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POSITION PAPER ON INVESTING Businesses that lose money are speculative.

Investment v. Speculative businesses become less valuable over time due to asset reductions, increased Most people think an is anything debt levels, or diluted ownership stakes. that might make you money. Take that And they can go out of business. These are concept plus add a critical feature—cash real costs. flow—and you have the right idea. If an asset has a , it is an investment. It Nonetheless, many ‘cash-burning’ generates businesses pay something PAPER ON VALUE INVESTING nice capital- tangible of value. raising fees and P. 1: Investment v. Speculation are popular on By this measure, Wall Street. only a few asset P. 2-4: Truth About Investing: The Right They are touted categories count Temperament, Investment Mistakes, The Power of for their as investment. Compounding, and The Paradox of Investing ‘obviously’ These include compelling P. 5-6: Definition of Value Investing: Distinguishing money-making Characteristics of a Value , and The prospects. businesses, Meaning of Prices income producing Anxiety and real estate and P. 6-7: How Value Investing Works, Strategy loss shadows investment grade Investing and speculation. To bonds. The be successful at income they make P. 7: The Case for Value Investing Right Now speculating, not for owners can be P. 8-10: ‘Predictive’ Behaviors & Factors, Owning only do you taken and spent, Individual Businesses, and ‘Skin-in-the-game’ need to predict or reinvested and the future, you allowed to grow. must correctly predict how also others will react might make you money; however, unlike to that future. That amounts to pure , they do not produce cash. gambling and a ‘mission-impossible’ for Worse, there is a cost to owning them. nearly everyone. Expenses associated with art, commodities, precious metals and raw land include storage On the other hand, investing is a gamble—in fees, insurance premiums and taxes. the run. Less than 10% of market price movements in any given year is

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a rational response to changing company underperform the actual results of those fortunes. Sentiment is responsible for the managers, which they consistently do by a other 90%. large .

In the run, investing is not gambling. So, here is the truth. Your own Investments have an underlying value based temperament is the greatest factor in on the cash being produced. Investment achieving a successful financial life. You prices will reflect how well that value may be highly intelligent and a star in your performs over time. chosen profession, but unless you have the right temperament, those attributes are of no Distinguishing help. That is between investment why plenty of and speculation is the smart and first step in our “In the long run, investing is not gambling. successful investment process. Investments have an underlying value based on people are We think, does the the cash being produced. Investment prices will terrible asset pay me, or do I . reflect how well that value performs over time.” have to pay it? It is a mindset that reduces anxiety, and increases the likelihood of making and keeping money over the long The Right Temperament run. Possessing the right temperament is The Truth About Investing difficult. It runs counter to human nature. For example, when faced with perceived danger we are hard-wired to run away from Investing is not a hard science, despite it. Our instinct is not to stop and engage in attempts over the past century to make it analysis. This instinct served us well when seem like one. The current use of artificial wild animals roamed the earth, but it is often intelligence is an example. Even when done the wrong response for an investor. by robots, investing has a human decision- making component. Smart machines have To make and keep money as an investor, biases. what counts is understanding our own foibles and biases. , the Everyone wants to be successful with their father of value investing and Warren money. Many believe rarefied financial Buffett’s teacher, said some 70 years ago, knowledge is key; failing that, having the “we have seen more money made and kept best money manager is critical. They are by ‘ordinary people’ who were wrong. There is no evidence showing temperamentally well-suited for the finance professors are better at investing investment process than those who lacked than other intelligent types. If simply hiring this quality, even though they had an managers with great records were the extensive knowledge of finance, accounting, answer, the typical investor would not and lore.” 2 | P a g e

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We all have ingrained tendencies that are the foundation on which value investing is detrimental to achieving investment success. built. They include thinking we know more than we do, being anchored by past decisions, Investment Mistakes and, most important, being impatient. Successful investing requires we bypass this There are two types of investment hard-wiring. mistakes—getting the timing wrong and being ‘precisely wrong.’ Even some forms of intelligence can be unhelpful. An ability to craft convincing In an absolute sense, timing mistakes are narratives to make sense of the world is a unavoidable. Stock prices are random in the sign of high intelligence. However, it is a short-term. So, if you buy a stock and it only trap to avoid when applied to the investment trends higher, the sole explanation is luck. process. Most of the time, the Unless you can control antidote for your emotions, “Your own temperament is the greatest factor in timing issues knowledge of how the achieving a successful financial life.” is patience. stock market works can be of little help. There may be Intellectually you may times when accept that a 10% drop in the stock market your patience is shorter than the time in any given year is within historical norms. horizon needed for the investment to be You may even know that every three or four successful. In those cases, timing mistakes years a plunge of 20% or more will probably are harmful. Overpaying is often the culprit. happen. Someone who bought an on the ‘Knowing’ is often of little help in S&P 500 at the turn of this century was still overcoming feelings of discomfort when underwater in real terms, nearly a decade pessimism reigns. Historical fact can offer and a half later. This is what can happen small comfort when you feel like a loser for when an investor ignores an essential fact: owning stuff bought at much higher prices. expensive markets have low yields and are Reason can be jettisoned when pundits have priced to deliver unattractive long-term a million explanations why things will get a returns. lot worse, and just making the pain go away feels like a top priority. Being ‘precisely wrong’ is when time is not your friend. Patience is ineffective and Despite the rise of ever more sophisticated paper losses become permanent. There are tools, human biases and emotions, including ways to reduce the probability of making irrational ones, will always be baked into the mistakes, but everyone is wrong from time- equation. Control your emotions, exhibit to-time, no matter how robust their great patience and you will gain an edge. investment process or sound their See it as your ‘competitive advantage.’ It is philosophy.

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Arguably the hardest risk to anticipate is Investor ‘B’ is not so talented. Nine of the related to innovation and the disruption it ten companies he owns go bankrupt. Nine can sow. Innovation-driven losses—such as hundred thousand dollars from the original when demand for horses & buggies was million becomes worthless. Zero. Luckily, wiped-out by the rise of the automobile, or one company does prosper greatly and its when many newspaper businesses were value compounds at the same 18% per year. destroyed by the Internet—are often obvious only in hindsight. Question. What is the rate-of-return for each investor on their original $1 million? Although rare, capital destroying The answer is innovation is simple for Investor “Unlike other investment paradoxes, managing permanent. Even ‘A,’ right? It is long-term funds to short-term concerns is a self- quality businesses 18%. The correct in these industries imposed one.” answer for can suffer, as well Investor ‘B’ is not as companies that so intuitive. When serve those firms. Despite dismissing much I teach this concept, students often guess the of the current chatter about a new Age of answer is somewhere around 1.8%. They Innovation as hype, we view ‘disruption are wrong. The correct answer is 11.40%. risk’ as an integral part of our analysis. Once you get past disbelief about the The Power of Compounding answer, hopefully you will begin to appreciate how compounding can serve as a Successful investors understand it is OK to powerful tool in achieving a successful be wrong. They also know that it is not OK investing life. Compounding money is an to stay wrong. Successful investors are integral part of every value investor’s kit, agile. They constantly question assumptions, and explains why we are long-term focused: and avoid linear thought. They comprehend Compounding only works if you give it time the out-sized role compounding plays in to work. helping to stay on-track financially. The Paradox of Investing For example, a thought experiment: Paradox and investing go hand in glove. Two investors each commit $1,000,000 to Some of the highest returns can be achieved the stock market. Both put $100,000 into from low risk investing. The best time to each of ten , and hold those companies buy is when everyone’s gloomy. Worrying for 40 years. about your investments only makes sense when things look great. Investing is simple Investor ‘A’, as it turns out, is one of the but not easy. greatest investors ever. Every one of the ten stocks compounds magically by 18% per The biggest paradox of all, however, is year during the 40-year span. related to behavior. No one wants to die

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soon. No one wants to outlive their money. will be seen in a similar light to the Every investor is therefore a long-term performance of your favorite sports team. A investor. Yet most investors act like traders, winning season is always welcome, but a particularly when markets decline. losing year is easily brushed off.

Unlike other investment paradoxes, The Definition of Value Investing managing long-term funds to short-term concerns is a self-imposed one. If you The sterile worry about the definition of market’s direction “AN INVESTOR’S ‘COMPETITIVE ADVANTAGE’ IS value-investing is in the coming a strategy of PATIENCE. DONE CORRECTLY, VALUE- months, or even in buying assets for INVESTING IS THE LEAST STRESSFUL FORM OF the next year or less than their three, you are a INVESTING.” intrinsic, or true, trader. If you think value. We think of your money in of it as seeking relation to an Index, you are a trader. Blame an adequate return by owning an asset when our zero-attention-span-culture with its 24/7 its price is low relative to the amount of cash news cycle and the implicit demand for it produces, and selling it when the opposite financial clairvoyance. The message happens. Buy low and sell high. bombards us: Pay attention because what the market did today is important to your life! Value-investing in a ‘nut-shell:’

As a practical matter, movements in the There is no single method used when stock market can only affect your financial implementing a value-investing strategy. life if you need to sell stocks, at unfavorable Numerous variations are being practiced levels, to meet obligations. Avoid this by across the globe. Most agree cash is king, having “safe-and-sacred” money socked determining intrinsic value is as much art as away in a risk-free place. If you are taking algorithm, and emotions play an out-sized income from your investments, see that it is role in investment outcomes. We all seek to not from speculative sources. harness the power of compounding money. There is a common recognition that patience Properly positioned, and armed with the is an investor’s ‘competitive advantage.’ correct temperament, market declines should Done correctly, value-investing is the least have no ill-effect on your emotions. You stressful form of investing. will stay on-track financially, no-matter- what. Despite different approaches, another common-bond for value-investors is what Plan for the next fear-cycle in the markets we look to as the source of investment by developing the value-investor mindset. It returns. It drives to the heart of value- will save you anxiety and help you avoid investing. needless tax bills and financial loss from premature sales. Stock market movements

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Distinguishing Characteristics of a Focusing on the asset itself in relation to our Value Investor: Source of Returns own requirement drives the best long-term behavior. If assets are priced to deliver an In the stock market, value investors believe adequate return, we are happy with what we the source of investment returns is derived own, so market declines are not anxiety- from a company’s internal value creation. inducing. If stocks instead are priced to If you buy a business and it prospers, you deliver low returns due to being expensive, will prosper too. First and foremost, value then greeting easy-to-make-money markets investors think of themselves as business with skepticism is a breeze. owners. If, on the other hand, you look to the stock This may seem market as the obvious, but source of “This emphasis on price drives investors to act practitioners of other returns, as is investment strategies as traders, not as business owners. And this common, then disagree. creates frustration and anxiety and bad security prices behavior.” have great investors, market- meaning. The timers and adherents practical effect is of look to the to wait until ‘things are better’ before stock market as the source of investment buying stocks, and to sell them when it returns. seems financial Armageddon is imminent. It can lead to a cycle of buying high and This is an important distinction because it selling low. affects how you think about stock prices which will, in turn, affect your investment The purpose of this paper is not to critique behavior. other strategies. It is to show how the emphasis on security prices in our culture The Meaning of Security Prices can be wealth destroying. This emphasis on price drives investors to act as traders, not The stock market simply exists as a as business owners. And this creates convenient way to buy and sell companies. frustration and anxiety and bad behavior. It Investors could still buy and sell businesses is why the typical investor underperforms without an exchange. The difference is that the stock market by an insane amount over it would be less convenient, akin to buying the long run. and selling a house. How Value Investing Works Value investors believe security prices can potentially tell us one thing only: Is the asset priced to produce an adequate return? Value investing makes sense to me. Finding That is why cash flow is so important. It bargains and understanding the power of allows us to compare a company’s yield compounding is within my intuitive grasp of against our own requirements. mathematics. Taking security prices with a grain-of-salt and thinking of myself as a 6 | P a g e

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business owner, not a market gambler, suits consistently outperform, but if you give my temperament. I confess patience is not them time to work, all can be used in an ingrained virtue of mine, but it is helping you to achieve a successful in- something I have worked on over the vesting life. Employing different strategies decades. as part of a long-term plan is called ‘Strategy Investing.’ Value investing is somehow thought to be old-fashioned, although it only dates to the ‘Strategy investing’ is a long-term, mean- 1930s. By comparison, momentum reverting process. The idea is that those that investing can be traced to the 17th Century, are first shall be last and vice-versa. to the late 1800s, and Another way of thinking about it—a .300 investing to the 1920s. The hitter should have a great second half of the Quants have been with us since 1900. The season if he’s hitting, say, .230 at the All- only old-fashioned thing about value Star break. And, vice-versa. To value investing is the belief investors, mean- instant gratification is reversion is like the result of luck, or, “From the Bubble’s peak through to the next compounding. simply a statistical cycle’s top in 2007, value stocks were up about It is yet another fluke. 40% plus …growth stocks did not powerful tool in recover fully from their overvaluation.” our box. Value investing works for two main Mean-reverting reasons. First, simple means you math. The great mathematician, Benoit should not chase performance, including Mandelbrot, aptly noted that it is, “…just ‘strategy success.’ Studies show a strategy’s common sense: A stock for which you most recent five-year performance is overpay from the start is less likely to give negatively correlated with its subsequent you a profit.” The opposite is also true. five-year performance. A considerable period of underperformance is required to There is also a value-investing ‘fear’ set the stage for future profitability. The premium. Think of it as a long-term reward opposite is also true. A period of for taking a contrarian position. You are underperformance sets the stage for buying inexpensive things that others shun outperformance. and avoiding what is popular. Hard to do unless you possess the correct temperament. The Case for Value Investing Right Now Strategy Investing and Mean Reversion Value investing has generated adequate returns during this eight-year bull market, Time-honored strategies that have generated but it has underperformed many bench- adequate returns over the decades include marks. Explanations are not relevant here. Value Investing, Trend Aggregation and What is important are the reasons to think Risk . None of these strategies value-investing is on the verge of a multi- year outperformance cycle. 7 | P a g e

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In many ways, we are in a similar situation ‘Predictive’ Behaviors and Factors to the late 1990s during the Internet Bubble. An outsized amount of stock market gains in ‘Predictive’ behaviors and factors are time- the Indexes have come from a tested actions and attributes shown to disproportionately small group of large produce long-term outcomes. An example growth companies. The overall stock market outside the investing realm is the idea that is expensive by any historical measure. eating properly, along with daily exercise— though no guarantee—will lead to a On the other hand, many individual healthier life, as opposed to a diet of junk companies, particularly the ones shunned by food and persistent inactivity. Exchange Traded Funds (ETFs), Investment continue to trade at success, like reasonable valuation “In many ways, we are in a similar situation to everything else in levels. Value stocks the late 1990s during the Internet Bubble.” life, can be are historically postponed or cheap relative to the eluded by rest of the market, unknowable due to many years of underperformance. factors and events. There are no It is noteworthy that when the previous era guarantees, but by focusing on ‘predictive’ ended, a powerful reversion-to-the-mean factors, we can create probabilities in adjustment started. The result? From the dealing with uncertainty, thereby improving Bubble’s peak through to the next cycle’s our chances for success. As we add factors, top in 2007, value stocks were up about 40% we increase probabilities and further our plus dividends. odds of a desirable outcome.

This compares to a rise of 8% in the S&P Staying with the healthy-life metaphor, add 500. Notably, growth stocks did not recover a history of longevity, meaningful work, fully from their overvaluation. Peak-to- moderation in all things, a smoke-free peak, growth stocks would generate a environment and a happy social circle to the negative return of -12% during the stretch. factors of proper diet and exercise, and the odds the person will indeed be healthy are Barrack Yard Investors, Llc. increased.

‘Predictive’ works the same Apart from our deep understanding of way. Not liquidating your stocks after a individual investor behavior, you should severe market decline, or viewing your consider our focus on ‘predictive’ behaviors holdings as pieces of operating businesses, and factors, our practice of owning or taking stock-market predictions with a individual businesses, and our ‘skin-in-the- grain-of-salt are examples. ‘Predictive’ game’ approach. factor investing can be used in implementing strategies such as paying attention to the

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Capital Cycle, or they can be the basis of an common-sense calculation, and the true investment checklist in identifying suitable is an unappetizing 2.4%. companies to own. In addition to reflecting the way indexes Without revealing too much of our secret report valuations, ETFs have an inherent sauce, we consider paying a fair price for a flaw with many implications. It is related to business that has consistently made money, an implicit promise of liquidity, and the earns high returns-on-investment capital assumption an ETF can be sold during the (ROIC) versus its weighted average cost of trading day at a price reflecting the value of capital (WACC), enjoys a modest debt each underlying component. profile, and has plenty In practice this of money-making “This drives ETF manufacturers to subordinate means an ETF reinvestment is only as good opportunities to be all investment decisions to liquidity considerations [with] some weird implications.” as its least ‘predictive’ factors. liquid Owning Individual component. Businesses This drives ETF manufacturers to subordinate all investment decisions to Our focus on individual businesses runs to liquidity considerations. This is an the heart of value investing. It allows us to anathema to our philosophy which considers avoid popular and overvalued assets, valuation to be the linchpin. It also has concentrating instead on companies that some weird implications. meet our yield requirements. For instance, companies with heavy insider We believe the current mania for so-called ownership (a ‘predictive’ success factor) are passive strategies, as evidenced by the often excluded from ETFs because popularity of ETFs, will eventually management-owned shares reduce the disappoint participants. US stocks, in stock’s liquidity. Many foreign country aggregate, are priced to deliver paltry long- ETFs have minority exposure to business term returns simply due to elevated being done in that country. Again, liquidity valuation levels. ETFs reflect this reality. is the culprit, resulting in portfolios of For example, the 100 Index multinationals with limited domestic reports an earnings yield of 4.3%. This is exposure. low by historical standards and implies unattractive future returns.

Given the way index creators calculate valuations, however, the yield is overstated. Strip away financial alchemy, use a

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Then there are ETFs that purport to be ‘Skin-in-the-game’ ‘Value’ portfolios but are indiscernible from other strategies. One of the biggest, the The phrase, ‘skin-in-the-game’ was coined iShares S&P 500 Value ETF, currently has by Warren Buffet. It simply means you valuation metrics not dissimilar to the actual have a personal stake in the outcome. It S&P 500 Index, which itself is historically shows an alignment of interests. In expensive. evaluating a company in which we may invest, In what can only be determining if explained as yet the people who “The potential return from owning “the market” another outcome of run the putting liquidity first, at today’s elevated levels, concentrated in expensive stocks, is just not worth the risk. business have Value ETFs and a meaningful Growth ETFs by the ownership same manufacturer stake, and often hold many of the whether they committed their own money to same companies! acquire the stake, is a key consideration. It A herding effect has taken hold of ETFs, is a ‘predictive factor.’ creating concentrated portfolios. Financials As portfolio manager at Barrack Yard comprise 28% of the iShares Value ETF— Advisors, the same standard applies. I have not exactly consistent with the spirit of the over 90% of my financial assets invested in “prudent man” rule regarding the same companies as my clients, along diversification. with the same fee structure. I eat my own Even the broad S&P 500 Index has cooking. concentrated risk, as a small number of -Marty Leclerc companies generate an outsized amount of the returns. Just one example. In 2015, two Winter 2017-2018 percent of the Index’s holdings (10 out of 500) generated more than 100% of its return Sources/influences: that year. Investment v. Speculation➔ The I believe the potential return from owning Interpretation of Financial Statements, “the market” at today’s elevated levels, Benjamin Graham; Free Cash Flow: Seeing concentrated in expensive stocks, is just not Through the Accounting Fog Machine to Find Great Growth Stocks George Christy; The worth the risk. A couple dozen good Intelligent Investor, Benjamin Graham, Chapter businesses with attractive yields is where my 1; The General Theory of Employment, money is invested. Interest and Money, John M. Keynes, Chapter 12; Investor returns: http://www.econ.yale.edu/~shiller for sources of share price . The Truth About Investing / The Right Temperament /

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Investment Mistakes / The Paradox of Individual Businesses➔ The true earnings Investing ➔ Dalbar studies on Individual yield on the NASDAQ 100: Investor returns; MIT Technology Review, http://horizonkinetics.com/wp- Forget Killer Robots—Bias Is the Real AI content/uploads/Under-the-Hood-When-is-a-PE- Danger Oct. 3, 2017; Blackrock and Dalbar not-a-PE_August-2017.pdf; Capital Cycle data from 1997-2016: 20-year annualized Investing refers to the ideas in Capital Returns “average” investor underperformed the S&P 500 by Edward Chancellor; Most of the data and by 7.68% per year, on average; Your Money & concepts regarding ETFs is from Horizon Asset Your Brain, Jason Zweig. The Intelligent Management’s Research, Murray Stahl. Investor, Chapter 8; Thinking Fast and Slow, Daniel Kahneman; Adaptive Markets: DISCLAIMER: Past performance is not Financial Evolution at the Speed of Thought, indicative of future results. Investments involve Andrew Lo; Irrational Exuberance, Robert varying degrees of risk. There is no assurance Shiller; Data for period after the Internet Bubble future performance of any investment, compares iShares S&P 500 Value Index (IVE) Investment strategy, or product (including the with SPDR S&P 500 ETF Trust (SPY); Charlie investments and/or investment strategies Munger—The Complete Investor, Tren Griffin; recommended or undertaken by Barrack Yard High Returns from Low Risk, Van Vliet and De Advisors, llc.), or any non-investment related Koning; Winning the Loser’s Game, Charles content, referenced directly or indirectly in this Ellis, Chapter 8. Definition of Value Investing / paper will be profitable, equal any Distinguishing Characteristics of a Value corresponding indicated historical performance Investor / The Meaning of Security Prices➔ level(s), be suitable for your portfolio or , Graham, Dodd & Cottle, individual situation, or prove successful. Due to Chapters 30 – 39; The Manual of Ideas, John various factors, including changing market Mihaljevic; , Benjamin conditions and/or applicable laws, the content Graham, Chapter 8; Blackrock and Dalbar data. may no longer be reflective of current opinions How Value Investing Works / Strategy or positions. No discussion or information Investing and Reversion-to-the Mean➔ The contained in this paper serves as the receipt of, (Mis)Behavior of Markets, Benoit Mandelbrot, or substitute for, personalized investment advice. Chapters IV and IX; Research Affiliates, papers Please consult with the professional advisor of dated January, July and September 2017; your choosing should any questions regarding Tweedy Brown, What Has Worked in the applicability of any specific issue discussed Investing (document from their website); AQR above arise. Barrack Yard Advisors, llc. is reports on their website regarding Strategy neither a law firm nor a certified public (Factor) Investing. Thinking Fast and Slow, accounting firm. No portion of this paper should Kahneman, Chapter 17; The Manual of Ideas, be construed as legal or accounting advice. John Mihaljevic. The Case for Value Investing Right Now➔ Bull!, Maggie Mahar, Chapters A copy of Barrack Yard Advisor’s current 13 & 17; Société Générale Research by Andrew written disclosure statement discussing our Lapthorne shows how high free-cash-flow yield advisory services and fees is available for review stocks almost always outperforms. The upon request. Martin Leclerc is an Investment exceptions? The late 1990s and the past 2-years. Advisory Representative with Barrack Yard Various SocGen Research July-October 2017; Advisors, llc. Investment Advisory Services are Data for period after the Internet Bubble offered through Barrack Yard Advisors, a compares iShares S&P 500 Value Index (IVE), Registered Investment Advisor, 2100 L Street, SPDRS&P 500 ETF Trust (SPY) and iShares NW, Suite 500, Washington, DC 20036. S&P 500 Growth Index (IVW); Owning

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