Pricing Power? Milk and Bread!

Buffett considers the best businesses to buy are the ones with pricing power.  His experience with Berkshire Hathaway's textile business and then See's Candies provided him with a significant contrast in the value of pricing power. In a lecture to students at Notre Dame Facility in 1991, Buffett explained the differences between the two businesses...

"Our textile business - That's a business that took me 22 years to figure out it wasn't very good. Well, in the textile business, we made over half of the men's suit linings in the United States.  You wore a men's suit, chances were that it had a Hathaway lining. And we made them during World War II, when customers couldn't get their linings from other people. Sears Roebuck voted us "Supplier of the Year." They were wild about us. The thing was, they wouldn't give us another half a cent a yard because nobody had ever gone into a men's clothing store and asked for a pin striped suit with a Hathaway lining. You just don't see that. As a practical matter, if some guy's going to offer them a lining for 79 cents, [it makes no difference] who's going to take them fishing, and supplied them during World War II, and was personal friends with the Chairman of Sears. Because we charged 79½ cents a yard, it was "no dice."

See's Candies, on the other hand, made something that people had an emotional attraction to, and a physical attraction you might say. We're almost to Valentine's Day, so can you imagine going to your wife or sweetheart, handing her a box of candy and saying "Honey, I took the low bid." Essentially, every year for 19 years I've raised the price of candy on December 26. And 19 years goes by and everyone keeps buying candy. Every ten years I tried to raise the price of linings a fraction of a cent, and they'd throw the linings back at me. Our linings were just as good as our candies. It was much harder to run the linings factory than it was to run the candy company. The problem is, just because a business is lousy doesn't mean it isn't difficult."

See's Candies was a phenomenal investment for Berkshire. See's cost Berkshire $25m in 1972, and Berkshire invested an additional $32m between 1972 and 2007. The volume of chocolate See's sold grew at just a 2% annual rate between 1972 and 2007, however See's pre-tax earnings grew from less than $5m in 1972 to $82m in 2007, and over the period from 1972 to 2007 they totalled $1.35b. By today, that number is close to $2b. 

“When we bought See’s Candy, we didn’t know the power of a good brand. Over time, we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.” Charlie Munger

Buffett expanded on the thought process to determine pricing power...

"One of the interesting things to do is walk through a supermarket sometime and think about who's got pricing power, and who's got a franchise, and who doesn't. If you go buy Oreo cookies, and I'm going to take home Oreo cookies or something that looks like Oreo cookies for the kids, or your spouse, or whomever, you'll buy the Oreo cookies. If the other is three cents a package cheaper, you'll still buy the Oreo cookies. You'll buy Jello instead of some other. You'll buy Kool Aid instead of Wyler's powdered soft drink. But, if you go to buy milk, it doesn't make any difference whether its Borden's, or Sealtest, or whatever. And you will not pay a premium to buy one milk over another. You will not pay a premium to buy one of frozen peas over another, probably. It's the difference between having a wonderful business and not a wonderful business. The milk business is not a good business."

In an interview in 2011 Buffett said “The single most important decision in evaluating a business is pricing power..  If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Buffett expanded on product differentiation in his 1982 letter ..

"We need to look at some major factors that affect levels of corporate profitability generally. Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. If .. costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous. Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn’t work with sugar (how often do you hear, “I’ll have a cup of coffee with cream and C & H sugar, please”). In many industries, differentiation simply can’t be made meaningful.  A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent."

It's important to think about how differentiated a company's products are or at least how differentiated they are perceived to be. Why do people buy the product? Is it an essential item? Are there substitutes? Is the price regulated? Is competition increasing or decreasing? Is it a small part of a larger purchase? Are there risks of obsolescence? Are the buyers consolidated or fragmented? What are the barriers to entry? Whether it's milk, bread or some other item, you need to consider what the buyer's psychological motivations are, their habits and their considerations around price? 

"Early in the process.. [we're] making sure we understand how business is really done in the space.  How do customers make purchase decisions? What’s the differentiation between companies’ products? Who, if anyone, has pricing power? What are the key secular trends? What’s going on at competitors? To really understand all this you have to talk to people in the industry.” Ricky Sandler

".. among other factors it is about pricing power. You have something that is so attractive to the consumer that they pay a premium to walk into your store and do something." Ted Weschler

“We want to own businesses with pricing power vis-à-vis their customers and suppliers – those that sell unique, highly valued products or services to customers who have little desire to switch to a competitor.” Brian Vollmer

“Buy businesses with pricing flexibility. For several years our investment philosophy has been based on the assumption that inflation over the next ten years will be the major enemy of capital. We assume that inflation may equal or exceed 7%. If this proves to be wrong, we will be delighted as the lower rate will lead to a much healthier stock market. If our assumption is borne out, the pricing flexibility of companies with dominant market positions will provide an important hedge against inflation.” Bill Ruane

“Nothing makes the job of a portfolio manager easier & happier than owning a basket of companies with untapped pricing power at discounted prices. If he is patient, he needs no other virtue.” Li Lu

In his book "Common Stocks and Common Sense," Ed Wachenheim discusses the bakery industry … 

"I knew that the bakery business is a miserable business, among the worst. Most shoppers do not have a strong preference for one brand of bread over another. White bread pretty much is white bread.  Whole wheat bread pretty much is whole wheat bread. This relative lack of brand preference gives stores bargaining power over bakeries. A store can threaten a bakery that, if it cannot purchase bread at a certain price, it will seek another supplier. Thus, stores can play one bakery off against another, and they do. Warren Buffett likes businesses that are protected by moats. There are no moats surrounding the bakery business. There are not even any fences or "beware of dog" signs. Therefore, the prices received by the bakeries often are driven to levels so low that it is difficult for the bakeries to earn a decent profit, if any profit at all. This is a key reason why the bread business is a miserable business."

Think about it…  milk and bread tend to be commodity products, like Berkshire Hathaway's linings. When you have a commodity product you need to be the low cost producer as commodity products tend to get priced by the marginal producer's cost of production. They also tend to be susceptible to over-capacity. Conversely, a differentiated, essential or unique product's price isn't based on the cost to produce in the absence of competition.  

"The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business." Warren Buffett

There are of course exceptions. I know of a milk company with pricing power. The company's milk contains different proteins produced from a certain breed of cow and people pay more than twice the price of standard milk. People will pay more for organic milk. The question to ask is, how sustainable is the premium? and how easy is it for other producers to replicate?

More recently Buffett expanded on his decision to buy Apple. Buffett saw a product with pricing power and a product intimately integrated into people's lives ....

“It’s amazing where Apple’s ended up with consumers. I can very easily determine the competitive position of Apple now and who’s trying to chase them and how easy it is to chase them. We happen to be well situated in terms of having these massive Home Furnishing stores. I can learn very easily how consumers react to different things there, probably easier than I can try and pick out what is really happening at Amazon at any given time. If you come in to buy a TV set at the Furniture Mart, price is extremely important. Obviously picture is, but they are all good pictures. You can have Samsung and all these different ones. If you put on a sale and you drop the price of Samsung ten percent you can fill that department with people who come out for it. You can’t move people by price in the smart phone market remotely like you can move them in appliances and all kinds of things. People want the product they don’t want the cheapest product. The loyalty is huge. That doesn’t mean somebody can’t come with a product that just jumps the field in some way. And then once you have the product the degree to which it sort of controls your life, it’s a very very very valuable product to the people that build their life around it. That’s true of 8 year olds and its true of 80 years olds.”

“So far you’ve had smart phones and big differences in price categories and if you had an Apple before you can have a much cheaper smart phone selling right next to it and they don’t look at it. If you have a cheaper TV [in the store] with pictures looking at you and you say what’s the difference, you buy the cheaper TV. Most items are price sensitive. That’s not to say an Apple has no price sensitivity, it’s very limited. Someone could come along and leapfrog the technology, and add benefits that would be the more competitive threat than price competition. It would be benefit competition.”

Notwithstanding the above, it’s untapped pricing pricing power that’s most valuable. Companies that abuse pricing power ordinarily end up attracting competition or regulatory backlash [eg. Valeant].

“We like to find businesses with pricing power. But to say that something has pricing power and to leave it there is really an incomplete line of thinking because nobody has unlimited pricing power.” David Abrams

“Growth in profits from increasing prices can simply build an umbrella beneath which competitors can flourish. We are more interested in companies which have physical growth in the merchandise or service sold than simple pricing power, although that’s nice too.” Terry Smith

Do the businesses you own have pricing power?

Some insights from Ted Weschler and Todd Combs

Ted Weschler and Todd Combs have been anointed to manage Berkshire's equity portfolio when Warren hands over the reigns.  Warren's decision to hire Todd and Ted was based on what they'd done, how they had done it and their character. Both now manage c$10b each of Berkshire capital.  

In a recent rare interview with Yahoo News, Warren, Ted and Todd talk about how they spend their days and how they think about investing.  

I've outlined below my key takeaways from the interview.. 

Reading:  Buffett spends most his day reading. So to does Ted Weschler and Todd Combs. In fact Warren said in the interview "These are the only two guys we could find that read as much as we did". So what do they read? 

Ted Weschler spends half the day reading random things like newspapers and trade periodicals. In a 2016 interview Ted pointed out "Being a successful investor you need to be hungry, intellectually curious, interested, read all the time. Read a lot of newspapers. You need a certain level of randomness in order to connect things that might give you an insight into where a business is going in five years that somebody else might not see." 

Todd Combs reads about 12 hours a day - newspapers, quarterly reports, SEC filings, transcripts and trade magazines. 

Like Buffett, they're hoping to find or confirm an edge - a thought, an idea, insight or trend that's not being recognized by the market. 

Hard Work: Ted and Todd spend most of their day reading.  Successful investing is hard work.  As Peter Lynch noted "The person that turns over the most rocks wins the game. And that's always been my philosophy."

Learning: It's important to be a life long learner. Ted Weschler notes the last 5 years have been the steepest learning curve of his life. Which is a pretty powerful statement at 50 years old. In a large part he believes this is due to the data set from the businesses he's been exposed to at Berkshire [and no doubt learning from Buffett].

Speaking to Corporates: Buffett believes he is a better investor because he has experience in business and a better businessman because he has had experience in investments. Buffett notes that Berkshire is about as good a place as you can find to really understand competitive dynamics. Both Ted and Todd have Berkshire businesses that report into them. As Berkshire owns dozens and dozens of businesses and touches almost every type of industry in one form or another it gives the portfolio managers the opportunity to speak to operating managers who know more about their businesses than an investor can learn in a lifetime. 

Generalists:  There are no rules of any kind on diversification or industries in which Todd and Ted can invest in.

Click here for link to the Yahoo News Interview. 

Click on the yellow links above to link to the Investment Masters Class Tutorials.

The Keys To Successful Equity Investments

Francois Rochon initially graduated as an electrical engineer, but he quickly developed a passion for investing when he came across the book 'One up on Wall Street' by Peter Lynch in 1992.  From this book he became interested in Warren Buffett, 'the greatest investor of all', in Peter Lynch's words.  Francois started managing his own money the next year and by 1996 he had left the engineering profession to work at a mutual fund.  Two years later, in 1998 he left to start Giverny Capital which focuses on 'owning outstanding companies for the long term'.

Mr Rochon's US portfolio has compounded at an average rate of 14.8% pa since 1993 versus 9.2% pa for the S&P500. The 5.6% out-performance over such a period has a large impact on returns, with a $100,000 investment in Mr Rochon's portfolio in July 1993 worth $2.6m as at December 2016 whereas if it were invested in the S&P500 it would be worth just $790,000.

I've always enjoyed reading Mr Rochon's investment letters which are available on the Giverny Capital website.   Giverny Capital has produced a paper titled "The Keys to Successful Investing" which contains eight keys which could help you in increasing your likelihood of success.  

Many of these are common to the Investment Masters.  The links provided in the key topics below connect to the relevant Investment Masters Class Tutorials.

1) Consider stocks as fractional ownership in real businesses

"When we study the great masters of investing and the many decades of available data, we find  a critical point in common: these investors behave like businessmen. When they buy a company’s stock, they first and foremost are buying part of an enterprise. Whether they are purchasing a hundred shares of Johnson & Johnson or several million  shares, these investors consider it no  different than if they were buying the company in its entirety."

2) Being present

"One of the flaws of many investors in trying to play the market is to attempt to time the market.  To experience returns on the markets, one must first and foremost be present with the market. "

3) Profit from market fluctuations rather than suffer from them

"The  metaphor  of  “Mr.  Market”,  as  taught  by  Warren  Buffett’s  mentor  Benjamin  Graham, illustrates the attitude that the rational investor must adopt when facing the market. In fact, the irrational attitude of Mr. Market is the source of investment opportunities for the investor who knows how  to stay rational and unemotional. This investor knows that stock market prices will reflect the fair value of the underlying enterprise in the long term. So, from this perspective, market fluctuations are your allies and not a source of suffering. "

4) Leaving yourself a margin of safety

"The concept of “margin of safety” is borrowed from the world of engineering. When an engineer is building a bridge that  has a capacity to support a five-ton truck, he will build it so that it can support a truck of eight or ten tons. This represents a margin of safety. When we use this concept within the context of investing in a company’s stock, it is the difference between what we think the company is worth versus the value of its stock price.   

The starting point is the intrinsic value of the company, which we determine theoretically by calculating the current value of the future cash flows generated by the company over the course of its life. Since this is a highly subjective analysis, we must consider a wide margin of error.    

The more the market is irrational about the value of a company during a selloff, the lower the  price we can pay for the company’s shares, thus increasing our margin of safety. 

Furthermore, one should consider that the margin of safety also exists with more qualitative factors as well. For example, the quality of the company’s management team, its competitive  advantages, and its intellectual property to name a few. Finding solid companies at attractive prices is the keystone to our approach.  

5) Stay within your circle of competence

"When it comes to selecting businesses to invest in, Warren Buffett is guided by what he calls his “circle of competence”. What is critically important, he says, is to know the limits of your circle  of competence.   For example, if you don’t know the difference between the atomic number of
Titanium and the one for Uranium, you should probably steer clear of this sector.  
 
To wander outside of your circle of competence significantly increases your probably of making a poor decision.  In the market, to realize better returns than others, you must have better knowledge regarding the value of the businesses in which you invest (the others are the market).  

To succeed, it is important to stay close to companies that one can understand well and evaluate well."

6) Know when to sell

"Philip Fisher, the famous investor, once said: “if you’ve done your work well when you’re  buying,  the time to sell is... almost  never”. Ideally, we would love to keep our outstanding companies forever, but life is not ideal and a realistic approach is necessary. 

We believe that the reasons for selling a stock should be harmonized with the reasons for buying it. We should consider selling if these reasons are no longer valid. In other words, once the investor becomes aware that he made an error in his analysis or the prospects of the business have deteriorated, it is the time to sell. Our firm evolves and companies evolve just as much, for better or for worse. Our investment approach must be aligned to the nature of the capitalist world within which it participates.   

Another more pragmatic reason for selling is that the majority of investors do not have unlimited sources of capital at their disposal and they may, quite simply, sell in order to invest in another company whose potential seems brighter. "

7) Learn from your mistakes

"Mistakes are inevitable in the investing world.  The key is to recognize them quickly and learn from them.  There are two categories of mistakes: mistakes of commission and mistakes of omission.  The first consists of failing in what you decided to buy, whereas the second consists of  failing to buy a stock that met all your purchasing criteria. Generally speaking, mistakes of omission are often the most costly. To miss a stock that climbed 1000% is ten times more costly than losing 90% of you  capital in a stock that did poorly. 

Other mistakes fall into the category of “psychological biases”, with anchoring and overconfidence being good examples. Anchoring is related to the fact that our human nature is such that we often remain anchored on first impressions or first data points, even when those perceptions become detached with reality.  For example, an investor bought stock ABC at $50 two years ago and it is now trading at $25 following news about the loss of a significant contract and/or lower profits. The investor remains anchored to the notion that his stock is worth $50 simply because this was the purchase price. In reality, there is no link whatsoever between the price paid for a stock and the value of the company. What matters is the future prospects of the company. 

Finally, overconfidence manifests itself often and under different forms. Its only remedy is humility."

8) A constructive attitude

What differentiates successful investors from others is not related to intelligence, but rather related to attitude.  

Warren Buffett often uses the adjective RATIONAL to describe good investors. Rational investors do not let themselves be influenced by fads or crises.  Aside from a rational attitude, another important quality (and one apparent in Warren Buffett) is the capacity to always want to learn and progress.    

The world is in a perpetual state of evolution and it is not easy to for someone to also constantly  evolve. To be in a constant state of learning, one must not only be passionate for their art, but also humble.

Without humility, there is no opening for something new. Therefore, paradoxically, successful  investors must be able to combine both a high confidence in their judgment while also remaining  constantly humble. A difficult and fragile equilibrium." 

An Earnings Miss?

"Estimates miss earnings, not vice versa." Market Veteran

An opportunity to purchase a quality business at an attractive prices often presents when a company misses a quarterly number and analysts downgrade their numbers to reflect the lower new estimate. This seems to have become more prevalent in recent times with investors and analysts having an increasing focus on short time periods, leading to an over-reaction in the share price. Fear, herding and other behavioural factors come into play. However, the key is to remain unemotional and analyse the situation in a calm and rational manner to form a view as to whether the earnings dip is simply a temporary blip in the business, or is symptomatic of issues that significantly impair the intrinsic value of the business.

“I am particularly interested in buying companies when their long term prospects are intact but they are cheap because they face short term issues.” Robert Vinall

"Companies that "miss" the analysts' consensus estimates can see their stock price decimated. Is the quarter-to-quarter earnings target really more important than a company's ability to increase shareholder value long term.” Christopher Browne

“If you are selling because of a missed earnings report or the trend of the market or something, you’ve stopped looking at the rate of return the company can achieve over time.” Chuck Akre

“You rarely get to purchase high quality businesses at cheap prices unless there is a ‘glitch’ which provides an opportunity to do so.” Terry Smith

“Usually company specific issues provide opportunities.” Chris Bloomstran

Common causes of an earnings miss include a poor product mix, a lost contract, weather impacts, higher than expected costs, new management re-basing earnings, investment in the business or more aggressive pricing from a competitor.  

It is important to remember, the intrinsic value of a company reflects the present value of the cash that can be taken out of the company over its lifetime. On this basis, one quarter, or even one years' earnings are unlikely to have a major impact on the long term value of the company.   

“A couple of bad years of earnings shouldn’t determine the intrinsic value of those companies.” Matthew McLennan

“It seems to us that one quarter’s missed earnings target rarely has a significant impact on the intrinsic value of companies. Warren Buffett makes no comment on the quarterly earnings of Berkshire Hathaway because he finds it ‘difficult to say anything new or meaningful each quarter about events of long-term significance.’” Marathon Asset Management

“The value of a business is determined by the present value of the cash it generates over its lifetime, not based on what next year’s earnings are going to be.  While the first year’s cashflows in a discounted cash flow valuation carry the most weight in the calculation, years two through 20 and thereafter contribute many multiples of year one’s value in determining the present value.” Bill Ackman

I am amazed at the number of analyst reports that focus on the upcoming earnings release as opposed to the longer term drivers of a business and its intrinsic value.  

“Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings.  We seek insights consistent with our holding period.” Marathon Asset Management

"Look beyond the next quarter and the next year and search, instead, for very long term trends." Ralph Wanger

“We are usually asking much longer term questions as we want to understand long term strategy. We don’t care about this quarter or next quarters earnings. We care about where the company is going over the long term.” Jeff Mueller

When the analysts are talking about 'lower sales due to fewer days in a quarter', 'recent weather impacts' or 'poor share price momentum' it can be an opportunity for the long term investor to find mis-priced securities.  

“It’s often a good sign when investors and analysts agree that ‘the stock is extremely cheap, but we shouldn’t buy it yet because there might be another bad quarter coming.”  Wally Weitz

Many of the Investment Masters spend their time thinking about the longer term business value. Remember a share is a part ownership of a business. Would a business owner sell a company on the basis of a poor quarter?

“In a time when financial television keeps score of quarterly “beats” (meaning a company beats estimates) we ignore financial models and are oblivious to consensus estimates. We don’t think quarterly “beats” are germane to intrinsic value. We prefer betting on company fundamentals, not investor psychology.” Allan Mecham

Finding mis-priced securities due to short term issues is referred to as 'Time Arbitrage' and is one of the most profitable edges employed by the Investment Masters.  

The next time a company you like, understand and think is high quality misses an earnings estimate, rather than run away it might be worth running towards it. The share prices of high quality companies will recover to reflect the longer term value residing in the company. It's just that the timing of any such recovery is unknowable.

Remember it's just an estimate. And estimates miss earnings - not vice versa.

“We think short-term earnings should be treated like appetizers at dinner: avoid overindulging or you’ll miss the main course.” Allan Mecham

The Buffett Series - The Science of Hitting

"Everybody knows how to hit - but very few really do." Ted Williams

Warren Buffett has long recognised the importance of exercising patience and sticking within your circle of competence when investing. Buffett regularly uses the analogy of the baseball player who only strikes the ball when it's in his or her sweet-spot. Unlike baseball there are no called strikes in investing. An investor can wait for the day a good pitch comes along.

Buffett often refers to the Hall-of-Fame slugger Ted Williams who played for the Boston Red Sox and is arguably the greatest batter of all time. 

Ted Williams approached batting in a methodical way, he worked out his optimal strike zone where the odds were in his favour and he maintained the discipline to only swing if the ball was in that zone. By the time Ted Williams retired he had a .344 batting average, 521 home runs, and a 0.482 on-base percentage, the highest of all time. 

Buffett referred to Ted Williams in his 1997 letter .... "We try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

In the recent HBO Documentary 'Becoming Warren Buffett', Buffett notes ..

"The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot, and if people are yelling, 'Swing, you bum!' ignore them."

Having recently read "The Science of Hitting" I was fascinated by the common threads between a baseball great and the world's Investment Masters. Below I've collated quotes from the book with the Investment Masters Class Tutorials.

Ted Williams noted ‘Everybody knows how to hit—but very few really do.’ I think the same can be said for investing.

The Profit is in the Buying

"Hitting is the most important part of the game, it is where the big money is."

Thinking is Key

"Something you must always take up there with you: proper thinking."

Patience is Critical to Successful Investing

"The longer a batter can wait on pitch, the less chance there is that he will be fooled."

Stick within your Circle of Competence

"You can see in the strike zone picture what I considered my happy areas, where I consistently hit the ball hard for high averages, and the areas graded down to those spots I learned to lay off, especially that low pitch on the outside 3½ inches of the plate. Ty Cobb once said, ‘Ted Williams sees more of the ball than any man alive—but he demands a perfect pitch. He takes too many bases on balls.’”

"I gave the pitcher the outer 2 or 3 inches of the plate on pitches over the low-outside corner"

Continue to Learn

"Hitting is self-education—thinking it out, learning the situations, knowing your opponent, and most important, knowing yourself."

Work Hard

"Practice, practice, practice. I said I hit until the blisters bled, and I did, it was something I forced myself to do to build up those hard, tough calluses."

Its not an Exact Science

"If there is such a thing as a science in sport, hitting a baseball is it. As with any science, there are fundamentals, certain tenets of hitting every good batter or batting coach could tell you. But it is not an exact science."

Control your Emotions

"Hitting a baseball—I’ve said this a thousand times, too—is 50 per cent from the neck up."

Understand Psychology

"Most hitting faults came from a lack of knowledge, uncertainty and fear—and that boils down to knowing yourself. You, the hitter, are the greatest variable in this game, because to know yourself takes dedication."

Find your Edge

"Now, you can sit on the bench, pick your nose, scratch your bottom, and it all goes by, and you’re the loser. The observant guy will get the edge. He’ll take advantage of every opening."

Stick with your Own Style

"Now, there are all kinds of hitting styles. The style must fit the player, not the other way around. It is not a Williams or a DiMaggio or a Ruth method. It is a matter of applying certain truths of hitting to a player’s natural makeup."

Be a Generalist

"They had an article in one of the magazines one year, quoting pitchers on how they pitched to Mantle and me. Billy Pierce said he hoped for “minimum damage” and that he varied his pitches as much as possible—sliders, fast balls, slow-breaking stuff and prayers... What they all were saying was that there was no accurate ‘book’ on me, and that’s what a batter strives for."

Love what you do

"I feel in my heart that nobody in this game ever devoted more concentration to the batter’s box than Theodore Samuel Williams, a guy who practiced until the blisters bled, and loved doing it, and got more delight out of examining by conversation and observation the art of hitting the ball."

Understand History

"I honestly believe I can recall everything there was to know about my first 300 home runs—who the pitcher was, the count, the pitch itself, where the ball landed. I didn’t have to keep a written book on pitchers—I lived a book on pitchers."

Human Nature Doesn't Change

"After two years of managing the Washington Senators, the one big impression I got was that the game hasn’t changed. It’s the same as it was when I played. I see the same type pitchers, the same type hitters."

Keep it Simple

"It’s not really so complicated. It’s a matter of being observant, of learning through trial and error, of picking up things."

Understand Batting Average

"... you are going to fail at your job seven out of ten times."

Learn from your Mistakes

"A great hitter isn’t born, he’s made. He’s made out of practice, fault correction and confidence.”

Focus on the Factors that Matter

"Have you done your homework? What’s this guy’s best pitch? What did he get you out on last time?"

Speak to People in the Know

"Where was the pitch that Frank Howard hit? What was it? Curve ball? Slider? Ask the guys on the bench, the pitchers, everybody. Get in the game, know what’s going on, know the reason when that pitcher takes the bread out of your mouth. That makes sense to me."

Test Investment Ideas

"I was a pain in the neck asking the older guys about pitchers. I was always asking about pitchers: What kind of pitcher is Bobo Newsom? What kind of pitcher is Red Ruffing? What about Tommy Bridges? Ted Lyons? Lefty Gomez? Schoolboy Rowe? I wanted the information, and I wanted to put it to use."

Stick to What you Know

"My strike zone, almost to the inch, was 22 by 32, or 4.8 square feet. Add two inches all around and it becomes 26 by 36, a total of 6.5 square feet—35 per cent more area for the pitcher to work on. Give a major league pitcher that kind of advantage and he’ll murder you."

Buy with a Margin of Safety

"The single most important thing for a hitter was ‘to get a good ball to hit.’”

Avoid Permanent Loss

"Now, if a .250 hitter up forty times gets 10 hits, maybe if he had laid off bad pitches he would have gotten five walks. That’s five fewer at-bats, or 10 hits for 35, or .286. And he would have scored more because he would have been on base more." 

Stick with a Process

"What I had more of wasn’t eyesight, it was discipline, and isn’t it funny? I took so many “close” pitches I wound up third in all-time bases-loaded home runs, among the top five in all-time home runs, in the top three in runs batted in per time at bat, and I drove in more than a fifth of the Red Sox’ runs in my twenty years in Boston. I averaged .344 for a career."

Buy Quality Companies

"There isn’t a hitter living who can hit a high ball as well as he can a low, or vice-versa, or outside as well as inside. All hitters have areas they like to hit in. But you can’t beat the fact that you’ve got to get a good ball to hit."

Avoid Value Traps

"More often than not, you hit a bad pitch in a tough spot and nothing happens."

"The greatest hitter living can’t hit bad balls good."

Watch Others

"I was forever trying a new stance, trying to hit like Greenberg or Foxx or somebody."

How Big to Position

"Well, it was obvious to me the first time I saw him play, when he was with the Dodgers in a World Series in 1963. I knew then exactly what I would say to him if I ever got the chance: the value of knowing the strike zone. The value of proper thinking at the plate. The importance of getting a good ball to hit. Of knowing when not to be too big with his swing."

Concentrate

"Ideally, for maximum power and efficiency, you want your stronger hand closer to the point of impact."

Be Adaptable

"The reason hitting a baseball is so tough is that even the best can’t hit all the balls just right. To do so is a matter of corrections every minute, in practice as well as in the game."

Dealing with Losses

"There is no question that some strikes are called balls, and some balls are called strikes, but you’re far better off forgetting the calls that hurt you and concentrating on that next pitch, or that next turn at bat."

"If you’ve struck out on a ball you thought was bad, don’t argue. Talk to a teammate, somebody you know pays as much attention to the game as you do. Ask him if the ball was low or outside or wherever you thought it was, and if he agrees with the umpire, file it in your memory. You’ve got some work to do on that particular pitch. You might even make a diagram for yourself to pinpoint the problem areas. Paul Waner did that, and I did it."

Using Intuition

"Guess? Yes! “Proper thinking” is 50 per cent of effective hitting, and it is more than just doing your homework on a pitcher or studying the situation in a game. It is “anticipating,” too, when you are at the plate, and a lot of hitters will say that is college talk for “guessing” and some will be heard to say in a loud voice, “don’t do it!” They’re wrong. Guessing, or anticipating, goes hand in hand with proper thinking."

"Well, you’ve got to guess, you’ve got to have an idea. All they ever write about the good hitters is what great reflexes they have, what great style, what strength, what quickness, but never how smart the guy is at the plate, and that’s 50 per cent of it. From the ideas come the ‘proper thinking,’ and the ‘anticipation,’ the ‘guessing.’”

"I had 20-10 vision. A lot of guys can see that well. I sure couldn’t read labels on revolving phonograph records as people wrote I did. I couldn’t “see” the bat hit the ball, another thing they wrote, but I knew by the feel of it. A good carpenter doesn’t have to see the head of the hammer strike the nail but he still hits it square every time."

Improving with Age

"I think there are things you learn growing older in the game which practice brings out."

"At eighteen I might not have been quite as strong as I was at twenty-eight or thirty-eight, but I had better eyesight, better reflexes, could run faster, etc. But at seventeen or eighteen I wasn’t thinking as clearly at the plate as I was later on. When I came up with San Diego in 1937, I hit .271, then .291. My average went up steadily thereafter because in those formative years I was exposed to experienced players who knew the game between the pitcher and batter."

Be Aware of the Macro

"The batter who is alert will consider the environment, the park, the background. What kind of a day is it? Is the wind blowing a gale from centerfield? If so, it will be silly to try to hit the ball 480 feet... Is it damp and rainy? The ball you hit won’t go as far because on a damp day the air is heavier. A curve-ball pitcher will be even more effective on a heavy day. Be alert to these things."

Balancing Confidence with Humility

"Oh, I can’t say I never had that little fear at the plate, especially in those early days when I’d be hitting against some guy who was a little out of my class. But I remember the time in Minneapolis, my third year as a professional, when a pitcher named Bill Zuber hit me in the head with a pitch. Knocked me out and put me in the hospital for two days. When I got back in the lineup, I dug in as hard as I could and said to myself, ‘Boy, this isn’t going to stop me. Not a bit.’”

"I know there are hitters who can be intimidated, and pitchers who believe in keeping you loose. Jimmy Piersall told me he was afraid at the plate when he was with the Red Sox, and I tried to needle him out of it. ‘If you’re afraid, you might as well go sell insurance. But why be afraid?’ He worked himself out of it. His confidence grew. If you stay intimidated, you’re done."

Investment Misconceptions - Volatility is Risk - Efficient Markets

"Much of it has been poorly defined, or not defined at all, and some things have been told wrong for years. The consequence is a collection of mistaken ideas that batters parrot around."

Goal is to Make Money

"I think that every player should have goals, goals to keep his interest up over the long haul, goals that are realistic and that reflect improvement. For me, if I couldn’t hit 35 home runs, I was unhappy. If I couldn’t drive in 100 runs, if I couldn’t hit at least .330, I was unhappy. Goals keep you on your toes, make you bear down, give you objectives at those times when you might otherwise be inclined to just go through the motions."

Let's hit the ballpark… 

References: 'The Science of Hitting' by Ted Williams and John Underwood, 1970
Photo sources: HBO Documentary - 'Becoming Warren Buffett', 2017
Further Reading: The Science of Hitting [video]

The Truth About Investing

Howard Marks recently presented at the CFA Society in India. His presentation was titled "The Truth about Investing".  

The 40 page presentation covers the core foundations of Howard Mark's investment philosophy. For those looking for more on Howard Mark's investment thoughts I highly recommend his book "The Most Important Thing - Uncommon Sense for the Thoughtful Investor" which is in my Top 5 recommended books. The book draws on many of the investing themes that Mr Marks has written about over the years in his investment memos.  These memos are available on the Oaktree Capital Management website. Click here to to access the memo archive.  

The video from the CFA Society can be accessed below:

Investment Thesis - Pen to Paper

Many of the Investment Masters recognise the benefits of writing to improve thinking and identify potential pitfalls and/or psychological biases that may have crept into the investment decision making process.

“I find this very useful when I write my annual report. I learn while I think when I write it out. Some of the things I think I think, I find don’t make any sense when I start tying to write them down and explain them to people. You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more.” Warren Buffett

“Beginning around 1980, I developed a discipline that whenever I put on a trade, I would write down the reasons on a pad. When I liquidated the trade, I would look at what actually happened and compare it with my reasoning and expectations when I put on the trade.” Ray Dalio

“I always write down when I make a purchase. I usually update those notes once a quarter on what the intrinsic value is. Why we bought? What are the drivers? I update those thoughts every three to six months. Those are useful because I can go back to the notes and say, ‘hey there was a method to the madness.’” Mohnish Pabrai

“Good writing clarifies your own thinking and that of your fellow shareholders.” Seth Klarman

“We’re keen to always have the portfolio managers put pencil to paper and work through their investment ideas in a structured way, above a pre-designed investment threshold.” Peter Schoenfeld

“‘Why do we bother with this? When nobody reads it?’… It’s not for the readers, It’s for us. We write it for ourselves. Putting ideas on paper forces you to think through things.” Shelby Davis

“We publish these fifteen-page quarterly letters because it forces us to write down and communicate in a very clear fashion what we think and why we think it. There are a lot of crumpled up pieces of paper that end up next to the garbage can when we do that. Yet, a lot of times they are a reminder that there are a couple of questions that we still have about an investment that we really should be addressing. It also helps because by synthesizing it, you sometimes realize just how good the investment that you have is.” Larry Robbins

"I used to always recommend to my students that they take a yellow pad like this and if they’re buying a hundred shares of General Motors at 30 and General Motors has whatever it has out, 600 million shares or a little less, that they say, ‘I’m going to buy the General Motors company for $18 billion, and here’s why’. And if they can’t give a good essay on that subject, they’ve got no business buying 100 shares or ten shares or one share at $30 per share because they are not subjecting it to business tests." Warren Buffett

“I was greatly helped by the discipline of having to write down my thoughts.” George Soros

“I think being a good writer is a really great tool to being a good investor. It's important to be able to articulate how you're thinking about things. It's important to be able to simplify your ideas down to a few key principles. Writings are a really great way to do that.” Mike Trigg

“Writing has always been a crucial part of my investment process and I believe it’s been a big contributor to our results over time. For me, I’ve found it to be the most effective way to work through challenging investment problems I’m working on.” John Huber

While writing down a thesis helps thinking, it's important to recognise the act of writing will increase a person's commitment to an idea, particularly if it is made public. Experiments show that people are more loyal to choices they make when they are written down.

"We are most consistent when we have made a public, effortful or voluntary commitment. The more public a decision is, the less likely we will change it. Written commitments are strong since they require more effort than verbal commitments and can also be made public." Peter Bevelin

"Yet another reason that written commitments are so effective is that they require more work than verbal ones. And the evidence is clear that the more effort that goes into a commitment, the greater is its ability to influence the attitudes of the person who made it." Robert Cialdini

One way to help overcome this is to consider a wide range of potential outcomes, not just the outcome your investment thesis is predicated on. By writing these down, it will make it harder to ignore facts that contradict you’re original hypothesis.

“It is incredibly important to list all possible hypotheses, not just the most probable ones but also the most absurd and outrageous ones. This is the only way to retain an open mind about all possible scenarios, not just the more probable ones. Once a hypothesis is foreclosed, it is incredibly difficult to put it back on the table. The corollary in investing would be to articulate competing hypotheses, for example that a Company does not have a moat or has a deteriorating moat. It is incredibly important to write things down. The human brain has a tendency to ignore or downplay hypotheses we disagree with and information that does not fit with our beliefs. The best antidote to this tendency is to physically write down competing hypotheses and all the facts. It is also important to write down the type of information, which, were it come to light in the research process, would invalidate a theory. This protects us from bending the theory to fit the facts rather than simply dismissing the theory.” Robert Vinall

It's paramount to remain open minded, to continually re-test the thesis and be prepared to exit a position if the original thesis is no longer valid.

"Charlie and I believe that when you find information that contradicts your existing beliefs, you've got a special obligation to look at it - and quickly." Warren Buffett

“It is incredibly important to seek out disconfirming as well confirming information. Having formed hypotheses, the natural inclination is to seek out confirming information. Given that there is so much information out there, this is not likely to be all that difficult to find. This makes it even more critical to seek out disconfirming information too.” Robert Vinall

"We try not to have many investing ‘rules,’” but there is one that has served us well: If we decide we were wrong about something, in terms of why we did it, we exit, period. We never invent new reasons to continue with a position when the original reasons are no longer available." David Einhorn

"You can't avoid wrong decisions. But if you recognise them promptly and do something about them, you can frequently turn the lemon into lemonade." Charlie Munger

It is a delicate balance between maintaining confidence in an idea and having the humility to recognise you may be wrong. 

"We know that we are fallible and must therefore consider the possibility that for every investment we make we may be wrong." Seth Klarman

Its time to start writing … 

Lessons from Valeant

Pershing Square's 2016 Annual report was released recently. While Bill Ackman's long term track record is impressive, he lost a substantial amount of money in Valeant. He wasn't alone, a few other high profile investors such as ValueAct and Sequoia also took significant losses. Like all good investors, Mr.Ackman acknowledged his mistakes and highlighted the lessons he learnt.

The Investment Masters recognise the importance of analyzing past mistakes, so as not to repeat them. In most cases we can learn more from our mistakes than our successes. We can also learn from the mistakes of other.

“When we make mistakes, we always try to do post-mortems.” Lou Simpson

"The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others." Sir John Templeton

Mr. Ackman recently exited the Valeant position. While he acknowledged he may have sold at a price that may look cheap, he detailed his rationale for selling. Valeant had plunged more than 90% from it's peak; a permanent loss of capital.

At the time of sale, Valeant represented just 3% of the Pershing’s portfolio. Ackman surmised that even if the share price increased substantially, the impact on the overall portfolio would be modest and wouldn't compensate for the human resources and significant mind-share the investment would consume.

Ackman stated, "Clearly, our investment in Valeant was a huge mistake. The highly acquisitive nature of Valeant's business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss."

Ackman noted the many lessons from the investment and raised some important considerations for investors:

• Management’s historic ability to deploy capital in acquisitions and earn high rates of return is not a sufficiently durable asset that one can assign material value to when assessing the intrinsic value of a business

• Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control and the existence of these factors is a highly important consideration in position sizing

• A management team with a superb long-term investment record is still capable of making significant mistakes

• A large stock price decline can destroy substantial amounts of intrinsic value due to its effects on morale, retention and recruitment, and the perception and reputation of a company

I recall reading Ackman's 110-page presentation on Valeant titled "The Outsider" where his detailed thesis explained why it was such a compelling opportunity. Ackman paralleled the similarities between Valeant and the highly successful companies profiled in William Thorndike's book, 'The Outsider CEO's'.  It was a pretty compelling sales pitch. 

Notwithstanding the benefit of hindsight, I've outlined some red flags that may assist in avoiding the next Valeant disaster.

Highly Acquisitive Company

Valeant was a highly acquisitive company, effectively a 'roll-up'.  Such companies always carry more risks. Ackman has acknowledged past performance in acquisitions is not a durable asset. In the "Outsiders" presentation Ackman noted, "Management has completed 100+ acquisitions and licenses, investing $19b+ since 2008" .. "Acquisitions have been highly accretive" .. "Valeant management expects the majority of the company's future free cash flow will be allocated to its value-creating acquisition strategy." It’s worth taking heed of the risks in acquisition driven companies, as stated by Phil Fisher some six decades ago!

"There may be quite a high degree of investment risk in a company that as a matter of basic investment policy is constantly and aggressively trying to grow by acquisition.. It is my own belief that this investment risk is significantly still further increased when one of two conditions exist in a company's organisational make-up. One is when the top executive officer regularly spends a sizeable amount of his time on mergers and acquisitions.  The other is when a company assigns one of its top officer group to making such matters one of his principal duties.  In either event powerful figures within a company usually soon acquire a sort of psychological vested interest in completing enough mergers or acquisitions to justify the time they are spending." Phil Fisher 1960

High Guidance

Valeant had a track record of providing aggressive guidance. Guidance in 2012 was 40-45% EPS growth. In 2013 it was c35%. In 2014 it was c40% and in 2015 guidance was c21-25%.

“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets, Managers that always promise to "make the numbers will at some point be tempted to make up the numbers.” Warren Buffett

“Having a person running a company to please Wall Street can really be problematic.” Jim Chanos

“Rejecting guidance is rare among public companies, though it’s a practice we applaud. We worry that providing quarterly guidance may tempt companies to publish aggressive growth targets to appease Wall Street. Our concern is not that the aggressive forecasts won’t be met, but rather that they will, at any cost! Earnings growth should be a consequence of sound strategy, not the object of it." Allan Mecham

Win/Lose

Valeant business model in part comprised buying pharmaceutical companies, stripping R&D costs out and aggressively raising prices on older drugs. Valeant certainly wasn't a win-win proposition for consumers, government budgets or the community at large.

"There was a lot wrong with Valeant. It was so aggressive and it was drugs people needed…  I don’t think capitalism requires you to make all the money you can. I think there times when you should be satisfied with less. Valeant looked at it like a game of chess, they didn’t think of any human consequences. They just stepped way over the line and in the end of course they were cheating” Charlie Munger

"We want our operations and the businesses we invest in to pass the “Win-Win Test” with all six counterparties: customers, employees, suppliers, stewards, shareholders, and the community. Win-Win is the only system that is sustainable over the long-term – any fatal flaw with any counterparty will inevitably self-correct. We believe by striving to eliminate Win-Lose, Lose-Win, and Lose-Lose situations we can go far in removing many of the blind spots that those unsustainable relationships nurture." Christopher Begg

Corporate Debt

Valeant's acquisition spree was funded via a massive increase in corporate debt. Fortune magazine noted, "Its debt-to-equity ratio, a measure of a company's financial leverage, is nearly eight times that of other big pharma companies like Pfizer, Novartis and Merck."

"I turn down many otherwise down attractive investments because of their weak balance sheets, and I believe that this discipline is a material reason for our success over the years." Ed Wachenheim

"Staying away from excessive leverage cures a lot of ills." Thomas Gayner

Position Size

Ackman reflected that given the risks facing Valeant that were outside of his control, the position size was too large. In Pershing Square's 2015 Interim Report, Ackman disclosed that Valeant was at odds with his usual principles of investment; Valeant required continued access to capital markets to achieve accelerated growth. With lower conviction and higher risk position sizes must be structured accordingly.

"Our lack of strong convictions about these businesses [Salomon, USAir Group, Champion International], however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics." Warren Buffett 1989

“Make your position size more a function of not how much you can make, but really how much you can lose. So manage your position based on your downward loss perspective not your upward potential.” James Dinan

Consistency / Commitment Bias

With the benefit of hindsight, it's easy to suggest Ackman should have cut his position earlier.  Ackman's close proximity to the company may have blinded him to the problems starting to surface. The "Outsiders" presentation noted a confidentiality agreement between Pershing Square and Valeant in 2014 allowed them to conduct "substantial due diligence". This included in-person meetings with the board, extensive management interviews, review of the R&D pipeline, selective local due diligence at the country level and review of bear thesis. Ackman was all-in.

"One of the most difficult intellectual confessions is to admit you are wrong.  Behaviourally we know we are subject to confirmation bias. Eagerly we wrap our minds around anything and everything than concurs with our statement. Too often, we misjudge stubbornness for conviction. We are willing to risk the appearance of being wrong long before a willingness to personally confess our own errors." Robert Hagstrom

Falling In Love

When investors make a large commitment to a stock and then publicly promote it, it can be psychologically challenging to change tack. It's paramount to stay open minded and not fall in love with a position or management. As Ackman acknowledged, even a management team with a superb track record can make a mistake.

“If we only confirm our beliefs, we will never discover if we’re wrong. Be self-critical and unlearn your best-loved ideas. Search for evidence that dis-confirms ideas and assumptions. Consider alternative outcomes, viewpoints and answers.” Peter Bevelin

"One thing my father taught me at a young age was not to fall in love with companies or the people running them." Lloyd Khaner

Get Out

Valeant had collapsed dramatically before Ackman finally sold. Sometimes when investing, the best option can be to sell. Running concentrated positions in a multi-billion dollar portfolio reduces flexibility. Ultimately, Ackman acknowledged the position was taking an emotional toll on the firm and it was in the best interest to move on. The small position size following the stocks collapse meant it's contribution to future returns was going to be marginal. Profits and losses are not symmetrical. If you lose 80% of your money you need to earn 400% to get back to break even. Better to cut your losses and focus your energies elsewhere.

"Large permanent losses can dampen the confidence of an investor - and I sternly believe that a good investor needs to be highly confident about his ability to make decisions, because investment decisions seldom are clear and usually are muddled with uncertainties and unknowns." Ed Wachenheim

"Even the most conservative investors can be paralysed by large losses, whether due to mistakes, premature judgements, or the effects of leverage.  If losses impair your future decision making, then the cost of a mistake is not just the loss from that investment alone, but the impact that loss may have on the future chain of events.  If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost may be far greater than the initial loss itself." Seth Klarman

All investors make mistakes, even the great ones. The key is to address them early and take action. Then learn from the mistake.

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

“Quickly identify mistakes and take action.” Charlie Munger

"If you feel you have made a mistake, get out fast" Roy Neuberger

“Whatever the outcome, we will heed a prime rule of investing; you don’t have to make it back the way you lost it.” Warren Buffett

Ultimately an investor is only as good as his or her next investment. Being on the lookout for red flags can help an investor from taking undue risks and impairing capital. It's important to remain open minded and continually test a thesis to ensure the outlook hasn't changed.

Remember the first rule of investing is don't lose money. And rule number 2 …. don't forget rule number one.

The Buffett Series - Buffett on Book Value

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters.  Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's [click here to read the other essays].  It's amazing how timeless and universal they are.  This short essay touches on the concept of "Book Value".

From the teachings of his mentor Ben Graham, Buffett focussed on book value early in his career.  In later years he recognised is was intrinsic value, not book value, that was the key to finding outstanding investments.  He recognised that a business can be worth multiples of book value.  Berkshire paid 4X book for See's Candy, 2X book for Scott Fetzer and more recently 2.8X book for Precision Cast Parts and 5X book for Iscar.

Over the years Buffett has written extensively about 'book value'.  I remember at different times over the last few decades when the markets had become focused on book value.  Investors talked of assets like steel mills, paper companies, mining stocks and shipping lines being attractive solely on the basis that they were trading at big discounts to book value.  In many cases, they were 'value traps'.  The industries had changed and the future returns just weren't what they used to be.   

One must remember book value is a historic number and provides little information about the future prospects for a business.  The best businesses are those with high returns on capital which need little further capital to grow earnings. 

I've included below some extracts from Buffett's letters which may assist your thinking when it comes to book value. 

"In past reports I have noted that book value at most companies differs widely from intrinsic business value - the number that really counts for owners." Berkshire 1986 Letter

"Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.

It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value." Berkshire 1983 Letter

"Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See’s candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people." Berkshire 1985 Letter

"Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimatee of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated." Berkshire  1993 Letter

"We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college education. Think of the education's cost as its "book value." If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value." Berkshire 1994 Letter

The Buffett Series - A Changing Media Landscape

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of "A Changing Media Landscape".

While everyone now recognises the changes going on in the media landscape due to disruption from the advent of high speed internet and the likes of Netflix and YouTube, this is not a new phenomenon. In fact, way back in 1990 Buffett recognised that media businesses were unlikely to be as profitable in the future as they had been in the past. Media businesses were transforming from quality franchises to ordinary businesses.

In his 1990 letter, Buffett acknowledged he was surprised at developments in the media industry that year and questioned whether the poor results of Berkshire's media investments was "just part of an aberration cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values". He concluded the latter … 

"Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment: While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvellous than I, the industry, or lenders thought would be the case only a few years ago.

The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses."

Buffett revisited the challenges facing the industry in his 1991 letter titled "A change in media economics and some valuation math"

"In last year's report, I stated my opinion that the decline in the profitability of media companies reflected secular as well as cyclical factors. The events of 1991 have fortified that case: The economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate. In the business world, unfortunately, the rear-view mirror is always clearer than the windshield: A few years back no one linked to the media business - neither lenders, owners nor financial analysts - saw the economic deterioration that was in store for the industry. (But give me a few years and I'll probably convince myself that I did.)

The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior. Let's take a quick look at the characteristics separating these two classes of enterprise, keeping in mind, however, that many operations fall in some middle ground and can best be described as weak franchises or strong businesses.

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

Until recently, media properties possessed the three characteristics of a franchise and consequently could both price aggressively and be managed loosely. Now, however, consumers looking for information and entertainment (their primary interest being the latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength".

Buffett uses an example to show that a hypothetical media business which earns $1m a year that can grow at 6% per annum in perpetuity is worth $25m. This is in contrast to a business earning the same $1m with no growth which is worth only $10m. While a multiple of twenty-five times earnings is appropriate for the first company the second company fetches ten times earnings.  

"The industry's weakened franchise has an impact on its value that goes far beyond the immediate effect on earnings. For an understanding of this phenomenon, let's look at some much over-simplified, but relevant, math.

A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)

Now change the assumption and posit that the $1 million represents "normal earning power" and that earnings will bob around this figure cyclically. A "bob-around" pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. Thus a seemingly modest shift in assumptions reduces the property's valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

Dollars are dollars whether they are derived from the operation of media properties or of steel mills. What in the past caused buyers to value a dollar of earnings from media far higher than a dollar from steel was that the earnings of a media property were expected to constantly grow (without the business requiring much additional capital), whereas steel earnings clearly fell in the bob-around category. Now, however, expectations for media have moved toward the bob-around model. And, as our simplified example illustrates, valuations must change dramatically when expectations are revised."

Buffett recognised back in 1990 that the media industry had changed and was likely to continue to do so. Today, the equity value of many of the traditional media companies have been decimated by change. The fall in value in many cases has been a slow burn. The internet destroyed the newspapers classified sections. The advent of high speed internet has allowed Netflix and YouTube to access a global audience unavailable to traditional TV licence and cable operators providing economies of scale not available to the incumbents.

When evaluating businesses it's important to think about how conditions are changing and whether the changes are structural or cyclical. Today, new technology can allow competitors to penetrate a business' 'moat' and change the industry economics for the better or worse. It's important to think about how the businesses in your portfolio are placed to survive an ever changing world.

Further Suggested Reading - Tutorials - Quality Businesses, Change, Rear-View Mirror, Alternative Scenarios, Tech Invest, Thinking about Management, Permanent Loss, Intrinsic Value.
 

The Buffett Series - Businesses you Know

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of "Businesses you Know."

In his 1994 letter, Buffett outlines why it can be profitable to revisit companies you know well. In investing it's important to understand the businesses you are investing in, know the limitations of your knowledge and stick within your circle of competence.

"Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. Last year we went that direction by enlarging our holdings in Coca-Cola and American Express.

Our history with American Express goes way back and, in fact, fits the pattern of my pulling current investment decisions out of past associations. In 1951, for example, GEICO shares comprised 70% of my personal portfolio and GEICO was also the first stock I sold - I was then 20 - as a security salesman (the sale was 100 shares to my Aunt Alice who, bless her, would have bought anything I suggested). Twenty-five years later, Berkshire purchased a major stake in GEICO at the time it was threatened with insolvency. In another instance, that of the Washington Post, about half of my initial investment funds came from delivering the paper in the 1940's. Three decades later Berkshire purchased a large position in the company two years after it went public. As for Coca-Cola, my first business venture - this was in the 1930's - was buying a six-pack of Coke for 25 cents and selling each bottle for 5 cents. It took only fifty years before I finally got it: The real money was in the syrup.

My American Express history includes a couple of episodes: In the mid-1960's, just after the stock was battered by the company's infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.'s capital into the stock - the largest investment the partnership had ever made. I should add that this commitment gave us over 5% ownership in Amex at a cost of $13 million. As I write this, we own just under 10%, which has cost us $1.36 billion. (Amex earned $12.5 million in 1964 and $1.4 billion in 1994.)

My history with Amex's IDS unit, which today contributes about a third of the earnings of the company, goes back even further. I first purchased stock in IDS in 1953 when it was growing rapidly and selling at a price-earnings ratio of only 3. (There was a lot of low-hanging fruit in those days.) I even produced a long report - do I ever write a short one? - on the company that I sold for $1 through an ad in the Wall Street Journal.

Obviously American Express and IDS (recently renamed American Express Financial Advisors) are far different operations today from what they were then. Nevertheless, I find that a long-term familiarity with a company and its products is often helpful in evaluating it."

Buffett recognised that dealing with companys he had a history with and could understand provided an edge. Given Buffett's distaste for change, it's likely it also gave him some level of confidence in the sustainability of the business model, thereby also reducing risk. Buffett has always been a big believer in sticking within his circle of competence. Revisiting company's within that circle has proved to be a successful investing strategy over the last 50+ years.

"In his fifty years of practice, Buffett added one more principle; through unremitting hard work over a long period, investors can build up their own circle of competence. This can give them a deeper understanding than others of a company or industry, and allow them to make better judgements of future performance. Your unique strength lies within this circle." Li Lu

The Buffett Series - Investment Analysis

Charlie Munger loves the concept of simplicity. When it comes to investing it's important to understand what a company does and what the key factors are that will determine the company's success. You don't need a 2,000 line spreadsheet to determine if an investment is likely to be successful. But you do need to think. Talking to people involved in the industry and with the product can provide a huge edge.  

In Berkshire Hathaway's 1997 annual letter, there's a great snippet where Buffett details how he came about building a significant position in Amex. Buffett had purchased $300m of American Express hybrids in a private placement in 1991. The hybrids were due to convert to common stock in 1994 and in the month before Buffett had been mulling over whether to sell upon conversion.  While he thought the CEO was outstanding and likely to maximise whatever Amex's potential was, he was leaning toward a sale, as the company faced relentless competition from a multitude of card issuers, led by Visa. Buffett continues ...

"Here's where I got lucky. During that month of decision, I played golf at Prouts Neck, Maine with Frank Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge of the card business. So from the first tee on I was quizzing him about the industry. By the time we reached the second green, Frank had convinced me that Amex's corporate card was a terrific franchise, and I had decided not to sell. On the back nine I turned buyer, and in a few months Berkshire owned 10% of the company.

We now have a $3 billion gain in our Amex shares, and I naturally feel very grateful to Frank. But George Gillespie, our mutual friend, says that I am confused about where my gratitude should go. After all, he points out, it was he who arranged the game and assigned me to Frank's foursome."

In a recent CNBC interview, Buffett explained some of the analysis he undertook when he bought Berkshire's $17b stake in Apple ….

"Well, I would say Apple's — I mean, obviously it's very, very, very tech-involved, but it's a consumer product to a great extent too. And I mean, it has consumer aspects to it. And one of the great books on investing, which I've touted before, is one that Phil Fisher wrote back around 1960 or thereabouts, called "Common Stocks and Uncommon Profits." It had an effect on me. I went out to meet Phil Fisher after reading the book, I found him in this little office in San Francisco. And I recommend any investor read that book. And it's still in print. And he talks about something called the scuttlebutt method, which made a big impression on me at the time. But I used it a lot, which is essentially going out and finding out as much as you can about how people feel about the products that they ... it's just asking questions, basically. And Apple strikes me as having quite a sticky product and enormously useful product that people would use, and not that I do. Tim Cook's always kidding me about that. But it's a decision-based ... but again, it gets down to the future earning power of Apple when you get right down to it. And I think Tim has done a terrific job, I think he's been very intelligent about capital deployment. And I don't know what goes on inside their research labs or anything of the sort. I do know what goes on in their customers' minds because I spend a lot of time talking to 'em."

Buffett expands on the scuttlebutt process… 

"I had learned that from a fella named Phil Fisher who wrote this great book called "Common Stocks and Uncommon Profits." And he calls it the scuttlebutt method. And Phil was a remarkable guy.  And I first used it back in 1963 when American Express had this great Salad Oil Scandal that people were worried about it bankrupting the company. So I went out to restaurants and saw what people were doing with the American Express card, and I went to banks to see what they were doing with travelers' checks and everything. And clearly American Express had lost some money from this scandal, but it hadn't affect their consumer franchise. So I ask people about products all the time. When I take my great-grandchildren to Dairy Queen they bring along friends sometimes. They've all got a iPhone and, you know, I ask 'em what they do with it and how ... whether they could live without it, and when they trade it in what they're gonna do with it. And of course, I see when they come to the furniture mart that people have this incredible stickiness of — with the product. I mean, if they bring in an iPhone, they buy a new iPhone. I mean, they're ... it just has that quality. It gets built into their lives. Now, that doesn't mean something can't come along that will disrupt it. But the continuity of the product is huge, and the degree to which their lives centre around it is huge. And it's a pretty nice, it's a pretty nice franchise to have with a consumer product."

and on the Apple products ...

"But what I do know is when I take a dozen kids, as I do on Sundays out to Dairy Queen they're all holding their Apple, they barely can talk to me except if I'm ordering ice cream or something like that. And then I ask 'em how they live their lives. And the stickiness really is something. I mean, they do build their lives around it, just like you were describing. And the interesting thing is, when they come into ... when they come into get a new one, they're gonna get they overwhelmingly get the same product. I mean, they got their photos on it and, I mean, yeah, I know you can ... you can make some shifts and all that. But they love it."

Buffett reminded us of the need for simplicity in his 1994 letter ...

"Our investments continue to be few in number and simple in concept:  The truly big investment idea can usually be explained in a short paragraph.  We like a business with enduring competitive advantages that is run by able and owner-oriented people.  When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).

Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."

While Buffett no doubt analysed Apple's historical financial statements, he recognised that it is Apple's future earnings power that will determine the success or failure of the investment. A key factor that will determine that future earnings power is the strength and sustainability of the consumer product franchise. Here, observing, speaking to, and thinking about the company's products and customers can provide an edge. Understanding the qualitative factors can be more important than the historical numbers. Keep it simple, it's not rocket science.

“The most important question you should be asking: will this business still be around a decade from now?  Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel

The Buffett Series - Look-Through Earnings

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner, Mr.Munger, haven't already worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about both businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr.Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay touches on the concept of ‘Look-Through Earnings.’

Buffett focuses on the earnings that are generated by the companies he owns. While a company may pay out some of the earnings it generates in the form of dividends, the retained earnings are no less valuable to an investor. In fact, if the company can retain and reinvest those earnings at a high rate of return, the investor is better served by the company doing so. Such companies are often referred to as compounding machines.  

Buffett recognises that while the price of a company's shares can fluctuate regardless of fundamentals over the short term, over the long term changes in the company's share price will reflect changes in the company's earnings.  

In his 1991 letter, Buffett advises investors ...

"We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a ‘company’) that will deliver him or her the highest possible look-through earnings a decade or so from now.  

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard."

In the 1994 letter Buffett related Berkshire's growth target with look-through earnings ...

"If our intrinsic value is to grow at our target rate of 15%, our look-through earnings, over time, must also grow at about that pace.”

In his 1996 letter Buffett once again advised …

"Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire's value."

Many successful investors adopt Buffett's approach to focus on earnings; rather than focus on short term share prices these investors build portfolios whose earnings will grow over time.  

“Note that I have no interest in the development of share prices. This is why I don’t waste your time with a discussion of the fund’s or individual company’s price development. If a company regularly increases its earnings power, the share price will track this over time. A robust investment process correctly identifies companies which increase their earnings power. A rising share price is the outcome. My sights are firmly trained on process.” Robert Vinall

“At Giverny Capital, we do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.” Francois Rochon

Paying a reasonable price for a portfolio of quality companies that can compound earnings in the years ahead is likely to deliver attractive returns.

The Buffett Series - A lower Tax Rate?

With the prospect of Corporate Tax cuts in the US post the election of Mr Trump it’s worth thinking about the implications for investments. Confronted with a change in the US corporate tax rate in the 1980's Buffett addressed the issue of winners and losers in his 1986 letter.

“The tax rate on corporate ordinary income is scheduled to decrease from 46% in 1986 to 34% in 1988. This change obviously affects us positively - and it also has a significant positive effect on two of our three major investees, Capital Cities/ABC and The Washington Post Company.”

I say this knowing that over the years there has been a lot of fuzzy and often partisan commentary about who really pays corporate taxes - businesses or their customers. The argument, of course, has usually turned around tax increases,  not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to consumers. According to these advocates, any corporate-tax increase will
simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents of the "pipeline" theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the taxes levied upon them, but absorb them also.  Consumers, this school says, will be unaffected by changes in corporate rates.

What really happens? When the corporate rate is cut, do Berkshire, The Washington Post, Cap Cities, etc., themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as for policymakers.

Our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in other cases the benefits are entirely, or almost entirely, passed through to the customer. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.

For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will rise, though often not as promptly.

A similar result occurs in a second arena - in the price-competitive industry, whose companies typically operate with very weak business franchises.  In such industries, the free market "regulates" after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price-competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong franchises, however, it’s a different story: the corporation and its shareholders are then the major beneficiaries of tax cuts. These companies benefit from a tax cut muchas the electric company would if it lacked a regulator to force down prices.

Many of our businesses, both those we own in whole and in part, possess such franchises.  Consequently, reductions in their taxes largely end up in our pockets rather than the pockets of our customers.  While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the local "franchise-holder" in his
or her specialty) to be reduced now that the top personal tax rate is being cut from 50% to 28%?

Your joy at our conclusion that lower rates benefit a number of our operating businesses and investees should be severely tempered, however, by another of our convictions: scheduled 1988 tax rates, both individual and corporate, seem totally unrealistic to us. These rates will very likely bestow a fiscal problem on Washington that will prove incompatible with price stability. We believe, therefore, that ultimately - within, say, five years - either higher tax rates or higher inflation rates are almost certain to materialize.  And it would not surprise us to see both."
 

The Buffett Series - Thinking about Bonds

The bond market has witnessed a truly spectacular rally over the last thirty five odd years. In recent times there have been trillions of dollars of bonds trading at negative yields - something that has never happened before. Over the years Mr Buffett has written about investing in bonds. Revisiting his 1984 letter, it's no wonder he wouldn't think of investing in bonds at current prices.

"Our approach to bond investment - treating it as an unusual sort of “business” with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.

If an investor had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck - he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)"

In a recent CNBC interview Mr Buffett once again re-iterated the attractiveness of American companies return on tangible capital which allows many companies to reinvest capital in their businesses well above current interest rates. With regards to bonds he made the following remarks ...

“The ten-year bond is selling at 40 times earnings. And it's not going to grow. And if you can buy some business that earns high returns on equity and has even got mild growth prospects, you know, at much lower multiple earnings, you are going to do better than buying ten-year bonds at 2.30 or 30-year bonds at three, or something of the sort. But that's been true for quite a while. And I've been talking about it the whole time. I said people were idiots in 2008 to put their money in cash. I mean, it was the one thing that wasn't going to go anyplace. And interest rates are enormously important over time. And that's – if bonds yield a whole lot more a year from now than they do now, stocks may well be lower.” 

“I think that when rates have been where they've been the last five or six years, or even a little longer, selling very long bonds makes sense for the same reason I think it's dumb to buy them. I wouldn't buy a 50-year bond, you know, in a million years at these rates. So if it's that dumb for me to buy it, it's probably pretty smart for the entity to sell them if I'm right. So I would say that the Treasury – I would've been – there's a lot of considerations they have. But I would be shoving out long bonds. And of course at Berkshire, you mentioned we had $80-some billion in very short stuff. I mean, everything we buy in the way of bonds is short.” 

“It absolutely baffles me who buys a 30 year bond. I just don't understand it. And-- they sell a lot of them so-- clearly, there's somebody out there buying them. But the idea of committing your money, you know, at roughly 3 percent for 30 years-- now-- I think Austria sold some 50 year bond here, you know, at-- below 2 percent. I just don't understand the-- in Europe, there are certain inducements actually for the banks in terms of capital requirements to load up on governments. But it doesn't make any sense to me”.

Those investors buying bonds at the negative or very low yields now on offer are likely doing so because a) they're scared, b) their mandate makes them or c) they're speculating rates will go even lower.  It's unlikely they're buying them because d) they think they're good value.  

Understanding history can provide an edge in investing and Buffett brings up the 1946 bond market as an example in his 1984 letter above [I recommend reading the David Dynasty chapter 4 on the 1940's bond market titled "The Last Hurrah for Bonds"]. It's important to remember that the recent past is not necessarily a good guide to the future, that the unexpected can happen and the crowd is usually wrong.  

The bond market looks very much like a bubble. Howard Marks makes an insightful observation regarding bubbles … "The belief that some fundamental limiter is no longer valid - and thus historic notions of fair value no longer matter - is invariably at the core of every bubble and consequent crash."

The first breach of a fundamental limiter was real bond returns had to be positive. The final limiter breached was bond investors accepting negative rates. It's likely investors of the future will look back on this era and ask … "What were they thinking?"

The Buffett Series - Thinking about Competitive Advantage

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay looks at competitive advantage.  

A key requirement for a company to earn high returns on capital over a long period of time is to have a competitive advantage, commonly referred to as a 'moat'. Mr Buffett addresses the issue of competition in his 1993 letter where he talks about the Nebraska Furniture Mart, a businesses he acquired from Rose Blumkin [aka Mrs B.] in 1983. Under the motto, "sell cheap and tell the truth," she worked in the business until the ripe old age of 103.

Nebraska Furniture Mart is a pretty simple business, it sells furniture, flooring and home appliances. It's easy to understand and it's unlikely to be subject to a lot of change. In ten years time it will still be selling furniture.  

"One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners." Warren Buffett 1993

Nebraska Furniture Mart's competitive advantage is the lower prices it offers it customers and its large range. It's a virtuous circle. Lower prices lead to more sales which allows the business to secure better pricing and spread its fixed costs over a wider revenue base and then offer the savings back to the customers. It's a win-win situation. The massive scale advantage makes it almost impossible for a newcomer to set up shop and offer cheaper products. 

While Buffett wasn't thinking about the internet back in 1983, today the major competitive threat to a retailer is on-line competition. The furniture business is more immune to on-line competition given product size and a customers desire to try before they buy. As a furniture retailer I know recently told me "I won't sell anything that fits in a car!"

It's important to take the time to think about a company's competitive advantage. How easy would it be to re-create the business, are there barriers to entry? What makes the company so unique that allows it to maintain high returns. What could change that? A business with high margins and low barriers to entry is unlikely to be able to maintain those margins for long.  

“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong a moat, and a  knight in that castle that knows what he’s doing.” Warren Buffett

"Frequently, you'll look at a business having fabulous results. And the question is, "How long can this continue?" Well, there's only one way I know to answer that. And that's to think about why the results are occurring now - and then to figure out the forces that could cause those results to stop occurring." Charlie Munger

The Buffett Series - What is Value Investing?

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. The first essay looks at "What is Value Investing?".

".. we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase."  Warren Buffett - 1992

Over the years Mr Buffett has shifted from buying fair companies at wonderful prices to buying wonderful companies at fair prices. Wonderful companies have the ability to compound earnings over time, unlike optically cheap companies which may provide a one off kicker.  

Some examples of such acquisitions by Mr. Buffett include buying See's Candy at 4X book, Scott Fetzer at 1.8X book and more recently Iscar at 5X book.  

"In GEICO, we paid 20 times earnings and a fairly sized multiple of book value." Warren Buffett, Berkshire 2013 Meeting.

Ultimately ‘Value’ is determined by what you get for what you give. While it is more difficult to ascertain the sustainability of high growth, it doesn't mean a high growth, high PE and high price to book value stock is not a ‘Value’ investment. At the same time, lots of stocks that trade on low PE's, low price to book values and high dividend yields have turned out to be terrible investments. They're generally referred to as "value traps". The key is to get back more in future returns than you give up at the time of acquisition. That's what investing is all about.

Daily Journal Meeting 2017

This Year's Daily Journal meeting contained lots of wit and wisdom from Charlie Munger, Warren Buffett's partner. He's got a cracking sense of humour at 93 years young.  

Some of the more interesting comments Mr Munger made where around the evolution of Warren Buffett as an investor. Buffett has recently purchased positions in airlines and Apple, two things he would never have done in the past given his dislike of the airline industry and his lack of understanding of tech.

Mr Munger also detailed the need for multi-disciplinary thinking, his thoughts on diversification and the need to rely on quality people.

Here are the key points from the meeting ..

On Picking Managers ..

“We are doing something that’s quite difficult. We are judging people because we don’t understand what the people do. And that’s what Andrew Carnegie did. He didn’t know anything about making steel, but he knew a lot about judging whether the people he was trusting making steel were any good at it. And of course that’s what Berkshire’s done, if you stop to think about it. We have a lot of businesses in Berkshire that neither Warren or I could tell you much about, but we’ve been pretty good at judging which people are capable of running those businesses.” 

On Capex …

“If it makes sense over the long term we just don’t give a damn what it looks like over the short term.”

On Wells Fargo ..

“They made a business judgement that was wrong. They got so caught up in cross-selling and so forth, they got incentive systems so aggressive that some people reacted badly and did things they shouldn’t. And then they used some misjudgement in reacting to the trouble they got in. I don’t think there is anything fundamentally wrong for the long haul with Wells Fargo. They made a mistake and it was an easy mistake to make”

“I don’t regard getting the incentives a little aggressive at Wells Fargo as the mistake , I think the mistake was when the bad news came they didn’t recognise it.” 

“I don’t think it impairs the future of Wells Fargo, in fact I think they’ll be better for it. One nice thing about doing something dumb is you probably won’t do it again.”

On choosing what to do in life ..

“In terms of picking what to do .. In my whole I life I’ve never succeeded much in what I wasn’t interested in. So I don’t think your going to succeed if what you’re doing all day doesn’t interest you. You’ve got to find something your interested in because it’s to much to expect from human nature that your going to be good as something you deeply dislike doing. That’s one big issue. And of course you have to play in a game where you’ve got some unusual talents. If your 5 foot one you do not want to play basket ball against a guy that’s 8 foot 3.”

About Amex/Payments Systems…

“If you think you understand exactly what’s going to happen to payments systems ten years out, your probably under some state of delusion. It’s very hard to know. They are doing the best they can, they have some huge advantages. It’s a reasonable bet, but nobody knows...  I don’t think those things are knowable, think about how fast they change.”

On multi-disciplinary learning…

“You have to know the big ideas in all the disciplines to be safe if you have a life lived outside a cave.”

“Frequently the problem in front of you is solvable if you reach outside the discipline. The idea is just over the fence. But if you’re trained to stay within the fence you won’t find it. I’ve done that so much of my life, it’s almost embarrassing. It makes me seem arrogant because I will frequently reach into the other guys discipline and come up with an idea he misses.. I do not observe professional boundaries”

 On Buffett changing..

“If you’re in a game and your passionate about learning more all the time and getting better and honing your skills etc, of course you get better over time and some people are better at that than others. It’s amazing what Warren has done. Berkshire would be a very modest company now if Warren never learned anything... But what really happened was we went out into fields like buying whole businesses and bought into things like Iscar that Warren never would have bought. 

Ben Graham would never had bought Iscar. We paid 5X book for Iscar and it wasn’t in the Graham play. And Warren learned under Graham, he just learned better over time. And I’ve learned better. The nice thing about the game is you can keep learning. And were still doing that.

Imagine, we’re in the press now for all of sudden buying airline stocks. What had we said about the airline business. We thought it was a joke it was such a terrible business. Now if you put all those stocks together we own one minor airline. We did the same thing in railroads, we said railroads were no damn good. Too many of them and truck competition, and we were right for about 80 years. Finally they get down to four main railroads and it was a better business. And something similar is happening in the airline business.”

On Investing now and the need for change …

“It’s got harder and harder, now we get little edges when before we had golden cinches. We don’t make the same returns we made when we could pick this low hanging fruit.”

“Warren bought Exxon as a cash substitute. He would never have done that in the old days.  We have a lot of cash and we thought it was better than cash over the short term. That’s a different kind of thinking from the way Warren came up. He’s changed. He’s changed when he buys airlines and Apple. Think of the hooey we’ve done over the years over high tech as outside our competency and the worst business in the world is airlines. And we now appear in the press with Apple and a bunch of airlines. I don’t think we’ve gone crazy, I think we’re adapting reasonably to a business that has got a lot more difficult. I don’t think we have a cinch due to those positions, I think we have the odds a little bit in our favour. And if that’s the best advantage we can get we’ll have to live with it.”

On Indexing with a small index …

“When you have a small index and it gets popular it’s a self defeating situation. When the nifty fifty were all the rage, JP Morgan talked everybody into buying these 50 stocks. They didn’t care what price the stocks were they just bought those 50 stocks. In time they forced up the stocks to 60X where upon it broke down and everything went down by 2/3rds quite fast. If you get too much faddishness in one sector or one narrow index of course you can get catastrophic changes like they had with the nifty fifty era.”

On funds management and big decisions ..

“The prices for managing really big sums of money are going down down down - 20 basis points and so on. The people who rose in investment management didn’t do it getting paid 20 basis points. I would hate to manage a trillion dollars in big stocks and try and beat the indexes, I don’t think I could do it. In fact if you look at Berkshire and take out 100 decisions, which is two a year, the success of Berkshire came from two decisions a year for fifty years. We may have beaten the indexes but we didn’t do it by having big portfolios of securities and having subdivisions managing the drugs etc.”

On Books ..

“I just read this new book by Thorp, the guy who beat the dealer in Las Vegas.. then he did computer algorithmic trading.  I really liked the book, I recommend Thorp’s new book.”

Destroying old ideas …

"I’m very busy destroying bad ideas. I actually like it when I destroy a bad idea. I know so many people whose main problem in life is that old ideas displace the entry of new ideas that are better. That is the absolute standard outcome in life. There is an old German folksaying ‘we’re too soon old and too late smart.’ That’s everybody’s problem”

“It’s a very important habit getting rid of the dumb ideas. Everytime I get rid of a much beloved idea I pat myself on the back. The price we pay for being able to accept a new idea is awesomely large.”

Ideas …

“A few good ideas is all you need. And when you find the few of course you have to act aggressively. That’s the Munger system. You’re not going to find a million good ideas.”

On Valeant..

“Interesting thing is how many high grade people it took in. It was too good to be true. There was a lot wrong with Valeant. It was so aggressive and it was drugs people needed…  I don’t think capitalism requires you to make all the money you can.  I think there times when you should be satisfied with less. Valeant looked at it like a game of chess, they didn’t think of any human consequences. They just stepped way over the line and in the end of course they were cheating.”

On diversification..

“Am I comfortable with a non-diversified portfolio. I care about the Mungers. The Munger’s have three stocks. We have a block of Berkshire, a block of Costco, a block of LiLu’s fund and the rest is dribs and drabs… Am I comfortable? Am I securely rich? Your damn right I am… Is three stocks enough? What is the chances that CostCo is going to fail?, Berkshire is going to fail? What are the chances LiLu’s portfolio in China’s going to fail. Chances of any one is almost zero.”

“I’ve never for one moment believed this boulder-dash they teach about wide diversification. If you are a no-nothing investor of course you should own the average. If your capable of figuring out something that will work better you’re just hurting yourself looking for 50, when three will suffice, one will suffice if you do it right. Once cinch, what else do you need in life.. To think we are teaching these professors to teach this crap to our young.  People are getting paid for teaching boulder-dash.”

On Banks and the investment in Irish bank investment in 2008..

“That was a mistake we shouldn’t have made. Both Warren and I know you can’t really trust any of the numbers put out by the banking industry. People who run banks are subject to enormous temptations. It’s easy to make a bank report more earnings. Even if you are really good at something, you can drift into a dumb mistake.”

On India..

“India is grossly defective because they have taken the worst elements of our culture. They forged their own chains and put them on themselves. I do not like the prospects of India compared to the prospects of China.”

 On market declines..

“I regard it as a part of manhood. If you’re going to be in this game for the long haul which is the way to do it. You better be able to handle a 50% decline without fussing too much. Conduct your life so you can handle a 50% decline with aplomb and grace. Don’t try to avoid it. It will come. And if it doesn’t come I’d say your not being aggressive enough”. 

On China..

“What I like about China is they have some companies that are very strong and still selling at low prices. The Chinese are formidable workers and they make wonderful employees and there is a lot of strength in that system. The Chinese government helps its businesses, it does not behave like the government of India which doesn’t help its businesses at all. That’s what I like about China. I have to admire taking up a billion and a half people in poverty that fast,  that was never done in the history of the world. What they have done is just an incredible achievement. They have taken a poor nation and saved half their income when they are poor.  It was unbelievably admirable and effective.”

“Chinese people only have one problem, they believe in luck. That is stupid. Your want to believe in odds. Some reason in the culture too many people believe in luck and gamble. That’s a national defect”

On adversity..

“The idea that life is a series of adversities and each one is an opportunity to behave well instead of badly is a very very good idea.”

On Manager fees..

“If your advising other people you oughta be pretty rich pretty soon. Why would I take a lot of advice from somebody who couldn’t himself get pretty rich pretty soon. And if you’re pretty rich why shouldn’t you put your money alongside your investors and go up and down with them. And if it’s a bad stretch why should you scrape money of the top when they are going down a notch. I like the Buffett system.”

On being rational ..

“Rationality is a moral duty. If your capable of being reasonable it’s a moral failure to be unreasonable when you have the capacity to be reasonable”

 On Complex systems..

“If your dealing with a complex system, the rules of thumb that worked in the complex system in year one may not work in year 40.  The laws of physics you can count on, but the rules of thumb in a complex civilisation changes. Who would want to live in a state of sameness, you may as well be dead.”

Portfolio Construction - Where is the risk?

A recent post by John Hempton of Bronte Capital on a fairly well known value investor's portfolio back in March 2008 posed the challenge of 'risk-assessing' the portfolio.  I don't know Mr Hempton personally but I enjoy reading his posts, he's an independent thinker.  

The post, titled "A puzzle for the risk manager", detailed the investment manager's stock portfolio which performed very poorly over the next 12 months.   Managing assets requires continued learning and you can learn a lot by studying not only your own mistakes but the mistakes of others.  

"The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others" Sir John Templeton

This case study provides a great opportunity to think about the process of portfolio construction, human psychology and history. 

Here is the portfolio:

I'll run through some of my thoughts on the portfolio and the issue of portfolio construction.

The key to managing risk is to think.  There is no substitute for thinking about the portfolio and how it may perform in adverse conditions.  Using screens and computer models of loss expectancy are a poor substitute for common sense and many fund managers who relied on such models learnt an expensive lesson in the financial crisis.

“The best way to minimize risk is to think” Warren Buffett

"In life as in investing, what kills you is what you don't know about and what you're not thinking about" Bruce Berkowitz

The number one risk a portfolio manager must avoid is the permanent loss of capital.   So the question becomes, does this portfolio pose the risk of the permanent loss of capital?  

Building an investment portfolio involves a lot more than just picking cheap stocks.  It requires consideration of position sizes, industry concentration, liquidity and how the overall portfolio will perform under different scenarios including those which may not have happened before.  The portfolio manager must be alert and aware of changes in the markets, economy, politics, and society at large.  Changing circumstances may warrant portfolio changes. 

In many cases, portfolio failure results from poor portfolio construction, a failure to recognise changing circumstances and/or the failure of imagination about what the future may portend. 
A portfolio must be constructed to withstand the unexpected.

"A fiduciary should think more about the safety of an entire portfolio than about any individual holding"  Seth Klarman

In assessing any portfolio, I like to think of the seven common causes of catastrophic failure   - excessive concentration, excessive correlation, illiquidity, excessive leverage, fraud, capital flight and valuation risk.

Let's assess the subject portfolio on each:

Concentration: The subject portfolio has 48% of its assets exposed to the financial sector. To me this is the biggest risk as financial stocks inherent leverage make them susceptible to failure.

While Warren Buffett has invested in financials he also acknowledged the significant risks.  His 1990 letter referenced his Wells Fargo investment that year...

"The banking business is no favourite of ours.  When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portfolio of assets can destroy a major portion of equity.  And mistakes have been the rule rather than the exception at many major banks."  

Mr Buffett thought broadly about the possible worst case scenarios facing both the banking sector and Wells Fargo.  Only after concluding such a worst case outcome would not 'distress him' did he invest.

"Of course, ownership of a bank - or about any other business - is far from riskless.  California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.  Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.  None of these eventualities can be ruled out."

Buffett noted at the time..

"Buying into the banking business is unusual for us.. but opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare.   Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly."

The key point Mr Buffett makes here is "understand".  The issue confronting investors prior to the financial crisis was that the banking industry had become increasing complex and opaque.   Innovation in capital markets had seen credit markets grow feverishly as banks securitised significant quantities of assets, increasingly relied on wholesale funding markets as opposed to deposits, played in credit derivatives and placed excessive trust in ratings agencies.  The global banking industry had become far more entwined and far more susceptible to fickle credit markets. 

“Complex systems are full of interdependencies—hard to detect—and non-linear responses.  In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.” Nassim Taleb

"The condensation of credit cycles and the increasing incidence of credit dislocations is a consequence of the globalisation of the world economy, technological advancements in the electronic transmission of information, and financial innovations such as derivatives and securitisation that blur the distinctions among markets and asset classes.  The confluence of these developments has perversely made the markets more informed but less informative.  Information and capital rocket around the world at unprecedented velocities and volumes, leaving investors to process market data before reacting.  Today, a pin dropping in Argentina can cause simultaneous ripples (or waves, or in rare cases tsunamis) as far away as Japan.  By the time the pin drops, it may already be too late for investors to protect their capital.  In a financial world dominated by innovation and new products that blur the traditional distinctions between debt and equity, disruptions in the credit markets are certain to affect all hedge fund strategies in all asset classes.  The increasing frequency and severity of extreme credit events points to the heightened risk of contagion among markets and asset classes. "  Michael Lewitt, 2003

It's hard to see how an investor could have had a reasonable understanding of the risks sitting on the books of many of the global banks.  Increasing reliance on credit markets posed risks, even for those banks with large deposit bases.  An investor with a generalist mindset and an appreciation of credit markets would be mindful of the potential for capital destruction in the sector.

"The analysis of credit cycles involves an understanding of monetary policy, financial and industry innovation, and regulatory change.  The ability to identify in advance those moments when credit cycles veer into crisis also requires imagination, an appreciation of human folly and a willingness to imagine worst case scenarios.  In order to identify times of maximum risk, understanding human psychology is at least as important as understanding economics.  Credit cycles involve a combination of historical, sociological, political, economic and psychological factors that are both unique to each specific cycle and common to all cycles.  Hard and soft data must be examined.  The unhappy truth is that markets don't learn their lessons very well.  Financial history tends to repeat itself.  The only questions are when and to what degree.  Hedge fund managers charged with preserving capital and producing positive returns in both good and bad markets must pay particular attention to the etiology of credit cycles and particularly those extreme turning points that lead to financial crisis that can consume years of returns in the blink of an eye"  Michael Lewitt 2003

The world's best investors take account of the fact that some things cannot be known.  Forecasts are often wrong.  Investors make mistakes.  Portfolios must be constructed to account for these limitations.

"We adhere to policies that will allow us to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions"  Warren Buffett

"A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns"  Warren Buffett

"We should all be humble enough to realize that once every 20 or 30 or 40 years, values go to real extremes. Any investment program must take into account the impossibility of knowing when and to what extent such extremes might occur." Paul Singer

While most successful investors run reasonably concentrated portfolios they diversify across industries in an attempt to limit downside risk, no matter how favourable one particular sector may look.

"We have had periods in which one or more areas looked absolutely fabulous, but it is part of our discipline to continue to invest in a number of areas in order to limit pain if we are wrong about any one"   Paul Singer

The subject portfolio had 26% of investments exposed to the tech sector [technology/semiconductor], 20% in beer investments and 15% in media assets. Industry exposure limits must be set relative to the potential risk, however a 20% limit is common amongst successful investors.

Correlation - It's not hard to see the significant risks a US recession/credit dislocation would pose on this portfolio given the increasing systemic risk in the global banking industry.

A global recession would also place pressure on consumer spending and business capex.  In times of turmoil correlations have a tendency to go to one.  So without hedges or cash, portfolios can be at risk of significant loss.  The key is ensuring they are not permanent. 

"If every position in the portfolio could be uncorrelated with every other position and also uncorrelated with the markets, we would be happy indeed.  However, as the world does not work that way, we approach diversification and seek uncorrelation in an incremental fashion." Paul Singer

"Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.  Correlation is often underestimated, especially because of the degree to which it increases in crisis.  A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, effecting everything similarly." Howard Marks

Establishing a checklist of risk factors that may negatively impact a portfolio and then calculating the percentage exposure can assist in identifying fault lines and downside risk in the portfolio.  Risk factors such as sector/industry exposure, market cap, liquidity, inflation, high gearing, interest rates, currency, housing market exposure, recession, market leverage/beta, consumer exposure, business capex, high PE, business quality, yield, credit market, index type, investor crowding, disruption, cyclical/defensive, growth/value, sovereign/geographic exposure etc are a good starting point. 

Building protection through cash holdings or hedges can limit portfolio risk.  The cost of such hedges maybe under-performance in a bull market.  This is a cost successful investors are prepared to accept.

Liquidity - Liquidity is important as it allows the manager to exit in case of a faulty or changed investment thesis or in the event of redemptions [capital flight].  Illiquidity and redemptions can be a deadly combination.  It would appear the subject portfolio was liquid enough to allow the manager to reduce losses before they became catastrophic.

Capital Flight - Any fund manager that experiences significant losses or relative under-performance is at risk of redemptions depending on the nature of the end client.  A portfolio may experience significant mark to market losses even while the intrinsic value of the stocks are little changed.  While volatility is ordinarily the friend of the value manager, in time of market chaos the manager may not get the opportunity to ride out the market decline should significant redemptions arise.  The issue for the subject portfolio is that the mark to market losses reflected permanent loss of capital which impeded a recovery.

"I may not care about volatility but the reality of having temporary capital is the volatility matters" Mohnish Pabrai

Leverage - This subject portfolio had debt at two levels, the stock level and the portfolio level.  The risk inherent in the financials positions was discussed above. 

The subject portfolio had long exposure of 127% and a short position of 11% providing a net exposure of 111%.  This means that for every $1 invested by a fund unitholders, the manager had $1.11 exposed to the market.  While not ridiculously aggressive, I personally don't understand why managers run net exposures over 100%.  Many long only fund managers mandates limit cash holdings which poses the question "who is making the call on whether the market is attractive?".  It appears this manager had the ability to run lower net and chose not to.  If you are going to run a short book I think it makes sense to use it to minimise portfolio risk not increase it.  The subject portfolio is no different to a geared long fund [absence any commentary on the shorts? ie high beta?].   

Valuation Risk - Mr Hempton noted the "PE ratios mostly looked reasonable".  On a "screening process" the portfolio probably looked attractive relative to the market.  At the time, the market was elevated and a M&A frenzy was driving stock multiples higher.  A 'value screen' at the time would take no account of the fact bank earnings were about to collapse [with the benefit of hindsight] and a low PE was no protection from a credit dislocation.  The banks were 'value traps'.

Fraud - while there is unlikely to be a case of fraud by the manager there was certainly fraud going on at the US housing level.

Ultimately the subject portfolio failed as it wasn't constructed to handle a credit crisis.  The portfolio's financial investments did not recover like the broader market due to bank recapitalisations, bankruptcies or nationalisations.  There was permanent loss of capital.

Other value managers faced severe drawdowns through the crisis but provided they had more permanent capital and/or liquid positions and their portfolio's intrinsic value wasn't impaired they could hold on for the market price to better reflect the underlying value of the stocks.  Owning, high quality businesses, with good cash flow and solid balance sheets allowed many investment managers to recover quickly from the market sell-off of 2008/2009.

"People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it"  Jeffrey Ubben

The chart below shows a portfolio containing an equal weighting of the subject portfolio's stocks which is a reasonable proxy for the subject portfolio [in white].  It highlights the subject portfolio's performance mirrored the S&P500 and FTSE Banks indices [a good reason sector ETF's aren't safe! but that's another topic].  These indices experienced significant permanent losses and never recovered like the broader market.

Some additional thoughts ..

History - the 2008/2009 global financial crisis wasn't the first time the banking industry had suffered serious losses.  Had the manager considered previous credit crisis it's unlikely he/she would have had such an aggressive exposure to banks.   There were plenty of warning signs a crisis may be coming.

Macro - the portfolio manager appears to have picked the portfolio on the basis of cheap stocks with little consideration of the macro risks.  Plenty of value managers who considered themselves 'stock pickers' paid dearly for ignoring the macro environment in 2008/2009.

Humility - there is every possibility the manager had a track record of success in the bank sector before which blinded him/her to the potential dangers. 

"There’s this balancing act between being stoic and an investor who’s maybe too ashamed to admit they’re wrong or in denial about being wrong. It’s a risk. If you’re so used to being right in the end, and if you’re used to your investment thesis working out “Sometimes the difference between success and failure was not just about our understanding and steadfast belief in the value of a holding, but how long we were willing to wait to achieve that result. In the long term, you can always lull yourself into a sense of complacency that everything will work out and that if you seem wrong today, you just wait a little while and you’ll be proven right. It can be a problem to trick yourself into believing too much in your own capabilities, if you are overly patient without being as discerning about whether it’s justified or not." Chris Mittleman

Social Proof - Mr Hempton noted "all of these positions could be found in quantity in the portfolios of other good investors."   The portfolio manager may have taken comfort from this.  While it can be useful to look at other investors holdings it doesn't abdicate the requirement for independent thought and analysis.  Other investors portfolios may have been constructed with less risk or hedged.  Other 'good' investors may be wrong.

"You are neither right nor wrong because the crowd agrees or disagrees with you. You are right because your data and reasoning are right." Warren Buffett

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

Losses - while the portfolio was under pressure I'd argue the manager had the opportunity to significantly reduce risk to minimise losses.  The chart below shows the portfolio was down c20% at the time the UK lender Northern Rock collapsed after the European credit markets closed shut.   Given the exposure to European Financials this should have flashed a warning sign.  The manager had liquid positions and the ability to cut losses.

A Portfolio manager's judgement can be impaired by losses and it can be difficult to implement hedges/risk reduction in a crisis. It's important to constantly review the portfolio, test your investment ideas, remain intellectually honest and address mistakes.

“The price of managing risk in the middle of a crisis is much too high so we try position the portfolio to thrive in a variety of market environments” Jake Rosser

"Large losses, though initially only on paper, often derail an otherwise rational investor. An illogical fear of loss insidiously exerts an undue influence on portfolio decision making. (Rationally, the lower prices go, ceteris paribus, the less the likelihood of further loss—a truism that falls on deaf ears when fear has the upper hand.)" Frank Martin

While this portfolio manager may have had a track record of success prior to 2008 the permanent loss of capital was significant.   As they say in this business, you're only as good as your next trade.  Unfortunately, a solid track record of success can be eliminated by the permanent loss of capital.  Never forget, any number times zero, is zero!

"In business and also investment, success is measured through the compounding of a series of returns.  Mathematically, the biggest risk to a compounded series of returns is large negative numbers or even a single negative number, if large enough.  Take however many spectacular annual outcomes and multiply them by just one zero and the answer is of course, zero"   Marathon Asset Management
 

Further Recommended Reading-
One of the best articles on risk management is 'Risk Control & Risk Management' by Paul Singer of Elliott Associates, whose 35 year-plus track record of consistent returns with only two small down years is astounding.  The article is featured in the book 'Evaluating and Implementing Hedge Fund Strategies', 3rd edition.

Michael Lewitt's essay "Understanding credit cycles and hedge fund strategies" forewarned of the risks in credit markets.  The essay is also featured in the book 'Evaluating and Implementing Hedge Fund Strategies' 3rd Edition.

The excellent book 'Capital Returns' by Marathon Asset Management contains their prescient forewarnings of the risks building in the global banking system before it's collapse in 2008 and 2009.

The book 'Ubiquity - Why Catastrophes Happen' by Mark Buchanan delves into complex systems and how catastrophes can happen.

The Tutorials in the Investment Masters Class cover many topics relevant to the analysis and the links have been provided above. 

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The Arbitrage Series - Part 3 : Time Arbitrage

Time Arbitrage is the term given to the process of seeking to profit from buying a security where the current market price does not reflect the expected value. The mispricing may result from a short term issue facing the company which is not expected to impact the long term intrinsic value of the company or the market misjudging the future economic performance of the company which will see its shares re-rated. In time, the share price is expected to converge with its value, hence the term 'Time Arbitrage'. 

“Value investing is a large-scale arbitrage between security prices and underlying business value.” Seth Klarman

The increasing short term focus of market participants often means investors place too much weight on short term factors impacting the company to the exclusion of the company's longer term potential. This can provide a structural edge. Many clients demand short term results and have little patience for short term underperformance, and this means fund managers risk losing both assets under management and their job if they don't focus on the next month, quarter, or maybe year at most. In addition, the increasing flow of money into passive and quant strategies and ETF's either chasing historical performance and/or on the basis of index composition can result in egregious mispricings of stocks.

“Time-arbitrage just means exploiting the fact that most investors - institutional, mutual funds or hedge funds - tend to have very short-term horizons, have rapid turnover or are trying to exploit very short term anomalies. So the market looks extremely efficient in the short run. In an environment with massive short-term data overload and with people concerned about minute-to-minute performance, the inefficiencies are likely to be looking out beyond, say, 12 months." Bill Miller

“The longer you can extend your time horizon the less competitive the game becomes, because most of the world is engaged over a very short time frame.” William Browne

"We are disinterested in short term results and thus have the luxury of focusing our research and purchases on the much less competitive universe of stocks that have less promise of near-term appreciation, but that have exciting longer term potential. This gives us a competitive edge." Ed Wachenheim

Focusing on the long term can also provide a ‘Behavioural Edge.' When a high quality stock is sold down due an earnings miss, a product issue, a management change, an industry or regulatory issue, a geopolitical event or some transitional business issue there's a decent chance investors have over-reacted to the negative news due to psychological biases. Peter Bevelin points out in his excellent book 'Seeking Wisdom - From Darwin to Munger' that "it is a natural tendency to act on impulse - to use emotion before reason.  The behaviours that were critical for survival and reproduction in our evolutionary history still apply today." The combination of fear, social proof [other investors are selling], loss aversion [we feel losses twice as much as gains] and recency bias [we overweigh what has happened recently and underweigh or ignore the long term evidence] counteract the average investors attempt to make a rational decision.  

"When we find companies we consider undervalued, it's typically due to short-term worries we believe are temporary." Francois Rochon

“We’re very focussed on paying a cheap price, and that only comes about when there’s some short term challenge.” David Herro

"Our thesis often is based on the passage of time. What makes a negative story negative may just be that the next three to six months - the time space in which Wall Street analysts live - don't look so great." Robert Kleinschmidt

Effective 'Time Arbitrage’ requires an investor to ensure the problem facing the company is temporary and likely to be resolved. Asking questions such as 'does the company remains structurally sound?', 'has there been any structural change in the competitive landscape?' 'is the balance sheet still strong?' will help identify whether the share price dislocation is likely to be temporary or entirely warranted due to permanent issues. When answering these questions the investor must be open-minded, intellectually honest and test the investment thesis to avoid the behavioural biases that can blind an investor to negative information.   

"We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have over-reacted to negative macro or company specific events. That's the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values" Bill Ackman

Most investors spend their time thinking about the short term as it's much easier than contemplating the future. Investors also fall into the trap of extrapolating the recent past into the future. This provides the opportunity to profit by focusing on how a company might be performing in a few years' time and developing an alternate thesis that most investors have overlooked. Positive developments can include a consolidating industry, a new product to be launched, a major cost reduction program, the end to a major capital expenditure program, reversal of a bad inventory decision, positive management changes, a technological change which will drive sales, or corporate activity.

"Common situations that result in a mismatch between share price and share value .. may simply be time arbitrage, where we think the business performance looking out 18 to 24 months will be much better than the share price implies." Robert Alpert

"In my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes what will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one's neck out - all efforts that human beings too often prefer to avoid." Ed Wachenheim

To be successful the investor must have an insight into the future that is different to the consensus otherwise the positive news will already be reflected in the company's share price.

"In order to earn outsized returns, we need to hold opinions about the future that are different and more accurate than those of the majority of other investors. In fact, it can be said that successful investing is all about predicting the future more accurately than the majority of other investors." Ed Wachenheim

“One of the few sure ways to make money is to have a view that is off-consensus and have that view turn out to be right. To be contrarian is not enough. You have to be right.  Contrarian is a plus. To be contrarian and be right on you judgement is when you get the golden ring. It doesn’t happen that much but when it does happen you make extraordinary amounts of money.” Michael Steinhardt

"I'm often asking "What's the next guy's thesis?" Why is he going to buy it from us 18 months from now when the stock is up 50%?  It's not just going to be that it's worth 50% more. It's important to imagine the narrative that will make the next investor think it's a good investment then." Ricky Sandler

"All of the consensus is already baked into the price. In order to be correct in the markets, in order to make money in the markets, you have to see something that the consensus doesn't see. So you have to have an independent point of view." Ray Dalio

“The number one principle would be do not look at the world today, what’s happened in the past and happening currently, is in the price. Try and think how the world may look differently in 18-24 months from now and try and base your investments on that and not what’s true today. It’s amazing what that single little exercise can do.” Stanley Druckenmiller

While the time frame and price outcomes associated with 'Time Arbitrage' are more uncertain than most 'risk arbitrage' investments, the returns can be significant. Many of the Investment Masters happily acknowledge that their edge is from taking a longer term time frame. Like any investment activity, success requires hard work and independent analysis. 

"Time Horizon Arbitrage .... If there is a free lunch on Wall Street, we feel it is the time horizon perspective." Christopher Begg

“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman

"I would say our edge is the willingness to take a longer view of a business." Glenn Greenberg

“You have to extend your time horizon if you want any chance of doing well. The competition in the space really thins out.  You have an opportunity to arbitrage time over others.” William Browne

Further Reading - 

The recent book 'Common Stocks & Common Sense' by Ed Wachenheim of Greenhaven gives an inside view into implementing 'time arbitrage' through case studies of 11 investments made since the fund was founded in 1987.  Greenhaven invests 'with a two to four year time horizon and cares little about the near term outlook for its holdings'.  Over the past 25 years, accounts managed by Greenhaven have achieved average annual returns of very close to 19 percent. Highly recommended reading.

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