A Value Investor Reveals his Secrets - An Interview With John Huber

John Huber, the Managing Member and Portfolio Manager of Saber Capital Management, is at the forefront of a new generation of value investors compounding their way through the bull market.   Huber has been running Saber for just over 5 years, and has amassed investment and a significant following as a thought leader in value investing.   He shares his insights at the  acclaimed blog Base Hit Investing, where he serves as editor.  Prior to founding Saber, Huber spent the better part of a decade investing in distressed and undervalued real estate, particularly after the burst of the housing bubble.

SumZero sat down with Huber to discuss value investing, his investment strategy, and the state of the market.

Luke Schiefelbein: What was your path to becoming a value investor?

John Huber: I’ve always loved investing. My father’s profession was engineering, but he was an avid investor in stocks, and by extension I became interested in markets pretty early. But I came to the world of investment management unconventionally. I began my career in the real estate business. I spent about ten years doing a variety of brokerage, management and investment activities. I established a few small real estate investment partnerships for family members and friends, and our main objective was acquiring undervalued or mismanaged income-producing properties.

However, I’ve always been interested in stocks. I realized early on that the stock market offered opportunities to acquire stakes in so many good businesses that could earn rates of return on their owners’ capital that far exceeded the return on capital I could earn from real estate investing. Plus, the passive nature of investing in good businesses that could compound over time was always an attractive concept in my view. I like the businesses that do the work for me!

About twelve years ago, I began more closely studying the work of Warren Buffett. Like many investors, the simple logic of value investing really resonated with me right from the start.

Schiefelbein: How did you come to launch Saber, what have you learnt, and what advice do you have for emerging managers?

When I began studying Buffett’s letters and biographies, I set a goal of establishing a partnership that was similar to the structure that Buffett set up in the 1950’s. After the better part of a decade, I was able to build up enough capital seed my investment firm.

Saber Capital Management was set up as a way for outside investors to invest alongside me. Saber runs separate managed accounts, so clients get the transparency and liquidity of their own brokerage account.

I think investing is a never-ending learning process, but one thing I’ve learned since starting my firm is how much the investment community focuses on the short-term (despite what most people say). I’ve learned that in today’s fast-moving world where information is a commodity, one way to gain a true edge is by being able to think about what a business will look like in 3 or 4 years, as opposed to 3 or 4 quarters. I’ve also observed that while many people say this general statement, few are set up to actually act this way.

The speed and breadth of information – which I think has shortened time horizons across the board and created an investing public that is generally much too impatient – has actually increased the advantage for those who can afford to sit quietly in a room and think about what a business will look like five years down the road.

Schiefelbein: What would you say the key points of your investment philosophy are?  How did you arrive at these?

Huber: Saber’s strategy is very simply to make meaningful investments in good companies when their stocks are undervalued.

This is obviously what most investors are trying to do, and so it begs the question: how do you make this strategy work?

I think the best way to execute this approach is to focus first on reducing unforced errors. And in my experience, the way to reduce unforced errors is to focus on the companies that you confidently believe will be doing better in the future than they are doing now.

My approach can be summed up by what Buffett said in his 1996 letter:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.

Over time, you will find only a few companies that meet these standards -- so when you see one that qualifies, you should buy a meaningful amount of stock...Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

My investment firm’s strategy is centered around the idea that companies can be put in one of two main buckets: those companies who will be more valuable in five years or so, and those who will be worth less. I try to stay focused on the first bucket - those companies that will have a higher intrinsic value. If that value is marching upward over time, it becomes a tailwind for me rather than a headwind. Another way of saying this is that my margin of safety widens over time.

I think it’s easier to minimize mistakes by sticking to the first bucket. It’s also easier to locate value. I’ve also noticed that many investors underestimate the value of good businesses, and often overestimate the value of bad businesses. In the latter case, investors sometimes project a slow and steady rate of decline. Sometimes, they assume the risks - even widely acknowledged risks – are far enough into the future that they won’t affect the investment during their holding period. In reality, mediocre companies can see their fundamentals deteriorate slowly, and then all of a sudden.

For example, Foot Locker still has a value of around $4.5 billion, even after a 60% decline in its stock price. The risk to the business is significant for a number of reasons. Fewer customers are visiting malls, and more significantly, brands like Nike are rapidly expanding their sales directly to customers, which reduces the value of Foot Locker’s reason for existence. A middleman adds value when he acts as a source of customers for suppliers and/or a source of product for customers. When the suppliers and customers can easily find each other on their own, the middleman has no purpose.

Foot Locker’s markup on any given product is no longer justified if it exceeds the cost of Nike selling it directly to customers. Foot Locker still might be adding incremental volume for some brands, but to the extent that the biggest suppliers can cut out their retail partners without a negative long-term impact to volume, then Foot Locker’s overall value proposition will be seriously impaired. Instead of adding value to each transaction by creating a sale that wouldn’t have occurred without them, they are now operating on borrowed time - extracting value from each sale that could have occurred without them.

But the company’s balance sheet and free cash flow is adequate enough that these risks won’t likely come to fruition over the next couple years, and with the stock trading at a very low multiple of cash flow, it appears cheap. But the value of that business, at least in my view, is slowly eroding. And in business, slow erosion can give way to a landslide without much warning. It is possible to buy this stock and sell it at a profit after a short period, but I think if we look back in five years, we are unlikely to see a situation where Foot Locker is a much more valuable enterprise than it is now.

To be sure, there are lots of opportunities to make money in the stock market from investing in the “second bucket”, but that requires a more critical focus on timing because as time moves forward, any gap between price and value at the time of purchase is slowly eroding as the intrinsic value declines. In short, I prefer sticking to good businesses. There is a lot of complexity in investing these days, but investors that have the ability to execute on a simple philosophy like buying attractively priced stocks of good businesses is still the best way to invest over time.

Schiefelbein: Would you walk us through your take on the current state of active management and value investing?

Huber: I think for the vast majority of investors, the best investment is the simplest one – an S&P 500 index fund. I know this has become popular lately with Buffett touting the benefits of passive investing, but I do believe that the vast majority of investment managers will not outperform the market over time after accounting for fees (and especially after accounting for taxes).

I think the reason for the poor performance of active managers is twofold: one, they hold too many stocks. It’s almost impossible to beat the market over the long-run if you own 20 stocks or more. There are managers that have done so, but it’s very rare. And most professional managers in both mutual funds and hedge funds own well over 20 stocks. There is very little incremental benefit from diversification for each new position over and above 7 or 8 stocks. So there are very few reasons to own much more than 8 or 10 stocks, but because of mindsets that are ingrained in the way institutional money managers behave, old habits will die hard.

Human nature doesn’t change. Our greed and fear, our focus on short-term thinking, our lack of patience, and more specifically, the pre-conditioning that so many of us have had regarding diversification and portfolio management will make it likely that active management, in general, will continue to produce poor results relative to the passive index fund.

All of this said, I obviously manage a portfolio with the intention of beating the market, as do many other investors like me. We all think that we’ll be – as Charlie Munger says – the 10% that make up the top 10%! (We try to ignore the fact that 90% will make up the bottom 90%).

I do think there will always be some active managers that will do better than the average. It is not luck. There will be some in this game that succeed over the long run. Warren Buffett himself elected to choose two such managers who he thought would outperform the index fund that he has championed so much in recent years.

So I think that it’s possible to beat the market if you have the right approach and the right discipline, but it’s not easy, and for many, an index fund will lead to a very successful result over time.

Schiefelbein: What are your key takeaways from the teachings of the value investing greats?  What principle(s) have been the most important to your success as an investor?

Huber: There are a number of key takeaways that I’ve learned from others that have become central to my investment approach, but two are worth highlighting.

The first is how important it is to focus on quality. As I said earlier, I’ve always loved the idea of a business that can do the work for you – meaning one that can compound its value over time. This means a business that has some sort of advantage over its competitors that allows it to earn consistently high returns on the capital. A good business earns high returns on the capital that investors funded it with, but a great business can take those earnings and reinvest them back into the business at similar high rates of return. A business in the former category can be a great investment if management allocates the free cash flow well (either through dividends, well-timed buybacks, or debt reduction), but a business in the latter category is ideal, as that is the business that compound its earning power over time, creating lots of value for owners in the process.

I’ve learned to focus more and more of my time on identifying the quality businesses, the ones that will be doing more business and be intrinsically worth more in the future than they are now. This is such an obvious concept, but I’ve learned that nearly all of my investment mistakes came not from overpaying for good businesses, but from paying what I thought was a cheap price for a mediocre business. So I try to reduce unforced errors by just eliminating these options from my list of possible investment opportunities.

The second major tenet of investment philosophy that is worth repeating is the importance of patience. This is another topic that gets a lot of lip service, but rarely seems to be practiced. I’ve become more and more convinced of the merit behind the concept that I think Jim Rogers summarizes best when he says: “I just wait until there is money lying in the corner, and then I walk over and pick it up.” I am a big believer that any investor might have one or two great ideas at a time, but other mediocre ideas can end up diluting those great ideas. Obviously, some diversification is necessary, but I am of the firm belief that the only way to produce great results over long periods of time is to sit patiently, pass on all the average or even moderately good ideas, and only invest when there is something really obvious.

As Charlie Munger has often said (as well as demonstrated throughout his career), there is a lot of sense in making very few bets, and then betting big when a really great idea comes along.

Schiefelbein: What do you think is most misunderstood in the market today?  What’s your most contrarian view on the state of the market? Any sectors or names in particular?

Huber: I don’t really have a view on the market. I don’t think it’s overly expensive, as many seem to think, but I really don’t spend much time trying to figure out the market’s valuation. In general, I try to focus all of my attention on thinking about the prospects of individual businesses. While there certainly will be plenty of bear markets and economic downturns in the coming decades, my overarching thesis is that if you invest in the right businesses, you’ll do well over time.

Regarding a contrarian view: I do think some of the best companies that are very popular today will still be the best companies tomorrow. This is probably a consensus view given the valuations of some of these stocks, but it might be contrarian relative to most value investors. Also, this is not a view of their stock prices, it is just a view I have regarding the quality of some of these companies. The top five largest companies in the US - Apple, Google, Microsoft, Amazon, and Facebook - collectively earned over $100 billion of free cash flow in the last year on just $50 billion of invested capital. They earned this cash flow despite spending over $60 billion on R&D and $45 billion on capital expenditures. Given their dominating lead in their respective core businesses, their incredible profitability, and their willingness to shell out massive sums of money defending their positions, I think they will be tough to dethrone.

I think the great investments of tomorrow will come from companies that have some of the common characteristics of these five great businesses: things such as strong network effects, great products, and economies of scale. But probably the most important common denominator (and one that I look for in new investments) is the focus on providing a product or service that the customer thinks is great. Businesses that are led by long-term oriented leaders who focus on what their customers want and have the flexibility and willingness to adapt to changing customer demands (even at the expense of short-term profit) have the best chance at creating high returns for shareholders over time.

Schiefelbein: Where do you see the most value in the market today? Any sectors or names in particular?

Huber: I try to focus on individual companies, and while sometimes there might be value in a sector (banks in the early to middle part of last year might be one example), I rarely have any useful opinion on broad industry valuations. In terms of specific investments, other than two small arbitrage situations, I have not made any investments yet in 2017. One of the last stocks I bought was Tencent (TCEHY).

I did a presentation earlier this year on Tencent, and the following is a short summary from one of my investor letters I wrote on Tencent, which I still think has a lot of value at current prices:

Tencent is a Chinese internet holding company with one of the most powerful network effects in the world. The company operates in numerous businesses that are well-positioned to benefit from the huge growth in China’s middle class. Tencent’s properties consist of video game publishing, music and video subscriptions, ecommerce, mobile payments, cloud computing, and online advertising.

But the company’s crown jewel is WeChat, which is a mobile app that is unlike any application that exists in the West. WeChat dominates China, and its 1 billion users spend more time on WeChat than US users spend on Facebook and Instagram combined. And it’s far from just a messaging and social media application. WeChat is used for just about everything in China including messaging, work communication, calls, social networking, online shopping, paying bills, transferring money, and much more. Incredibly, one-third of WeChat users spend more than 4 hours a day inside the WeChat universe.

Despite its strong position, WeChat is an asset that has barely been monetized yet. It has enormous potential to show much more ad volume in the future, and it is in prime position to capitalize on numerous fast-growing industries like mobile advertising, online shopping, and mobile payments.

Tencent has a truly exceptional collection of businesses. With its 30% net profit margins, Tencent turns a good chunk of its fast-growing revenue into free cash flow for the company to reinvest. Despite a vast untapped potential in some of those markets referenced above, the company is already highly profitable, producing huge returns on capital, and growing its already sizable $10 billion of free cash flow at over 40% per year.

Growth obviously will slow down at some point, but given its unique competitive position and the huge size of the markets it operates in, there is likely a very long runway ahead for the company, despite already being one of the most valuable companies in China.

The stock has had quite a run this year, and like any stock, I have no idea where it goes in the next year, but I think over a long period of time Tencent shares will likely compound at a rate that roughly mirrors the growth of the company’s intrinsic value – and I think this rate of compounding will be quite high for a number of years to come.

Schiefelbein: What’s the biggest investment decision you would have made differently if you knew what you knew now? [from a process perspective]

Huber: I’ve made a number of investment decisions that I would reverse if I could go back in time, but one general mistake is something I referenced earlier: I’ve often been enticed by what looks like a cheap valuation for a business of mediocre quality. There are two problems I’ve noticed when it comes to cheap stocks. One is that the stock has to be sold in a relatively short amount of time, as these types of companies are often slowly getting worse (their earning power is slowly declining, which means that time is against you – the margin of safety you had when you bought the stock is slowly eroding). This results in a second problem, which is that even if you are able to sell the stock at a profit, you have to find another investment to replace it with.

Finding great investment ideas is hard work, and great ideas are rare. So for me, an investment approach that requires a lot of decision making is more error-prone. And I think too many decisions dilute the results of your best ideas – the ideas that you had the most conviction on initially.

There are many ways to skin the investing cat, and some investors have built a great record by investing in special situations or by buying cheap stocks of average companies. But I’ve never been comfortable with it, and haven’t proven to be much good at it either.  I think one of the keys to investing is to understand your own personality, and to be honest with yourself about your own strengths and weaknesses. For me, I’ve learned that I can reduce a lot of mistakes by just avoiding companies that are mediocre, regardless of how attractive their stock price appears to be.

This runs counter to what a lot of value investors would think, but it is an approach that works better for me personally, and fits with how I like to work. I think that while this approach sacrifices certain investment opportunities, it also reduces a lot of mistakes. I will still make plenty of mistakes, but I think my batting average and slugging percentage increases by sticking with this approach to patiently waiting for attractive prices on good businesses. In the meantime, I spend a lot of time reading, researching and learning – trying to always expand my list of possible investment opportunities.