Interview

The king of buy and hold

How Nick Train, the star fund manager from the UK, never sells and yet make mammoth gains

If you thought that value investing is buying below book or buying a low P/E stock or going contrarian, you have much to learn from well-known British fund manager Nick Train. Nick doesn't look for any of these when hunting for stocks. He doesn't even try to spot the next multi-bagger. And yet, when he finds companies that he likes, he keeps them for years. An avid fan of Buffett, Nick tells Mohammed Ekramul Haque and every value investor how to invest for value and more.

The king of buy and hold

On equities, markets and market valuations

Q1. John Templeton once said, "History shows that time, not timing, is the key to investment success. Therefore the best time to buy stocks is when you have money," - a philosophy you share. What would you do in a 1999 or 2007-like scenario? Continue to invest? Another view says, "Wait, till there is 'blood in the streets'." How do you reconcile these two?
I have never suffered from any delusion that I am an unusually smart or far-sighted investor. A keen sense of my many investing limitations means I have had to keep my approach simple. I am mostly concerned with avoiding obviously bad or "losing" investment behaviour - such as over-trading, or backing low quality companies and I'm willing to stick with basic investment principles that seem to me likely to work over time, even accepting there will be periods when they don't.

Your first question is a good example. For a while as an inexperienced investment professional I tried to judge whether equity markets were cheap or expensive. I even allowed myself to express pessimistic views about market prospects in public and, worse, to act on them. Now looking back over the thirty or more years of my career it seems to me every one of those negative calls I made on markets was just plain wrong. They've gone up a lot over time and, in hindsight there was always something to be enthused about. And likely there always will be.

Eventually I acknowledged the, for me, futility of such guesswork about market levels and concluded that it makes good commercial, investment and - perhaps most importantly - emotional sense to be permanently bullish. This, I believe, is good, "winning" investment behaviour. Being bullish brings a competitive advantage over the many market participants who are either negative because that is their habitual outlook on life (an outlook that tends to overstate temporary problems and to underestimate human problem-solving ingenuity) or who back themselves to trade in and out of equity markets on the basis of their hunches about market levels; or both. Of all the losing investment approaches out there, that of being a pessimistic trader must be the most certain to lead to disappointing returns. So I practise the exact opposite - I'm an optimistic buy-and-holder. In this way I put history on my side, given the long-term propensity of stock markets to go up over time, Anglo-Saxon ones at least. In addition, I feel a lot better about myself - being optimistic keeps you young!

Admittedly this determined bullishness means that periodically I am "long and wrong" about stock markets, including 1999 and 2007. This is no fun at the time, but holding cash when markets are recovering is even less so.

Q2. What according to you, indicates the market is expensive or cheap? Are dividend yields a good indicator?
In my opinion nothing reliably indicates markets as cheap or expensive. For this reason, as outlined above, I believe it is a better bet to assume that equity markets are always cheap. The long term returns from stocks suggests that this is not as deluded a proposition as might appear.

The fact is stock markets are driven by technology innovation and the associated rise and fall of industries brought about by that innovation As a result the constituents and industry weights of markets are always changing, so trying to judge the value they offer in relationship to a different historical period is pointless.

It is wrong to think that stock markets exist in order to make investors wealthy. This is a possible but by no means certain outcome. No, markets have evolved as the most efficient means so far to test and finance new ideas about how to satisfy human needs and wants. Investors fret about the cyclical wobbles of economies and periodic spikes and dips in equity prices but these are irrelevant to this central function of stock markets and to their long term trajectory. For instance, people worry today about a turn in global interest rates. I understand this is an issue if you invest in government bonds. But what equity investors should really be worrying about is whether Moore's Law still holds (whether computer power will continue to double every two years, as it has for the past fifty). This is far more relevant to the outlook for stocks than the vacillations of interest rates. Take a look at a long term chart of the S&P 500. Every bull market you see, the remorseless accumulation of long term value, is associated with the emergence of new industries, new companies or the productivity gains brought to existing business by new technology. The ups and downs of interest rates? Not so much.

I'm sure that if you're optimistic about technology and innovation then you should be optimistic about equity markets. And in that sense markets are always cheap.

Q3. When market yields are below gilt yields - do you still buy equities or wait it out?
Gilt yields and stock market average dividend yields are irrelevant if you have identified a good equity idea. Good ideas are rare, in my experience - so buy.

Q4. Equities, you mentioned in one of your Insights, perform well in recession years. How do they do that, if earnings are down?
The "duration" of the stock market can be thought of as its dividend yield divided into 100. So a 3% market yield gives a duration of 33 years. One or two years of recession-depressed earnings are of little importance when investors, whether they know it or not, are looking out over this sort of time horizon.

Q5. You have quoted Deirdre McCloskey, "a more reasonable diagnosis...is that booms and busts arise from uncorrectable optimism and pessimism about novelties," - Do you see any novelties that can become a boom-bust scenario ahead?
I certainly hope so. Booms and busts are integral to markets and without them they can't do their job - namely finance new ideas. We pejoratively describe booms as "manias", suggesting that individual investors have become irrational - carried away by greed. This may be so, but at societal level these manias are, in fact, quite rational and beneficial. We wouldn't have Facebook and Google without the mania of 1997-2000. And many treatments for previously intractable medical conditions will emerge from the current biotechnology boom.

On companies

Q1. You ascribe a lot of significance on dividend-paying companies. What of companies that skip dividends to invest in growth?
Yes, dividends are interesting, particularly long-term dividend histories of industries and companies. But maybe not for the reasons you might think. Here's why.

Technology change is the big driver of both wealth creation and destruction. How does an equity investor respond to its challenge? Some look to participate in cutting edge technology itself and this is probably the most rewarding approach, particularly if you have a superior understanding of the technology and the competitive advantages of the companies you choose. I do not have this expertise. Instead I've chosen another response. That of identifying companies whose value-added is unaffected by technology change, or, even better, companies whose value-added can be enhanced by applying technology to its existing franchise. For example, Burberry is a company whose brand and heritage have made its products desirable for well over 100 years. And Burberry is now demonstrating how the deployment of digital marketing techniques can make its brand and heritage even more aspirational. Technology can't disintermediate Burberry's products as it might, say, a telephone company. But the company can use technology to reach more customers and understand them better.

This means that longevity, tradition and predictability are important investment criteria for me. If a business has not just survived but thrived over previous periods of technology change then there is a possibility, never a certainty, that it will continue to do so. For this reason I am interested in the long term dividend histories of companies. If a company has proven capable of paying growing real dividends over long periods it is a signifier that here is a business model or set of assets that has retained relevance and offered protection against past disruptive technology change and the effects of monetary inflation. Of course the past is no certain guide to the future. But I prefer to start from identifying existing great, durable franchises and asking what could hurt them, rather than trying to predict the next generation. If at all possible I avoid companies that appear to be certainly vulnerable to technology change - however "cheap" they may appear. That seems to me to be the most difficult approach of all.

Q2. You hold companies for many years. When, in your view, does a company start losing the plot and is on the sure path of decline? Are there any indicators?
I don't like it when a theoretically cash generative business model stops generating free cash. Also if debt builds up for no good reason alarm bells ring. A long time ago I made a bad mistake investing in the music industry. I failed to understand how technology was unravelling the record labels' superior economics based on copyright. The problems soon showed up in falling free cash flow and rising debt. I should've reacted quicker.

Generally though I agree with Buffett that investors are too ready to sell out of investments. That they are too confident that doing something, as opposed to nothing, will make a positive difference. It seems to me that it is more likely that experienced, smart managers of a company with temporary problems will find a solution to those problems than that I will successfully switch out of said challenged company into a better one. That might sound defeatist - but in a competitive capital market, with other investors highly alert to risks and opportunities everywhere it is hard, particularly after costs, to demonstrate that regularly trading in and out of companies adds value.

Q3. Why is mismanagement of retained earnings significant? Are there any indicators that signal such mismanagement?
Sadly not until it's too late.

On stock picking

Q1, What is a bagger? What are the qualities you look for in a bagger (or in a prospective investment stock) and what, not?
A bagger is a stock that goes up multiple times on its purchase price. So far as I know the first investor to use the term and to build an investment approach around looking to capture as many baggers as possible was Fidelity great, Peter Lynch. But credit too to Bill Miller, whose dictum - "He who has the lowest book cost wins" expresses a similar idea. It seems almost a pointless truism - that the best investment you can make is one which rises many times over and that you never have to sell. But my observation is that few people invest in such a way as to give themselves the best chance of multiplying their capital - because they're always, as the cliché runs, pulling up the plant to look at the roots.

In the end I think there is a psychological factor here. There are those who love to trade - to take cutely timed profits and move on to the next idea. Variety keeps them engaged. Then there are the hoarders. People who painstakingly accumulate holdings in valuable companies over the years, harbouring them during periods of underperformance, buying more on the dips - monitoring the gradual build-up of book value and dividends over time. It takes patience. Both are equally valid. Perhaps the most important learning for every new investor is to figure out what psychological type they are.

An old friend of mine - an investment banker actually - likes to point out that the dividend per share he receives today from his longest-standing personal equity holding is higher than the price per share that he paid for the stock - although, admittedly, it was purchased 25 years ago. Isn't that amazing? Only equity can do that for you. But you have to own the right company and you have to be patient. I always tell our clients that we expect to be invested in the companies we commit their capital to for a long time. We're looking to stay invested over the course of several business and stock market cycles - way, way longer than many professional investors. Of course this sort of strategic approach is not perfect. We're not nimble - not because we couldn't be, but because we don't choose to be. We'll hold underperforming businesses and shares maybe for too long. But there is a big benefit too in what we do. We're giving ourselves and our clients the best possible chance to benefit from the effects of compounding - which take time.

Q2. Both, in your UK Equity Fund and the Global Equity Fund, you have no investments in commodities, industrials, mines, cement, steel and real estate. Why?
Investing is challenging - both intellectually and emotionally. I prefer to avoid investing in industries which I know for sure have gross cyclicality of earnings and/or which rely on borrowings to make their returns. I'm not saying there aren't great opportunities to make money in these sectors. It's just that you always have to remember to sell and I, being a hoarder, prefer to own stuff I hope never to have to sell.

My two favourite pieces of investment advice help explain these preferences. "Never invest in any company that makes anything out of metal." And "If you find a company whose products taste good; buy the shares." By and large those two rules have helped me avoid the worst investment errors and pointed me to some of my best ideas.

Q3. In some stocks with high dividend yields, is there not a risk of getting into a value trap - where the stock behaves like an annuity but does not offer much long-term stock price appreciation? How do you identify and do you invest in such stocks?
Just never buy anything for dividend yield alone.

Q4. In a recent interview, you said you have not bought anything new for the last four years. What did you mean, and what did you do during that period? Do you wait for a fat pitch, as Buffett says? How long?
Yes - I've just been through a four year drought when no new idea seemed sufficiently compelling to supersede existing holdings. I've been lucky enough over that period to enjoy strong flows into my fund and had no problem investing that cash into the current constituents. Doesn't Buffett say somewhere; "Often the best idea for new money is to buy more of what you already own"? I think it's interesting that this four year period has coincided with a streak of competitive absolute and relative performance from the strategy. Activity is overrated!

On stock valuations

Q1. Exceptional companies with durable competitive advantages are often not cheap. Would you buy a Diageo at 40x or 50x earnings? What is the maximum you would pay for such companies in terms of earnings multiples?
Actually I'd argue the opposite. To me it appears that "exceptional companies with durable competitive advantages" are in fact cheap almost all the time.

The point is such companies are rare. It is plain wrong to expect them to be valued similarly to what is the vast majority of ephemeral, low value-added businesses. I like to think about the conundrum of 20. Many investors presented with a stock on 20x earnings - Diageo for instance - will say that's expensive, relative to, for example, the long run average P/E multiple for Anglo-Saxon markets of 15x. However, if I offered those same sceptical investors the opportunity to invest in an asset with a guaranteed 5% yield, with likely protection against inflation over the next 25 years, with some real, above inflation growth thrown in too - they'd fall over themselves to buy. Diageo seems to me to offer such potential, by the way. Yet, of course, the "high" P/E of 20x and the attractive real yield of 5% are one and the same.

So, a rule of thumb for me is that an exceptional business can easily justify an up to 30x P/E, or a real earnings yield of over 3%. After all, inflation-protected government bonds are keenly bought by investing institutions today with starting yields of lower than 1%.

Q2. How can investors use the gilt rate to come up with a discounting rate to arrive at the intrinsic value? Can you explain with examples?
I do use the long gilt yield as a discounting rate, but it is important to understand that any resulting measure of value is very imprecise.

To my mind the real benefit of the exercise is the questions it forces you to answer about the company you are proposing to value. The longest dated government bonds have lives of thirty up to fifty years. If you're going to use these instruments to value an equity then first you must have a reasonable expectation that the company will have a similarly long life. Otherwise you are not comparing like with like. Of course most companies will not survive for 30 years or more. Most companies fail. So just applying this filter - will such and such a company likely be around in 30 years - savagely reduces the universe of potential investments for me. But every so often you come across a business with a brand or a franchise that has survived and thrived over many decades and where it doesn't seem totally absurd to expect it to continue to do so. Then you can start thinking about its value compared to a long bond. The next question is - how likely is it that this durable corporate asset will be able to grow its cash earnings over the next 30 or more years ahead of the rate of inflation, whatever that turns out to be? Again, this is another unanswerable question; but again history suggests few companies are able to maintain the real value of their products or services over time.

But say you decide that Diageo's brands - Johnnie Walker, Guinness, Captain Morgan etc - are likely to at least maintain their real pricing power over the next three decades and might even offer some inflation-beating volume growth too, as the world's spirit drinking population grows. If you have made that decision then you're immediately faced with the critical question at the heart of our investment approach. Why should Diageo, or any other of these rare wonderful corporations, be valued at less than a government bond? We know for sure that the bond will pay its fixed coupon for the next 30-50 years. That's something. But we also know for sure that the government bond will be unable to protect investors against the effects of unanticipated monetary inflation over time - because the coupon is fixed.

Meanwhile, we've already agreed that Diageo will not only have survived over the life of the long bond, it will likely, in addition, have grown its earnings ahead of inflation. This means Diageo ought to be worth very much more than a government bond to a long term investor. But when you look at current valuations you find that this is not the case. The longest UK gilt has a redemption yield of 2.4%, or a P/E of 41.7x (100/2.4). In contrast Diageo trades on a prospective P/E of 20x (according to Bloomberg) or a yield of 5% (100/20). If Diageo were to be valued just in line with the UK long gilt it should today be trading at c£40, rather than its market price of £18. And there is a clear case to argue that Diageo ought to be worth more than a gilt because of the likely real growth it offers.

The above is in no sense a formal target price for Diageo. I don't know any certain way of arriving at the "correct" value of any asset. What I do know though is that I've been asking the right questions about the attraction of any equity asset. And the thing is history supports the proposition that those companies that do succeed in growing real value over long periods of time are not only rare they are also extraordinarily valuable.

Q3- India's bank deposit rate is about 8.5 per cent. Should this be the minimum yield rate to demand from quality stocks? What if the yield rate (dividend or free cash flow, - which do you follow here) offered by high-quality stocks is lower than the 8.5 per cent? Should one wait for markets to cool down or yield rates to go up?
No. Short term interest rates have no bearing on the long term value of a real asset like a quality stock. Given long enough, its share price will correlate perfectly with its growth in free cash flow.

Q4. How do you value whether a company is undervalued or overvalued? DCF, free cash flows or private market value? Or a combination of all?
On my time horizon the calibre of a company is much more important than its value. You can be wrong about value in the short term, but still have a great investment over time. My worst errors have come from overestimating a company's business model, not overestimating the worth of a fine company.

That said, I pay a lot of attention to M&A activity in the sectors that I invest in. One actual transaction - when serious business people, staking long term corporate capital, are prepared to buy or sell 100% of the equity of a business - is worth dozens of investment bank research notes.

>On selling

Q1- When should a person sell a long-term investment and when not? Do you sell or clip your holdings in a heated market in anticipation of lower prices when markets will eventually crash?
Best to never sell.

Nick Train is a co-founder and portfolio manager at Lindsell Train Limited, a UK-based investment management firm.


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