I’m curious how you think about time when it comes to the reward at the IMA dinner. You mentioned one of the interesting things about investing is that you don’t know when the reward comes, and you quoted Seneca. How do you deal with the opportunity cost of time, especially in a market where price discovery seems to be impaired or at least working differently than it did in the past?
Integrating Time into Our Investment Process
That’s a great question. We’ve integrated this thinking deeply into our investment process, and let me explain how we do it.
When we look at a company, every stock in our portfolio, we assign a fair value four, five, or more years out, and then discount it back to the present. Why does that matter? Let’s say there’s a company that’s not growing earnings, and another that is growing earnings. If I look five years out at the company that’s growing earnings, I’m getting paid through that earnings appreciation. But if the other company is not growing earnings, then time actually works against it.
In that case, the discount at which I buy the stock has to be much greater. In other words, if it takes five years for the market to revalue the company and it’s not growing earnings, I have to buy it much cheaper. We have companies with different growth profiles, but our internal rate of return, projected five years out, basically equalizes that. That’s how we account for time.
Another thing this process does is change the types of companies in my portfolio. When I started investing, like many value investors, I began in the “dumpster,” buying companies that looked statistically cheap, say, a coal stock trading at six times earnings. Almost every value investor I know starts this way because it’s easy: you’re trained to look at numbers, and it’s simple to say that a company trading at 10 times earnings is cheaper than one trading at 15.
But true analysis comes when you look deeper, when you assess whether the company has a significant competitive advantage, the quality of its management, how well it allocates capital, its debt or lease obligations, and so on. That’s when qualitative analysis enters the picture. Many investors graduate from purely quantitative analysis to a blend of qualitative and quantitative, often after losing money and making mistakes, as I did.
There is real value in growth. I’m a value investor, and yet one of my largest positions is Uber. When a company doubles, triples, or quadruples its earnings, it becomes worth more. Of course, what you pay matters, it doesn’t mean anything that’s growing is worth buying. But introducing growth into the portfolio makes sense.
If you were to analyze my portfolio from the outside, you might say, “You’re a value investor but you own Uber,” and it might break your model. That’s fine—that’s their problem. We integrate all these components into our framework by valuing positions five years out and discounting them back.
You touched on competitive advantages and the multi-faceted nature of investing. Not all earnings growth is equal. For companies with wide moats and the ability to generate returns above their cost of capital, how do you factor that in? You can have a company that’s growing earnings but, over time, harming its ability to generate excess returns. How do you incorporate that into your IRR analysis?
Why Quality Is a Non-Negotiable Filter
The math speaks for itself. If a company doesn’t earn its cost of capital, then to generate those earnings five years out, it will likely need to either increase debt or raise equity. That’s an oversimplification, but it’s generally true.
Also, such a company probably wouldn’t pass our quality screen. Over time, I’ve realized that life is too short to own low-quality companies. Quality has become an absolute bar for us.
For example, we recently looked at a company that was one of the cheapest stocks I’ve ever seen, truly a dollar trading for 20 cents. But then we looked at management. They paid themselves huge amounts, made terrible capital allocation decisions in the past, and showed no evidence of changing.
The old me would have said, “But it’s so cheap!” The new me says, “Life is too short.” And we move on.
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