Finding Stocks based on Michael Burry's early methods.

Looking at Burry's first fund, his MSN articles and his "Silicon Investor" posts

'This piece is an opinion and for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.'

Before Michael Burry became famous by shorting the mortgage market in 2008, he was already known in the value investor world. Writing in the "Silicon Investor" forum, on MSN money and through the shareholder letters of his first fund, he shared the wisdom on how he achieved great returns through the bear market of the early 2000s.

One of Mohnish Pabrai's ten investment commandments is "Thou shall shamelessly clone". While I believe that cloning is a great method to find companies, blind cloning without understanding the essence of the investment and the conviction behind it, might lead to trouble during bear markets. With the help of Michael Burry's writing, I tried to extract his early investment methods and try to find companies that fit that framework as potential investment candidates.

Investment Philosophy

While his value fund's holdings aren't comparable to the S&P500, he still chooses it as his benchmark. Due to its incredible resilience, it outperformed most money managers and other indices over the long run. By using the historically best performing index, the  investment must have outstanding potential.

Burry's strategy is to entirely avoid and otherwise minimize the price risk in individual securities. One needs to first and foremost minimize the downside. This is based on the premise that on a percentage basis it is much harder to replace lost dollars than gained dollars are to lose. As a result the concept "margin of safety" is one of the most important tenets of his investment philosophy.

Instead of forecasting the markets, he tries to look in inefficient parts of the market.During the bear market in 2000, there were several opportunities that were in his framework of a 20% hurdle rate.

Volatility doesn't determine risk. A dollar selling for 50 cents one day, 60 cents the next and 40 cents the next week is not a risk, but an opportunity as the dollar is still worth one dollar. The stock market is full of dollars selling for much more than their value and he tries to avoid those investments.  Due to the mistaken, but Nobel-prize winning impression that volatility and risk have some relation, volatility is often on sale. Risk is minimized not through minimizing volatility but through proper business evaluations.

Concentrated investing in illiquid undervalued positions was a big reason why he was able to considerably outperform the S&P500 during the recession of the early 2000s.

The world's best companies often get too optimistic forecasts and as a result remain overvalued. In early 2001 his fund was more biased towards small cap value, but his fund will always go where the value is. It strikes him as ridiculous to put restrictions on a portfolio.

He prefers to hold 15-25 securities long, while holding a small cash position in order to benefit from valuable opportunities without leveraging the fund or rashly selling a position.

Buying stocks that provoke the "ick" reaction and look like "roadkill" are often neglected deep value plays. If he has difficulty finding opportunities, he will allocate capital to simple cash.

Stock characteristics

This is mainly based on his "MSN articles" and his posts in Silicon Investor.

• Stocks in or smaller than the S&P Midcap 400 ($22b was the biggest company in the index in May 2021).

• High and consistent ROE (around 20%)

• Compare capital expenditures to cash flows.

• Look at the last 10 years of earnings consistency and growth, at least doubling in 10 years without more than one down year. (Would be around 7% annual EPS growth)

• Conservative debt

• Focus on free cash flow and at the Enterprise Value (market cap less cash plus debt)/EBITDA ratio.

• Tends to ignore PE ratios as the true free cash flow is more important.

• Prefers to buy within a 10% to 15% of a 52 week low that has shown itself to offer some price support. He uses bare-bones technical analysis and often cuts the loss when it breaks to a new low.

• Current Ratio > 3

• Insider Ownership is preferred (20% or more) and even better if they are buying.

• Buybacks or dividends can both be great. (Prefers steady dividend payment for 10 years without suspension)

• Prefers to have Return on Capital around 12-25%. Too high ROC "attracts competition and is not likely to continue indefinitely"

Findings stocks

As I want to find international companies, I use the trial version by finbox with the following inputs.

After removing multiple listings, companies on exchanges I can't buy and biotech the initial screen of 315 shrinks to 86. Next up I will remove all companies that don't have an insider ownership of at least 10%. With 55 companies left, the next step for me is to remove every company that either doesn't pay a dividend or hasn’t bought back shares. I also removed every company that had a big share dilution over the last few years. If it does pay a dividend, I require a payout ratio of under 70%. That leaves me with 23 companies. Most of the companies are not listed on the NYSE.

I will also remove companies that have accrued more long-term debt over the last years, except when it was used for acquisitions and the earnings have moved in tandem with the debt. Since I only want stable companies, I also remove companies that had negative net income the last few years or are too cyclical for my taste. I also remove IT service providers as I generally dislike the business models where companies charge a lot, to do as little work as possible. That leaves us with 18 stocks.

As Burry wants to buy stock in the 10-15% range near the 52 week low, I also add that statistic. However due to the Corona-Virus and the subsequent market crash in March 2020, a lot of stocks are quite above that. As a compromise I took the 10 stocks closest to the 52 week low.

I will review those in the next edition. Feel free to contact me on twitter @InvestRoiss

Sources:
https://www.valuewalk.com/2014/04/michael-burry-silicon-investor/
http://csinvesting.org/wp-content/uploads/2013/07/Michael-Burry-Case-Studies.pdf
https://www.valuewalk.com/wp-content/uploads/2016/02/Scion-Capital-Letters.pdf