Learning from the Outsiders

Capital allocation can be defined as the process of deciding how to deploy a firm's resources to earn the best possible return for shareholders. Understanding and evaluating a company's capital allocation decisions, process and history is therefore critical to analysing potential investments.

One of my favourite books on capital allocation is The Outsiders. This book was written by William Thorndike who reflected that "Surprisingly, in business the best are not studied as closely as in other fields like medicine, the law, politics or sports," and "Despite its importance, there are no courses on capital allocation at the top business schools."

The book focusses on eight unconventional CEOs whose company's share prices massively outperformed the market. The list of CEO's include Henry Singleton from Teledyne, John Malone from Liberty Media, Katherine Graham from the Washington Post, Tom Murphy from Capital Cities Broadcasting and of course Warren Buffett of Berkshire Hathaway. In fact the book was the number one book on Mr Buffett's recommended reading list in 2012. Mr Thorndike noted these CEOs "thought more like investors than managers." It's no surprise many of the characteristics that define great company managers are common to the Investment Masters.

"Effective capital allocation .. requires a certain temperament. To be successful you have to think like an investor, dispassionately and probabilistically, with a certain coolness." Michael Maboussin

While each of the Outsider CEOs operated in different industries - some growing while others declining, with different capital intensities - there were many commonalities in how they managed their businesses. While it wasn't rocket science, the management style and initiatives these eight CEOs implemented, was unconventional for the time.

Some of the common characteristics included:

Acquisitions - while most of the CEOs were involved in acquisitions they were both opportunistic and patient. Acquisitions were only made when there was compelling discrepancies between value and price or when significant cost savings could be extracted. These CEOs either refrained from or were reluctant to issue scrip for acquisitions and only if the scrip was expensive and the 'Business Value' [ie intrinsic value] acquired was greater than the 'business value' given.

This latter point, in my view, is one of the most common mistakes CEOs and company boards make. They acquire expensive assets funded via either scrip mergers or capital raisings when their own share prices do not reflect their company's worth. While acquired assets may be high quality and accretive to earnings, these acquisitions can be hugely value destroying.

In his 1982 annual Berkshire letter, Warren Buffett provided an excellent overview of this common situation.

"Our share issuances follow a simple basic rule; we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."

"[In relation to] the acquirer who ends up using an undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvellous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilisation of gold - or even silver - valued as lead." Warren Buffett

Divestments - the Outsider CEOs were not in the business of growing for growth's sake. If another party wanted to pay an inflated price for an asset and the CEO no longer saw the growth potential of that asset they would not be afraid to shrink the business, sometimes substantially. If the market was undervaluing a part of the business the CEO would look to spin-off the division to realise that value. Should a business be underperforming with little prospect for a turnaround it was likely slated for sale or closed. The Outsider CEOs were not emotionally attached to any division and they cut their losing businesses. Capital investment was reserved only for those businesses with attractive returns on capital. The core focus was maximising long term value per share, not organisational size or growth.

Buy-backs - the CEOs were opportunistic acquirers of their own shares, BUT only when they deemed them to be trading below 'Business Value'. In many cases shares were repurchased in bear markets or when P/E's were at cyclical lows. Sometimes these buybacks were substantial. For example, in the case of Teledyne, over 90% of the shares on issue. All potential acquisitions were compared with the returns available from buybacks. Once again CEOs were not afraid to shrink their businesses.

Cash Flow - the CEOs focussed on cash flow per share not reported net income. The Outsider CEOs believed the "key to long-term value creation was to optimise free cash flow, and this emphasis on cash informed all aspects of how they ran their companies - from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems."

Humility - the Outsider CEOs were humble, understated and analytical. The Outsider CEOs were distinctly "unpromotional". Mr Thorndike noted they "had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results."

Guidance/Dividends - none of the Outsider CEOs gave Wall Street guidance. Their focus was increasing the long term value per share. Taking a longer term view meant, at times, making investments or capital expenditures that may have detracted from short term earnings but added to long term value. The Outsider CEOs were frugal with regards dividends, realising the compounding benefits of reinvesting capital either in the business or in their own shares should their prices be depressed. 

Decentralisation - the CEOs ran decentralised organisations where significant autonomy was given to operating managers. This allowed managers at the coal face to respond quickly to a changing marketplace and for the CEOs to focus on capital allocation and strategic planning.

Flexibility - the CEOs recognised the need to remain flexible as business conditions and markets were uncertain and constantly changing. At certain times it made sense to make acquisitions while other times favoured selling or spinning off assets. The Outsider CEOs did not have an ideology and were not bound by a strategy.

Mr Thorndike noted that, "although the outsider CEOs were an extraordinarily talented group, their advantage relative to their peers was one of temperament, not intellect." Great CEOs possess patience, independence, humility and a contrarian streak for success. It's the CEOs that get caught up in the emotional tides of the market, overpay for acquisitions, issue scrip at the wrong prices, focus on the short term and refuse to adapt to change that will destroy companies and your portfolio's returns.

Further Reading -
'Capital Allocation - Evidence, Analytical Methods, and Assessment Guidance' by Michael Maboussin (Credit Suisse)
'Phil Fisher on Mergers & Acquisitions' (Investment Masters Class)
'The Essays of Warren Buffett' - 'Mergers & Acquisitions'

The Arbitrage Series - Part 2

'Merger arbitrage', a form of 'risk' arbitrage, is the term given to buying stocks involved in a takeover situation to capture the spread between the market price and the takeover price. The target stock usually trades at a discount to the takeover price to reflect the risk the takeover fails as well as the time value of money until the deal completes.  

However, unlike 'classic arbitrage,’ there is a risk the deal won't happen. If a deal breaks, the target stock price generally falls back towards it's pre-deal level [the price can fall lower or retain some of the premium depending on the situation] leading to large losses. Thus the term 'risk arbitrage'.  

In a cash deal, the investor will buy the target's shares at a discount to the takeover price which are exchanged for cash at deal completion. In a scrip deal, the investor will buy the target's shares and short the acquirer's shares, in the appropriate ratio, to lock in the 'spread'. At completion the target's shares will be exchanged for the acquirer's shares which will be used to net off the short position.  

"Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49. Now most investors don't want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over $50 is roughly a two percent return. And let's say it's a tender offer and will close in 60 days. That means you can do the deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short term investment." John Paulson

The key attraction of merger arbitrage compared to investing in a company based on fundamentals is that you are less exposed to the broader influences of the stock market given the somewhat specific price and time outcome.

"The beauty of arbitrage is you can earn good returns that are non-correlated with the market." John Paulson

However, in stressed markets and/or economic environments, merger arbitrage returns tend to become more highly correlated with the broader market given financing can dry up, market-out and/or material adverse change clauses get triggered, and funds face redemptions.

Buffett has been actively involved in merger arbitrage in both the Buffett Partnership, and then, Berkshire Hathaway. Buffett only participated in ‘announced’ deals, unlike many investors who look to participate in pre-announced deals, where a deal maybe rumoured [rumourtrage], a company may disclose they are considering corporate actions/strategic alternatives or there is speculated to be further corporate action given significant merger activity in a sector.

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumours or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities." Warren Buffett, 1988

Merger arbitrage is a specialised area requiring skills in valuation, portfolio/risk management, takeover laws/regulatory rules, industry dynamics, human psychology, tax rules etc.

"A legal education helps us in the analytical process. It instills discipline." Brian Stark

“One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside.” John Phelan

"To be successful requires very specialised skills unique to the arbitrageur. One must be an expert in evaluating the financing, legal, regulatory, accounting, market and business issues that may affect a deal's outcome. To properly evaluate these risks, the arbitrageur must have expertise in analysing merger agreements, financing agreements, strategic issues and financial statements, as well as federal, state and local regulatory issues." John Paulson

Given the merger 'spread' is normally quite slim, the profits from merger arbitrage tends to be small relative to the loss you can incur if a deal fails. In the example above, an investor risked fourteen dollars to make one dollar. This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.

“The strategy, while properly executed, can produce non-correlated, low-volatility returns, [however] any individual deal may carry substantial risk. This is because the upside in a transaction is very small compared to the potential downside. While the annualised return may be high, the absolute return is small, and the downside can be 10 times, 20 times or even 30 times the amount of potential gain.” John Paulson

“When things go wrong in merger arbitrage, they can go very wrong – often in an asymmetric way.” Joel Greenblatt

"Premiums, ranging generally from 10 percent to even 50 percent - exceptionally even 100 percent - maybe offered for acquisition targets. An arbitrageur, when he takes his long position, is thereby assuming a great part of this premium in the price he pays. Should the deal be sabotaged for some reason, the downside price slide can be rather large. So one must carefully calculate the downside risk." Guy Wyser-Pratte

To make money in merger arbitrage the investor needs the deal to complete. As a starting point it's worth considering a few basics. Prior to analysing a deal it's worth asking a few questions with regards to the jurisdiction of the deal. Roddy Campbell of Cross Asset Management poses the following three questions: Is there, 1) a level playing field? 2) a decent body of precedent of corporate law decisions? and 3) an ability to predict the behaviour of participants and comprehend their motives? If you answer NO on any of those, it's probably best to move on t0 the next opportunity.

It's worth establishing a checklist of key considerations to ensure items are not overlooked. Some considerations include:

Deal type - is the deal announced or rumoured? Announced deals carry significantly lower risk.
Type of Buyer - is the buyer a financial buyer [ie private equity] or a strategic buyer? If private equity, is management participating? what do they know? Sensible strategic acquisitions by larger corporates in the same industry tend to have a higher likelihood of success [in the absence of competition issues] than financial buyers.
Nature of Target - was the company being shopped for sale? A company being shopped means the company is 'in play' and the board is open to a transaction. Other buyers may emerge if the deal breaks. Conversely, the list of alternate buyers may already be exhausted. If the market was aware the company was being shopped the pre-deal price is likely to have some takeover premium in it which may disappear if the deal breaks.
Type of Bid - is the buyer paying cash or scrip, a combination of both, or some other form of payment? Is the deal a takeover, scheme of arrangement or other type of transaction? 
Borrow - if the deal is a scrip deal, is there ample borrow? What are the borrow costs?
Hostile or Friendly - has the seller agreed to the terms of the deal or is it a hostile takeover? Friendly deals have a much greater chance of proceeding.
Size of the deal - is the target company a small or large company relative to the buyer. Smaller deals relative to the size of the acquirer tend to be lower risk.
Funding of the Buyer - if a cash bid, does the bidder need/have financing in place and if not what is the appetite among lenders? Are the financial metrics acceptable, is the acquirer or the proposed combined entity too heavily geared? Will the financial metrics limit the acquirers ability to pay more?

"Among other things, it's offer was contingent upon obtaining 'satisfactory financing'. A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage." Warren Buffett, 1988

Value of the target - are the deal metrics comparable with other takeovers? Is the company valuation fair at the bid price? Could the bidder pay more for the company? A low valuation increases the chance of a contested bid and generally means less downside risk. A target or their shareholders, however, are more likely to reject a hostile bid at a low valuation.
Track record of Buyer - does the buyer have a track record of closing similar transactions?
Synergies of the deal - what is the upside from putting the companies together, how important is the deal to the acquirer? Could another party get more synergies?
Target Agreements - do the target's customers, financiers, suppliers etc have change of control clauses?
Shareholders of the target - will the target shareholders agree to the deal and is there any shareholder or group of shareholders who could block the deal? Are there any other corporates on the register who may bid?
Pre-bid stake - has the acquirer already built up a stake in the target? i.e. how committed are they? Is it sufficient to block alternative bids?
Break fees/No Shop clauses - is the acquirer/target liable for break fees? Will they put off another buyer? Is the target prevented from seeking a higher bid?
Post deal announcement price of the acquirer - has the market reacted favourably to the proposed acquisition? Are the acquirer's shareholders supportive of the transaction?  
Potential Counter bidders - is it likely another buyer for the company will emerge? The potential for a contested takeover can improve the asymmetry of returns.

"Generally, the characteristics that lead to a higher bid include: a low relative valuation, an attractive target, an industry experiencing consolidation, no lock-ups and the company not having been shopped prior to deal announcement." John Paulson

Acquirer bid - is there a chance another party could bid for the acquirer? Was the acquirer buying for defensive reasons? Will the deal break if an offer is made for the acquirer? This is a major risk to a trade, particularly if you have bought the target and short the acquirer. 
Fraud - Is the acquirer buying to mask an earnings hole/structural decline in their own business? Is the target likely to reject the acquirer's scrip? Are there question marks over the acquirers financials/cash flows/roll-up strategy?
Conditionality of bid - does the bid have few or a lot of conditions that need to be fulfilled for the deal to complete? How onerous are the conditions? The more conditions, the more chance of a deal break.
Market Out-clause - does the bidder have a market out-clause if stock markets or commodities etc fall or interest rates rise? Absence of out-clauses reduce the risk of a deal break.
Defence Options - what could the target company do to scuttle the deal, poison pills etc?
Anti-trust/Competition issues - are there any issues which may mean the deal is blocked by a competition regulator? Are there useful precedents?
Timing/Delays? - are there likely to be delays to the completion time? Competition /regulatory/ court rulings/ due diligence etc. Delays ordinarily reduce the returns unless the deal compensates for a delay in the timetable.
Regulatory Issues - are their regulatory issues outside competition? Are there national interest/sovereign issues? Is the deal in a country with a strong rule of law? Are there deal precedents?
Tax Issues - does the deal require a favourable tax ruling?
'Break' downside - where is the stock likely to trade if the deal breaks?  Does the bid highlight value not previously appreciated by the market, or is it likely to fall back to levels prior to the deal being announced or speculated? Is there a risk that new and disappointing information may come to light during the negotiation?
Company Performance - the underlying performance of both the target and acquirer can impact the probability of a deal closing. The more cyclical the industry the more risk either party's business may change significantly which may alter the deal outcome.

The investor must consider the above issues at a minimum to determine whether to participate in a deal. Every transaction is different.  

Often investors will work out a probability weighted outcome based on different scenarios [ie 15% chance of deal break which will see stock fall to 5% below undisturbed price [ie price stock trading before deal], 60% chance of deal complete at stated time, 25% chance of competing bidder paying 20% more for target]. The investor will calculate the annualised return the current spread provides. The difficulty is in weighing up the factors and estimating the probabilities.

"It's very easy to compute what the returns are from a spread. But what's not easy to compute is what the risks of the deal breaking apart are." John Paulson

The investor is unlikely to have concrete answers to all the necessary questions and will need to make informed judgements.   

"In arbitrage you have to be able to pull the trigger, even when your information is imperfect and your questions can’t all be answered. You have to make a decision: should I make this investment or not? You begin with probing questions and end up having to accept that some of them will be imperfectly answered – or not answered at all." Robert Rubin

"One of the things I do very well in investing is I gather a lot of information, but I never know the whole picture. I have a lot of inputs, but never everything. And I have to make a decision on incomplete information. And I feel very comfortable doing it." James Dinan

"Investing isn't black or white. It's different shades of grey, and what was common to all of us [in Goldman's risk arbitrage team] was that we could see the different shades of grey and handicap them. There were very few second chances. The process had to be good." Richard Perry

The investor must constantly monitor the takeover's progress as well as general market and industry conditions to manage risk and optimise returns.  

"The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share price fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely." Robert Rubin

"Merger arbitrage is not a one decision investment. It is an ongoing process: prices fluctuate, the economy changes, government actions are taken, stock is always being bought and sold. Merger arbitrage is not a part-time activity. It required constant vigilance." Ivan Boesky

Ultimately, an investor must be comfortable with the worse case outcome and the effect on their overall portfolio. I've seen plenty of situations where a deal break results in a share price trading significantly below the pre-bid trading price. For example when a takeover premium was already in the price and the register has become dominated by non-natural holders who need to sell, an acquirer walks due to any one of a number of possible reasons, or the target fails to act in the shareholder's best interests.   

“Risk arbitrage sometimes involved taking large losses, but if you did your analysis properly and didn’t get swept up into the psychology of the herd, you could be successful. Intermittent losses – sometimes greatly in excess of your worst case expectations – were part of the business.” Robert Rubin

Pure merger arbitrage funds limit position sizes and look to participate in many transactions to spread risk and minimise the loss from a single deal breaking.     

"Of course, an arbitrageur would be involved in many deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages.” Robert Rubin

"A common approach to managing a merger arbitrage portfolio is to diversify a portfolio across a broad range of small positions. By minimising position sizes, the manager can protect himself from significant drawdowns [loss] in the event of an adverse deal outcome. This broadly diversified approach, however, should lead to no better than average returns." John Paulson

“Of course, some investment strategies for instance, our efforts in arbitrage over the years require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favoured by probabilities, but refuse to accept a single, huge bet.“ Warren Buffett

While Warren Buffett recognized the benefits of a diversified approach he tended to concentrate in a small number of attractive deals. The merger activity was part of a broader portfolio of investment styles that could absorb any large loss.

"Our relatively heavy concentration in just a few situations per year (some of the large arbitrage houses may become involved in fifty or more workouts per annum) gives more variation in yearly results than an across-the-board approach. I feel the average profitability will be good with our policy." Warren Buffett, Buffett Partnership Letter

"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far Berkshire has not had a really bad experience. But we will - and when it happens we'll report the gory details to you." Warren Buffett, Berkshire Letter

“We do not do a lot of arbitrage, but participate in extreme opportunities.” David Einhorn

Like many investment strategies, when there has been a history of returns money flows into the strategy which lowers its returns. Similarly, in the absence of deals, too much money chasing too few opportunities affects returns.

Easy credit and a bull market leads to increasing deal activity and the potential for contested deals. The merger boom leading into the Financial Crisis was a case in point. Deals regularly traded at premiums to the takeover prices as a credit bubble fueled a private equity buying binge resulting in a flurry of contested deals. Sell-side research analysts spent their days running LBO screens over company financials to identify the next potential target. All was well until the credit markets closed.

“When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns.” Seth Klarman

"The strategy has its cycles based on the overall level of deal activity as well as the supply of capital." John Paulson

Buffett succinctly outlined the requirements for successful merger arbitrage in his 1998 letter..

“To evaluate arbitrage situations you must answer four questions 1) How likely is it that the promised event will indeed occur? How long will your money be tied up? 3) What chance is there that something still better will transpire – a competing takeover bid, for example? And 4) what will happen if the event does not take place because of anti-trust action, financing glitches etc?” Warren Buffett

The key to successfully employing merger arbitrage is to avoid deal breaks.  

"Risk arbitrage is not about making money, it's about not losing money." John Paulson

"The common characteristics of deals that break are poor earnings, an inability to consummate financing and/or regulatory obstacles. By eliminating deals that exhibit these characteristics, one can reduce the insistence of deal breakage." John Paulson

John Paulson, of Paulson Partners outlines his strategy for success..

"Our particular strategy to manage the portfolio for outperformance is comprised of five basic principles: 1) avoid deals that may break, 2) optimise returns from the spread portfolio, 3) weight the portfolio to possible competitive bid situations 4) focus on deals with unique structures that offer high returns; and 5) selectively short the weaker transactions." John Paulson

While merger arbitrage is unlikely to offer the same opportunity for returns as finding compounding machines, at times it can be a useful complement to value investing. Over the years, the best merger arbitrage opportunities I've witnessed are deals with very low conditionality that provide optionality for a bidding war. In these situations the return profile can move from negative to positive asymmetry. It's interesting, that despite John Paulsen's history in merger arbitrage it was buying sub-prime CDS's with massive positive asymmetry that made him billions. He risked a small amount for a massive pay-off.

Further reading - 

The Arbitrage Series - Part 1

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur.” Warren Buffett

Arbitrage can be defined as 'the simultaneous or near simultaneous purchase and sale of the same securities or commodities in different markets to make a profit on the (often small) differences in price'.

This essay will take a brief look at 'classic arbitrage' and 'risk arbitrage'. Part two of the series will cover 'merger arbitrage', part three will cover 'time arbitrage.'

'Classic Arbitrage' refers to, for example, a trader noting a price differential between New York and London gold prices and then buying gold in the cheaper market to quickly on sell in the more expensive market to capture the 'spread' [ie profit] with almost no risk. Gold prices in London were kept in line with New York, as arbitrageurs like this trader exploited any pricing anomalies.    

"A century ago, when you bought the same security in New York and London, there was just a little variation in price from one city to the other. The professional bought the identical security in one city and sold it in another for a very small, but almost sure, profit." Roy Neuberger

With the rapid advancement of high-speed communications and computer technology, the traditional landscape of classic arbitrage has undergone a profound transformation. A contemporary illustration of this shift is embodied in the practices of high-frequency traders, who exploit pricing differentials across various stock exchanges within each market. These traders leverage sophisticated algorithms capable of intercepting trade data at lightning speed, executing market orders within nanoseconds to capitalize on pricing inefficiencies.

In this dynamic environment, computers are strategically positioned at exchanges, incurring premium rents for co-location, to gain an early advantage in accessing market data. Employing cutting-edge technology, such as microwave communication and state-of-the-art computer chips and low-latency order routing. Their objective is often to identify potential orders en route to other exchanges and execute ahead of them ["dirty poker?"]

The ascendance of these automated systems marks the demise of the era of 'classic arbitrage' for human participants. The rise of the machines signifies a paradigm shift, relegating traditional arbitrage strategies to obsolescence in the face of technologically-driven market dynamics.

The key idea in classic arbitrage is taking advantage of a pricing inefficiency with the absence of risk.

"Risk arbitrage" strategically exploits pricing inefficiencies arising from trading imbalances or information uncertainty triggered by various corporate events. These events encompass mergers, tender offers, liquidations, spin-offs, stub trades, and corporate reorganizations, among others.

The arbitrageur's primary goal is to seize the spread between the current trading price and the genuine value of the security. This spread encapsulates both the time value of money until the event concludes and a risk premium associated with the potential non-completion of the deal, hence the epithet 'risk' arbitrage.

Fundamentally, the arbitrageur endeavors to pinpoint mispriced risks within the market. Several factors contribute to this mispricing, such as a stock's exit from an equity index, a lack of Wall Street coverage for a spun-off company, the stigma surrounding a bankruptcy reorganization, heightened risk aversion due to uncertainties about a deal's success, involvement in cross-border transactions outside existing shareholder mandates, or the intricacies and lack of understanding regarding the nuances of the event.

"Since World War 1 the definition of arbitrage - or 'risk arbitrage', as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganisation, liquidation, self-tender etc." Warren Buffett

“Risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.” Seth Klarman

The strength of 'risk arbitrage' lies in its low correlation with the broader stock market, attributed to the defined timeline associated with the event that is anticipated to rectify the pricing anomaly. This inherent characteristic serves as a safeguard for the portfolio during market downturns. Such investments are commonly denoted as 'special situations' or 'event investing.'

"The risk pertains not primarily to general market behaviour (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialise." Warren Buffett 1963

“In the first place, with respect to a special situation as it is known in Wall Street. That is a security which upon study is believed to have a probability of increasing in value for reasons not related to the movement in stock prices in general, but related to some development in the company’s affairs. That would be particularly a matter such as recapitalization and re-organisation, merger and so forth.” Ben Graham

"The unique aspect of the strategy is its ability to earn attractive returns that are not dependent on the market's direction." John Paulson

"Our goal is to make money independent of the direction of the market.. We always do this through arbitrage." Brian Stark

"Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.” Seth Klarman

Warren Buffett referred to these types of investments as 'work-outs' and employed the strategies at both the Buffett Partnership and then Berkshire Hathaway.

"Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%." Warren Buffett, 1988

Buffett recognised the benefits risk arbitrage positions would add to the overall portfolio. In down markets, arbitrage positions tend to outperform. While they are likely to be a drag on performance in strong bull markets, it's outperformance in down markets which is the key to high long term returns.

"I continue to attempt to invest in situations at least partially insulated from the behaviour of the general market." Warren Buffett, 1960

"This category produces more steady absolute profits from year to year than the generals [fundamental value investments] do. In years of market decline, it piles up a big edge for us; during bull markets it is a drag on performance. On a long term basis, I expect to achieve the same sort of margin over the Dow attained by generals." Warren Buffett, 1963

Although risk arbitrage returns typically demonstrate a lack of correlation with the overall market, it's essential to acknowledge that during periods of market stress, correlations often elevate. This occurs as mergers and tender offers are more likely to fail as acquirers re-assess the prices they are prepared to pay, deteriorating business conditions may trigger material adverse change conditions, market-out-clauses come into effect, financing dries up or spin-offs trade poorly. Spreads can also widen if dedicated arbitrage funds experience increasing redemptions.  

"The greatest risk in arbitrage is if capital leaves at the wrong time. You are attempting to exploit temporary mis-pricings between one security and another. Most of your success comes when the correct relationship between those securities is restored. When the relationship is out of whack and your capital leaves is when you get hurt." Brian Stark

As the arbitrageur is collecting the time value of money until deal completion, plus the risk premium for the risk of deal failure, the return can be computed as an annualised rate of return. This return can then be compared to current interest rates. When interest rates are low, annualised returns from risk arbitrage also tend to be low. Some mutual funds use arbitrage as a proxy for cash when they are nervous about markets but mandated to remain fully invested. Warren Buffett uses arbitrage as a proxy for cash, but only when returns are attractive. 

"Arbitrage positions are a substitute for short-term cash equivalents, and during the year we held relatively low levels of cash. In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes to close to playing the greater fool game (As Wall Streeter Ray DeVoe says: 'Fools rush in where angels fear to trade)." Warren Buffett, 1989

While risk arbitrage can serve as a viable alternative to cash, it comes with a notable caveat—when deals fall through, the resulting returns bear little resemblance to cash returns. In instances like merger arbitrage and tender offers, the losses incurred can be disproportionately higher, often ranging from 10 to 20 times the anticipated return from the successful completion of the deal. This inherent asymmetry is likened to the metaphor of 'picking up nickels in front of a steamroller,' emphasizing the perilous nature of the strategy.

Recognizing this risk, many investors adopt a strategy of diversification and impose limits on position sizes to effectively mitigate the potential downsides inherent in risk arbitrage. This cautious approach aims to strike a balance between the pursuit of returns and the prudence required to navigate the inherent uncertainties associated with these investment endeavors.

"The gross profits in many 'work-outs' appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return." Warren Buffett

Many specialist investors use leverage which enhances the annualised returns, but may significantly increase the risk profile. While there is no optimal level of debt, an investor must consider the impact on the portfolio in stressed market conditions or when there are multiple deal breaks.  

"I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behaviour. My self imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs." Warren Buffett

"We believe that reasonably leveraged and well-hedge arbitrage portfolios are considerably less risky than unhedged, outright equity portfolios." Brian Stark

Successful risk arbitrage requires identifying the attractive potential investments where the probability of success is high.  

“We will engage in arbitrage from time to time – sometimes on a large scale – but only when we like the odds.” Warren Buffett

 "For every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced." Warren Buffett

The strategy tends to be cyclical and like all forms of investing, this style will not guarantee success. At times when interest rates are low, there is a surge in M&A activity or an excess of capital pursuing too few available deals, returns maybe unattractive. 

"Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year, or for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: for every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better strategy than selecting a portfolio by throwing darts.” Warren Buffett, 1988

"We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: "If something can’t go on forever, it will end." Warren Buffett, 1988

Even the best arbitrageurs can have bad luck. The key is to ensure the portfolio can handle the downside should the worst case scenario happen.

"Our experience in workouts this year has been atrocious - during this period I have felt like the bird that inadvertently flew into the middle of a badminton game." Warren Buffett, 1969

Engaging in risk arbitrage has the potential to enhance portfolio returns, but it's certainly not a pursuit for the faint-hearted. This highly specialized strategy demands a diverse skill set for effective execution. Just like any form of investing, success hinges on having a distinct edge, operating within one's circle of competence, and meticulously assessing each investment within the broader context of the entire portfolio.

"Corporations will forever be buying, selling and restructuring their way into better businesses, creating fodder for event-driven investors for years to come." Jason Huemer

Further suggested reading:

"The hedge fund manager's edge: an overview of event investing" Chapter 8 - Jason Huemer.  Evaluating and Implementing Hedge Fund Strategies" - Third Edition
 

Value - Market, Intrinsic and Private

There's lots of ways to think about value. When I studied property valuation at university we were taught that value was, ‘the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.’

Unfortunately, in the stock market there is no one-size-fits-all definition of value. It's worth focusing on market value, intrinsic value and private  value.  

Intrinsic value, also referred to as underlying or business value, reflects a company's worth and is probably most closely aligned with the definition of value in the opening paragraph. A company is worth the discounted value of the future cash flows an owner will receive. The Investment Masters focus on the free cash flows coming out of the business rather than earnings.

"In reality, earnings can be as pliable as putty when a charlatan heads the company reporting them" Warren Buffett

"Cash flow, not reported earnings, is what determines long-term value" William Thorndike

An investor forgoes capital today to achieve higher returns in the future. While a company's shares can theoretically trade at any price, a company is not worth more than the value of those discounted cash flows.

“Intrinsic value, is in its simplest form the discounted present value of future cash flows” Frank Martin

"Intrinsic value is the number, that if you were all knowing about the future and you could predict all the cash a business would give you between now and judgement day, discounted at the proper discount rate, that number is what the intrinsic value of the business is. In other words, the only reason for making an investment and laying out money now is to get back more money later on. That's what investing is all about. When you look at a bond it's very easy to tell what you get back, it says it right on the bond, it says when you get the interest payments and the principal. The cashflows are printed on the bond, the cash flows aren't printed on the stock certificate. That's the job of the analyst, to change that stock certificate, to change that into a bond. To say that's what I think it will pay out in the future." Warren Buffett

“Bear in mind - this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett

“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them.” Howard Marks

Those cash flows will be received in the future and the future is unknown. Some company's cash flows are simpler to estimate like a REIT with contracted lease payments while other company's cash flows are much harder to forecast such as a new technology venture. As future cash flows are uncertain it's impossible to ascertain a precise value for what a company is worth. Therefore an estimate of a company's worth is a range and not a single figure. In cases such as technology it may not be possible to estimate future cash flows which significantly raises the risk of investment.

"It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions" Jean-Marie Eveillard

“Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.” Warren Buffett

A company's intrinsic value is subject to changes in earnings expectations and changes in investor return requirements but really shouldn't fluctuate that much. The more certain the cash flows the more stable the company's intrinsic value. Intrinsic value tends to be far less volatile than a company's market value.

"Value to some extent is in the eye of the beholder. It is very hard to pin down what the value of a future set of cash flows from a business, be it a cable TV or biotechnology, is going to be. Some are easier to predict than others. But it is very hard to predict what those future cash flows are going to be. And it is very hard to ascertain the correct discount rate to bring them back to the present with." Seth Klarman

As cash flows are inherently unpredictable, its makes sense to be conservative when making estimates. The more conservative the estimates, the greater the margin of safety.

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.” Warren Buffett

"When we look at value, we tend to look at it on a very conservative basis - not making optimistic forecasts many years into the future, not assuming growth, not assuming favourable cost savings, not assuming anything like that. Rather looking at where it is right now, looking backward and saying, is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year and is it unlikely to be repeated?" Seth Klarman

Market value is the value of the company at any one point in time as reflected in it's share price. The value of the whole company is the last share price multiplied by the number of shares on issue plus the company's debt, also known as enterprise value.

In reality, market value can be, and often is, significantly different from both intrinsic value and private value. Just because a stock trades at a certain price does not mean the company is worth that amount. If you have a small parcel of shares you may be able to achieve that price. If you own a large stake in the company it may not be possible to sell them all at that price.

"The underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles” Seth Klarman

Market value can be significantly above intrinsic value. Plenty of people pay more for companies than they are really worth. This may occur when they expect someone else to pay even more [ie they are speculating], they have unrealistic growth expectations, they have an investment mandate that means they have to buy, they are focused on the short term outlook, they are too optimistic, their buying decisions are quant driven [eg momentum], or they believe the share price looks cheap relative to other companies etc. 

Conversely, a company's market value can be significantly below intrinsic value - the future maybe uncertain, macro factors maybe overwhelming fundamentals, investors maybe focused on the short term outlook, investors may be acting irrationally, or investors may have a mandate requiring them to sell the shares etc.

“Mr. Market gives you opportunities to buy above and below intrinsic value.” Mario Gabelli

"Growth in corporate intrinsic value is often obfuscated by stock price movement, which does not appropriately track the accretion in business value. That’s good for all of us who are appraisers of businesses, because it means you get more mispricing and better opportunity to get a franchise at a cheap price." Mason Hawkins

Market value is influenced by the same factors that affect intrinsic value but even more so by the human emotions of fear and greed. Lots of investors buy and sell shares without respect to intrinsic value. As a result, market value tends to be far more volatile than intrinsic value. It's this volatility that provides the opportunity to buy businesses below their intrinsic worth.

"Prices fluctuate more than values - so therein lies opportunity" Joel Greenblatt

"Market price is the price the stock is currently trading at. It is determined by supply and demand of sellers at a point in time and may have no relationship with private market or intrinsic value." Li Lu

"The stock market is dominated by participants that perceive stocks almost as casino chips. With that knowledge, we can then buy great businesses sometimes well below their intrinsic value" Francois Rochon

Finally, private value is the value of the company based on a price another company or private investor may pay for the whole company. Private value is influenced by the same factors as intrinsic value and is often higher than intrinsic value. This is because another company who buys the whole company has access to all of the cash flows (not just the dividends), can determine capital allocation, may get tax benefits and, or maybe able to remove duplicate costs to achieve synergy benefits to increase earnings.

It is possible for another company or private investor to pay too much above intrinsic value for the same reasons an investor pays too much - emotional factors like greed, cheap financing or a private equity buyer flush with cash, over-estimating future earnings, relying on multiples of other companies or transaction multiples etc. 

"The ultimate irony is that private market value, being defined as what business people would pay was, in fact a moot point [in the mid to late 1980's]. There were no business people doing deals because the Wall Street leverage artists had prices way above what prudent business people would pay. We always attempted to define private market value as what we would pay to own a business." Seth Klarman

So how do you take advantage of the three different types of values?

Value investors like to buy shares in companies when the market value is significantly below intrinsic and private value. Share prices, while they may move significantly from intrinsic value in the short term, have a tendency to reflect intrinsic value long term. Over time underlying business fundamentals tend to determine share prices rather than short term factors. 

"The price of any particular security can be pictured as something resembling a captive balloon attached, not to the ground but to a wide line traveling through space. That line represents "intrinsic" value. As time goes on, if a company's earning power and true prospects improve, the line climbs higher and higher. If these or other basic ingredients of intrinsic value get worse, the line declines correspondingly. At any one time, the psychological influences (i.e., how the financial community is appraising these more fundamental matters of intrinsic value) will cause the price of the particular stock to be anywhere from well above this line to well below it. However, while momentary mass enthusiasm or unwarranted pessimism will cause the stock price to be far above or well below intrinsic value, it, like our captive balloon, can never get completely away from the line of true value and will always be pulled back toward that line sooner or later." Phil Fisher

The Investment Masters often refer to buying stocks well below intrinsic value as buying dollars for fifty cents or so.

“If a business is worth a dollar and I can buy it for 40 cents, something good may happen” Water Schloss

Buying shares with respect to longer term intrinsic value is a common investment strategy of many of the Investment Masters and is commonly referred to as 'time arbitrage'. 

"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

Investors who buy at a discount to intrinsic value are buying with a 'margin of safety'. If a company trades at a wide enough discount to its intrinsic value it's likely to attract other investors, other companies or private equity to take advantage of the under valuation.

"The beauty of stocks is that they do sell at silly prices from time to time. That's how Charlie and I have gotten rich." Warren Buffett

“I never want to pay above intrinsic value for stock – with very rare exceptions where someone like Warren Buffett is in charge." Charlie Munger

"The concept of a margin of safety is that an investor should purchase a security at a price sufficiently below his estimate of its intrinsic value that he will have protection against permanent loss even if his estimate proves somewhat optimistic. An analogy is an investor standing on the 10th floor of a building, waiting for an elevator to carry him to the lobby. The elevator door opens. The investor notices that the elevator is rated for 600 pounds. There already are two relatively obese men in the elevator. The investor estimates their weights at about 200 pounds each. The investor knows that he weighs 175 pounds. The investor should not enter the elevator. There is an inadequate margin of safety. Maybe he underestimated the weights of the two obese men. Maybe the elevator company overestimated the strength of the elevator’s cable. The investor waits for the next elevator. The door opens. There is one skinny old lady in the elevator. The investor says hello to the lady and enters the elevator. On his ride to the lobby, he will enjoy a large margin of safety." Ed Wachenheim

Many value investors look to the prices paid in mergers and acquisitions of similar companies to determine the potential private value of a company. When a company trades at a wide discount to that value it can provide an investment opportunity.

“Look at the prices paid in corporate mergers and acquisitions to find stocks that are selling at a significant discount to what they are actually worth to a knowledgeable buyer” Christopher Browne

The beauty of listed shares is that they are heavily influenced by human emotions. Investors are subject to tendencies and biases like groupthink, herd behaviour and basing investment decisions on recent performance. Intrinsic value and private value tend to be less influenced by human emotions.

“The big difference between private acquisitions and public equities is a negotiated transaction versus the non-negotiated transaction. When I buy stocks in the public markets, I am dealing with unintelligent sellers for the most part, or sometimes sellers that are very influenced by psychology on market nuances.” Mohnish Pabrai

This is one of the reasons many investment masters are cautious with new IPO's. The price tends to be set by rational individual[s] who look for the optimal time to maximise the sale price of the company.

“An intelligent investor in common stocks will do better in the secondary market than he will doing buying new issues. The reason has to do with the way prices are set in each instance.  The secondary market, which is periodically ruled by mass folly, is constantly setting a 'clearing price'. No matter how foolish that price may be, it's what counts for the holder of a stock or bond who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth x in business value have sold in the market for 1/2 x or less. The new issue market, on the other hand is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavourable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction. It's rare you'll find x for 1/2 x here.” Warren Buffett

Finally, many Investment Masters look for a catalyst that will close the gap between market value and intrinsic or private value. This may include things like asset sales, spin-offs, new management, buy-backs, insider buying, fixing balance sheets, closing unprofitable divisions etc. The quicker the gap can be closed the less the share price is exposed to general movements in the share market.

“One of the approaches I take is to look for a stock in the public market that is selling at a significant discount to private market value where I can identify catalysts for potential change” Leon Cooperman

"Investors should pay attention not only to whether but also to why current holdings are undervalued. Look for investments with catalysts that may assist directly in the realization of underlying value." Seth Klarman

The stock market coupled with the emotions of participants provide the opportunities for investors to buy companies below what they are worth. Provided market prices are determined by human nature that's unlikely to change.

Quality Companies, Compounders and Value Traps

Many of the world’s greatest investors have evolved to focus on high quality companies. In the post 'Evolution of a Value Manager' I outlined how Buffett, with help from Charlie Munger and the insights from the acquisition of See's Candy, transitioned from seeking cheap companies [ie low PE/, price/book etc] to searching for high quality companies at reasonable prices. Li Lu, C.T Fitzpatrick and Mohnish Pabrai are three Buffett disciples who have made a similar transition.  

"See's Candies - it was acquired at a premium over book [value] and it worked. Hochschild, Kohn, the department store chain was bought at a discount from book and liquidating value. It didn't work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses." Charlie Munger

The key to understanding the value of high quality companies is compounding. There is no universal definition of what high quality is but I think it's fair to say a high quality company is one which is understandable, dominant in it's industry, enjoys high barriers to entry, has attractive profit margins and a sustainable rate of return which is above average. Other attributes include strong free-cash-flow, a capital light business model, a good runway for sales growth, high quality management and a rock solid balance sheet. The highest quality companies have the ability to re-invest free-cashflow back into the business at high rates of return. These are often referred to as ‘compounding machines’.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett

In the case of See's Candies, it was a very high quality company but it didn't offer the same potential re-investment opportunity of a Coke or Gillette as it didn't have the global sales runway of these universal brands. For Buffett though, this didn't matter, he could send the profits back to Berkshire headquarters for redeployment into other attractive investments.

"We've tried 50 different ways to put money into See's. If we knew a way to put additional money into See's and produce a quarter of what we're getting out of the existing business, we would do it in a second. We love it. We play around with different ideas, but we don't know how to do it." Warren Buffett

"If we hadn't bought See's, we wouldn't have bought Coke. So thank See's for the $12 billion.  We had the luck to buy the whole business and that taught us a lot." Warren Buffett

So how do you identify high quality? It's important to consider common stocks as businesses and not just pieces of paper. This helps remove some of the emotional influences and human biases an investor faces and guides an investor to the key factors that will drive future earnings. Earnings are the lifeblood of the company and a company's worth is the discounted value of the earnings it can deliver over it's lifetime. While in the short term, a stock price may vary significantly from the underlying value of the business, in the long term, share prices and value converge.  

To identify high quality businesses you need to think about the characteristics of the business that  will determine its success over time. It's important to understand the basics of the businesses. What does the business sell? Is it a necessity, a commodity, a fad, a royalty stream? Is it subject to technological obsolescence? Why do the customers buy the product from the company and not someone else? Do they buy based on price, quality, convenience, subscription, referral etc? What demand is the product fulfilling? Is the product a small part of a much larger purchase? Is the company a win-win for all stake-holders? Does the business have some unique aspect that makes it hard for others to compete with it [ie network effects, 'winner takes all', geographic advantage, scale advantage, government licence, patent, cost advantage, strong brand,  high switching costs etc]. Does the business operate in  a competitive industry?  Are competitors entering or exiting the industry? Does the business have lots of competitors, suppliers and customers, or few? Will technology impact the business in a positive or negative way? Can the business put up prices without impacting sales? Does the business have a long runway for sales growth? What is the market penetration? Is the business facing the law of large numbers? Does the business need a lot of capital to grow? Does the business have a structural tailwind or headwind? Is the business subject to regulatory change? Is the business improving or declining? How is the business impacted by inflation?

While investment checklists aren't a panacea for thinking they can help an investor avoid common mental short-cuts and investment pitfalls.

A business with a history of profitability through different economic environments is a lower risk proposition than a start up. It's been stress-tested by economic cycles. Some high quality businesses are boring, they don't attract competition. Some high quality businesses maybe on the cusp of a technological development that will escalate future growth. A good example was Disney, which Munger recognised owned a valuable film library, which could suddenly be monetised with the invention of the DVD.  

High quality businesses have superior management who can adapt to change, are aligned with their shareholders and have a track record of deploying capital skillfully. High quality businesses also have solid balance sheets and high levels of free cash flow.

Once you've identified a high quality business the question is what to pay? Buffett paid three times book value for See's Candy and a P/E multiple above twenty for his last purchases of Coke. So if you can find a compounding machine it can be worth paying up for.  

"Is Costco worth 25 times earnings? I think: Yes.  Am I ready to sell any Costco? No. Would I buy more Costco at 25X earnings? I’m probably wrong, but I’d certainly rather buy Costco at 25X earnings than 90% of the other stocks." Charlie Munger

The difficulty is in identifying the few businesses that will grow into their multiple and beyond as most won't. Allan Mecham of Arlington Capital noted ‘Home Depot which in 1984 traded for 48 times earnings and even from such a lofty valuation went on to compound at 20% over the following 29 years’ .. but, ‘Home Depots are extremely rare.’ Paying too much for a business can result in poor returns.

Conversely, value traps tend to have characteristics at the other end of the spectrum of high quality companies. They are optically cheap, hence the name value trap. These businesses are commonly referred to as 'melting ice cubes' as the intrinsic value of the business melts away.  

“If you’re in a lousy business for a long time, you’re going to get a lousy result even if you buy it cheap.” Warren Buffett

A good example of value traps over the last ten or so years are businesses which have been subject to technological obsolescence. These businesses in many cases were high quality compounding machines in an earlier life but who have since seen their barriers to entry destroyed by some innovation. Kodak is a good example. Kodak dominated the market for film and photographic paper prior to the invention of the digital camera. In the beginning digital camera images were seen as inferior low resolution. Then at a sudden tipping point, when digital camera prices plummeted and quality improved, Kodak's earnings and stock price was decimated.  

A similar thematic played out with newspapers. The newspapers had few competitors, huge scale advantages, and a monopoly on advertising and news. Slowly at first, classified websites offering better search functions and lower costs started to gain a following. A tipping point was reached and many newspapers went bankrupt.

Cable TV operators are facing a similar threat from high speed internet because now you no longer need a cable network for distribution. The cable network was once the barrier to entry. Netflix doesn't need a cable monopoly or a local TV licence to deliver content to its customers. Anyone in the world with high-speed internet in now a potential customer. The more customers Netflix can sell to, the more it can pay for programming, the more customers it can attract. It's a virtuous circle.  

The internet has decimated traditional businesses and provided the means for the early adopters to move to a 'winner takes all' position which wasn't previously possible.  

The common characteristics of value traps are declining businesses. While the impact at first tends to be slow, it escalates rapidly when adoption hits a tipping point.

Value traps can also arise where management is misaligned with investors and/or makes poor capital allocation decisions. Even in high quality businesses management who deploy capital poorly can destroy value. Seeking businesses where management is aligned through stock ownership or appropriate incentives helps avoid these problems. Vetting management’s track record should be part of the due diligence process.  

In declining businesses it is common for management to try and buy their way out of trouble by making acquisitions in unrelated fields to dilute or cover-up the core business performance. This almost always ends badly.

The best way to avoid value traps is to think deeply about the business and the forces that could harm its earnings potential and focus on high quality companies. Don’t let a low valuation metric lure you into poor quality investments.

Further reading:
Tutorials - Quality Companies, Compounding Machines, Value Traps
Other - Fear of paying a high multiple (Valuation heuristics) - RV Capital
Don't Confuse Cheap with Value - Broyhill Asset Management

The Ten Commandments of Business Failure

“I like to study failure… we want to see what has caused businesses to go bad." Warren Buffett

"If I were ordaining rules for running boards of directors, I'd require that three hours be spent examining stupid blunders." Charlie Munger

Most business schools spend time studying the ingredients for business success. Many of the Investment Masters acknowledge the benefits of inverting a concept, looking at an investment question or problem in another way. Instead of searching for the ingredients that make for a successful business, trying to identify the common factors that will kill a business, can both help you avoid potential loss and help you identify businesses worth pursuing.

A great starting place is Don Keough’s book, "The Ten Commandments for Business Failure." Don Keough, a philosophy major, is a former CEO of the Coca-Cola Company and Berkshire Board Member. The book is introduced by his good friend, Warren Buffett.

Mr Keough notes, "A company doesn't fail to do anything. Individuals do, and when you probe a bit you usually find that failure lies not in a litany of strategic mistakes - though they all may be present in one form or another - but the real fault lies, as Shakespeare noted, in ourselves, the leaders of the business."

"Businesses are the products and extension of the personal characteristics of its leaders - the lengthened shadows of the men and women who run them. They are the main actors on the business stage and when, through one of more personal failings, they take a business in the wrong direction, then the business is headed for failure".  

Mr Keough recognises the commandments aren't startling breakthroughs in management thinking. They just make 'common sense.’ Mr Keough challenges the reader, ‘Show me a failed business, even one based on the latest wikinomics, and I will bet you with considerable assurance that their leaders have violated more than one of these commandments. One step towards failure unchecked, leads to another.’

I've outlined the Ten Commandments and added some comments along the way.

1) QUIT TAKING RISKS

When you are comfortable in your position there is a temptation to quit taking risks. The one constant for a business is change. A business must adapt to change, try out new products, processes and services and respond to changing technology, economics and customer needs.  

In light of the speed of technological change disrupting industries it is paramount businesses continue to evolve. Evolving means taking risks. I recently read an interview with Jorge Paulo Lemann, the 19th richest person in the world, and a founder of 3G. 3G is an investment company that has had enormous success buying and growing global businesses.

"Something that I always thought college doesn't give is the ability to assess and take risks.  It will teach you how to assess risks mathematically or theoretically, but hardly. And in general, it teaches you not to take risks, which is to say be careful. And I think in life, you have to take risks, and I think the only way you learn to take risks is practicing, practicing. So I practiced on the waves, playing tennis tournaments, later in business etc. I only mention this because I think a lot of people study hard, and I think in order to do more, or do exceptional, you have to take risks." Jorge Paulo Lemann

In the book 'Adapt - Why success always starts with failure', Tim Harford discusses failure when there is a pathological inability to experiment. He offers a method for experimentation known as the 'Palchinsky Principles;' first, seek out new ideas and try new things; second, when trying something new, do it on a scale where failure is survivable; third, seek feedback and learn from your mistakes as you go along.’

Phil Fisher touched on this concept in his writings, 'Developing an Investment Philosophy’,“The company that doesn’t pioneer, doesn’t take chances, and merely goes along with the crowd is liable to prove a rather mediocre investment in this highly competitive age.”

2) BE INFLEXIBLE

Companies and investors, that refuse to change when it is clearly evident a strategy or process isn't working are bound for failure. The newspaper companies that failed to adapt to the rise of the internet are a case in point. They lost their edge in real estate classifieds, employment advertising and general advertising. So too have the TV networks that failed to recognise the global reach of the internet will far surpass free-to-air and cable networks limited geography.

Mr Keough believes, "flexibility is a continual, deeply thoughtful process of examining situations and, when warranted, quickly adapting to changing circumstances. It is, in essence, the key to Darwin's whole notion of the survival of the fittest.”

3) ISOLATE YOURSELF

CEO's who isolate themselves from their businesses or who surround themselves with only ‘yes people’ are likely to fail. Managers that do well understand their marketplace and understand their customers, their staff and their competitors.  

Mr Keough points out Charles Kettering, the great engineering genius who helped steer GM during its glory years, said "Don't bring me anything but trouble. Good news weakens me." If you isolate yourself you will not only not know what you don't know about your business, but you will remain supremely and serenely confident that what you know is right.   

So too, the great investors are seekers of truth. They ask what they do and do not know. They look to have investment ideas tested.  

4) ASSUME INFALLIBILITY

Mr Keough notes "Annual reports often amuse me, particularly the letter to shareholders. In one report after another, even if the company has had a thoroughly disastrous year, the chairman's letter is frequently an artful exercise in finger pointing at a number of causes ranging from unforeseen currency fluctuations to the unusually active hurricane season."

Once again, like good investors, managers must acknowledge and address mistakes, learn from them and move on. Ignoring or sweeping problems under the rug or finger pointing will lead to failure. "If you want to increase your chances of failure, deny the possibility that you are not always 100% perfect in your judgement. Ignore the fact that sometimes others do know a thing or two." Do the same in investing, and you'll fail too.

5) PLAY THE GAME CLOSE TO THE FOUL LINE

Trust is an essential foundation of any business. Mr Keough notes, "All business finally boils down to matters of trust - consumers trust the product will do what it promises it is supposed to - investors trust that management is competent - employees trust management to live up to its obligations.”  

Many of the great investors focus on companies whose culture is win-win. Over time studies shows businesses with good cultures outperform those with poor cultures.

6) DON'T TAKE THE TIME TO THINK

There are plenty of example of business failure which could have been averted if management stopped to think about the consequences of their decisions. Being human, managers suffer the same emotional biases investors do.

Confirmation bias, greed and fear and groupthink are a few examples. Like investors, managers can test ideas, study similar situations/mistakes, and invert concepts to aid their thinking process. Mr Koeugh notes "If you want to fail, don't take time to think. If you want to succeed, take lots of time to think. Thinking is the best investment you'll ever make in your company, in your career, in your life."

“Thinking is the hardest work there is, which is probably the reason so few engage in it.” Henry Ford

7) PUT ALL YOUR FAITH IN EXPERTS AND OUTSIDE CONSULTANTS

Experts and consultants have vested interests, biases and shortcomings. Just like stock market forecasters, business and industry forecasters track records usually tell you more about the forecaster than what’s likely in the future. Be skeptical of companies that cite and rely on industry analysis to support acquisitions or major corporate change.  

Mr Keough notes, "You'll fail if you don't stop to think. Well, you'll also fail big time if you let yourself be flattered, and there is never a shortage of charming con artists in just about every field who will use flattery as a sales tool."

“Anyone who says businessmen deal in facts, not fiction, has never read old five-year projections.” Malcolm Forbes

“I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one." Charlie Munger

"Organisations that take the word of overconfident experts can expect costly consequences … however, optimism is highly valued, socially and in the market; people and firms reward the providers of dangerously misleading information more than they reward truth tellers.” Daniel Kahneman

8) LOVE YOUR BEAURACRACY

The same limitation and dangers of a committee approach to investing often applies to the process of running a business. Committees suffer from Groupthink. Warren Buffett once reported that in the first month of ownership of one acquired company, they eliminated fifty-four committees that were chewing up about ten thousand man-hours. Berkshire Hathaway operates with 25 people at head office.  

To combat bureaucracy at the Coca-Cola Company, Mr Keough isolated the core of the business to drive decision making, "every expense we made, every department we created, every project we took on had to answer to the basic question: Will this help to create and serve customers? If the answer was not a ringing and positive ‘Yes?’ whatever it was we were spending or undertaking had to be eliminated. Once you decide you have fifty things to do that are unrelated to your customer, soon you have fifty bureaucracies composed of individuals doing things extremely well that they shouldn't have been doing because it didn't serve the customers in any way."

With business, as with investing, focus on the factors that matter.

In his 2014 letter Warren Buffett made the point that his successor would need one other particular strength, "the ability to fight off the ABC's of business decay, which are arrogance [see point 4 above], bureaucracy and complacency [see point 1 above]." He noted "When these corporate cancers metastasise, even the strongest of companies can falter."

9) SEND MIXED MESSAGES

Mr Keough notes, "sending mixed or confused messages to your employees or your customers will jeopardise your competitive position, and result in failure.” 

Companies need to ensure their employees are rowing in the right direction. In part this has a lot to do with having the right incentives, values and purpose. History is littered with companies whose move into unrelated businesses took the focus off their core business.

“A majority of life’s errors are caused by forgetting what one is really trying to do.” Charlie Munger

10) BE AFRAID OF THE FUTURE

Mr Keough notes, "When you focus on the failures of the world day in and day out, it shapes your whole attitude toward life and the future.”

One optimist in a sea of pessimists can make all the difference. If you want to succeed, approach the future with optimism - and passion.

* 11) LOSE YOUR PASSION FOR WORK  - FOR LIFE *

Mr Keough added a little bonus - an eleventh commandment. He notes "I have never met a successful person who did not express love for what he did and care about it passionately.” He suggests making an emotional connection with your customers. Remind yourself every day as to just what the customer is looking for, expects, and wants from your company.  

As in investing, management must have a passion for what they do. The business environment does not afford the luxury of complacency.

The same human foibles that undermine investors can undermine management and their businesses. Mr Keough states "Human nature is the reason I have, regrettably, such confidence in the principles of this little book." 

Recognising those common factors and red flags of business failure can assist investors in avoiding companies more susceptible to failure. After all, avoiding the permanent loss of capital is key to successful investing. 

Sources:
'The Ten Commandments for Business Failure' - by Don Keough

Further Study: 
'Adapt - Why success always starts with failure' - Tim Harford
Video: ‘Warren Buffett & Don Keough: The Ten Commandments of Businesses Failure & Buying Coca-Cola’

Avoiding GroupThink

"Society teaches us from childhood that it pays to be part of the group and not be too different." Wilfred Trotter

"Groups can bring out the worst as well as the best in man." Irving Janus

Over the years I've witnessed plenty of costly decisions made by corporate boards and investors as a result of poor group decisions.  

A few years ago I was reading an interview with Adam Weiss of Scout Capital who recommended the book "Groupthink" written by Irving Janus, a Yale psychologist, in 1982. I always like to read the books recommended by investors with solid track records of compounding capital.

“Both James [Crichton] and I recently read Groupthink, Irving Janis’ classic study of how small, cohesive groups of very smart people can make really bad decisions, such as getting deeper into Korea, the Bay of Pigs, and Vietnam. The main point is to make sure you have a culture that questions everything and vets out all the alternatives before zeroing in on one of them.” Adam Weiss

Irving Janus defined the term 'groupthink' as "a mode of thinking that people engage in when they are deeply involved in a cohesive group, when the members' striving for unanimity override their motivation to realistically appraise alternative courses of action. Groupthink refers to a deterioration of mental efficiency, reality testing, and moral judgement that results from in-group pressures."

“When smart men and women combine their intellects to presumably optimise a solution, the result tends to be surprisingly counterproductive. Rather than being boosted by brilliance, groupthink has a perversely dilatory effect on collective reasoning.” Frank Martin

Mr Janus notes "Groupthink is conducive to errors in decision-making, and such errors increase the likelihood of a poor outcome.  Often the result is a fiasco, but not always." 

The book recounts the fascinating historical account of the fiascos of Pearl Harbor, the escalation of the Vietnam War, The Bay of Pigs invasion, the invasion of North Korea and the Watergate cover-up. Each of these catastrophic outcomes was a product of a group decision from a small body of government officials and advisers who constituted a cohesive group. Each instance contained the characteristics of gross miscalculation about both the practical and moral consequences of the decisions by a group of intelligent individuals who ignored contrary information and failed to sufficiently consider alternative outcomes.

Understanding 'groupthink' provides a key to better decision making. While the book's case studies relate to political fiascos they have implications for all types of decision making by groups, particularly financial decisions. Whether a group is involved in managing an investment portfolio or choosing an investment manager or a corporate board is considering a major acquisition, capital is at risk.   

With respect to managing a portfolio, many of the Investment Masters acknowledge the limitations of group decision making, and instead prefer to manage capital on a sole basis. 

"It has been my experience that the more power given to the investment specialist and the smaller the influence of the individuals on investment committees, the better the quality of the work accomplished." Phil Fisher

"If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either." Peter Lynch

"Like art, portfolio management can rarely be done in teams (or worst in committees). We can add experience but we lose in personal creativity. Like Warren Buffett once said: “My vision of a group decision is to look into a mirror.” Francois Rochon

"If there were such thing as the Laws of Investing, they would have been written by Graham, Buffett and Munger. A small team size (ideally one) would be one of these laws." Mohnish Pabrai

"Investing probably is not played best as a group sport." Leon Levy

Mr Janus identifies eight major symptoms of 'groupthink' which he splits into three types as noted below [I have included references for investment consideration in italics].

Type 1 - Overestimations of the group - its power and morality

1. An illusion of invulnerability, shared by most or all of the members, which creates excessive optimism and encourages extreme risk taking.

A classic case study is the violent collapse of the hedge fund, Long Term Capital Management [LTCM] , in 1998. This fund comprising legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, had an aura of invincibility combined with phenomenal risk, which almost led to the downfall of the US financial system.   

With respect to LTCM, Howard Marks noted "Brilliance like pride, often goes before the fall.  Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management"  

A more recent case study is the significant de-rating of Valeant, a US pharmaceutical company with a successful early track record and strong CEO which led the company to undertake ever larger acquisitions and implement aggressive drug pricing strategies, that became its undoing.  

2. An unquestioned belief in the group's inherent morality, inclining the members to ignore the ethical or moral consequences of their decisions.

The late 1990's collapse of Enron and Worldcom provide two examples of unethical corporate behaviour with respect to corporate accounting and fraud. The more recent conduct of the credit ratings agencies and investment banks in the sub-prime mortgage market that contributed to the Global Financial Crisis is likely a consequence of groupthink.

Type 2 - Closed Mindedness

3. Collective efforts to rationalise in order to discount warnings or other information that might lead the members to reconsider their assumptions before they recommit themselves to their past policy decisions.

"I would say that the typical organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants." Warren Buffett

4. Stereotyped views of enemy leaders as too evil to warrant genuine attempts to negotiate, or as too weak or stupid to counter whatever risky attempts are made to defeat their purposes.

“I try to assume that the guy on the other side of a trade knows at least as much as I do. Let’s say I buy Texaco at $52 and it suddenly goes down to $50. Whoever sold Texaco at $52 had a perception dramatically different to mine. It is incumbent on me to find out what his perception was.” Michael Steinhardt

“In order to invest, we need to have a sizeable analytical edge over the person on the other side of the trade. The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor.” David Einhorn

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger

Type 3 - Pressure Towards Conformity

5. Self-censorship of deviations from the apparent group consensus, reflecting each member's inclination to minimize to himself the importance of his doubts and counter-arguments.

"Independent directors have to be hard-working people who will attend meetings diligently, ask tough questions and challenge management. We're in the process of looking for directors for one of our companies. Someone I asked about a prospect said "He'll be a pain in the ass to management". Within reason, that's what I want to hear. Relaxed attitudes negate the concept of independence. Directors who serve in perpetuity should be looked at. After enough years, they can conclude their loyalty is to management." Howard Marks

"The reality is that neither the decades-old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees – and who may wish to enhance his income through election to other boards – is deemed independent. That is nonsense." Warren Buffett

"CEO's get very diluted information. They're told what people believe they want to hear. We tell them the facts. We call a spade a spade" Richard Perry

6. A shared illusion of unanimity concerning judgments conforming to the majority view (partly resulting from self-censorship of deviations, augmented by the false assumption that silence means consent).

"It's equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisers are present and unanimously support his decision (They wouldn't be in the room if they didn't)." Warren Buffett

7. Direct pressure on any member who expresses strong arguments against any of the group's stereotypes, illusions, or commitments, making clear that this type of dissent is contrary to what is expected of all loyal members.

"Whistle-blower Sherrin Watkins has said that questioning CEO Jeff Skilling about the proprietary of the partnerships would have been 'job suicide". CFO Andrew Fastow is said to have cursed at the Enron representatives who negotiated against the partnerships he ran and tried to get one fired." Howard Marks [2002 memo 'Learning from Enron']

8. The emergence of self-appointed members who protect the group from adverse information that might shatter their shared complacency about the effectiveness and morality of their decisions.

Peter Bevelin succinctly described the issues with group decisions in his book 'Seeking Wisdom - From Darwin to Munger'…  "In a group we feel anonymous, which reduces our feelings of responsibility. We can't be blamed. This can lead to over-confident risk behaviour. We may also become impulsive and destructive. Imitation, obedience to authority, and the fear of being different are forces that drive crowds. Groups don't encourage differences of opinion. If a member of a group disagrees, he may seem disloyal. Unanimity is better than independent thought. Individuals in the group reinforce each other into believing that they collectively are right. They focus on favourable consequences and ignore the downside."

Mr Janus offers a number of prescriptions to help avoid groupthink including:

1.  The leader of the policy forming group should assign the role of critical evaluator to each member, encouraging the group to give high priority to airing objections and doubt.

“One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction.” Bill Ackman

“I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong.” Ray Dalio

2. The leaders should be impartial instead of stating preferences and expectations at the outset.

3. The organisation should routinely set up several independent groups working on the same policy question under a different leader.

4. The policy making group should from time to time divide into two or more subgroups to meet separately and then come together to hammer out their differences.

"These 'social' difficulties argue for outside directors regularly meeting without the CEO - a reform that is being instituted and that I enthusiastically endorse." Warren Buffett

5. Each member of the policy making group should discuss periodically the groups deliberations with trusted associates in his her unit and report back their reactions.

"I have several times leveraged the partners on specific investments because we have so many entrepreneurs and CEO's in our midst with deep domain knowledge. Many times when I have looked at the list and then presented it to one to three of them with my analytics and said to them "Please don't go buy the stock, but could you tell me if I'm thinking about this the right way; What's your take on it or what insight do you have that I may not know?"  Mohnish Pabrai

6. One or more outside experts or qualified colleagues who are not core members of the policy-making group should be invited to each meeting and be encouraged to challenge views of core members.

"I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." Charles Koch

7. At every meeting to evaluate alternatives at least one member should be assigned role of devil's advocate.

"My thought is, if there's no natural sceptic on an investment maybe it would be wise to appoint one to play devil's advocate anyway." Peter Cundill

"I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear." Lee Ainslie

"We’ve also started to assign an “appointed bear” for big positions. This is an insight from one of my favorite books, Groupthink by Irving Janis.. You need to bless someone to take the contrary position because there are a lot of reasons people won’t do it. I think it’s made a big difference in the quality of our discussions."

8. Whenever the policy issue involves relations with a rival nation a sizeable block of time should be spent surveying all warning signals from the rivals and constructing alternative scenarios of the rival's intentions.

"We continually challenge ourselves by asking, "What can go wrong?" with investments we own or consider owning. By playing mental war games against our best ideas we may gain or lose confidence in an initial thesis, or perhaps come to accept that a long-loved holding should be let go. We call this stress testing process "killing the company." Bruce Berkowitz

“The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market." George Soros

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments." Seth Klarman

"Charlie and I both think about worst case scenarios a lot." Warren Buffett

9. After reaching a preliminary consensus about what seems to be best policy alternative, the policy-making group should hold a 'second chance' meeting at which members are expected to express as vividly as they can all their residual doubts and to rethink the entire issue before making a definitive choice.

"We are very careful not to close ourselves off to opportunities to hear a well- developed counterview on any of our investments. Vibrant debate is part of our internal process; however, there is no substitute for the argument of an investor who has risked real capital on a view that is in opposition to ours. Without fail, this shines a light on the potential soft spots of an investment and causes us to work even harder to bottom-out the critical elements of our own thesis." Jim Mooney

Avoiding Groupthink is a necessary pre-requisite for investment success. Many of the Investment Masters employ strategies to combat the negative effects of groupthink. As Barton Biggs asserts in his excellent essay "Groupthink = Groupstink" that ‘Although there are some groupthink countermeasures, the only real defence against this intellectual cancer is awareness’.   

Further Reading: Investment Masters Class tutorials - Investment Committees, Testing Ideas, Alternative Scenarios, What you Know, Hubris & Humility, Understanding History, Invert, Confirmation Bias, and Checklists.

Sources: 'Groupthink - Psychological Studies of Policy Decisions and Fiascos' by Irving Janus [Yale University].  1982 Houghton Mifflin Company
'Hedge Hogging' by Barton Biggs. 2006 John Wiley and Sons" - see Chapter 12
"Dare to be Great" Memo - 2006 Howard Marks - Oaktree Capital
'The Essays of Warren Buffett' by Laurence Cunningham, 2nd Edition 2008 - see 'Boards and Managers' and 'Acquisition Policy'

 

 

10 Timeless Lessons from Bernard Baruch

Known as "The Lone Wolf of Wall Street", Bernard Baruch was one of the the world's most famous speculators of the 20th Century. By the age of 30, Mr Baruch had amassed a fortune.  He went on to advise US presidents and congressional leaders from 1918 to 1948.  

His memoirs, "My Own Story", written in 1957, provides a fascinating account of Baruch's life, his insight into human psychology and the history of speculation. His first hand account of market panics, bull markets and short squeezes and the associated emotional reaction of the markets provide timeless wisdom.  

Mr Baruch lays down 10 guidelines from his lifetime of experience in the markets which he notes 'may be worth listing for those who are able to muster the necessary self discipline'. Like all of the Investment Masters there are many common threads that form the foundation of his success. With the exception of Mr Baruch's commentary on taxes, all of the 10 guidelines are tutorial topics in the Investment Masters Class.

1. Don't speculate unless you can make it a full-time job

2. Beware of barbers, beauticians, waiters - of anyone - bringing gifts of "inside" information or "tips."

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don't try to buy at the bottom and sell at the top. This can't be done except by liars.

5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible

6. Don't buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don't try to be a jack of all investments. Stick to the field you know best. 

[Source: "Baruch - My Own Story" Published by Henry Holt & Co., 1958.]

100 Common Threads of the Investment Masters

The Investment Masters Class is based on the wisdom of the world's greatest investors.  Over the last few decades following investors with strong track records of compounding capital I've found that many common threads consistently surface. These common threads encompass a broad range of areas such as investor's goals, processes, opportunities, obstacles, psychological construct, outlook and market views. Many are timeless. Below are 100 common threads of the Investment Masters which form the foundation of the Investment Masters Class tutorials. 

1. The Number One Rule is don't lose money

2. Harnessing the power of compounding is the key to investment success

3. It’s better to be street smart than book smart when it comes to the market

4. Investing is an art, study the Masters

5. There are no get quick rich schemes, NIL, ZILCH

6. Successful investing is hard work

7. The Investment Masters read  

8. Continuous learning is one of the keys to successful investing

9. As an Investor you must have an edge

10. The Investment Masters love their jobs

11. Checklists help avoid human biases

12. Studying history gives you an edge, most things have happened before

13. All Investors make mistakes, the Investment Masters learn from theirs and others

14. Being an Investment Generalist helps one widen the scope of view

15. Understand what you own

16. Value Investors dominate the Investment Masters ranks

17. Prices maybe wrong

18. Risk and return are not correlated

19. Volatility is NOT risk. Volatility creates opportunities

20. Cash is an asset in a portfolio

21. Investment Masters understand the folly of forecasts

22. Don't forget, markets can turn on a dime

23. Pessimism can be a clarion call

24. Weak markets set the stage for high returns

25. Ignore tips

26. Investment Masters don't stray outside their circle of competence

27. Outperforming in down markets is the key to investment success

28. No Index Hugger has made the Investment Masters Hall of Fame

29. Only an Absolute Return focus is consistent with the First Rule of Investing: Preserve Capital

30. The Investment Masters get on base [rather than hit home-runs]

31. Valuation is a range not a number

32. Don't invest without a Margin Of Safety

33. Opportunities arise when prices don't reflect Private Market Value

34. Having a longer Time Horizon can give you an investment edge

35. Never assume interest rates will stay low indefinitely

36. Find Compounding Machines

37. The Investment Masters count the Cash coming out of the business

38. Don't waste your time trying to pick the bottom

39. Testing Investment Ideas helps identify where a thesis may be wrong

40. Don't let your investments go stale

41. Never forget things are always evolving

42. High levels of Correlation can lead to trouble

43. The Investment Master looks at less and sees more, their Unconscious skill-set is more highly evolved

44. The greatest Investment Master of our time thinks the Efficient Market Hypothesis is garbage. Most Business Schools study the hypothesis not the Master

45. Shorts can help protect capital, but the analysis of shorts differs significantly than for longs

46. You need to understand the benefits and pitfalls of Diversification

47. Focus on the Variables that are going to drive or destroy a company

48. There is no One Size fits all. Positions should be sized depending on a multitude of factors

49. Portfolio management is a LOT more than picking the right stocks

50. Management can break a company

51. Understanding Psychology can be the most important thing

52. The key to successful investing is overcoming your Emotions

53. The market humbles everyone

54. All you need is a little Patience

55. Don't fall in Love with three letters

56. It's Mr Market who provides the opportunities for high compound returns

57. The more people you have the more likely you will suffer from Groupthink

58. Human nature evolved for the survival of the species, not individual investors

59. It's important to understand the Bounds of your Knowledge

60. When people Hate a stock, there's more chance it's going to be mis-priced

61. The Investment Masters use Leverage sparingly if at all

62. Excessive Debt on a company's balance sheet can lead to investment ruin

63. Be on the lookout for Value Traps

64. The higher the rating the higher the potential for de-rating

65. There are Bubbles everywhere, be careful

66. The Investment Masters are the only Crowd you should follow

67. Don't put your faith in a Computer Model, keep thinking

68. Make sure you keep your eyes on the road ahead or you might drive off a cliff

69. New Eras ordinarily turn out to be mirages

70. Ignore the Macro at your peril

71. What is RISK? …  Permanent Loss of Capital

72. Don't be unprepared for the Unexpected

73. You can drown in the absence of Liquidity

74. Capital Allocation is a required skill-set for Corporate Management

75. Be careful when companies are on an M&A binge

76. It's Asymmetry that's beautiful in investing

77. Trawl through the New Low Lists

78. Take notice of what Investment Masters are active in

79. Playing in Spin-offs can be profitable

80. Catalysts can speed up the crystalization of profits

81. Invert [a thesis] so you don't face plant

82. The Investment Masters seek Quality

83. In Win-Win situations, you're less likely to lose

84. Industries that are Gonna Change the World for the positive may change your P&L for the negative

85. There is no margin of safety in Commodity Companies

86. The Investment Masters eat their Own Cooking

87. GOLD isn't a compound[er]

88. The Investment Masters age like a good wine

89. The dark art [of charting] is still practiced

90. Sometimes you need a removed view

91. Don't confuse skill with luck

92. The scorecard is the P&L

93. Buy well

94. When it's not working get off the Tracks

95. Conventional is Not Conservative and vice versa

96. Projects suffer from Time Asymmetry and Human Biases

97. Only at the right price, Buybacks add value

98. Evolutionary biases can kill you in the market

99. It's important to understand the crowd behaviour in Bull Markets

100. Be mindful of Technological Obsolescence

DISCLAIMER - TERMS OF USE

Investing - Art or Science?

One of the premises behind the Investment Masters Class is the belief that investing is far more art than it is science. Whether it is an art or science has implications as to how one should approach investing, what one should study and the necessary skills for success.

This paper will draw together many of the tutorial topics included in the Investment Masters Class [including 'Art or Science', 'Education and Smarts', 'Invert always Invert', 'Rear-view mirror', 'Keeping Stock Valuations simple', 'Investment Factors', 'Investing Instinct'. 'Stock Market Magic Formula'].

"Investing is more art than science." Howard Marks

Science is associated with consistent, independent and timeless outcomes. Science can be studied in a textbook, applied in an experiment and deliver an expected result. If investing were a science, in theory, you should be able to buy an investing textbook, apply the knowledge and achieve excellent returns. There would be an investment formula you could apply to achieve results. Unfortunately, there are no magic formulas or formulaic textbooks that guarantee success.

"If there was one formula, one way to do it, we'd all be zillionaires." Paul Tudor Jones

If investing were a science it's likely that investors with the highest IQ would outperform. You would expect investors that attended pre-eminent business schools to be the finest. The fact that the majority of professional money managers do have highly regarded education qualifications and under-perform the market indices, suggests finance courses don't correlate well with performance. In fact, I'd be prepared to wager there is no statistically significant correlation between, say those holding a CFA or Applied Finance qualification and those that don't, and their respective investment performance.

"Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. " Warren Buffett

Building more detailed and complex investment models doesn't ensure investment success either. There is no relationship between the detail or complexity of an analysts model and the likelihood of investment success. In fact the Investment Masters tend to keep valuations simple and instead take the time to think about the key factors that impact a common stock's performance. A much more fruitful exercise than building a 2,000+ line spreadsheet model.

“Keep it simple. Your thesis should be on the back of a postcard if it’s right.” Bruce Berkowitz

Relying on the science of formulas such as 'Value at Risk' as opposed to a common sense assessment of risk has blown up plenty of investment funds.  

"Things like Gaussian curves and Value at Risk (VAR) were some of the dumbest ideas ever put forward." Charlie Munger

Understanding the efficient market hypothesis and the capital asset pricing model hasn't secured a place for any investor in the ranks of the Investment Masters. Most of the Investment Masters are critical of such theories.

"The elegance of the efficient market theory is at odds with the reality of how the financial markets operate." Seth Klarman

So if investing isn't a science, is it an art? What is Art? Most of the Investment Masters do consider investing more art than science. 

Art can be defined as the 'expression or application of human creative skill and imagination.' The ability for an investment manager to consider alternative outcomes, to connect disparate information, to step away from the crowd, and to imagine and contemplate business performance are prerequisites for investment success.  

So how do you study art? If you were to study classic art you would likely start by studying the great masters - Picasso, Renoir, Van Gogh, Monet and the like. You would explore their work, style and techniques. You would contemplate their thought processes, the times in which they lived and their creative progression. It's unlikely you would spend time studying the physical process of painting or the composition of the paint.

Investing is no different. To become a successful investor it pays to start learning from the Investment Masters. How do/did they operate, their psychological considerations and the common themes behind their success.   

Art involves creativity and imagination and is associated with the right-side of the brain. This is the side that also deals with ideas and intuition. 

These are functions commonly cited by the Investment Masters as prerequisites for investment success. Examples include the ability to create unique investment theses and to imagine alternative investment scenarios and the implications for a stock or market.  

"Creativity and independence of thought are the essence of the hedge-fund craft.” Paul Singer

“We put great emphasis on a consistent investment process that demands enormous creativity, energetic sourcing, outside-the-box thinking, intellectual honesty, and vibrant debate.” Seth Klarman

“We think we try harder than most to be rational and creative.” Nick Sleep

"I always tried to balance risk aversion with some measure of creativity." John Neff

The ability to stand against the crowd is a key ingredient for investment success. It also requires creativity ..

"From our empirical observations, it seems that some members of our species are immune to this call of the herd. They can go left when the rest of the tribe goes towards the right. Their attitude isn’t influenced by the behaviour of the tribe. Their genetic code seems to not have the “tribal gene”. It’s difficult to evaluate what percentage of humans have this particularity but it’s a minority. And it’s probably those who eventually become creators (artists, scientists, writers, entrepreneurs, etc), as the act of creation requires the capacity to make something new and to forge a new path different from others. To create is to go where there was nothing before. Creating is the antonym of following." Francois Rochon

“It’s imperative to be creative because a stock currently is selling at a price that the average investor thinks is the right price, so you have to come to a decision that that price is wrong and that the stock deserves to sell at a higher price for some reason. That reasoning is creative thinking because other people aren’t thinking that way because if other people were thinking that way, the stock would be at a higher price. Every idea is a creative idea.” Ed Wachenheim

The ability to subconsciously connect seemingly unrelated pieces of information to provide an insight is a right-brain function. As is the intuition that comes from years of time in the market.

"Creativity is the power to connect the seemingly unconnected." William Plomer

“Intuition, whether positive or negative, is quite another matter. It is a vital component of my art.” Peter Cundill

“Being an investor and running a fund requires you to be part financial analyst, part accountant, part financier, part social scientist, part philosopher. You have to tie the right brain and the left brain together. If there’s an edge to be had, it’s in understanding the different components of the analytical process or the selection process. Understanding there’s an element of creativity, emotion, analytics and intuition. Maybe the thing we call intuition is the ability to tie all those things together.” Dan Loeb

Conversely, the left-side of the brain deals with the 'science' functions. These functions - logic, verbal reasoning, mathematics, linear thinking, factuality - commonly get investors into trouble.  

For example, making the assumption recent trends will continue into the future [looking in the rear-view mirror], investing according to a strict formula and considering only the observable facts without seeking further information or disconfirming evidence are key investment pitfalls. Focusing too much on the numbers at the expense of the big picture is another common investment mistake.  

"Computers and their endless databases cause investors to focus on the past. More than ever before, people are looking backward into the future." Shelby Davis

Most business school curriculums are focussed on learning and testing utilizing the left-side of the brain. It's much easier.

"Testing is best suited for left-brain-dominant students. It's much easier to test for sequential thinking and problem solving, recall, etc., than for right-brain attributes. For example, how do you test for intuition or artistry? So economics has become largely quantitative. Of course, modern portfolio theory (MPT) is the ultimate in the application of mathematics to what really is a soft science. So even though MPT is an important part of the CFA program and the curriculum in most graduate business schools Buffett and I consider it almost laughable. Yet it continues as core curriculum because that's what teachers have been taught to teach, and it's hard for this battleship to change direction. In a recent New York Times edition, Bob Schiller, with whom I've had communications, wrote that behavioural economics is the new frontier. Even though it's gaining currency at Harvard, Yale, and a number of other leading schools, it's going to be difficult to institutionalise because it's so intuitive. So l would love for schools to teach right-brain thinking and applications as well, but it won't be easy to quantifiably integrate it into the curriculum." Frank Martin

It's no surprise that many of the Investment Masters have backgrounds or experiences in areas associated with the right-side of the brain. For example, Leon Levy, George Soros, Paul Singer and Peter Lynch studied psychology. Michael Steinhardt majored in sociology. John Burbank, Glenn Greenberg and Bruce Kovner spent time as a teacher while Stanley Druckenmiller wanted to be an English Professor. Chuck Akre obtained a BA in English Literature. Paul Tudor Jones learnt more in journalistic studies than business school while Warren Buffett has said if he wasn't an investor he'd like to be a journalist.

"In college, except for the obligatory courses, I avoided science, math, and accounting all the normal preparations for business. I was on the arts side of school, and along with the usual history, psychology, and political science, I also studied metaphysics, epistemology, logic, religion, and the philosophy of the ancient Greeks. 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. Investing in stocks is an art, not a science, and people who've been trained to rigidly quantify everything have a big disadvantage." Peter Lynch

Julian Robertson took time off to write a novel in New Zealand. The study of Japanese [and Lao Tsu] were instrumental in shaping Howard Mark's investment philosophy. Peter Lynch, Chris Davis, Carl Icahn and Jim Rogers studied philosophy while David Abrams, Terry Smith, James Anderson and Nick Train majored in history. Nick Sleep studied Geography. James Dinan credits his liberal arts studies as most valuable. Meditation, a form of engaging the right side of the brain, has been instrumental to Ray Dalio and Dan Loeb's success. 

"I think yoga and meditation are good for your brain and good for your body. They help you think more clearly, improve your memory, and help you become a more balanced, self-aware person. And I think those are all really important things that make a good investor." Dan Loeb

To help avoid the pitfalls of relying too much on the left-side of the brain, some common tools used by the Investment Masters include checklists and inverting.

Checklists developed with reference to realised investment mistakes help overcome common missteps by ensuring key items are not overlooked.  

“I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.” Charlie Munger

Inversion helps engage the right side of the brain by introducing unfamiliar concepts. Some of the classic artistic masters would turn their paintings upside down to find fault in them. So to, the Investment Masters turn an investment thesis upside down to identify faults.

“Once a person has an idea, we then start whacking at it. We invert the concept. Instead of trying to prove a person’s idea, we try to kill it, and if we can’t kill it then the person is onto something. Whether it is my own idea or someone else’s, that is the process we go through.” Bruce Berkowitz

Successful investing requires more than an excel spreadsheet. It requires thoughtfulness, intuition, creativity and an edge. It amazes me that the majority of business schools focus on theories that practitioners with long track records of investment success consider ineffectual. 

I meet lots of graduates with formal finance qualifications who know nothing of Warren Buffett, Charlie Munger or Peter Lynch, know zero financial history and have spent little time understanding human psychology.

The world's greatest investor Warren Buffett considers the efficient market hypothesis garbage. Yet, most business schools study the hypothesis not the master. In contrast, the Investment Masters Class focuses on the lessons of the Investment Masters.

Phil Fisher on Mergers & Acquisitions

Over the past few decades I've found I have learnt the most about investing from reading the books recommended or written by the Investment Masters.

I was recently reading Francois Rochon's annual letters and came across a reference to a Phil Fisher book called, "Paths to Wealth Through Common Stocks." Far less well known than Mr Fisher's highly regarded, "Common Stocks and Uncommon Profits" of 1958, this book was published in 1960. I managed to pick up an original copy at AbeBooks.  

What I find most insightful from older books are the lessons and ideas that contribute to investment success that have remained constant over long periods of time. In the terms of Nicholas Nassim Taleb, these ideas are ‘anti-fragile’. In his book of the same name, Taleb notes ..

"If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This simply, as a rule, tells you why things that have been around for a long time are not "ageing" like persons, but "ageing" in reverse.  Every year that passes without extinction doubles the additional life expectancy. This is an indicator of some robustness. The robustness of an item is proportional to its life!"

Reading Phil Fisher's book, I was surprised how timeless the commentary was on Mergers & Acquisitions. Remember this book is nearly 60 years old yet its lessons are as relevant today as they were then. A lot of that has to do with the fact that human nature doesn't change and also that the basis of Mr Fisher's analysis, when you take the time to think about it, really is common sense.

In recent months I've witnessed a whole host of companies that have blown up investors capital due specifically to Mergers & Acquisitions. Investors may have saved themselves a lot of heartache over the last 50+ years if they'd taken note of the observations of Phil Fisher all those decades ago.

"Why do mergers and acquisitions carry such a high degree of risk?" Mr Fisher asks.

"There are three main sources of danger to investors from mergers or acquisitions. These possible dangers should be kept in mind at all times, both by managements considering acquisitions and by stockholders in companies where such matters are under consideration"

The three dangers are, firstly that the struggle for top positions in the combined firms will so engross and disturb key personnel that former smooth working teams will degenerate into a hotbed of internal fighting and friction. I like to think of this as a clash of cultures.

Secondly, that top management will get involved with so many problems in fields with which they were not previously familiar with that they will find themselves unable to carry on with their former efficiency. The classic example of this is when management spends an inordinate amount of time dealing with their new 'problem child' at the expense of their core business.

Finally, the seller nearly always knows more about his or her business than the buyer such that the acquirer subsequently finds faults far worse than allowed for in the price of acquisition.

"Many acquisitions do not turn out as planned. The sellers know more than the buyers and may know of problems or uncertainties that are not apparent to the buyers." Ed Wachenheim

"We have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale – a time when the business is likely to be walking ‘just fine.’" Warren Buffett

Mr Fisher notes that acquisitions that help integrate a company backward, such as acquiring a captive source of some of its raw materials, component parts or other supplies, seldom involve a sizeable degree of investment risk. This is because there is less likely to be a power struggle in management, the acquirer likely knows the business well and is unlikely to be out-traded with regards to purchase price. These acquisitions are unlikely, however, to be tremendously beneficial to the shareholder.

When it comes to acquisitions that integrate forwards, such as acquiring a captive customer outlet, similar expectations ordinarily apply. The exception to this is if management makes the mistake of acquiring one company that competes with a number of its existing customers and fails to allow for a loss of sales to these former customers as they are now deemed competitors. Mr Fisher notes ‘such a move can be very costly.’

Ordinarily small bolt-on acquisitions tend to be of limited risk yet too small to make much of a difference to the stock holder. Mr Fisher recognises "occasionally this is not true". Such a scenario is where the tiny acquired company brings a new product line which can be scaled by the acquiring company or when one or two outstanding individuals from the small company can make a major contribution to management; "Acquisition of this sort can not only be the least hazardous but also the most profitable in the entire field of mergers."

Mr Fisher finds the mergers or acquisitions that have the greatest prospect of being a long term success involve companies in similar lines of business that have been aware of each others activities for years and have a thorough understanding of each others problems.

Conversely, the greatest chances of a costly failure occurs when a merger or acquisition happens quickly between two companies in quite dissimilar lines that were previously only vaguely aware of each other. This is a red flag for shareholders. I can think of plenty of cases over the years where companies have acquired businesses outside their core competencies with disastrous results.  

"If a company must acquire something, I'd prefer it to be a related business, but acquisitions in general make me nervous. There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them." Peter Lynch   

“The fact of the matter is that, for most declining businesses, management tends to redeploy cash flow into things outside of their core competencies in a desperate attempt to save their jobs.” Jim Chanos

Mr Fisher notes the most successful record has been made by companies that only make acquisitions very occasionally, in similar businesses, and when all measurable factors seem overwhelmingly propitious. Such deals are usually a good deal for shareholders because the acquiring company "only does what comes naturally" and, is not “straining to be making deals" all the time.

“With acquisitions, patience is a virtue .. as is occasional boldness.” William Thorndike

“Two thirds of acquisitions don’t work. Ours work because we don’t try to do acquisitions — we wait for no-brainers.” Charlie Munger

Conversely there maybe quite a high degree of investment risk in a company that as a matter of basic management policy is constantly trying to grow by acquisition.These companies are what are commonly referred to today as 'roll-ups' - think Valeant [see more on the history and risks associated with 'roll-ups' here].  

Mr Fisher notes the risk is even greater when the CEO spends a sizeable amount of time on mergers and acquisitions or the company assigns one of its top officer group to making such matters one of its principal duties. In either event, powerful figures within a company usually acquire a sort of psychological vested interest in completing enough mergers and acquisitions to justify the time they are spending. I've witnessed a lot of permanent capital loss arising when the psychological forces of greed, groupthink, commitment and confirmation bias come to the fore in mergers and acquisitions.

"In the field of mergers and acquisitions, multi-million even billion-dollar deals get under way and the momentum builds, the rivalries among the players come to the fore, the game - a game it becomes - goes ahead, no holds barred. Someone is determined to win! They can taste it! All the cash lying on the table, all the supposedly solid rationale behind the deal, all the people involved-nothing matters except winning! "I want my way," says the biggest ego in the room! There are dreams of being in the press conference spotlight and big headlines in the Wall Street Journal. It's all too glamorous  and we convince ourselves that the numbers do add up - even when they are about as sound as astrological predictions. The "animal spirits" that John Maynard Keynes wrote of are more powerful than most business people would like to admit. Look at the recent dreadful fits - Daimler and Chrysler Time, Warner and AOL, Kmart and Sears, Quaker Oats and Snapple. Should these really have ever happened?" Donald Keough

"Berkshire, by design, had methodological advantages to supplement its better opportunities. It never has the equivalent of a "department of acquisitions" under pressure to buy. And it never relied on advice from "helpers" sure to be prejudiced in favour of transactions." Charlie Munger

The least desirable acquisitions are those where a not particularly attractive business is acquired at a very low price in relation to existing assets and past earnings. Mr Fisher notes that companies that would otherwise have been a magnificent opportunity for shareholders have a number of times been made quite unattractive by a management with one good line of great intrinsic strength and potential, acquiring several weak or run-of-the-mill businesses. Usually this is done with the explanation to shareholders that by diversifying the company's activities, the shareholders position is being strengthened. When this happens, the previously steady upward trend of the price of the company's shares sometimes comes to an abrupt and perhaps permanent halt.

"A serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette). Loss of focus is what worries Charlie and me when we contemplate investing in businesses that in general look outstanding." Warren Buffett

"Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated di-worsifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximised." Peter Lynch

Mr Fisher concludes that mergers or acquisitions, other than between companies in vastly different size in quite different lines of business, should be studied with the greatest care and greatest suspicion.  

"Mergers then may be summed up as matters the investment significance of which can vary enormously, one from another, depending on the nature of each. The really big ones, I believe, usually contain far more pitfalls to the shareholder than they do promise."

The more things change the more they stay the same. 

Roy Neuberger and Anti-fragility

I enjoy reading biographies and autobiographies from the Investment Masters, successful business icons and interesting individuals. I recently read Roy Neuberger's "So Far, So Good - the First 94 Years". Born in 1903, Mr Neuberger was a founding partner of the investment firm Neuberger & Berman. Mr Neuberger was a mentor to Jim Rogers and counted Alfred Winslow Jones [credited with starting the first modern hedge fund] as a client. At the time of writing he had spent 68 years on Wall Street. In that time, he'd never had a down year!

While the majority of the book is devoted to his love of art, there are nuggets of investment wisdom throughout including Chapter 11 which outlines the "Ten Principles of Successful Investing."

What I find most insightful are the lessons and ideas that contribute to investment success that have remained constant over a long period of time. In the terms of Nicholas Nassim Taleb, these ideas are "anti-fragile." In his book of the same name, Taleb notes,

"If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This simply, as a rule, tells you why things that have been around for a long time are not "aging" like persons, but "aging" in reverse. Every year that passes without extinction doubles the additional life expectancy.  This is an indicator of some robustness. The robustness of an item is proportional to its life!"

The Ten Principles:

1) Know Thyself - Mr Neuberger advises that before you begin studying companies for investment study yourself. Emotion is the great undoing of most investors and it's important to understand your own strengths, weakness, fears and biases.

2) Study Great Investors - Mr Neuberger advises, that while you should study the great investors, you should not follow them blindly. You must find a style that is appropriate for you. Mr Neuberger cites numerous examples (eg Warren Buffett, Ben Graham, Peter Lynch, George Soros), and all (with the exception of the private investors) feature prominently in the Investment Masters Tutorials.

3) Beware of the Sheep Market - Mr Neuberger recommends not falling in with the crowd. He cites the importance of doing your own research and choosing stocks based on merit not crowd behaviour.

4) Keep a Long Term Perspective - while the Wall Street community appears to be obsessed with finding out what is happening to corporate earnings from minute to minute, Mr Neuberger recommends keeping a long-term perspective. This is a common trait amongst the Investment Masters and is commonly referred to as "time arbitrage". He recommends four criteria that stand the test of time (1) a good product (2) a necessary product (3) honest, effective management, and (4) honest reporting.

5) Get in and out in time - timing might not be everything but it is a lot. Mr Neuberger notes timing is partly intuitive and partly contrary. He advises additional caution in bull markets and counsels to be quick getting out when you're wrong. 

6) Analyze the companies closely - Mr Neuberger recommends analysing company's management and assets. The trick is to find growth stocks before others and he warns against paying high P/E's for stocks. 

7) Don't fall in Love - Mr Neuberger highlights the need to be sceptical and flexible, not stubborn, about a stock. The last thing you want is to fall in love with a security.

8) Diversify, but don't hedge [short] - Although Mr Neuberger did indeed short stocks himself, he recommends it be done only with the help of someone experienced. He also suggests diversifying your investments.

9) Watch the environment - by environment, Mr Neuberger is referring to the general market trends as well as the world outside the market. He advocates the need to adjust to market conditions in which you are operating. He proffers watching energy supplies, auto sales, economic conditions and interest rates.

10) Don't follow the rules - Finally, Mr Neuberger suggests you find your own style, learn from your mistakes and be prepared to change.

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 most analysts spend their time building spreadsheet models, you’ll find the world's greatest investors spend their time reading and thinking. The tutorials that form part of the Investment Masters Class seek to identify the common threads within their thought processes. As each Investment Master is unique there are often differentiated insights and learnings to be garnered to complement these common threads. Studying investor letters, interviews and books can open up novel ways of thinking about companies, help with analysing investments and develop new insights previously not considered. It is the accumulation of knowledge across a broad spectrum of topics which builds wisdom.

Over the years, I’ve learnt something from almost every book I've read [my favourites are here]. Usually there’s at least one or two ‘Investing Nuggets’ to be picked up. An Investing Nugget often reinforces a view, at times it challenges a previously held conviction and occasionally it can open up a completely new way of thinking.  

I've included four '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 dispace them.  

When a reputation for quality and reliability in a company’s product is ackowledged 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.

The Goal of Investing

The Investing Goal? What Is It?

If you quiz most people regarding their investment ambitions, the answer is likely to be ..  "grow my money", or thereabouts. Joe average isn’t striving to beat an index, and he’s certainly not trying to capture ‘attractive risk-adjusted returns’. Quite simply, most people want an adequate nest egg for retirement; which requires the protection and growth of their capital at an attractive rate considering the effects of inflation.

Inverting the question, ‘What is it you want to avoid?’. Common sense would suggest the answer: "not lose my money".

It raises some industry issues…

Relative Returns

The industry is fixated on relative returns. Nowadays, the majority of funds are trying [and mostly failing] to beat an index. The foundation of this strategy is: stock markets generally rise over time, if you make a little more in up periods and lose a little less in down periods [ie. better relative returns], you'll end up with a lot more money compared to investing in an index fund. Those few percentage points of annual outperformance mushroom into significant return differentials as the time horizon expands.

Unfortunately, markets don't always go up. Indices, even mainstream ones, can go for long periods with negative returns. Consider Japan's Nikkei index and America’s S&P500. Having peaked in 1989 at nearly 39,000, the Nikkei’s current level is just 16,700. The S&P500 has spent quite a few ten year periods, and more, without a positive return.

"Investors can lose sight of the fact that the market has gone through long periods when returns were minimal. During the 14 year period from the middle of 1968 to the middle of 1982 the S&P500 appreciated by less than 1% per year.” Lee Ainslie

"Say you were forty-eight years old in 1964 and put $100,000 into the Dow on the last day of 1964 with instructions that dividends be reinvested, confident that you would have a nice nest egg when you retired at age sixty-five. When the last day of 1981 rolled around, your money would be worth statistically less than your initial investment because of a moribund market and the depredations of inflation." Leon Levy
 
“There have been periods of longer than a decade for which investing in the stock market in expectation of a 7 percent real return turned out to be a devastating mistake. It took the market twenty-five years to regain its levels of 1929.” Andy Redleaf

An index fund or a relative return strategy might not be appropriate for an investor who can’t look ten years or beyond.

While index returns can remain stubbornly low or negative for long periods, most individual investors fail to capture the index return regardless of when they enter the market. Numerous studies highlight most individuals significantly under-perform the index. Downturns scare them out, only do they re-enter once momentum returns; sell low, buy high.

"In 2014, Dalbar released its 20th report QAIB (Quantitative Analysis of Investor Behaviour) and the results for the two decades are very instructive. From 1994 to 2013, the average return of investors in 14 equity funds was 5.02% compared to 9.22% for the S&P 500. Over 20 years, the total return to investors was 166% versus 484% for the S&P 500. This is an astronomical difference. And this shortfall is what might be called a "behavioral penalty." Francois Rochon

In contrast, an index has no emotion, it doesn't get scared out at the bottom. An index rides out the lows.

While relative returns are standard in markets, they may not be aligned to most customer demands. The majority of investors would probably rather a +15% return in a +20% market, than a -15% in a market -20%. Yet, a relative return manager would be deemed more skilful delivering the latter.

“We start with a deep truth, which is that if you were to ask the average portfolio manager, would you rather compound at 14 percent a year and have the market compound at 15 or would you rather compound at four and have the market compound at three? The vast majority might take the latter choice, because they would say, well, my firm will be enormous. We’re the opposite. We would use, A, all day.” Chris Davis

While relative outperformance in a market downturn maybe acceptable, many investors struggle with large losses. Large negative returns, even if they are good on a relative basis, are more likely to scare an investor out of a fund at the exact wrong time.

Asset Allocation

The investment industry derived the ‘Asset Allocation’ process to help individuals achieve their retirement goals. This process states younger investors should have higher exposure to equities, given their higher long term historic returns. As an investor ages, equities exposure should be reduced and replaced with less volatile bonds.

In principle, an increased equity exposure makes sense for younger investors provided funds are regularly added to the account. Remembering, whether you lose 10% in year 1, 10 or 20, if the capital doesn't change, you'll end up with the same amount regardless of when the loss occurred.

Most asset allocation models, while they might adjust for age, make no reference to the relative attractiveness of each asset class. The manager with say, 60% equities exposure, is usually mandated to be fully invested. While she's the resident expert on equities she can't go to cash if suitable investments aren’t available. Her best bet is to buy defensive stocks. Unfortunately in a bear market, even these may not be spared.

“The idea that you say, “I’ve got 60 percent in stocks and 40 percent in bonds,” and then have a big announcement, now we’re moving it to 65/35, as some strategists or whatever they call them in Wall Street do. I mean, that has to be pure nonsense. I mean, 60/40 or 65/30 — it just doesn’t make any sense.” Warren Buffett

The bond manager with a 40% slice of the money has a few options. She can move to shorter duration bonds to help protect the fund from rising rates. But if rates are very low, as they are now, it maybe difficult, or impossible to earn attractive [real &/or nominal] returns. Time has not always been kind to bond investors.

“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital” David Dreman

Over the last 30 odd years, the typical 40/60 portfolio has delivered. Bond yields trended lower and equities, though volatile, have trended higher. That’s the rear view mirror. Today’s bond yields are at or near record lows. Bond risk appears more asymmetric; bond yields have little room to fall. They could rise a lot. Low yields no longer provide an attractive income stream. It's return-free risk.

You shouldn’t expect a 40/60 portfolio to deliver returns over the next 10 years that mirror the last 30 years. It’s not likely to happen.

What do the Investment Masters do..

The Investment Masters, unlike most mutual funds, are FIRST trying to preserve capital. Making money comes next. The focus is on absolute, not relative returns; avoiding the permanent loss of capital is paramount.

Index agnosticism combined with an ability to hold cash when opportunities are scarce differentiate durable versus fragile portfolios.

While the Masters portfolios may appear unconventional, they’re often more conservative. Conventional investing doesn’t equate to conservatism. A portfolio's historic performance may provide some colour to it’s conservatism, it can’t fortell the future risk of permanent capital loss; the risk that matters.

The Investment Masters acknowledge the cost of outperforming in down markets will be accompanied by under-performance in bull markets. In the quest for higher long term returns this is a worthy price to pay.

"We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%." Warren Buffett

Profits and Losses are Not Symmetrical

Consider the following two investment funds:

Fund A .. loses 50% in year 1, makes 50% in year 2 and then makes 10% in year 3
Fund B.. loses 50% in year 1, gets back to break-even in year 2 and makes 0% in year 3

Which would you prefer?  

Fund B should be your preference. You get your money back. Fund A is still down 17.5% at the end of year 3. To get back to break-even, Fund A would have needed to deliver +81.8% in year 2 (not +50%) and then 10% in Year 3.  

Is you fund focused on preserving capital? Is your fund focused on outperforming down markets while accepting of some level of under-performance in strong markets?  

The Top 12 Investment Books

Over the years I've read a lot of books on investing, many of which are on the great investors. I've included a lot of my favourites in the further reading section here. I've read all of the books in that section and learnt something from everyone of them. I'm constantly revisiting these books as they provide a different context to investment environments, in addition to assisting me to better understand investing and human biases. The following books are my Top 12. They cover many of the great investors, the psychology of markets and they provide a glimpse into financial history. I have included a brief description of each below. It wasn't easy coming up with the Top 12 as there are plenty of other great books. As the Investment Masters advise .. keep reading!

1) The Intelligent Investor - Benjamin Graham

The world's greatest investor Warren Buffett wrote "By far the best book on investment ever written". This book belongs on every investors bookshelf. Ben Graham was recognised as the 'Dean of Value Investing'. Covers the key concepts of Margin of Safety and Mr Market. Mr. Buffett stated “Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years, I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.”

2) Margin of safety - Seth Klarman

Mr Klarman runs Baupost Group, one of the world's most successful hedge funds. Timeless reading, Mr Klarman says "he wrote the book for the average person". While now out of print, this book provides great insights into the psychological aspects of investing, financial history, the inefficiency of markets and where to look for opportunities. Recommended by Warren Buffett, Bill Ackman, Joel Greenblatt, David Einhorn and Frank Martin.

3) The mind of wall street - Leon Levy

In my view one of the greatest minds of Wall Street, the late Leon Levy's book is his story of his life in the markets. Mr Levy was the founder of Oppenheimer Funds and started the hedge fund Odyssey Partners. With amazing insight Mr Levy's book written in 2002 forewarned of the coming financial crisis, the implications of the removal in 1999 of the Glass-Steagall Act of 1933 and the lessons of Hyman Minsky and 'Too big to Fail'. He outlined his prescient views on what would be the forthcoming troubles of the euro currency. The book mixes psychology with market intelligence.  On Bruce Berkowitz and Chris Mittleman's recommended reading list.  One of my favourite books.

4) The Essays of Warren Buffett

Warren Buffett is the greatest investor of the 20th century and he shares his wisdom through his annual Berkshire letters. This book collates the letters into various themes providing practical and sensible lessons for investors. The more investing books I have read the more I have come to realise that Mr. Buffett and Mr. Munger, together, really did work out the secrets to successful investing and business. Mr Buffet's ability to distil his thoughts and his generosity to share them is a gift to investors.  I am always revisiting this book for it's timeless wisdom. Recommended by Bruce Berkowitz, Tom Steyer, Seth Klarman and Mohnish Pabrai. A must read.

5) Poor Charlie's Almanack

Poor Charlie's Almanack provides a marvellous insight into the mind of one of the world's greatest investors. Covering the multitude of mental models used by Charlie Munger in his assessment of investments. More a coffee table book format this book contains endless wisdom that you will keep coming back to. Rated as the best book ever read by Mohnish Pabrai. On Bruce Berkowitz's recommended reading list.

6) the most important thing - Howard Marks

Howard Marks is the founder of the hugely successful Oaktree Capital Management. This book sets forth his investment philosophy with each chapter covering the various "important things" such as value, risk and investor psychology. Simple to read, this book will help formulate the mindset to be a successful investor. Recommended by Warren Buffett, Seth Klarman, Joel Greenblatt and Chris Davis.

7) The LITTLE BOOK OF VALUE INVESTING - CHRISTOPHER BROWNE

Christopher Browne started at his father's firm Tweedy Browne in 1969. This great little book is an easy read, laying out the basics of value investing in a simple and engaging manner. The book covers the topics of what to buy, where to look and how to analyse companies through Mr Browne's checklist. Recommended by Charles Royce, Marty Whitman and Bruce Greenwald. Another one of my favourite books.

8) The Outsiders - William Thorndike

The Ousiders is an exploration of 8 great American CEO's who built substantial value in their business such as John Malone, Henry Singleton and Katherine Graham. The book sets out the common characteristics of great leaders with particular emphasis on capital allocation. For the investor, the book provides a guide to identifying and finding company's that may be compounding machines. I've bought this book for numerous CEO's over the years. Outsiders was #1 on Warren Buffett's recommended reading list in 2012.

9) Fooled by Randomness - Nassim Nicholas Taleb

A great book on understanding the role of luck and skill in investing. Howard Marks of Oaktree cited 'Fooled by Randomness' as one of the most important books in shaping his thinking. This book will change the way you think about investing, probabilities, risk and the inherent uncertainty in the investing process. Like Taleb's other excellent books, Antifragile and Black Swan, not an easy read, but well worth the effort. 

10) The davis dynasty - John Rothchild

A fantastic book covering the history of one of Wall Street's greatest families, the Davis Family. Providing a vivid account of the financial markets in which they operated and the investment philosophy that enabled them to successfully traverse a multitude of market environments. This story of the Davis family enlightens readers to the trends, manias and follies through the last century and will better prepare them for a repeat of history.  Recommended by Mohnish Pabrai and Peter Bernstein.

11) A DECADE OF DELUSIONS - FRANK MARTIN

A Decade of Delusions contains the annual partner letters from Frank Martin of Martin Capital Management. The letters focus on the periods before and after the tech bubble in 2000 and before and after the Financial Crisis of 2008 and 2009. The comprehensive letters cover financial history, the psychology of investors and provide a real time commentary through two fascinating investment eras from the desktop of a great investor. Mr Martin set out the roadmap for what would become the tech crash and the greatest financial collapse since the great depression. A truly remarkable mind and a brilliant writer. This book is unequivocal evidence against the notion that no-one saw the Financial Crisis coming. Recommended by Warren Buffett and Seth Klarman.

12) Seeking Wisdom - From darwin to munger - Peter Bevelin

Seeking Wisdom from Darwin to Munger takes a tour of the evolution of man and wisdom.  The book focuses on how our thoughts are influenced, why we make misjudgements and tools to improve our thinking. The book covers biology, psychology, neuroscience, physics and mathematics and combines a collection of wisdom from Darwin, Einstein and Feynman to Munger and Buffett. The book will appeal to investors looking to broaden their knowledge and thinking when it comes to investing.  A Tour de Force.

The Evolution of a Value Investor

Over the years reading plenty of books on investing and studying many of the world's greatest investors I've come to recognise how truly insightful the combination of Warren Buffett and Charlie Munger really are.  

While Warren Buffett cites the book ‘The Intelligent Investor’ as "by far the best book on investing ever written" his style evolved over the years, in a large part influenced by Charlie Munger.  

"Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact Charlie had on me. It took a powerful force to move me on from Graham's limiting views. It was the power of Charlie's mind. He expanded my horizons" Warren Buffett

I think a lot of value investors evolve in a similar fashion. They start out on the hunt for cheap stocks and gradually they move towards the great businesses, the ‘compounding machines’, that can generate attractive returns over long periods of time. They transition from the search for low multiples for what are often poor businesses, to seeking truly great businesses at fair prices.

Here's a look at the evolution of Warren Buffett, as I see it.

The Buffett Partnership Years..

Warren ran the Buffett Partnership prior to undertaking his investment activities in Berkshire Hathaway where he employed a combination of value, event and activist investing styles. The portfolio was constructed to outperform in down markets and perform well [but likely under-perform] in very strong markets.  

Warren sought protection from weak markets by investing in uncorrelated strategies and focusing on bargain purchases. While the portfolio was unconventional when compared to the investment funds of then and now, Warren deemed it more conservative given its ability to protect capital in weak markets.

Many of the events Warren invested in are typical of the hedge fund strategies of today. These were split into three broad categories and their respective weighting were determined based on each categories level of attractiveness. Buffett named them the 'Generals', the 'Work-Outs', and the 'Controls'.

The 'Generals' consisted of generally undervalued securities where there was nothing to say about corporate policies and no timetable as to when the undervaluation would correct itself. They were bought primarily on quantitative factors [but with considerable attention to qualitative factors] with a margin of safety, a diversity of holdings and a 'bargain price' substantially below what careful analysis indicated value to a private owner to be. These securities would be sold at some level between what they were purchased at and what was regarded as fair value to a private owner. Warren sought good management, a decent industry and 'ferment' in a previously dormant management or stockholder group. While being most correlated with the stock market this portion of the portfolio was expected to achieve a satisfactory margin over the Dow over the years. Warren expected this category to be the star performer in a strongly advancing market.

The second category consisted of 'Work-Outs'. These strategies are typical of 'event' hedge funds today and include spin-offs, mergers, liquidations, sell-outs and re-organisation trades. These securities were purchased after company announcements. As the share prices depended on corporate action the timing of the return could be predicted. The attraction of this category was downside protection [most of the time] from falling markets, a big edge. The category was expected to be a drag on performance during bull markets. Despite the gross profits in each 'work-out' being quite small, the predictability coupled with a short holding period, produced quite decent annual rates of return with more steady absolute profits from year to year than the 'Generals'. Like modern hedge funds Warren used borrowed money to offset a portion of the 'work-out' portfolio. On a long term basis, Warren expected the 'work-outs' to achieve the same sort of margin over the Dow as attained by the 'generals'.  

The final category were 'Control' situations where Warren either controlled the company or took a very large position and attempted to influence policies of the company. This is akin to today's activist/private equity investors. Positions tended to develop from the 'generals' purchases unless a sizeable block of stock was purchased. Warren preferred to be passive unless an active role was considered necessary to optimise the employment of capital. This may have involved strengthening management, re-directing the utilisation of capital or effecting a sale or merger. When building stakes in 'control' situations the prices tended to be correlated with the stock market but once a position was built they tended to act more like the 'work-out' portfolio. Once control was achieved the value of the investment was determined by the value of the enterprise, not the market. The asset value was far less volatile than the stock market which provided downside protection in weak markets.  

In the early days, Warren remained focused on avoiding the permanent loss of capital and sticking with businesses he knew that could be bought at a significant discount to what a private owner may pay for the whole business. The 'Control' situations and 'Work-outs' provided the means to insulate the portfolio against market sell-offs. 

In 1969 Buffett announced his retirement from the partnership and returned funds and proportional interests in Berkshire Hathaway to the investment partners. The partnership had delivered an astonishing annual compounded return of 31.6%pa between 1957 and 1968 versus +9.1%pa for the Dow.

onto Berkshire Hathaway...

Berkshire Hathaway then became Warren's investment vehicle. Buffett met Munger in 1959 and they swapped investment ideas before Munger officially joined Berkshire as Chairman in 1968. While Buffett still engaged in activities such as merger arbitrage at Berkshire there was an increasing focus on 'Controls' and in particular, quality companies.

It was the acquisition of See's Candy that enlightened Munger and Buffett to realise they had under-estimated the value of quality.

“If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have,” Munger said. “And that’s because Graham wasn’t trying to do what we did.”

"See’s Candy did teach us both a wonderful lesson. And it’ll teach you a lesson if I tell you the full story. If See’s Candy had asked $100,000 more, Warren and I would’ve walked. That’s how dumb we were at that time. And one of the reasons we didn’t walk is while we were making this wonderful decision we weren’t going to pay a dime more, Ira Marshall said to us, “You guys are crazy. There are some things you should pay up for,” quality of business — quality, and so forth. “You’re underestimating quality.” Well, Warren and I instead of behaving the way they do in a lot of places, we listened to the criticism. We changed our mind." Charlie Munger

At See's Candy, Munger and Buffett recognised the enormous value of pricing power. Munger convinced Buffett it was better to pay a higher price for a great business than a cheap price for an average or poor business. Buffett expanded on his evolution at the 2003 Berkshire meeting:

"There was not a strong, bright red line of demarcation where we went from cigar butts to wonderful companies. But we moved in that direction, occasionally moved back, because there is money made in cigar butts. But overall, we’ve kept moving in the direction of better and better companies, and now we’ve got a collection of wonderful companies." Warren Buffett

At Berkshire, Munger and Buffett honed their investment skills. Peter Kaufman, in his excellent book 'Poor Charlie's Almanac' notes ‘Charlie's approach to investing is quite different from the more rudimentary systems used by most investors. Instead of making a superficial stand alone assessment of a company's financial information, Charlie conducts a comprehensive analysis of both the internal workings of the investment candidate as well as the larger, integrated "ecosystem" in which it operates. He calls the tools he uses to conduct this review 'Multiple Mental Models'. They borrow from and neatly stitch together the analytical tools, methods, and formulas from such traditional disciplines as history, psychology, physiology, mathematics, engineering, biology, physics, chemistry, statistics, economics and so on’.

Munger and Buffett sought businesses where a combination of factors could lead to extraordinary results, or as Munger called them, ‘Lollapalooza Effects’.  

The investment in Coke is a great example. Buffett paid a c25X price-earnings multiple for the last piece of Coke he bought. But Buffett and Munger recognised the enormous potential in the business. They started to focus more on a company's moat to protect the businesses economics, a company's ability to raises prices without hurting sales, the ability to re-invest incremental capital at very high rates of return, the huge operating leverage in the business, the large runway for global sales, the economies of scale from a massive distribution business and customer footprint [ie advertising] and the psychological factors that influence a company's customers decision to purchase and how these can be strengthened and reinforced. They also focused on the skill of management in deploying capital. This was the ultimate type of business.  

As Berkshire grew, it's range of investment opportunities like Coke became more limited. At Berkshire’s AGM in 2016 Munger noted they had to revert to Plan B.

More recently Berkshire has acquired far more capital intensive business like the railway business, Burlington Northern Santa Fe. While still a monopoly type of asset, the asset is far more capital intensive than a typical Buffett investment. Buffett has also invested in more mature businesses like Heinz with Brazilian investor 3G who has a reputation for streamlining businesses and getting them re-focused on growth.

It's no doubt Munger and Buffett would love to be able to outlay large licks of capital in attractive businesses like Coke was at the time of acquisition. Given their distaste for technology they have avoided the likes of Google, Ebay and Facebook. Outside of the technology angle these latter businesses would have ticked off a lot of the mental models that Munger loves .. winner-takes-all, first-mover-advantage, network effects, strong and growing moats, high return on incremental capital and economies of scale.

The greatest investing duo of the last century have evolved through the decades. They still focus on value yet their analysis of that value has evolved and improved. They have profressed their skills to better capture the power of compounding. And they are still evolving.

For further reading I highly recommend reading Buffett's Partnership letters, The Berkshire Hathaway annual letters and Poor Charlie's Almanac.  The recent lecture at UCA by Mohnish Pabrai on Berkshire's See's Candy/Coke investment is also excellent.

The Seven Deadly Sins of Portfolio Management

"Seven deadly sins, seven ways to die"

I read a great quote by Zeke Ashton of Centaur Capital on how funds blow up: 

“In almost every case of catastrophic failure that we’ve observed, we believe the root cause can ultimately be boiled down to one or a combination of just five factors. The five factors are 1) leverage 2) excessive concentration 3) excessive correlation 4) illiquidity and 5) capital flight.” Zeke Ashton

Most investors start the investment process by looking up. The objective: make money. Identify those stocks which can go up a lot and fill the portfolio with them. They focus on the upside. Very few investors start out by looking down. Instead they should be asking, “What could go wrong? What downside protection do the stocks provide? What happens if the expected scenarios fail to materialise? Are there existential risks?”

Charlie Munger has long advised "inverting" problems. As a portfolio manager, instead of first asking, "How can I make money?", ask, "How can I avoid that which loses money?" By ensuring individual stocks in the portfolio and the portfolio of stocks together minimise the risk of permanent capital impairment [aka the real risk of investing], you’ll be well on your way to investment success.

Below, I’ve outlined my observations of the key factors that blow-up funds, the ‘Seven Deadly Sins of Portfolio Management’ [I've added two more of my own]. Ordinarily it's a combination of these factors that get fund managers into trouble.

Sin 1 - Excessive Leverage

Remember leverage gives someone else the right to say when the game is over. Too much leverage at the portfolio level and/or in the companies that you own can lead to the permanent loss of capital. Within a long/short portfolio, high gross exposure [even when net exposure is low] can impair capital quickly if prices diverge the wrong way. For these reasons, the Investment Masters limit leverage and avoid companies with excessive corporate debt.

Leverage can also come in the form of derivative exposure or shorts. Both can provide unlimited downside, effectively wrong-way asymmetric bets. A telling example were the hedge funds that shorted Volkswagen in 2008. They learnt the hard way the asymmetrical danger of shorting. For a moment Volkswagen became the world’s most valuable company and a new term entered the investment lexicon, ‘getting Volkwagened’. Esoteric strategies using derivative structures can create unintended risks when unexpected circumstances arise. The normal distribution curves assumed in investment models can be upended by tail events.

‘Volkwagened’ Source: Bloomberg

Sin 2 - Excessive Concentration

Mistakes in investing are inevitable given the magnitude of variables involved and imperfect information. Having too much exposure to one stock or sector can be costly. Large positions can become illiquid and if they become publicly known, may attract predatory activity. The Investment Masters tend to limit their position sizes [even more so for shorts] to minimise this risk.

Sin 3 - Excessive Correlation

On occasion, stocks may become correlated and move in the same direction, offsetting the benefits of diversification. Correlations can "go to 1" in difficult market conditions. Things you expect to be uncorrelated may become correlated due to crowding, index implications, money flows, economic factors or geographic/geopolitical events. There is little protection in a bear market outside of short positions and cash. Investment Masters tend to seek diversification, limit sector exposure, hold cash and constantly consider and manage the potential correlation risks in the portfolio.  

Sin 4 - Illiquidity

Illiquidity hurts when an investment thesis changes and/or the portfolio manager needs cash and wishes to exit a position. At times, there may be no market to sell into. If investors can remove capital from a fund at any time this can create a liquidity crunch and a portfolio manager may need to sell assets that are ‘saleable,’ as opposed to those they would prefer to sell. This can lead to further portfolio concentration, further losses, and capital flight. The Investment Masters monitor portfolio liquidity and manage position sizes according to stock liquidity, overall portfolio liquidity and their mandate’s redemption criteria.

Sin 5 - Capital Flight

Capital flight occurs when investors demand their money back at the same time, ordinarily coinciding with weak markets and lower stock prices. Selling a stock at the lows results in the permanent loss of capital. Howard Marks often says ‘the cardinal sin of investing is selling the lows.’ It's even more risky when positions are illiquid. A negative feedback loop can develop where selling stocks to fund redemptions creates further losses and subsequent redemptions. The Investment Masters tend to seek like-minded investors who understand the investment process, have longer time horizons and/or seek more permanent sources of capital.

Sin 6 - High Flyers

When expensive stocks de-rate or a stock market bubble bursts, the result tends to be a permanent impairment of capital. For example, a portfolio loaded with tech stocks at the height of the Nasdaq boom in 2000 or in the ‘Nifty-Fifty’ stocks in the late 1960's ended in significant losses for investors when each bubble burst. The Investment Masters tend to adopt conservative forecasts and avoid paying excessive multiples for stocks unsupported by intrinsic value.

Sin 7  - Fraud

Fraudulent acts by investment managers or a company can be disastrous, a’la Bernie Madoff’s ponzi scheme and Enron’s accounting scandal. Ensuring you really understand how the businesses or funds you own operate and by analysing the long term track record of management will go a long way to avoid these problems. The fact the Investment Masters "eat their own cooking" helps align a managers interest with co-investors.

Summary

Thinking about how a portfolio is structured with regard to the ‘Seven Sins’ is a useful starting point. Almost every fund that has blown-up, and will blow-up in the future, will have one or more of these attributes.  

Portfolio management is a skill that requires a broader skillset than picking a bunch of stocks you like. It requires considered thinking. Each and every stock and it's respective size, valuation, riskiness, liquidity, cross-correlation, complexity etc must be considered in the context of the whole portfolio. Furthermore, having like-minded investors who understand your investment process and the nature and volatility of the likely return profile is also critical.

And choosing passive products is no panacea to avoiding these sins. Many index funds and ETF’s have excessive exposure to certain sectors and/or expensive stocks; they won’t be immune to capital flight and illiquidity in weak markets. You don't avoid these risks by being a passive investor. 

Remember, successful investing starts by not losing. Indulge in the ‘Seven Sins’ at your peril.

COMPOUNDING SHORT STORIES - A KING, COLUMBUS and INDIANS

Compounding really is the magic of investing. To be a successful investor you only have to do two things .. don't lose money and compound capital at a reasonable rate of return.

The Investment Masters understand that losing money inhibits the power of compounding and that is why they focus on avoiding the permanent loss of capital as opposed to beating an index.

Below are some of my favourite excerpts on the power of compounding. The story of the 'Peasant and the King' comes from the book 'Classics - An Investors Anthology' while the story of Columbus, the Mona Lisa and the Manhattan Indians come from Warren Buffett's early partnership letters. The final short extract comes from a 2011 letter from Jeremy Grantham.

The Peasant and the King ['Classics - An Investors Anthology']

And then there was the king who held a chess tournament among the peasants- I may have this story a little wrong, but the point holds- and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third-and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels [18,500,000,000,000,000,000] or enough, if each kernel is a quarter inch long, to stretch to the sun and back 391,320 times That was nothing more than one kernel's compounding at 100 percent per square for 64 squares. 

[This story really does highlight the absurdity of achieving 100% returns a year. Assume a 20 year old lives to 84 years [equivalent to 64 chess board squares of investing years] and starts with $1. Doubling his stake every year the old man would end up with $18,500,000,000,000,000,000]

Columbus's Journey - The Joys of Compounding [Buffett Partnership Letter 1962]

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

Mona Lisa - Joys of Compounding - Part II [Buffett Partnership Letter 1963]

Now to the pulse-quickening portion of our essay. Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu 4,000 converted out to about $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment.

However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound. Below are shown the gains from $100,000 compounded at various rates:

It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.

Some of you may be downcast because I have not included in the above table the rate of 22.3% mentioned on page 3. This rate, of course, is before income taxes which are paid directly by you --not the Partnership. Even excluding this factor, such a calculation would only prove the absurdity of the idea of compounding at very high rates -- even with initially modest sums. My opinion is that the Dow is quite unlikely to compound for any important length of time at the rate it has during the past seven years and, as mentioned earlier, I believe our margin over the Dow cannot be maintained at its level to date. The product of these assumptions would be a materially lower average rate of compound for BPL in the future than the rate achieved to date. Injecting a minus 30% year (which is going to happen from time to time) into our tabulation of actual results to date, with, say, a corresponding minus 40% for the Dow brings both the figures on the Dow and BPL more in line with longer range possibilities. As the compounding table above suggests, such a lowered rate can still provide highly satisfactory long term investment results.

Manhattan Indians - The Joys of Compounding Part III [Buffet Partnership 1964]

Readers of our early annual letters registered discontent at a mere recital of contemporary investment experience, but instead hungered for the intellectual stimulation that only could be provided by a depth study of investment strategy spanning the centuries. Hence, this section.

Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.

Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.

So much for that.

Some of you may view your investment policies on a shorter term basis. For your convenience, we include our usual table indicating the gains from compounding $100,000 at various rates:

This table indicates the financial advantages of:

(1) A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah Technique)

(2) A high compound rate

(3) A combination of both (especially recommended by this author)

To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.

Finally, an extract from Jeremy Grantham's 2011 Letter..

I briefly referred to our lack of numeracy as a species, and I would like to look at one aspect of this in greater detail: our inability to understand and internalize the effects of compound growth.

This incapacity has played a large role in our willingness to ignore the effects of our compounding growth in demand on limited resources. Four years ago I was talking to a group of super quants, mostly PhDs in mathematics, about finance and the environment. I used the growth rate of the global economy back then – 4.5% for two years, back to back – and I argued that it was the growth rate to which we now aspired. To point to the ludicrous unsustainability of this compound growth I suggested that we imagine the Ancient Egyptians whose gods, pharaohs, language, and general culture lasted for well over 3,000 years. Starting with only a cubic meter of physical possessions (to make calculations easy), I asked how much physical wealth they would have had 3,000 years later at 4.5% compounded growth.

Now, these were trained mathematicians, so I teased them: “Come on, make a guess. Internalize the general idea. You know it’s a very big number.” And the answers came back: “Miles deep around the planet,” “No, it’s much bigger than that, from here to the moon.” Big quantities to be sure, but no one came close. In fact, not one of these potential experts came within one billionth of 1% of the actual number, which is approximately 10^57, a number so vast that it could not be squeezed into a billion of our Solar Systems. Go on, check it. If trained mathematicians get it so wrong, how can an ordinary specimen of Homo Sapiens have a clue?

Well, he doesn’t. So, I then went on. “Let’s try 1% compound growth in either their wealth or their population,” (for comparison, 1% since Malthus’ time is less than the population growth in England). In 3,000 years the original population of Egypt – let’s say 3 million – would have been multiplied 9 trillion times! There would be nowhere to park the people, let alone the wealth. Even at a lowly 0.1% compound growth, their population or wealth would have multiplied by 20 times, or about 10 times more than actually happened. And this 0.1% rate is probably the highest compound growth that could be maintained for a few thousand years, and even that rate would sometimes break the system.

The bottom line really, though, is that no compound growth can be sustainable. Yet, how far this reality is from the way we live today, with our unrealistic levels of expectations and, above all, the optimistic outcomes that are simply assumed by our leaders. Now no one, in round numbers, wants to buy into the implication that we must rescale our collective growth ambitions.

STUDY HISTORY

"History never repeats itself but it rhymes." Mark Twain

Studying history can provide an enormous edge in investing. While history never exactly repeats itself I have witnessed plenty of examples over the last twenty plus years that leave me convinced that a lot of what happens we've seen before. Hopefully this post will highlight that there is never much new in investing.

One of the most memorable examples for me was just ahead of the Financial Crisis when the credit markets had slammed shut in late 2007 after the initial Bear Stearns hedge fund liquidity problems in June was followed by a run on the UK lender Northern Rock in September. Northern Rock was subsequently bailed out by the UK government. I was in charge of the Hedge Fund advisory business at a global investment bank which had just IPO'd a 'shadow banking' home lender whose funding relied on the wholesale credit markets. While the credit markets were effectively closed, the equity market did not peak for another month [See chart below]. At the time I was reading about Jessie Livermore. This paragraph about Jessie Livermore stood out to me at the time..

"While his tape-reading skills were still important, they were not as important as studying the fundamentals of each company and the credit conditions of the stock market and the economy. His first successful “raid” on the stock market based on his sound, fundamental studies occurred during the Panic of 1907. As credit conditions tightened and as a number of businesses and Wall Street brokerages went bankrupt during the summer, Livermore could sense that something was wrong – despite the hopes of the public evident in the still-rising stock market. Sooner or later, Livermore concluded, there will be a huge break of epic proportions. Livermore continued to establish his short positions, and by October, the decline of the stock market started accelerating with the collapse of the Knickerbocker Trust in New York City and Westinghouse Electric. J.P. Morgan eventually stepped in to avert the collapse of the banking system and the New York Stock Exchange, but only after Livermore managed to make more than one million dollars by shorting the most popular stocks (and covering on a plea from J.P. Morgan himself) in the stock market."

Keen to learn more about this era, I picked up the book 'The House of Morgan' by Ron Chenow which chronicled the history of J.P Morgan. A few chapters provided an excellent summary of the booming stock market of the late 1920's ahead of the ensuing crash and great depression.

During the 2009 Financial Crisis I wrote a note to my clients titled, ‘How Will We Look Back on This Crisis’. The note was a compilation of quotes from this 1990 book and while they referred to the 1920's and 1930's they were just as apt to the modern times. Consider the following ...

"Prophets of the age espoused an ideology of endless prosperity and talked of a new economic era."

The Fed's Greenspan and others, ahead of the Financial Crisis, were espousing the 'Great Moderation.' Greenspan presided over nearly two decades of prosperity and the lavish praise on the economy reflected the belief that Greenspan's deft changes in interest rates and crisis interventions had stabilised the economy without rekindling inflation.

In his book 'The Most Important Thing,' Howard Marks noted, "On November 15, 1996 The Wall Street Journal reported on a growing consensus, ‘From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging; The big, bad business cycle has been tamed.’"

"For many pundits, the sheer abundance of cash precluded any crash."

"There is a vast amount of money awaiting investment. Thousands of traders have been waiting for an opportunity to buy stocks on just such a break as has occurred over the last several weeks. The excess cash was viewed as a sign of wealth, not an omen of dwindling opportunities for productive investment."

Greenspan cut interest rates after the tech crash and left rates low which fuelled a rally in asset prices.

"Riding this cash boom, the American financial services industry grew explosively."

The American financial system also grew explosively ahead of the Financial Crisis. During the peak of the housing boom, in October 2007, the S&P Financials sector reached 20.1% of the S&P 500. Not even two years later in March 2009, that weighting had collapsed to 8.9% - the same level of twenty year’s prior. In tandem, the shadow banking market had expanded rapidly.

"There was a fad for foreign bonds, especially from Latin America, with small investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad Latin American debt and packaged it in bonds that were sold through their securities affiliates."

Let's rephrase that … "There was a fad for mortgage backed bonds, especially from sub-prime borrowers with global investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad mortgage debt and packaged it in bonds that were sold through their securities affiliates."

"The 1920s were also a time of manic deal making. As Otto Kahn recalled, there was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The public was so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments."

Let's rephrase that … "The years leading into the Financial Crisis were also a time of manic deal making. There was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The private equity funds were so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments."

"Wall Street was being swept by new forms of leveraging… many brokerage houses, including Goldman Sachs, introduced leveraged mutual funds, called "investment trusts". A second favourite device was the holding company. Holding companies would take over many small operating companies and use their dividends to pay off their bond holders, who had financed the takeovers in the first place. This permitted an infinite chain of acquisitions."

Wall Street was awash with new forms of leveraging before the Financial Crisis. RMBS', CDO's, CDS, SIV's, PIK loans and many other types of credit derivatives were growing exponentially. In April 2007, The Economist noted "According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year. With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion. The investment banks and private equity firms were up to their eyeballs in debt fuelled acquisitions.”

"As masters of leverage, the Van Sweringens used each new purchase as collateral for the next. Their holding companies took control of other holding companies in an endless hall of mirrors, all supported by little cash but powerful Morgan connections. By 1929, the Van Sweringen railroads ruled America's fifth largest railroad system atop a forty story Cleveland tower and controlled trackage equal in length to all Britains railroads."

This was close to home for me. It sounded very much like Babcock & Brown [which ultimately went bust], not to mention the investment banks and private equity firms.

"Leffingwell subscribed to the cheap-money theory of the crash, that is he blamed excessively low interest rates for the speculation in stock. In 1927, Monty Norman had visited New York and asked Ben Strong [Governor of Federal Reserve] for lower interest rates to take pressure off the pound. Strong obliged by lowering the discount rate. Leffingwell believed this had triggered the stock market boom. In early March 1929, when Leffingwell heard reports that Monty was getting 'panicky' about frothy condition on Wall Street he impatiently told Lamont "Monty and Ben have sowed the wind. I expect we shall have to reap the whirlwind .. I think we are going to have a world credit crisis"

Many observers also blamed The Fed's Greenspan for keeping rates artificially low after the tech bubble for inflating the housing bubble and booming stock market. It too ended in a world credit crisis.

"Were the increasing number of stock mergers grounds for concern? And should the federal government take action to stop speculation on Wall Street."

Mergers and acquisitions surged in the year before the Financial Crisis, all funded with cheap debt and lax lending covenants. Ahead of the crisis, the Fed's Greenspan was confident the stability and structure of the financial markets had improved and it was not the Fed's job to address asset bubbles.

"Both the market and public faith in bankers were collapsing."

The public at large and the publics faith in bankers collapsed after Bear Stearns was bailed out, Lehman went bust and the Fed had to bail out the banking system at large.

"Harrison [took over the Fed in 1928 after Strong's death] lowered interest rates and pumped in billions of dollars in credit to buoy banks with heavy loans to brokers."

Ben Bernanke, Harrison's equivalent, also aggressively lowered interest rates and the US Treasury pumped more than a trillion dollars into the financial companies via TARP, swap lines and other measures in an attempt to stabilise the system. 

"He bought up to $100 million in government bonds per day and made sure Wall Street banks had adequate reserves with which to deal with the emergency. In scale and sophistication, his post crash actions made Pierpont's in 1907 look antediluvian in comparison, for he expanded credit as needed. Harrison confirmed the principle of government responsibility in financial panics."

Bernanke also expanded the Fed's balance sheet and provided credit to financial institutions. He expanded the collateral accepted and his actions were on an unprecedented scale. On numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority to authorise new broad-based programs and financial assistance to individual institutions to stabilise financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008.

"The stereotype of bankers as conservative, careful, prudent individuals was shattered in 1929."

Certainly bankers reputations were decimated following the Financial Crisis.

"The consequences of such an economic debauch are inevitable," said the Philadelphia Fed Governor. "Can they be corrected and removed by cheap money? We do not believe they can." .. That fall Hoover complained to Lamont about bear raids, short selling and other unpatriotic assaults against national pride. The following year would be the worst in stock market history."

The Fed also attempted to resolve the crisis with cheap money. In 2008 the US's SEC banned short selling of financial companies to ‘protect the integrity and quality of the securities market and strengthen investor confidence.’ The U.K. FSA took similar action.

"The House of Morgan arranged a $10m line of credit. Under Whitney's tutelage, the old Kidder, Peabody was folded."

On Friday March 14, 2008, Bear Stearns secured a 28-day loan from JPMorgan and thought it would receive access to the New York Federal Reserve’s discount window for additional funding. Those hopes were dashed before the weekend was out though, and by that Sunday the firm had been sold to JPMorgan for $2, a price ultimately raised to $10 two weeks later.

"A proposed rescue plan for the Bank of the United States got a cool reception on Wall Street, even after Leutenant Governor Herbert H. Lehman, the state banking authorities, and the new York Fed all pleaded for it. The regulators wanted to merge the Bank of the United States with three other banks, backed by a $30 million loan from Wall Street Banks."

"At an emotional meeting, Joseph A Broderick, the state banking chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Broderick reminded them how they had just rescued Kidder, Peabody and how they had banded together years before to save Guarantee Trust."

"But they refused to save the Jewish bank, pulling out of their $30 million commitment at the last minute. "I asked if their decision to drop the plan was final", Broderick recalled. "They told me it was. Then I warned them they were making a colossal mistake in the banking history of New York." The biggest bank failure in American history, the Bank of the United States bankruptcy fed a psychology of fear that already gripped depositors across the country."

Let's rephrase that … "A proposed rescue plan for Lehman Brothers got a cool reception on Wall Street, even after Henry Paulsen, the US Treasury Secretary , and the New York Fed all pleaded for it. The regulators wanted to merge Lehman Brothers with Barclays Bank or Bank of America."

"At an emotional meeting, Timothy Geithner, the NY Fed chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Geithner reminded them how they had just rescued Bear Stearns and how they had banded together years before to save Long Term Capital Management."

"But the UK regulator refused to approve the deal with Barclays and save the bank at the last minute. ‘I asked if their decision to drop the plan was final,’ Geithner recalled. ‘They told me it was. Then I warned them they were making a colossal mistake in the banking history of New York.’ The biggest bank failure in American history, Lehman Brothers bankruptcy fed a psychology of fear that already gripped depositors across the country."

".. The banks failure shook confidence across America, It was a failure that could have been easily avoided by the proposed merger."

The failure of Lehman Brothers shook confidence across America.

"The Morgan-Hoover feud over debt was mild compared with their debate over short selling on Wall Street.. Hoover now shared the average American's view of Wall Street as a giant casino rigged by professionals."

"Now the crisis shifted to London, as investors traced financial ties between Germany and England. During the summer of 1931, investors dumped sterling in massive amounts."

"Prime Minister Ramsay MacDonald and Philip Snowden knew the pound couldn't be defended without a foreign loan."

"Foreign bankers insisted that he close the budget gap as the pre-condition for a loan. But any such austerity talk bought outcries from Labour ministers, who saw it as a betrayal of their followers to appease rich bankers".

Similarly, the crisis in the US travelled to Europe where the Euro came under pressure as a result of the PIGS [Portugal, Italy, Greece and Spain] economic turmoil and their inability to pay off their debts. The German government demanded austerity measures as a condition of a bail-out.

The Global Financial Crisis and the early 1920's and 1930's had strikingly similar conditions. Many of the issues that arose had been experienced before. Most of what occurred was not new. The packaging of sub-prime loans ahead of the crisis was a replay of banks activities in the late 1920's. Once again, from the 'House of Morgan'..

"Pecora also studied the operations of the National City Company whose 1900 salesmen had unloaded risky Latin American bonds on the masses. It emerged that in touting bonds from Brazil, Peru, Chile and Cuba to investors, the bank hushed up internal reports on problems in these countries. After bank examiners criticised sugar loans made by the parent bank, the securities affiliates sold them as bonds to investors.”

In the Financial Crisis the Investment Banks were also charged with unloading poor quality loans on unsuspecting buyers. The rating agencies aided and abetted this process by placing AAA ratings on some of the sub-prime loan tranches. That too had happened before in the junk bond crisis of the 1980's. In Seth Klarman's 1991 book, 'Margin of Safety' he notes..

"One of the last junk-bond-market innovations was the collateralised bond obligation [CBO]."

"What attracted underwriters as well as investors to junk-bond CBO's was that the ratings agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment grade rating."

"The existence of CBO's was predicated on the receipt of the investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of extra basis points above the yield on other investment-grade securities.”

"The rating agencies performed studies showing the investment-grade rating was warranted. Predictably these studies used historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate re-financings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it."

History repeats, it's deja vu all over again. Spending the time to understand the history of financial markets will help you avoid some of the pitfalls investors often fall into. Some of my favourite books that touch on the history of the markets include The Davis Dynasty [1930's onwards], A Decade of Delusions [Tech Crash and Financial Crisis], Too Big to Fail [Financial Crisis] and the House of Morgan [great chapters on the 1920's and 1930's]. 

Edward Chancellor in 'Capital Returns' noted, ‘It's not true, however, to say nobody in the financial world saw it [the Financial Crisis] coming. On the contrary, in the years prior to 2008 many serious investors and strategists were alert to the dangers posed by strong credit growth, dubious financial innovation and the appearance of various housing bubbles around the world.’ Seth Klarman noted in 2008, ‘People say that what has happened recently was completely unpredictable and god knows how many sigma event, but that's just not right. This was completely predictable and I could cite eight or ten people who in one way or another predicted it.’ I concur. In the Baupost’s 2005 Annual Letter, Klarman noted..

"Finally, as Northern Trust’s Paul Kasriel recently highlighted in the New York Times, household borrowing is out of control, and this debt is clearly propping up the U.S. economy. By way of example, in the third quarter of 2005, households spent a record annual rate of $531 billion more than their after-tax earnings. Historically, consumers regularly earned more than they spent; the recent binge in borrowing for consumption is truly unprecedented. It has (thus far) resulted in consumer spending at a record high 76% share of GDP.

"Consumers are using their increasingly valuable homes as quasi-ATMs, extracting $280 billion of cash through home equity borrowings in the second quarter of 2005 alone. This is a surprisingly new phenomenon; in the last three decades of the 1900s, there was virtually no net home equity extraction by consumers. While we cannot predict how these excesses will play out, it seems clear that such trends cannot continue indefinitely, and that a restoration of fiscal sanity will bring with it wrenching, largely unexpected, and painful adjustments.

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalysable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system."

If you remain in doubt I suggest you read Frank Martin's excellent book. ‘A Decade of Delusions’ which contain his annual letters from before and during the crisis. He laid out a prescient roadmap of the carnage that was to become the Global Financial Crisis. The 2005 and 2006 annual letters include the following headers “The Perfect Storm?,” “The Blossoming of the Financial Economy: The Cataclysm in the Creation of Credit,” “Bubbles Are Indigenous to the Financial Economy,” and “If Housing Prices Roll Over.” Chapter 10 (2007 MCM annual report excerpts) included a draft letter to clients in 2007 proposing a strategy to buy put options on selected investment banks, as well as subtitles that included, “Edging toward the Precipice” and “Credit-Default Swap Alchemy: Transmuting Junk into Gold.”

ROLL UP ROLL UP - CIRCUS TRICKS

A roll-up is effectively an arbitrage play.  An acquisitive listed company buys another company [usually unlisted, but not necessarily] on a lower multiple which ordinarily is accretive to the acquirers earnings.  The market/analyst community rewards the acquisitive company with high future earnings forecasts and a higher multiple to reflect this higher growth. 

The acquisitive company is often consolidating a fragmented industry and the stock market puts a premium multiple on the company which allows the acquisitive company to raise equity or debt to continue to buy other assets [ie roll-up the industry] and drive earnings.  It becomes a circular function.  It all works well in theory until it doesn't.

Over the years I've seen a lot of roll-ups blow up and usually there are a number of common factors involved.  

David Einhorn described the process in his book 'Fooling Some of the People All of the Time' when discussing his short position in 'Century Business Services (CBIZ), a 'roll-up' of accounting service firms with lousy accounting itself'  ...

"In a roll-up, a consolidator typically buys small, private companies at a lower multiple than the consolidator receives in public markets.  Every acquisition is accretive to earnings, which drives the stock price higher and enables the consolidator to use its currency to do more acquisitions of private companies in a never ending virtuous circle."

The discussion on roll-ups is well explained by George Soros's REFLEXIVITY theory in his book the Alchemy of Finance [see The Case for Mortgage Trusts - pg61]. In discussing the roll-up trend in mortgage trusts Soros notes..

"The conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price investors may be willing to pay for those earnings.  This method is inappropriate to the analysis of mortgage trusts because the price investors are willing to pay for shares is an important factor in determining the future course of earnings."

The key difference between a roll-up and a normal corporate is that the roll-up requires an ongoing premium market multiple to continue to drive growth and maintain that premium multiple. Plenty of analysts overlook this FACT.   

Most companies earnings are not reliant on the whim of the stock market [financials/highly geared companies can be an exception]. Seth Klarman explains this with reference to George Soros's REFLEXIVITY theory in his book Margin of Safety..

"Stock price[s] can at times significantly influence the value of a businesses.  Investors must not lose sight of this possibility.  Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability and bankruptcy."

Common Problems

Poor acquisitions - M&A is not easy and most transactions fail.  In the case of selling businesses, the vendors are in a position of power. They know the business better than the buyer.

"We have all the difficulties in perceiving the future that other acquisition minded companies do.  Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking 'just fine.'" Warren Buffett

Lack of Organic Growth - the roll-ups typically need acquisitions to fuel growth as pedestrian underlying growth alone will not justify the high multiple placed on the company.   When management is largely focused on acquisitions often their existing business are mis-managed and promised acquisition synergies may not materialise.

Accounting Issues - There can be questionable practices in regards to accounting of the acquired companies to boost EPS growth. While accounting earnings may look good often cash flow does not.

Law of Large Numbers - In the early days, a roll-ups acquisitions tend to represent a larger percentage of the underlying asset base so can be highly accretive. Over time, larger and larger acquisitions are required to move the dial on EPS growth as the asset base expands.  As the industry consolidates, often imitators enter the market increasing competition and the prices to be paid for further business acquisitions. Larger acquisitions tend to increase the risk profile of the company and may require bridging finance.

Debt - Roll-ups often utilise debt as an interim measure to fund acquisitions prior to equity raising. As debt levels rise risk also rises. When combined with accounting issues [ie earnings higher than cash flow] this can be a deadly combination. 

Marathon Asset Management remind us..

"When debt propels growth rates and equity returns higher, enthusiastic investors may too easily forget the dangers inherent in financial leverage."

"When conditions change, very quickly (and more often than not, very unexpectedly) debt, hitherto unnoticed takes centre stage.  Those who comfortably applauded the results of leverage in the good times then find themselves caught in a negative spiral as the process reverses."  

Fraud/Over Promotion - when management need to keep promising growth via acquisitions there can be a temptation to try and paper over underlying business issues to meet market expectations.

Overconfidence/Groupthink  - when a management team has made a string of successful acquisitions they can become overconfident. Without a thorough unbiased review of the business, a board may overlook risks involved in the acquisition process.

"Of one thing, however be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairytales are emperors told they are naked." Warren Buffett

The end result is ordinarily an equity market de-rating of the stock.   When expectations of strong growth slow the stock price can get decimated as analysts cut their earnings forecast and investors no longer are willing to pay such a high premium. A double whammy - earnings and PE de-rate. When equity prices sink below the price of previous capital raising investors often lose support for the stock. Stocks can enter a death spiral.

Both Warren Buffett and George Soros have discussed the conglomerate roll-ups in the 1960's.  In the Alchemy of Finance, Soros noted ..

"The key to the conglomerate boom was a prevailing misconceptions among investors. Investors had come to value growth in per-share earnings and failed to discriminate about the way earnings growth was accomplished." 

Warren Buffett's 2014 Annual Letter also touched on the subject.

“In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his “bold, imaginative accounting.” Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be.

 Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice. Once again, it became evident that business models based on the serial issuances of overpriced shares – just like chain-letter models – most assuredly redistribute wealth, but in no way create it. Both phenomena, nevertheless, periodically blossom in our country – they are every promoter’s dream – though often they appear in a carefully-crafted disguise. The ending is always the same: Money flows from the gullible to the fraudster. And with stocks, unlike chain letters, the sums hijacked can be staggering.

At both BPL and Berkshire, we have never invested in companies that are hell-bent on issuing shares. That behaviour is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.” 

Valeant Corporation is a more recent example of a roll-up that has been decimated.

Omega's Leon Cooperman described the issues on CNBC recently ..

“I’ve seen this movie before. The company grew as a result of a roll-up strategy.  They took a high priced stock, bought a lot of businesses, used a lot of debt.  They lost their multiple which meant their equity was not a currency for acquisition and they’ve exercised their debt option so they couldn’t put more debt on the balance sheet and do acquisitions. So the market is striving to figure out what the internal level of recurring earnings is and this companies faux pas is statements or restatement that don’t engender any confidence.”

Wally Weitz of Weitz Investment Management stated on Wealthtrack that when he asked the Valeant CEO how he managed a far-flung business the CEO responded "we tell managers 'make your numbers or we will get someone who will.'" Mr Weitz noted "When there is pressure from the top to make numbers, sometimes people succumb to that and bad things happen. Management is so important," “The Philidor deal made us wonder what other arrangements they might have."

As Warren Buffett has reminded us ..

“Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.” 

And Marathon Asset Management note..

“An obsession with growth, combined with over-promotion, is likely to end in tears.” 

And it's not a new phenomena. Phil Fisher recognised the risks of an acquisition focused company in 1960 .. 

"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

In a recent interview with the FT famed short seller Jim Chanos talked how he liked to find short positions in roll-ups and what he saw at Valeant ..

"We're just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they're actually growth companies by virtue of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between announcement of the deal and the closing of the deal so they look better once you fold them in. And so we love those kinds of stories, the roll-ups, or as they been deemed, the 'platform companies.’”

"Valeant is a good example. The first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said : "this looks like Tyco." In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell bent on buying companies and making them fit no matter what."

".. and again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sort of things before. And having a person running a company to please Wall Street can be really problematic, and even on the first pass though you would see that with a company like Valeant, and that's why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to.. for a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great roll-ups of the late 90s and early 2000s. So I think that was helpful for us."

"So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and WorldCom.  You're probably on the right track if you're a short seller if it reminds you of not only one of those, but three of those."

Chanos's first problem was it's way of doing business.  Cutting R&D spend at the acquired companies and raising drug prices of the newly acquired drugs to boost earnings.  Chanos believed earnings were overstated as there was no R&D spend to support future earnings as drugs don't last forever.

"So he [the Valent CEO] got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5."

Not everyone avoided losing money on Valeant including famed investors Bill Ackman and Sequoia Funds.  Ackman made an exception for Valeant .. From the Interim 2015 Pershing Square Holdings Report...

"We select investments in companies that meet our extremely high standards for business quality. We primarily invest in businesses that are simple, predictable, and free-cash-flow-generative with substantial barriers to competition and strong pricing power due to brands, unique assets, long-term contracts, and/or dominant market position. We vastly prefer businesses that have limited exposure to macroeconomic factors by generally avoiding companies that are highly exposed to commodity prices, material changes in interest rates, and other extrinsic factors we cannot control. We focus on large capitalization, North-American-domiciled businesses that earn the substantial majority of their profits in North America. We often hedge large non-U.S. currency exposures in the portfolio. We seek investments that trade at a discount to intrinsic value as is, and an even wider spread as optimized.

The result of this approach is a portfolio comprised of the highest quality collection of businesses that we have ever owned, managed by the strongest management teams that we have worked with, all trading at substantial discounts to intrinsic values. These businesses are generally conservatively financed, often investment grade or soon to be, generate substantial amounts of recurring free cash flow, typically don’t need access to equity capital to survive or thrive, and often return capital to shareholders through buybacks or dividends. As a result of these characteristics, the intrinsic value of the businesses we own is not particularly correlated with equity or credit market volatility.

We may make occasional exceptions to the above principles if we believe the additional risks are compensated for by greater potential profitability. For example, we own a number of highly acquisitive businesses, namely – Valeant, Platform Specialty Products and Nomad – for whom access to capital is necessary to achieve accelerated growth. Even in these cases, however, if the capital markets were to shut, their growth would slow from their current extremely high levels, but their businesses would remain profitable and cash generative. In each case, the current valuations reflect no value for these companies’ ability to make economically attractive acquisitions."

Even the world's best investors make mistakes.  So what are the lessons for investors.  Some traders [eg Soros] have profited from identifying roll-ups in the early stages of their growth/industry consolidation phase given their growth prospects and reflexivity. 

However, being on the wrong side of a roll-up can lead to the permanent loss of capital.  If you are going to buy a company reliant on acquisitions for growth watch out for the pitfalls outlined above. I'll let Buffett conclude...

"I think if you had to look at one of the primary indicators of what sort of species you’re viewing, you would see whether somebody’s issuing — if they’re issuing stock continuously, one way or another, they’ve probably got a chain letter game going on. And that does come to a bad end." Warren Buffett