Investing Framework (Philosophy + Process)

My revised and updated investing framework as of June 2024

Every so often I review and update my notes on philosophy & process. This isn’t a new concept; plenty of other investors use a similar list. It’s a good lens into my approach and hopefully sheds some light on the types of ideas I cover in the newsletter…

Core Philosophy

1. The philosophy is relatively simple. The practice is really hard. -- Li Lu

2. Here is my bucketed approach

   1. Core – High quality businesses, great cash flow, growing, ample balance sheet capacity – companies you could/would hold for multiple years or forever

   2. Generals – Mostly special situations (spin-offs, post-bankruptcy, management changes, tenders, etc.), event-driven ideas, trades, or lower quality businesses that are just plain cheap. Generals are most vulnerable in a declining market. Just because something is cheap doesn’t mean it can’t get cheaper.

   3. Options – Typically balance sheet bets (negative EV, net-nets, NOL shells, huge cash pile, hidden asset, etc.) but can sometimes be highly levered businesses with good cash flow trying to “survive” (AT, TEVA, etc.)

3. Value investing to the core – looking for cheap stocks across several valuation metrics against: 1) that stock’s own historic valuations; 2) compared with peers; 3) my own return hurdle

4. Smaller is better – greater chance for dislocation, less competition, easier access to management

5. Concentration is overrated – don’t obsess over only having a few positions, let the quality and quantity of available ideas drive how concentrated the portfolio is

6. Size bets based on downside first

7. Cash is king – focus on businesses that generate cash flow

8. Speculation is ok in small amounts but recognize upfront when you’re speculating

9. Weightings driven by the bucket they’re in:

   1. Core – Fewer quantity of holdings but generally larger weightings

   2. General – Can be a wide range of quantity and weighting

   3. Option – Larger quantity of holdings and lower weightings – in aggregate shouldn’t be more than 10-15% of the portfolio

10. Extremely high quality businesses (”compounders”) are much less prevalent than most investors think — maybe able to find 1 per year (if that) at a good price

11. Selling is difficult – allow Core positions to work for you over long periods of time; Generals and Options should be price target driven

12. Because of my demand for low valuations I’ll almost always be buying Class B or C businesses. Very rarely will I pay the full price for a Class A business or industry.

13. Buying Class A businesses makes the most sense during an industry or market wide sell off or outright panic (COVID, banking crisis, GFC, etc.)

14. What matters at various points in time:

    1. Long-term — all that matters is FCF and FCF per share growth

    2. Medium-term — directionally growing or declining?

    3. Short-term — sentiment, narrative, EPS miss/beat

15. Look for businesses that appear crummy but are actually good

    1. Profitable division/segment (crown jewel)

    2. Industry turning cover (i.e. TEVA)

    3. Temporary issues (MDP)

Core Process

1. Weightings driven by the bucket their in:

   1. Core – Fewer quantity of holdings but generally larger weightings

   2. General – Can be a wide range of quantity and weighting

   3. Option – Larger quantity of holdings and lower weightings – in aggregate shouldn’t be more than 10-15% of portfolio

2. Simple thesis rule — be able to explain the idea in a quick 2 sentence blurb; use modified version of Steinhardt’s 4 criteria:

   1. Why is it down (or why it trades where it does)

   2. Valuation

   3. Why own it

3. Allow the quantity/availability of good ideas to drive the size of the portfolio – no requirement to hold a certain level of concentration or diversification

4. Keep a portfolio management spreadsheet — my estimates plus upside/downside target price

5. Review “beaten up” industries – stocks and sectors that are out of favor or hitting the 52-week lows lists

6. Position sizing — start small and allow growth based on comfort around execution/ thesis; top of the book should meet the “simple thesis rule”

Business Analysis & Valuation

1. Trajectory of fundamentals more important than absolute levels — get the direction right, don’t worry so much about the precise level of sales, earnings, etc.

2. Favor net sellers of assets over net buyers – i.e. divesting businesses or assets consistently

3. Great businesses turn a high percentage of EBITDA into free cash flow — always review how a company is reconciling EBITDA to FCF

4. Beware of businesses that have a long list of adjustments from earnings to adjusted earnings – intangible amortization should be the primary driver of this

5. Even better businesses don’t have to report “adjusted” numbers!

6. Crummy businesses can be ok investments – not when the bet relies on: “earnings / cash flow will decline at a slower rate than the market expects”

7. Look for companies undergoing a dramatic change in direction – breaking up, exiting business lines completely, changing policies, etc.

8. Cash flow > income statement

9. Look at leverage as a multiple of debt to cash flow (in addition to EBITDA)

10. Perform “sources & uses” analysis for every investment

    1. This is a true test for capital allocation – indicates how cash was actually deployed

11. Always compare closest competitors – most industries should move together but understand key differences and why

12. Median historic multiples – buy below long-term trends

13. No single metric is perfect but still take a look at each of them – PE, EV/Revenue, PB, EV/EBITDA, P/OCF, FCF yield, etc.

14. There are a ton of assumptions built into a single “multiple” on a stock but don’t ignore completely as this is how many stocks get priced in the short term

15. Stock prices follow earnings – this adage holds some truth

16. Look for the corporate “double play” — where earnings are set to rise and market not giving credit

17. Cheap stocks can (and will) get cheaper!

18. Every quarter, take out a blank piece of paper and “rebuild” your portfolio with only 20-25 positions — see which names make the cut and take a hard look at those that don’t

Idea Generation

1. Turnover stones and keep good notes

2. Run some high-level generic screens to create jumping off points and sift through the pool

   1. Extremely low EV to sales

   2. Cash flow multiples

   3. Net cash to market cap

3. Special situations – spin-offs, post-reorg, CEO changes, insider buying, M&A acquisitions/divestitures (especially the ones that really change the overall business)

   1. Take some caution with unseasoned securities – limited history and uncharted waters with new trading

   2. Every spin worth at least a cursory review

4. “Management by walking around” – read, look at 13F filings, etc. – allow yourself to stumble upon good ideas by accident

5. Beaten up stocks and industries – check the 52-week lows

6. Dramatic change – a somewhat different take on the “special situation” – these are companies changing their internal policies / strategy – breaking up, exiting business lines completely, changing policies, etc.

7. Balance sheet transformations — look for businesses that sell a division/asset and quickly move from highly levered to minimally levered (or even net cash!) — these need to be significant, think from 6x leverage to 2x or from 3-4x leverage to a net cash position

8. Twitter is a great source for real-time news and new ideas

9. Blogs, websites like Value Investors Club, and Substacks are great resources for finding new ideas