Tom Gayner’s Four Lenses for Investing



Great investors are intelligent fanatics as well. I’ve always enjoyed Tom Gayner’s thoughts on investing. We recently transcribed this wonderful Google Talk – Tom Gayner: Evolution of a Value Investor for our members. Members can access the transcript [HERE]. Not a Member? Join Now.

Here is an excerpt of the presentation where Tom explains how he has evolved as an investor and gives his four lenses for investing.

What I have evolved to and the path that I’ve been on for a long time, and the reason I got on that path is because I found that, that notion of spotting value and thinking that those value gaps would close right after I showed up to buy some stock, it didn’t work. So it’s not as if I found that technique, and I learned that, and it worked, and produced great wealth. It didn’t, so you got to take the next step in trying to figure something else out.

So I moved from spotting value to spotting the creation of value. Value creators, as opposed to value spotters. So instead of a snapshot, instead of a picture, how about a movie? What’s this movie going to look like? How’s this reel going to unfurl over time? So instead of saying, “That I firmly believe that something is worth this, I’m now asking myself, well, what will it be worth next year? And the year after that? And the year after that? And the decade after that?”

And, to have some sense of something that is increasing in value over time, at an appropriate rate. Well, that’s what I’m really hunting for, and that’s what I’m really trying to find and spot. And I think this has applications, not just for investing, but for leadership, for management, for relationships that you could have on a social, as well as a professional basis. So it’s an integrated thought as to how life is unfurling.

So with that sort of thought in mind, I came up with a four-point view of what it is that I’m specifically looking for and how I specifically think about things that I might invest in.

1. Profitable Business

So the first thing that I look to invest in is a profitable business, with good returns on capital, it doesn’t use too much leverage to do it. And, again, each and every one of those words came about because I made a mistake somewhere along the line, things did not work, and as a consequence, it was a hard, searing lesson when I lost some of my own money.

And as Saurabh said in his introduction, I’m cheap and I really hate losing money, so hard lessons are learned with the kind that sink in and sear most deeply. So the profitable business with good returns on capital. Now we live in, you live in a part of the world here, where there are a lot of dreams, a lot of venture capital things, where people will describe things that are going to happen, “Someday.” And a lot of that does come true, especially around here.

This is a vibrant community and this place stands as a testament to sometimes there’s people who have an idea about something that has never been done before, and we’re going to do it, and it’ll be spectacular. And that does happen sometimes, and it’s marvelous when it does. But, I don’t know how to do that. So I’m not a venture capitalist. It’s a legitimate discipline, but that’s not what I am good at.

I like to see a … In Virginia, we joke about, once you do something twice, it becomes a tradition, so then you have to keep doing it, unless there’s some reason not to do it. So Virginia might have a different sort of sense about history than what might be the case here, and thinking about things that were in the past, as opposed to the future. So I like to see a demonstrated record of profitability.

Now the other reason that I like to see that, in addition to just my own limits and not having the skills to see into the future as well as some others do, is that if you think about what a business is designed to do, and it is to serve others. So the most successful business you will ever find is one that the customers are glad they’re doing business with you. Because that means, their lives are getting better, there’s some value that is being created for the customer. Not for the business, but for the customer because of that company being in business.

And the mark of the business doing that well is a profit, because if you have a business that is not making a profit, that means one of two things is the case. A, the business is either doing something that the world just doesn’t really care about. People don’t need it, people don’t want it. For whatever reason, it’s not getting the recognition or demand in the marketplace, such that the business is able to do all the things it needs to do, and still have a margin of profit left over. So that’s of no interest to me, because in order to invest and invest successfully, a business needs to be able to have profits to pay dividends, to pay its employees, to grow, and invest over time, so I want to see a profit there.

The second reason that a business might not be profitable is that they’re not very good at it, so I don’t know how much anybody’s interested in sports around here, but I’m a Washington Redskins fan, and I hate to admit that because they’re not very successful. But neither are the Oakland Raiders, which are very close to here, so those two teams are sort of decade-long competition for what the worst team in the NFL is going to be. And I can’t believe that they [inaudible 00:12:43], they do, which is kind of surprising.

But think about that as a business, that if you had a business that was consistently at or near the bottom of things, you would not think that that is very good business. And as a consequence, how can that be a very good investment? If I really want to give someone my hard-earned capital to that business and think that I’m going to get more of it years later, I want that business to be successful. So that’s why I look for businesses that are profitable and earn good returns on capital.

And I add the part about leverage, because again, from mistakes in the 2008-2009 financial crisis, I had some tough losses. And again, I think you learn more from things that don’t go well, than when things do go well. And I looked at some businesses that I did not really appreciate how much leverage was inherent in what they were doing. So if you have financial leverage, you might have a very good business, you might be taking care of your customers, you might be serving them well, they might be happy to do business with you, but you might have to refinance your debt and have capital resupplied to you, at a time when the markets just don’t want to give it to you.

And if you’re in that situation, basically, I mean, that’s like being a card player, and you got some really good cards in your hand, but somebody just comes and rips the cards out of your hand before you can finish playing the hand, and I’ve seen that happen firsthand. I’ve had gobs of flesh taken from me, figuratively, not literally. I’ve still got my gobs of flesh, but I’ve seen that. So as a consequence, I’ve become very sensitive about leverage and not having too much leverage.

There’s also another factor of leverage, and that is character, and I’ll segue into my second lens in a bit, is that I can remember when Markel first started down the path of buying non-insurance businesses and expanding what we did, there was one elderly gentlemen, who gave me a spectacularly good piece of advice. And he said, “If you’re looking to buy businesses, don’t buy businesses where they use a lot of debt.” And I wondered, “Why?” And he said, “Well, if you want to make sure you’re dealing with high-quality, high-integrity people, generally speaking, high-quality, high-integrity people don’t use a lot of debt.” Or, not so much that, but if you were a bad person, if you were sort of a little bit of a crook, or had a little bit of larceny in your heart, it’s unlikely that you would use a 100% equity finance.

Because when it’s equity finance, that means it’s your own money. When it’s debt, you’re running your business on other peoples’ money. He says, “Crooks don’t steal their own money, they steal other peoples’ money.” So when you see a business that sort of relies on a bunch of debt to operate and be successful, that adds a layer of concern or diligence that you have to think about, that you don’t have to if you look at a business that just doesn’t use very much debt. So it’s a margin of safety, that’s a word and a phrase that Ben Graham used quite a bit, in thinking about investing, that by looking at companies that don’t use much debt, that just really protects your downside, and protects you from bad things happening.

2. Management with Character, Integrity, and Ability

The second lens that I look at anything through is the management, and the management teams that are running the business. I’m not running these businesses that either we invest in, as shareholders and buy stock in, or that we buy that we’re majority owners of, or a 100% owners of. I mean, there are people, who are running these businesses, and those people will make those businesses the success or failure that they are doomed to be.

And when I’m looking at people, I’m looking for two attributes. One, is I want character, integrity, and ability. Two things, character and the ability because one without the other is worthless. If you have people who have high-integrity, they’re good character people, but they’re not very talented. Well, they may be nice people, you may like them, they may be good friends, good neighbors, good coaches of your kids’ soccer team, things of that nature. But in the context of business, they can’t get the job done, so as a consequence, that doesn’t do you any good because the business does have to be profitable to continue to persist, and grow, and last over long periods of time.

You got to see that talent there. The character is nice, but it is not sufficient, in and of itself. If you have people who are talented, who are whip smart, who are very skilled at what they do, but yet have a character or an integrity flaw of some sort, well, they may do well, but you, as their outside, silent, non-controlling partner, are not. That will not end well. And again, this talk is, I’ll get to your questions in just a few minutes, I sure will.

That’s not just about picking stocks, that’s about relationships. So if you were picking a spouse or a partner in a venture or anything like that, to see both of those features in place, in large enough quantities that you have confidence, that you’re dealing with people of character, and integrity, and talent. That’s an important thing to look for. In fact, I can’t think of anything that’s more important.

3. Great Reinvestment Dynamics

The third thing that I think about when investing in anything, is what are the reinvestment dynamics of a business? And that’s a somewhat complicated way of saying things, but what I mean is, and Saurabh is a graduate of the University of Pennsylvania, and we were chatting about this earlier. So Ben Franklin was the Founder of Penn, and he’s sort of the revered figure of the Penn Quakers. And Ben Franklin said, “Money makes more money, and the money, money makes, makes more money.”

So he intuitively understood the power of compound interest. Einstein said, “It was the most powerful force in the universe, compound interest.” Einstein further went onto say, “That those who understand compound interest earn it, and those who do not understand it pay it.” So what is the reinvestment dynamic of a business? What’s the compounding feature? And one of the ways you could think about that is, think about the restaurant business. In a spectacular five-star gourmet, lovely restaurant, typically, those tend to be owned by the people who are there every day.

They’re not chains of the best restaurants in the world, from sort of a gourmet perspective. Usually, the owner is the chef, or right there at the front of the house, he’s there all the time. So that business, that restaurant can be very successful, but typically, that is not a model that is set up to be able to replicate it again, and again, and again, and again, and again. It may provide a very nice living for the owner and their family, an employee and their family, and great service to the world, great food, great prices, all that sort of stuff, but it’s not replicable.

So there are some businesses that you’ll see that are like that, that are boutiques in some form or fashion, it’s a limiting factor to really be able to apply capital and see it grow. There are other businesses, and it’s in the news these days, that people may wonder whether their time has passed, and I won’t enter into that debate, but clearly, this would be an example of where somebody was able to figure out a restaurant model that was replicable, and able to be done over, and over, and over again.

But go back in time 50 years, at the start of McDonald’s and then another McDonald’s, and another McDonald’s, and another McDonald’s, one right after the other, that’s a perfect example of where that reinvestment dynamic kicks in. So when I’m looking at something, I’m thinking, “How big can this be? How scalable is it? How replicable is it?” Because in order for you to really apply a bunch of capital to it, it has to be something that you can keep reinvesting in.

And if you think about things in a spectrum, and I would encourage to always think about things in more than one dimension. And in a spectrum, things, generally speaking, are not binary, they’re not yes or no, they’re not white or black, they’re shades of gray all the way along the line. So a perfect business is one that earns very good returns on its capital, and can take that capital that it makes, and then reinvest that, and keep compounding to the same sort of rate, year after year, after year, that’s the North Star. That would be the absolute perfection.

The worst kind of business is one that doesn’t earn very good returns on capital, and yet, seems to need gobs of it all the time. And again, this might be old data, because the world seems to change, but I used to joke that airlines fit that category. So there are all these airlines, and the airlines were always coming and going, and people always seemed to want to get in the business, but they never really made good returns on capital. These days, they are. Whether they will continue to do so or not, I don’t know, but that’s kind of the spectrum of business. So I just try to get as close to this end of the spectrum as possible.

Now in the real world, this does not really exist very often or very frequently, and oftentimes, it’s very richly priced when you see it. But how close can you get to it? Because the second best business in the world is one that earns a very good returns on capital, it can’t reinvest it. But the management knows that, they’re intellectually honest that they have to do something else with the money. And what are their choices? Well, they could make acquisitions, they can pay dividends, they could buy in their own stock, but they’re thoughtful and they know that.

And Berkshire really is the best example of a company that had that in place, where you had the genius at the top, who knew that the original business, which was a textile business, whatever money that made, it was best to invest that somewhere else, and that’s what Buffett has done for 50 years, is to reinvest the cash flows of the various businesses that feed into Berkshire, in other places. So that is the maestro-like effect he has had at Berkshire. So that’s a legitimate way of handling the notion that you can’t reinvest in the business that you have, but you can be thoughtful about what you do with that money when it comes in.

4. Attractive Price Valuation

And then the fourth and final lens is price valuation. And that’s really where a lot of people start in investing, because there are books you can read, there are spreadsheets that you can do, there are well-trodden paths you can follow that talk about what’s a reasonable price earnings ration, what’s a reasonable price to book ratio, or what’s a reasonable dividend? All of these quantitative factors, and those are all good, but as I said, they’re not enough. They go into the thinking, they go into the thought process of whether this is a good investment or not, but the mistake that I see … There’s two types of mistake you could make when you’re doing your valuation work.

One is that you pay too much for something, so you make this judgment about what something is worth, or you make an error in those calculations, and you pay more than something is worth, and that’s a frustrating error. But you’ve laid out some money and it doesn’t really earn much of a return, or less of a return, or maybe even loses money compared to what you paid out for it. That’s not the worst thing that’s ever going to happen to you. That’s an error that you can recover from.

The kind of errors that are harder, and that really cost you more, although it’s a hidden cost and it’s an implicit cost, is that you’ve thought about what something was worth, and you thought about what you wanted to pay for it, and this was something that actually did compound, and you never bought it because it never met your test of valuation, but it’s just kept on compounding over time. That example, it’s easy not to talk about it, and I think if there’s one thing that I’ve been thinking about a lot recently is, as human beings, we tend to have very vivid memories of things that we did, and things that happened to us, and especially that happened to us recently.

We tend to not have vivid memories and not do well about thinking about the things that didn’t happen to us. Or, that we didn’t do, and we can brush away those experiences relatively easy because we don’t have firsthand experience with it. So we probably all have stories about something, and the older you get, the more stories you’ll have like this, where you thought about something, or you thought something might have been a good idea, or you thought that might have been a good business, or you thought that might have been a good stock at a certain point in time, but for whatever reason, pricing, or whatever, you didn’t buy it at that time. And then you never got around to buying it. Those are the things that really hurt, and that money that you didn’t make will end up being a far bigger subtraction from your theoretical end net worth than the things that you did buy, that perhaps did not work as well as you hoped they would.

So those are the four points and the four lenses of how I think about investing and how I’ve learned to think differently than the way I thought when I was first starting out as an accountant, as very quantitatively-driven, as very disciplined about sticking to certain metrics that I thought were markers of valuation, and I’ve started to think more qualitatively, and if there was one of those four, that’s the one that I would think about the most, it would be the third point, the reinvestment. What will happen over time to this business? Will it get better? Will it get worse? Are the conditions behind it improving or deteriorating?

And it’s a tough world, it’s tough, it is very tough to find things that you have confidence in that would continue in your best judgment, to continue to compound in value over time. But when you do, don’t be a penny pinch, and I’m as tight as they come, but don’t be a penny pincher when you find businesses like that. So with that, I want to stop and start taking some questions.

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