Brian Bares On His Qualitative Value Investing ProcessVW Staff
Manual Of Ideas Exclusive Interview With Brian Bares
We are pleased to bring you an interview with Austin, Texas-based investor Brian Bares this month. Bares started his investment firm, Bares Capital Management, in 2000, focusing initially on micro-cap public companies. The firm launched a small-cap institutional strategy in 2001 and now manages assets in two value-oriented strategies. Bares Capital Management is quite unique in the institutional asset management world, as it has adhered to a disciplined business strategy, limiting the growth of assets under management to benefit investment performance. Both of Bares’s institutional strategies have beaten their respective benchmark indices by wide margins since inception.
Q&A with Brian Bares of Bares Capital Management
MOI: Since starting your firm nearly ten years ago, you have focused on investing in small public companies. What prompted this focus, and has your approach changed at all in light of the fact that many large companies have looked inefficiently priced recently?
Brian Bares: There are really two reasons for our focus on small companies. The first is that small companies are more likely to be inefficiently priced. Our investment process mandates a comprehensive understanding of our portfolio companies. It is much more likely that we can profit from this understanding in small caps, where information scarcity allows for opportunity. We also cap assets to maintain our focus on small companies. Our competitors have a difficult time running a strategy like ours because success creates profit motives that tend to move them up the market cap spectrum or into excessively diversified portfolios in order to accommodate a larger asset base.
The second reason is structural. Our firm manages money in replicated separate accounts, and our relationships are largely direct with foundation and endowment clients. These clients employ many specialist managers in a number of different niche areas. They understand that our value to them is our area of competence — small-company common stocks. And they pay for our best ideas as we typically hold between 10 and 20 positions. Our clients allow us to do this because they have other managers looking at mid- and large-caps, international, commodities, real estate, etc. So we have really absolved ourselves of making many difficult macro and asset allocation decisions. Instead, we simply hunker down and focus on our little corner of the market. Our success is judged against small company benchmarks. The only time we think about what is happening with large-caps, international stocks, and other asset classes is when factors affecting these could affect the underlying business performance of the companies we own.
MOI: When it comes to stock selection, what are the key criteria you look for? Is there a price at which you would buy into a bad business, or do you weed out such companies before valuation even enters the picture?
Brian Bares: We are unique in that we start with qualitative analysis. Our research process begins with company-level information. We want to understand on a very detailed level exactly what a company does, who it competes against, and the forces affecting its ability to earn sustained economic profits over long periods of time. We also want to understand the motivation of the people running the company. Are there incentives in place to align management’s success with the success of passive shareholders? Is management doing what they said they would do? What is their history? Questions like these and many other qualitative factors are examined before we allow a company to be considered for the portfolio.
Only after a company meets our internal qualitative criteria, and only after the idea has gone through an internal presentation and discussion, will we do valuation work. We understand that this process is the reverse of many managers, but we want to prevent ourselves from being drawn into seductively cheap subpar businesses. Our process is built specifically to guard against this. We understand that it is hard for resource-constrained small-cap managers to look at the thousands of companies in their universe. Most of our competitors compensate by using a multi-factor screening tool to help whittle down their investable universe. The problem with doing this is that backward looking accounting data tells you very little about a company’s current competitive position, management, strategy, and all of the things key to the internal compounding that will determine your success or failure as a stockholder.
MOI: High returns on capital are generally of little value if they can’t be replicated with reinvested capital for a long period of time. Many businesses with apparent sustainable competitive advantage — such as Polaroid or The New York Times — actually had no such advantage. How do you determine the sustainability of competitive advantage?
Brian Bares: That is a great point, and one that debunks multi-factor screening as a useful tool, in my opinion. A screen for high returns on invested capital may provide you with a list of companies that did well in the past, but tells you nothing about what will happen going forward. And for the going concern, value is 100% driven by what happens in the future. Our process is shaped by the premise that stock returns will follow the value created by internal business compounding over time, and that above average-business compounding will inevitably decline through competitive forces absent a durable advantage. Not to beat a dead horse, but this is why we spend so much time on the qualitative issues that influence internal compounding.
As you illustrate, competitive advantage is most often temporary. Even though we think of ourselves as long-term investors, we have the luxury of a liquid portfolio. This allows us to be decisive and sell out of a position if we perceive deterioration in a company’s competitive position.
To determine the sustainability of a company’s advantage, we must look at all of the factors that make the company unique, and understand how their positioning fits within their industry. We walk through a Porter’s “five forces” analysis of each of our ideas before they make it into the portfolio. We try to assess management’s competitive strategy. Each idea is very different; some companies have natural network effects that create huge barriers to entry, some have IP or trade secret protections, some lock-in their customers through complexity and contracts, some have locked-in superior distribution, and so on. We’re not perfect in our analysis, but we usually have a good handle on the competitive threats facing our businesses. In the case of The New York Times, their historical advantage was real, but certainly not permanent. And this may be presumptuous, but we feel like we would have sold Polaroid long before the mass adoption of digital photography had we been investors. We have gotten it wrong in our portfolio before, and we will again. The keys for us are to get it right a lot more than we get it wrong — which in our opinion is easier with a concentrated portfolio — and to be decisive in our selling when we recognize deterioration in competitive position. I think our track record over the last nine years illustrates above-average execution in these two areas.
See full PDF below.