With so many investors all trying to beat the market, what separates a truly Great Investor from the pack? One major factor is that Great Investors know the territory that lies underneath the map.
Guy Spier is a Zurich-based investor and author of a book on investing entitled The Education of a Value Investor and is well known for bidding $650,100 with Mohnish Pabrai for a charity lunch with Warren Buffett in June 2007.
Guy says his investment theory comes down to zigging when all the others are zagging—and the ability to know the difference between the “map” and the “territory”.
Between the map and the territory
The “map”, he goes on to explain, shows data and other salient information about a company that on the surface appears to reveal what’s going on inside but, in reality, is covering up the true value and obscuring future prospects.
A firm’s quarterly report, for example, is a “map” created by the accountants who estimate sales and future earnings based on a number of assumptions, when, in fact, those assumptions often don’t pan out. To assess the actual value, Guy stresses the importance of looking more deeply into the “territory” for the degree of divergence between the two. For example, is a company posting revenue figures at the point when clients have actually bought or are they throwing out higher numbers that reflect only the intention of clients to buy? A great investor looks for that divergence and moves when the divergence swings in his favor.
Warren Buffett defines the moat.
Just as in days of old when plundering knights were thwarted by an open drawbridge over the moat surrounding the castle, attractive investments are those that have defensible characteristics.
Warren Buffett has been quoted many times about the moat which he explains somewhat as a tall bridge across a sea mass, where the only way you can drive a car from point A to point B in that area is over that bridge. A company that is protected in such a way that renders it not vulnerable to competition is becoming even more rare in the digital age. Buffett’s partner, Charlie Munger, has stated, “Moats are getting attacked in many, many different areas and whole corporations that were set up for a certain kind of information and economic infrastructure are having to adjust. Some will adjust and some won’t.”
With moats breaking down, the challenge to the investor is even greater, says Guy, and “the problems we face as investors is that those moats have become even more highly valued because people realize they’re even rarer than they were before.” Those fewer companies that are protected by a moat become even more valuable, leading in some cases to extreme over-evaluation.
What’s in Guy Spier’s wallet?
The question we always ask of our Great Investors is “what’s in your wallet?”
Guy answered that even though investing in smaller cap companies is a better place to be, it’s also more likely to be more vulnerable to changes in the competitive dynamics in a way that larger companies aren’t. “This has created a bias in me to want to be and feel safer in larger companies. One of the best places to protect yourself from inflation, if you’re an investor, is to be in financial stocks because their earnings tend to rise with inflation, which is not necessarily the case with industrial stocks. That was at least half of my reason for getting into these American large cap financials, which would be a very good place to be in an inflationary environment. Once expectations of rising inflation start to kick in, these stocks should go up.”
Guy also looks for under-valued companies with a moat, and the automobile industry is a prime example, for several reasons. One is the perception with the general public that self-driving cars are coming to a car lot near you, putting the old-fashioned companies out of business. They are coming, says Guy, but not any time soon and, meanwhile, there is a great deal of time for the car companies to continue making a lot of money selling those traditional models. Another reason is that the investing public still harbors some antagonism against the big car manufacturers for the bailouts granted them back in 2009, causing depressed evaluations of many of these companies.
Steve Pomeranz: My guest is Guy Spier. Guy lives in Zurich, Switzerland. He’s the author of the book, The Education of the Value Investor, and he’s well known for winning the Charity Lunch with Mohnish Pabrai, where he sat down with Warren Buffett in June of 2007. Speaking of Mohnish, he was also recently a part of our Great Investor Series a few weeks ago, which you can find on our home page under World’s Greatest Investor Section at Stevepomeranz.com, that’s P-O-M-E-R-A-N-Z, Steve pomeranz.com. Guy joins us from London today. Welcome back to the show, Guy.
Guy Spier: Steve, it’s a pleasure to be on your show and it’s a pleasure to join you whether in the United States, London, or Zurich.
Steve Pomeranz: Well, we’re airing here from Boca Raton, Florida, so we’re kind of half a world away, but we’ve got a lot of wonderful concepts that we have in common here we can talk about. Let’s start. My goal here is to try to parse out the thinking of great investors and what separates someone from the pack, from all of the other investors out there that are really trying to do the same thing. Now, in a recent interview, you spoke about valuing companies and trying to understand what companies are all about, and one statement that you made that was really quite fascinating is you said, “The map is not the territory.” Can you explain that to us?
Guy Spier: You know, it’s just an idea that I learned a long time ago and it’s not an original idea for me but I’ve been thinking about it a lot recently. What enables investors to beat the market is this idea of zigging when everybody else is zagging. People do that when they have a different view of what is going on and when they have a more accurate view of what is going on. It came to the realization for me, with the recent election that surprised so many people, that a lot of us inhabit a world in which we have a map, a representation of what is going on but that representation doesn’t represent the reality of what’s going on. So just to take the election analogy: we were focused, all of us, on the polls, but the polls did not represent what the electorate was about to do.
It’s the same with companies. We can look at their financial statements; we can look at their earnings reports. We can look at a whole bunch of data that those companies produce about what’s going on, but that is a map, it’s not the underlying reality of what the company’s actually going to do. I think that the people who succeed in investing, one of the many attributes that they need to have is this ability to distinguish between the two and to see when there’s a sharp divergence, when the map of the world says one thing and the common map that people have is say, Hillary’s up in the polls, and the underlying reality is something very, very different. Just to take it into the investing world, one example would be with the evaluation of banks, pre-and-post 2009. Prior to 2009, increasing leverage was not enough. The banks were safe and they were taking, they were careful in the risks that they were taking. Then, post-2009, too much capital was not enough. It didn’t matter how much capital the banks had from some people’s perspective, they needed more and more and more. That is a map of how much the capital a bank needs, which could diverge very much from what is actually underlying their balance sheets. In an example, and sorry to make a long point of this.
Steve Pomeranz: Go ahead.
Guy Spier: In an environment of improving housing prices in the United States, post-2009, which would lead to an improvement in the banks’ capital ratios just through the collateral of the loans that they’re making, the regulators were telling them something that was completely opposite to that. The regulators had a different map to the reality, which created an opportunity I would argue.
Steve Pomeranz: Well, there is always this dichotomy between, let’s use banks as an example, the actuality of doing business in a local economy and then these national banks, in a national economy, and then the perception of the government to try to protect the depositor and to protect the banking system, and the desire to regulate to some degree. Now, banks have been regulated for decades and decades and yet there is a point that the banks, at some point, will over-regulate and at some point they may under-regulate. I think what you’re saying right now is that with the terrible crisis of 2008, where the map, everybody’s map was wrong, the banks, the Fed. Everybody misunderstood what was going on. Now, the pendulum has swung completely the other way, but getting to your point about the map.
When I look at a company’s annual report or I look at the quarterly report and I see what the accountants are saying is the true picture of the inside goings on of a company. I think I’m seeing reality. Am I, or am I just seeing a map?
Guy Spier: Yeah. No, absolutely, and so that’s the company’s accounts are a map, so that we can take, we can start by acknowledging there are so many numbers in the company’s accounts which are estimates. They cannot, the accountants, and what’s important is the management itself don’t really know. They have to estimate. One simple example with a line that’s very hard to manipulate is the revenue line. Any company that has sales at dealerships, for example, have to make assumptions about when do they recognize a sale? Is the sale recognized when the dealer pays for the car, when the dealer sells the car off the lot, when the client pays? All of those will affect the revenue numbers for the year, so we see a revenue number based on assumptions that were made by the accountants, perhaps the management as well, that we don’t know actually know if those were the actual sales. We’d have to dig quite a lot deeper to find out if that was the case.
Steve Pomeranz: Guy, how does an investor who’s trying to become a great investor, deal with all of these inherent built-in challenges?
Guy Spier: Yes. Here I think it becomes a little easier—if your listeners are feeling overwhelmed by this idea—it becomes easier because, actually, we’re looking for just large movement. One of the things I try to do, when I look at a corporate account is the first rule, it’s the map. It’s not the territory but now I’m trying to see, does the map understate or overstate the territory? Is this, am I getting clues from these accounts that suggest that this management team and their accountants are trying very hard to show less value than what is actually there or the other way around. We would see that through, for example, their choices in depreciation policy. Are they depreciating their assets quickly, which would imply that they’re trying to be conservative in what they show or are they trying to depreciate their assets very, very slowly. In their acknowledgment of revenues, are they taking, are they acknowledging revenues at the very last moment when the client has paid cash or are they acknowledging their revenues when the client has just indicated the intention to buy? What we’re looking for is divergence in which the divergence is in our favor.
Steve Pomeranz: I see. One of the key characteristics of great investing is this idea of finding companies that have built up what is called a moat around them. Describe what this moat means, briefly.
Guy Spier: The best example, the best moat that I could describe to your listeners is not coming from me. It’s one described by Warren Buffett which would be a tall bridge across a sea mass, where that is the only way that you can drive a car from point A to point B in that area. If you can control that toll bridge, you can charge any price and it doesn’t matter what you do so long as the bridge is up. That is a fantastic model. That is a business where the client has no alternative and there’s no competition around. That is your bridge, if you like.
Steve Pomeranz: All right.
Guy Spier: We’re looking for businesses that have those kinds of defensible characteristics. Just to give another example, imagine a bunch of fishermen going out to sea to fish. Any fisherman is going to have to just work harder than the next guy to get more fish. There’s no moat at all. He’s just got to work, get up earlier, get to the fishing grounds sooner, have better nets. There’s no moat there. There’s no sitting back and relaxing, so in a certain sense, we’re looking for moats because, when you have a moat, you can sit back and relax and the profits come in, if you like. Those are the places where we want to be as investors, especially given that we don’t control the company ourselves, the management may be good or bad. There are all sorts of other factors that come into it.
Steve Pomeranz: Now, the issue that you brought up in a previous interview was that with the digital economy, these moats are starting to break down and these toll roads are starting to be circumvented in other ways. Is it becoming more difficult now to find companies with strong economic protections around them?
Guy Spier: Yes. This is not just coming from me. Charlie Munger is one of the comments that sticks with me very clearly from this, the most recent Berkshire Hathaway annual meeting, where he just said, “Look, moats are getting attacked in many, many different areas and whole corporations that were set up for a certain kind of information infrastructure and economic infrastructure are having to adjust, and some will adjust and some won’t.” That becomes very hard for us as outside, passive minority investors who are looking for a safe place to put our money, other than government bonds. It makes our job an awful lot harder and what’s worth adding, Steve, is that when there are clear moats, like the idea of the toll bridge, that is a moat that is not going to be taken away by the new technologies that have come around in the last ten years.
The problems that I face or that we face as investors are that those moats have become even more highly valued because people realize that they’re even rarer than they were before, so I know that we were mentioning two businesses in the United States. One is Mohawk, which makes copper coverings—that is a phenomenal moat. It’s a very expensive moat. It will never be made obsolete by the Internet or by the Cloud or by the iPhone because, no matter what kind of technology we have, we’re still going to want to live in homes that have floor coverings of one kind or another.
Steve Pomeranz: Let me break in for a moment. Let’s use this Mohawk as an example. You’re saying that the price being very high, as the market values this moat beyond other kinds of companies that don’t have it, makes it a difficult investment because the future value is diminished if you’re paying so much for the company. A good period of opportunity would be, if there was a big general market sell off, and the structure of the company didn’t change. The moat stayed in place but the price was brought down by this general downturn in the economy. That might be a period of opportunity and that discrepancy, perhaps, between the map, which is a bad market, a bad economy, and the reality which is, “Hey, here’s a company that has a moat.”
Guy Spier: Steve, I could not have put it better. I have nothing to add. That is absolutely right.
Steve Pomeranz: Guy, we have a section in our Great Investors Series which says, which asks the question, “What’s in their wallet,” talking about the great investors. I know that you have many dollars under asset management and I’d like to know a little bit about what’s in your wallet. I’m not going to ask for specific investments. We never do, but upon reading about you and what you’re currently doing, I noticed that you’re very much in the large-cap area. You’re very much in financials these days. You’ve got some automotive. Tell us a little bit about that. We don’t have that much time. Tell us if that’s different from what you would normally invest in due to current economic conditions.
Guy Spier: You know, I’m agnostic across market cap sizes and, in general, we know that investing in smaller cap companies is a better place to be. The issue is that when you have a smaller cap company, it’s even more likely or it can be even more vulnerable to changes in the competitive dynamics in a way that larger companies aren’t. I think that that partly created a bias in me to want to be and feel safer in larger companies. I also, and I was completed wrong-footed on this, I saw the massive increase in the Fed’s balance sheet and in Central Bank’s balance sheets around the world and I said, “This has got to lead to inflation. It’s got to lead into inflation pretty soon and, therefore, I want to be inflation protected.” One of the best places to protect yourself from inflation, if you’re an investor, is to be in financial stocks because their earnings tend to rise with inflation, which is not necessarily the case with industrial stocks, so that was kind of at least half of my reason for getting into these American large cap financials, which would be a very good place to be in an inflationary environment, and as expectations of inflation have kicked in, those stocks have had a move.
The other place was, as you described, you want to be in a place where people don’t give the moat the value that it deserves and straight after 2009, the banks were hated. Because they were hated, their moats were given a lower value than I think they deserved, but it is also worth saying that their moats are under attack, and we don’t know the final outcome of all the innovation that’s going on in Finntech and how it will impact those moats. If you pushed me, I would say their moats are shrinking but their moats were still vastly undervalued by the market, who just hated them. I guess that’s sort of my rationale for some of those large-cap financial institutions that I have in my portfolio.
To talk about automobiles for a second, I think, and again it’s this sort of what does the public perceive versus what is the reality. The public, the investing public, perceives that we’re going to be in self-driving cars tomorrow, not quite that but pretty soon. There’s an enormous amount of excitement around it. I think that the reality is that mobility is going to change a lot more slowly. There are all sorts of reasons why self-driving cars will take a long time to get implemented. Meanwhile, the established automobile makers have an awfully important role to play and can make very good money doing so. It’s not that the automobile manufacturers are necessarily the best businesses in the world, but they’re being grossly undervalued by an investing public that hates the bailouts that they received during the financial crisis, and also believes that they’re going out of business. I’m saying, “Well, that’s just not the case.” It’s not that bad, if you like.
Steve Pomeranz: Interesting talk with Guy Spier. Guy lives in Zurich, Switzerland. He’s author of the book, The Education of the Value Investor. He’s been on our show a number of times, and you can see why I have him back. He always offers insightful information that’s easy to understand so the rest of us can get our investing just right. To find out more about Guy Spier and to hear this interview again, don’t forget to join the conversation at Stevepomeranz.com, that’s P-O-M-E-R-A-N-Z, Stevepomeranz.com. Hey Guy, thank you so much for joining us from London today.
Guy Spier: Steve, I have to tell you that I’ve learned in this interview yet again why you have such a popular show. You’re an incredible educator and you make ideas that sometimes seem difficult, very simple for your listeners and you help me to explain those ideas, so thank you for doing that.
Steve Pomeranz: Thank you very much, Guy Spier.