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There and Back Again: A Value Investor’s Tale

“Opportunity is missed by most people because it is dressed in overalls and looks like work.” Thomas Edison

In studying the world’s most prodigious value creators, or Builders as we call them, we have found at least a dozen behavioral commonalities. But by far, one of the most pronounced similarities between them all, is their ability to see what others don’t. They go where competition hasn’t even dreamt off, either creating entirely new products or services, or facing a very uncrowded competitive landscape because few dare to go there.

Furthermore, Builders who achieve turbo–charged success, which is pretty much everyone at the top of the current wealthiest list, are highly adept investors. When their knowledge starkly contrasts to the views of market participants, which we call the expectations gap, they make bold moves.

It is a definitional attribute of a value creator, that one cannot stand above their competitive landscape, without doing something significantly different from their peers. As Eric Schmidt and Jonathan Rosenberg wrote in How Google Works, companies that obsess over what their competitors are doing are doomed to mediocrity as they’ll always be emulating the average. These emulators never breakthrough with anything innovative or novel.

Value investing traditionally looks for opportunities in areas, industries, and companies, that the market has shunned for one reason or another. Getting a cheap price for an asset that everyone seems to hate, implies going towards pain, tension, and despair. Often times numerous valid reasons are cited to justify the bargain price. But there are always babies thrown out with the bathwater. More recently, we’ve been able to find investments where these worries are tied more towards volatility and near term anxiety, than anything well–warranted or tied to fundamentals beyond the next couple of quarters. We can thank momentum and quantitative strategies for many of these opportunities, as well as the evaporation of human counter-parties in day to day trading. We don’t believe we’ve had to give up our quality focus in order stay disciplined on deep value investing, we just look for it in areas where investors aren’t looking. We look for them outside of silicon valley.

The Omaha Herd Turns

The idea for this article came from listening to Tom Gayner of Markel speak last month in Omaha. Tom noted how the Alterra acquisition marked the beginning of the company’s tendency to pay up for higher-quality assets, rather than sticking with their traditional history of rooting around the bargain basement for a diamond in the rough. Tom echoed an innumerable number of “value” investors that weekend espousing the virtues of high quality companies. The weekend most infamous for celebrating the principles of value investing had essentially converted to a weekend of feel-good quality discussions where momentum (madness of crowds) disguises as intellect. One could hardly blame these investors, as the spread between the performance of value stocks and the general market has never been wider. This means value investing has just generated the worst returns since the craft was first articulated by Ben Graham.

Exhibit 1: Forward Earnings Spread between Value Stocks & the Market

Source: JP Morgan, Marketwatch

The herd on Wall Street has fully embraced the Quality Compounders mantra, and has lost any sense of discipline when it comes to determining a fair price to pay for these assets.

To be fair, as we highlighted in an article in which we examined mistakes we have made, after we combined our value lens with a quality lens, our error rate went down materially. In a concentrated portfolio, one’s error rate is inversely correlated to the alpha, or above-market returns we can generate.

Yet as Mr. Buffett and Mr. Gayner’s own track records show, the period in which they outperformed the market the most, they were undeniably focused only on value (or the price they paid relative to fundamental value), and considered quality only as an afterthought. Buffett took a career-making concentrated 40% (of his portfolio) position in American Express, as it was undergoing the Salad Oil scandal in 1963, whereby the stock was cut in half in a relatively short time frame. While he did judge that it was a high quality asset with a defensible brand, the near bankrupt valuation was what attracted him to it in the first place.

Value investing produces the returns that builds reputations.

But it seems as both with Mr. Buffett and Mr. Gayner, that once the reputation is built, the focus evolves to quality. It feels better. You make less mistakes, as we have found, which means when the stakes are high and the spotlights are on, you have a lower chance of getting an egg on your face. This seems perfectly rational. In fact, it almost seems irrational to not adopt a safer strategy after building massive wealth. It is almost universal human behavior that after you have built a fortune, you only care about protecting it, not growing it. That is perfectly rational. But it is also perfectly mediocre. It is a path Builders do not follow. They nearly always follow the road less travelled.

It wasn’t until the decade after Charlie Munger joined the group as Vice Chairman, in the 1980s, did Berkshire emphasize the virtues of quality with equal importance as value in investing. Berkshire Hathaway letters during the late 1980s talk about the “sainted seven,” which were seven companies that were acquired by Berkshire mostly in the 1980s, that had high quality returns on invested capital with sustainable moats (or at least at the time, as some of these businesses were later eviscerated by technology). While the influence of quality had started creeping in ever since the days of the big American Express bet at Buffett Partners, and the acquisition of See’s Candy in 1972, the dialogue didn’t change materially until the 1980s.

Exhibit 2: Buffett Partners & Berkshire Hathaway Annual Alpha (Compared to S&P 500)

As we can see from exhibit 2, there is a pronounced decline in annual alpha generated by Berkshire after the emphasis on quality became pervasive. Yet, there was also more consistency and less volatility in the returns. Aside from the Nasdaq bubble and Global Financial Crisis of 2008, Buffett and Munger have delivered consistent and impressive alpha, particularly for a group whose investable universe has shrunk as they’ve grown. But since the Sainted Seven, the dynamic duo hasn’t produced the heroic >20% alpha that Buffett generated earlier in his career when he stuck to despair-ridden valuations.

Of course, some of the reduction in alpha can be attributed to both the larger size of Berkshire Hathaway, and also a far more competitive investment landscape, particularly in the United States where the Omaha partners have tended to focus.

Yet, looking at an equally venerable track record which was more recently built during these years of increased investment competition, we see an even starker trend.

By his own admission, Tom Gayner shifted Markel’s focus in acquisitions away from value prices to that of higher quality companies at more fair prices when he made the controversial (at the time) acquisition of Alterra.

Exhibit 3: Markel’s Book Value Alpha vs. S&P 500

Here, the difference in alpha generation is even more stark than with Berkshire. During the earlier value days, the same period it was harder for Buffett and Munger to generate alpha >20% per year, Gayner was able to generate these staggering returns in a much more competitive environment. His stock picking style had both quality and value lenses, but his acquisitions were done at bargain basement prices. Since the quality focus has taken hold, the company has struggled to generate alpha. But the audience size at Markel’s Omaha meeting continues to compound. It feels good to talk about high quality brands.

In some ways measuring book value at both Berkshire and Markel isn’t fair, as both companies are focusing on acquiring operating businesses, which do not measure value creation through growth in book value per share. In fact, with many businesses, maximizing book value growth actually yields subpar value creation. Focusing on capturing as much profit in retained earnings often lowers the long-term viability and value of the business. So these comparisons of pre and post-quality focus is somewhat unfair to all three gentlemen.

Yet, when Tobias Carlisle, portfolio manager of The Acquirers Fund (ZIG:NYSE), compared the overall returns from value vs. quality investment styles, the conclusions were the same over a far larger data set. In The Acquirer’s Multiple, Carlisle demonstrated that contrarian deep value companies generated 18.6% annual returns from 1972 to 2007 while higher quality “magic formula” stocks generated 16.2%. While the 2.4% annual spread may not sound like much, compounded over the past nearly five decades, this meant the contrarian deep value stocks outperformed the higher quality and higher-return stocks by 2.5x.

European Builders

Turning to a few European examples, we can see the most staggering alpha that Exor generated was coming out of the periods in which its main holding, Fiat, was under severe pressure. When we purchased Fiat in 2011-2012, we knew that we were taking very little fundamental risk, as Ferrari was always going to be spun out to investors and would provide a backstop value in a worst-case scenario. At the time, the valuation of Fiat reflected significant risk of a near-term insolvency. Other “value” investors thought we were nuts and one notable investor even went on stage at a famous investing conference calling the company “shitty.”

Exhibit 4: Exor Annual NAV Alpha vs. MSCI ACWI

Our largest position in Europe, where we have a board seat and are working with a new management team to transform the company, is most likely going to become a holding company. Around 30% of the revenue of this company is generated in a “shitty” industry that has no chance of becoming a growth business. But it is a local monopoly with substantial barriers to entry.

Furthermore, it provides the platform upon which we can build its other businesses and launch a significant number of new growth initiatives. Excluding two assets which generate none of the cash flow today, we have obtained a €100 million cashflow stream for free. Free is a good price to pay, particularly when there is no bankruptcy risk nor debt.

This setup is eerily similar to our purchase of Fiat whereby we got Ferrari at a deep value price of €4.5 billion, and got the rest of the business for free. Eventually, shareholders of both companies have and will end up owning multiple pieces of paper.

In every industry vertical we participate in, except one, we have a substantial advantage versus our competition. We have just this week set the strategy to transform the one weak segment into a potentially very powerful compounder through a significant change in strategy. We are going to be doing things in a near polar opposite fashion as our competitors. We look forward to eating their lunch.

In short, our assets and businesses are mostly high quality, similar to Exor’s upon its formation. Like American Express and Ferrari, we have a durable brand value and high barriers to direct competition. Despite the market’s concern over near term “visibility,” we have all of the tools we need to turn this into a “high quality compounder” despite the bargain basement free price.

And this quality, despite our prior arguments for value over quality, is highly important. Value drives the short-term results, but quality drives the long-term. Two oddly similar examples from France show the importance quality has in driving returns.

Midnight In Paris

It’s the early 1980s. Two French companies have recently undergone deep distress and are about to be foreclosed upon by the debtors. Both businesses were sold to courageous young entrepreneurial businessmen for a single franc. One was Vincent Bolloré taking over his family paper-rolling business from Kimberly Clark and Edmund Rothschild for a single franc in 1981. The other was Bernard Arnault, taking over the bankrupt textiles company Boussac, which owned Christian Dior, for, you guessed it, a single franc.

One business had segments within it which had distinct and well-known brands. The other was an industrial company dependent on the whims of currencies and commodity prices. Both men have had very similar buy-and-build approaches, or as their critics say, raid and control. They have been equally decisive and bold in acquiring controlling stakes in businesses and building them. Yet Bolloré stuck to industrial and logistics businesses, with a late focus on media, while Arnault focused on very high quality brands with global name recognition.

Four decades later, both men have generated staggering returns for their fellow shareholders. But Arnault, who combined a bankrupt valuation with a high quality asset, has won decisively. He is now the third wealthiest man, at $101 billion, in the world, and his luxury powerhouses LVMH and Christian Dior are worth €267 billion. In contrast, Vincent Bolloré is currently worth $6 billion and his company has an €11 billion market valuation. Today, one is highly expensive but performing well, the other has a bargain basement valuation and is performing nearly just as well.

Both results are incredibly impressive, especially when considering they both started with a single franc. But after nearly four decades of compounding, only the quality+value approach generated such staggering results. But let’s be clear, until only very recently, Arnault was able to purchase very high quality brands for very cheap prices due to either distressed finances or control disputes which he was able to take advantage of. Luxury companies have been re-valued to atmospheric levels, making his more recent acquisitions highly expensive.

There and Back Again

And this Value Investor’s tale brings us back to today with Arnault making headlines of being the world’s third wealthiest man. Value investors in Omaha have lost that lovin’ feeling for value and have switched to quality at the same time Value Investing has never been more out of favor. The last time the market was this bifurcated was the peak of the Nasdaq bubble, which also brought the largest career underperformance for Messers. Buffett and Gayner. But the subsequent years also produced significant alpha for these value investors.

After a decade of central bankers’ best efforts to make Long-Term Capital Management (LTCM) look like a minor blip, through their deeply irresponsible behavior of inflating asset prices at any cost, tension is rising. This asset inflation has asymmetrically benefited LVMH’s customers and perhaps led to late cycle paranormal growth for Arnault and LVMH, as well as aided and abetted the momentum of “quality compounders.” While Arnault has deservedly earned a place among the greatest Builders of all time, taking the net worth pulse now is perhaps taking it at the most opportune time in history. Conversely, it is a highly inopportune time to measure Bolloré or Buffett’s net worth, with value investments at peak relative under-valuation.

Intelligent investors usually evolve to incorporating asset quality into their purchase consideration. But after we migrate towards quality, we all need to remember that value is always the most important underpinning purchase consideration, as it was for even “quality” investors earlier in their careers. Taking the road less travelled is the only way to create something meaningful. So after we all experience the very crowded superhighway of “high quality” investing, which has already made its way to Omaha, we need to remember to always return to value. At this stage in the economic and market cycle, when we have all gone there, it’s time to go back again.


This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

Past performance is no guarantee of future results.

This Post Has 6 Comments

  1. Thanks for your insights. What ever the company (“Our largest position in Europe”) is, it looks really interesting?.


    1. Hey Sri – we’re staying tight lipped for now. We don’t want a crowd going into it. Thanks though!

  2. If we characterize traditional value investing as ‘identifying low valuation’ and quality investing as ‘identifying value creators’ then its easy to see why simply ‘identifying low valuation’ isn’t a thrilling investment proposition except when markets go down and those companies already at knock-down prices don’t fall much further. However, the value creators pretty quickly compound their way back ahead of the merely cheap.
    The skill you are praising is to identify unrealized value, buy it at a low (knock-down) valuation and realize the value in it. Anyone could buy Boussac for one franc – not everyone can realize the value in Boussac.
    So, the message for me from your article is that there must be a value realization plan and you might have to be a part of it. Simply identifying low valuations isn’t enough. You might have to be an activist.
    Then the question is what will you activate? A change in the company’s culture: its capital allocation; or its operations? Culture doesn’t change easily and you’re not likely capable or operating the assets much better than existing management. I’d bet your success rate goes up a lot if its the capital allocation bit you get to influence.

    1. Ed – thanks for sharing these take-aways, only sorry it took me so long to see this! I think we agree here, realize that your comment implies the market is rational. If we look at this from a few thousand feet in the air, yes, growth is better long-term because the compounding takes care of it. Equally, if the company is not creating value (value trap), then you can’t rely on the realization of value. Totally on the same page. Where we differ is we believe we are able to reliably (at least for a decade now) buy assets where the valuation is mismatched to the quality. We’re always looking for a combination of the two, and we’ll accept a lower upside opportunity if the asset is higher quality and creating value more quickly. It’s not black or white, but unfortunately for “Rules,” grey.
      We believe our largest position is not only fairly high quality, it’s priced to go bankrupt (with no real debt so to speak) and yes, our activism is adding value strategically, operationally and through capital allocation. Stay tuned if you’re interested to see it play out! After the jets start firing, we’ll talk more openly about it. Until then, we want to be able to take advantage of the valuation through both our own balance sheet and the company’s. Cheers, Steven

  3. Hey Steven, just read the article for the second time with great interest. I want to commend you on writing great pieces like this. I do have something I’d like to point out, though.

    For Markel, you zoom in on the development of book value and derive the alpha generation from this development. While this is usually a good way of assessing value creation by insurance companies, I do have a quarrel with this method. For the last couple of years (coincidentally the same years since the Alterra acquisition), Markel has done acquisitions of increasingly larger size within the Ventures segment. These acquired companies are not carried at fair value within the company’s books, even though a strong argument can be made that these companies have (significantly) increased in value since their acquisition. Therefore, I think (changes in) book value do not fully reflect the value creation at the company. And of course book value was significantly impacted by the fact that 2017 and 2018 were two of the toughest years with cat losses in modern history. Even though you do briefly mention this in the article itself, I think the fact that the lower level of book value alpha generation coincides with this increased activity in Markel Ventures deserves some extra attention.

    Also, the fact that Gayner was able to shine in a period where Berkshire started to lag, had of course a lot to do with the relative size of the company at the time. It can also be argued that Markel is slowing down because it also achieved a certain critical mass at some point.

    Again, I want to highlight that it’s indeed a great article and I do agree with your general conclusion(s), but in addition to Exor and Bolloré (and the GreenWood fund of course!) I also remain a high conviction shareholder of Markel (and Berkshire to a smaller extent). I feel there’s room for both in a balanced portfolio. And of course, I have to take the view of a wealth manager that composes client portfolio’s, so there has to be a bit more diversification than a solely deep value approach allows for. The last ten years were brutal for pure value strategies, unfortunately.

    1. Fully agree with you Michael! I tried to highlight that it’s not entirely fair to these gentlemen to measure book value.
      But the overall data does support that value matters first, and only secondarily does quality help. For Europeans, I think you all are on your own thought cycle, but Americans are 100% in the tank on quality only and value is basically laughed out of the room. That’s what the context of the article was.

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