Hello everyone,

Last week I came across an interesting little post by Scott Reardon at Dakota Value Funds. Scott is a quantitative value investor by trade and, in an effort to improve his investment process, set out to collect 20+ year track records. The result is this nifty table as well as a few observations on shared characteristics:

While there is diversity in styles, Scott believes two patterns surfaced among a lot of these investors: the search for outsize payoffs and bets on what he calls “sameness.”

“The greats harnessed a principle that’s applicable not just to markets but to life as well: If you’re going to play, play for stakes.”

In other words, they focused on the most profitable opportunities.

“Generally they were looking for companies where free cash flow yield + growth rate equaled 20% or more. In other words, they were looking for returns double the market average, which is exactly what all of them achieved over their long careers.”
“Using yield instead of multiples, we were shocked by how many of the greats, including Munger, Buffett and Glenn Greenberg, used the following equation to determine forever value: Free cash flow yield + growth rate = return.”

Scott also believes the majority of these investors bet on sameness or “the persistence of history.” This could take the form of reversion to the mean (valuation and fundamentals recover as the cycle turns and sentiment improves) but also of identifying franchises with predictability and a persistence of high returns on capital.

“Bill Stewart, for instance, was a growth investor. His returns came entirely from each portfolio company’s earnings growth. He, like Buffett, only wanted firms whose growth was assured to the point of being inevitable.”

“So much of the world is in flux. In response, top investors were attempting to find gateways where the future would resemble the past. Pockets of sameness.”

Scott put the majority of these investors in the value camp:

“We think value works because, far more than any other approach, it exists at the intersection of payoffs and sameness. Value is all about investing in situations with large upside in the event the underlying asset reverts back to long-term character.”

There are of course significant limitations to this data and I don’t agree with every characterization. For example, I would move Julian Robertson into the value bucket. Still, it is an interesting piece with some fun anecdotes and you might find it good weekend reading. Perhaps you’ll find a new investor to study. You can find it: here.

What follows is a brief Q&A with Scott about his work. Enjoy!

Disclaimer: I write for entertainment purposes only. This commentary reflects a personal opinion, is not investment advice, and should not be relied on to make investment decisions. The views reflected in this commentary are subject to change at any time without notice. Do your own work and seek your own financial, tax, and legal advice before making any investment decisions.

Q&A with Scott Reardon

“Many of the greats were obsessed with financial history. Actually there’s probably no one else more obsessed with financial history than they are. Why does the past interest them so much? Because they believed it was destined to repeat.”

Q: We talked about the challenges that quantitative value approaches have had over the past decade. Tell me about your experience sharing ideas generated by the model with human investors on Value Investors Club. What did you learn from the feedback about the strengths and weaknesses of quantitative and discretionary investing?

The investors on Value Investors Club showed me that there's a large part of reality that the quantitative approach can never access. What's so wonderful about quant is its breadth. It allows you to backtest a strategy in any market period and know whether it's robust or not. As a result, it's a powerful way to discover what survives the only test that matters: the test of time. But while quant has a lot of breadth, its weakness is its lack of depth. Quant can't really show you qualitative dynamics of an industry. It can't show you business risk or staying power. And that's why it concerns itself with superficial definitions of risk like volatility.

When I'd post ideas from our quantitative model on Value Investors Club, I noticed that other investors had criticisms that often came true. Most of those criticisms centered on my writeup not accounting for the long-term nature of the company's industry. Those other investors understood the company's historical character and knew not to bet on it changing whereas I, at the time, did not.

For example, I did a writeup on a Japanese shipbuilding firm that was one of the cheapest stocks in the world based on EV/EBIT. And someone on Value Investors Club explained why all these shipbuilders had been over-earning and how those earnings shouldn't be the basis of a valuation. And that person was dead-on.

Q: Tell me about your effort to collect track records. How did you select people? What was your key takeaway? What groups or types of investors did you identify? Can you explain what you mean by betting on sameness?

It took us years to create a database of successful investors. We limited the database to investors who'd outperformed over at least 20 years, which is roughly three market cycles. Anyone who's outperformed that long has shown that it was probably talent and not luck that got them there.

By far, the most common type of investor in the database are value investors. Two-thirds of the most successful investors in history were value investors, which is astonishing when you consider that only 5-10% of financial assets are managed by true value managers. This tells us something very important: Value doesn't just put up significant outperformance, it's the highest-percentage way to outperform.

Something else we found was that a lot of top investors bet heavily on sameness. In part, this is reversion to the mean. But actually the concept is much larger than that. Buffett has a great quote about how, in baseball, no one thinks a .200 hitter will suddenly become a .300 hitter, but in business people believe that all the time. What he's referring to is betting on something's fixed character rather than against it. So often in investing, an investment's success thesis requires a tiger to change its stripes and for a company to sustain boom-time economics that are flat-out counter to its history. What you really want is to find high-percentage situations that offer high payoffs. These are rare, which is why so many great investors ran extremely concentrated portfolios.

Q: How did you collect the track record information? How do you think about the accuracy and also the limitations of this information?

I got the information from articles, online sources and often from the funds themselves. I think the track records are pretty accurate. I tried to use only reputable sources (e.g. Barron's, Graham and Doddsville, the fund's audited returns). The returns are generally net of fees, except where I indicate gross returns or alpha in the data table.

Q: How did this exercise affect how you think about your own investment approach?

It completely changed my life as an investor. Without it, I would have been limited to my own narrow personal experience. But by studying others and by studying history, you're able to learn vicariously. It's almost a form of leverage. And hopefully you're able to get a sense of what's worked over time and what's failed. That's really the only ground to stand on in this great game of ours.

What's interesting is how few people do that. So many of the great investors we researched were obsessed with financial history. In fact, I've never come across anyone as obsessed as many of them were. They were almost like the vampires you see in a movie that's 200 years old and has seen it all before. Another analogy would be poker players playing over and over and developing their pattern recognition. By contrast, most investors are focused on the merits of the specific investment in front of them. And they're focused on the world as it exists today. But the problem is that the world as it exists today is just a drop in a giant ocean.

Q: Tell me about your firm - what do you invest in and what is next on your plate?

We run two strategies. One is a quantitative deep value strategy, which buys stocks in the cheapest decile of the market. The other is a strategy that we created based on our study of great investors. That strategy invests only in firms with strong market share which are "inevitables" in the sense that they're likely to survive for a long, long time. Basically we want to go around the world buying a country's crown jewel assets at once-a-decade valuations when everyone else has either given up or never been that interested in the first place. We try very hard to marry high payoffs with high-percentage businesses.

In terms of what's next, I'm starting a podcast about life and markets and looking forward to getting that launched.

I’m looking forward to that as well! Thank you so much, Scott!

Neckar's Minds of the Market

Q&A with Scott Reardon: Great Investor Track…