Src : http://manualofideas.com/members/pmr201004_allan_mecham_interview.pdf
MOI: Let’s switch gears and discuss the investment philosophy behind your track record. Help us understand the kind of investor you are, perhaps by highlighting a couple of examples of companies you have invested in or decided to pass up. What are the key criteria you employ when making an investment decision?
Mecham: It’s really quite simple. I need to understand the business like an owner. The firm needs to have staying power; I want to be confident about the general nature of the business and industry landscape on a longer term basis. I’m big on track records, and generally stay away from unproven companies with short operating histories. I also believe a heavy dose of humility and intellectual honesty is important when looking at potential ideas.
There’s a strong undercurrent constantly percolating to buy something — it’s fun, exciting and feels like that’s what you’re getting paid for. This makes it easy to trick yourself into thinking you understand something well enough when you don’t, especially if you are in the investment derby of producing quarterly and yearly returns! When looking at ideas, I have a Richard Feynman quote tattooed in the back of my brain: “Don’t fool yourself, and remember you are the easiest person to fool.”
Ultimately, what tends to cover all the bases is the mentality of buying the business outright and retaining management. Critical to implementing this approach is, again, having a compatible investor base. “Whose bread I eat his song I sing”… An owner’s mentality forces you to think hard about the important variables and makes you think long term, as opposed to in quarterly increments. In fact, I think very little about quarterly earnings and more about the barriers to entry, competitive landscape/threats, the ongoing capital needs and overall economics, and most importantly, the durability of the business.
Over the years I’ve come to realize the importance of management, so we look hard at the people running the business as well. And, obviously, the price needs to make sense.
The criteria bar is set high; we really try to avoid mediocre situations where restlessness causes you to relax investment standards in one area or another. We also stress test the business under various economic scenarios and look to a normalized earnings power. We passed up many seemingly attractive ideas over the years as we would ask, “What happens under 7-10% unemployment (when unemployment was in the 4-5% range) and 6-8% interest rates?” And we would ask, “Is the business overly reliant on loose credit extension and frivolous spending?” Many names didn’t hold up under these stress test scenarios, so we passed. We bought AutoZone [AZO] a few years back as it held up under various adverse macro scenarios, and in fact performed exceptionally well throughout the Great Recession. I constantly try and guard against investing in situations where the intrinsic value of the business is seriously impaired under adverse macro conditions. We prefer cockroach-like businesses — very hardy and almost impossible to kill!
MOI: You have said that “analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers.” Can you give us an example of how this tendency occasionally creates an attractive investment opportunity for the rest of us?
Mecham: Sure. In a generic form, I think there are many instances where a company hits a speed bump and reports ugly “numbers,” yet the long-term earnings power and franchise value remain intact. Oftentimes a key cog of value is in a form that’s difficult to measure — brands, mindshare/loyal customers, exclusive distribution rights, locations, management, etc. Sometimes it’s the location of assets that can be hugely valuable. Waste Management [WM] and USG [USG] both have assets that are uniquely located and almost impossible to duplicate, which provides a low-cost advantage in certain geographies.Reputation is valuable in business, though hard to measure in numerical form. Reputation throughout the value chain can be a strong source of value and competitive advantage. I think Berkshire Hathaway’s reputation is very valuable in a variety of areas, most obviously in acquiring other companies.
The various cogs of value differ between companies, but many times the key variable(s) are difficult to capture in a spreadsheet model and/or are not given the weight they deserve.
MOI: You wrote recently that your “appetite is paltry for risky investments, almost regardless of potential reward. Theoretically this stance is illogical as ‘pot odds’ can dictate taking a ‘flyer’ — where the potential payoff compensates for the chance of loss — however these situations are difficult to handicap, and can entice one to skew probabilities and payoffs.” You put your finger on an interesting phenomenon: Many investors systematically overestimate the probability and magnitude of favorable outcomes. We recall the countless times we have read investment write-ups that peg the expected return at 50-100%, yet virtually no investor manages to achieve even 20+% performance over any meaningful period of time. What kinds of situations do you consider too risky or, more appropriately, too susceptible to the skewing of probabilities and payoffs?
Mecham: I’m not sure I can categorize the situations… Any time you are paying a price today that’s dependent on heroics tomorrow — fantastic growth far into the future, favorable macro environment, R&D breakthroughs, patent approval, synergies/restructurings, dramatic margin improvements, large payoff from capex, etc. — you run the risk of inviting pesky over-optimism (psychologists have shown overconfidence tends to infect most of us), which can result in skewed probabilities and payoffs. We want to see a return today and not base our thesis on optimistic projections about the future. Many earlystage companies with short track records fall into the “too risky” category for us. nvestments based on projections that are disconnected from any historical record make us leery. Investments dependent upon a continued frothy macro environment (housing, loose credit) are prone to over-optimism as well — how many housing-related/consumer credit companies were trading at 6x multiples growing 15%+ inviting IV estimates 5x the current quote?
Many times I think it can be a situation where you just don’t understand the business well enough and the bullish thesis is the nudge that sedates the lingering risks you don’t fully grasp. It’s important to keep the litany of subconscious biases in mind when investing. Charlie Munger talks about using a two-track analysis when looking at ideas. I think that’s an extremely valuable concept to implement when looking at investment opportunities. You have to understand the nature and facts governing the business/idea and, equally important, you need to understand the subconscious biases driving your decision making — you need to understand the business, but you also need to understand yourself!
MOI: How do you generate investment ideas?
Mecham: Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know.
That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.
MOI: You have stated that your “old fashioned style embraces humble skepticism and is wary of most modern risk management tools and ideas.” Give us a glimpse into how you construct and manage your portfolio — and how you protect it from the kind of upheaval the markets experienced in late 2008 and early 2009.
Mecham: There’s no substitute for diligence and critical thinking. It’s ingrained in my DNA to think about the downside before any potential upside. We try and stick with companies we understand, where we have a high degree of confidence in the staying power of the firm. We spend considerable effort thinking critically about competitive threats (Porter’s five forces, etc). We really stress long-term staying power and management teams with proven track records that are focused on building long-term value. Then we always “stress test” the thesis against difficult economic environments. As I said earlier, we try and guard against investing in businesses reliant on some type of macro tailwind.
If you have the above, combined with the freedom to take the long view, managing the portfolio is based more on intellectual honesty and common sense rather than any sophisticated “tools,” “models,” or “formulas.” If the financial crisis taught nothing else, it showed how elegant financial models that calculate risk to decimal point precision act like a sedative towards critical thinking and even common sense — “risk models” were like the bell that told the brain it was time for recess! I also think risk management by groups can have similar effects. Being diligent, humble and thinking independently are key ingredients to solid risk management.
MOI: What is the single biggest mistake that keeps investors from reaching their goals?
Mecham: Patience, discipline and intellectual honesty are the main factors in my opinion. Most investors are their own worst enemies — buying and selling too often, ignoring the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity
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