Three Very Short Stories - Mission and Purpose

The success of a business is dependent on various factors, including a clear vision, shared purpose, and effective communication. These factors can not only motivate employees but also lead to the achievement of extraordinary results. The leaders of Porsche, Cintas, and Helzberg Diamonds have shared the following short stories, highlighting the importance of prioritizing the mission and purpose of a business over the pursuit of money. By doing so, a business is more likely to create a culture of passion and dedication among its employees, resulting in increased productivity, efficiency, and long-term success.

‘Building the Cathedral’

“I used to tell the story about a man walking down the street in the middle of a big city and how he came upon a construction site. Bulldozers and earthmoving machines were busy on the site. People were working hard.

He came across three men in a ditch. He asked the first man, "What are you doing?" "I'm digging a ditch," the first man said. Our protagonist asked the second man, "What are you doing?" "We're digging a ditch for the water line for that building going up over there," the second man said. Our protagonist asked the third man, "What are you doing?" The man looked up and replied, "We're building a cathedral. It will be a big beautiful cathedral with five big tall spires and beautiful stained glass windows. It will seat 500 people. It will be the most beautiful church in this city. That's what we're doing."

Every time I'd tell that story, I'd ask my audience which of those men do you think is most motivated. Obviously the man building a beautiful church will be more committed than the others because he shares a vision. He may be in a ditch, but he is proud of what he is doing. That simple story demonstrates why it's important to have a vision and share it with everyone.” Richard Farmer, Cintas [Founder]

‘Busting Rocks’

“There is a wonderful old story about the importance of knowing "why we are here." Three men were working on a construction site. All three were performing exactly the same task. A passerby asked the first one, "What are you doing here?" The answer was, "I am busting rocks." The passerby asked the second man the same question. (Remember, he was doing the same thing as the first man.) This time the answer was, "I am earning my living."

These are two possible views of work. They differ slightly in their perspective, but neither is a good answer to the question, why are we here? If the people in the organization believe they are busting rocks in order to earn a living, how might they decide to improve their job? They might ask: How can I bust fewer rocks for more money? And what is management thinking? How can I get people to bust more rocks for less money? This is unlikely to result in a happy relationship; it is certainly not the key to getting extraordinary results. I have known many highly educated and experienced managers who view management in that adversarial manner. When the passerby asked the third man what he was doing, he got a very different answer. The third man's answer was, I am helping my colleagues build a temple.

It is not the activity that defines a job, but how someone sees their activity in the context of an organisation’s culture and style that matters. If people are working together to build a temple, the hammers are not as heavy, the rocks are not as hard, and the days are not as long. It is no longer the same task. It is not what people are doing, but how they view their collective effort as part of a mission that puts passion into the activity; passion that can lead to extraordinary results. To create and sustain real driving force, people must build a temple together, not bust rocks for a living.

The definition of the temple is not only a statement of what is to be accomplished, but includes a value statement of what will not be done (or tolerated) in the process. There are always rules and values associated with a temple. "We will never go to any race without the objective of winning" turned out to be such a statement. It is up to management to define the temple. If management cannot (or will not) communicate what sort of a temple the organization is building, the work ethic can easily become: How can I bust fewer rocks for more money?” Peter Schutz, Porsche [CEO 1981-1987]

‘The Wheelbarrow Story’

“When a young Charles Percy (later Senator Percy) was the head of Bell and Howell (a maker of fine cameras at that time), he increased productivity to an amazing extent. When asked how he did it, he said he used the ‘Wheelbarrow Story.’ Percy explained that he did not believe in merely telling a worker in the factory to wheelbarrow needed parts to the other side of the plant. His philosophy was that the worker would perform the task better and more willingly if his supervisor took the time to explain the task's importance to the success of the entire plant. For example, the production line depends on wheelbarrowing those parts to the right place at the right time. “Production shuts down without your efforts.”

Another true example, this time of how to discourage associates from buying into an operation's success. A consultant asked the manager of an incredibly expensive new warehouse, '“Were you consulted on the new design? How is it working?" To which the manager replied, "It's a disaster! The big shots built it with the advice of some egghead consultant who came in from out of town. Do you think this individual will go out of his way to prove the new warehouse works? I don't think so.” Bennett Helzberg, CEO [Helzberg Diamonds - A BRK Company]

Summary

These three short stories highlight the importance of having a clear mission and purpose that goes beyond just making money. Having a purpose-driven organization can motivate employees, foster a positive work culture, and lead to better results in the long run. When management also instills employee ownership and a culture of empowerment, the outcomes can be remarkable. From the story of building a cathedral to the wheelbarrow story, the moral of the story is that when employees see their collective effort as part of a mission, it can lead to extraordinary results.

References:
Schutz, P., & Woollard, R. (1991). “The Driving Force: Extraordinary Results with Ordinary People.” Business One Irwin.

Farmer, R. (2004). “Rags to riches: How Corporate Culture Spawned a Great Company.” Orange Frazer Press.

Helzberg, B. (2003). “What I learned before I sold to Warren Buffett: An Entrepreneur's Guide to Developing a Highly Successful Company.” John Wiley & Sons.

Follow us on Twitter : @mastersinvest
Visit the Blog Archive

TERMS OF USE: DISCLAIMER

Beware of Averages, Zeros & Non-Linearity

Over the two decades that I have been advising institutional clients on markets, I've experienced my fair share of extreme stock market volatility. This has included market crashes, stock price death spirals and short squeezes. During this time I've often witnessed whole analyst communities get blindsided by unexpected outcomes, rendering their forecasts and recommendations completely obsolete. I've also seen investors lose significant sums. Some of these outcomes may have been avoided by recognising a few simple mathematical concepts, namely Averages, Zeros and Non-Linearity. 

Understanding these three concepts, which as you'll see, can often be inter-related, can help you avoid the permanent loss of capital.

Averages

Averages are a form of simplification. They can summarize a lot of information into one key output. You'll often see market commentators reference an average to support a recommendation ... "Historically, the market has rallied/fallen x% when xyz happens."

The danger in relying on averages is that the range of historic outcomes may be very wide; the range may contain a zero, or the future outcome may end up being far outside those historic outcomes. It's also quite likely the outcome will be nowhere near the historic average.

“Averages mislead by hiding a spread in a single number.” Hans Rosling

The average annual stock market return over the last century is a case in point. While the average return for the S&P500 has been c10% pa, the typical yearly return is far from that. The average can conceal more than it reveals. Buffett made that point in his 2004 letter ... 

"In one respect, 2004 was a remarkable year for the stock market, a fact buried in the maze of numbers on page 2. If you examine the 35 years since the 1960s ended, you will find that an investor's return, including dividends, from owning the S&P has averaged 11.2% annually. But if you look for years with returns anywhere close to that 11.2% - say, between 8% and 14% - you will find only one before 2004. In other words, last year's 'normal' return is anything but."

Whenever I hear references to an 'average', I remind myself of the story of the 6-foot man who drowned crossing the river that was, on average, 5-feet deep. 

“Over the past 100 years, it is generally understood that the stock market’s annualized return is approximately 10%. That 100 year annualized return for the S&P 500 Index masks a great deal of volatility, or variability around the average. It calls to mind the parable of the 6-foot man who drowned in the 5-foot average depth river. The lesson: beware of averages!” Chuck Akre

"Never forget about the man who was six-foot-tall, who drowned crossing the stream that was five feet deep on average. To be a successful investor, at minimum, you have to survive. Surviving on the good days is not the issue. You have to be able to survive on the bad days. The idea of surviving on average is not sufficient. You have to be able to survive on the worst days." Howard Marks 

Another limitation of averages is that the future might look a lot different to the past. Billions of dollars were lost in the Global Financial Crisis as people relied on the notion that`On a National basis, US house prices never go down'. Never forget that absence of evidence is not evidence of absence.

“The mother of all harmful investment errors is mistaking the absence of evidence... for the evidence of absence. In other words, assuming that just because historically infrequent and potentially catastrophic events, known as Black Swans, haven’t happened… they won’t.” Frank Martin

As an investor you must structure your portfolio to cope with the unexpected. This means stress-testing individual ideas and the assumptions that underpin them and taking the time to think about what a worst case scenario might do to each position and the portfolio as a whole.

"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

Zeros

Averages also mask historic outcomes that resulted in zeros. Regardless of the potential return, if there is a possibility of a complete loss, investors should steer clear.

“Makes sure that the probability of the unacceptable (i.e: the risk of ruin) is nil.” Ray Dalio

Zero means game over.

"Never forget that anything times zero is zero. No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn to pumpkins and mice.” Warren Buffett

"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

“There is a difference between opportunities missed and capital lost, with which most investors, anecdotally, do not appear adequately familiar. You can miss a million opportunities in a lifetime and still become very rich. Every asset that has risen in price that one didn’t purchase was an opportunity lost. Capital losses are not so forgiving. If you lose 100 percent of your capital – just once – you're broke.” Frank Martin

"One single loss can eradicate a century of profits." Nicholas Nassim Taleb

"No matter what price you pay for a stock, when it goes to zero you've lost 100% of your money." Peter Lynch

And, as we saw above, history may not be a good guide to the future. To manage that risk requires creative thinking, consideration of potential alternative outcomes and acknowledging worst case scenarios.

“In my book 'The Most Important Thing', I mentioned something I call “the failure of imagination.” I defined it as, “either being unable to conceive the full range of possible outcomes, or not understanding the consequences of the more extreme occurrences.” Howard Marks

"In life, both financial and social, sometimes events swing to extremes that seem inconceivable to conventional minds." Barton Biggs

As Warren Buffett noted above, a common cause of investment ruin is leverage. I've seen plenty of over-leveraged companies turn into zeros.

"The floor for any business is different. If a company is highly levered, the floor could be zero." Mohnish Pabrai

"More than anything else, it's debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk." Peter Lynch

Another danger is complex businesses that are difficult to understand or lack transparency. I recently witnessed a well-capitalized insurance company turn to dust when a fraction of its long-tail reinsurance liabilities blew up the balance sheet. Earlier this year Buffett said: "You can make big mistakes in insurance.”

It's no wonder the Investment Masters generally steer clear of companies with lots of debt, lack transparency or that are difficult to understand. 

Non-Linearity

Humans are wired to think in a linear fashion. Most things in life work that way, but we often fail to see the potential for non-linear outcomes.

“The greatest shortcoming of the human race is our inability to understand the exponential function.” Albert Allen Bartlett

“Our intuitions are not cut out for nonlinearities. Consider our life in a primitive environment where process and result are closely connected. You are thirsty; drinking brings you adequate satisfaction. Or even in a not-so-primitive environment, when you engage in building, say, a bridge or a stone house, more work will lead to more apparent results, so your mood is propped up by visible continuous feedback.” Nassim Nicholas Taleb

“Decades of research in cognitive psychology show that the human mind struggles to understand non-linear relationships. Our brain wants to make simple straight lines. In many situations, that kind of thinking serves us well: If you can store 50 books on a shelf, you can store 100 books if you add another shelf, and 150 books if you add yet another. Similarly, if the price of coffee is $2, you can buy five coffees with $10, 10 coffees with $20, and 15 coffees with $30. But in business there are many highly non-linear relationships, and we need to recognize when they’re in play. This is true for generalists and specialists alike, because even experts who are aware of non-linearity in their fields can fail to take it into account and default instead to relying on their gut. But when people do that, they often end up making poor decisions.” Whitney Tilson

But in markets small changes can have large impacts on outcomes. Sometimes things don't work in a linear fashion.

“With linearities, relationships between variables are clear, crisp, and constant, therefore platonically easy to grasp in a single sentence, such as, "A 10 percent increase in money in the bank corresponds to a 10 percent increase in interest income and a 5 percent increase in obsequiousness on the part of the personal banker." If you have more money in the bank, you get more interest. Non-linear relationships can vary; perhaps the best way to describe them is to say that they cannot be expressed verbally in a way that does justice to them.” Nassim Nicholas Taleb

Jamie Dimon touched on this topic in his recent annual letter ... 

"I am a little perplexed when people are surprised by large market moves. Oftentimes, it takes only an unexpected supply/demand imbalance of a few percent and changing sentiment to dramatically move markets. We have seen that condition occur recently in oil, but I have also seen it multiple times in my career in cotton, corn, aluminium, soybeans, chicken, beef, copper, iron – you get the point.

Each industry or commodity has continually changing supply and demand, different investment horizons to add or subtract supply, varying marginal and fixed costs, and different inventory and supply lines. In all cases, extreme volatility can be created by slightly changing factors.

It is fundamentally the same for stocks, bonds, and interest rates and currencies. Changing expectations, whether around inflation, growth or recession (yes, there will be another recession – we just don’t know when), supply and demand, sentiment and other factors, can cause drastic volatility."

Over the years I've witnessed numerous events cause unexpected negative outcomes due to non-linearity. Here are a few ..

High Fixed Operating Cost Businesses - when businesses have high fixed operating costs and low profit margins, small changes in top line revenue can have a huge impact on a businesses profitability. When sales are booming this is a great benefit, but when things turn down, profit can disappear quickly.

Highly Leveraged Businesses - when businesses carrying a lot of debt turn down, profit can disappear quickly. While the value of the enterprise might decline by 50%, if the business is 50% geared it means the equity is wiped out. These can be very profitable short candidates..

“You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock only wipes out 5% of the total capitalization. You have to look at the total capitalization.” Jim Chanos

Commodity Companies - Analysts often expect supply and demand curves to be linear. Often they are not. A good example was when China entered the iron ore market in the early 2000's. The chart below shows a stable iron ore price from c1985 until 2009 when a supply bottleneck saw prices spike dramatically. Analysts expected the iron ore to be supported by the high Chinese marginal cost of production post c2012. Huge increases in supply and large debt loads that needed to be serviced saw iron ore prices collapse as the supply and demand curve proved non-linear.

Peter Brandt, a CTA since 1976, summed it up nicely in regards to commodities trading below costs ... "But, you might say, this kind of drop is impossible because producers must make money. Who says?? Markets in supply surplus tend to go the production price of the most efficient producers. Plus, who would have ever believed when Crude was at $148 in mid-2008 that prices would retreat to below $40 in just six months. So take your pet macro-economic/fundamental scenario and burn it with the trash!"

Non-linear outcomes can lead to extreme events, also known as 'tail risks'. They too, don't show up in past averages.

“Averages mask non-linearity and lead to prediction errors.” Bart de Langhe

Having an understanding and awareness of the possibility of non-linear outcomes can better prepare you and your portfolio for success in the markets. 

"Don’t project along a straight line." Jim Tisch

"Nonlinear outcomes, those exponentially greater than the apparent precipitating causes, are a great threat to financial and economic stability. Having even a crude understanding of power laws, as they are known,particularly in the area of fat tails, is critically important for effective risk management, for appreciating the potential magnitude of rare market upheavals." Frank Martin

I particularly like the anecdote about the six foot man to explain most of this. Consider that if the average depth of the river he wanted to cross was 5', and the shallowest depth was 0', the deepest part of the water could be well in excess of his 6' height. Which is why he drowned. The message is don't rely on averages. Or expect that all things will conveniently follow a straight line. Buffett's comment that the market's returns bore a resemblance to the average in only one year across the 35 years he was reviewing, is quite simply, astonishing. And let's face it, who wants to drown? Or suffer a permanent loss of capital? 

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Mental Models - Middlemen

Middlemen have historically been essential to success for most supply chains. Traditionally, manufacturers have relied on these businesses to assist in distribution, to develop their markets (or to leverage existing ones), especially when the manufacturer has lacked either the resources or the customer base to 'go it alone.'

I recently read a great interview with John Huber of Saber Capital on Forbes.com, where he opined on the changing role of middlemen in the value chain. Mr Huber's investment focus has evolved over the years to the point where, like many great investors, he seeks only quality businesses or 'compounding machines'. These are businesses whose value is likely to grow over the years. This investing style is in contrast to those investors who try to buy stocks cheaply regardless of whether the company's value is likely to grow or shrink. Those shrinking businesses are often referred to as 'melting ice cubes' - think yellow pages, newspapers, free-to-air-TV companies, etc.

Mr Huber recognises new technology is disrupting existing business models. Businesses are changing, and the internet is disrupting almost all businesses as old moats get filled in and barriers to entry are broken down. In many cases it is the middleman who face existential risk. Think of the cable-TV-company being disrupted by Netflix, the retailer disrupted by Amazon, the music store disrupted by I-tunes, the travel agent disrupted by Expedia, etc. 

Mr Huber gives the example of Footlocker, whose role as a middleman to buyers, is being marginalised by the internet. I'll let him explain...

".. Foot Locker still has a value of around $4.5 billion, even after a 60% decline in its stock price. The risk to the business is significant for a number of reasons. Fewer customers are visiting malls, and more significantly, brands like Nike are rapidly expanding their sales directly to customers, which reduces the value of Foot Locker’s reason for existence. A middleman adds value when he acts as a source of customers for suppliers and/or a source of product for customers. When the suppliers and customers can easily find each other on their own, the middleman has no purpose.

Foot Locker’s markup on any given product is no longer justified if it exceeds the cost of Nike selling it directly to customers. Foot Locker still might be adding incremental volume for some brands, but to the extent that the biggest suppliers can cut out their retail partners without a negative long-term impact to volume, then Foot Locker’s overall value proposition will be seriously impaired. Instead of adding value to each transaction by creating a sale that wouldn’t have occurred without them, they are now operating on borrowed time - extracting value from each sale that could have occurred without them.

But the company’s balance sheet and free cash flow is adequate enough that these risks won’t likely come to fruition over the next couple years, and with the stock trading at a very low multiple of cash flow, it appears cheap. But the value of that business, at least in my view, is slowly eroding. And in business, slow erosion can give way to a landslide without much warning. It is possible to buy this stock and sell it at a profit after a short period, but I think if we look back in five years, we are unlikely to see a situation where Foot Locker is a much more valuable enterprise than it is now." John Huber

The most obvious example of technological advancement impacting distribution channels is the internet. Last year, I picked up an interesting new 'mental model' from Jeffrey Ubben of ValueAct. In an investor letter, Mr Ubben detailed his new focus on businesses that were using the internet to bypass middlemen.

"We often describe ourselves as business model-centric, not industry-centric. This is evidenced by the amount of time we spend analyzing business models, including how companies produce goods and services, how they interact with customers and how they get paid. These dynamics change slowly, but their impacts are profound on the companies' returns on capital, and can very often overwhelm macro-economic cycles and be more long-lasting in effect.

One common theme we have explicitly chosen to invest in across multiple industries is direct customer engagement and disintermediation. Said another way, we look for opportunities where a company can remove intermediaries that distribute, resell, install, service and maintain their products. In the case of a company with diffused customers and limited internal resources, the "middlemen" can be extremely helpful. However, this help comes with a cost as the middlemen need to get paid, extracting economics from the industry. They also own the customer relationships, often leaving the supplier in the dark as to the customers' identities, locations, behaviours, preferences and level of activity. In the case of intangible goods, such as software or media, this loss of control can lead to widespread piracy. A direct relationship with the customer can enable more specific market intelligence, fostering faster, iterative product development cycles that work to further align interests between companies and their customers." Jeffrey Ubben

Jeffrey Ubben specifically mentioned SAS businesses which now benefit from having a "direct connection with the end-users, allowing a real time study of usage patterns, near-continuous product updates and a host of other features.  This was not possible when their software was indirectly distributed and ran on the island or a PC or a corporate data centre."

Its not all bad news for middlemen however.

Mr Ubben's analysis led me to an interesting medical device company who, rather than cutting out the middleman, has implemented cloud-connectivity which is creating a win-win environment for the business, the end customer and the middleman. By internet-enabling their medical device, for the first time the business has a direct relationship with the customer [a patient] which was previously the exclusive domain of the middleman [a home-care services provider]. 

This new customer connectivity is a win-win for all parties involved. The medical device has been cloud-connected and sends the patient's engagement and health data directly to the device manufacturer. This data is also made available to the home-care services provider via an on-line data analytics package and to the patient via an internet application.  When a patient engages with the app the company has found patient engagement levels significantly improve - to the point where one country's Government recently allowed higher reimbursement for cloud-connected devices.  

The medical device uses durable add-on equipment (consumables) which needs regular replacement. By accessing patient data via cloud-connectivity, the medical device manufacturer is able to automate the replenishment cycle resulting in a 50%-60% labor saving for the home-care provider. This has led to increased sales of the high-margin consumables and allowed the home-care provider to both focus more time on non-engaged/non-compliant patients and also to find new patients in what is a largely under-penetrated end market. 

The home-services provider is more productive, the level of patient care improved, and more patients are being located to purchase the medical device. Not only that, but the home-care provider is now far less likely to opt for a new competitor product given the alignment with the medical device manufacturer's data management system. Ultimately, the company's moat has been significantly widened.

The other mental model I like, and one that Jeffrey Ubben recognises above, is a model with a 'diffused' customer base. These are most attractive when the product has a reputation for reliability, where quality control is paramount, the product is a small cost versus the end cost [i.e. interior wall paints vs labour cost, small plumbing components, aeronautical parts, etc], the end market is fragmented and the product's use is service-based. Allan Mecham of Arlington Value Capital expanded on this concept in an interview with the 'Manual of Ideas'...

"I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers".

Its important to identify with these dynamic changes to industries and middlemen, particularly when they relate to either businesses you own or ones you are considering investing in. Whilst not all middlemen are being affected by these changes, many are, resulting in potential 'melting ice-cubes'. Its not a bad idea to add this criteria to your checklists, to ensure you can spot the risk before taking on a company with potentially shrinking value, or even identify the same risk with ones you already own. Your investments could quickly move from the foot locker to the hurt locker if you don't. 

Is the Company's Product Attractive?

Charlie Munger has long reiterated the need to have multiple mental models to aid the investment process. This short essay looks at some of the product attributes that appeal to the Investment Masters.

A company which produces a single product faces a higher risk should that product become obsolete. 

“If it’s a company with a single product and it’s a product that you have some sense might just have in it the possibility it could be leapfrogged, that is someone is going to come up with a better mouse-trap. That’s risk. Your business dissolves pretty quickly.” William Browne

“Another issue would be where there’s a major concentration in one product line. That would be something that I would be hesitant to do again. I had a couple of experiences where I invested in a business with revenues that were overly concentrated in one product line and that product line was ultimately usurped by something else; a better mouse trap. I would be better off avoiding those situations.” Chris Mittleman

Warren Buffett considered the risk of a product being leapfrogged after his recent purchase of a stake in Apple ..  "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”.

It appears Buffett considered significant consumer loyalty outweighed the risk stating "Apple strikes me as having quite a sticky product and enormously useful product that people would use ... 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.”

It's important to consider if the product is unique. If a product has no differentiating features or is a commodity then the only competitive advantage is to be the lowest cost producer.

"Products are not islands. There is an indirect competition, for example, for consumer's dollars. As prices change, some products may lose attractiveness even in well-run, low cost companies." Phil Fisher

“When relatively non-differentiable products are sold on their price, the manufacturers of the products normally need to have low cost structures if they wish to be competitive and earn reasonable profits.” Ed Wachenheim

"When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important." Warren Buffett

Companies selling specialized products which are a small part of a customer's cost structure, but crucial for performance, can be attractive investment opportunities.

“If it’s an industrial business what you want to own is the company that makes the valve that goes into the $100,000 pump which goes into the billion dollar refinery. They’re not going to scrimp on the valve. They want the very best valve they can get. If you’re the valve supplier you’ve got a good business. They’re going to buy your product and you’re going to be able to price your product aggressively because it’s a very low cost component to the end product. So you look for these businesses.” William Browne

“The cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier.” Phil Fisher

“What are the key elements of what you consider a high-quality business? At a basic level, the product or service being sold is critical to customers but is only a small part of their cost structure, and the customer relationship tends to be sticky and recurring." Jeffrey Ubben

“Businesses selling a product or service that’s mission critical, yet is a small fraction of total costs, like you find in some aerospace businesses (or rating agencies in some ways), are always interesting with long-lived advantages due to switching costs.” Allan Mecham

A product with brand strength that is purchased by 'name' can command a price related to usage value rather than the cost of production limiting the potential for competition.

“Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.” Warren Buffett

“You really want something where, if they don’t have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said “I’d like a Cadillac with steel that came from the South Works of US Steel.” It just doesn’t work that way, so that when General Motors buys they call in all the steel companies and say “here’s the best price we’ve got so far, and you’ve got to decide if you want to beat their price, or have your plant sit idle.” Warren Buffett

When a product is enmeshed in a customer's workflow or the customer benefits from network effects it can lead to high sustainable rates of return and this can provide an attractive investment opportunity.

“Sometimes a product is so embedded in a customer's workflow that the risk of changing outweighs any potential cost savings – for instance in subscription based services like computer systems (Oracle) or payroll processing (ADP, Paychex.) Networks, where the customer benefits from a company's scale, as in the security business (Secom), industrial gases (Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are another example. Finally, technological leadership (Intel, Linear Technology) can be another important intangible asset although this is perhaps one of the less durable sources of pricing power, unless combined with others. The very best economics appear when some of the above characteristics combine in a situation in which the cost of the product or service is low relative to its importance. For example, the analog semiconductor chip which activate the car airbag, yet costs little more than a dollar.” Marathon Asset Management

Some companies will sell a product at low margins to deter competition yet collect high returns from servicing/parts revenue into the future. Examples include large equipment manufacturers [eg commercial jet engine manufacturers, earthmoving equipment, mainframe computers, medical devices etc] and even coffee merchants and video game companies..

"We really like businesses where you sell a big piece of OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into." Bill Nygren

“Gillette’s practice of effectively giving away razors for free and charging for consumables – “A few billion blades later, this business model is now the foundation of entire industries: Give away the cell phone, sell the monthly plan; Make the video game console cheap and sell expensive games; Install fancy coffee machines in offices...” Yes – this is the model generating profits for Canon and Mondelez (coffee) and for Nintendo (increasingly so as Nintendo moves to distributing “free” smart phone games then selling upgrades to hooked customers). Intuit too is giving away access to its basic service, then looking to make profit on upgrades. Despite all the hoo-ha about a “New Economy” there are fewer things new under the sun than you might think.” Nick Train

Once you've established the attractiveness of a product it's important to consider how big the runway for future sales could be.

“Any time you look at an investment, you want to look at what percentage of its market it has and how big it can get.” Rory Priday

“It’s nice to have markets like that that are relatively untapped.” Warren Buffett

It's important to remember that markets, industries and consumer tastes can change rapidly and these changes can significantly alter the demand for a company's products. In a recent letter, Steve Romick of FPA Funds noted:

"Innovative technology is driving business transformation faster than ever before. As a result, the expected tenure of a company in the S&P 500 is expected to drop from 25 years to 14 years. We want to avoid those companies whose businesses are existentially challenged."

Jeff Bezos, has talked about the shifting power from companies to consumers ...

“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.” Jeff Bezos

Phil Fisher recognized these risks more than 50 years ago, in 'Common Stocks and Uncommon Profits' ..

"For a company to be a truly worthwhile investment, it must not only be able to sell its products, but also be able to appraise the changing needs and desires of its customers." Phil Fisher

Don't lose sight of the fact that a company that sells a great product can always be a bad investment if you pay too much. Notwithstanding, having a checklist of mental models related to product attributes such as these, which the Investment Masters focus on, is likely to improve your investment returns. Good luck!

How to Build a Better Investing Mind

The Investment Masters recognize the benefits of having mental models to help understand the key characteristics of a business, the factors driving it's success and the likelihood of maintaining a competitive advantage to drive future growth. In the book, the Psychology of Intelligence Analysis, Richards Heuer noted "little attention is devoted to improving how analysts think". In the book's opening chapter, entitled "Thinking about Thinking", he notes:

"[Analysts] construct their own version of "reality" on the basis of information provided by the senses, but this sensory input is mediated by complex mental process that determine which information is attended to, how it is organized, and the meaning attributed to it…To achieve the clearest possible image .. analysts need more than information ..They also need to understand the lenses through which this information passes. These lenses are known by many terms - mental models, mind-sets, biases or analytic assumptions."

Charlie Munger is a huge advocate of the need for a wide array of mental models for sound judgement. In a speech to Stanford Law School titled "A Lesson on Elementary, Wordly Wisdom, Revisited" he asserted:

"I've long believed that a certain system - which almost any intelligent person can learn - works way better than the systems that most people use… What you need is a latticework of mental models in your head. And you hang your actual experience and your vicarious experience (that you get from reading and so forth) on this latticework of powerful models.  And, with that system, things gradually get to fit together in a way that enhances cognition."

Charlie Munger recognized the need to take the big ideas from other faculties such as science, mathematics, psychology, history, behavioural economics and biology and have them at hand to draw inferences from in the investment process.

"If you want to be a good thinker, you must develop a mind that can jump the jurisdictional boundaries.  You don't have to know it all.  Just take the big ideas from all the disciplines. And it's not that hard to do."

“For some odd reason, I had an early and extreme multi-disciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.” 

"You must routinely use all the easy-to-learn concepts from the freshman course in every basic subject. Where elementary ideas will serve, your problem solving must not be limited, as academia and many business bureaucracies are limited, by extreme balkanisation into disciplines and sub disciplines, with strong taboos against any venture outside assigned territory."

Studying broadly and applying different models from outside the realms of finance can help an investor better understand a business. Concepts such as networks effects, non-linearity, economies of scale, psychological biases, winner-takes-all, leverage, first-mover-advantage, Darwinian evolution, complex adaptive systems, self-organised criticality, incentives/agency costs and autocatalysis are just a few.

Charlie Munger considers there are about one hundred mental models to learn and different models are relevant to different businesses.

"You've got to learn one-hundred models and a few mental tricks and keep doing it all your life. It's not that hard." Charlie Munger

"You have to learn the models so that they become part of your ever-used repertoire." Charlie Munger

"You need a different checklist and different mental models for different companies." Charlie Munger

It's more than likely if you studied a typical finance course, you missed a large part of what's important in investing [Columbia is a rare exception]. Most finance courses don't cover human psychology, philosophy, financial history nor do they spend the time teaching the lessons behind the Investment Masters success. In fact, most finance courses focus on building investment spreadsheet models, analyzing financial ratios and understanding the capital asset pricing model and efficient market theory. The latter two are mental models considered laughable by most of the Investment Masters.

It's important to continue the learning process and broaden your education to enhance multi-disciplinary thinking to increase the odds of investment success.

"As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics."  Peter Lynch

"The neat theories I had learned at university didn't come close to describing the true complexities of the economy or financial markets." Guy Spier

“If I’ve learned anything over the past decade it is this: The art of stock picking is more about synthesizing information across disciplines and making decisions than a strict devotion to finance.” Allan Mecham

"If your professors won't give you an appropriate multi-disciplinary approach, if each wants to overuse his models and underuse the important models in other disciplines, you can correct that folly yourself." Charlie Munger

"Professor Newcomb taught [me] not only political economy, but philosophy, logic ethics, and psychology - all in one course.  Today these subjects would be fragmented among several professors.  I believe there was considerable advantages in being taught all these subjects by the same man.  Too many educators seem to have forgotten that you cannot teach good economics, good politics, good ethics, or good logic unless they are considered together as parts of one whole.  Colleges as a rule teach economics badly.  With over-specialisation has also come a tendency to mistake information for education, to turn out "quiz experts" who are crammed full of useful detail but who have not been trained how to think."  Bernard Baruch

The value of mental models are embraced by many of the world's greatest investors..

“You’ve got to learn everything. I started with physics and mathematics and I got into economics, history, law and politics. I like everything and that’s what you need. You might need models from biology.” Li Lu

“Our core philosophy starts with the belief that making intelligent, rational decisions requires a multi-disciplinary framework that informs broad and deep understanding.” Christopher Begg

"Some people think in words, some use numbers, and still others work with visual images.  I do all of these, but I also think using models."  Ed Thorp

“You’ve got to mesh many different disciplines into one. That’s our edge.” Marc Lasry

“When we have enticed the college graduate into our graduate schools, we at once encourage him to grow professional blinders which will confine his vision to the narrow research track, and we endeavour – often successfully – to make out of him a truffle-hound, or if you prefer, a race-horse, finely trained for a single small purpose and not much good for any other ... Jacob Viner, in 1950, argued that academic departments needed to encourage their students in broader intellectual fields since solving real world problems was likely to involve skills learned in several different disciplines. Charlie Munger, long-time Vice Chairman of Berkshire Hathaway, has encouraged a similarly multi-disciplinary approach to investment, a proposal which Marathon has consistently echoed.” Marathon Asset Management

“You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another’ So you must have the models, and you must see the relatedness and the effects from the relatedness.” Charlie Munger

“I have been in the business since 1973, so I have been looking at companies for a long time.  There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn’t going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models.” Glenn Greenberg

"We don’t really use screens. Instead, we use ‘mental models’ which help us find good investments. Some examples of these are the capital cycle, the power of incentives and insider ownership." James Seddon, Hosking Partners

A latticework of mental models improves creativity as Richards Heuer noted in the 'Psychology of Intelligence Analysis':

"Talking about breaking mind-sets, or creativity, or even just openness to new information is really talking about spinning new links and new paths through the web of memory. New ideas result from association of old elements in new combinations. Previously remote elements of thought suddenly become associated in a new and useful combination. When the linkage is made, the light dawns. This ability to bring previously unrelated information and ideas together in meaningful ways is what marks the open-minded, imaginative, creative artist."

The application of different mental models and multidisciplinary thinking can provide an edge by opening up investment insights that others haven't considered and hence are yet to be reflected in a security's price. 

"If you have the patience and if you have the interest to really dig deep, then what you're going to find is if it's commonly held information or known information, you may come up with insights that others have not.  This is what Charlie Munger talks about the latticework of mental models.  You look at things through a different lens to try to see what can be different."  Mohnish Pabrai

“You have to be naturally interested and curious about everything – any kind of businesses, politics, science, technology, humanities, history, poetry, literature, everything really effects your business. It will help you. And then occasionally you will find a few insights out of those studies that will give you tremendous opportunities that other people couldn’t think of.” Li Lu

"It's a multi- disciplinary habit that fosters some creative thinking. Throughout the week between conversations about business- specific objectives we will tend to revisit further questions and insights somebody has read on the subject. Subjects are typically in the large data sets of physics, biology, and human history." Christopher Begg

It's one of the reasons the Investment Masters spend more time thinking about businesses in preference to building huge spreadsheet models.  The most important thing is to identify the key factors that are going to drive the business in the future and establish where a business will be over the medium to long term as opposed to next quarter's earnings.  

“The best way to think about investments is to be in a room with no one else and just think. And if that doesn‘t work, nothing else is going to work.” Warren Buffett

“It’s not about the numbers.  For most investments the factors that will drive long term success don’t have much to do with spreadsheets.  They have to do with something other, either understanding human nature or understanding nuances about how certain aspects of how things work rather than running spreadsheets.”  Mohnish Pabrai

The ultimate investments arise when a multitude of big ideas combine to create what Charlie Munger refers to as 'Lollapalooza Effects'. Consider a business such as Facebook which has benefited from the combination of a multitude of factors: winner-takes-all, network effects, economies-of-scale, human psychology [classical conditioning [pavlov], reciprocation, virtual empathy, habit/addiction etc], tailwinds from increased internet penetration/improved global bandwidth to name just a few.

“The most important thing to keep in mind is the idea that especially big forces often come out of these one hundred models. When several models combine, you get lollapalooza effects; this is when two, three, or four forces are all operating in the same direction. And, frequently, you don’t get simple addition. It's often like a critical mass in physics where you get a nuclear explosion if you get to a certain point of mass - and you don't get anything much worth seeing if you don't reach the mass." Charlie Munger

“Investment decisions are more likely to be correct when ideas from other disciplines lead to the same conclusions. That is the top most payoff – broader understanding makes us better investors… True learning and lasting success come to those who make the effort to first build a latticework of mental models and then learn to think in an associative, multi-disciplinary manner.” Robert Hagstrom

One you've started to build a repertoire of mental models it's important to keep learning and refining your models. There will be times when old models need to be discarded. To do so you must remain open minded.

"There's no rule that you can't add another model or two even fairly late in life.  In fact, Ive clearly done that.  I got most of the big ones quite early [however]." Charlie Munger

"In a system of multiple models across multiple disciplines, I should add as an extra rule that you should be very wary of heavy ideology." Charlie Munger

"Minds are like parachutes. They only function when they are open." Richards Heuer

It's time to put some mental models on the latticework ….

Further Recommended Reading:

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

“It’s tempting for great businesses to leverage their strong market position through high price increases to the benefit of near-term earnings. We often hear terms such as ‘pricing power’ or ‘high switching costs’ as justification for asking customers to pay more for the same product or service. Increasing prices at a rate well above inflation is common in businesses with short-term–minded management who define success based on this year’s profit number. In squeezing customers through pricing, great businesses often compromise their future. As the value of what they deliver relative to the price they charge becomes a little less attractive, customers are more likely to seek out alternatives and the door for competitors opens a little wider. Price increases also diminish a customer’s appetite to take additional products or services from a supplier, or to recommend a supplier to a friend. Revenue per customer today may increase, but the lifetime value of each customer relationship moves in the opposite direction. Aggressive pricing increases the likelihood of fade. Businesses that successfully fight the fade don’t just preserve the value they deliver relative to the cost they charge over time; they improve it. Taking this approach, they keep their customers for longer, sell more products and services to them, progressively win more customers and keep competition at bay.” Stephen Arnold

Do the businesses you own have pricing power?

Investing Nuggets

"The difficulty lies, not in the new ideas, but in escaping the old ones.” John Maynard Keynes

“If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time.” Charlie Munger

"Read as many investment books as you can get your hands on. I've been able to learn something from almost every book I have read." Lee Ainslie

While many analysts dedicate their efforts to constructing spreadsheet models, the world's most successful investors prioritize reading and deep contemplation. The tutorials within the Investment Masters Class aim to uncover the underlying principles guiding their decision-making processes. Although each Investment Master possesses unique qualities, there are often shared insights and perspectives to be gleaned, enriching our understanding of investing. Delving into investor letters, interviews, and books can offer fresh perspectives on company analysis, uncover new investment opportunities, and foster insights previously overlooked. It's the cumulative acquisition of knowledge across various domains that cultivates wisdom in the realm of investment.

Over the years, I’ve learnt something from almost every book I've read (my favourites are here). Each book typically contains at least one or two ‘Investing Nuggets’ worth extracting. These nuggets can serve to reinforce existing beliefs, challenge previously held convictions, or even introduce entirely novel perspectives.

I've included five 'Investing Nuggets' below ...

The Alchemy of Finance [George Soros] - "escalator up, elevator down"

Mr Soros effectively defined his own theory for markets noting ‘existing theories about the behaviour of stock prices are remarkably inadequate. They are of so little value to the practitioner that I am not even fully familiar with them. The fact I could get by without them speaks for itself.’

The Alchemy of Finance provides an alternative explanation for asset bubbles, offering an explanation as to why markets tend to drift higher, yet decline rapidly. A market euphemism that ‘Stocks take an escalator on the way up and an elevator on the way down’. 

Why should that be so?

Soros noted that markets can become irrational when participants lose sight of the fundamentals, ‘those who are inclined to fight the trend are progressively eliminated and in the end only trend followers survive as active participants. As speculation gains in importance, other factors lose their influence. There is nothing to guide speculators but the market itself, and the market is dominated by trend followers."

As all trends eventually end, ‘when a long term trend loses it's momentum, short term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disorientated.’

It is then that the market can decline precipitously, ‘when a change in trend is recognised, the volume of speculative transactions is likely to undergo a dramatic, not to say catastrophic, increase. While a trend persists, speculative flows are incremental; but a reversal involves not only the current flow but also the accumulated stock of speculative capital. The longer the trend has persisted, the larger the accumulation.’

Soros concludes, ‘speculation is progressively destabilising. The destabilizing effect arises not because the speculative capital flows must be eventually reversed but exactly because they need not be reversed until much later. If they had to be reversed in short order, capital transactions would provide a welcome cushion for making the adjustment process less painful. If they need not be reversed, the participants get to depend on them so that eventually when the turn comes the adjustment becomes that much more painful.’ 

Capital Returns [Marathon Asset Management] - ‘… here comes the supply!’

This recent book edited by Edward Chancellor contains a collection of investment letters from the UK's Marathon Asset Management. The Marathon Global Equity Fund has delivered 9.7% pa since inception in 1986, outperforming their benchmark by almost 5% per annum.

The book is chock full of investing wisdom. The key theme of the book is an industry's 'capital cycle' and how that cycle impacts investment returns. 

The book contains Marathon’s prescient newsletters on global house prices, credit markets and the commodity super-cycle. Each event resulted in significant investment losses for those investors oblivious to the capital cycle. Other letters reflect on capital allocation, industry dynamics, company culture, corporate management, technological disruption and the associated themes of 'network effects' and 'winner takes all'.

So what is the capital cycle? Marathon explains, ‘The first notion is that high returns tend to attract capital, just as low returns repel it.  The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways - what we like to call the capital cycle’. 

‘The key to the 'capital cycle' approach is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns.’ 

Most investors spend 90% of their time focused on the demand side of the equation, an area inherently subject to large forecasting errors. In contrast, Marathon spend the majority of their time focused on supply, which is far less uncertain.   

Focusing on the magnitude of capital entering or exiting an industry can provide an investment edge, aiding the discovery of potential investments and/or highlighting risk to an existing thesis.

Influence [Robert Cialdini]  - ‘why can't we change our minds?'

Charlie Munger has credited Robert Cialdini's bestseller, 'Influence' with filling many of the gaps in his mental framework. 

The book contains a fascinating short story of a cult of thirty members of otherwise ordinary people - housewives, college students, a high school boy, a publisher, a doctor, a hardware-store clerk - which had been infiltrated by two scientific researchers.  

The leader of the cult informed her members that she had begun to receive messages from 'Guardians', spiritual beings located on other planets. These transmissions gained significance when they began to foretell of an impending disaster - a flood that would eventually engulf the world. Alarmed at first, further messages assured the members they would be saved; before the calamity, spacemen were to arrive on a specific date and carry off the members in flying saucers to a place of safety, presumably on another planet.

Two specific aspects of the member's behaviour was noted by the two scientific researchers. First, the level of commitment to the cult's belief system was very high. Evidence included the irrevocable steps many members had taken; quitting their jobs and giving away personal belonging ahead of the 'specific' date. Secondly, members did surprisingly little to spread the word and avoided publicity when an inquiring newspaper started investigations into the cult.

On the 'specific' date, at the specified time, unsurprisingly, no spaceship arrived. The group seemed near dissolution as cracks emerged in the believers confidence. But then, the researchers witnessed a pair of remarkable incidents. The cult leader told the members she had received an urgent message from the Guardians stating, ‘the little group had spread so much light that God had saved the world from destruction’. Having previously shunned publicity, the cult leader then at once called the newspaper, to spread urgent message. Other members followed suit placing calls to various media outlets. 

Mr Cialdini noted the group members had gone too far, and given up too much for their efforts to see them destroyed. From a young women with a three-year old child:

"I have to believe the flood is coming on the twenty-first because I've spent all my money.  I quit my job, I quit computer school .. I have to believe."

So massive was the commitment to the cult that no other truth was tolerable. Member's beliefs should have been destroyed when no saucer landed, no spacemen arrived and no flood had come. In fact, nothing prophesized happened. 

The group had one way out. Members had to establish another type of proof for the validity of their beliefs: social proof. The leader still believing let other members believe.

This short story helps explain why analysts and investors so often remain non-fussed in light of obvious disconfirming news about an investment - they are too committed. The fact other investors and analysts are steadfast in their views reinforces the behaviour. Watching stocks fail to respond to what should be negative news maybe a case in point. Everyone is watching each other.

Common Stocks and Uncommon Profits [Phil Fisher] - ‘… small price really’

Phil Fisher's writings are recommended by many of the great investors, Buffett, Munger and Li Lu included.  

In 'Common Stocks and Uncommon Profits', Phil Fisher's analysis of factors that can sustain high profit margins reminded me of Berkshire's AGM this year when Munger, reflecting on competitive structure, divulged his preference for Precision Castparts above the reinsurance business. Munger opined that Precision Castparts’ customers ‘would be totally crazy to hire some other supplier because Precision Castparts is so much more reliable and so much better.’

Mr Fisher touched on the characteristics which can sustain high profit margins; a company can create in its customers the habit of almost automatically specifying it's products for re-order in a way that makes it rather uneconomical for a competitor to displace them.  

When a reputation for quality and reliability in a company’s product is acknowledged as very important for the proper conduct of a customers business, the company is in a powerful pricing position. It’s even better if it’s likely an inferior or malfunctioning product would cause serious problems [think Aircraft parts!]. When there are no competitors serving more than a minor segment of the market the dominant company is nearly synonymous with the source of supply.  Finally, the cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier.  

Mr Fisher went even further to note that even this was not enough to sustain an above-average profit margin year after year. The product needs to be sold to many small customers rather than a few large ones. The customers must be sufficiently specialized in their nature that it would be unlikely for a potential competitor to feel they could be reached through advertising media such as magazines or television. The company can be then displaced only by informed salesmen making individual calls. Yet the size of each customer's orders make such a selling effort totally uneconomical!  

Such a company can, through marketing, maintain an above-average profit margin almost indefinitely unless a major shift in technology or a slippage in its own efficiency should displace it.

A Zebra in Lion Country [Ralph Wanger] - ‘who benefits from the technology?’

Ralph Wanger's 1996 book, 'A Zebra in Lion Country', contains a chapter titled ‘Downstream from Technology’, which discusses the opportunities and obstacle of new technology. In today’s era of disruption, it's worth thinking through the implications for investing.

Many of the Investment Masters are cautious in the technology sector due to short product cycles and the risk of technological obsolescence. As Mr Wanger notes, ‘New products are dangerous, especially in the computer field as technological breakthroughs bring price slashing every year.’

Mr Wanger continues, ‘What I have always looked for instead are the downstream users of new technologies. I’ve bought the stocks of companies that buy, use, and exploit the computers and electronics to reduce costs, revitalise their businesses, and add functionality to their products.’

‘Since the Industrial Revolution began, going downstream – investing in businesses that will benefit from new technology rather than investing in the technology companies themselves – has often proved the smarter strategy.’

‘Those who really made money out of the new technology (of steam locomotives) were not the transportation people but those who bought real estate in Chicago in the 1880’s and 1890’s.’

‘Recognizing a transforming technology and then investing downstream from it should be a key concept for any direct stock investor.’

‘With the internet small companies can now compete against giants.’

‘The armoured knights couldn’t beat armies of commoners with muskets, and the corporate nobility of today is similarly vulnerable to upstart companies with smart, energetic, and competitive management.’

The ability for companies to harness technology is not a new phenomena. Charlie Munger recognised the enormous value of technology that arrived with the invention of the VHS player.

‘Disney is an amazing example of autocatalysis .. They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the video cassette was invented, Disney didn’t have to invent anything except take the thing out of the can and stick it on the cassette. And every parent and grandparent wanted his descendants to sit around and watch that stuff at home on video cassette. So Disney got this enormous tail wind from life. And it was billions of dollars worth of tail wind.’ 

More recently we've witnessed an exponential increase in digital disruption. The combination of Youtube, Facebook and Amazon webservers has allowed Dollar Shave Club to take on the once invincible Gillette. High speed internet has allowed Netflix to harness and monetise the world population causing havoc for free-to-air TV and cable operators and their finite markets. The internet and GPS has allowed Uber to disrupt the global taxi industry. Facebook and Google have disrupted the global advertising markets. 

The future will bring increasing threats to old world industries who are not embracing technological change while providing the potential for significant investment opportunities.  Maybe it’s time to look downstream.