The goal of the book is to answer two simple questions:
- How did Overlook achieve its success?
- How can Overlook best ensure future success?
The Overlook Model
Overlook Investment Philosophy
The most successful fund management companies, in their experience, operate with quiet modesty. They worked hard for their success, fought to overcome many challenges, learned from mistakes, and gave credit to others who helped along the way.
Overlook seeks to identify companies with superior businesses, capable management, and long-term investment prospects. They do not invest in trendy stocks or chase speculative markets. They invest in value. However, identifying value requires method and discipline.
- Superior businesses
- High profitability: Superior businesses possess high profitability. The latter generates free cash flow that makes dividends and equitable corporate governance easy for executives to deliver to shareholders.
- Predictable EPS growth: The following attributes are commonly found in companies that can maintain steady growth: low cyclicality of business, steady demand for its products or services; ability to increase market share; and a track record of consistent earnings over a long period of time
- Successful allocation of free cash flow: Reinvestment must enhance a company’s future business.
- Dominant pricing power: Pricing power is the most valuable corporate asset. The more pricing power a company has, the better.
- Superior company managers
- COLA:
– Capital allocation,
– Operational excellence,
– Leadership/strategy and
– Alignment of interests with all shareholders
- COLA:
- Valuation discipline
- Long-term investment horizon
- The compounding effect of earnings over the long term is powerful.
- Anticipating a company’s future earnings gets much easier with a consistent track record of performance. For Overlook, a track record is a gold mine for deep financial analysis.
The Overlook Pyramid: Generating Outperformance
At the top of the Pyramid is a small collection of companies that have characteristics described in the Overlook Investment Philosophy.
If investors can manage to push their portfolio toward the top of the Pyramid and keep it there for at least five years, the portfolio is positioned to generate outperformance over the universe. There are two caveats:
- Investors cannot badly overpay for these great companies.
Overpayment has the effect of pulling your portfolio towards the bottom of the Pyramid and erodes the ability to outperform. - As the size of the fund grows ever larger, a higher proportion of holdings will overlap with the universe and put at risk the fund’s ability to generate non-correlated gains.
The Overlook Margin of Safety is the ability to consistently and reliably deliver superior investment returns to investors through the confluence of their Investment Philosophy and Business Practices. This is the final result of The Overlook Model.
Lessons from Bear Markets
You must survive.
The author’s favourite analogy to describe bear markets is that they act as a flushing of a toilet. The weak get flushed and the strong survive. Bear markets are the ultimate test of survival of the fittest—especially big Bear Markets like the 1997/98 Asian Crisis, the 2007/08 Global Financial Crisis, and China’s 2007/13 Bear Market.
Bear markets particularly hurt two categories of stocks: first, companies that are heavily indebted and financially overextended; and second, the stocks that are the hottest momentum plays in the last stage of bull markets.
Prepare for bear markets, don’t predict
We can’t predict the next bear market, but we can prepare for it today and tomorrow. Balance sheets take on greater importance in the opening acts of bear markets, a time that our friend David Scott aptly calls the “time of discovery.”
It’s only when the tide goes out that you learn who’s been swimming naked. — Warran Buffett
Getting balance sheets wrong in a bear market multiplies the pain. Overlook believes balance sheets matter all the time, not just once bear markets start.
Four-part strategy to survive bear markets
- Invest in Net Cash and Cash Flow Positive Companies
- Concentrate on Companies with Pricing Power
The equation is based on our belief that companies with a high level of pricing power have shown an ability to earn high cash gross profit margins with low volatility through economic cycles. - Prevent Overlook from Becoming a Value Trap
Do not overly focus on short-term performance and have a high allocation to high-risk asset classes. - Commit to Disciplines of “Old-Fashioned” Investing
A focus on cash flow, high rates of return on equity, dividends, honest management, reasonable valuations and fair investment structures will prevail.
A common failing of investment managers during bear markets is that they focus too much of their time on trying to predict the macroeconomic future.
Investment opportunities improve during bear markets
Valuations near the end of bear markets become so compelling that years later you wonder how stocks ever got that cheap.
They act as a self-correcting mechanism and force changes on economies, companies, consumers and investors that form the basis for valuable and durable recoveries. As the weak get flushed, IPO markets close, assets are marked down, and change begins in earnest. Capital becomes scarce and owners of capital naturally earn higher returns. Irrational competition ends and favorable industry conditions are left for the survivors. Raw materials and input costs drop, making profit margins wider and expansion projects more profitable. Macroeconomic and bank loan growth remains slow, but improved market share and self-financed growth drive earnings higher.
The more severe the bear market, the more dramatic and beneficial the changes. Hard to believe, but history shows this to be true.
Corporations survived by abandoning their sloppy habits and adopting the hard-nosed skills of blocking and tackling. We call these the New Winners. Bull markets introduce aggressive new capital into established industries, often causing a general decline in profit margins and returns on investment. And they inevitably end with a bust, pulling down perfectly good companies in their wake.
If you are standing at the end and manage to successfully navigate the bear market, you can win—and win big. Bear markets are among the few periods in the investment business when fund managers can deliver investors four to five years of outperformance.
Bear markets eventually recover, and bull markets eventually die. The cyclicality is built-in. During bear markets, it sometimes feels that the whole world is crashing down, while bull markets sometimes feel like a complacent paradise.
Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. — Sir John Templeton
It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk. — Seth Klarman
No investor can be successful without experiencing failure. Early successes only lure new investors into complacency about the risks and pitfalls that exist. Failure, however, teaches lessons.
Bear markets are essential times when we must show our mettle. You can’t swing and miss in a bear market.
Mistakes are times of critical learning.
Selling
The best way to ensure a correct exit is to think about an investment’s duration.
Before they initiate any new position, they write an investment thesis stating its opportunities and risks. In doing so, the investment is categorized, in Overlook terminology, into one of the following groups:
- Tier 1, 2, 3
- Superior Cyclicals
- Defensives
- Financials
Six reasons to sell:
- Acquisitions
- Mistakes
- More ideas than space in the portfolio
- Rebalancing
- Changing Investment Thesis
- Tomorrow’s Price Today
Investments have different durations that derive from the risks associated with them. Knowing whether time is working for or against an investment is a crucial first step. With insights, an appropriate exit strategy can be constructed. Overlook’s tiering system guides as to the likely manner of the sale. Accordingly, it is made a component of The Overlook Model.
The Value of Bear Markets by Marc Faber
The commonality of all bull markets is that they develop some leadership among stocks or sectors. Another characteristic of bull markets that have a concentrated leadership among selected sectors is that they inevitably lead to some sort of “bubble” or “investment mania.
The beauty of this most speculative phase of the bull market is that it creates a poor allocation of capital. Performance-hungry investors and short-term speculators’ funds flow into the “bubble” sectors because that is where the upside action takes place. This speculative phase is accompanied by the media’s captivation with “new era” stocks and a massive increase in new issues related to the subject of speculation.
For the value investor, this is the most painful but also the most interesting phase of bull markets. Why? Painful it is because value investors will all underperform the soaring stock market, which is driven by a narrow leadership. It is, because all the world’s money flows into the boom sectors and, therefore, completely neglects other sectors of the economy. Economists call this phenomenon a misallocation of capital.
Now, thanks to the “great deal of stupid money” in the hands of “a great deal of stupid people” the undervaluation of the neglected sectors or countries reaches extremes that provide the patient and disciplined investor “a great deal of lifetime investment opportunities.”
For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value. A neglected stock or a neglected sector, which by definition becomes attractively valued, is also very illiquid. This is so because during the time this sector has become unpopular it moved from weak holders into strong hands, and insiders and deep-value investors who will only be prepared to part with their holdings at much higher prices.
The importance of bear markets in shifting money out of overvalued sectors of markets into sectors and stocks where most people would shake their heads because they cannot see why anyone would touch such a country, commodity, stock, property, bond, etc., even with a ten-foot pole.
Marc has high confidence in The Overlook Model because it combines integrity (aligning the client’s interest with their own), courage (taking large, concentrated positions in attractively priced companies after extensive analysis), patience (all investors say they are patient until a 10% decline in the value of their investments turns them into impatient nervous wrecks), and discipline (having power over your mind, which lets you find strength and excellence).
