Here are a couple ways to think about augmenting one’s investment process that I believe to be helpful.

Fixed Income Investing

I have been re-reading and watching a lot of Howard Marks lately, and I’ve come to the realization that equity investors are better off thinking like fixed income investors—after all, the equity flows from the debt. In particular, thinking like a high-yield investor may be the best way improve investment results. I believe Marks’s best idea is that “there is no such thing as a bad asset, just bad prices”. This is critical for any investor in the capital structure to understand. If you’re buying an interest in the best companies, your result matters very little on the quality (in the short-run) and a huge deal on the valuation – the price you pay.

I recently spoke with an investor who had been connected to Michael Milken, the financier credited for creating the junk bond market. Milken made the case that what had appeared to be the riskiest bonds were the safest. The best that could happen to AAA bond is nothing…. the company wouldn’t magically get a fourth ‘A’. What’s more likely is the quality of the business worsens (ROIC approaches WACC) and its credit deteriorates. It’s not exactly the rosy picture you’d imagine of investing only in investment grade credit.

Looking down the credit spectrum is different. If a company is speculative grade but its fundamentals are improving and growth is real and sustainable… what stops its credit rating from going up? Not much, really.

Lately, I’ve recently been valuing a lot of businesses using net asset value and earnings power value. Some argue this approach is redundant and an poor use of time. While there is some merit to that critique, I don’t believe it tells the story completely. I think it is fair to incorporate growth even when the company of interest doesn’t have the most formidable competitive advantages – you just have to be cognizant of the likelihood of that growth not materializing as planned. In other words, by having a greater appreciation of the probabilities at play, you can form an informed investment decision. Over longer periods of time this point does become weaker due to the skewness of stock returns.

The fact is that most companies do not earn a rate of return above their cost of capital and 58% of stocks have holding period returns less than those of one-month Treasuries over their full lifetime as Henrik Bessembinder illustrated in aptly titled paper Do Stocks Outperform Treasury Bills?. I don’t believe that most individuals appreciate the existence of positive skewness in stock price returns and even more so the extent of its impact. According to Michael Mauboussin, only two percent (2%!!!) of companies were responsible for more than 90 percent of aggregate net wealth creation. To capture this positive skewness an individual investor only has two approaches to consider:

(1) Diversify one’s portfolio seeking to capture some of that positive skewness and return

(2) Concentrate one’s portfolio seeking to invest in the 2% of companies that create wealth and become quite wealthy.

I, like others, have chosen the second path.

Activism

After investing alongside some notable activists in one of my more recent ideas, I’ve also been reading up on other ventures in the activist space. I’ve personally enjoyed reading Trian’s letter to Solventum shareholders & Starboard’s deck on the many issues at Autodesk. The ability these firms have to enact change at the top of corporations make their theses more compelling to evaluate. Investors are best off entering positions right before an inflection in returns on capital as they are most likely to benefit from improvements in the earnings of the business as well as multiple expansion as the market re-rates to reflect the improved. Activists campaign working out successfully tends to be the timing of that inflection point.

I believe all long-only investment firms are better off acting as engaged-owners. That doesn’t mean they have to behave like activists waging public struggles over board composition or on strategic direction. Instead, engaged ownership can be expressed through thoughtful voting or by voicing concerns privately in meetings with management. While excellent equity stories don’t make for excellent credit stories, employing the same focus on cash flows (& asset values) as a fixed income investor is equally as important to investment results.