Business owner, not value investor

Unfortunately, the term 'value investor' is mostly misunderstood. 'Business owner' is a better label for a sensible form of investing that emphasizes what-to-own before getting to what-to-pay.

“Fry the penis in hot oil” – Samaithu Paar (Cook & See), Iconic cookbook by Meenakshi Ammal

No, the venerable author of the greatest cookbook ever written wasn’t a proponent of cannibalistic misandry. She was merely elaborating her recipe for a vegetarian delicacy called Pathir Peni.

Why start with clickbait slander? To make the point that inferring meaning from words isn’t always straightforward. Words have to be viewed in context, in spirit, and in totality to ascribe the right meaning to them, especially one that was intended in the first place. Once wrong meaning gets ascribed often enough to certain words, it becomes almost impossible to restore them to their original, intended meaning. My pet peeve on this front are the words “value investing”.

“Value investing”, as a descriptor, is distorted beyond redemption

I cringe every time see I see a “value outperforms growth” headline. Almost all popular references to “value investing” are nonsense. Likewise with its country cousins: value factor, value index, value style-box. The term has become an oversimplified label for formulaic buying and selling of cheap crap with little regard for the nature of the underlying business. While this isn’t illegal, it is a misnomer. This activity is better represented by replacing “value” with “cheapness” in all media references. Cheapness investing, cheapness factor, cheapness index, cheapness style-box and cheapness screens. What is called value investing is often neither value nor investing.

This confusion is especially severe since the greatest proponent of the term – Warren Buffett – hasn’t practiced cheapness investing in five decades. “Value investing” ends up leading a double life, one referring to Buffett and his disciples and another to mechanical application of cheapness filters. I am a member of the former camp, a disciple (by correspondence course, ed-tech if you prefer) and a value investor. However, I rarely label myself “value investor” in my writing since it will mean something very different outside my head.

From an investing viewpoint, former camp is far more lucrative, scalable and conducive to sound sleep than latter approach of chasing cheapness. Tenets of that school of investing, best articulated in Buffett’s annual letters, are worth assimilating. Unfortunately, muddled meaning of “value investing” gets in the way of this assimilation, as learners get confused between value and cheapness. Instead of starting with “what’s worth owning”, many start with “what’s cheap”.

With any brand, meaning is what resides in the minds of most people who encounter it. So, it is too late to rescue “value investing” from this connotation of formulaic cheapness. What is required is a different term that is better shorthand for its original meaning and one that better aligns with the superior investing approach practiced by the greats.  

“Business owner”, not “value investor”

If allowed only two words to pass on my investment approach, I’d go with “Own businesses”. Understood in the right spirit, it covers everything: timeframe, nature of business, priorities of investor, how to think about stock-price.

First, “own” suggests an indefinitely long timeframe, if not permanence. Second, this in turn implies a very high bar on businesses that are worth owning. If a business isn’t sustainably safe and good, it is impossible to own for an extended period. Automatically, the first and most important question becomes “is this business worth owning at all”. An owner is limited to far fewer businesses than an investor, whether ‘value’ or otherwise. Just as we are a lot more discerning with the home we own than the apartment we rent.

Third, focus is entirely on business, not stock-price. Before owning, we spend all our time understanding the nature of the business, the context it operates in, what makes it sustainably good and what risks can spoil the party. Many businesses will drop off our list, either because they’re clearly not worth owning or it’s simply too hard to reliably establish these traits. Likewise, after owning, our focus is entirely on whether the business continues to be worth owning. Owners lead a sedate life tracking business performance, not a frenzied one following price action.

Fourth, for the few businesses that are worth owning, owners seek a rational valuation not a cheap one. Continuing with the theme of words and connotations they evoke, the very phrase “business owner” is more suggestive of rationality than stock-market investor (my family shudders when I inadvertently call myself so). While no one knows exactly what any business is worth, it’s not hard to set rough limits above which business purchase becomes unreasonable.

Fifth, this automatically puts in perspective the relative importance of stock-price vs business fundamentals. Stock-price matters, but only occasionally. Except on rare occasions when markets offer a rational price for owning a business, squiggly lines can be ignored. This is surprisingly good for sanity and sleep.

Lastly, without a “business owner” mindset, it is impossible to give time for compounding to do its thing. A business owner’s mind isn’t preoccupied with selling out, much like the owner of a farm or a home. He isn’t even looking for a quote on most days. While a business owner may occasionally consider parting with his interest in the face of an absurdly irrational offer, he is generally indifferent to valuations across a broad spectrum of stock-prices that fall short of it. On an ongoing basis, the question on an owner’s mind is “how’s my business doing”, not “what’s it quoting at today”.

As you can see from the above, a value orientation is one part of being a business owner. No more, no less. To the extent that owners think rationally about their businesses, that rationality extends to the terms at which we acquire our ownership. Business owners are value investors, just not in the formulaic, commonplace usage of the term. We obsess a lot more about what to own than about what to pay, though the latter also matters. And weirdly, we are more blasé about value on the way out. Go figure.

Why isn’t “business owner” a thing already?

Because profs hate businesses. Not because academia is left-leaning. Because social scientists with physics envy try to model the world, not make sense of it. Economics, finance and investing academia are all about reducing our messy world into closed form equations and numerical answers. Goal is papers and tenure, not accurate representation. Since none of them are practitioners judged by a real-world P&L, they can get away choosing elegance over correctness.

From this viewpoint, business is highly inconvenient. It’s a fuzzy blob that cannot be reduced to an oversimplified number. Business can only be understood holistically, not mechanically. Think of what matters most to any real-world investor: business quality, competitive position, industry attractiveness, risk, people in charge, trust, focus, moat, prospects. Not one of these is amenable to an equation or a number. So, what does finance academia do? Ignore them entirely to come up with fake metrics like beta, sigma, cost of capital and EVA. Instead of understanding how businesses compounding drives investment returns, they overfit returns into a hotchpotch of factors and pretend to have explained the world. Unfortunately, “value” became one victim of this charade, leading to grotesque distortion of “value investing”.

My world starts and ends with an axiom: a stock is a part-ownership in a business. Next time you read a finance textbook, check if this axiom is ever referred to, let alone used as an input into theory. Nearly all of what’s discussed – CAPM, MPT, EMH, efficient frontier, Black-Scholes – exists with no reference to stock being a part interest in a business. Stock is just a squiggly line with no connection to real world. It’s therefore no surprise that “owning businesses” has no place in finance literature or lexicon. That’s left to fringe elements like that those two blokes whose only qualification is turning $ 10 million into $ 600 billion.

How can you spot a “business owner”

Way more investors claim to be business owners than are business owners. It just feels more respectable to claim to own great businesses for posterity than to admit to punting on any stonk that looks hot. We are also notoriously unreliable in our claims about how wonderful our businesses are. So, my preferred metric for spotting a business owner is actual holding period (or its inverse, turnover ratio). I view any investor with turnover ratio in the 20% ballpark or lower as a business owner. By way of reference, Lou Simpson or Terry Smith fall in this range. If an investor is, on average, owning stocks for over five years, it’s likely that there is selectivity about what to own. At the least, they’re likely to avoid crap as it’s hard to hold those for years. Once can also check on tangible business metrics across portfolio (return on capital, free cash flow), but it’s not uncommon to find good businesses held for short periods. Hold period is harder to fudge.

Does “owning businesses” deliver superior returns?

I don’t know. Depends.

If you find this disconcerting after all my sanctimonious gyan on superiority of owning businesses, it is by design. Practitioners know that investment strategies don’t work in the abstract. Any strategy can work. Whether is actually does is up to whoever is implementing it. It is up to a capable practitioner of that strategy to demonstrate superior results over decades using their version of that broad approach. In the real world, investment strategy cannot be separated from the people implementing them.

That said, I believe that owning safe and good businesses, purchased at sensible valuations, held for long, delivers satisfactory returns. Names I have mentioned earlier are some illustrations. Any good that we have directly experienced at Nalanda is a direct consequence of our business owner mindset.

However, aim of this essay isn’t to convince you of efficacy of this approach. It is to articulate this approach in some detail, and give it a label (that I hope sticks) to distinguish it from what is passed off as “value investing” in popular references. If there can be categories called value investors, growth investors and momentum investors, there can damn well be a category called “business owners”. To summarize what I said above, business owners approach investing with:

·       Indefinitely long timeframe

·       High bar on business

·       Rational, not cheap, entry valuation

·       Primary focus on business, not markets

·       Stock-price as occasional input

·       Allowing ample time for compounding to do its thing

Those who effectively practice the “business owner” approach to investing are reasonably likely to achieve satisfactory returns and sound sleep, with a sense of superiority as a bonus.