Carl Gustav Jacob Jacobi, the famous German mathematician from the 1800s, said “man muss immer umkehren” which translates to “invert, always invert.” From my experience as an investment manager and as an ardent student of history, I’ve found that identifying the characteristics which make for unsuccessful investing can be just as helpful as identifying the qualities that makes for successful investing. True investing is very much a business endeavor and treating it in any other manner generally means that one is more likely to be speculating. Speculation can lead to satisfactory results in fortuitous market conditions, but it is when turmoil hits and markets collapse that the accuracy of an investment rationale must hold true.
Recently, there was an interview with two of the great investors of all time, Howard Marks and Leon Cooperman. In their discussion, it came up that private equity investments have tended to generate some of the best investment results. Their conclusion as to why private equity tends to outperform was quite prescient, as they referenced the fact that because private equity funds tend to have 5 or 7 year lock-up periods; the lack of liquidity is extremely beneficial for investors, as it lets them benefit from full market cycles, as opposed to getting caught up in rapid trading like most market participants do. This conversation got me thinking about my experiences working with thousands of clients in various capacities over my career and what separated those that were successful and those that were not.
Unsuccessful “investors,” in my experience, are those that engage in timing the market. A gut feeling, or bad news and media hype, tends to scare them out of prudent investments that just need time to mature. They are the ones that get obsessed with Federal Reserve prognostications or care about what some media pundit is screaming about on the TV at any given hour. Unsuccessful market participants are not focusing on what a business is actually worth based on a careful analysis of the facts. This creates a situation where any slight market disruption can cause them to question their “investments,” often leading to selling at inopportune times, generally when they would be better off buying more of the investment as it has come down in price, creating a greater margin of safety. In the stock market, the constant fluctuations in price make it so easy to buy and sell on impulse that most market participants get lost by trying to internalize too much data, as opposed to focusing on what is important.
When a prudent businessman acquires a private business, he or she looks at the quantitative and qualitative characteristics of the business. There is no price chart available and one is not likely to find an assortment of analyst earnings estimates or buy ratings. The prudent businessman looks at the balance sheet and financial condition of a company. The prudent businessman looks at the earnings power of a company and makes projections on growth rates and free cash flows, with very little interest on any one quarter’s results, because the businessman is forced to have a longer-term time horizon due to the lack of liquidity in the private business market. This is the same mentality that private equity investors use and other control investors such as Warren Buffett.
When you invest with a long-term mentality and ignore short-term issues, you are able to take advantage of the biggest pricing disparities. This offers the investor both the greatest margin of safety, while also providing for the most upside potential. Time horizon and patience can put one ahead of the vast majority of market participants, far more than a few extra IQ points could. For a look at why this is the case, I’ll provide an example:
Over the last several years, AIG has transformed itself from being an enormously complicated and reviled company in tremendous debt the U.S. Treasury, to a financially strong and relatively basic insurance and investments business. As of the end of the 2nd quarter, AIG’s book value was in excess of $75 per share, but the stock trades for less than $55. Book value, which is the best proxy for liquidation value, has been growing rapidly due to retained earnings from positive business results and stock buybacks done at a discount to book value. In addition, the company has over $10 billion of excess capital that ultimately will be available for more stock buybacks, dividends and/or acquisitions.
Analysts would tell you that AIG trades at a discount to book value due to its low returns on equity and regulatory concerns. Heighted regulations have resulted in reduced leverage and increased compliance costs. These factors have lowered returns on equity but have also resulted in a less risky business model, which ultimately should lead to a higher valuation, similarly to how highly regulated businesses such as utilities tend to trade. Even more importantly, the incredibly low interest rate environment has reduced investment returns on AIG’s massive portfolio making it very difficult to generate double digit returns on equity.
Looking forward, AIG has cut costs and streamlined its operations. It has invested enormously on compliance and improved underwriting based on modern analytics, which should lead to improved underwriting results and better margins. The company is over-capitalized, so as regulators permit, the company could massively grow book value per share by aggressively buying back stock as long as the discount to book value persists, and management has said that they intend on doing just that. Interest rates will not stay low forever, so the combination of improved underwriting results, higher investment returns and a lower capital base due to the buybacks, should put returns on equity comfortably above the 10%-12% level several years from now. If one has a short-term time horizon, the waiting game is not an option as there is very little reason for someone to believe that the next quarter will have some huge news, which causes the stock to soar. But for the business-like investor, the deep discount to intrinsic value offers both a massive margin of safety in that the stock can be liquidated for more than its current price, and huge upside potential as book value should grow in excess of 10% per annum, while the evaluation will likely exceed that book value at some point.
At T&T Capital Management (TTCM), our entire portfolio consists of these types of undervalued investments. That doesn’t mean that we aren’t susceptible to short-term drops in price as we most certainly have and will experience them, but instead of fearing them we look forward to them as opportunities for more attractive investing. Reacting to short-term volatility by exiting intelligent investments is like jumping out of a plane when you experience turbulence. You know that risk is out there; if you fly you’ll feel it, so don’t get in that plane if you aren’t willing to endure it. Many investors might be surprised but I rarely look at our performance results, and I don’t feel that anything less than 3 years of performance history is very helpful in analyzing the skill of an investor. The process at which one invests is much more important to understand, and it is the crux of why I’m confident that we should be able to outperform the S&P 500 and most investors over the long-term. If you can avoid the key mistake of short-termism and maintain a business-like approach throughout market cycles, you can outperform as well!