The Axe of Quality

A Small Update In My Process and Thinking

I stumbled upon a fascinating quote from James Montier’s The Little Book of Behavioral Investing a few weeks ago where Spencer Davidson of General American Investors states the following:

“An early mentor of mine started out during the Depression and used to always say we were in the rejection business – that we’re paid to be cynical and that a big part of success in investing is knowing how to say no.”

In the same chapter, Montier says: 

“Many of these great investors generally run concentrated portfolios, with the default question being ‘why should I own this investment?’ Whereas for fund managers who are obsessed with tracking error and career risk, the default question changes to ‘why shouldn't I own this stock?’ This subtle distinction in default questions can have a dramatic impact upon performance.”

Finally, Montier quotes Berkowitz:

“We try every which way to kill our best idea. If we can’t kill it, maybe we’re onto something. If you go with companies that are prepared for difficult times, especially if they are linked to managers who are engineered for those difficult times, then you almost want those times because they plant the seeds of greatness.”

During the same week, I happened to listen to an interview with an investor I admire who talked about “killing ideas quickly.” 

I, very clearly, have never thought about it that way. My default state was “buy the business unless it’s really bad” rather than “pass on the business unless it’s really good.” A case in point – I bought 5 out of the first 7 companies I analyzed when I first started in 2020. These names include Global Cord Blood Corporation (now liquidated), Tutor Perini Corporation (down over 60%), Green Brick Partners (essentially flat), Ethan Allen Interiors (up slightly), and Alibaba (you know how that worked out). Almost all of these businesses were mediocre at best (I still think Alibaba is a good business, but should have never owned it), with one being a full-out fraud.

If I were to use the “pass unless really good” approach, I would have owned a comfortable 0 of the mentioned names. 

Our default state should be to pass on opportunities. After all, wonderful businesses are a rare anomaly rather than a guaranteed occurrence. You kill ideas, one after another, until something comes up that is genuinely strong and incredibly attractive. 

Going in, your goal should be to kill the business as quickly as possible, rather than finding reasons to buy (moat, management, and so on.) Something that is [almost] unkillable will, sort of by default, have some type of durable advantage. In other words, I think that this is a game of omission (pass unless good) rather than commission (buy unless bad).

For example, I ran a screener several weeks ago where I had only one criteria – companies with a market cap below $300mm. I then wrote down 147 names (out of something like 2400) that I thought were worth looking into. With each business, my first “filter” was “how easily can I kill this?” Some companies took just a few minutes to kill (you’d be surprised at how bad some of these were) while others took several days to over a week. In the end, none of the 147 businesses survived the “axe of quality.” There are, however, some honorable mentions – Acme United, Where Food Comes From, and a couple others.

Yesterday, I ran another screener, from $300mm to $2b, and now have a total of 398 names in my value journal (so an additional 251 businesses to kill). I’m, of course, hoping to find something here, but I am not going to force my hand like I have done before. If it’s not there – it’s not there. Making up facts or tricking yourself into buying (Alibaba comes to mind) is not how the game works. I also just really enjoy this “treasure hunt” aspect of the process, so it’s not like I’m suffering when trying to find something to look into.

When I do find something, I’m more than comfortable spending a decent amount of time on it (the last few businesses I ended up buying took me just over a month, not including maintenance DD). As most already know, we need just 1-2 good ideas to do well, so when we do buy, we better be sure we have a good reason to do so!

All of us have just 100% (i.e. our portfolio) to allocate however we want, into whatever we want. Some portfolios are in the hundreds of millions or billions of dollars, while others are in the handful of thousands. Regardless of size, however, all we ultimately have is the 100% – a blank canvas, so to speak, onto which any view or opinion you have can be painted.

You can, quite literally, turn this 100% into anything.

It can be an all-in bet on crypto, a 50+ cigar-butt portfolio, a blend of special situations, a group of dividend stocks, a collection of wonderful businesses or – and this is the cool part – any combination of the mentioned categories (and more), arranged and sized however you want!

I personally choose to be very picky with my 100%. For example, it makes very little sense to me to allocate a portion of my 100% into a cigar-butt or dividend type of idea “for diversification” when there are more attractive opportunities (and businesses) out there. Why would I want to have 70, 80, or 90% in my “gems” when I can have 100%? 

Simply put, I am very greedy with my 100%, and am more than willing to wait until something very obvious comes by. 

Side Note:

I will from now on be posting only things I am actually buying. Wasting time on write-ups for companies I end up killing doesn’t make much sense, especially when there are so many interesting opportunities out there. I’ll occasionally share thoughts (like I did here) and I might include some stories I find fascinating, but this means that I’ll likely only be posting about 1-2 write-ups per year. When I do, however, it will be on companies I feel very strongly about.