I invested in HP and Best Buy mostly because of quantitative aspects of the business. Their stock seemed very inexpensive compared to their cash flows. Their balance sheet was also not weak and the only reason they were so cheap was because the market had lost trust in their future. In these cases, sometimes the market is wrong. At other times though, the market’s appraisal seems too optimistic. This was the case with HP and in some respects with Best Buy. Both companies were broken in the qualitative sense. They were both facing declining businesses and the management did not seem strong enough to realize the predicament they were in.
Since Southeastern’s inception, we have focused on Ben Graham’s imperative that
every investment should qualify quantitatively and qualitatively. However, any [quantitative] appraisal incorporates critically important qualitative assumptions about a company’s future competitive position and management’s ability to effectively operate and wisely allocate capital for prudent building of intrinsic value per share. When we have assessed these mandatory qualitative factors well, we have had huge investment success as with DIRECTV, Disney, Yum! Brands, Texas Industries, Dillard’s, Philips, and Fairfax. Where we have been wrong on our qualitative inputs, our returns have suffered, as with Dell, Chesapeake, Level 3, and HRT. To further improve our investment execution and results, we will be laser focused on whether a company’s competitive advantages are strengthening; management is operating effectively; and the board and CEO are wisely deploying the business’
financial resources. If an investee falls short on any of these critical necessities, we will move with alacrity to rectify the shortcoming or exit the investment.
As with all of our investments, the companies we highlighted as disappointments initially met our quantitative hurdles, had competitive advantages versus peers, and were led by CE Os with histories of building value for shareholders. What separated the winners from the losers over time was not the quantitative, but rather management’s ability to overcome challenges and generate value growth over time.
They have also found ways to avoid such situations. The following is what they advise.
We have taken an even more
skeptical view of managements without
ownership and/or heavily aligned incentives
(particularly in Japan), companies with
substantial debt/enterprise value (limited
flexibility in adversity even with great assets), and
asset-rich businesses that produce little cash flow
(too reliant on things going right).
We will not add to a position when
value is declining or a case is uncertain, barring
unique circumstances. We will avoid being
seduced by more attractive P/Vs if generated by
lower prices without higher values. As indicated
by our recent actions to improve governance at
Chesapeake, Level 3, and HRT, and to fight the
Dell buyout, we are holding CEOs and boards
more accountable for doing what they promise
and delivering what we expect in a timely
manner. We believe in a long-term time horizon
for stock returns – we are less patient about value
We will exit more quickly – as we did
within a few quarters at Republic Services,
Leucadia, Vivendi, and Anglo American last year –
when competitive advantages or values appear at
risk and we do not believe becoming more active
would yield results.