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
The philosophy is relatively simple. The practice is really hard. -- Li Lu
Here is my bucketed approach
Core – High quality businesses, great cash flow, growing, ample balance sheet capacity – companies you could/would hold for multiple years or forever
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.
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.)
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
Smaller is better – greater chance for dislocation, less competition, easier access to management
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
Size bets based on downside first
Cash is king – focus on businesses that generate cash flow
Speculation is ok in small amounts but recognize upfront when you’re speculating
Weightings driven by the bucket they’re in:
Core – Fewer quantity of holdings but generally larger weightings
General – Can be a wide range of quantity and weighting
Option – Larger quantity of holdings and lower weightings – in aggregate shouldn’t be more than 10-15% of the portfolio
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
Selling is difficult – allow Core positions to work for you over long periods of time; Generals and Options should be price target driven
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.
Buying Class A businesses makes the most sense during an industry or market wide sell off or outright panic (COVID, banking crisis, GFC, etc.)
What matters at various points in time:
Long-term — all that matters is FCF and FCF per share growth
Medium-term — directionally growing or declining?
Short-term — sentiment, narrative, EPS miss/beat
Look for businesses that appear crummy but are actually good
Profitable division/segment (crown jewel)
Industry turning cover (i.e. TEVA)
Temporary issues (MDP)
Core Process
Weightings driven by the bucket their in:
Core – Fewer quantity of holdings but generally larger weightings
General – Can be a wide range of quantity and weighting
Option – Larger quantity of holdings and lower weightings – in aggregate shouldn’t be more than 10-15% of portfolio
Simple thesis rule — be able to explain the idea in a quick 2 sentence blurb; use modified version of Steinhardt’s 4 criteria:
Why is it down (or why it trades where it does)
Valuation
Why own it
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
Keep a portfolio management spreadsheet — my estimates plus upside/downside target price
Review “beaten up” industries – stocks and sectors that are out of favor or hitting the 52-week lows lists
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
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.
Favor net sellers of assets over net buyers – i.e. divesting businesses or assets consistently
Great businesses turn a high percentage of EBITDA into free cash flow — always review how a company is reconciling EBITDA to FCF
Beware of businesses that have a long list of adjustments from earnings to adjusted earnings – intangible amortization should be the primary driver of this
Even better businesses don’t have to report “adjusted” numbers!
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”
Look for companies undergoing a dramatic change in direction – breaking up, exiting business lines completely, changing policies, etc.
Cash flow > income statement
Look at leverage as a multiple of debt to cash flow (in addition to EBITDA)
Perform “sources & uses” analysis for every investment
This is a true test for capital allocation – indicates how cash was actually deployed
Always compare closest competitors – most industries should move together but understand key differences and why
Median historic multiples – buy below long-term trends
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.
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
Stock prices follow earnings – this adage holds some truth
Look for the corporate “double play” — where earnings are set to rise and market not giving credit
Cheap stocks can (and will) get cheaper!
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
Turnover stones and keep good notes
Run some high-level generic screens to create jumping off points and sift through the pool
Extremely low EV to sales
Cash flow multiples
Net cash to market cap
Special situations – spin-offs, post-reorg, CEO changes, insider buying, M&A acquisitions/divestitures (especially the ones that really change the overall business)
Take some caution with unseasoned securities – limited history and uncharted waters with new trading
Every spin worth at least a cursory review
“Management by walking around” – read, look at 13F filings, etc. – allow yourself to stumble upon good ideas by accident
Beaten up stocks and industries – check the 52-week lows
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.
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
Twitter is a great source for real-time news and new ideas
Blogs, websites like Value Investors Club, and Substacks are great resources for finding new ideas
Great list. Also - have fun! Enjoy the ride.