[00:02:16] Shawn O’Malley: So under the buffet partnership model, if the fund earns 12%, then the manager gets 25% of the difference between 12% minus 6%, which results in a 1.5% fee. While that is pretty lucrative in the good times, managers under this structure earn nothing in down years or in years where a return of 6% or less is generated.

[00:02:36] Shawn O’Malley: In other words, investors in a fund only pay a fee if the partners running it deliver attractive returns above what is roughly the historic market average. Again, this is just really uncommon, and you’ll find essentially no ETFs or mutual funds set up this way and only a handful of hedge funds. An investor like Huber, who structures his fund in the same way, is really putting his livelihood on the line to ensure his incentives are fully aligned with the investors in his fund.

[00:03:01] Shawn O’Malley: Likewise, John and his family have almost their entire net worth invested into Sabre Capital, so again, I just really admire any investor who bets on themselves and positions themselves to only profit when they’re delivering solid returns. It would be far easier to just charge a 1 percent management fee every year, regardless of performance as is so common across actively managed investment funds.

[00:03:22] Shawn O’Malley: And honestly, many hedge funds charge twice that amount while also taking a cut of any profits they deliver. So with that said about the Buffett partnership fee structure that Huber adheres to actually talk about his investment philosophy. I’ll just go ahead and read some quotes from Huber on his approach to investing.

[00:03:39] Shawn O’Malley: He says Sabre’s investment philosophy is simply that quote, in the long run, the best investments come from the best businesses. Our strategy is to carefully study and selectively invest in exceptional companies that we expect will compound value over the next decade. Great companies are unique, but often share five common traits, profitable unit economics with expanding returns and capital growth, tailwinds, a moat that widens as the business grows, talented people who are adaptable to change and a product that pleases customers.

[00:04:06] Shawn O’Malley: Our investments tend to fall into one of two categories, one being unfinished companies with significant growth potential that are reinvesting into their business, or two dominant moats that are currently collecting quote unquote monopoly rents. He adds to this by saying, quote, even the largest, most well followed companies in the world can get mispriced even when their moat is obvious for everyone watching.

[00:04:28] Shawn O’Malley: This occurs because many market participants have a short term time horizon. Fear of falling stock prices in the near term often leads to investment decisions that are driven by emotion and not valuation, and this creates routine opportunities in the stock market. Sabre’s main advantage is we are set up to capitalize on this time arbitrage.

[00:04:46] Shawn O’Malley: That term time arbitrage is super interesting to me in a 2017 article titled, what is your investing edge? Huber builds on this idea more by discussing how most investors focus on trying to gain information that others don’t have to give themselves an advantage in markets. Yet an informational advantage is the most fleeting and competitively challenged advantage an investor could have.

[00:05:06] Shawn O’Malley: Even worse is that short term information is rarely helpful in determining the long term value of a company. Instead, the advantage that investors should lean into more is in their time horizon. In Huber’s view, which I agree with, an investor who is patient enough to look at a business through a long term lens is likelier to find more sustainable advantages, which dwindle down as time frames get shorter and shorter.

[00:05:27] Shawn O’Malley: The question, what is your edge, gets thrown around a lot whenever people share their thoughts about a company, especially when pitching big companies and indexes like the S& P 500, where there’s an implication that because they’re so well-known and broadly followed on wall street, that there’s really no edge to be gained.

[00:05:41] Shawn O’Malley: It’s often said correspondingly that an edge can only be found from closely researching small, underfollowed companies where there’s a higher chance that the market is at any moment. Mispricing their shares. On the one hand, it is true that lesser known stocks will probably have a less efficient market for trading their shares, which creates more opportunities generally for investors to buy in at discounts to intrinsic value.

[00:06:01] Shawn O’Malley: But in Huber’s opinion, the informational advantage available with small companies is typically overstated. That is to say, investors can have three types of advantages. Either an informational advantage where they know something the market doesn’t and analytical advantage where they’re superior at interpreting information that’s widely known and a time horizon advantage where they simply exploit the fact that most investors either do not have the leeway, faith, or discipline to wait for longer term theses to come true.

[00:06:28] Shawn O’Malley: In the days before the internet, it was far easier to have an informational or analytical advantage than it is today. As Huber writes, quote, I think a lot of the low hanging fruit has since been arbitraged away because the breadth of information and the ease with which we can access it has leveled the playing field.

[00:06:44] Shawn O’Malley: Everyone is out looking for bargains now. Where Buffett in the 1950s may have been able to find attractive stocks at cheap prices by simply flipping through the pages of Moody’s Manual on stocks, investors now must come to terms with the reality that anyone can run a stock screener in less than 30 seconds that filters through thousands of companies based on their trends in sales, price to earnings ratio, 52 week lows, and countless other factors.

[00:07:07] Shawn O’Malley: Huber adds, I’m completely in favor of working very hard to locate undervalued ideas, and I’m completely in favor of looking at small cap stocks for investment ideas. But unlike so many other investors, I’m just as willing to look to widely followed large cap stocks for ideas. His answer then to the question of what edge can an investor have when looking at any stock, but especially large cap ones, is that he’s simply willing to look at the company through a different perspective.

[00:07:33] Shawn O’Malley: He’s not imagining what will happen next month, next quarter, or even next year. He’s pondering what the next decade may look like for a given company. Looking at satellite photos of Walmart parking lots to predict trends in foot traffic and therefore whether Walmart is likely to beat its next earnings estimate is a game some have the resources to play and can do well, but it’s not the only way to win in markets, and for more resource constrained individual investors, we must turn to time arbitrage for a reliable edge.

[00:07:59] Shawn O’Malley: That time horizon advantage has only expanded over time too, as the average holding time for stocks has fallen from more than 8 years in the 1960s to less than 8 months today. Despite all the talk and cliches about thinking long term, in practice, the average investor’s holding period is just a few months for any given stock.

[00:08:16] Shawn O’Malley: Even if people pay a lot of lip service to thinking long term, in reality, they’re hardly even investing in the intermediate term. Huber argues that, if anything, the culture of hyper fixating on quarterly results, catalysts, and other short term data all only increase the edge available to those who are simply willing to buy good companies and hold them for a long time.

[00:08:35] Shawn O’Malley: With no clear explanation for doing so beyond knowing that the company is likely to continue doing well on a decade plus time horizon or longer. To make the point, Huber uses a chart of the 10 largest companies in the S& P 500 as of June 2016 and shows the percentage difference between their highs and lows over the course of that year.

[00:08:53] Shawn O’Malley: In just 52 weeks, companies like Apple, Google, Microsoft, Amazon, and ExxonMobil, among other recognizable names, all saw their stocks fluctuate 30%, 40%, 50 percent or more from their highs to their lows. We’re talking about swings in market value of hundreds of billions of dollars for what are literally the biggest companies in the world but are the most well followed and supposedly the best understood.

[00:09:15] Shawn O’Malley: It goes without saying that the intrinsic value of Apple shares certainly didn’t swing by 50 percent in 12 months. And even if it did, the same can’t be true for the other nine biggest publicly traded companies who saw their share prices fluctuate by similar amounts. Amazon and General Electric that year both saw their market valuations rise and fall by 70 percent from their highs to their lows.

[00:09:34] Shawn O’Malley: Funny enough, the company that saw the smallest gap of just 19 percent between his 52 week high and low was Berkshire Hathaway, where investors had the chance to follow Warren Buffett’s lead in determining whether shares are fairly priced. Without Buffett’s guidance, the market otherwise seems fairly helpless at valuing the biggest companies accurately on even an annual basis.

[00:09:54] Shawn O’Malley: If you’re watching this on YouTube, you’ll be able to see the graphic I’m talking about, and even though it’s from 2016, I’m confident you’d see the exact same sort of thing happening in more recent years too. When the market pendulum swings back and forth this dramatically, there are surely opportunities to buy companies at attractive prices relative to their value to long term oriented shareholders.

[00:10:13] Shawn O’Malley: As Warren Buffett’s mentor Ben Graham would tell us, we should use the market’s volatility to serve us. Opportunities for long term investors will be particularly attractive when some adverse factor is likely to weigh on a company’s results for a few quarters. With the short to intermediate term outlook looking bleak, investors operating on those timeframes will sell the stock and drag down the price.

[00:10:33] Shawn O’Malley: For any investor willing to buy in amid this fog of uncertainty and wait for things to clear up, they’ll be rewarded for weathering that storm. Uber says, quote, the edge is less about knowing more than everyone else about a specific stock and more about the mindset, the discipline and the time horizon that you maintain as an investor.

[00:10:50] Shawn O’Malley: So I keep coming back to that idea of time arbitrage as I look over my notes this episode, and the concept just really stands out to me. I really believe it’s the biggest advantage we have as individual investors. Professional money managers get judged by the results every quarter and every year, so they can’t afford to endure rough patches because the investors in their fund might try to flee and withdraw their money, which means less income from fees for them.

[00:11:13] Shawn O’Malley: Not having to manage anyone but yourself is a structural advantage for individual investors that many don’t realize they have. The time horizon edge could be summed up this way. Price of gaining this edge is the volatility that would occur in the near term. You have to be willing to accept the possibility that your stock will go down before it goes up.

[00:11:30] Shawn O’Malley: Very few investors are willing to pay that price, which is why even large cap stocks can become disconnected from their long term fair values. Now, since my colleague Clay Finck had Huber on our We Study Billionaires show back in May, I want to share a clip from their conversation together that paints some more color around his quality focused approach to investing.

[00:11:49] Clay Finck: I noticed in your yearend letter for 2023, your top five positions accounted for around half of your portfolio, which I always like to see a concentrated approach that puts a lot of their money in their best ideas. And your top position was actually a pretty sizable portion of that. And I don’t want to get into exact percentages here, but how did that top holding get to become pretty highly concentrated? And how do you think about managing that level of concentration?

[00:12:16] John Huber: Yeah. I mean, the biggest investments for me are the ones where I feel extremely confident in the downside or lack thereof. Like I’m looking for companies where my biggest investments are the ones where I think I have the lowest likelihood of losing money permanently.

[00:12:31] John Huber: And obviously that’s not, Meaning the stock price, any stock price can go down, but in terms of losing money permanently. And so, you know, I’m thinking about things like, what does the balance sheet look like? How much cash do they have? What’s the liquidity? What’s the margin profile? This particular company, they own mineral rights and they are, it’s a, it’s a bit of a special situation, but they’re very soon to be debt free and they will have no liabilities whatsoever.

[00:12:55] John Huber: And they have an essentially, they’re because they’re mineral rights, they take a royalty. And they have virtually no operating expenses. So it’s like, literally, it’s a 90 percent profit margin business. And so there’s very little business risk. They have reserves in the ground, which you can measure and have an idea of how long these reserves last and it’s many decades.

[00:13:14] John Huber: And so there’s a lot of things that give me comfort that this business has a margin of safety and has very low. Likelihood of permanent capital loss. And then when you couple that with the valuation, in this case, the valuation is really compelling, very high dividend yield. I think there’s very low likelihood of losing money on it in a nutshell.

[00:13:32] John Huber: And so those are my biggest positions. And so it’s a comfort level. Those don’t come around very often, but from time to time, you know, I find a business where in a stock where I think everything lines up and I like the management team, I like the business. I like the durability, the competitive advantage it has.

[00:13:47] John Huber: And the prospect for, you know, attractive future returns and so those tend to be my biggest positions, but yeah, I think, like, it makes sense to have some diversification. I don’t think you want to have all your eggs in 1 basket, but I think, like, having, you know, having 8 to 10 stocks represent 70 or 80 percent of your portfolio is adequate diversification while also giving you the chance to outperform.

[00:14:08] John Huber: You know, if you’re right on balance. And so that’s, that generally tends to be how I think about my portfolio. We do have a, that third category I mentioned of bargains, those tend to be smaller positions and they tend to be more numbers based. Um, so that you could almost think of those as a basket and they, they sometimes work out in a fashion that’s uncorrelated to the general market, which is nice.

[00:14:29] John Huber: We do have a few more investments recently in that category, but for the most part, yeah, we own a concentrated group of companies.

[00:14:38] Shawn O’Malley: With that said, I want to now turn to a series that Huber did back in 2014 on the concept of ROIC and how it is so important for finding great companies who can compound returns over time.

[00:14:49] Shawn O’Malley: If you’re not familiar, ROIC stands for Return On Invested Capital, and many of the best investors use it as their preferred metric for assessing whether a company is worthy of their investment. I’ll just mention too that I’ll include formulas in the show notes below for any terms I use in this episode, like ROIC, so you can follow along with exactly what I’m talking about and how it’s calculated.

[00:15:08] Shawn O’Malley: Joel Greenblatt’s so called magic formula of investing, for example, relies heavily on ROIC. In Berkshire Hathaway’s 1987 shareholder letter, Warren Buffett gives a pretty good breakdown of why returns on capital matter. He mentions that Berkshire’s seven largest non-financial subsidiaries made 180 million in operating earnings and 100 million after taxes.

[00:15:29] Shawn O’Malley: Yet, quote, by itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital, debt, and equity was needed to produce these earnings. So, making 10 in profit from 100 is a lot more impressive than making a 10 profit using 1, 000. A quality business is, at least in part, one that can crank out more profit with relatively fewer resources invested into it.

[00:15:54] Shawn O’Malley: Buffett uses a study from Fortune to make the point even further. Of the 1, 000 largest U. S. stocks that Fortune examined, only 6 of them averaged over 30 percent returns on equity over the previous decade, from 1977 to 1986. And only 25 of the 1, 000 companies studied averaged returns on equity of over 20 percent and had no single year worth lower than a 15 percent ROE.

[00:16:18] Shawn O’Malley: These 25 business superstars were also stock market superstars as 24 out of 25 outperformed the S& P 500 during the 1977 to 1986 period. Returns on equity are another variation of measuring returns on capital. And this pretty well makes the point that for decades, returns in capital have correlated strongly with exceptional stock market returns.

[00:16:40] Shawn O’Malley: And you can also use ROIC as a very rough proxy of business quality, where better businesses will earn higher returns on capital and worst ones will have a lower ROIC number over any given time period. But as Huber points out, this often leads to a conversation among long term investors about whether it’s better to focus on the highest quality companies with the best returns on capital, or whether it’s better to focus on cheapness and buy the companies that are most attractively priced relative to their returns on capital, which may or may not be that impressive.

[00:17:10] Shawn O’Malley: There’s been a lot of academic work done on studying cheapness, and it’s pretty well documented that at least in the past, you could earn market beating returns by focusing on companies that were classified as cheap based on some valuation metric, Like having a low price to earnings ratio or a low price to book ratio.

[00:17:24] Shawn O’Malley: By just buying cheap, you would have done pretty well, and you wouldn’t have even needed to worry about ROIC and business quality. As Huber points out though, what these studies typically leave out is over what holding period this is true for. They might declare that it’s best to focus on cheapness by following some strategy that buys the companies with the lowest valuation multiples and then sells them a year or two later.

[00:17:45] Shawn O’Malley: As a result, this approach ends up with a good bit of annual portfolio turnover, as he says, quote, I think many value investors see these studies and get excited about valuation, leaving quality far behind. Who needs quality when valuation is all that matters? As Huber puts it, though, I completely agree with these studies and with the practitioners who favor valuation over quality if their holding period is only one to two years.

[00:18:07] Shawn O’Malley: On balance, paying a high price for even a great business will not always work out well if you have to sell that business in one to two years or even in three to five years. But if you plan to hold your stocks for longer periods of time, five years, 10 years or longer, then quality becomes much, much more important than valuation.

[00:18:24] Shawn O’Malley: I completely agree with this assessment, and it just makes sense intuitively. When you buy the cheapest stocks and sell them a year later, you’re taking advantage of the fact that the market probably overreacted to bad news relating to these companies and pushed down their valuations too much, and after a year, you’ve sort of rode the wave a bit as those valuations normalize again.

[00:18:42] Shawn O’Malley: You’re really not investing, you’re just making a bet on meaner version and market sentiment. And holding these companies for any longer doesn’t work out that well, because there’s probably a good reason those stocks were so cheap. Maybe they were oversold, and on a 12 month time frame, you’re able to benefit from that, but they’re probably not anywhere close to being the best company in their industry, or if they are, they might just be in a terrible industry.

[00:19:04] Shawn O’Malley: Personally, I want to truly invest in companies, which means riding through the ups and downs and buying stakes in companies that I want to own for a very, very long time. For one thing, it’s just a simpler approach. It’s a lot easier to pay close attention to a small handful of companies than it is to turn your portfolio over completely every year or so.

[00:19:23] Shawn O’Malley: And then on top of that, there’s another conversation to be had about taxes and trading costs. You’re trading less and holding your positions for longer. We’re going to rack up a lot fewer frictional costs, which will add up in your favor over time. As a long term investor, how well a company is run and whether the industry they compete in is conducive to attractive returns really matters.

[00:19:42] Shawn O’Malley: With enough time, a bank stock earning 15 percent returns on equity will always create more wealth for shareholders than a bank earning 7 percent returns on equity. To continue the example of quality versus cheapness further, over a narrower time horizon, it might pay off better to buy the lower quality bank stock that earns a 7 percent ROE if you can get it at a 50 percent discount to book value.

[00:20:03] Shawn O’Malley: But after its valuation has corrected, you’re left holding a bank that’s just fundamentally less profitable than its peer that can earn twice its return on equity. Yes, you got a tailwind for buying the stock cheap at first, but for the next decade, if you held the less profitable bank, you’re going to handicap your returns.

[00:20:19] Shawn O’Malley: This is something I learned from studying Mohnish Pabrai but operating with a shorter time horizon and frequently trying to find cheap stocks and then flipping them just requires a lot more decision making, where each decision represents a point of vulnerability that you could be wrong about. Over a 15 year period, you might buy and sell 7 or 8 different cheap bank stocks just to earn the same returns that you would have gotten from holding that one superior bank for that entire time.

[00:20:44] Shawn O’Malley: One approach is just a whole lot simpler and less stressful than the other, and I know which one I prefer. I’d rather put the extra effort into studying that higher quality business so I can feel confident about owning it for a decade plus, instead of trying to make a dozen buy or sell decisions for lower quality companies based on whether I think they’re still cheap.

[00:21:00] Shawn O’Malley: It sounds too good to be true, but investing long term in quality businesses with superior returns on capital can truly be less labor intensive and less stressful because you’re taking full advantage of that time arbitrage concept we’ve already discussed. Still, there’s room for both cheapness and quality among long term investors.

[00:21:16] Shawn O’Malley: These styles are different, but not as different as most people think. Yes, the tactics used differ, but the objective is exactly the same, trying to buy something for less than what it’s really worth. Both strategies rely on Ben Graham’s famous margin of safety concept, which is probably the most important concept in the investing discipline.

[00:21:33] Shawn O’Malley: Huber, in part, uses price as a margin of safety to minimize the downside if he’s wrong, but he also uses business quality as a margin of safety too. He says that his ideal investment is the type of business that can produce high returns on capital and, importantly, reinvest large chunks of those profits into opportunities that’ll earn similarly high returns.

[00:21:52] Shawn O’Malley: That’s quality and while things can still go wrong for companies with attractive reinvestment opportunities before them, they just have a tailwind behind them that others don’t, and that offers a degree of protection. As Warren Buffett’s right hand man, Charlie Munger, has been known to say, we want to find a business that can write us a check at the end of the year.

[00:22:10] Shawn O’Malley: In other words, companies that produce more cash from operations than needed to maintain their current competitive position. Huber adds that he likes to keep a list of these types of companies that have produced at least 10 years of consecutive positive free cash flows. You probably can’t go wrong owning businesses that are profitable in this way and spin off tons of cash, but even better is a business that has opportunities to instead take those cash flows and plow them into new investments with equally as attractive or even more attractive profit margins.

[00:22:36] Shawn O’Malley: As Huber puts it, quote, this is where a business achieves true compounding power. Typically, these compounders enjoy a niche or some kind of competitive advantage that allows them to achieve consistent high returns on capital. This point often gets overlooked, but the opportunities for reinvestment are what matter most in determining quality.

[00:22:52] Shawn O’Malley: Some companies have legacy moats, as Huber refers to them, where some advantage affords them very attractive returns on their existing business, but they don’t have many attractive opportunities to take those profits and invest them into profitable growth. An even stricter standard for quality investing focuses on companies that not only have enduring moats in their businesses, but also great opportunities to continue to grow their existing moats or form new ones.

[00:23:14] Shawn O’Malley: If you’re not familiar with that term moats, it’s a term connecting back to Warren Buffett who uses it to describe companies that are like castles with deep moats protecting their profits from attackers. The fact that so many people and their friends and family all use Apple products and are deeply entwined into the Apple ecosystem, that’s a competitive moat for the company.

[00:23:33] Shawn O’Malley: Going back to that point on having a company with a reinvestment moat versus just a legacy moat, if a company earned 20 percent returns on capital over the last decade, that’s great and shareholders in it probably have done very well. But as an investor, you want to be looking forward and trying to determine whether a company can continue to earn those rates of return.

[00:23:50] Shawn O’Malley: It’s always possible that new competition has entered the market or that a company has simply exhausted its opportunity for those sorts of returns on capital. So there’s very much a qualitative aspect to all of this. You can’t just look at a business and say, Oh, great. They had the best returns and capital in their industry for the last five years.

[00:24:06] Shawn O’Malley: So I’m going to buy them. Everything else being equal, that’s actually not a bad place to start in identifying companies with legacy moats, but still the point remains, you have to do the qualitative work to understand the company and decide for yourself how sustainable those superior returns are. If you’re looking at Lululemon, for example, you’d have to decide for yourself whether you think its products have real staying power, or whether it was just a trend in sportswear that everyone will have moved on from in 5 years from now.

[00:24:32] Shawn O’Malley: Lulu lemon is actually a timely example because the company has earned incredible returns on invested capital of well over 30 percent per year in the last five years, but the stock is down almost 50 percent so far in 2024. The company has a great track record, but there’s obviously a good deal of pessimism about whether Lululemon can continue to generate those sorts of returns.

[00:24:51] Shawn O’Malley: Either Lulu will continue to compound returns at 20 30 percent per year, and this will have looked like the buying opportunity of a lifetime, or its stock price will have correctly anticipated that its returns on capital would fall off, and you’d be left catching a falling knife. The hard part about investing is you just don’t know which it will be or whether it will be something in between.

[00:25:11] Shawn O’Malley: I’ve probably belabored the point, but looking at historic returns on capital is a good place to start, but then you have to have some degree of confidence about what rate of return a company can earn on the capital it’s incrementally reinvesting. As Huber puts it, quote, The problem is that capitalism is tough, and unpredictable things can occur that can harm a business’s economics.

[00:25:30] Shawn O’Malley: So, I rely on valuation as my safety net. I prefer to find really cheap stocks, but I want them to be businesses that I think can grow their intrinsic value. This provides me with a margin of safety not just in the valuation, but also because the gap between price and intrinsic value will widen over time as the business continues to grow its value.

[00:25:49] Shawn O’Malley: He adds, as Buffett once said, I want to have my cake and eat it too. I like quality businesses. I like great capital allocation. I like high returns on capital, but I demand value. Finding great compounders over time is namely a question of correctly identifying business quality and price can be used as a hedge against whether you’re able to do that correctly.

[00:26:09] Shawn O’Malley: If you buy a company, you think is a high quality compounder based both on its track record and opportunities looking forward, and you can buy it near its 52 week low, you’re probably going to come out okay on the investment even if its returns on capital going forward are considerably lower than expected.

[00:26:23] Shawn O’Malley: You may or may not earn a market beating profit on it, but you’ll at least have a decent company and you’ll probably have paid a very reasonable price for it. Few people have gone broke doing that. As they say, shoot for the moon because even if you miss, you’ll land among the stars. To quote Mohnish Pabrai again, he loves to say, Heads I win, tails I don’t lose much.

[00:26:43] Shawn O’Malley: While it is hard to find truly exceptional companies for cheap outside of market crashes, this mostly applies to companies that are well known for being exceptional like Apple or Walmart. http: TheBusinessProfessor.com But, as Huber argues, there are plenty of relatively unknown companies with very high quality businesses that can compound their intrinsic values per share at 10 12 percent per year and which can occasionally be purchased at quite cheap prices.

[00:27:05] Shawn O’Malley: He cites one example of a small company he studied that has a market cap of less than 250 million but has compounded returns for shareholders 17 percent per year for two and a half decades. While you might think that a company able to compound like that for so long would be much bigger, he says the business has returned an incredible amount of capital to shareholders through buybacks and dividends.

[00:27:26] Shawn O’Malley: Huber writes, basically the company sold shares initially for a grand total of 1. 7 million in proceeds, and that is the only time the company has ever issued stock in its history. Since that time, the company has returned around 130 million to those happy original shareholders via buybacks and dividends.

[00:27:43] Shawn O’Malley: And the stock itself is 50 times more valuable than it was then as well. That is to say high quality companies with exceptional returns on invested capital come in all shapes and sizes. You just have to know what to look for. With that, I want to continue with going through Huber’s series on the importance of ROIC with respect to both high quality compounders and cheap stocks.

[00:28:02] Shawn O’Malley: I teased at this a bit already, but the industry a company competes in can really shape its destiny. Whereas a healthcare company might have pretty steady earnings, steel companies are going to be highly levered to the economic cycle. When the economy is booming, there’s going to be a lot of construction and steel companies will benefit from all that demand.

[00:28:19] Shawn O’Malley: And then things will swing in the other direction. And those same names will bleed money as construction freezes and demand for steel falls off. So no single point in the cycle is really representative of the types of sustainable returns on capital that steel companies can earn. You have to average it out across the business cycle.

[00:28:36] Shawn O’Malley: And generally speaking, steel companies have very mediocre average returns on capital of just four to 6%. It’s a cyclical competitive commodity business, so it shouldn’t be too surprising that the industry has generally been a poor place for shareholders to invest, but it’s a great illustration of why we must pay attention to the ecosystem that a company competes in.

[00:28:54] Shawn O’Malley: Obviously, finding a great steel company that can compound returns for shareholders at 15 percent per year is probably going to be a lot harder to find than in other industries. And there’s also probably a higher risk of being lured into steel stocks that look cheap relative to some estimate of intrinsic value, but which are really just terrible businesses that deserve a low relative valuation.

[00:29:14] Shawn O’Malley: To make the point, Huber looks at one of the best known steel companies, U. S. Steel. From 1991 to 2014, the stock was essentially flat with some huge swings up and down. And In the early 90s, the company earned about 3 per share, so you could have bought it at a P. E. ratio of 10 and paid 30 for the stock, while a price to earnings of 10 sounds pretty cheap.

[00:29:35] Shawn O’Malley: That cheapness wouldn’t have mattered since U. S. Steel was unable to generate reliably profitable returns, and after some periods of impressive profitability and periods where it was bleeding money, it was in roughly the same position in the mid-2010s as it was in 1991. And as Huber explains, even if you had bought the stock at what seemed like an unbelievably cheap price of 9 per share in the 90s, which would have been a price to earnings ratio of just three, your average returns over that more than 20 year period would have only been 5 percent per year.

[00:30:03] Shawn O’Malley: The takeaway being, while cheapness can provide a margin of safety that reduces losses, it is no substitute in the long term for quality. For a company to generate stellar double digit returns for shareholders over many years, it needs many years of double digit average returns on invested capital. I know I’m cherry picking examples a bit, but it is helpful to illustrate things with real companies.

[00:30:24] Shawn O’Malley: Fastenal, ticker F A S T, has been one of the best performing stocks of the past few decades. In line with its roughly 20 percent per year returns on capital, the stock has generated an average annual return of about 20 percent per year going back to the 1990s and early 2000s. Even if you had paid 50x earnings for shares of Fastenal in 1989, your compounded annual returns would have fallen only from 21.

[00:30:46] Shawn O’Malley: 8 percent to 18. 4 percent per year, at least through 2014, so you still would have done quite well over time even after seemingly overpaying for the stock. I hope the lesson here isn’t that it’s okay to pay any price for a company if you think it’s going to do really well in the future, especially since it’s difficult to predict how well a given business will perform, but rather that when it comes to the highest quality companies with the best returns on capital, there can be a lot of room for error on purchase price.

[00:31:12] Shawn O’Malley: And that returns in capital will be what primarily determines outcomes for shareholders over time. As Huber writes, quote, I certainly am not recommending paying 50 times earnings, even for great businesses. Capitalism is too competitive and the future is too uncertain to be able to consistently pick out the next Fast and All.

[00:31:29] Shawn O’Malley: Which, if I were to update this writing here, you could NVIDIA for Fast and All. The ads quote, I cannot emphasize enough that valuation is more important over shorter time periods while quality is more important over long time periods, the longer you hold a stock, the more important the quality of that company is as your long term returns will approximate the company’s business results and their internal returns on capital over time.

[00:31:53] Shawn O’Malley: In terms of assessing compounding power, Huber outlines three factors. Firstly, the percentage of earnings that a business can reinvest into growing its business. Secondly, the return that the business can achieve on this investment. And thirdly, what the business does with excess cash flows if it isn’t reinvesting 100 percent of those funds.

[00:32:11] Shawn O’Malley: For that third point, that is to say, what it’s doing with the cash that’s not being reinvested. Is that cash just piling up on its balance sheet? Is it paying back debt? Is it buying back stock? Or is it going toward paying dividends to shareholders? This is capital allocation at its core, and the decisions that management makes on this front will shape the returns that shareholders enjoy.

[00:32:31] Shawn O’Malley: The math of compounding though is simple in theory. A company’s compounded returns for shareholders over time will be roughly equal to the product of its returns on capital and its reinvestment rate, which is the percentage of profits that the company reinvests into growing or maintaining the business.

[00:32:46] Shawn O’Malley: If a business can achieve 20 percent returns on its incremental investments and it reinvests 50 percent of its earnings each year, then the intrinsic value of the business will compound by 10 percent annually. I get that 10 percent number simply from multiplying 50 percent times 20%. Similarly, a company that reinvests all of its earnings into new projects that generate 10 percent returns on average will also compound its intrinsic value at 10 percent per year.

[00:33:11] Shawn O’Malley: Everything else being equal, while both companies are theoretically compounding their intrinsic value at 10 percent per year, they are not. The first business is better to own because it’s higher return on invested capital enables it to only reinvest half its profits, leaving the other half of its earnings to be used toward buying back stock or paying dividends to shareholders on top of the business’s intrinsic value compounding at 10%.

[00:33:31] Shawn O’Malley: So, companies with higher returns on capital just have more leeway to create value for shareholders even if they’re reinvesting relatively less than companies that earn lower returns on capital. Bear with me here because I’ll be throwing some numbers around to show how intrinsic value and returns for shareholders can compound over time.

[00:33:46] Shawn O’Malley: You might want to listen to this part over a few times. If a company starts with 1 of earnings per share in year 1 and earns a 20 percent return on capital for 15 years while reinvesting 100 percent of its earnings at that 20 percent ROIC, then by year 15, it’ll be generating 15. 40 in earnings per share.

[00:34:05] Shawn O’Malley: Assuming you initially bought the shares at a price to earnings ratio of 25, after those 15 years, your returns will vary depending on the stock’s PE ratio at the end of that period. You sell at a PE of 10 and the shares would be worth 154, which is just 10 times 15 and 40 cents and earnings. And you’d have earned a return of 12.

[00:34:26] Shawn O’Malley: 9 percent per year at a higher PE ratio of 15 at your sales price. Your returns would be 16 percent per year. And at a PE of 20, you have gotten an 18. 2 percent compounded annual return. So obviously as that price to earnings ratio that you sell at scales up the annual return that you receive in exchange also goes up too.

[00:34:46] Shawn O’Malley: So even with a significant decline in the multiple, a high quality compounder will still leave you with market beating returns over time. Even better is that in reality, while it’s rare to find companies that can compound at such a high rate so steadily, the valuation multiple probably isn’t going to decline.

[00:35:02] Shawn O’Malley: Investors would generally want to pay a premium to own such a fantastic stock that’s compounding at 20 percent a year. And so with that kind of track record, the price to earnings ratio would probably at least stay flat at 25 or more likely rise considerably, providing a further tailwind to your returns when you finally sell it.

[00:35:19] Shawn O’Malley: After having said all this, you should have a pretty good feel for why I said earlier that great investors pay such close attention to returns on invested capital. As is the theme for much of today’s episode, the question remains on exactly how much to pay for quality. Like I just showed, to some extent, this requires us to be informed about how the price we pay today can shape the returns we receive, assuming the company compounds at a range of possible rates.

[00:35:42] Shawn O’Malley: We can talk endlessly about abstractly paying more or less for companies of varying degrees of quality, but it’s fair to wonder, you know, how much higher of a price to earnings ratio you should pay for a company that earns, say, 30 percent returns on capital versus a company that can earn only 15%. To help answer this, Huber begins by saying that he tries to imagine what his stock and its underlying company’s earnings power would be worth to someone who owned it privately.

[00:36:06] Shawn O’Malley: Meaning, if you couldn’t see the market price and valuation for a company, what would it be worth to you on its own? Not as a part of a portfolio, not considering its volatility, but in isolation, what is this company worth? And to put some numbers behind that, Huber says that again, he roughly follows Buffett’s guidance using a rule of thumb that Buffett has offered in the past, that is, to target a 10 percent pretax earnings yield.

[00:36:28] Shawn O’Malley: That would be the profits per share that the company earns before paying taxes divided by the cost per share to buy the stock. If a company earns 10 per share before paying taxes and its shares cost 100 to buy, then the pretax earnings yield is 10%. That is 10 per share of pretax profits divided by a price of 100 per share.

[00:36:47] Shawn O’Malley: The earnings yield here then is of course a function of the profits per share a company can generate, but in terms of the value you get as a shareholder, the earnings yield is the result of the average price you pay to own the stock. As I said, Buffett and Huber both generally look for opportunities where they expect to get at least a 10 percent pretax earnings yield.

[00:37:05] Shawn O’Malley: And I’d agree that’s a pretty good place to start when assessing companies. If you paid 50 per share for the same company stock, your pretax earnings yield would double to 20%. And conversely, if you paid 200 per share for the stock, your pretax earnings yield would fall to 5%. So the earnings yield is actually just the inverse of the price to earnings ratio.

[00:37:24] Shawn O’Malley: That said, it’s far more important to worry about investing in the right business than it is to worry about whether you pay 10 times, 12 times, or 14 times earnings for its stock. As Huber says, quote, there are lots of mediocre businesses available at 10 times earnings, which will lead to mediocre results over time for long term owners.

[00:37:41] Shawn O’Malley: And I’ll add, many companies that long term owners hold will turn into mediocre businesses over time, as competition inevitably erodes away whatever advantages they have. In that case, once it becomes clear that a company is in decline and that its intrinsic value is going in the wrong direction, you’d want to sell as soon as you can unless you have some very good explanation for and confidence in why it’s a temporary decline.

[00:38:03] Shawn O’Malley: Once your thesis about a company’s quality has changed measured by its ability to earn double digit returns on invested capital, preferably 15 to 20 percent per year or higher, there’s no shame in selling. Having a long term mindset doesn’t obligate you to hold a stock forever. In fact, having a long term ownership mindset is more about finding and owning quality businesses and then continuing to hold them if their business quality remains the same or better.

[00:38:26] Shawn O’Malley: It becomes more art than science when to determine whether that quality has changed, but obviously if a company’s incremental returns on capital fall from 20 percent to 10 percent over some meaningful time period, say two years, then you’d want to be pretty skeptical about whether your original case for that company is still intact.

[00:38:42] Shawn O’Malley: That’s going to change a lot on a case by case basis, so you’d want to pair this downturn and results with your own qualitative assessment of what’s happening with the company, too. In short, I really like this line from Huber about investing in quality companies long term, and I think it captures the essence of what we’ve covered today.

[00:38:58] Shawn O’Malley: He says, quote, I like having my stocks work for me, and that’s really what it’s all about. As a shareholder, in a way, you’re exchanging your money for shares in the company while the company is putting that capital to work to generate returns for you. Which companies you choose determines how effectively your stocks work for you.

[00:39:14] Shawn O’Malley: In 2001, Warren Buffett put it like this, quote, If you’re right about the business, you’ll make a lot of money. And to me, especially long term, being right about the business comes from accurately assessing whether they can compound returns on capital from incremental investments that generate double digit returns.

[00:39:29] Shawn O’Malley: And companies in favorable industries with strong track records of compounding are the best position to do this. This is why Buffett is always talking about great businesses. It’s not just because he wants to sound like a wise grandfather, it’s because of the math. If you pick the right business, the multiples you pay for the business is far less significant for your returns than the quality and sustainability of the company’s returns and capital.

[00:39:52] Shawn O’Malley: With that, I want to play one last excerpt for you today from Clay’s interview with John Huber to tie things together. This is more specifically on his process for reflecting on investment decisions. Take a listen.

[00:40:05] Clay Finck: You had mentioned earlier that writing and doing things sort of in public isn’t something that’s very selfless, you know, you get a lot of benefit yourself from doing it, especially just like in the writing process.

[00:40:17] Clay Finck: There’s a fund manager I follow who releases these very thorough investment memorandums where he outlines essentially his investment thesis in a company. I was curious for your investments. If you do something for yourself, right? Some sort of investment memorandum that outlines your thesis for the investment and not so much to, it requires a lot of work to do something like that, right?

[00:40:40] Clay Finck: A 10, 20, 30 page memo on your thesis for a company. Is that something you do with each investment?

[00:40:47] John Huber: I don’t write a 10 or 20 page write up. No, but I do write a, you know, mine tend to be quite simple. So I do a large amount of research and there might be 10 or 20 pages of what I would call like scratch notes, you know, digital scratch notes where I’m collecting all sorts of data from the 10 K’s and I’m clipping different sections and linking to different things and sort of building almost like a journalist trying to build a story.

[00:41:09] John Huber: Right? You’re, you’re collecting information from all over. Yeah. Notes on phone calls you’ve made all that stuff does add up to a lot, but in terms of the final write up, I do a write up. Yes. I try to make it very simple. Like, you know, one page, two pages. Sometimes they’re longer. I’ve tried to actually get better at writing more succinctly.

[00:41:26] John Huber: And I joked in one of my last letters, like, I only have time to write a long letter, like the Mark Twain quote, like, I didn’t have time for a short letter. So I wrote a long 1 instead. It’s always a challenge to do that, but I think if you can boil down your investment thesis into 1 page or 1000 words or less.

[00:41:42] John Huber: You really don’t need a lot of the minutiae that’s more for you than it is for whoever’s reading it. You want to capture the essence of the investment and the key drivers, the key variables that will impact that investment. And to me, that doesn’t need 10 or 20 pages, although I don’t begrudge anyone for doing that.

[00:41:59] John Huber: I mean, different schools of thought on that. And I’m not saying you shouldn’t write 20 pages, but to me, that’s, you know, I don’t do that. That, that would be overkill for me, but I keep a journal. I write daily. I write a lot.

[00:42:13] Shawn O’Malley: So we’ve covered a good bit today. And you may even feel as though you have a pretty good feel for what it takes to be a long term quality focused investor who uses low prices as a hedge.

[00:42:22] Shawn O’Malley: Personally, I can’t think of a better approach to investing. That’s more fitting for individual investors, especially those with the patience and discipline to think like an owner of the businesses underlying their stock investments. I’ve had fun digging through Huber’s writings. And as I’ve said, you’ll find a bunch of relevant resources below in the show notes from Huber’s blog posts to the formulas for some of the metrics I mentioned today, like ROIC.

[00:42:43] Shawn O’Malley: If you have any questions about quality investing, you can always email me at shawn@theinvestorspodcast.com. It’s one of my favorite topics to discuss. And so with that, I want to wrap up today’s episode with a quote that sums up and adds to our discussion here. Pretty well. The quote comes from the well-known quality investor, Alan Meacham, who says the following if investors focus on reducing unforced errors, as opposed to hitting the next home run, their returns would improve dramatically.

[00:43:09] Shawn O’Malley: My challenge to you, then, is to think about how you can reduce your unforced errors. Maybe it’s in avoiding stocks at 52 week highs or filtering out companies without a track record of double digit sales growth or returns on invested capital over a certain period of time. Whatever it is, don’t let your pursuit of quality companies become about obsessing over the next home run.

[00:43:27] Shawn O’Malley: As Meacham says, and as matches the themes from Huber’s writings, it’s much better to see a focus on quality as a way to reduce unforced errors. Let quality, and specifically ROIC, be your North Star guiding you as an investor. That’s all for today, folks. I’ll see you again next week.

[00:43:44] Outro: Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes to access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.