’t. Sometimes, you have that usual time horizon arbitrage that value investors always talk about. That’s very real, because you go to a bunch of PMs in their suits, in their offices, who are waiting for their bonus, and get paid in one, three-year numbers, I was one of them.
So, I know [laughs] where they live. You give them the following proposition, you are going to get a 20% CAGR in the stock, but the first four years will be flat and negative. It all comes in your five. How about it? And they will all say no. Meaning, maybe in an interview, they’ll say yes, but in their portfolios, they’ll say no, because they’ll get fired or they won’t get– No, they won’t get paid, they like to get paid. There is a real institutional imperative out there that leads to short termism plus our own minds. We all like to eat a cookie today, except for whatever the 0.1% of the people who pass the cookie test, and they’re super smart, and… something like that. That’s about how long people can defer gratification as adults as well.
Regardless, I think that’s a pattern that exists. This is something I learned from reading Seth Klarman stuff or Joel Greenblatt’s special situations, forced or uneconomic selling. Why does it occur? Sometimes, it’s the classic spin-off, small ugly duckling being spun off, the owners, the old parent don’t want it. So, they’re selling it regardless of price, because they have a four-basis point position that came from their 50 base point position from the end. They just don’t want to do the work, and it’s 4 bips and it doesn’t matter, flush, it goes. That’s a great opportunity to look at things, because they’re not competing with you analytically. They’re not studying the company really hard and saying, gee, is it mispriced.
Finding Ugly Ducklings
I think Klarman talks about the ugly ducklings or complexity. Ugly ducklings and complexity naturally repulse people. They don’t even do the work. I was a victim to this. I remember talking to an analyst about this maybe 10+ years ago on the old News Corps at lunch, and I was telling them, “Well, what about the newspaper business, is in a decline, blah, blah,” and he politely smiled and nodded. Then, I realized what an idiot I was, because his point was that even if you assume the newspaper business is worth zero, the rest of the assets are worth more than the stock was trading for, and I missed it.
There were other stocks that were attractive as well, so I don’t feel completely terrible. But there was a behavioral mistake, because I fell for it, just like every other investor, almost every other investor, and focusing on the one problematic area to the exclusion of the rest. That’s a common pattern.
I call it the good business, bad business pattern. The way it works in a generic form is, let’s say, a company is earning $1 a share, and it’s trading at $10, or something like that, but that dollar is comprised of plus two from division A and minus one from division B. Essentially, the market is valuing the negative earnings of division B as worth negative And all of a sudden, management wakes up, or some activist comes in or something, and let’s say they just shut down division B. Now, all of a sudden, you have $2 of earnings and voila, the stock rerates very quickly or better yet, they sell division B to someone who can make it profitable, and maybe there’s now an even more valuable business overall. So, that’s a pattern, and I think that just being really patient, and looking at situations where people overextrapolate the recent past.
Overextrapolation Of Recent Trends
That’s another behavioral pattern that I observed, and it happens in both directions. For instance, on the good side, you have, like, if a company beat earnings for the last three quarters, clearly, they’re on a new growth trajectory, and they’re going to grow for the next five years. That’s how the market thinks. I’m exaggerating a little bit, but not too much. On the flip side, if a company has had a disappointment of some sort, the market maybe the first time gives them a pass, but the second time, certainly not.
So, you have this overextrapolation of recent trends, and that’s just natural, it’s just how the human mind works. I find that if you focused on predictable businesses, meaning there’s some gravitational pull of the business value for why all of a sudden that– Part of the point of predictable businesses is that their values are unlikely to change rapidly, adversely.
If you read Security Analysis, which I’ve now read three times, one of the things Graham says is that, “The analyst needs to guard against the future.” The first time, I didn’t get it, but in the second or third reading, well, if you underwrite the business to be worth x, you’re worried about future adverse scenarios, which will make it worth far less than x, and so much less than x that even your price margin of safety is not enough to give you a good return.
So, if you focus on predictable businesses, then I think within that subset, looking for companies with problems could be fruitful, because there’s a higher-than-average chance that those problems are temporary. One of my core bread-and-butter patterns is looking for problems within predictable businesses, and using fundamental analysis to determine whether the problems are temporary or structural, and to the degree that if it’s temporary, combine that with my time horizon arbitrage to basically make the investment believing that three years from now, five years from now, no one’s going to be talking about this if I’m right about the business.
Four Streams For Finding Investments
Tobias: Given that’s the style of thing that you’re looking for, what’s your process for searching for these kinds of businesses?
Gary: Yeah, I believe in multisourcing, and I’ll explain what I mean. I think sometimes people are very focused on one method, whether it’s scuttlebutt or whether it’s talking to investors, or screening. I think that most of those have a place. I have four streams of ideas that I put into the funnel. The first is value screens. Everyone uses them. I would say that they’re least useful now, but I like within that to focus on a seven-year average free cash flow yield. The reason I do that is because I think that first eliminates companies that don’t have free cash flow, which I try not to look at anyway for the most part. It also stabilizes the variation away from a temporary peak or a trough in profitability.
That yields some ideas occasionally, but it’s been challenging to find things because– by the way, if you’re running a screen and you find a stock that’s really statistically cheap, should you be really psyched and be like, “Yes, this is clearly a bargain,” or “Huh, what’s wrong with it? I’m not the only guy with a laptop and a Bloomberg. Other people have that. So, people must have passed on that some reason.” That’s not a reason not to invest in it, but it’s a reason not to be arrogant and just say, wait, just because it’s cheap doesn’t mean it’s mispriced. So, screening is one.
I do think that having a list of high-quality watch lists, so to speak, is a valuable source of information, because those are businesses– I won’t lie and say I know them all perfectly, I don’t, because it’s a few hundred companies. Some of them I know very well, some of them I know enough to include in that list, and that’s about it. But that allows me to complement my cheap stream of ideas with companies that are maybe not statistically cheap, but I know they’re pretty darn good businesses. If there’s a temporary price dislocation, it’s an invitation for me to dig deeper and look, and that’s global, probably 400 or 500 companies now I added to that list.
Then, there’s special situation, event-driven things, whether it’s spinoffs, recapitalization, the standard Joel Greenblatt plus repertoire at this point in time. It still works. It may be is certainly more followed than the typical– there was when he wrote, “You can be a stock market genius,” but it certainly still works. You just have to be more selective. There are more spinoffs. Not every spinoff is great. But he never said every spin has to be great. That’s why he had eight positions or something like that, is just a positively skewed sub-universe to search through.
The last stream is I like to use other value investors that I respect, whether it’s a conversation with a small manager who doesn’t even file who I know, I like his process, or the filings of well-known investors. You’ll find it’ll be less useful, because what I would really like to know is what would Warren Buffett buy with $100 million, if that’s all he was managing? We don’t get that information from his filings/ We get information, what does Warren Buffett buy with $500 billion? That’s a heck of a lot less interesting. So, I find some of the best ideas can come from other smaller, hungrier managers who are not constrained by size, and they also speak the language of intrinsic value investing. Therefore, we might look at things a little differently, but we’re at least speaking a common tongue, so to speak.
Tobias: You’ve described what goes into the top of the funnel, but then how are you filtering and validating those ideas for the ones that actually make it through into the portfolio?
Gary: Yeah, I think early on in my career, I was guilty of a lot of these– I talked about the newspaper, “Oh, it’s newspaper, I’m not going to touch it.” Or, I used to save anything related to cars, just not going to do it, because it’s a bad value chain, it’s structural and unattractive. I find now that it’s better to include things very loosely at the top of the funnel. So, I have the include step, which I just described.
The second step is the kill step where I’m trying to find if there’s anything wrong with it all based on my process, I’m going to kill it. The argument being that, if there’s something that’s going to cause me to say no after a lot of work, it’s better to say no without doing a lot of work. So, I’m looking for reasons to exclude. As I’m going through this process, now usually, there’s a couple of plus stocks at the top of the funnel, very loose. An investor I respect buys it, goes into the top. By the way, I erase the source. I don’t remember, which are the four streams the ideas came from, because I don’t want to be biased. Okay, Warren Buffett bought this. So, therefore, I’m going to give this greater respect than something else. Once something is in the funnel, it doesn’t matter where it came from.
Then there’s the kill step, and after the kill step, I usually am left with about 15 to 20 investments. So, maybe 10% of the initial universe remains. Then, what I do is I probably spend maybe 30 minutes to an hour on each company, so I’m progressively deepening. I’m a CS junkie from MIT. So, So, I remember from my AI class, you can go all the way down the decision tree to the leaf and come up or you can progressively deepen to one level, exhaust all.
That’s what I’m doing here, I’m progressively deepening, and I’m saying, “Okay, let me read the presentation. Let me maybe read the transcript,” something like that, and “Let me look up the proxy and see what the management incentives are,” and I’m reading the companies on four things. I’m reading them on business, people in balance sheet, but also complexity. Meaning, complexity, not of the company but of the potential thesis, how complicated will it be for me to figure out the last mile of whether it’s actually a good investment or not?
So, what I tend to do is I tend to rank things by– among things that pass, I rank them one through five, one, being the most actionable. Four and five is random, because once something is below a three, it really doesn’t matter. I don’t short, so I’m not looking for symmetry. But usually, on my second pass, some of the companies that were a two on the second category become a three on further examination, that eliminates some of 15 to 20. Others just get a pretty high complexity rating. It’s kind of lukewarm attractiveness, plus it’s pretty complicated. So, let’s do prioritize that.
I usually get two or three, where– I like to work on two things in parallel, because sometimes you get stocks, sometimes let’s say you’re scheduling a call or trying to do a primary research call, and just get stuck with someone’s schedule. So, doing a couple at a time allows me– at that point, I put it through my five-step research process.
5 Step Research Process
I really try to understand the business quality of the first. That’s the first, because I think it’s a huge mistake to start modeling right away, because it’s like garbage in, garbage out. The people with the biggest models are not the people who are the best investors. I think understanding the business well enough to make sure you understand the key drivers is really key and understanding is it a good enough business to even continue.
The step two is key economic drivers. What are the one, two, three, four things that I want to know about the business in five years to really understand the economics? Then, step three is financial modeling. Step four is valuation. Step five, which is a little different from some people, is behavioral checklist. I like it to be as specific as possible, meaning, what are some potential behavioral biases that I might be fallible to? Because I think a lot of people are much better at playing behavioral offense, meaning taking advantage of mispricings than they are playing behavioral defense, which is being introspective and trying to guard against their own behavioral errors, and I try to have a checklist approach, so that– I can’t eliminate it, I would be arrogant to think it can get down to zero, but at least lessen the impact of the behavioral biases I’m pretty sure I have.
When To Sell
Tobias: Let’s talk a little bit about your selling discipline, because you’ve got quite a well-thought-out structured process for selling, So, would you take us through them?
Gary: Yeah, well, thank you for the compliment because I actually think I struggle with selling, and it was probably the weakest part of my process, and I don’t know how to make it. I’m working on strengthening it. The best situation is the price to value gap closes. I’m very disciplined in that. I have my bait– So, I have three values. My worst case, my best case, that’s the range, and there is the base of the most likely case, and when the stock reaches a certain percentage of the base case, I begin to reduce.
The higher the quality of the business, the closer to full value I let is get, partly because in theory, the higher the quality, the more confident am I in the business value and the tighter the range should be. Now, to me, quality means a predictable business, so it would be nonsensical to say something’s a high-quality business, but this range of outcomes is the widest ever, unless it’s asymmetric, unless it’s very little downside, and there’s a long right tail, which could be a really high-quality business.
I try not to deal with below average. So, for an average business, I start selling at 85% of my base case, and it’s about a third, a third, a third. So, a third of 85, a third of 90, a third of 95. Whereas for highest-quality businesses, I will start selling at 95, 100, 105. It sounds really nice and neat, but you find that there’s probably a lot of false precision in there, and sometimes, I think the bigger question, this is something I’m struggling with and I’m trying to think through is, how good am I at correctly updating the value?
Here’s what I mean. I think I’ve seen this, I’ve done this for 20 years now, and I’ve seen enough of my own mistakes and the mistakes of others, where I think value investors, even though they try really hard not to be affected by the context when they’re underwriting investment initially, really do two things. One is they do let the environment affect their underwriting. Meaning, let’s say, if you have a cyclical depression, and you’re buying a company at a cyclical low, I find that we all tend to value the business a little bit less than what’s it’s worth or moderate amount less.
The reason I think is, you can justify the purchase anyway, so why push it? Then, that sin gets paired with a second sin, which is problematic, which is anchoring. I think value investors are taught that you have to be very disciplined, and that we’re all taught to look down self-analysts who just stock gets to their price, they raise their price, stock gets to their price, they raise it again. And the price, it’s like a carrot in front of a donkey. The price target is not there to be eaten, it’s there to move the donkey forward. It happens all the time.
So, we as value investors [unintelligible [00:42:45], “Uh-huh. I can’t behave like that because that’s weak, that’s undisciplined.” In our quest for discipline, I think there’s this potential for a behavioral error of just anchoring, because there’s two things that happens to values. One is there’s a natural uncertainty. We’re not sure what something is worth. Two is values change. Think about a goldmine. You thought there was a 50% chance of striking a gold vein, and you have some expected value. Well, if you actually strike the gold, it’s now 100% it’s there. So, the value has to be higher after you’ve struck the gold. Obviously, using this as an analogy, I think we as value investors frequently don’t update for the business equivalent of striking the gold enough.
I’ve been guilty of selling too early so many times that it’s painful, that I almost don’t want to sell anymore. I know it’s a bias because it’s rising market and this will change. I think even adjusting for the rising market, I think that there is serious anchoring that’s happening, where just like many value investors, I’m probably guilty of selling winners too early and holding on to losers too long.
The Thesis Tracker
So, what I’ve done is, I put this thesis tracker, and this thesis tracker has all my stocks, and it has color-coded boxes for each quarter. The color is from bright green to bright red and the shades in the middle. There’s five levels, I’m not trying to be too cute there. Each quarter, I judge the new information against the thesis as either a strong positive surprise, not against the street numbers, but against my thesis. If my thesis is business should grow 5% give or take, and it grows 15%, there’ll be a bright green box. But if it grows minus 10%, there will be a bright red box for instance.
I’m not using any excuses. It doesn’t matter if it was a onetime charge or if it was a cyclical recession, I’m trying to not allow some kind of a narrative bias to creep in and say, “No, I know that it minus 10, but there are these three extenuating circumstances.” No, let just put the facts versus expectations. And then, what I do is I force– If I have several disappointments… three, I’ll re-underwrite from scratch. That’s to lessen the probability of holding on to a loser for too long.
Conversely, if I have several moderate surprises or one really big surprise, even if it’s 100 cents on the dollar, I don’t sell it, I first re-underwrite. Again, because I’m saying there’s a signal there that potentially I’m too anchored to my original value. I know this is a short question, probably expecting a short answer, but I think it’s a complicated topic, because it’s easy to be mathematically disciplined, but you want to also make sure you’re, in a Bayesian updating sense, properly processing new information as it comes in around the business, because as Peter Lynch once said, “You don’t want to be watering the weeds and cutting the flowers.” That would be tragic.
Methodical Value Investing
Tobias: I did notice that chart in your– I think, was in your letter, and I thought it was really impressive. The other thing that I really liked is you track your portfolio against what you think the base value is. So, at any given time, you know roughly your whole portfolio versus what you think the portfolio was worth. Can you just talk a little bit about that graphic that you included in the chart?
Gary: Yeah, sure. It’s helpful, because for a few reasons. First, it tells me a little bit about how attractive things are. By the way, I don’t time the market, but I like cash via residuals. Sometimes, I will have cash, which by the way, if you cannot be an absolute value investor and not have a possibility of owning cash, because if you have to be fully invested, by definition, you’re a relative value investor. That’s not a put down, but it’s just a different thing. I’m an absolute value investor, which means that my buys are disconnected from myself. Meaning, if something reaches my sell point that we just discussed and there’s nothing to buy, it goes into cash.
So, I think one thing that price to value, which is again, it’s the weighted average ratio of all the price to values for the holdings, value being the base case value of that range, it lets me see, well, okay, now, how attractive is the portfolio on average? I do play around. I don’t have some optimizer, I do play around with it a little bit, but there’s also this– You won’t be careful about optimizing for the lowest number, because that’s one dimension but the other dimension is quality, where would I rather have an amazing business at 70% of value, or an average business of 50? If you’re just trying to get that number as low as possible, you’re climbing to the top of a very short hill sometimes.
Another thing that this price to value chart lets me– communicate with my partner. Sometimes, partners ask me, “Hey, is this a good time to add capital?” Of course, the answer is always and the more the better. But the joke and salesmanship aside, it allows me to answer that a little bit more fact based.
Usually, I say is look, right now, which is the case, the portfolio is in the 60s, mid-60s percent of intrinsic value, and there’s pretty good dispersion, meaning, it’s not like one company is a 10 and everything is at 90. But I can honestly tell you that right now, I could put the mind to work, which by the way, doesn’t mean that you shouldn’t say if it was 80, now, hopefully, someone’s partnering with me for many years, so, they shouldn’t just use the current attraction as a portfolio. But [unintelligible [00:48:31] there was now a particularly good time, it gives me a more objective way of answering that.
I think it also allows me to monitor over time. I like the time series aspect of it to say, “Okay, where has the portfolio been price to value?” Also, after a long enough period of time, what have been maybe the subsequent five year returns or something like that from low point price to value versus a higher point. Presumably, if I’m roughly writing the value, if I’m starting with a low price to value, that [unintelligible [00:49:04] returns should be higher than if I’m starting from a higher price to value. Now, the partnership has been operating for five years. I don’t have enough five-year holding periods to have the answer to that yet.
Tobias: Well, it’s a very methodical process, Gary, I commend you for it. If folks are interested in talking to you further or following along with what you do, how do they go about doing that?
Gary: Sure. Always happy if you connect with me on LinkedIn. You can reach me at firstname.lastname@example.org, all one word. If you actually spell it correctly, you’ll actually reach me. So, I also write really monthly articles on behavioralvalueinvestor.com, so a lot on value investing and behavioral finance. So, happy to get feedback. Just start a dialogue anytime.
Tobias: Gary Mishuris, Silver Ring Value Partners, thank you very much.
Gary: Thank you so much, Tobias. I really appreciate you having me.
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