Editor’s note: Epsilon loves books on investing, and not just quant literature! Every month or so, we’ll post a review on a book that we found particularly compelling.  While this review is of an asset manager, there is no affiliation to the mentioned firm; only admiration and respect.

Ed Wachenheim’s Greenhaven Associates is one of the most under-publicized value-oriented investment firms.  According to his wonderful book Common Sense and Common Stocks, Wachenheim states that Greenhaven has annualized at nearly 19% net for about 29 years.  That’s a track record that should have Greenhaven in the same conversation as Baupost, Berkshire Hathaway, or Oaktree.  And yet the firm seems to operate on a lower register of visibility.

Unlike many famous value investors, Wachenheim’s strategy isn’t a unique strand of value investing.  He didn’t coin the moat concept like Buffett, the circle of competence like Munger, or the margin of safety per Klarman.  Yet, he seems to incorporate aspects of each with the sole goal of generating outsized returns.  I would characterize Wachenheim’s investment style akin to value-oriented catalytic investing.  He self-describes it as a focus on “undervalued securities of strong and growing companies that likely will appreciate sharply as a result of positive developments.”

The book highlights case studies of nearly a dozen Greenhaven investments which fit this mold.  What becomes clear across all of them is Wachenheim’s focus on adopting a contrarian perspective to drawing a 2 to 3-year fundamental valuation.  Wachenheim acknowledges that a variant perspective is often the key to unlocking alpha; or as Howard Marks says, “you must learn things others don’t, see things differently or do a better job of analyzing them.”

The question of course is how to do this, as contrarianism has many potential behavioral pitfalls.  In value-investing, we call them value traps.  Or to borrow from Marks, to be contrarian and wrong is probably worse than being consensus and right (negative alpha versus beta).  To unpack it, I’ll highlight some investor characteristics of Wachenheim as evinced by his own words.  These characteristics work synergistically, and it is likely the unique combination of each of them which helps unpack Wachenheim’s extraordinary success.

Patience

I probably run thousands of screens, but only a tiny fraction of 1 percent have resulted in a successful investment idea

Wachenheim details his daily process in the introduction, and highlights it in various case studies.  While it is a full schedule, it tends to be more deep thought compared to busy work.  More often than not, that deep thought leads to little tangible activity.  The sheer level of inactivity might drive others stir-crazy, but he firmly believes if the opportunity set doesn’t present lucrative options with margin of safety, one should not act out of impulse.  He highlights the beginning of 2014 as a period that was particularly challenging to act, after a torrential rally in domestic equities (2013) led to a dearth of value opportunities.

This is a common strain across value investors (especially in this cycle), which leads to abnormal cash accumulation for many of these managers.  However, Wachenheim believes in being fully (or nearly) invested in most market scenarios.  The two almost seem at odds with each other and must require a deft touch to balance.  Given the tailwind of historical equity market appreciation, it allows for his portfolio of superior businesses to compound growth while he searches for a lucrative opportunity to add to the portfolio.

In short, he won’t invest in a poor business that has the probability of short-term appreciation, because it provides negligible margin of safety, and it provides less optionality should there be a dearth of catalytic situations to replace a fully valued name.  Further, he plays to his strengths, knowing that market timing is extremely hard, and shorting profitably is even harder.  As he says, “there are risks to owning securities, but there are also risks in not owning securities that have favorable risk-reward profiles.”

Process Orientation

Because we believe that information reduces uncertainty, we try to gather as much information as possible

This dovetails synergistically with patience.  In each of the investment case studies laid out in the book, Wachenheim details the scrupulous effort to screen a name, to dig into its balance sheet, to understand base case sentiment, to soberly evaluate management, and to ultimately underwrite a thesis.

As an example, when Wachenheim models EPS 24 to 36 months out, he places a multiple within a band of reason based upon a 50-year market average.  He doesn’t reverse engineer a reason why this cycle deserves a higher or lower multiple, and he doesn’t bother with ornate macroeconomic indicators which deviate from his firm’s core competence.  As he says, “Many investors tend to project high growth rates far into the future without fully considering forces that eventually will lead to slower growth.”

You can equate this to understanding the base rate fallacy or the inside versus outside view, that behavioral finance thinkers like Kahneman and later, Mauboussin have discussed.  This likely means that a healthy amount of opportunities must be passed.  Nonetheless, staying true to his process is what has allowed the firm to flourish.  He specifically cites NIFTY 50 stocks in the early 70s which provides an eerie cautionary tale given our current environment.

Judgement

there is a large difference between knowledge and judgment

I believe that investors sometimes need to be open to new ideas that challenge previous convictions.  In the investment business, as in life, one becomes disadvantaged if one develops tunnel vision.

Sticking true to process requires not only patience, but correct judgment.  This refers to what I discussed earlier with contrarians falling prone to value traps.  The ability to be contrarian and yet be open-minded to new perspectives, to admitting failure, and to understanding probabilistic outcomes is an ever-rare trait.  It is one that Greenhaven has exhibited in its decorated past.

Wachenheim highlights the firm’s mistake in AIG during the lead-up to the financial crisis.  Many value-investors will anchor to losing positions by never questioning their original investment thesis.  In doing so, a stock moving against them tantalizes the manager to add to his or her position, like a siren’s call.  Wachenheim describes Greenhaven’s deliberate approach to realizing losers when they become apparent, and avoiding permanent loss of capital.  This doesn’t mean permanent loss in that single holding (which may cause a manager to hold onto a position with false pretense), but incorporates the opportunity cost of moving on to better risk/reward.

Intrinsic motivation

Settle was not part of my investing vocabulary and would not be in the future.  All my life I enjoyed the thrill of competing to win

Wachenheim describes the challenges in recent years of finding ripe opportunities to deploy meaningful capital, as the fund’s assets have grown substantially.  This is a common problem for successful asset managers which we call the paradox of diseconomies of scale.  Nonetheless, he highlights an adamant, almost hellbent, focus on maintaining return expectations.

This flies in contrast with the economic reality of a large fund whose unit economics can provide the owners large financial upside, irrespective of middling performance.  Fund managers, being schooled in calculated risk, will often dial down risk as they grow assets.  This of course is highly correlated to funds who’s motivation is extrinsic (wealth, status, prestige), rather than intrinsic.  As he says, “I aspire to build a ladder to the stars and climb on every single rung.” He still highlights the same aggressive position sizing, and the same meticulous process for his portfolio in 2014 versus 1994.  The market cap of the portfolio companies may have grown at Greenhaven, but the pursuit of excellence has not.

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