The investment manifesto (1½/2)

You can read the first part of The investment manifesto (1/2) here.

The exclusion process

In the previous post on the investment manifesto I ended with a presentation of my margin of safety definition. The purpose of that definition is to sort out those companies that I won’t allow myself to invest in. In a sense, I use my margin of safety definition as a exclusion process. In other words, the exclusion process is a negative screen to sort out companies that I don’t think I can satisfactorily determine their downside protection. Those companies get excluded and automatically put in my too-hard-pile. Thinking about investing, at least initially, as a negative art, what you don’t want to own, is an underappreciated approach in my opinion. This is based on a belief that risk- (i.e. permanent loss of capital) control should be the main emphasis for all investors. A quote that reminds me of the importance of controlling risk is this one:

“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – W. Buffett

However, a quote that in my opinion best explains the reason for the importance of risk control is this one:

Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Margin for error gives you staying power and gets you through  the low spots. – H. Marks

Or as one of my favorite authors stated in his newly published book Skin in the Game:

“In order to succeed, you must first survive.” – N. Taleb

The statements and thinking above goes back to my belief that only after one has established a population of ideas with solid downside protection should one move on and start to think about their upside potential. In conclusion so far, downside protection (survival) is more important than upside potential (returns) as one starts to think about which companies to invest in. As you will see in this post, I won’t go as far as; Focus on the Downside, and Let the Upside Take Care of Itself, but almost…

The inclusion process

The population of companies that have survived the exclusion process I termed; The Liquidation Oxymoron’s in the last post. If you haven’t already figured out my reasoning for choosing this name I’ll make sure to explain it now. The companies that have survived the exclusion process all fit under the following oxymoronic statement;

They are going concerns selling below their liquidation value.

My belief is that the population of liquidation oxymoron’s creates a powerful starting point of companies to potentially invest in. The basis for that belief is that the oxymoronic statement establish that there exists a fundamental difference between consensus and value for these companies. In a recent post you can read about why I consider this difference to be the most important thing to establish and take into consideration if one strives to be a successful investor: Consensus is what you pay; the relationship between consensus and value determines what you get.

But now, let’s move on from the margin of safety and downside protection argument and take a look at my inclusion process. The positive screen if you like. I will divide the presentation for this process under three headings; 1) upside potential, 2) catalysts and 3) other factors and characteristics. Remember, the companies I look at during the inclusion process (the companies that have survived my exclusion process) are all potential investment ideas that I would be willing to invest in. More specifically, the inclusion process is about determining if I’m going to invest in company A, B or C at a certain point in time. I will come back to my reasoning for this approach of picking stocks when I present my thoughts for the buying- and selling process for the Liquidation Oxymoron portfolio.

Upside potential

As you would expect, most companies get excluded as a result of the first criteria in my margin of safety definition. That is: Selling below liquidation value (i.e. price below readily ascertainable net asset value = raNAV). The reason why I have put this criterion first is because I think the valuation aspect as it relates to downside protection is the most important one, independent of how one defines “value”, to take into consideration as an investor. Furthermore, I think the same holds true about the valuation aspect from an upside potential perspective. Again, if you are interested in my reasoning for these statements you can read more about that topic in the following post: Consensus is what you pay; the relationship between consensus and value determines what you get. 

However, the valuation aspect is far from what describes the complete picture regarding the upside potential of companies. Unlike the margin of safety definition that should be developed individually, the definition for upside potential is an universal one I would argue. The best way, in my opinion, to think about upside potential is to think of a return formula with three components. One should note that I’m by no means the inventor of this formula. For this I would like to give credit to Fred Lui at Hayden Capital and more specifically his Investor presentation and Calculating Incremental ROIC’s presentation but also John Huber at the Base Hit Investing blog and all posts on ROIIC.

What the two investors just mentioned have concluded is that the upside potential (i.e. future returns) is to be determined by the following three components (some minor adjustments done by me). I have termed this the return formula:

1. Intrinsic value compounding yield (ROIC × reinvestment rate = earnings growth)
2. Shareholder yield (stock buybacks / issuance + dividends + net borrowings)
3. Valuation yield (valuation multiple expansion / contraction)

= upside potential (i.e. future returns)

Although the return formula might seem like a manageable calculation exercise one should not be fooled into a sense security or precision. In investing, should happen ≠ will happen. Therefore, I would again like to stress the importance to only engage with the return formula once one is done with the exclusion process. Furthermore, I would like to point out that one should not cry oneself to sleep if one struggles with all the components of the return formula. For some investment ideas, the calculation of intrinsic value compounding yield will almost be impossible to calculate. Or it might be almost impossible to determine what a fair valuation multiple is for a specific investment idea. Nonetheless, those statements begs the question: Should one stay away from companies for which you can’t calculate their upside potential?

My opinion is; no, companies whose upside potential that is hard to determine should not per definition be avoided. Rather, the important aspect is the certainty of the fundamental difference between consensus and value of the company for which you are trying to calculate upside potential. For me personally, this goes back to my thinking and reasoning for the name of the Liquidation Oxymoron’s and what that name implies. Or explained in a more colorful way with the help of one of my favorite quotes in investing:

“You don’t have to know a man’s exact weight to know that he’s fat.” – B. Graham

In conclusion, I will always try to calculate upside potential based on the return formula stated above. For some investment ideas this calculation exercise will be quite thorough and detailed (e.g. HEL:SAGCV, analysis not published). For some investment ideas (e.g. NASDAQ:GIGM, analysis not published) I will more or less fall back on my assessment that the company is a Liquidation Oxymoron (i.e. makes it through the exclusion process) with high certainty in regards to the current fundamental difference between consensus and value. In conclusion, I will not exclude or rank the Liquidation Oxymoron’s population based on the outcome of their return formula calculations. Rather, I will rank the investment ideas in terms of my conviction for their upside potential, i.e. most probable upside potentialIn order to make such an assessment I have to take into consideration potential catalysts and other factors and characteristics for the Liquidation Oxymoron’s.


The circumstances for what a posteriori is determined as the catalysts is hard to determine and arrive at a priori. I’m not the first one to make this unsatisfactory conclusion as the following statement from 1955 will show:

Skärmavbild 2018-03-04 kl. 16.24.09
p. 544

Related to the statement above is his famous quote:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – B. Graham

Although I ascribe to the belief that value is its own catalyst there are nonetheless some circumstances and signs that I keep my eyes open for when I’m to determine my conviction for the Liquidation Oxymoron’s upside potential. Furthermore, the reason why catalysts, other than the mentioned realisation of value from Mr. Market over time, are important to take into consideration has to do with the time factor of investing. Specifically, these catalysts have the potential to unlock value in a direct and fast manner. I would argue that the time factor is an important component if one, like myself, think in terms of CAGR.

For the Liquidation Oxymoron’s I will specifically evaluate and take into consideration any signs of:

  • shareholder activism.
  • major asset sales, spinoffs or mergers plans.
  • acquisition and/or expansion plans.
  • dividend and/or share buyback plans.
  • buyout or takeover plans.
  • changes in management.

Note that what I have stated above is not to be considered an exhaustive list of catalysts. Rather, the evaluation of potential catalysts and their respective probabilities has to be done on an idea per idea basis since they will be highly individual and context dependent.

Other factors and characteristics

The factors and characteristics I will mention below are not to be considered “make it or break it” components for the investment ideas of the Liquidation Oxymoron population. Rather, they are factors and characteristics that have the potential to improve both the upside potential and the probability of upside potential. As you will see, non of these are original or special in any way but should in my opinion nevertheless be taken into consideration during the stock picking process:

  • Small market capitalisation (preferably nano or micro cap).
  • The trading of the company shares is illiquid.
  • Large insider ownership and/or insider are recent net-buyers of company shares.
  • Reasonable insider pay.
  • Famous deep value investors on the shareholder list and/or they are recent net-buyers of company shares.
  • Company has improving fundamentals (e.g. high F-score).
  • Low-level of debt or high level of debt but the company is aggressively paying down debt.
  • Company has historically paid dividends.
  • Company has historically been net-buyers of company shares.
  • Company conducts business in a stable and/or boring industry.
  • Company has been active for some time (preferably more than ten years).
  • Company shares are currently trading near historical lows.
  • The company is not a perennial Liquidation Oxymoron (i.e. the company has historically trade above raNAV).
  • A big portion of raNAV consists of cash and cash equivalents.
  • Company has hidden/undervalued asset values not reflected on the balance sheet.
  • Positive or low raNAV burn-rate.
  • Low valuation compared to operating earnings and/or free cash flow.

Again, the list above is not to be considered an exhaustive list of factors and characteristics that should be taken into consideration during the inclusion process. The ones mentioned above I usually consider but I might retract and/or add factors and characteristics to the list in the future.

The buying- and selling process

Similar to the situation for the first post on the Investment Manifesto, this one became longer than I had expected. As a result, I will save my thoughts and ideas about the selling- and buying process for the Liquidation Oxymoron portfolio for yet another post. I promise, this will be the last part in my series of post related to the Investment Manifesto.


Consensus is what you pay; the relationship between consensus and value determines what you get.

The foundation of “value investing” is built on a narrative that price and value are two distinguishable components. Benjamin Graham, also known as the father of value investing, is often credited as the first author of this narrative. The best evidence for this, if we exclude the The Intelligent Investor and Security Analysis, is a quote from one of his famous disciples:

“Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – W. Buffett [2008 Berkshire Shareholder Letter]

The “Price is what you pay; value is what you get” phrase has become one of the most quoted expression in investing. It has also become, in my opinion, one of the most misunderstood and misused quotes in investing. Still, I would argue that it is the most important quote in investing. This is what this post will be about.

We are all value investors, but…

I have previously made the argument that independent of our investment approach, fundamental analysis, technical analysis, indexing or pure speculation to buy low and sell high, no-one will buy something for more than what they think it is worth (i.e. the basic premise of what constitutes value investing). In other words, all investors have the intention to make money when they buy an asset. The opposite would be oxymoronic and although I believe that we humans are not very rational I also believe we are not irrational. There is a difference. My point is, all market participants strive to be value investors. It is inherent in our DNA, whether we like it or not.

But let us take a step back and consider this:

Not all successful investors call themselves value-investors and not all investors that call themselves value-investors are successful.

or if I haven’t convinced you with my “we are all value investors” argument:

Not all successful investors call themselves [insert investing philosophy]-investors and not all investors that call themselves [insert investing philosophy]-investors are successful.

First of all, I make the statement above to point out that there exists no need to put investing-labels on ourselves or to fight on Twitter with a purpose to defend our investment-style-turf. I have been there myself and I can honestly say that nothing fruitful come out of these discussions. I think that is true for anyone involved. Outside Twitter the same phenomena exist in books on investing, in blog posts and podcasts on investing etc. Again, I have to admit that I too have been a contributor to this with my blog posts. That is not to say that this phenomena of labelling ourselves and that we defend our turf with nails and claws is not interesting. To the contrary, this is extremely interesting!

What fascinates me is that it almost seems like we have an inherent urge and need to belong to a certain tribe of investors. An urge and need to subscribe to a certain investing philosophy with the simultaneous exclusion of other approaches although we might share some common ground. I think the same phenomena can be found in discussions about politics, sports, religions etc. In the case of investing, I would argue that this urge and need makes us blind for the path towards the holy grail of investing. It makes us forget about the only question an investor needs to focus on. That is the question of:

What determines the success of an investor?

The holy grail of investing

I can assure you, answering the question above and you have attained the map to the holy grail of investing. Answering the question and you have almost figured it all out. The answer is “simple but not easy” as Mr Munger has famously said about investing in general. Let me give you the answer:

The success of an investor is determined by the exploitation of price and value, i.e. buying assets for less than they are worth. 

This conclusion goes back to my argument that we all strive to be value investors. With the help of inversion; if we buy something for more than it is worth we will be unsuccessful investors. However, the simple answer is not easy to implement successfully. The reasons for that are multiple. On an overall level, I would argue that it has to do with a basic misunderstanding of the value/worth component as it relates to the price paid for an asset.

The quality-fallacy

The basic misunderstanding is this:

Buying good things ≠ Buying things good

or said differently:

Quality ≠ Value

What I mean with the two statements above is that quality characteristics of an asset (good things) is not a substitute for buying assets for less than they are worth (buying things good). I would argue that investors fall for this “quality-fallacy” all the time. All else equal, it is far easier to buy and own what is considered to be of quality (good asset) than what is considered non-quality (bad asset). The problem though in investing is that the quality of an asset is not a determinant for the value you will get. This is a mistake that people make all the time in investing. This is even true if one isn’t careful to think about what the quote that started this post “Price is what you pay; value is what you get.” really implies. Let me explain.

A simple misunderstanding

What people don’t understand or misinterpret about the quote is that the value component, “what you get”, is a residual. The value, the residual, is the difference between the price paid for an asset in relation to the value of that asset. That is the value you will “get”. Again, I would like to point out that value in this quote is not a synonym for the quality of that asset, as some people would like to believe. Making this mistake is not something to be ashamed of considering how the quote was framed by Mr Buffett. I would even argue that Mr Buffett made a quality-fallacy argument when he quoted Mr Graham:

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – W. Buffett [2008 Berkshire Shareholder Letter]

I know that buying quality companies has been key to Mr Buffett and Mr Munger (Berkshire’s) success. However, people forget that they have still bought those companies at a price below their worth. Too often I see their philosophy for what constitutes a good investment dwarfed into an argument that a “good company = good investment”. Although their methods for determining value were different from those used by Mr Graham they never deviated from the lesson of what determines the success of an investor, i.e. buying assets for less than they are worth.

Evolving the quote

In order to make what I consider the most important quote in investing a bit clearer and to summarise this post I thought I would end with an evolved quote. In order to fully understand it I would like frame it with the help of two other favourite quotes of mine. These quotes will help to explain the “price” component and the drivers behind what makes an investor not only successful but more successful than everybody else. Both quotes are from the famous investor Howard Marks:

The price of a security at a given time reflects the consensus value. The big gains arise when the consensus turns out to have underestimated reality [value], or to have miss-estimated reality [value]. To be able to take advantage of such situations, you must be able to think in a way that’s away from the consensus. You must think different and you must think better. It’s clear that if you think the same as everybody else, you’ll act the same as everybody else, and have the same results as everybody else. – Howard Marks

[value] has been inserted by me in the quote above.

Note that Mr Marks is not saying ‘different and right’ in the quote above, he is saying different and better‘. 

Superior performance does not come from being right, but from being more right than the consensus. You can be right about something and perform just average if everyone is right too. Or you can be wrong and outperform if everyone else is more wrong. – Howard Marks

Based on what I have concluded in this post and what Mr Marks has helped to explain above:

“Price is what you pay; value is what you get.”

evolves into:

Consensus is what you pay; the relationship between consensus and value determines what you get.