I'm a stock picker, not a philosopher. Nevertheless, I think a little philosophy is in order before I start kicking the tires of individual companies -- which is what I'll be doing most every week in the future of this Monday column.
My hope is that by sharing my investment philosophy with you today, you'll be in a better position to: (a) know if my approach interests you; (b) understand the context of my future investment opinions; and, (c) hold me accountable for this philosophy. On that last point, if you ever see me highlight a company a good investment, and you think it doesn't fit the framework I'm about to share with you, then by all means, please email me at [email protected]. One of the best parts of writing online is getting your feedback.
So with that, I'll dive into my investment philosophy. Those of you who read last week's column have a leg up in understanding some of the key lessons that have shaped my philosophy over the past seven years. To sum it up, my approach today is to look for cash-generating businesses run by good people with a stock price that's significantly undervalued.
No, the business/people/price framework is not original (credit goes to Mason Hawkins, chairman of Longleaf Funds) -- but I'm not one to shy away from piggy-backing off others' great ideas! And while mine is a framework many investors could lay claim to, I think my approach has certain peculiarities and special emphases that make it uniquely my own.
1. Business: Generates consistent free cash flow, with every likelihood of continuing to do so.
Ask a group of investors to describe what makes for a quality business, and you'll hear answers like: sustainable competitive advantage, reliable recurring revenues, strong profitability, above-average growth, and high returns on invested capital. Every one of those things matters, and I'm on the lookout for each. But, I don't consider any one of those qualities to be essential in every situation.
Hear me out so you don't misunderstand. In special situations, I'll settle for lumpy revenues or meager profitability or unimpressive returns on invested capital. I'll even invest in situations where the competitive advantage is weak or uncertain. Any one or two of these negative conditions can be tolerated at the right price, which is to say a very cheap price.
But the one business characteristic I demand -- without exception, regardless of price -- is the ability to generate consistent free cash flow. In simple language, free cash flow is the cash left over at the end of the day -- after all sales are tallied, all expenses paid, and all capital upgrades for property and equipment complete. It's the cash left over for shareholders' benefit.
The best thing about free cash flow is its ability to deliver immediate and indisputable economic benefit to shareholders (not necessarily "economic value," as it's technically defined, but definitely economic benefit). Free cash flow can be used for such goodies as dividends, share repurchases, or a cash acquisition. Even if a company just lets its cash pile up on the balance sheet, that cash value will have an additive impact upon the share price. (That said, I prefer not to see a company hoard its cash for long, but rather to deploy it for shareholders' benefit by one of the above three methods.)
Because of the many ways free cash flow can benefit shareholders, even the most obscure company will eventually be recognized and rewarded by the market if it's able to generate consistent free cash flow. This is a more expansive way of saying that the value of free cash flow is intrinsic.
Of course, past free cash flow is good, but what really matters is a company's ability to generate future free cash flow -- year in and year out. After all, a company is only worth the discounted value of all future free cash flows. (If this concept is confusing, I encourage you to read one of Fooldom's all-time great series: The Dollar Machine, Part 1, Part 2, Part 3 -- scroll down on each link.)
Take a look at the valuations of any tobacco company as an example of how the market will not assign much value to yesterday's free cash flow if there's doubt about tomorrow's free cash flow. On this point, it's important to consider a company's competitive position and assess whether any threats exist that might erode its future ability to generate free cash flow. This can be difficult to gauge, but it's always something to think about.
2. People: Owner-operators who manage the business ethically and with a pro-shareholder orientation.
Perhaps the one exception to the intrinsic value of free cash flow is if management is too unethical or stupid to use free cash flow for shareholders' benefit. That's why it's so important to pay attention to the people running the show. Admittedly, it's tough -- very tough, actually -- to know management and whether its motivations are good. In general, though, I look for the following qualities:
- Owner-operators: Managers who have meaningful share ownership.
- Ethical and honest: No hype, no shady dealings, and no inconsistencies in the company's story.
- Pro-shareholder: Reasonable cash compensation and option grants; intelligent capital allocation in present and past dividends, share buybacks, and acquisitions.
This is just a summary of what I like to see. Fellow Fool Zeke Ashton has written a fabulous article, The High Cost of Bad Management, that explains how to assess management and what questions to ask. Also on this point, one of the best resources for finding the dirt on management is the proxy statement.
3. Price: No more than two-thirds of conservatively estimated intrinsic value.
By common terminology, I'm a value investor -- but let's make sure we're on the same page about what that means. Some understand "value" as equivalent to investing in boring, subpar, no-growth businesses. I frequently defy that stereotype. Nor do I fall into the strict value camp of investing in stocks with a P/E less than 7 or a price-to-book ratio less than 1.
For me, being a value investor means I invest in companies I reasonably believe to be undervalued. Similarly, I sell stocks once they reach full value. Whether a stock's value manifests itself in four days or four years, I don't care. My only aim is to buy assets for less than their worth and hold them until they're fully valued.
But what makes a stock "undervalued"? I'm a discounted cash flow (DCF) guy. For most companies I analyze, I'll construct a DCF spreadsheet where I attempt to conservatively forecast future free cash flows, and then discount them back to present value. That present value of the business plus any net cash per share equals the stock's "intrinsic value" or "fair value." Many times, I'll build a couple of different models using different growth assumptions to develop a range of intrinsic value for a stock. Please understand that this involves a lot of guesswork, so the outcomes aren't scientific.
The key to making these imprecise models worthwhile is to be conservative in all assumptions and to allow for a margin of safety. For example, if I calculate a fair value estimate of $20 for a stock based on conservative inputs, then I'll happily buy that stock for anything less than $13.33. By limiting my buys to situations in which I pay no more than two-thirds of my estimate of fair value, then I build in a significant margin of safety. (There's nothing magic about paying exactly two-thirds of fair value -- that's just the cutoff I normally use. Sometimes, I'll allow for a smaller margin of safety when the downside risk is especially low, which happens occasionally when a stock has substantial liquid asset value.)
Conclusion
There you have it -- my investment philosophy, as it exists today. Next Monday, I'll put this framework into use as I pick apart some company or another. I have several on my value radar that I want to get to know better, plus companies in my own portfolio that I try to review on a regular basis.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. He's not as young as he looks in that picture up there. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.
