Note: This interview with Kenneth Jeffrey Marshall was originally published in the November 2017 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.
Kenneth Jeffrey Marshall is an American value investor, teacher, and author. He teaches value investing in the masters in finance program at the Stockholm School of Economics in Sweden, and at Stanford University. He also teaches asset management in the MBA program at the Haas School of Business at the University of California, Berkeley. He is the author of the 2017 bestselling book Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance published by McGraw-Hill. He holds a BA in Economics, International Area Studies from the University of California, Los Angeles; and an MBA from Harvard University. He splits his time between California and Sweden.
Safal Niveshak (SN): Thanks for doing this interview, Kenneth! Please tell us a little about your background and journey, and how you got into value investing?
Kenneth Marshall (KM): Well, I was first shown value investing in the late 1980’s. But it wasn’t like some sudden enlightenment. It actually took me a decade to get it. I’d rather not think about the cost of that delay.
I grew up in Irvine, California; between Los Angeles and San Diego. My best friend’s father started a value fund in 1979. We were kids then, of course. But when we graduated from college in 1989, my friend went to work for the fund. He’d tell me about fundamental analysis, how they went to Omaha every May, and so forth. But I was slow to appreciate what I was being handed. It wasn’t until the dot-com hypefest of the late 1990’s that I started to grasp the common-sense approach that value offers.
What did it for me was drawing the link between value investing and freedom. Once I got that value investing meant high returns, and that high returns meant personal freedom, value became irresistible to me. So it remains.
SN: You also teach value investing. When did you start teaching the subject and what have been your key learnings as a teacher of the subject?
KM: I first taught value investing at Stanford in early 2014. I proposed the course, and luckily, the department agreed to put it in the catalog. But it did so on the condition that at least 15 students register. So I was ready to enroll my infant daughter, deceased relatives – anyone that would take me over the hurdle.
Fortunately, the course turned out to be quite popular. About 20 students signed up right away, then 20 more, then 20 more. I kept getting upgraded to larger and larger classrooms. In the end, we topped out at 90 students, and the class was held in an auditorium in Stanford’s Lane History Corner building. It’s a big oak-paneled hall that looks like a television set for a show about college. It was great. I still teach that course today.
What I’ve learned from teaching is that people with no financial background can become good investors. Those from the hard sciences – physics, engineering, chemistry – seem to have a particular advantage. They’re already trained to chase solid answers via logic and math. They’re not satisfied with ambiguity; they want the truth. That’s a very useful mindset to have.
SN: That’s interesting! Which is more challenging – practicing value investing or teaching it – and why?
KM: Well, challenging isn’t the word I’d use to describe either. Neither is a cinch, of course. And if I aimed to get 25% annual average returns, or standing ovations every time I walked into a classroom, I’d find it all challenging to the point of impossible. But I don’t.
Plus, by now, investing and teaching have for me become inseparable. At Stanford, whatever company I’m analyzing myself that week becomes our case. Class becomes like walking into a room full of motivated analysts.
Teaching makes me a much better investor. Much. It does so in at least three ways.
First, students directly improve my framework. For example, a few years ago in my masters course at the Stockholm School of Economics we considered Geberit. It’s a Swiss manufacturer of plumbing components. The topic turned to moat. Did the company have one? It seemed to, but it was hard to identify its source. Was it brand? Kind of. European plumbers thought highly of Geberit. But it seemed deeper. Then a Swiss student described how the company involved itself in the careers of plumbers. It offered professional certifications, free project planning software, training – it ingrained itself into the worklife of its channel customers. That student’s remark led to the concept of ingrainedness. It’s one of six sources of moat that I lay out in the book.
A second way teaching makes me a better investor is by forcing clarity in my thinking. It’s one thing to understand a potential investment well enough to satisfy yourself. But it’s more demanding to understand it to the point where you can run a discussion on it.
Third, I get better investment ideas. Because I teach in both the US and Europe, I hear about all kinds of things. For instance, this week I’m looking at a European natural resources company that I never would have heard of had one of my Stockholm students not mentioned it. She grew up near it.
SN: You’ve written this nice book Good Stocks Cheap. What’s the core premise of the book and which section did you like writing the most?
KM: The core premise is that good value investors know what to do, do it, and don’t do anything else.
If a step in that flow is missing, outperformance is unlikely. Consider angel investing. It’s an activity that – over time and on average – returns poorly. Sure, it’s exciting. And it puts one in the company of engaged, gifted people. But on balance it doesn’t work. So, a value investor that angel invests on the side is likely to stunt overall returns. And that’s a deserved outcome. It’s a violation of the third step, don’t do anything else.
I loved writing the whole book. I really did. I loved needing to resonate with people I’d never met – people with different backgrounds, different interests, and often with different native languages. It conjured up discipline in my writing. So did limiting my time frame. I committed to delivering the manuscript to McGraw-Hill by September 1, which – given my teaching schedule – gave me exactly five months finish it.
I remember Michael Eisner – the old Disney CEO – once saying that his job was to take a creative project and put it in a box, a box with sides defined by the constraints of a timeline and a budget. I think that this was from back when he was running the Paramount Pictures film studio. Anyway, that’s what I tried to do with myself. I put myself in a box, a box with sides defined by the constraints of a September 1 deadline and a 60,000 word budget.
I’m lucky to have viewed writing not just as a way to get my thoughts out, but as something to get right on its own. So, I read books about writing. The best was On Writing by Stephen King. It’s beautiful. And it recommends another great one, The Elements of Style by Strunk and White. That my undergraduate curriculum at UCLA didn’t include that book is shameful.
Another reason that I loved writing the book is that McGraw-Hill was so good with editing. They made few changes, but when they did, they really nailed it. For example, some investors consider the amount of a company’s excess cash to be equal to 5% of its annual revenue. I think that’s insane. Different businesses are different. My original sentence on this was “Applying the same percent every time is like always using chopsticks regardless of what’s for lunch.” I pictured some bozo trying to lift up a sandwich with chopsticks, an image that I thought made the point nicely.
But then my proofreader said “you know, in some parts of the world they really do use chopsticks regardless of what’s for lunch. Why not say spoon?” That’s smart editing.
SN: Let’s now talk about Kenneth Jeffrey Marshall, the investor. How have you evolved as an investor and what’s your broad investment philosophy? Has your investment policy changed much through the years?
KM: I’ve evolved from an investor of modest talent and no strategy into an investor of modest talent and a value strategy. And my returns have improved. So that improvement can only be attributed to value.
Since committing to value at the end of the century, my investment policy hasn’t changed much. The only shift is that I stopped selling. Most of my errors had come from selling prematurely. They were profitable sales, so it wasn’t natural to see them as mistakes. But I’d rub my nose in the high returns that those businesses continued to enjoy long after I’d left their shareholder rosters. That was a useful exercise.
SN: What are your thoughts on the disruption that’s killing businesses all around? How does one identify businesses that can sustain competitive advantages over a period of time in such an environment?
KM: Is disruption truly killing businesses all around? I’m not sure that I’d agree with that. Some retailers are getting their comeuppance, yes, often because of the collision between debt and the internet. Print news is dying because compared to the web it’s costly and late. Taxis are in trouble because smartphones increased the capacity utilization of privately-owned cars.
But, on balance, there’s not greater disruption today there was in earlier decades. Admittedly, this is hard to see. After all, yesterday’s disruptions made today’s status quo.
Earnings power is always sloshing around. That’s a feature of a dynamic economy. We wouldn’t want it otherwise.
But there are businesses with sustainable advantages, ones that survive disruptions. They’re the ones that Nassim Taleb would call antifragile. They strengthen under stress. And spotting them is straightforward. The book shares four tools for doing it.
The first is what I call breadth analysis. It asks, is the customer base broad and unlikely to consolidate? And, is the supplier base broad and unlikely to consolidate?
Second is what I call forces analysis. It’s my twist on Porter’s five forces model. It forecasts the profitability of a single business, as opposed to the average profitability of an industry, which I think was more Porter’s aim.
Third is moat assessment, a way to see if there’s a real barrier that protects a business from competition. And last is market growth assessment, a basic check to make sure that a company’s market isn’t shriveling up.
SN: Thanks for your thoughts on disruption. Anyways, how does one build in a margin of safety to minimize this risk when choosing a portfolio of companies?
KM: For me, the margin of safety doesn’t come from minimizing disruption risk. It comes from price. I try to buy good companies that I understand, and to do so at a discount of at least 30% from the lower end of my estimate of value. That discount is where the margin of safety comes from.
If a company faces a real disruption risk, it’s not a good company. I don’t want it. I’d never pretend that I get a margin of safety by buying it at, say, a 60% discount. Others play that game, some to success. But they’re smarter than me. They can buy well and sell well. I have just enough watts to get the first half right.
SN: What has been the best time – that tested you – and worst time – that tested you – in your experience as an investor?
KM: The big tests come when prices plunge, and when prices soar. A plunge test came in 2008, during the financial crisis. Listed equities went on sale because there was a scramble for liquidity. Folks needed cash to make good on other obligations. So I gave them their cash. I bought.
It’s possible that we’re heading towards the second sort of test – a soar test – now. I say this based on the observation that my cash balance is higher than I’d prefer. I don’t have some profound macroeconomic insight or anything. It’s just that good companies that I understand haven’t gone on sale in a while. What’s particularly trying this time is that the interest earned on cash is so low. In some of Europe it’s negative. But I hope to pass this test too.
SN: How do you think about valuations? Which is your favourite valuation model that has stood the test of time?
KM: Well, the book spends a chapter on this. It lays out the four price metrics that I like. My favorite is enterprise value to operating income, or EV/OI. It’s based on the work of Joel Greenblatt, at Columbia. He’s a great thinker.
In enterprise value, we get the price of all of the stock, all of the debt, and all of the minority interest. In other words, we get the cost of buying out all of the other investors, regardless of what kind of security they hold. EV ignores capital structure.
That’s particularly useful when EV is ratioed against operating income, a line that’s high up on the income statement. OI doesn’t capture interest expense or tax expense. So there’s consistency between numerator and denominator. From operating income comes the means to deliver returns to all investors, whether they hold shares, debt, or minority interests.
Operating income is also nice because interest and tax contexts can change over the long period of time that I plan to own a company. They’re one recapitalization or reincorporation away from shifting. This isn’t to say that recapitalizations and reincorporations are easy. But they’re often easier than improving the core economics of an operating business. Ask anyone who’s tried.
SN: You have mentioned about never selling your stocks. But just in case, are there some specific rules for selling you have?
KM: Yes. Don’t.
Everything I buy I intend to hold indefinitely. Of course sometimes a company that I own gets acquired. That happened with BNSF, Anheuser-Busch, and some others. I had no say in those cases. But I don’t want to sell. And that makes me a better buyer. If I know that I’m stuck with whatever I put in the portfolio, that portfolio becomes pretty robust. It has to.
My no-sell policy has hurt me just once. It was in 1998, when Coke shares flew past $80. As I say in the book, that price suggested that every man, woman, and child on earth had just pledged to drink a bathtub full of soda a week for life. But I held, foolishly, and was treated to a long, slow decline to $40. And rightly so.
But greater pain came when I failed to hold. For example, I sold Nike profitably, but early. Nike continued to sprint ahead without me. And of course your brokerage statements never tell you that. They don’t say how you would have done had you not sold. And yet that’s exactly what those prone to cashing out would do well to see.
SN: When you look back at your investment mistakes, were there any common elements or themes? A real-life example would be helpful.
KM: It really always was premature selling. I would bag these beauties and then on some goofy day decide to dump one of them. Like Nike. So I just stopped placing sell orders. That was over a decade ago.
SN: How can an investor improve the quality of his/her decision making? How have you done it?
KM: There’s a lot of data that I just don’t take in. I don’t own a smartphone. I don’t own a television. I don’t have a Bloomberg terminal. All of that seems to have led to better decisions. There’s less noise, and little loss of signal.
But when I’m in the financial districts of San Francisco or Stockholm, what do I see? In the street, faces hovering over smartphones. In offices, eyes on televisions and Bloomberg terminals. I see environments that encourage a casual descent into mindlessness. How one can reflect while attacked by pixels eludes me.
I love to read, I love to think, and I love to talk to people who are in the thick of an industry. Not equity analysts that cover the industry, but the people that drive the trucks, repair the units, make the products – those kinds of people. So I do those things. But I don’t do the other things, the things that are popular but fruitless. I unclutter.
SN: How do you think about risk? How do you employ that in your investing?
KM: Risk to me is the chance of a bad outcome. Those are the words I use to define it in the glossary of the book. And to anyone thinking about risk in everyday life, it makes sense.
So to me, risk is reduced by paying an inexpensive price for shares. It’s reduced by waiting for those infrequent, unjustified moments when good companies go on sale. This by itself makes bad outcomes less likely.
I reject wholesale the suggestion that risk is related to the average daily change in the price of a stock. That’s volatility. And it’s irrelevant.
In most endeavors, a theory that fails empirically gets tossed from the endeavor. If some nutcase civil engineer came up with the idea that suspension bridges should be held up with dental floss, that idea would fail, and would be dismissed. But look what we’ve done in finance. We’ve taken volatility – – a total canard – – and dressed it up as a linchpin of our endeavor. We’re stringing up suspension bridges with dental floss.
SN: Which is one widely held notion that value investors believe in, which you believe is wrong or does not work anymore?
KM: There’s not a widely held notion I can think of that I’d reject outright. But there’s a few terms that puzzle me.
Take enterprise value, for example. Shouldn’t it be enterprise price? After all, it’s the theoretical takeover price of the whole company. It’s what you’d pay to take out all other financially interested parties. Value is what you get, isn’t it?
Another term that puzzles me is value stock. Stock in a company that’s good, and that I understand, might be a value at $9. But it might be overpriced at $20. So value would seem to attach to a situation, not to a stock.
All of this may sound like minutiae. But language really drives behavior. So if you want the right behavior, you want the right language.
In this spirit I actually introduce 17 new terms in the book. I didn’t set out to. It just happened that there were some long-recognized notions in value investing that lacked terms. Ingrainedness, for example.
Another is miscontrast. It’s a mental bias. It’s when something looks good just because everything around it looks worse. This surfaces in bull markets. If every stock is trading at 40 times earnings, and one drops to 30 times earnings, that one might look cheap. But it’s only cheap in a relative sense, since 30 times earnings isn’t obviously inexpensive in an absolute sense. But it’s harder to spot this trap if you don’t have a word for it.
SN: What’s your concluding advice to students wanting to get into value investing after learning through your course? What are the most important things they must practice, and the pitfalls they must be aware of?
KM: Well, one big pitfall is drift. It’s so easy to drift away from value investing and into some lesser strategy, particularly when you first start out, because value takes some time to deliver.
You buy some very profitable brick manufacturer when it gets cheap because of a lousy housing starts report, and a few years down the road the price hasn’t budged. Meanwhile some knucklehead just made $1,000,000 on a freak currency arbitrage. Who wouldn’t be tempted?
But over the long term, value really does seem to work best. And remember, we live longer now. Many of us will see age 80, or 90. The long term has become our term. So we shouldn’t trade as if we had the lifespans of fruit flies.
SN: Which unconventional books/resources do you recommend to a budding investor for learning investing and multidisciplinary thinking? If you were to give away all your books but one, which one would it be and why?
KM: Most of my reading is outside finance. My formal training in the hard sciences is weak, and I’m fascinated by those subjects, so I like books on things like physics and medicine. If something I’m reading makes me feel dumb I know I’m spending my time well. I want to be awed.
This carries over socially, by the way. I love talking to chemists, astronomers – people of accomplishment in fields far away from my sphere. I was at a child’s birthday party last month and the dad was a postdoc in fish pathology. I wouldn’t let him go. Everyone’s eating cake and I’m pushing for details on sea lice.
Regarding more conventional books that I’d hang on to, I think highly of Pabrai’s The Dhando Investor. I don’t get his Kelly formula chapter, but other than that, it’s solid. I also like Cialdini’s Influence and Taleb’s Fooled By Randomness. Taleb’s insight that history is a fiction we tell ourselves to make outcomes seem inevitable is brilliant. I also like Swensen’s second book, Pioneering Portfolio Management. I like it so much that it’s become the required text in my MBA course at Berkeley.
SN: Which investor/investment thinker(s)/business owner you hold in high esteem? And why?
KM: Well, you’ll please forgive me for citing someone with my same last name, but my father was a real crackerjack entrepreneur. He built a serious business that became part of Nuance, the company that makes Siri for Apple. He really knew how to make things happen. I couldn’t have hoped for a better influence.
SN: What other things do you do apart from investing and teaching?
KM: I swim and bike a lot. I just got back from a two hour bike ride, actually. I’m lucky to still be able to do those things. And not just because of the physical benefits.
Near Stanford we have a big, 50-meter outdoor public pool. One morning a few years ago I finished my laps there just as did another regular, an older fellow. We got out of the pool at the same time. He stretched his fists up towards the blue sky, sighed, and turned to me and said, “you know, swimming is always a good idea.”
He was right. The mind runs some sort of defragmenting utility when you swim. Or when you bike, or even just walk. Afterwards I always seem to think better about whatever I’ve been working on.
I also still do some exploratory travel. If I’m giving a talk somewhere I often stay for a few extra days just to look around. I just did this in southern France, near Monaco, where I’d never been. Last year I did it in Riga, Latvia; where the Stockholm School of Economics has a satellite campus.
I don’t speak Latvian, or French. Nor am I particularly familiar with either culture. But dropping yourself into an environment where you’re without bearings – where you’re essentially a child again – is enlivening. It triggers a mental energy – a forced alertness – that we all had when we started this game. I love that feeling.
SN: Wonderful, Kenneth! Thanks for sharing your insights. I wish you all the best for your work and life.
KM: Thank you Vishal.
Note: This interview was originally published in the November 2017 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.