Joel shares what P/E ratios and free cash flow yields he looks to pay and also discusses what he tries to avoid when picking stocks
January 9, 2024
This article appears from guest contributor John Rotonti. John is the host of the JRo Show and is a long-time friend of 7investing.
To celebrate Joel Tillinghast’s incredible investing career and all his teachings through interviews like this one, I want to first share 5 of my favorite quotes from him:
“Crisply put, you want low P/E stocks that are also high quality and growing, with a high degree of certainty about the long-term outlook.”
“Instead of chasing the highest potential returns, I emphasize the durability of profit streams and the credibility of forecasts.”
“Many ignore the question of value because they think it’s too tough to answer.”
“People avoid reason until they have tried everything else.”
“Without any concept of intrinsic value, it’s impossible to gauge whether the market has already picked up on your insight.”
Joel Tillinghast retired from Fidelity on December 31, 2023 after a 30-plus year legendary stock-picking career. He will remain a mentor and advisor to the Fidelity Investing team. I thought now was a great time to speak with him about his book and his investing process and philosophy.
Joel was the portfolio manager of a few different Fidelity strategies including the Fidelity Low-Priced Stock Fund with $26 billion in AUM.
Joel is an investing GOAT (“Greatest Of All Time”) and value-investing legend. He was named Morningstar’s Domestic Stock Fund Manager of the Year in 2002 AND winner of the 2021 Morningstar Award for Investing Excellence in the “Outstanding Portfolio Manager” category.
Since Joel started the Low-Priced Stock Fund in December 1989 through December 31, 2023, he generated annualized returns of 12.95% compared to the primary benchmark Russell 2000, which generated annualized returns of 9.16% over the same time frame.
So, over the last 34 years, Joel and his team have generated average annual alpha of a whopping 3.79% points. Nearly 400 basis points of annualized alpha over more than three decades puts Joel Tillinghast in elite status. Joel is also the author of easily one of my top five favorite investing books of all time titled “Big Money Thinks Small.” (Buy it! Read it! Trust me! And thank me later!)
In the forward to the book Peter Lynch says that Joel is “one of the greatest, most successful stock pickers of all time.” I agree, and I’m so honored to learn from Joel today.
The interview that follows was conducted over email.
First, I want to quickly ask you about the title of your book. What does “thinking small” mean to you?
Thinking small means paying attention to the important details that others might have missed, or thought were not important.
Another title question: What does the “Low Priced Stock Fund” convey? What is the meaning of “low priced” in the context of the fund you managed at Fidelity for over 30 years?
Low Priced Stock initially meant a stock priced under $15, which was later raised to $25 and then $35. It also means priced low relative to intrinsic value.
Joel, you were hired by Peter Lynch and worked for Peter Lynch. How would you describe Peter Lynch as an investor? Peter generated 29% annualized returns over 13 years. What made him so great? What were his strengths as an investor?
Peter considered a very wide range of investment possibilities, both companies and scenarios. He always wanted current information and adjusted his beliefs accordingly. He has an extraordinarily open mind.
Peter Lynch trained you. What did you learn from him?
I learned too many things to summarize them quickly. Focus on things you understand well and can adjust to. Know your own behavioral weaknesses.
When Peter Lynch hired you at Fidelity he said that you were “as strong [of an analyst] as anyone he’d ever met.” That’s quite a statement coming from Lynch. What did you do to develop your investing skills before you arrived at Fidelity?
I worked at Value Line Investment Survey and had bought some stocks personally.
Peter Lynch also says that you have an “unworldly analytical ability” to “consume mountains of information.” In your book you also say that you look at a “mosaic of data.” Do you think you were born with the ability to analyze data better than others? And how important do you think this data analysis skill is to long-term investing success?
Different people use different approaches to investing, and data is central to my approach. Every investment has an opportunity cost in terms of the roads not taken, so I always like to rank the possible choices. But I’ve seen others invest successfully with less data by seeking management teams or market opportunities that stand out as extraordinary.
Every investment has an opportunity cost in terms of the roads not taken, so I always like to rank the possible choices.
Sticking with your ability to analyze mountain of data, what are you analyzing? Are you analyzing company-specific as well as macro data points? Are there any data points, either business related or economic related, that you spend more time on than others?
Mostly I’m looking at how stable numbers and ratios are over time to see whether I dare to extrapolate them into the future. Anything that bears on my ability to estimate future earnings and cash flows is helpful. Macro data can affect those forecasts, but usually my conception of the future involves rotating through a series of backdrops. There will be recessions. And booms, too.
Peter Lynch also says that you are a “one-of-a-kind investor” that can’t be replicated. So, how would you describe your investing strategy and philosophy, and what skillsets and mindset do you have that makes you such a successful investor?
I’m trying to compare a stock’s price with its intrinsic value, which is the present value of future free cash flows from here to eternity. Cash flows that you can believe in are worth more than those you don’t, and growing cash flows are worth more. But you also must constantly compare opportunities.
Lynch also says that you “work as hard as any of the best investors.” How important is hard work to investing success?
Peter—and all the best investors I know—work very hard.
In the book you also say that the stock market pays you to be a nerd. So, I’m curious: what does hard, nerdy work look like to you? How do you spend your workday? What are the hours that you work? How many hours a day are you reading? What are you doing with the quiet time in your office?
Most successful investors do a lot of reading at all hours of the day and need quieter periods to read denser texts like 10-K’s or books. When I’m reading something dense my mind often wanders to broader and narrower questions like “Did management choose this accounting principle to flatter results or because they thought it represented reality?” A lot of office time gets used in meetings with analysts and company managements.
You say that every skilled investor you’ve ever met “reads broadly and constantly.” What are you reading beyond corporate filings? What are your go-to sources? Whether its certain newspapers, or industry journals, or sell-side research, or in-house Fidelity research? What do you spend most of your time reading?
My subscriptions include the Wall Street Journal, the Financial Times, the New York Times, the Economist, the Journal of Portfolio Management, the Financial Analyst’s Journal, and Grant’s Interest Rate Observer. A go-to source aspires to get to the truth by presenting all sides of a controversy. That has become harder to find especially on the internet. Fidelity research produces dozens of research notes a day, so I only read the stocks of interest to me and the notes with catchy headlines.
In your book you say that the greatest danger for investors is to get caught up in FOMO and to have a misunderstanding of reality. You say that too many investors are looking for today’s El Dorado and that they have a shared hallucination about cities of gold. You also say that one of the five biggest mistakes investors can make is overpaying for story stocks. You say that speculators and gamblers “think in terms of a story without numbers.” Where do you think market psychology stands today with regards to FOMO?
My attention span has gotten shorter with all the Outlook, Teams, and phone alerts, not to mention social media. A shorter attention span focuses you on vivid current things and is fertile ground for FOMO. Except for billions, most numbers aren’t very attention grabbing.
A shorter attention span focuses you on vivid current things and is fertile ground for FOMO.
You say that stock pickers should start out by “cutting out the stuff that drags down returns.” And you say that too much debt is one of the things you cut out from the beginning. What else do you filter out early on in your research process?
I cut out industries where I have no reliable way of somewhat accurately predicting a company’s earnings five or ten years from now. I cut out managements that are not trustworthy and which have a history of using capital in ways that produce poor returns. I cut out companies that can not control their destiny, either because debt is too high, or the business is an undifferentiated commodity.
You define an investment as “the product of thorough research.” So, I’m curious what does the research process look like at Fidelity? And what is the interaction like between you and the army of analysts? Do they research a business on their own and then pitch it to you when they are ready? And then what happens after the stock pitch? Do you send them back to do more work? Do you then start researching it on your own? Please tell us about the process of how ideas are shared with you and then how an idea makes it into the portfolio. What are the steps that need to happen?
All of the above! Fidelity research is an interactive process, where analysts must serve many fund managers. Analysts are assigned the larger companies to follow but may choose among the smaller ones. Sometimes a fund manager has researched and held a stock, as the analyst is just learning about it. Often, I will buy a small quantity and add more as I learn more about a company or the analyst updates information.
What is it like being an analyst at Fidelity today? Are they generalists or specialists? How many stocks do they typically cover? What is expected of them?
Most analysts are industry specialists, following about two dozen assigned companies. Some small cap analysts are generalists, but most are specialists in larger groups, such as technology or consumer. Small cap analysts are expected to be more free range.
You write that “not thinking independently is absolutely toxic.” Can you please explain why independent thinking and why doing your own research and building your own conviction is so important to long-term investing success?
The person who did your thinking for you won’t always be there when something changes. You won’t know what to do! Stressful moments like this often offer the opportunity to make, or lose, huge amounts of money.
The person who did your thinking for you won’t always be there when something changes.
You write that investment managers “should be able to explain clearly what they are doing uniquely and why it succeeds.” Well, you outperformed by about 4 percentage points per year for over 30 years. So, what would you say you did uniquely?
I considered a lot of opportunities that many portfolio managers ignored as too small; choosing from more opportunities results in better opportunities. I tried to focus on industries I understand, which might result in more accurate guesses. I tried to focus on industries that are not too commodity-like, and companies that do something that customers think is special, which should produce higher profitability. In the rare cases where I found an extraordinary business, I made it a large holding.
According to your book, a portfolio manager’s main job is risk management. How do you manage risk in your portfolio?
I reduce behavioral risks by thinking about my bad habits and trying to avoid situations where they come into play. I reduce ignorance risk by focusing on industries and businesses I understand. I reduce agency risk by steering clear of crooked and inept management teams. I reduce business risk by focusing on more resilient, adaptive businesses. I don’t pay more than fair value.
You prefer to invest in slower-growing oligopolies that are fantastically profitable and have long life spans because it’s easier to estimate normalized earnings five years out. How important is estimating normal, mid-cycle earnings to your process? Do you avoid stocks where you can’t confidently estimate future earnings?
Yes. If I can’t estimate earnings into the future, I can’t estimate value.
Your book says that investing in businesses that you know is great advice, but you also say that to understand a business you must be able to “more of less” accurately estimate future earnings? Do you think retail investors should be picking individual stocks if they can’t estimate normalized, mid-cycle earnings for the businesses they are considering buying stock in?
Possibly not. If they don’t have a theory of why a stock might be undervalued, or at least of what a company does that is special to customers, no. Not everyone is a value investor, but they should be clear about what approach they are using.
Why do you own about 800 stocks? Is it because Fidelity’s army of analysts make it possible for you to do so?
The tiny holdings are indications that I thought I saw something better than average in a stock, and hoped analysts would do more research to help me build conviction and add to the holding. Or the analyst thought it was interesting, and I need to study it more before I buy more.
You look for stock ideas in the print version of Value Line. What do you like about Value Line and what are you looking for as you are paging through the issues? What jumps off the page at you and signals that it may be a company and stock that you want to research further?
About 15 years of statistics are presented on each company page. I’m looking for consistently high profitability over that time, with some organic sales growth. It helps if they have cumulatively bought back a lot of stock and if management owns more than 1% of the stock.
You look for companies “earning outstanding profits.” What profit metrics and levels of profitability are you looking for? Do you look for a minimum ROE or ROIC?
A ROE of 10% or ROIC of 10% would be on the cusp of average, but if repeated for many years (especially into the future) would be well above average, especially in small caps and in Japan.
You say that a debt/EBITDA of over 4x is usually scary. Are there any other rough guidelines for metrics you use? Do you look for certain interest coverage ratios? Or certain growth rates? Or certain FCF-to-net income (which is something else you talk about a lot in the book, this concept of FCF conversion)?
Debt becomes a problem in a bad year, so I’d look at current debt relative to EBITDA in the worst recent year. Is debt rising relative to EBITDA because of poor cash conversion?
One of the main, recurring themes in your book is that you pay low P/E ratios (or the inverse high earnings yields). Why do you aim to pay low P/Es?
Low P/Es are a shortcut to high FCF yields although that isn’t always the case. A company with a low P/E will on average have less downside than a high P/E because it can return more cash by dividends and buybacks.
A company with a low P/E will on average have less downside than a high P/E because it can return more cash by dividends and buybacks.
In the book you give several examples of where you paid single digit P/E ratios. How low of a P/E do you look to pay?
It depends on what’s available in the market. For average or middling businesses, I want a single digit P/E.
You say, “gaudy P/Es produce miserable returns.” Under what circumstances will you pay a higher P/E and how high of a P/E are you comfortable paying?
For better businesses, I will pay a teens P/E. It must be an exceptional business to get me to pay a low twenties multiple. But I do hold more expensive stocks that I wouldn’t buy.
Joel, would it be fair to say that all else equal you’d prefer a stock with a 10% earnings yield with expected growth of only 5% versus a stock with a 1% earnings yield but with expected growth of 14%? Why or why not?
Yes. If the company with a 14% growth rate continues for 17 years, it still doesn’t reach a 10% earnings yield on the starting price, which the first company does in the first year and continues to do. There are also a lot of considerations about dividends and use of free cash in the background.
What are signs of a strong corporate character?
Conservative accounting principles. Prompt full disclosure of bad news. Taking the long view.
You talk about several red flags including too much debt, negative free cash flow, return on equity much higher than ROIC because of debt, especially when FCF is negative, receivables and inventory growing faster than sales, rising DSOs, high intangibles as a percentage of total assets. Are those the main ones or are there other red flags that you pay close attention to?
Those are the main red flags. Lots of companies have an orange flag or two.
What are your thoughts on SBC (Stock Based Compensation) and large dilution? Do you avoid companies with consistently rising share counts and large SBC as a percentage of sales or as a percentage of operating cash flow?
I do. GAAP earnings are one way of thinking about this. Another is “flat share-count free cash flow.” That is, if a company issues a million shares under options at $10 and would have to buy them back at $50, free cash flow is $40 million lower.
The four elements of value are profits, life span, growth, and certainty. Why is business certainty or predictability so important to your process? And maybe you can also tell us about what you mean by “margin of unsafety.”
You are trying to estimate earnings far into the future, which is guaranteed to be wrong. If you do not separate the estimates by predictability and believability, the models will maximize errors. They will tell you to buy unpredictable things that you don’t quite believe. A “margin of unsafety” is the amount by which a stock price exceeds its fair value. Good things must happen to justify the stock price.
You are trying to estimate earnings far into the future, which is guaranteed to be wrong. If you do not separate the estimates by predictability and believability, the models will maximize errors.
You write that many companies have a terminal value of zero. What’s an example of a company or an industry that you think has a high terminal value and why?
I don’t really believe in the idea of terminal value (other than cash or maybe book value), as it collects all the assumptions that you do not want to examine too closely.
In the book you gave a couple of examples of multi-bagger investments when you bought oil and gas stocks selling at low single digit P/E multiples. Some oil and gas stocks are selling at single digit multiples today (with oil at around $75 per barrel). So, do you own oil and gas stocks today? Why or why not?
I do own oil and gas stocks, tilted towards gas which might be slightly greener. The shift to greener energy sources will take time. Oil and gas consumption is still growing in many parts of the world where use is far below that of wealthy countries like the US. But oil and gas are commodities, and it is hard to find companies with a durable cost advantage in production.
There is an idea out there popular with public market tech investors that take a VC approach to public markets investing, and that idea is that one massive winner can make up for a bunch of massive losers in a portfolio. But you seem to be cautious about this approach to investing. Why is that?
In the casino approach the sum of the prizes is less than the amount invested. Skilled venture capitalists have many wipeouts, but the sum of the winners exceeds the amount invested. I have no way to estimate venture capital returns other than asking, “have you been lucky?”
You place a lot of emphasis on free cash flow, but you also say that in most cases you prefer GAAP earnings to non-GAAP (adjusted) earnings. Why is that?
GAAP accounting is not always more economically accurate, but it is usually easier to compare accounts between companies. When I adjust, I try to make the same adjustment for all companies.
You write that, “For stocks that have rallied sharply from an absurdly undervalued price, Fidelity fund manager Peter Lynch advised “mental whiteout” of the gains you have missed, in order to focus on today’s opportunity for further gains.” Can you think of a successful stock investment you made after the stock had run up sharply?
Sadly no. For me, it’s hard to use mental whiteout when buying a stock, and a lot easier when I’m considering selling a stock. If you have “confirmation bias”, as I do, it’s good to know that about yourself.
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