Newsletter - February 25th, 2023

Dear Reader,

Attached is our latest list of stocks generated from basic value screens (low p/e, ev/ebitda, debt/equity, etc.), which don’t meet our investment criteria - and our reasoning.

This may help you avoid a few ‘value traps’ or stocks that aren’t sufficiently attractive compared to the opportunities available today.

For reports of stock ideas that pass our quantitative and qualitative standards, join at the link below:

Join Here

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Notes from the past week below including Templeton on determining bargains, Buffett's "surest way of making money", Core capital allocation questions shareholders must ask, and more:

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Terry Smith of Fundsmith - Quality First, Price Second

As we've mentioned in previous newsletters, we love learning from investors with fundamental value approaches that are different from our own. We've heard of Terry Smith and Fundsmith but never heard from him directly until a few days ago. He's an articulate investor and we've included notes from some of his talks below:

8:45 What makes a "good" company?

Here, Smith outlines his definition of a good company; the first two points are:

1) High returns on capital employed in cash; and

2) Growth driven from reinvestment of cash flows at high rates of return

Buffett has emphasized high returns on equity as the best financial indicator of quality, and this is mirrored in 1).

Two points we've noted from experience: a) Almost everybody in the stock market seems to be searching for such quality; and b) When you do find high returns on equity, 2) is usually lacking - especially if you insist on cheap valuations.

But Smith's success is undeniable earning 15%+returns over a decade managing almost £20bn.

Also worth noting the remaining qualitative points he looks for - we admire the way he excludes large swathes of industry (energy, banks, etc.), and sticks to his knitting.

42:00 Cheapness Isn't Important (!)

Smith's secondary emphasis on price is fascinating. Over long periods of time, the mathematics is clear. You're going to do a lot better emphasizing highly profitable companies over price if the business can sustain such reinvestment for long periods of time and you can hold on to it.

Caveat: Our holding periods are short-term (two to four years), which is usually sufficient time for stocks to approximate intrinsic value if we've purchased them at bargain prices. P/E re-ratings are remunerative.

Nevertheless, it's fascinating to see good long-term performance with less emphasis on valuation - though Smith did underperform -17.8% vs -11.3% (MSCI World Index) in the first half of 2022. An investor placing less emphasis on valuation should probably expect underperformance in down markets.

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Breakeven P/E Ratio

Smith undertook a study that hits at the nub of what we wanted to know: What's the breakeven p/e multiple to match the market performance when buying 'quality' stocks - because logically, there is always a price limit for a sensible investment purchase (and many 'growth' investors fail to address this):

4x the market multiple over 30 years! Clearly, there is a lot more investors can pay for quality companies if they're confident in their judgments for future growth.

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Investors' Chronicle Interview

10:00 Basic Capital Allocation Decision

How does management decide among the following options for cash generated from operations?

1) Re-invest in the business

2) Acquire other businesses

3) Distribute cash to shareholders

This is a key question for investors - gets to the core of capital allocation.

15:00 Investing is Relative

Though we have absolute investment standards, investing is ultimately a choice among alternatives available to you (including bonds). It is a relative game, and investors need to adapt as market conditions change. Sticking to unrealistic absolute standards may be harmful to long-term wealth creation.

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2016 Berkshire AGM Notes

Notes at timestamps below:

51:30 Hydrocarbons will be fully used

Though Munger said this seven years ago, it's highly likely that hydrocarbons will be fully used despite government attempts at mandating full transition to renewables by (ever-shifting) deadlines. More recently, Munger has said that hydrocarbons will likely be important for the next 200 years. Seems right to us.

54:00 Bank of America's Derivative Book

Interesting to note Buffett didn't know much about BofA's derivative book before making his investment in its 5% preferred in 2011 - just that management would've done a conscientious job and worked hard in evaluating its derivative positions.

[Note that Buffett is likely to have viewed this as more of an equity investment (due to the warrants) than a debt investment as the 5% yield is a lot lower than what he generally demands of debt investments.]

1:59:00 Low energy Investing

Inactivity is underrated in investing. This is harder to implement when investors are constantly learning but the lesson is worth keeping in mind when adopting your own investment philosophy.

2:22:00 "Surest way to make money"

Buying $ bills at a discount. No forecasts necessary. (On buying Berkshire stock below 1.2x book value; He also echoes Ben Graham's ethical concern of managements exploiting exiting shareholders buying back their stock at large discounts to intrinsic value - Management must convey all relevant information to shareholders before buying back stock.)

2:55:30 Obvious Truths the World Doesn't Grasp

a) Observation of human folly (reduce irrationality)

b) Recognizing what you can't do

c) Swing only in your strike zone

d) Emotional control

e) Never risk important things for unimportant things; avoid self-destruction

f) Patience combined with opportunism

g) Behave well

Wise.

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Templeton on Determining Bargains

How low (is price) in relation to:

a) Earnings

b) Growth Trend

c) Dividends

d) Book Value

e) Competitors

Well summarized.

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Until next time, Have a great week!