Learning from Rory Sutherland

What if, as an investment opportunity, I offered you a stake in a beverage business that had one drink as their product and that the drink possessed a taste that everyone hated. Would you invest in that? Probably not, right? And why? Because it wouldn’t be logical.

But what if I offered you a stake in the same business, but in this instance I told you the business was Red Bull? How about now? Would you invest?

As human beings we are often shackled by our beliefs and indeed, need for things to fit into neat, logical reasoning. We search for validation for our decisions based on mathematical models; if the spreadsheet says it will be successful, then, logically, it must be.

By contrast, some of the most innovative products ever to grace our markets were developed using everything but. Logic simply never came into it. They were the product of imagination and daring and luck, and often in fact, despite this, those truly innovative products were at first rubbish. The first cars were certainly no better than horses, and the first airplanes were nothing more than flying death traps. Would you have invested in those businesses when those products were first invented? Few would, because there was no logical argument to support doing so. Yet now, those same products are revered in our society and their markets are worth billions. If we had of applied logic to the business cases when they were first developed, those two products alone would probably still be sitting on the scrap heap, and no one would have wanted a stake. No one would buy a plane that had a high propensity for killing its passengers, and certainly no one would want a car that was slower than a horse.

Some of man’s most noble achievements have been the product of imagination, daring to dream and in some cases, pure luck. Or so says Rory Sutherland.

‘Alchemy: The dark art and curious science of creating magic in brands, business, and life.” Rory Sutherland

I stumbled across Rory Sutherland on a podcast discussing a press release about the recently refurbished London St Pancras Station, which promoted the station’s champagne bar as ‘The Longest in Europe’. Sutherland’s curiosity was piqued when this bizarre fact seemed to resonate with journalists, who all faithfully reported the news. Most people wouldn’t think twice about a statement like that, but to Rory it was pure ‘Alchemy’.

Sutherland noted ‘Generally, people don’t care all that much how long champagne bars are. No one has ever, I think, asked the question ‘I feel like going to a champagne bar – can you tell me some nearby places – ordered in declining order of length.’ But to human perception, that sentence was a burst of pure green light. Because in one sentence it conveyed that this station was not a mere utilitarian transit hub – it was a place of entertainment; a destination in its own right.” Rory sees things most people don’t. He understands the foibles of human nature on a much deeper level. Curiosity and thinking are his calling cards.

If there’s such a thing as the ‘Charlie Munger of Advertising’, Rory Sutherland’s it. Rory is the Vice Chairman of Ogilvy, and co-founded a behavioural science practice within the agency. Like Munger, Rory draws on an immense catalogue of disciplines. In his recent book ‘Alchemy’, Sutherland shows us that the answers to many of our problems won’t be found in science and logic, but instead through an alchemy drawing on observation, psychology, human nature, evolution, trial and error - a process he refers to as psycho-logic.

The book contains an abundance of useful analogies and mental models. Upon completing the read, you’ll have another perspective to observe the world. Little wonder, it’s recommended reading by some of the world’s most successful investors - Rajiv Jain, James O’Shaughnessy and Clifford Sosin - to name a few.

“Looking around you is the most important skill.” Nick Sleep

The book’s usefulness stems from the many stories it contains about the seemingly irrationality of human behaviour, businesses and life which can be explained through psycho-logic. I’ve collected some of my favourite extracts below. While they only just scratch the surface of the book’s wisdom, hopefully they provide a glimpse into a different type of seeing and thinking.

Logic

“The models that dominate all human decision-making today are duly heavy on simplistic logic, and light on magic - a spreadsheet leaves no room for miracles.”

“The economy is not a machine - it is a highly complex system. Machines don’t allow for magic, but complex systems do.”

“Problems almost always have a plethora of seemingly irrational solutions waiting to be discovered, but that nobody is looking for them; everyone is too preoccupied with logic to look anywhere else.”

“Entrepreneurs are disproportionately valuable precisely because they are not confined to doing only those things that makes sense to a committee. Interestingly, the likes of Steve Jobs, James Dyson, Elon Musk and Peter Thiel often seem certifiably bonkers.”

“When you demand logic, you pay a hidden price: you destroy magic.”

“The human mind does not run on logic any more than a horse runs on petrol.”

“Logic is what makes a successful engineer or mathematician, but psycho-logic is what made us a successful breed of monkey, that has survived and flourished over time.”

“We have faster trains with uncomfortable seats departing from stark, modernist stations, whereas our unconscious may well prefer the opposite; slower trains with comfortable seats departing from ornate structures.”

Emotions Rule

“Think about it. There are some phrases that just wouldn’t appear in the English language:

‘I chose not to be angry.’
‘He plans to fall in love at 4.30pm tomorrow.’
‘She decided that she was no longer to feel uneasy in his presence.’
‘From that moment on, she determined no longer to be afraid of heights.’
‘He decided to like spiders and snakes.’”

Data

“More data leads to better decisions. Except when it doesn’t.”

“The need to rely on data can also blind you to important facts that lie outside your model.”

“Strangely, as we have gained access to more information, data, processing power and better communications, we may also be losing the ability to see things in more than one way, the more data we have, the less room there is for things that can’t easily be used in computation.”

“Bad maths can lead to collective insanity, and it is far easier to be massively wrong mathematically than most people realise - a single dud data point or false assumption can lead to results that are wrong by many orders of magnitude.”

“Just a few wrong assumptions in statistics, when compounded, can lead to an intelligent man being wrong by a factor of about 100,000,000 - tarot cards are rarely this dangerous.”

“A single rogue outlier can lead to an extraordinary distortion of reality - just as when Bill Gates can walk into a football stadium and raise the average level of wealth of everyone in it by $1m.”

“We should at times be wary of paying too much attention to numerical metrics. When buying a house, numbers (such as number of rooms, floor space or journey time to work) are easy to compare, and tend to monopolise our attention. Architectural quality does not have a numerical score, and tends to sink lower in our priorities as a result, but there is no reason to assume that something is more important just because it is numerically expressible.”

“Our brains did not evolve to make perfect decisions using mathematical precision - there wasn’t much call for this kind of thing on the African savannah. Instead we have developed the ability to arrive at pretty good, non-catastrophic decisions based on limited non-numerical information, some of which may be deceptive.”

“The risk with the growing use of cheap computational power is that it encourages us to take simple, mathematically expressible part of a complicated question, solve it to a high degree of mathematical precision, and assume we have solved the whole problem.”

“We fetishise precise numerical answers because they make us look scientific - and we crave the illusion of certainty. But the real genius of humanity lies in being vaguely right - the reason that we do not follow the assumptions of economists about what is rational behaviour is not because we are stupid. It may be because part of our brain has evolved to ignore the map, or to replace the initial question with another one - not so much to find a right answer as to avoid a disastrously wrong one.”

“To use the analogy of the needle in the haystack, more data does increase the number of needles, but it also increases the volume of hay, as well as the frequency of false needles — things we will believe are significant when really they aren’t. The risk of spurious correlations, ephemeral correlations, confounding variables, or confirmation bias can lead to more dumb decisions than insightful ones, with the data giving us a confidence in these decisions that is simply not warranted.”

“In reality, all valuable information starts with very little data - the lookout on the Titanic only had one data point .. ‘Iceberg ahead,’ but they were more important than any huge survey on iceberg frequency.”

“The data might suggest people won’t pay £49 for a jar of coffee and that’s true, mostly. However people will pay 30p for a single Nespresso capsule which amounts to a similar cost - without understanding human perception it is unable to distinguish between the two. Big data makes the assumption that reality maps neatly on to behaviour but it doesn’t. Context changes everything.”

“We should also remember that all big data comes from the same place: the past. Yet a single change in the context can change human behaviour significantly. For instance, all the behavioural data in 1993 would have predicted a great future for the fax machine.”

“It is possible to construct a plausible reason for any course of action, by cherry-picking the data you choose to include in your model and ignoring inconvenient facts. The more data you have, the easier it is to find support for some spurious, self-serving narrative. The profusion of data will not settle arguments: it will make them worse.”

Innovation

“Metrics, and especially averages, encourage you to focus on the middle of a market, but innovation happens at the extremes.”

“If you look at the history of inventions and discoveries, sequential deductive reasoning has contributed to relatively few of them.”

“A good guess which stands up to observation is still science. So is a lucky accident.”

“Business and politics have become far more boring and sensible than they need to be.”

“Most valuable discoveries don’t make sense at first; if they did, somebody would have discovered them already.”

“In coming up with anything genuinely new, unconscious instinct, luck and simple random experimentation play a far greater part in the problem-solving process than we ever admit.”

“We constantly rewrite the past to form a narrative which cuts out the non-critical points - and which replaces luck and random experimentation with conscious intent. In reality almost everything is more evolutionary than we care to admit.”

“It is surprisingly common for significant innovations to emerge from the removal of features rather than the addition. Google is, to put it bluntly, Yahoo without all the extraneous crap cluttering up the search page. Similarly, Twitter’s entire raison d’etre came from the limitation on the number of characters it allowed. McDonalds deleted 99% of items from traditional American diner repertoire; Starbucks placed little emphasis on food for the first decade of its existence.”

“In the early stages of any significant innovation, there may be an awkward stage where the new product is no better that what it is seeking to replace. For instance, early cars were in most respects worse than horses. Early aircraft were insanely dangerous. Early washing machines were unreliable. The appeal of these products was based on their status as much as their utility.”

More Logic

“To solve logic-proof problems requires intelligent, logical people to admit the possibility they might be wrong about something, but these people’s minds are often most resistant to change - perhaps because their status is deeply entwined with their capacity for reason.. Highly educated people don’t merely use logic; it is part of their identity. When I told one economist that you can often increase the sales of a product by increasing its price, the reaction was one not of curiosity, but of anger.”

“It is perfectly possible to be both rational and wrong. Logical ideas often fail because logic demands universally applicable laws but humans, unlike atoms, are not consistent enough in their behaviour for such laws to hold very broadly.”

“Imagine you are a company whose product is not selling well. Which of the following proposals would be easier to make in a board meeting called to resolve the problem? a) ‘We should reduce the price’ or b) ‘We should feature more ducks in our advertising.’ The first of course - and yet the second could, in fact, be much more profitable.”

“The fatal issue is that logic always gets you to exactly the same place as your competitors. Our mantra is, ‘Test counterintuitive things, because no-one else ever does.'"

“Stubborn problems are probably stubborn, because they are logic proof.”

“All progress involves guesswork, but it helps to start with a wide range of guesses.”

“If a problem is solved using a discipline other than that practised by those who believe themselves the rightful guardians of the solution, you’ll face an uphill struggle no matter how much evidence you can amass… Surgeons felt challenged by keyhole surgery and other less invasive procedures that can be carried out with the support of radiographers, because they used skills different from those that they had spent a lifetime perfecting.”

“Human behaviour is an enigma. Learn to crack the code.”

“Real life is not a conventional science - the tools which work so well when designing a Boeing 787, say, will not work so well when designing a customer experience or a tax programme. People are not nearly as pliable or predictable as carbon fibre or metal alloys, and we should not pretend that they are.”

“Hillary thinks like an economist, while Donald is a game theorist, and is able to achieve with one tweet what would take Clinton four years of congressional infighting. That’s alchemy; you may hate it, but it works.”

“The single worst thing that can happen in a criminal investigation is for everyone involved to become fixated on the same theory, because one false assumption shared by everyone can undermine the entire investigation. There’s a name for this - it’s called ‘privileging the hypothesis.’

“If science did not allow for such lucky accidents, its record would be much poorer - imagine if we forbade the use of penicillin, because its discovery was not predicted in advance. Yet policy and business decisions are overwhelmingly based on a ‘reason first, discovery later’ methodology, which seems wasteful in the extreme. Evolution, too, is a haphazard process that discovers what can survive in the world where some things are predictable but others aren’t. It works because each gene reaps the rewards and costs from its lucky or unlucky mistakes, but it doesn’t give a damn about reasons.”

“Conventional logic is a straightforward mental process that is equally available to all and will therefore get you to the same place as everyone else.”

Models

“The models of human behaviour devised and promoted by economists and other conventionally rational people are wholly inadequate at predicting human behaviour.”

“Notice that ordinary people are never allowed to pronounce on complex problems. When do you ever hear an immigration officer interviewed about immigration, or a street cop interviewed about crime? These people patently know far more about these issues than economists or sociologists, and yet we instead seek wisdom from people with models and theories rather than actual experience.”

“If this book provides you with nothing else, I hope it gives you permission to suggest slightly silly things from time to time. To fail a little more often. To think unlike an economist.”

“The 2008 financial crisis arose after people placed unquestioning faith in mathematically neat models of an artificially simple reality.”

“In any complex system, an overemphasis on the importance of some metrics will lead to weaknesses developing in other over-looked ones. It’s surely better to find satisfactory solutions for a realistic world, than perfect solutions for an unrealistic one.”

New Ideas

“After all, no big business idea makes sense at first. I mean, just imagine proposing the following ideas to a group of skeptical investors .. ‘What people want is a really cool vacuum cleaner’ (Dyson), ‘And best of all the drink has a taste which consumers say they hate.’ (Red Bull), ‘.. and just watch as perfectly sane people pay $5 for a drink they can make at home for a few pence’ (Starbucks).”

Reasoning

“The evolutionary psychologist Robert Kurzban, explains that we do not have full access to the reasons behind our decision-making because, in evolutionary terms, we are better off not knowing, we have evolved to deceive ourselves, in order that we are better at deceiving others.”

“If you want to change people’s behaviour, listening to their rational explanations for their behaviour may be misleading, because it isn’t the real why.”

“We consciously believe our actions are guided by reason, but this does not mean that they are - it may simply be evolutionary advantageous for us to believe this.”

“One astonishing possible explanation for the function of reason only emerged about ten years ago: the argumentative hypothesis suggests reason arose in the human brain not to inform our actions and beliefs, but to explain them and defend them to others. In other words, it was an adaption necessitated by our being a highly social species. We may use reason to detect lying in others, to resolve disputes, to attempt to influence other people or to explain our actions in retrospect, but it seems not to play the decisive role in individual decision-making. In this model, reason is not as Descartes thought, the brain’s science and research and development function - it is the brains legal and PR department.”

“The fact that we can deploy reason to explain our actions post-hoc does not mean that it was reason that decided on that action in the first place, or indeed that the use of reason can help obtain it.”

Customers

“Just as we infer a great deal about an air carrier from their on-board catering, while neglecting to care about the $150m aircraft or make of the engines, we are just as likely to be unhappy with a hospital because the reception area is neglected, the magazines are out of date and the nurse didn’t spare us much time. The truth is that ancillary details have a far greater effect on our emotional response, and hence our behaviour, than measured outcomes.”

“For a business to be truly customer-focused it needs to ignore what people say. Instead it needs to concentrate of what people feel.”

Short Term Optimisation

“A company pursuing only profit but not considering the impact of its profit seeking upon customer satisfaction, trust or long-term resilience, could do very well in the short term, but its long term future may be perilous. There is a parallel in the behaviour of bees, which do not make the most of the system they have evolved to collect nectar and pollen. Although they have an efficient way of communicating about the direction of reliable food sources, the waggle dance, a significant proportion of the hive seems to ignore it altogether and journeys off at random. In the short term, the hive would be better off all bees slavishly followed the waggle dance, and for a time this random behaviour baffled scientists, who wondered why 20 million years of bee evolution had not enforced a greater level of behavioural compliance. However, what they discovered was fascinating: without these rogue bees, the hive would get stuck in what complexity theorists call ‘a local maximum'; they would be so efficient at collecting food from known sources that, once these existing sources of food dried up, they wouldn’t know where to go next and the hive would starve to death. So the rogues bees are, in a sense, the hive’s research and development function, and their efficiency pays off handsomely when they discover a fresh source of food. It is precisely because they do not concentrate exclusively on short-term efficiency that bees have survived so many million years. If you optimise something in one direction, you may be creating a weakness somewhere else.”

Silly Questions

“The reason we do not ask basic questions is because, once our brain provides a logical answer, we stop looking for better ones: with a little alchemy, better answers can be found.”

“To reach intelligent answers, you often need to ask really dumb questions.”

“Perhaps advertising agencies are largely valuable simply because they create a culture in which it is acceptable to ask daft questions and make foolish suggestions.”

How You Ask Questions

“One of the great contributions to the profit of high-end restaurants is the fact that bottled water comes in two types, enabling a waiter to ask ‘still or sparkling?’, making it rather difficult to say ‘just tap.’”

Change

“An inability to change perspective is equivalent to a loss of intelligence.”

Efficiency Doesn’t Always Pay

“I rang a company’s call centre the other day, and the experience was exemplary: helpful, knowledgeable and charming. The firm was a client of ours, so I asked them what they did to make their telephone operators so good. The response was unexpected: ‘to be perfectly honest, we probably overpay them.’.. The staff weren’t regarded as a ‘cost’ - they were a significant reason for the company’s success. However, modern capitalism dictates that it will only be a matter of time before some beady-eyed consultants pitch up at a board meeting with a PowerPoint presentation entitled ‘Rightsizing Customer Service Costs Through Offshoring and Resource Management.’ or something similar. Soon nobody will phone to place orders because they won’t be able to understand a word they are saying, but that won’t matter when the company presents its quarterly earnings to analysts and one chart contains the bullet point: ‘Labour cost reduction through call centre relocation/downsizing.”

“Today the principal activity of any publicly held company is rarely the creation of products to satisfy a market need. Management attention is instead largely directed towards the invention of plausible sounding efficiency narratives to satisfy financial analysts, many of whom know nothing about the businesses they claim to analyse, beyond what they can read on a spreadsheet.”

Psychology

“In psychology, one plus one can equal three.”

“We don’t value things we value their meaning. What they bare is determined by the laws of physics, but what they mean is determined by the laws of psychology. Companies which look for opportunities to make magic, like Apple or Disney, routinely feature in lists of the most valuable and profitable brands in the world; you might think economists would have notice this by now.”

“Nearly all really successful businesses, as much as they pretend to be popular for rational reasons, owe most of their success to have stumbled on a psychological magic trick, sometimes unwittingly. Google, Dyson, Uber, Red Bull, Diet Coke, McDonalds, Just Eat, Apple, Starbucks and Amazon have all deliberately or accidentally happened on a form of mental alchemy.”

“According to research from the University of Illinois, descriptive menu labels raised sales by 27% in restaurants, compared to food items without descriptors.”

“So much for economic orthodoxy - in fact, it is not uncommon for premium priced products to have a high market share, as any of those financial analysts might have realised had they reached into their pockets to find an I-phone or the key to an Audi.”

“If there is a mystery at the heart of this book, it is why psychology has been so peculiarly uninfluential in business and in policy making when, whether done well or badly, it makes a spectacular difference.”

“If a customer has a problem and a brand resolves it in a satisfactory manner, the customer becomes a more loyal customer than if the fault had not occurred in the first place.”

“Much of the paraphernalia and practice of the military - flags, drums, uniforms, square-bashing, regalia, mascots and so forth - might be effectively bravery placebos, environmental cues designed to foster bravery and solidarity.”

“People want cheap, abundant and nice tasting drinks, surely? And yet the success of Red Bull proves they don’t.”

Hiring

“I have never seen evidence that academic success accurately predicts workplace success.”

“It is now common practice in British firms to interview people with an upper second-class degree or above, a criterion that is applied with no evidence but simply because it is logical.”

“An unconventional rule for spotting talent that nobody else uses may be far better than a ‘better’ rule which is in common use, because it will allow you to find talent that is undervalued by everyone else.”

Diversity

“As I always advise young people, ‘Find one or two things your boss is rubbish at and be quite good at them.’ Complementary talent is far more valuable than conformist talent.”

Summary

Every investor needs an edge and seeing things that others don’t can be one of those. Building a latticework of mental models provides more tools. As Charlie Munger warns, ‘to a man with a hammer, every problem looks like a nail.’ One of my favourite mental models is Sutherland’s observation about the bees and the waggle dance. There’s a real analogy here for investors. If you keep doing the same things, buying the same types of investments, you might risk missing the changing world. In our portfolio we’ve started to experiment with very small positions in businesses we’d likely have overlooked a few years ago. We make an effort to read and listen to investors in adjacent disciplines like venture capital and private equity. We keep pushing into broader intellectual fields to identify lessons and mental models we can incorporate in our own investing. And we listen to investors we disagree with who test our long held assumptions about how we define successful investing. We’re hoping, like the bees and the waggle dance, it will help us survive and flourish over the long term.

Sources:
‘Alchemy’ by Rory Sutherland. 2019. Harper Collins

Podcasts:
‘My Conversation with Rory Sutherland’, Farnham Street.
‘Rory Sutherland: The Alchemist's Mix of Behavioral Science’, The Behaviourist.

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Learning from Captain Abrashoff

You don’t have to search too far to find the many parallels that exist in successful businesses. Leadership, Culture, People; all are examples of things we find time and time again in companies that have stood out from their competition and been both shining lights in their industry and excellent companies to have invested in.

Interestingly, its not only in business that we can find these parallels. Success comes in many forms, and one of the more interesting I’ve discovered was a US Naval Ship. What makes it all the more fascinating is that the military is ordinarily viewed as nothing short of autocratic. Leadership is maintained through the hierarchy of rank; orders are to be followed regardless of how lower ranks regard their superiors. In light of this, how did one man take a Guided Missile Destroyer with a divided and troubled crew, that was regarded as the worst in it’s fleet, and turn it into the best ship in the Navy?

'It’s Your Ship’ is the story of Captain D. Michael Abrashoff, the commanding officer of USS Benfold. The book outlines how, by unconventional means, Abrashoff tapped into the latent human potential aboard Benfold to turn it into the ‘gem of the ocean.’

Peter Kaufman, Chairman and CEO of Glenair, (a business whom Charlie Munger classifies as one of the best three operating companies he’s aware of) recommended his outside directors read the book, along with ‘Plain Talk’ and ‘The Carolina Way.’ Of the three, Kaufman noted, ‘Michael Abrashoff had the toughest hand of all - turning the worst performing ship in the Pacific fleet into the best in the Navy, without changing a single crew member.’

And why should that be relevant to us, as investors? Because business is about people. Management and culture matter. Kaufman explains:

‘Despite widely different fields and completely different circumstances in terms of context, the leadership and cultural principles set forth are virtually the same as ours.’

‘In my experience, a high-morale group, properly motivated and incentivised, can out-perform a low-morale peer group by a factor of 5X or more. The typically untapped, latent potential of human beings is stunning, and can be unleashed by the right cultural framework. Unleashing that latent potential, is how, over three decades, Nucor and Glenair have respectively posted seemingly impossible compounded returns of 17% and 18%, with no losses or layoffs.’

The management techniques deployed and subsequent culture created by Abrashoff are prevalent in the world’s best companies we’ve studied. If you’ve read Thomas Peters, ‘In Search of Excellence,’ accredited by Buffett as “A landmark book; without question the most important and useful book on what makes organisations effective, ever written,” you’ll notice the same examples jump out of almost every page; Empowering employees from the depths of the hierarchy to the top, management walking the floors, full transparency, accepting of mistakes, constant innovation, and questioning conventional wisdom are but a few.

Good investments start with good businesses. It’s often the qualitative aspects that determine success. An analysis of the quantitative data on USS Benfold; crew size, diversity, pay, skill level, won’t shed any light on it’s competency. However, an understanding of management philosophy and culture would have given you a strong sense of likely success. It’s a very useful case study, as unlike companies, it’s possible to compare Benfold’s results with it’s identical sister ships over time.

‘First is you could take pairs of companies at a given moment in history that were very similar. They were similar at the point of start-up, the same environment, the same technologies, same changes and same circumstances, and one became a great company and the other one didn’t.” Jim Collins

Initially, the Benford’s crew retention rate was a dismal 28%. Following Abrashoff taking command, all of Benfold’s career sailors re-enlisted for an additional tour, the ships retention rate for the two most critical categories jumped from 28% to 100% and stayed there.

While the Benford’s results were quantitative, in the sense of metrics like re-enlistment rates, combat readiness, re-fuelling efficiency, the means to achieving the results were qualitative. it wasn’t about more pay, a more highly skilled workforce, or more diversity, it was about leadership, motivating others and unleashing human potential.

The Captain challenged Navy procedure to transform a complex organisation. He improvised techniques to build morale and unity. He created a new environment comprising a company of collaborators who flourished in a spirit of relaxed discipline, creativity, humour and pride. In the process, the USS Benfold went on to beat nearly every metric in the Pacific fleet.

Abrashoff noted that the ship he eventually left to his successor, though once divided and troubled, was all a captain could wish for - the gem of the ocean.

Following are some of the gems from the book:

Mission

“In business terms, I viewed Benfold during it’s Persian Gulf deployment as a very productive company with one major customer - my boss, a three-star admiral in command of the Fifth Fleet. To dominate market share, our ship had to top all others in the categories most important to my customer.”

“By getting very good at both inspecting tankers and shooting cruise missiles, Benfold achieved two coveted areas of expertise. The higher-ups were forever fighting over who got to use our services. That should be the goal of any business; Strive to offer high quality at low cost in versatile areas such that customers fight to place their orders.”

Empower People

“Helping people realise their full potential can lead to attaining goals that would be impossible to reach under command-and-control.”

“I found the more control I gave up, the more control I got. In the beginning, people kept asking my permission to do things. Eventually, I told the crew, ‘It’s your ship. You’re responsible for it. Make a decision and see what happens.’ Hence the Benfold watchword was ‘It’s your ship.’ Every sailor felt that Benfold was his or her responsibility. Show me an organization in which employees take ownership, and I will show you one that beats its competitors.”

“The timeless challenge is to help less talented people transcend their limitations.”

“A ship commanded by a micromanager and his or her hierarchy of sub-micromanagers is no breeding ground for individual initiative.”

“I wanted everyone to be involved in the common cause of creating the best ship in the Pacific Fleet.”

“Empowering people means defining the parameters in which people are allowed to operate, and then setting them free.”

“As I saw it, my job was to create the climate that enabled people to unleash their potential. Given the right environment, there are few limits to what people can achieve.”

“Whenever the consequences of a decision had the potential to kill or injure someone, waste taxpayers’ money, or damage the ship, I had to be consulted. Short of those contingencies, the crew was authorised to make their own decisions. Even if decisions were wrong, I would stand by my crew. Hopefully, they would learn from their mistakes. And the more responsibility they were given, the more they learned.”

“When people feel they own an organisation, they perform with greater care and devotion.”

“I am absolutely convinced that with good leadership, freedom does not weaken discipline - it strengthens it. Free people have a powerful incentive not to screw up.”

“Empower your people, and at the same time give them guidelines within which they are allowed to roam.”

“We empowered our young sailors to assume major responsibilities - including giving calm, expert tours of the ships to VIPs so high on the food chain that officers on other ships would probably stutter in their presence.”

“Unlike some leaders, I prefer to build myself up by strengthening others and helping them feel good about their jobs and themselves. When that happens, their work improves, and my own morale leaps.”

“I think [our sister ships] hit a performance ceiling because they didn’t create a supportive climate that encouraged sailors to reach beyond their own expectations. Ultimately, that was Benfold’s edge.”

Value People

“As the new captain of Benfold, I read some exit surveys, interviews conducted by the military to find out why people are leaving. I assumed that low pay would be the first reason, but in fact it was fifth. The top reason was not being treated with respect and dignity; second was being prevented from making an impact on the organisation; third, not being listened to; and, fourth, not being rewarded with more responsibility. Talk about an eye opener. Further research disclosed an unexpected parallel with civilian life. According to a recent survey, low pay is also number five on the list of reasons why private employees jump from one company to another. And the top four reasons are virtually the same. The inescapable conclusion is that, as leaders, we are all doing the same things wrong.”

“As a manager, the one thing you need to steadily send to your people is how important they are to you. In fact, nothing is more important to you.”

“Be there for your people. Find out who they are. Recognise the effects you have on them and how you can make them grow taller.”

“Shortly after I took command of Benfold, I vowed to treat every encounter with every person on the ship as the most important thing at that moment.”

“I said to myself, ‘The only way I can create the right climate is to tell every sailor, in person, that this is the climate I want to create.’ I decided to interview each crew member on the ship so he or she could hear my expectations directly.'“

“In just about every case, my sailors were not born with anything remotely resembling a silver spoon in their mouths. But each and everyone of them was trying to make something meaningful of their lives. Something happened in me as a result of those interview: I came to respect my crew enormously. No longer were they nameless bodies at which I barked orders. I realised they were just like me: They had hopes, dreams, loved ones, and they wanted to believe that what they were doing was important. And they wanted to be treated with respect.”

“Like any workforce, mine appreciated hearing from top management.”

“Keep talking. Tell everyone personally what’s in store for him or her - new goals, new work descriptions, new organisational structure, and yes, job losses, if that’s the case. Explain why the company is making the changes. People can absorb anything if they are not deceived or treated arrogantly.”

“Benfold’s crew lived and worked by the Golden Rule. We trusted that everyone would be treated with dignity and respect, and we expected no less [from anyone]”

“I wanted everyone on the ship to see one another as people and shipmates.”

“Of course, I treated people with the same dignity and respect I expected of them, and I made sure they truly liked their jobs. Freed from top-down-itis, Benfold’s sailors were given responsibilities to make decisions, correct mistakes, and prove to themselves that they were part of a superb crew.”

“Instead of tearing people down to make them into robots, I tried to show them I trusted them and believed in them. Show me a manager who ignores the power of praise, and I will show you a lousy manager. Praise is infinitely more productive than punishment.”

“The commanding officer of a ship is authorised to hand out 15 medals a year. I wanted to err on the side of excess, so in my first year I passed out 115.”

“Newbies are important, treat them well. I greeted each the same way: ‘Welcome .. I appreciate having you on our ship.’ All too often, a gung-ho newcomer runs smack into a poisoned corporate culture that sucks the enthusiasm right out of her. I wanted the newcomers to remain so revved up that they would recharge the batteries of those who no longer felt that way.”

“Try to make the people who work for you feel needed and highly valued. Help them believe in that wonderful old truism, ‘A rising tide lifts all boats.’ With perhaps few exceptions, every organisation’s success is a collective achievement.”

Low End Of The Hierarchy

“Breaking out of our stratified systems to trust the people who work for us, especially those at or near the low end of the hierarchy, was a useful, progressive change.”

“How much brainpower does the Navy - or any organisation, for that matter - waste because those in charge don’t recognise the full potential hiding at the low end of the hierarchy. If we stopped pinning labels on people and stopped treating them as if they were stupid, they would perform better. Why not instead assume everyone is inherently talented, and then spur them to live up to those expectations? Too idealistic? On the contrary, that’s exactly how Benfold became the best damn ship in the Navy.”

Walk the Floors - No Ivory Tower

“The key to being a successful skipper is to see the ship through the eyes of the crew. Only then can you find out what’s really wrong and, in so doing, help the sailors empower themselves to fix it.”

“It seemed to me only prudent for the captain to work hard at seeing the ship through the crew’s eyes. My first step was trying to learn the names of everyone onboard. It wasn’t easy. Try attaching 310 names to 310 faces in one month.”

“I tried to establish a personal relationship with each crew member.”

“Knowing my people well was a huge asset.”

“We used every possible means of communication, including private email to key superiors; daily newsletters for the crew; my own cheerleading for good ideas and walking around the ship chatting.”

“I started eating at least one meal per week on the mess decks with the crew. It paid big dividends; I learned a great deal and got to know people that way, and after a while my officers began taking occasional meals there, too.”

“Many leaders almost never leave their office. Recall how you feel when your boss tells you, ‘Good job.’ Do your people (and yourself) a favour. Say it in person, if you can. Press the flesh. Open yourself. Coldness congeals. Warmth heals. Little things make big successes.”

“Gestures such as joining the enlisted people at cookouts [on the ship’s deck], having lunch once a week with the crew on the mess decks, and making sure visiting VIP’s got to talk to the crew, I tried to show the officers that in human terms we were all in this together, and each person was indispensable to the unity of the Benfold team.”

“When I can build people up, their work improves, and my morale leaps. My approach with the cooks was to walk through the galley just about every other day, telling them how much I appreciated their hard work. And the food got a lot better.”

Reciprocation

“The more I went around meeting sailors, the more they talked to me openly and intelligently. The more I thanked them for hard work, the harder they worked. The payoff in morale was palpable.”

Tone From The Top

“A leader will never accomplish what he or she wants by ordering it done. Real leadership must be done by example, not precept. Whether you like it or not, your people follow your example.”

“Leaders need to understand how profoundly they affect people, how their optimism and pessimism are equally infectious, how directly they set the tone and spirit of everyone around them.”

“It is well known that every leader sets the tone for his or her organisation. Show me an enthusiastic leader, and I will show you an enthusiastic workforce.”

“In desperate times I always grabbed the microphone to communicate. Your people want to hear it from the top that everything is going to be all right after all. In times of peril, people always turn to the guy at the top and look for guidance.”

“When I took command of Benfold, I saw a crew of 310 men and women with untapped talent, untested spirit and unlimited potential. I was determined to be the captain these sailors deserved.”

Purpose

“The whole secret of leading a ship or managing a company is to articulate a common goal that inspires a diverse group of people to work hard together. That’s what my sailors got: a purpose that transformed their lives and made Benfold a composite of an elite school, a lively church, a winning football team, and - best of all - the hottest go-to-ship in the US Navy.”

Generate Unity

“Generate unity. I substituted [the diversity training] for unity training, concentrating on people’s likeness and our common goals rather than differences.”

“If you surround yourself with people exactly like yourself, you run the dangerous risk of groupthink, and no one has creativity to come up with new ideas. The goal is not to create a group of clones, culturally engineered to mimic one another. Rather, unity is about maximising uniqueness and channeling that toward the common goal of the group."

“Unity of purpose is quite achievable, even against heavy odds, and sometimes because of them. We created unity on Benfold.”

Transparency

“Some leaders feel that by keeping people in the dark, they maintain a measure of control. But that is a leader’s folly and an organisation’s failure. Secrecy spawns isolation, not success.”

“As I rose through the ranks in the Navy, I was continually frustrated by how information was stopped at mid-level regions.”

USS Benfold

Common Sense

“The art of leadership lies in simple things - common sense actions that ensure high morale and increase the odds of winning.”

Little Things

“Little things make big successes. Within a couple of months of my taking over, other ship commanders began visiting Benfold to find out how we were getting our sailors to work so well. I was delighted to share all our secrets. They were hardly profound; mainly, we were attentive to people’s feelings and potential. A lot of seemingly small gestures added up to a friendly and supportive atmosphere.”

Innovation & Ideas

“Organisations should reward risk-takers, even if they fall short once in a while. Let them know that promotions and glory go to innovators and pioneers, not to stand-patters who fear controversy and avoid trying to improve anything. To me, that’s the key to keeping an organisation young, vital, growing, and successful. Stasis is death to any organisation. Evolve or die: It’s the law of life.”

“I began with the idea that there is always a better way to do things, and that, contrary to tradition, the crew’s insights might be more profound than even the captain’s. Accordingly, we spent several months analysing every process on the ship. I asked everyone, ‘Is there a better way to do what you do?’. Time after time, the answer is yes, and many of the answers were revelations to me.”

“I decided my job was to listen aggressively and to pick up every good idea the crew had for improving the ship’s operation. After all, the people who do the nuts-and-bolts work on the ship constantly see things that officers don’t.”

“Innovation knows no rank. Good ideas are where you find them - even on the fo’c’sle. My officers were ready to discard a great idea because it came from a lowly enlisted man. Fortunately, I happened to overhear his recommendation. Every leader needs big ears and zero tolerance for stereotypes.”

“In my interviews with the crew, I got feedback in ways I never imagined. After we implemented the lower deck’s ideas on how to improve the way we did business, the ship’s energy began heating up.”

“Innovation and progress are achieved only by those who venture beyond Standard Operating Procedure. You have to think imaginatively, but realistically, about what may lie ahead, and prepare to meet it.”

Creativity

“The management committee always wants to see metrics before they allow you to launch new ideas. Since, by definition, new ideas don’t have metrics, the result is that great ideas tend to be stillborn in most companies today.”

“If I had been forced to chart a course defined by metrics, the creativity we sparked and the changes we achieved probably could not have happened.”

“Rigidity gets in the way of creativity. Instead of salutes, I wanted results, which to me meant achieving combat readiness. The way to accomplish this was not to order it from the top, which is demoralising and squashes initiative. I wanted sailors to open their minds, use their imaginations, and find better ways of doing everything. I wanted officers to understand that ideas and initiative could emerge from the lower deck as well as muscle and obedience.”

Seek and Accept Input

“Let your crew feel free to speak up. I was determined to create a culture where everyone on board felt comfortable enough to say to me, ‘Captain, have you thought of this?’ or ‘Captain, I’m worried about something,’ or even ‘Captain, I think you’re dead wrong and here’s why.’ Yes-people are a cancer in any organisation, and dangerous to boot.’

“After every major decision, event, or maneuver, those involved gathered around my chair on the bridge wing and critiqued it. Even if things had gone well, we still analysed them. Sometimes things go right by accident, and you are left with the dangerous illusion that it was your doing.”

“There was no retribution for any comments. I encouraged people to challenge or criticise anyone in the group; the most junior seaman could criticise the commanding officer.”

“If I was causing [the crew] unnecessary work, then I wanted to know about it. If the crew had a problem with what I was doing, I wanted them to tell me so I could fix it or explain why I had to do things that way, thus expanding my crew’s knowledge of the limitations or requirements imposed on me.”

“When people saw me opening myself to criticism, they opened up themselves. That’s how we made dramatic improvements. People could get inside one another’s mind. They could work together for the best possible Benfold. The result? We never made the same mistake twice, and everyone got to understand the big picture.”

“Even when the reluctance to speak up stems from admiration for the commanding officer’s skill and experience, a climate to question decisions must be created in order to foster double-checking.”

“Make your people feel they can speak freely, no matter what they want to say. If they see that the captain wears no clothes, facts are facts and deserve attention, not retribution.’

Multi-Skill

“In the current squeeze on business costs, many companies have cut back so much that they are only one-deep in critical positions, leaving no margin for error. My goal was to cross-train in every critical area.”

“There is no downside to having employees who know how every division of an organisation functions. The challenge is finding incentives to motivate them to want to do so.”

“Build a strong, deep bench. Cross-training became our mantra. We had young sailors, barely out of boot camp, doing the jobs of first-class petty officers with several hash marks, and doing them well.”

Bad News

“It’s critical that leaders don’t shoot the messenger who brings bad news. A boss who does will not hear about future problems until they are out of hand.”

“Bad news does not improve with age. The longer you wait, the less time your boss has to help you come up with a solution.”

“It’s been my experience in management that while good news makes you feel warm inside, it’s the negative news that makes you learn and helps improve your performance on the job.”

Unconventional

“At first, my unconventional approach to the job evoked fear and undermined authoritarian personality that had been imprinted on the ship. But instead of constantly scrutinising the members of my crew with the presumption they would screw up, I assumed they wanted to do well and be the best.”

“My sailors were free to question conventional wisdom and dream up better ways to do their jobs.”

“As captain, I was charged with enforcing 225 years of accumulated Navy regulations, policies, and procedures. But every last one of those rules was up for negotiation whenever my people came up with a better way of doing things.”

“You will seldom get in trouble for following Standard Operating Procedure. On the other hand, you will rarely get outstanding results. And all too often, SOP is a sop - it distracts people from what’s really important.”

Have Fun

“I focused my leadership efforts on encouraging people to not only find better ways to do their jobs, but also to have fun as they did. And sometimes - actually, a lot of times - I encouraged them to have fun for fun’s sake.”

“When I interviewed my sailors, I asked them not only how we could improve the ship’s performance, but also how we could have fun at work. The responses were amazing.”

“We tried to instill fun in everything we did, especially mundane, repetitive jobs such as loading food aboard the ship.”

“The point was that having fun with your friends creates infinitely more social glue for any organisation than stock options and bonuses will ever provide.”

“The secret to good work? Good play. We were the offbeat ship that wasn’t afraid to loosen up, make the best of what had to be done, and share fun with everyone. Giving our people the freedom to act a little crazy seemed to confirm that we really cared about them.”

“This shows what you can accomplish when you throw formality to the winds and free your people to have a life on your time, which soon becomes the time of their lives. None of this required big money, only imagination and goodwill. On USS Benfold, the secret of good work was good play.”

Accept Mistakes

“I’d like to live in a culture that allows people to candidly acknowledge mistakes and take responsibility. It’s far more useful to focus on making sure the accident never happens again rather than finding someone to blame.”

“Unfortunately, organisations all too often promote only those who have never made a mistake. Show me someone who has never made a mistake, and I will show you someone who is not doing anything to improve your organisation.”

Freedom to Fail

“I worked hard to create a climate that encouraged quixotic pursuits and celebrated freedom to fail.”

Ethics

“I was always careful never to take any ethical shortcuts.”

“I just asked myself this: If what I’m about to do appeared on the front page of the Washington Post tomorrow, would I be proud or embarrassed? If I knew I would be embarrassed, I would not do it. If I’d be proud, I knew I was generally on the right track.”

Bureaucracies

“More often than not, bureaucracies create rules and then forget why they were needed in the first place, or fail to see the reasons for them to no longer exist. When it comes to purging outdated regulations, bureaucracies are sclerotic.”

Continual Learning

“I was determined to turn the ship into an institution of continual learning.”

Competition

“I didn’t consider [the other ships in the fleet] rivals.; I didn’t have any rivals. I was in competition only with myself, to have the best ship we possibly could.”

Conclusion

The characteristics that defined USS Benfold’s success weren’t quantitative. They were qualitative and they were all about people. The physical asset, the ship, was no different to any other in the fleet; it was the people that made all the difference. In a similar fashion, most businesses are defined by their people, too. Investigating the philosophies, values and culture that permeate a business, it’s management and people can provide the clues to it’s ultimate success.

From an investing standpoint I’ve always been cautious of investing in business turnarounds. The base-rates are too low for my liking. Captain Abrashoff’s book got me thinking that just maybe, with the right approach, success in a turnaround can be more easily gauged.

Ultimately, this is a book about humanity and the psychological forces that drive people to work together and achieve. Captain Abrashoff leveraged the levers that drive group output to achieve outstanding performance, regardless of the fact he was on a naval ship. The lessons contained within are not only relevant to the military, they are integral to the success of the any business, and more importantly those that we either are or are wanting to, invest in.

Given our daily interactions with people and society, we can all learn from Captain Abrashoff.

Learning From Copart’s Willis Johnson

True Rags to Riches stories are actually few and far between. We often hear of the biggies; the Jeff Bezos’ story, the Bill Gates story, the Steve Jobs’ story or even Warren Buffett’s history. The thing that is common among most of the ones we know is that they tend to be tech gurus or famous investors. They’ve all built companies that are the envy of the world and become famous along the way. But how often do you hear about a guy who only went to high school, was given a junkyard, and was able to turn it into a multi-billion dollar company? Not often, I bet.

Willis Johnson’s incredible story is a rag-to-riches tale of a budding young American entrepreneur who scrapped and saved, kept trying new things and ultimately turned a small auto junkyard into a multi-billion dollar business. An investment in Willis’ Copart in 1994 has been a veritable 150-bagger!!

Johnson tells the story of Copart in his 2014 auto-biography ‘Junk to Gold’. An easy read, it contains a wealth of business wisdom and life lessons. Johnson’s passion for wheeling & dealing emerged while buying, dismantling and selling old cars as a teenager with his entrepreneurial father. It also tells how he was conscripted to the US Army and did a tour of duty in Vietnam where only half his unit survived, how he also earned a Purple Heart and some new skills to apply to the dismantling yard he purchased on his return. With his newly acquired junkyard, Johnson strived for growth.

In the words of Charlie Munger, Johnson is a ‘Talented Fanatic’ who disdained standard industry practice. Instead, he introduced clean and organised stores that more closely resembled a retail store than the typical ‘bunch of wrecked cars in a field’. He was the first to dismantle not just cars, but parts, which he refurbished for sale. Introducing an industry catalogue and improving customer communications made him a valued partner to customers.

Like Charles Schwab at Schwab Corporation, Willis wasn’t afraid to embrace new technology if it meant increased efficiency and improved customer service. It also provided a jump on competitors. In Sam Walton style, Willis unashamedly copied ideas from everywhere: competitors, other industries; even Disneyland and a John Wayne movie.

As Willis redefined the role and scope of junkyard operations he built scale through acquisitions. Never shy of trying new things, Willis jumped at an opportunity to add a salvage auction business to his broadening interests. Introducing new technology, leveraging national scale for customers and introducing a new innovative pricing mechanism that turned the customer incentive structure on its head, Willis expanded the salvage auction business to become the core of the multi-billion dollar enterprise that Copart is today.

COPART Share Price vs S&P500 Normalised [Source: Bloomberg]

I’ve included some of my favourite extracts from the book below..

Common Sense

“Earn a PhD in Common Sense. The time I spent as a kid with my dad was much more of an education for me than what went on between school bells.”

Know What You Don’t Know

“I know what I don’t know. I also think it’s a good idea to learn as much as you can.”

Integrity

“Both my dad and I also built reputations in the business world of always standing by our word and never doing business if a deal felt wrong. We both walked away from opportunities that may have helped our businesses but would have crossed a moral or ethical line.”

“With any deal, you want to treat folks right, like you’d like to be treated.”

A Bias For Action

“Although times were hard [in the early days], I never stopped dreaming big and looking for something better.”

Business Model

‘Think of us [Copart salvage auctions] like the local sewer system. We’re a utility. Nothing can get rid of us - nothing. Two of the biggest businesses in the world are car manufacturers and insurance companies. If insurance companies don’t write insurance policies on cars, then they’re out of business. If manufacturers don’t make cars, then they’re out of business. They’re always gonna make cars, and they’re always gonna insure them. We’re the guy in between. As long as we’ve got the land in the right place to put the cars on, we can’t fail. We are like the septic tanks of the sewer system. You can’t have the system without us.”

Cost Conscious

“Dad also had an expression: ‘Take care of your pennies and the dollars will take care of themselves.’ It’s a phrase I have also passed on to others so they would learn the same lesson I learned from him - that small amounts of money can add up to either big profits or big losses. You can’t ignore the small expenses or the small amounts of money unaccounted for if you hope to succeed at the end of the day.”

Customers

‘I tripled the income at the yard by taking good care of customers and calling body shops and mechanics to tell them what inventory we had in stock.”

“Be your customer’s most valuable partner. My continued passion for the business helped me find new ways to innovate Copart. One of the biggest innovations was the Percentage Incentive Program, or PIP, which I started as a test with the Fireman’s Fund - an insurance company that was a client of Copart. I knew I could get the insurance company more money if I cleaned these [smashed] cars up [before sale], but I also knew I would have to charge the insurance companies for that service. That was a problem because insurance companies didn’t want to pay you to clean up a wrecked car. To them it was junk so I had to find another way.

I proposed a deal to the Fireman’s Fund. Instead of charging fees [to transport and auction the wrecked cars], I would keep a percentage of the sale price for each car. The Fireman’s Fund was thrilled because they were seeing their returns go up. And I was watching Copart’s profits go up with the returns. But maybe, most importantly, PIP represented a significant shift in the industry. Now the salvage auction was a partner with the insurance company, with the goal of getting the best possible price for each car, eliminating any arguments over fees.”

“Copart needed to provide not just a good service but legendary service - service that left customers saying, ‘Wow, how did they do that?’ and telling others about the experience.”

“Do the right thing. Through the [Katrina Hurricane] ordeal, Copart did not pass any of its added costs on to its customers. Copart chose to absorb costs because it was the right thing to do. Copart also absorbed costs because it wanted to prove to its customers it was not just a vendor but a business partner they could rely on even at the worst possible time.”

Investors

“Be careful who you go into business with. [At the Copart IPO] Most investors thought it was all about them liking me. But in my case, I also had to like them. I wasn’t doing business with just anyone with a cheque book. I have to trust you - and you have have to be someone I feel good about being associated with.”

Stick to The Knitting

“One thing I’ve taught all the executives in the company is that while you may be good in our business, that doesn’t mean you are good in any other business. Don’t get a big head and think you know it all, because that’s when you lose. You’re really good in the car business. You’re really good in the recycling business. You’re not necessarily good in everything else, and you need to understand that. Stay with what you are good at, venture out if you see an opportunity, but pull your horns in if you make a mistake.”

Military Lessons

“The military teaches you order, timing and discipline. It teaches you how to work as a team. It was the best education I could get.”

“[The military] taught me cleanliness and order. Keeping things lined up makes for efficiency. In the military, we were told to face right and line everything up shoulder to nose. I bought that back to the dismantling business, lining up the cars in the yard in a perfect row. I also learned that a coat of paint helped cover up a lot of bad stuff and was the cheapest way to make something bad look good.”

“The war taught me how to make the best decisions for the people around me, not just myself.”

Innovation

“I built Copart’s culture on change and embracing new ideas.”

“I’m not afraid to break the mould and go where no one else has gone before. When people tell me, ‘Willis you can’t do that,’ it just pushes me to show them I can.’”

“I expanded the [scrapping] business to a large dairy farm next door and got it zoned so they could rent out some of the land to local dismantlers. Customers going to the other dismantlers would have to drive by our yard first, which led to more business. I would also purchase parts from other dismantlers and turn them for a profit. Dad didn’t like this at all. He didn’t want me helping his competitors make money - even if it meant we made more money.”

“My dream was to build up the parts side of the scrap business was starting to come true. As I was able to buy better cars, [I] was able to stock more and better parts, including motors, transmissions, and rear ends. As this happened the business relied less on scrap iron, which gradually went from the main revenue stream to a byproduct of the parts business.”

“I was the first in the industry to dismantle parts, not just cars. By the time I was done, I could get $700 for the same parts sold separately that were sold together by my competitor [as a whole engine] for $400. And the customer was happier. I also had fewer buy-backs because I didn’t have to guarantee all the parts on the motor. This caused my profit margin to far exceed that of my competitors.”

“I knew that to really compete with other auto dismantlers in the Sacramento region, I would need to do something different... If we were going to compete, we needed to specialise in a car the other dismantlers in town didn’t want to carry.”

“I’m not the kind of guy who says, ‘Look, kid, I’ve been doing this for twenty years, and I’m not interested in changing.’ I never have a problem if someone tells me something is broken. I have always wanted to do things better and improve on the model.”

“Taking chances and changing things up made Copart what it is today. It’s the spirit of the company, and that spirit will never change.”

Build A Brand / Geographic Reach

“Now a public company, Copart had the resources and reputation needed to expand its footprint so we could not only keep up with IAA but also continue to be able to give big insurance companies a broader geographical range of services.”

“I wanted to be able to build a network of locations so I could take on national contracts. I didn’t want just to be able to handle some of Allstate’s cars; I wanted all of them.”

“I just didn’t want to grow to grow. I wanted to build a brand. I wanted anything with a Copart logo on it to run the same way - same computer system, same pricing, same way of treating our employees - so people started relating our name to a certain way of doing business.”

Technology

“Most people kept paper records of all their parts. But I was one of the first in the business to computerise inventory. I spent $110,000 on a large reel-to-reel computer, about double the amount most people spent on a house at the time. Other people thought I was crazy (or stupid - or maybe both) to spend so much money on a computer for a wrecking yard. But I was never afraid to spend money on technology if it could help us be more efficient. And it turned out that the whole industry would end up computerising once they saw the benefits it gave people. As large and foreign as this machine seemed back then it paid off because it gave me a complete picture of the business and the inventory, which in turn gave me more knowledge and control over the yard which helped me make money.”

“Any company today has to pay attention to technology and how the world is changing and incorporate that if it wants to survive. You can’t do things the same way and expect to be around in ten years. The world moves too quickly.”

“VB2 [a Virtual bidding tech platform] put Copart ahead of the technology curve. But it had not just been VB2. The fact we computerised early, the company developed CAS to share data and keep track of all its inventory, and [we] embraced the internet when it first came out all led up to Copart being prepared to develop and implement technology ahead of its competition.”

Ideas

“Ideas can come from anywhere - even John Wayne. One rare night, I was in the trailer watching an old John Wayne movie about WWII. In the movie John Wayne kicked down the doors of a Quonset hut that housed the officer’s club. The movie made me think of my own prefabricated, semicircular steel hut in a new light. I thought, Well, if they can make it look decent in the movie, decorate it all up for officers, maybe I can do that.”

“I’d mine other wrecking yards for ideas I could take home and implement. We’d suck in all their ideas, and they didn’t care if they told us because we weren’t direct competitors.”

“You have to do your research and if you don’t stay on top of reading about other people’s ideas, you never come up with ideas yourself. It’s good to learn from others.”

“Learn from Walmart. What made the U-Pull-It model [wrecked cars on stands where hobbyists/home mechanics pay an entry fee to come in and dismantle cars parts themselves] unique was the high volume of cars it could turnaround. I liken it to the Walmart of dismantling.”

“Make your business like Disneyland. I got my inspiration to create new services within my companies from Disneyland. Disneyland to me was a model of how to build businesses within a business. I paid a fee to get in the gate. And then I went to a restaurant, I paid to eat and drink. Then I paid at the gift shops. I paid for tickets to the rides. Everything I did was another business. Okay, I’ve got to find a business that has multiple revenue streams within it. Disneyland taught me about building other revenue streams. Every time you can add revenue streams to the same pipeline, the profit margin change drastically. You are putting more through that pipe.”

“If [employees] have the ability to speak their mind, the company benefits too because that’s when great ideas are born”

Tone From the Top

“I never expected anything from anyone that I wouldn’t do myself. I used to dismantle cars alongside my employees.”

Value Employees

“If employees are happy, that translates directly to how we treat our customers and how we can move forward as a company.”

“I always made sure I knew what the average pay was in the area and paid more and gave more benefits. I didn’t want people to leave, and I didn’t want them to be in a union.”

“Tell them you love them. We learnt it wasn’t just enough to treat your employees nice, give them good benefits, and hope they got it. We treated the employee nice, gave them as many benefits as we could, and treated them like we didn’t want them to leave - because we didn’t. But we didn’t tell them we loved them; we didn’t show them how much they meant to the company. That’s where we had fallen short.”

Culture

“From 2002 Copart was going to be a company that didn’t just hire based on skill-sets or IQ. It was going to hire based on attitude - EQ. We were going to be a company in which people liked their co-workers and had fun at what they did.”

“Becoming a big, public company, we decided, didn’t mean we had to sacrifice having a culture where people worked hard, had fun and were rewarded for it.”

Mistakes

“Admit your mistakes. Everyone makes bad decisions, and I’m not immune. The good thing about Copart is even though sometimes we have bad ideas, we learn from them and correct them. Any time you make a mistake or bad news comes and you’re really upset about it, remember there’s a lesson in it. Just chalk it up as a lesson, and don’t let it happen again. When you lose a customer because you bid wrong, don’t get mad at the customer. Ask yourself, ‘What did we do wrong to not get the contract?’”

Summary

Although I didn’t mention them above, Willis’ expectation that people weren’t going to fly as much after 9/11, but rather drive, gave him the insight that more cars were going to be wrecked allowing a better preparedness for growth. It’s little kernels of history like this that can spark ideas in situations we face today.

Willis’ analogy of the ‘local sewer system’ is a useful mental model when thinking about other businesses. So is inverting the pricing mechanism for salvage auctions from fixed prices to a commission structure that instantly aligned the customer with the auctioneer. It created a win-win relationship where both parties benefited from higher prices. When combined with the national scale to reduce the transportation costs of salvaged vehicles, it provided a competitive advantage difficult to replicate. Applying technology for efficiency and geographic reach [via virtual bidding] made the company’s moat even wider. The makings of a Lollapalooza effect!

“Extreme success is likely to be caused by adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.” Charlie Munger

While not all great businesses share the same characteristics, they often have at least a handful that unify them. In the case of Copart, those common themes include being close to the customer, win-win relationships, scale advantages, a large runway for growth, network effects (connecting more buyers and sellers), constant innovation, embracing technology, valuing employees, good culture, first mover advantages, sticking to the knitting and tone from the top. And let’s not forget the creative fanatic driving the whole process, Willis Johnson.

Sources:
‘Junk to Gold’ by Willis Johnson. 2014. Westbow Press.

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Learning from Polen Capital

One of the keys to sound investing is having the right information. Its everywhere around us; we just need to know where to look. One of my preferred methods for finding new facts and for learning is to listen to podcasts, and you can’t go past Columbia Business School’s Podcast series: ‘Value Investing with Legends.’

I enjoyed their recent interview with Polen Capital’s Dan Davidowitz and Jeff Mueller. Polen Capital’s track record of outperformance over three decades stems from their ownership of high quality businesses. I’d put them in the class of investor with the likes of Chuck Akre, Nick Train, Terry Smith, Francois Rochon, Paul Black and Nicholas Sleep, who’ve earned their returns from the compounding power of the underlying businesses they’ve chosen to own. These ‘compounding machines’ are often large well-known businesses, each with enduring competitive advantages that support high returns on capital, defying capitalism’s reversion to the mean. Rather than focus on buying cheap and selling higher, these successful investors ride the exponential curve these great companies create. While these stocks may not appear optically cheap, it’s the power of compounding that can render them structurally undervalued for long periods of time.

The podcast reminded me of some useful mental models that only surface from time to time, some of my favourites were the need for a long runway for growth, ‘Culture’ as a competitive advantage, the concept of ‘Attacking the Moat’, and the lollapalooza effect of many competitive advantages working together.

I’ve included some notes below:

Compounders

“The first take away is that nearly all compounders have high returns on capital and high returns on equity. Capitalism is a brutal place and if you don't have the comparative advantage to protect your high returns, new entrants are going to come in and eat away that competitive advantage.

The fact a company sustains high returns is a signal. The necessary condition is the competitive advantage - the high return on equity or capital is typically the output. All compounders tend to have high returns on capital but not all companies with high returns on capital are compounders. That’s important because it means you can’t just run a screen and buy. There is real critical thought and judgement required.

The second takeaway, is that P/E multiples that are optically expensive are often very cheap prices for compounders. No matter how many decimal places you go out to in excel, you're not going to find critical judgement in a spreadsheet. So a clear understanding of a compounders’ sources of competitive advantage is critical for owning one for long periods of time. You have to have a competitive advantage and that has to be rock solid. It has to exist and be sustainable.

Oftentimes for compounders you need low total addressable market penetration, ideally in a very large total addressable market and even more ideally, in one that is growing. This is often an enabler of reinvesting free cash flow at high incremental returns on each dollar invested. The very act of redeploying this capital back in the business at higher returns not only enables the compounding but it also serves to improve, expand and extend the business’ competitive advantages if allocated properly.” Jeff Mueller

“Structurally with the market, it’s very rare that even the third year of earnings is priced into these business [compounders] let alone the fifth, seventh or tenth year. When you find these companies with real durability that can compound for long period of time, the optically high multiple, when in hindsight that was a smoking deal five years ago” Jeff Mueller

What is Value?

“What does ‘value’ mean today? It doesn’t necessarily mean low PE or low price to book. That style of investing is increasingly difficult because it's easier to arbitrage away. It's easier in a modern age of technology and speed of networks and information to find big outliers before they become really big outliers. I think that’s why you’re finding less opportunity in the so-called cheap, deep value places and where you are seeing them is usually in structurally challenged industries. 

Our definition of ‘value investing’ is not just finding companies at a discount to intrinsic value but a permanence to their business and a margin of safety much more tied to the strength of their financials, and a massive competitive advantage and some big secular tailwind usually being created by the company itself that is driving them over the long term.

The market has a hard time discounting properly great growth companies. They have a really hard time putting a near term PE multiple on a company that can grow earnings at 15-20% for ten, fifteen, twenty years. So we find those companies to be structurally undervalued a lot of the time even though their near term multiples look relatively high.” Jeff Mueller

“Using the term ‘value investing’ became a loaded term a long time ago. If you ask me, I’m not a value investor, I’m a growth investor. But it doesn’t really matter. They are two sides of the same coin. We are all searching for the same thing - people want to buy companies at a discount to their intrinsic value and benefit from the growth in that intrinsic value. I think there are plenty of opportunities. We invest in some of the biggest most well-followed companies in the most efficient market in the world. If we can do it, I can imagine there are other people. We are not the brightest people on the planet.” Dan Davidowitz

Long Term

“The industry is structurally built for the short term. How many people are engaged every day are ‘calling the quarter?’ We are playing a different game. We have a five year time horizon and beyond.” Jeff Mueller

Source: Polen Capital - Q1 2020 Newsletter - Focus Growth

Patience

“The first thing we do is really take our time. Our average holding period is a little over five years. This gives you plenty of time to do the research and do diligence on all the companies that might be in the on-deck circle. In 2015, we worked on Adobe for 15 months. Taking your time is critical in assessing the sustainability of competitive advantages.” 

Competitive Advantages

“Competitive advantages come in many forms. There are network effects; Facebook is a terrific example. I would say culture is a competitive advantage that a lot of people would probably take issue with me mentioning because it can’t be measured. But you look at O’Reilly or Rawlins - phenomenal cultures. Intellectual property, like Align Technology, or biotech companies like Allergan. Switching costs can be a competitive advantage; Microsoft 365 or Oracle. It’s been said switching off Oracle is like dental surgery without anesthesia. Economies of Scale and Monopolies and Brands are other examples. Business Model Innovation like Vail resorts. They come in many forms.” Jeff Mueller

Lollapalooza Effects

“There’s this song by Blink 182 called ‘All the Small Things’. For some reason when I think about competitive advantages it pops into my head. The best compounders I’ve studied and the best ones we’ve invested in don’t just have one competitive advantage where you point to it and say ‘yep, that’s it’. They usually have built this mosaic pulling from almost all the competitive advantages; they have networks, and a great culture, and a safe or aspirational brand and also economies of scale. When you get a lot of these working in the same direction it makes the companies almost impossible to really compete with out in the market place.” Jeff Mueller

Keep It Simple

Polen’s Dan Davidowitz

“We’re trying to do it the easiest possible way. We’re not looking to discover the undiscovered gem. We are looking for very very obvious competitive advantages. They are no secrets. You're going to know most of those companies [we own]. They are well covered. Yet still, there’s great opportunities in those companies. We are looking to get the compounding of earnings growth and hopefully the returns in the easiest possible way with the most advantaged companies. It sounds a little too good to be true you can do it that way, but we've been doing it for thirty years and it’s still there”. Dan Davidowitz

Compounding

“We’ve only owned 123 companies in 31 years and that includes the 21 we own today. The compounding is really what drive the returns. You align yourself with 20 or 25 great companies that can compound for not just years but decades oftentimes and they do the hard work for you. You can sit back and spend your time getting to know the companies. We’re getting the same information as everybody else. We are usually asking much longer term questions as we want to understand long term strategy. We don’t care about this quarter or next quarters earnings. We care about where the company is going over the long term.” Jeff Mueller

“You cannot invest in businesses that go very wrong. You need to stay in the game and compound; that is the name of the game. That’s why we try to keep things relatively simple and straightforward and respect our guardrails. The compounding is not that hard as long a you don’t do anything stupid.” Dan Davidowitz

Humility / No Perfection

“The more you know, you start to realise there is a lot more that you don’t. That’s an enlightened place to be. You can study and study companies but you’re never going to know everything you’d like to know. You’re going to know a fraction of what an insider knows and they don’t know everything either. You have to be careful because you’re never going to know everything. So for us it’s a never ending quest for knowledge on our companies. Everyday you have to try to keep finding more and more about the companies you want to know more about.” Jeff Mueller

‘Moat Attack’

“There is a theory you can’t truly know the moat or barriers to entry exist until that moat is attacked and the attack is repelled. The bigger and more well-capitalised the attacker the better. I think of capitalism like nature, it’s just a brutal place; these attacks are happening all the time. This isn’t a concept that has any absolutism but I do think it is a useful tool. When these things happen there is something probably there. We don’t have any blackboxes at Polen. You can open up the Financial Times and see that there is a large company attacking a company or partnering with a company to attack a company and investigate it, ask Why?” Jeff Mueller

Guard Rails

“Which guard rail is the most important? There is a lot of simplicity around our five guard rails. ROE of 20% or greater sustained is a real signal there is something special going on. You know mathematically you could add leverage and really juice the ROE, so the fact the majority of our companies are in a net cash position and also have sustainable ROE of 20% or greater is a pretty special group of companies. Munger said the number one rule of fishing is ‘fish where the fish are’. These guard rails take us down to the pond we like to fish in. In difficult times like this, not only can our companies go on the defensive, but a lot of their competitors are twisting and turning trying to avoid debt covenants in a credit stressed environment. So by widening the gap, they are even more advantaged relative to people who have become less disciplined with their balance sheets.” Jeff Mueller

Human Behaviour

“I think about the world in pretty simple terms. The one thing that hasn’t changed is that behind a lot of the movements in markets are humans and human behaviour. That is important to know because you can take advantage of opportunities when human behaviour drives companies valuations to places they shouldn't go either on the upside or downside.”

Change

“Things change in the real world. Competitive advantages change, the way humans behave changes. It requires good thought and pragmatic thought to figure out which companies are going to benefit. You don't need to find 1,000’s of good ideas. A handful is all you have to find.” Dan Davidowitz

Summary

There are some critical mental models in this; things to look for when you’re searching for those great businesses. Polen’s Guardrails such as a sustainable ROE of >20% and a strong balance sheet, taking a long term view when looking at a company’s future earnings rather than those to be found in the next quarter, and a business having a host of competitive advantages rather than just one. Even more interesting, a large number of the underlying success factors described by Polen can’t be found in a spreadsheet: Culture, Human Behaviour, Critical Thought and Judgement, and Humility are some good examples of those.

Oh, and when searching for and assessing high quality businesses they like to keep it simple. Like Munger has said: ‘the number one rule of fishing is ‘fish where the fish are’.

Source:
Columbia Business School Podcast Series - Polen Capital

Further Reading:
Polen Capital Interview - Graham & Doddesville. Columbia Business School Newsletter. Winter 2019.
Polen Capital Website - Insights

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Note: This post is for educational purposes only. I have no relationship with Polen Capital or Columbia Business School.

Lollapalooza Time

We’re all looking for great businesses to invest in. Those companies that seem to defy the natural order; that succeed in industries or sectors where others quite simply, don’t. They each have a difference, an advantage over their competitors which is quite often something so simple that it leaves others wondering why they hadn’t thought of it themselves.

It doesn’t sound like rocket science, and often it’s not; it could be a combination of lots of little things producing results that defy the incremental benefits. Often the results are non-linear; one plus one equals more than two. It’s something Charlie Munger refers to as Lollapalooza effects.

“Really big effects, lollapalooza effects, will often come only from large combinations of factors.” Charlie Munger

A few years ago I met with the CFO of a highly successful national furniture chain. This family business had achieved financial metrics that defied its industry; returns on equity consistently above 50%, gross margins above 60% and payback on new stores of under six months. Quizzing the CFO I asked, “Should the economy turn down, you could always cut margins a little?” To which he replied, “No, you don’t understand how the business works.” Expanding a little further, “The CEO starts with the 60%+ margins and works backwards. That’s the goal. A two hundred dollar chair is a two hundred dollar chair. Price it at two-hundred and fifty dollars and you won’t sell any. The CEO does the buying (how many other furniture store CEO’s do?). The CEO works with the suppliers to deliver that chair at a price that allows a 60%+ margin. It might mean removing the number of buttons, changing the fabric or redesigning the chair a little to get that outcome. It’s not about dropping price.” Wow, I thought to myself, that’s the silver bullet. That’s what makes this business so successful. A few months later I had the opportunity to ask the CEO directly, “What’s the key to success? Is it in the sourcing of product?,” I asked. Expecting confirmation of the silver bullet I’d uncovered, he replied, “yes that’s one thing, but really it’s the fact we do lots of little things a little better.”

This combination of factors often creates an impenetrable barrier for competitors. Polen Capital’s Jeff Mueller touched on this in a recent Columbia Business School podcast:

“There’s this song by Blink 182 called ‘All the Small Things’. For some reason when I think about competitive advantages it pops into my head. The best compounders I’ve studied and the best ones we’ve invested in don’t just have one competitive advantage where you point to it and say ‘yep, that’s it’. They usually have built this mosaic pulling from almost all the competitive advantages; they have networks, and a great culture, and a safe or aspirational brand and also economies of scale. When you get a lot of these working in the same direction it makes the companies almost impossible to really compete with out in the market place.” Jeff Mueller

Such firms are often more predictable businesses than firms which rely on a single competitive advantage (e.g. a patent).

"There is no a priori reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed an interlocking, self-reinforcing network of small actions may be more successful than one big thing… Firms that have a process to do many things a little better than their rivals may be less risky than firms that do one thing right [e.g. develop/own a patent] because their future success is more predictable. They are simply harder to beat. And if they’re harder to beat then they may be very valuable businesses indeed." Nick Sleep

In the book, ‘In Search of Excellence - Lessons from America’s Best Run Companies’, McKinsey alumni Thomas Peters & Robert Waterman identified a number of ‘strikingly similar themes’ that characterised the excellent companies they’d researched. It was a combination of these that accounted for the outperformance:

“The most important notion, as we’ve said time and again, is that there aren’t any one or two things that make it all work. [It can be] a dozen factors. And it’s all of them functioning in concert.”

Despite almost four decades passing since the book’s publication, the themes are as relevant today as they were then. Little wonder the book has been accredited by Warren Buffett as, “A landmark book, without question the most important and useful book on what makes organisations effective, ever written.”

I was reminded of this concept recently when reading a Forbes article about an aircraft parts manufacturer called Heico. The title certainly grabbed my attention, ‘The 47,500% Return: Meet The Billionaire Family Behind The Hottest Stock Of The Past 30 Years”. I couldn’t help but notice many of the factors that had surfaced in Thomas Peters & Robert Waterman’s research.

I’ve extracted a selection of the more interesting comments from the Heico article complemented by a few other sources, and where relevant, provided extracts from ‘In Search of Excellence' [ISOE].

Family Business:

HEICO: “I mean, it’s hard to envision family businesses that have been this successful for this long.”

ISOE: “Many of the best companies really do view themselves as an extended family.”

Culture:

HEICO: “Our culture is what ultimately drives the bottom line.”

ISOE: “The excellent companies are marked by very strong cultures.”

ISOE: “Without exception, the dominance and coherence of culture proved to be an essential quality of the excellent companies.”

Focus on the Customer:

HEICO: “We believe that the customer is the most important person in our overall organization. So we are here to serve the customer. And we pride ourselves on making good profits but not gouging the customer in terms of pricing.”

HEICO: “Our customers are our highest priority. After all, without customers, we have no business.”

ISOE: “Whether bending tin, frying hamburgers, or providing rooms for rent, virtually all of the excellent companies had, it seemed, defined themselves as de facto services businesses. Customers reign supreme.”

Close to The Customer:

HEICO: “Typically, our new products are designed in response to direct customer specifications or requests, not as general concepts offered for sale which we hope will later be purchased. This allows us to have a laser-sharp focus on our exact customer requirements.”

HEICO: “Our approach has been, and will continue to be, to learn from our customers what they need, not to develop products and then try to convince our customers to buy the products.”

ISOE - “The excellent companies are better listeners. They get a benefit from market closeness. Most of the real innovation comes from the market. The best companies are pushed around by their customers and they love it.”

ISOE: “The excellent companies pay close attention to what customers want. From listening. From inviting the customer into the company. The customer is truly in a partnership with the effective companies and vice versa. Successful firms understand user needs better. Successful innovations have fewer problems.”

Cheap Prices:

HEICO: “They have done so by acquiring 78 companies over the years and by pricing their parts cheaply.”

Diversified Products / Customers:

HEICO: “Heico produced nearly 100,000 parts, sold to nearly every major airline in the world, as well as defence customers like the U.S. government.”

Wrong Incentives:

HEICO: “The board [of the original Heico company] owned nothing—owned no shares,” recalls Larry. “They weren’t motivated.”

Barriers To Entry:

HEICO: “They found [the after-parts market] to be particularly alluring. Everything needed Federal Aviation Administration approval, which ensured that not every Tom, Dick and Larry could easily enter the industry.”

But Not Too Many Barriers:

HEICO: “Replacement parts weren’t generally patent-protected, so all the Mendelsons had to do was reverse engineer them, then prove to the FAA that they were up to snuff.”

ISOE: “The so-called high tech companies are not, first and foremost, the leaders in technology. They are in high tech businesses, but their main attribute is reliable, high value-added products and services for their customers.”

Win-Win:

HEICO: “Among our greatest strengths over the past five decades is our emphasis on building relationships — relationships with team members, customers, suppliers, shareholders and other stakeholders.”

ISOE: “We have a host of big American companies that are doing it right from the standpoint of all their constituents - customers, employees, shareholders, and the public at large. They’ve been doing it right for years.”

Product Quality Critical:

HEICO: “We do a full metallurgical inspection on every single lot of parts we produce. That includes material hardness, grain size, grain-flow structure, coatings. . . . The reason we do it is because we can’t afford to have a failure.”

ISOE: “Raychem sells complicated ‘smart’ electrical connectors… They sell their connectors on the basis of high economic value of the product to the customer… The connectors are a microscopic fraction of the value of the eventual product - for example, large aircraft; therefore , the customer can, in fact, afford to pay a bundle.”

ISOE: “Quality Obsession. Many of our excellent companies are obsessed by service. At least as many act the same way over quality and reliability.”

Social Proof:

HEICO: “Lufthansa’s investment in Heico—a tacit stamp of approval.”

Investment in Price-Giveback / ‘Jam Tomorrow’:

HEICO: “As their business gained altitude, Larry insisted they live by a blunt rule: “We don’t try to screw the customer.” Heico keeps its prices locked between a third to a half off what an original manufacturer would charge. Heico’s net margin hovers around 15%. It could be more than that if the Mendelsons pushed harder (and some defence products are more profitable). “They’ve historically been reluctant to print a margin over 20%,” says Hebert, the Canaccord Genuity analyst. “They never want to be perceived as gouging or excessively profiting from their airlines.”

HEICO: “Heico’s low-cost, high reliability solutions save each of our airline partners an average of $25m annually.”

Acquire Cost Conscious Founder Businesses:

HEICO: “The Mendelsons are shrewd buyers themselves, having in 2019 completed seven more acquisitions. They shop for owners or top executives who resemble them. “The companies we buy are very entrepreneurial—entrepreneurs that started years ago, started businesses in their garages,” says Larry. “They started with nothing,” which, he says, means “they watch every nickel.”

ISOE: “A few companies have thrived on growth via acquisition, but via a ‘small is beautiful’ strategy. They don’t believe, apparently, in the oft-cited wisdom that ‘A $500 million acquisition is no tougher to assimilate than a $50 million one, so make one deal instead of ten.”

Proper Incentives / Alignment:

HEICO: “The Mendelsons don’t usually buy an entire firm. More often than not, they leave a fifth of it in the hands of the owners or the chief executives running the place to keep them incentivized.”

Incumbents Won’t Compete:

HEICO: “The Mendelsons have been able to earn a foothold in an industry dominated by the so-called original equipment manufacturers, the GEs and Boeings of the world, who are the first to develop the parts and keep prices high on any replacements to help recoup the original R&D costs.”

Innovate:

HEICO: “One of our key tenets is that we must constantly develop, produce and sell new products to add to our existing product lines. Simply put, we are not interested in having our existing businesses remain static.”

ISOE: “There are some associated rules. For example, each division [at 3M] has an ironclad requirement that at least 25 percent of sales must be derived from products that did not exist five years ago.”

Stick to the Knitting:

HEICO: “It wasn’t long before they were casting about for similar opportunities in the after-parts market, which they found to be particularly alluring.”

ISOE: “Our principal finding is clear and simple. Organisations that do branch out (whether by acquisition or internal diversification) but stick very close to their knitting outperform the others.”

ISOE: “Acquisitions followed a simple rule. They have been small businesses that could be readily assimilated without changing the character of the acquiring organization. And small enough so that if there is a failure, the company can divest or write it off without substantial financial damage.”

Source: Forbes

Decentralise / Autonomy

HEICO: “As long as you do what you say you’re going to do, they”—the Mendelsons—“leave you alone,” Barnes says. “And they ask, ‘Do you need anything?’” 

HEICO: “We understand that entrepreneurs have unique skills and that they focus on their businesses in critical ways; we generally go to great lengths to avoid losing that. This entails greater autonomy for the businesses than many large companies are willing to give, and an aversion to consolidating acquired companies, but we are committed to this model.”

ISOE: “If the manager of a business can control all aspects of his business it will run a lot better. We believe a lot of the efficiencies you are supposed to get from economies of scale are not real at all. They are elusive.”

ISOE: Regardless of industry or apparent scale needs, virtually all of the companies we talked to placed high value on pushing authority far down the line, and on preserving and maximising practical autonomy for large numbers of people.”

Value Employees

HEICO: “We feel very good about the way that we are taking care of our team members. Some organisations say their people are employees; we prefer to say team members.”

ISOE: “Most impressive of all the language characteristics in the excellent companies are the phrases that upgrade the status of the individual employee. Again, we know it sounds corny, but words like Associate (Wal-mart), Crew Member (McDonald’s) and Cast Member (Disney) describe the very special importance of individuals in the excellent companies.”

ISOE: “Treating people - not money, machines, or minds - as the natural resource may be the key to it all.”

Encourage Ownership:

HEICO: “The Mendelsons have long encouraged their employees to take advantage of a lucrative retirement plan. They match up to 5% of what workers sock away in their 401(k)s—not in cash but in Heico stock. So, put in $5,000, get $5,000 worth of Heico shares, which, of course, have done nothing in the past 29 years but wildly appreciate. In other words, the stock has turned a lot of ordinary Heiconians, especially early staffers, into millionaires. No, that’s incorrect, Larry says. “Multimillionaires.”

HEICO: “The people who work in the company: the machine operators, the secretary, shipping clerks, floor sweepers, cleaning people - anybody associated with HEICO who is on the payroll, is eligible for that 5% match.”

Head Office:

HEICO: “Our corporate head office consists of only six people.”

ISOE: “Top level staffs are lean; it is not uncommon to find corporate staff of fewer than 100 people running multi-billion dollar enterprises.”

Long-Term:

HEICO: “When we came to this company 33 years ago, we decided we wanted to build something for the long term, and it wasn't going to be built for years or a single decade, it was going to be built for multiple decades. And frankly, every single thing that we've done and every decision that we take has been designed to drive sustained long-term growth of the business as opposed to any short-term focus. So when we've got to make decisions on everything from inventory, capital expenditures, people, customer relationships, everything is focused on cash generation as a result of also maintaining low debt, and being able to create a culture which drives long-term performance.”

HEICO: “The thing that's interesting is, I think that these margins are a result of frankly what we did a decade and two decades ago. They're not as a result of what we've done in the last year or two. When you treat your customers right, you treat your people right, you get into a virtuous cycle and I think that's very much where we are. And I think, we're reaping the benefits of the long-term culture that we put into place over 20 years ago, 30 years ago and that's what's driving these numbers.”

Summary

There’s a plethora of useful mental models in the above:

Industry Structure [Incumbents don’t discount so they can recoup previous R&D expense] / Small Cost of Product vs Total Cost / Fragmented Customers / Fragmented Products / Mission Critical - Quality Products / Barrier to Entry [ie FAA Approval] / Reputational Advantage / Pricing Power / Investment-in-Price-Giveback / Decentralisation - Autonomy / Innovation / Close To The Customer / Encourage Ownership / Sensible - Smaller Acquisitions / Aligned Management / Minimal Headquarters - Valued Staff

These attributes together create a formidable ‘Barrier to Entry’ for Heico.

Perhaps, unsurprisingly, you’ll notice that many of the same attributes above are also evident in the great companies covered in these pages before. The majority of these are qualitative in nature - you won’t find them in a spreadsheet.

“Economists talk about ‘barriers to entry,’ what it takes to compete in an industry. As is so often the case, the rational model leads us to get ‘hard’ and ‘soft’ mixed up on this one, too. We usually think of principal barriers to entry as concrete and metal - the investment cost of building the bellwether plant capacity addition. We have come to think, on the basis of the excellent companies data however, that that’s usually dead wrong. The real barrier to entry are the 75-year investment in getting hundreds of thousands to live service, quality, and customer problem solving at IBM, or the 150-year investment in quality at P&G. These are the truly insuperable ‘barriers to entry', based on people capital tied up in ironclad traditions of service, reliability, and quality.” ISOE

While we haven’t covered all the useful mental models from ‘In Search of Excellence’ we’ve ticked off a lot of them. By studying the characteristics that have made businesses excellent, we can then search these out in other potential investments. When a multitude of factors create an impenetrable barrier, a Lollapalooza effect could be in the making - but don’t just look for that single silver bullet; it might just be made up by a lot of little things.

Sources: Forbes - ‘The 47,500% Return: Meet The Billionaire Family Behind The Hottest Stock Of The Past 30 Years’. Abram Brown. January 2020.

‘In Search of Excellence - Lessons from America’s Best-Run Companies’. Harper & Row Publishers. 1983

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Railroader - Learning from Hunter Harrison

“It may not be ‘cool’ or sophisticated to operate in a low capability field, but ‘contrast’ is optimised by being a super performer, in the weakest of fields.” Peter D Kaufman

The second law of thermodynamics holds: ‘The greatest thermodynamic efficiency is achieved by working with the hottest possible source and the coldest possible sink’. In Munger like fashion, Peter D Kaufman, Chairman and CEO of Glenair, adopted this as a useful mental model in business: ‘we should strive in our performance to be the ‘hottest possible source’, in combination with the ‘coldest possible sink’ of competitive field, niche or system.’ A telling example is the Railroad industry; an industry that hadn’t adapted for a generation and then combined with a ‘super performer’ named Hunter Harrison.

The late Hunter Harrison was a tour de force, a railroading genius who worked his way up from the rail yards at eighteen to run four publicly traded railroads, at the same time delivering billions in value to their shareholders. Harrison’s story is told by Howard Green in the recent book ‘Railroader - The Unfiltered Genius and Controversy of Four-Time CEO Hunter Harrison’. Warren Buffett, a railroad owner himself, noted ‘It’s an interesting read.’

Harrison’s story highlights the potential for a brilliant operator to significantly improve the operating performance of a lazy capital-intensive asset. Having developed a more efficient operating philosophy, ‘Precision Scheduled Railroading’, Harrison achieved operating margins and profitability which were the envy of competitors.

In contrast to the win-win philosophy evident in many of the recent businesses we’ve studied, at times Harrison’s approach drew criticism from employees and customers. This is an important differential, as his success suggests different cultures may be appropriate for different business models. WCM Investment Management’s Paul Black, suggested something similar, in that it’s important to ensure a business’ culture aligns with the company’s competitive advantage.

"Sam Walton really embraced the notion that you have to bring people along, you have to get people excited, you have to make people happy. You have to pay people well and tie them into the bottom line. He built this culture where people just loved coming to work and they had a lot of fun doing it. As a result they took on these old stale bureaucratic centralised organisations. That works for a retailer. But do you really need happy employees to run a railroad? Probably not. You want people that are highly accountable, that probably think in certain way, more linear, because it's all about delivering an on-time product in an efficient, cost effective manner. There is a high cost of failure. Different stresses. Very difficult corporate culture is needed for that than for a retailer. We found there are different cultures you find for different businesses that are effective." Paul Black

The book is an enjoyable read. In particular, the story of how Bill Ackman’s Pershing Square, having recognised Harrison’s innate abilities, made billions buying a stake in Canadian Pacific and recruiting Harrison to run the business.

I’ve included some of my favourite quotes below:

Super Performer

“For decades, Hunter Harrison, an American from working class Memphis, would repeatedly show people how to do it better than anyone else.”

“While Harrison, the unrivaled operator, did not envision a global computing Goliath, in certain respects, he was the Steve Jobs of railroading: uncompromising, unrelenting, fierce, antagonistic, confrontational, and a winner.'"

Shareholder Value

“Railroading wasn’t about being a train aficionado. It was only a route to shareholder value creation. That was everything.”

Stakeholders

“You don’t turn around capital-intensive businesses with legacy costs and thousands of employees, making them the most efficient major railroads in North America, without leaving some ‘blood on the tracks'.’”

“‘My mandate in these jobs has never been to be Mr. Popularity’. Indeed, Shareholders of four railroads hired Mr. Un-Popularity to turn around their flagging fortunes. The willingness to not be loved was the price he paid to get things done.”

Capital Intensity, Sweating Assets & Lots of Little Things

“So much of what Harrison taught came down to assets. Few things bothered him more than under-utilised ones. If an asset isn’t used, he wrote, ‘It’s a liability’ because of the costs associated with owning it. ‘Railroads only make money when cars are moving. Track is a railroad’s most expensive physical asset. Track has a 40 year life. So why would we lay down tracks to have cars sit idle?’”

“Railroads, he wrote ‘were awash in long-lived assets’ - track, locomotives, and cars. He went deeper. What if dwell times in yards were cut to eight or twelves hours instead of twenty-four? What if customers unloaded faster so their cars were there for half the time? What if average velocity went from twenty-five to thirty miles an hour? ‘Now we’re getting more cycles from the same equipment.’ As he would say, a thousand little things equal a lot of money.’

Data

“It was during his time at Burlington National that Harrison became intrigued by computers.. Harrison was acutely aware of the value of data.”

“The birth of MCSM (Major Corridor Service Measurement), a system that tracked traffic patterns from origins to destinations. From that day on, there became pressure to measure like that. The team would define an acceptable amount of time for a boxcar to get from origin to destination and then monitor it to see if it made it in the set time. If it didn’t, the system showed them where a car lost time and why. [Harrison] was the only one who actually understood what the data meant. He could look at the data and know exactly what that meant from an operating perspective.”

“Soon [Harrison] was scrutinising the return on assets, capital spending, depreciation, cash flow, and revenue. He also wanted all the regions of the railroad to be cognisant of these numbers.'“

“Hunter Harrison would drool over such data like a kid over a comic book. More precision was being built into the railroad’s schedule, a step toward heaven for the obsessed, continuous learner and improver. Every possible scenario had to be accounted for so it could be in the algorithm and the algorithm could figure out what was supposed to happen.”

“Previously, CN quoted delivery times in days - plus or minus a day or two for flex. Edmonton to Chicago was seven to nine days. Sometimes is was five or six, other times ten or eleven. That drove Harrison nuts. He wanted to quote in hours not days. If a train was scheduled to leave at 8am, whether there were sixty or one hundred cars. If you measured in hours, everything got more precise. Taking it even further, if you measured car inspections in seconds, they got faster too.”

“Trouble was often avoided by a deep understanding of railroading - and a deep understanding also meant measurement, something Harrison was big on.’

Competitive Advantage / Precision Scheduled Railroading

“As Harrison said, his basic view didn’t change during the decades he ran railroads - service customers, control costs, utilise assets, don’t get anybody hurt, and recognise and develop people.”

“Leadership skills and boxcar moving skills would one day coalesce into Precision Scheduled Railroading, the operating philosophy that would become his calling card worldwide.”

“Freight trains ran on volume. Customarily, when the car was full, it would depart. Neither the railroad nor the customer knew when that would be. He said, we’re going to flip this very basic premise and run on schedule. By doing so, the railroad would utilise its assets at maximum efficiency and get rid of ones it didn’t need, saving huge amounts of money.”

“What produced results [at Illinois Central] was the approach he would preach for the next two and a half decades - what train velocity does for efficiency, what longer trains mean for efficiency, and on and on. He saw better processes for everything, base hit after base hit.”

“Everywhere I’ve been, we’ve gained market share and been able to increase price. And I think that’s the important thing, and that’s driven on the product you have.”

“Harrison predicted CSX could take about 10 to 15 percent of Norfolk Southern’s business. He said CSX would get its cost lower than NS’s and then price more aggressively.’

Common Sense

“While much of what Harrison did was based on an intellectual approach that had developed over years of observation, thought, and the honing of processes, much of it was also common sense.”

Operating Ratios

“Harrison’s operating ratios were not, however, aberrations. Illinois Central was usually ten points better on Operating Ratio than the next best - and twelve or thirteen points better than the average. For Harrison, a lot of it came back to his time as a train master.”

“By most performance metrics, the CP turnaround had been off the charts. At the end of 2016, the operating ratio was 58.6 percent, the best on record at the railroad - and down from more than 80 in 2012.”

Source: Fortune Magazine

Customers

“[Harrison came] to the conclusion that if you said yes to everything the customer wanted, you wouldn’t make any money. That approach would help him make enormous profits in later years, but it would also eventually result in criticism that would later hound him.”

Culture

“I’ve never seen a guy grab hold of a company,’ Gray said [CN Board Member], ‘and change the culture and the results in such a short period of time.’ Was it all warm and fuzzy? Gray asked rhetorically. ‘Not on your life.’”

“[At Hunter Camps for senior executives,] Harrison wanted the campers to internalise his key principles - provide service, control costs, utilise assets properly, concentrate on people, and not get anybody hurt. He didn’t necessarily want the smartest people in the world, he wanted the hardest working people in the world.”

“[He wanted attendees at Hunter Camps] to be passionate, arguing that people - employees - were dying to do something that mattered, to be inspired. ‘Just care’, he pleaded. He told the room he viewed Hunter Camps as the most important thing he could do at the railroad - changing the culture.”

“Among the factors highest on Harrison’s list was culture. CSX, he said, was the sum of putting together more previous railroads than any of the other Class 1’s. ‘We don’t have a culture.’, he said. ‘We have about nineteen.’ As a result, he said staff ‘don’t know where they belong.’ To enact cultural change, Hunter Camps would be revived.’

Industry Structure & Change

“Harrison was a ‘change agent,’ and the status quo, while comfortable for most people, was uncomfortable with him. Railroads, Gray [CN Board Member] said, were ‘slow to adapt’. The industry had not evolved for a generation. Given that the sector was ripe to be whipped into shape, he said it was inevitable that someone like Hunter Harrison would come along eventually. ‘I’d never seen anybody who was more appropriate for the time and the changes required than Hunter.”

“Harrison quoted the former chief of staff of the US Army, General Eric Shinseki: “If you don’t like change, you are going to like irrelevance even less.” He pointed no further than the cassette tape and the compact disc. As for those who say businesses just mature and get commoditised, Harrison wrote in one of his manuals, “this is simply the excuse of losers… Time after time, people and organisations entered stable, mature markets and turned them on their ears. Haagen-Daazs did it with ice-cream, Starbucks did it with coffee, and Canadian National keeps doing it again and again with railroads.’

Competitors

“When asked, however if competitors would up their game and perhaps try to copy what he was doing, he said they could buy the books he’d written at CN. “[They’re each] on eBay for a thousand dollars,” he cracked, adding that he hoped they would try to emulate his operating methods, because he viewed his competitors as partners, since railroads depend on each other’s lines to get their cars where they need to go.”

Boards

“Harrison had little patience for boards. Put simply, they were a pain, a waste of time and money.”

“Did a board add shareholder value? In the final analysis, Harrison would say no, at least at a railroad.”

Head Office

“[Upon joining CP] Harrison also didn’t like head office, which he called the ‘glass house’ in downtown Calgary. It would not be long for this world… It was also the opposite of what he thought a revamped railroad needed - in-your face contact with rail cars. Harrison would soon announce that he was relocating head office to a rail yard. CP’s headquarters would be where the action was - next to the tracks.”

Mergers

“Hunter Harrison once said, ‘They ain’t buildin’ any more railroads.’ Critical infrastructure was constructed decades, if not more than a century ago, as cities built up around rail lines. The only way for existing railroads to get bigger and more efficient was to swallow others.”

Failure

“‘Success is a lousy teacher,’ Harrison wrote. ‘It seduces smart people into thinking they can’t lose.’ He preferred types like those who came up with the household lubricant WD-40, named numerically because the inventor failed 39 times before coming up with the magic formula.”

Team

“Harrison invoked ‘the team’ and studied great sport coaches of the modern era. While many CEO’s love reading biographies of political leaders, Harrison’s shelves were full of books about winning coaches. While he drew lessons from all of them, he favoured the no-nonsense, tough-guy styles of the past - Vince Lombardi of the Green Bay Packers and Bear Bryant of the University of Alabama. Both were feared and respected.”

“‘Great teams don’t allow people who don’t want to really play to stay,’ he wrote in his first manual.”

“Soon, non-operating people like computer programmers would be trained as conductors. Managers would learn how to drive trains. This would not only give the company flexibility, but office workers would learn what it was like on the front lines of actually operating a railroad. ‘Nothing was sacred’ was the message.”

Reward Employees

“More than half of the employee base at CN had joined the stock purchase plan, and the improvement in the operating ratio and the stock price benefitted many.”

Walk The Floors - Tone At The Top

“Harrison travelled constantly, so employees everywhere saw him in action.”

“Like at CN, nose-to-nose encounters with the new chief had a way of resonating throughout the organisation.”

Consultants, Monthly Budgets & Rule Books

“Rule number one: no consultants without Harrison’s approval - and he added they wouldn’t get his approval.”

“Then came the assault on the monthly ‘outlook.’ He growled that compiling it was simply busy work, again adding no value, The team drew up the budget for the year in the fall. Unless something changed drastically, he didn’t want high-priced employees fooling with spreadsheet updates. ‘Shit, we ain’t nuthin’ but statisticians .. I want to move boxcars’ and serve customers, he added. ‘I want to know who in the shit you do this for?’ Again, silence.”

“Thumbing through the CSX employee rulebook, which resembled a phonebook from a mid-sized city, he shook his head .. He argued that voluminous rulebooks gave people a false sense of security. He planned to eliminate it and have a new one written that would fit in a pocket and not tell people ‘how to walk'.’”

Summary

Hunter Harrison was a maverick in an industry largely unchanged for decades. His intimate understanding, like a sixth sense, allowed him to extract costs and increase efficiencies across the companies he ran. Assets had to keep moving, otherwise they were a liability. Inverting the incumbent operating system, harnessing technology and data, and optimising hundreds of small processes created a superior operating system that maximised profitability.

While some customers may not have welcomed some of the changes Harrison implemented, they benefitted from a faster and more reliable freight service. At times, despite employees and management considering his approach ‘too tough’, Harrison deemed it essential to achieve the cultural changes so required for a successful turnaround.

Ultimately, shareholders were rewarded. Harrison’s record of improvement was so astonishing, a few investors sought him out to run other underperforming railroads.

“Canadian Pacific is shipping 20% more freight than it did before we started, or than it has ever shipped in the past. And it’s shipping that freight 40% faster than ever, with record on-time performance, 40% fewer locomotives, 35% fewer people, and 14% improved fuel efficiency—all while maintaining an industry-leading safety record. In sum, CP is doing much, much better and more safely—and with far less. For our investors, these changes have resulted in an explosion of cash flows. When we made our investment five years ago, the company was worth only $8 billion, reflecting the poor performance of the railroad. Today, with the improvements cemented, it’s worth $30 billion. Bottom line, there are large amounts of latent value in public companies waiting to be unlocked. All it takes is some fresh eyes and hard work.” Paul Hilal, Pershing Square, 2016.

It’s little wonder Buffett has kept a close eye on Hunter Harrison’s railroad success.

“All of those companies [run by Hunter Harrison] dramatically improved their profit margins, and they had varying degrees of difficulty with customer service in the implementing of it. We are not above copying anything that is successful. And I think that there’s been a good deal that’s been learned by watching these four railroads, and if we think we can serve our customers well and get more efficient in the process, we will adopt whatever we observe.. there’s been growing evidence that we can learn something from what they do.” Warren Buffett 2019

‘Cold sink’ industry investments coupled with ‘super-performers’ can be a recipe for billions.

Further Reading:
Pershing Square Presentation on Canadian Pacific
’Value Creation by Active Investors (and Its Potential for Addressing Social Problems)’ - Columbia Business School, 2015

Reference:
‘Railroader - The Unfiltered Genius & Controversy Of Four-Time CEO Hunter Harrison.’ Howard Green, 2018. Page Two Books

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Learning from Charles Schwab

Many of the great Investors have left their mark on our investment world. Some have been innovators, others have been pioneers and all have been performers. And unsurprisingly, all have posted consistently outstanding results because of it. Each in their own way has crafted individual legacies which can teach us new ways of thinking when we trade. When it comes to the business of trading one man stands out from the crowd and has significantly changed the way Americans buy and sell investments.

And that one man is Charles Schwab.

In doing so, he built a Fortune 500 company whose value compounded at an average rate of 19% a year since IPO in 1987; twice the growth rate of the S&P500. Central to his belief; the customer was at the heart of everything Schwab did. He entered a race that for fear of revenue loss, the large incumbent brokers didn’t want to be involved with, a lucrative niche providing customers with cut-price stock transactions which he exploited and expanded with new technologies.

Charles Schwab tells his story in a recent book, ‘Invested - Changing Forever The Way Americans Invest’. On the dust jacket, Warren Buffett notes, ‘I’ve admired Chuck Schwab for a long time. When you read this book, you’ll understand why.’

In many ways Charles Schwab epitomises the ‘Scale-Economics Shared’ model employed by many of the great enduring companies. In a recent investor letter, IP Capital Partners noted, ‘Throughout its history, Schwab has continually cut the cost of investing through its platform and kept its competitors under constant pressure.’ Lower prices = more customers & increased revenue. Lower costs = increased profits. Return profit to customers via even lower prices. Repeat.

“Never underestimate the power of a low-cost structure: if you can make a profit by offering consumers good value; it’s a great business plan.” Francois Rochon

Charles Schwab vs S&P500 - 1987-2020 [Source: Bloomberg]

As a veteran of markets for over forty years, Charles’ reflections on the 1987 crash and the Global Financial Crisis are timely reminders of the need to remove emotion and maintain an investment plan in times of panic. I’ve collected some of my favourite quotes from the book below, but don’t be surprised to see many of the common themes we’ve seen with the other great businesses we’ve studied.

Competitive Niche

“Everybody said to me, ‘Wait until Merrill Lynch decides to go into your business. You are going to be crushed.’ I was worried, but Merrill was an entrenched member of the Wall Street establishment. It was still beholden to its many commissioned brokers, and its highly profitable investment banking and research business. It couldn’t just chuck all that out the window.”

“I thought if I could strip away all the fluff surrounding the purchase and sale of stocks - the tainted research, the bogus analysis, the flimsy recommendations, all the ways that Wall Street had historically justified high commission - and sell just the plain-vanilla service of executing trades, I could slash overhead, focus on efficiency, cut prices dramatically - by as much as 75% - and still make a profit.”

“How would my firm differ from the kind of firms that had ruled Wall Street for so many years? For one thing, I meant to serve an entirely new client base, composed of what we now call independent investors.”

“We were the common enemy of every big firm that had ever prospered under the old, protected system (regulated commissions).”

“If you take brokers out of the equation - as I was proposing to do - how then do you sell stocks? Well, you don’t sell. You market. My big aha! was when I realised I didn’t have to sell at all. All I had to do was market the discount brokerage service and then provide the best possible customer service.”

“Recognising a business opportunity is only one part of succeeding as an entrepreneur. The key is acting on your business insight and following through.”

“Our business was based on finding ways to break compromises. That was the magic behind lower trading costs, 24-hour phone service, local branches, no-fee IRAs, and internet trading.”

“A business like ours comes down to two things; a big idea that makes a difference in people’s lives, and people who believe in it and will see it through to fruition day after day, despite what may get in the way. You have to get both right.”

Leverage Change

“I was starting Schwab hoping to take advantage of the significant changes that would come from the deregulation of the brokerage industry.”

Low Costs

“Our whole business plan revolved around keeping costs low. No lavish expense accounts, no fancy digs, no high salaries or fat commissions for our brokers.”

“I wanted to cut out all the frivolous costs so that I could make the price to the investor substantially lower than had ever been seen before - as much as 75% lower than traditional firms were charging. It would be a fact that practically jumped off the page at independent investors when we began advertising.”

Technology

“We paid a price early on by automating well ahead of our competitors, but the leverage we gained for later growth was enormous.”

“People often ask why Schwab got into technology so early and in such a big way to make it a defining part of who we are and how we operate to this day. In some ways, necessity is the mother of invention. We had to get more efficient or we were dead in the water. When I first started Schwab and slashed commissions by 75%, I had just a vague idea that I could make it work. I knew it would take volume.”

“I’m no technology expert, but I have always been willing to invest in technology, and not just because it lowers our costs and gives us a competitive advantage. The way I see it, every time we make another advance, we strip away one more layer of intermediation between the masses and the markets. That’s always good.”

“With each new technological advance, we provided a level of service a cut above other discounters; and we brought our clients one step closer to my ideal of direct, unmediated participation in the market.”

“We were trying as many things as we could to get ahead in technology. Not all of them were working but we kept pushing forward - knowing the future was coming at us fast, and the future was all about technology.”

Culture

“[We had] an entrepreneurial culture that was big on creativity and imagination and not so big on structures, details, and planning.”

Path to Freedom

“Today, I remain more convinced than ever that investing is the individual’s path to financial freedom.”

Be An Optimist

“I’m an optimist. And investing has always seemed to me to be the ultimate act of optimism. You’ve got to have confidence that the money you invest today is going to grow; otherwise, you might as well stuff it under the mattress. You have to believe tomorrow will be better than today.”

“I believed it then, I believed it when I started Schwab against so many odds, and I still believe it today. To be a successful investor, you have to be optimistic.”

Approach to Money

“Trying to build a life in the wake of the Depression had an enormous impact on my parents’ attitude toward money, saving, and risk that lasted their entire lives… So much of a person’s attitudes and habits towards money get formed when they are young. We see it with clients at Schwab every day.”

“A person’s approach to money, his or her saving and spending habits, and comfort or discomfort with risk are all deeply ingrained, and more emotional than rational.”

Reciprocation

“I’m sure one of the reasons for my success over the years has been that people generally like me - and the secret to that is just human nature: I pay attention to them. I listen to their stories and take a genuine interest. And it’s made for a richer life. People are endlessly fascinating and their stories are motivating.”

Reading

“I read a lot of biographies of people who had accomplished great things, people such as John D Rockefeller, J.P. Morgan, Charles M Schwab, the steel magnate (no relation), and many others. I saw the importance of determination, or passion and fighting hard for what you believed in, and the importance of optimism and believing good things are possible. All the people I read about had a maniacal focus on growth.”

Public Speaking

“To this day I encourage young executives to get training in public speaking. No matter how good they are, mastering those moments in front of an audience is crucial to leading others, and it rarely comes naturally.”

The Stock Market & Investing

“With the stock market, there are no guarantees. You can guarantee service, costs, quality, and certainly integrity. But you can’t guarantee performance; Risk is just part of the deal.”

“I don’t think human nature deals very well with the patience and strong stomach investing requires. We’re wired for fight or flight.”

“I have now seen nine crashes in my life, and it still troubles me that investors react this way [sit on the sidelines], because it always ends the same. The market roars back and leaves too many investors sitting on the sidelines missing out. Sometimes I wish I could just tie them to their chairs to help them ride out the temporary storm. To this day our advice is the same: ‘Panic is not a strategy, stick with your investment plan, and don’t let emotions get the better of you.’ Heeding that advice when you’re in full panic mode is just not easy. People aren’t wired to be good investors.”

“The most natural instinct is to run for the door. To sell. Sell everything,’ I said [in 2008 when reaching out to clients]. ‘You’ve got to fight that emotion because you want to be able to hang on for the recovery. Which has happened every time we have had an experience like this in my career .. and that goes back now some 40 years … nine different cracks in the market like this. Smart investing is about taking it year by year. It is a little bit of a nightmare, but we handle those by living through them and looking forward to better days.’ Did I get the timing right with my advice? Not exactly. You never do. And that’s exactly the point… Timing the market is impossible. As the saying goes, it’s not timing the market that counts, but time in the market.”

“Successful investing is not easy, that’s the bottom line. It involves so much of your emotions, your sense of self-worth, your ego.”

The Unexpected

“To be fair, every worst-case scenario at the time [prior to 1987 crash] assumed a sudden market decline of 5%, not 25%. What happened on Black Monday was a previously unimaginable event, which, after the fact, becomes a calculable risk against which responsible parties take steps to protect themselves in the future. It’s those extreme moments when things come out of a dark closet and into the light so that you see them… [One account] exposed a hole in our defences. Today, we take those measures to new heights, running crisis scenarios that are far out of the realm of any prior experience, trying to make the unknown, if not knowable, at least manageable.”

Decisions & Process

“You control your decisions and you control how well you execute them; you don’t control the environment.”

“Don’t panic and overreact to the economic environment or the stock price; stay focused on what works.”

Mistakes

“I’ve always felt that when you make mistakes, if you stand up and admit them, people will give you the benefit of the doubt. Acknowledge and own up to problems and people will trust you. That will be helpful the next time. If you blame somebody else or try to sugarcoat the problem, you may get away with it once.”

Encourage Ownership

“Experiencing how powerful and motivating that sense of ownership is, I’ve always encouraged and helped my employees over the years to be owners in our company as well.”

Reward Staff

“I paid people what I thought they were worth, regardless of seniority, and I used perks and bonuses to reward my stars.”

“Employees are your most important resource. Helping them take care of their health is simply good for business.”

People

“Business is all about people and you need to find those who share your vision and values, who will bring their own passion and strengths to the task. And you need that at every level of the organisation, from the mailroom up to the boardroom.”

“An entrepreneur who is afraid to hire people who can do something better than he can is doomed.”

Growth

“I always wanted our company to be a growth company.”

“In my experience earnings follow growth, and stock prices follow earnings. My philosophy is that with growth, everyone wins: clients get better service; investors get a better return; employees get jobs and rising pay; the community gets support; and, of course, the government gets taxes.”

“I believe it is incumbent on every leader of a company that the number one thing on their mind is growth. You don’t prosper without it.”

“We are growth junkies - people who thrive on change and adaptability and the next new thing.”

“It’s an irony: growth is a sign of success and shows you’re on to something that people want, but with a young company like ours the growth outpaces your sources of capital. You’re reinvesting every penny of profit you can, and it’s not enough.”

Source: Schwab.com

Risk

“Gamblers like taking risks, not entrepreneurs. Entrepreneurs start with a vision and accept, reluctantly, that no vision was ever realised without risking something important. But a true entrepreneur seeks to control his risks as much as possible.”

“Taking and managing risk is a critical part of any successful endeavour. In business particularly, you have to have an appetite for it or you stagnate and don’t do things that delight the customers and keep them coming back.”

“My role was to embrace risk when I saw an opportunity for a huge reward. I’ve always tried to encourage my operating people to make big leaps that could have a significant impact on the company’s bottom line.”

“You’re never gambling the whole house, you take calculated risks. You’ve thought things through, and experience and maturity and intuition and the tests you go through give you incrementally better odds each time.”

Innovate & Accept Mistakes

“You have to be willing to embrace client-focused innovation, even when it competes with your own existing business. Sometimes the most important competitor you confront is yourself. That’s how you stay a step ahead of everyone else. You can’t think just because you’re big, just because you’re successful, that you can’t disrupt yourself. You can - and in fact in today’s world, you have to.”

“We tried a lot of things that didn’t work. For a while it was one failure after another. But that never worried me. Innovators should expect failure, it’s part of the process. As head of the organisation, it was my job to encourage experimentation, not punish it.”

“We had a history - a culture of innovation - that helped prepare us for the internet.”

“You try a lot of things as an entrepreneur. You learn as you go. And sometimes you wind up with something that works that wasn’t planned.”

“The work, the innovation, is never done. There’s always another new idea, another convention to challenge, a million ways to make investing better. We just need to do it.”

Help the Customer

“Our clients have always been the heart of our business.”

"I always believed that profits were something that come naturally at the end of the line, if you got the first part right - finding new ways to help the customer succeed."

“We had a lot to learn on the way to becoming a company that could be proud of its customer service, which was the goal, and it took us a long time to get there.”

“All I ever set out to do was build a firm that serves the customer the way I’d want to be served myself.”

“We have never been the cheapest discount broker, but we have always tried to offer our customers the most value.”

“Every client interaction changes our company’s future - either to the positive or negative.”

“It was really one thing that bought us success: a zealous team of people on a mission that I fondly refer to as ‘Chuck’s secret sauce', all of them in lockstep pursuing a simple innovation, total empathy for our clients: make it better, easier, more successful for the investor. I call it the mother lode of our innovations, more important than any single technology or new product. It was building a company from a basic belief; view your decisions through your clients’ eyes.”

Nuisance Fees

“[In 2004] we were struggling to grow, and Schwab has always been a growth company. Now we were doing things to solve our problems that created difficulties for our clients. Our prices weren’t competitive, and we’d let some nuisance fees creep in. Walt Bettinger, who was then leading the branch network, called them gotcha fees, which we tried to avoid. We’d gotten harder to work with. We made our struggles into our clients’ problem, and that couldn’t stand.”

Walk The Floors

“I had never paid much attention to what my competitors were doing. I did not waste time thinking about how to exploit their weaknesses. Instead, I was always keyed into my own clients. To me the trick was coming up with products and services that satisfied investor needs before anyone else did. Get out ahead and others would be playing catch up. .. The only way that works is if you have first hand knowledge. I got mine spending a lot of time in the branches - talking to customers, watching what they were doing, trying to understand what they were thinking.”

Cost Cutting

“You can’t cut a company to greatness.”

Branch Offices

“It turns out there is something about having a nearby presence that helps persuade people to do business with you.”

“The branch offices turned out to be spectacular growth engines.. We opened somewhere and, boom, our business exploded by a factor of 15. Here, I saw, was the key to growth on a grand scale - the kind of growth I had been seeking ever since I founded Schwab.”

“It took roughly four years on average for a branch to become profitable. Opening branches is expensive, it eats into profits. But not forever - that’s the key.”

Debt

“We face enough risk and uncertainty every day in our business, not just normal operating risk, like any other company, but also stock market risk. To compound that double uncertainty with a mountain of debt strikes me as unwise. Plus I spent too many years as a young man having to scratch and claw for money. If that means we keep more cash around than some analysts think is appropriate for maximising shareholder value, so be it.”

“[We’ve] always been conservative with the balance sheet.”

Wall Street

“When it comes to telling tales aimed at garnering sales - as I know from hard experience - brokers are the best. I suffered my share of bubbles as a young investor.”

“Our employees weren’t compensated in a way that encouraged them to persuade clients to do more trading.”

Advertising - Social Proof

“The biggest obstacle we had to overcome was a perceived lack of credibility. Most of our customers knew us only as a telephone number… One way we fought that perception was the same way McDonald’s did - by counting our customers and bragging constantly about our growing numbers; ‘16,000 investors can’t be wrong,’ we said in one of our early newspaper ads.”

“Nothing compares to the word of mouth that results from good PR. It was true then, and is truer today, with the explosion of social media.”

“[Our agency] floated the idea of using my picture as the centrepiece for all our print advertising .. We had to find a way to personalise our clients relationship with the firm, or we were just a phone number and a mailing address.”

Acquisitions

“A lesson about acquisitions: understand the culture you’re buying, really figure that one out. Is it compatible with yours? Or do you have an opportunity to transform their culture so it aligns with yours?”

“You get so confident about things, willing to do anything to acquire companies, but you still have to do your analysis to see, ‘Does it really fit?’ In my experience, the biggest potential problem, is always culture.”

Summary

Schwab’s initial competitive advantage exploited the changes in regulated commissions at a time the incumbent brokers refused to compete for fear of lost revenue. Like Amazon’s AWS in cloud computing and Starbucks’ Coffee Shops, this provided a long runway for growth before like-minded competition entered.

A culture of continuous innovation coupled with an unrelenting focus on satisfying customer needs fed Schwab’s unbridled demand for growth. The willingness to adopt a longer term view allowed the business to sacrifice near term profits as technology spend ramped to further automate and scale. This provided the opportunity to cut prices and grow volume, dissuading others from entering the market while widening the company’s competitive advantage. Investors, whether employee owners, shareholders, or customers of the Charles Schwab company have been amply rewarded.

Finally, Charles Schwab is an optimist. After more than forty years witnessing investor behaviour and umpteen markets dislocations, he vehemently maintains optimism is the right mindset for an investor. Self awareness is another key component. For as Chuck says, in good times or bad:

Sometimes the most important competitor you confront is yourself.

Further Reading:
Ip Capital Parters Letter [No Association]

Reference:

‘Charles Schwab - Invested. Changing Forever The Way Americans Invest’, 2019. Penguin Random House.

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Sit On Your Ass

Outperforming the market is hard. Over the last five years, it was easy. Easy if you owned just one stock. The world’s largest. You just had to buy Apple. And NOT sell it.

John Huber of Saber Capital touched on this in his annual letter:

“Over the past 5 years, with exceptions that you could probably count on two hands, Apple has outperformed the entire hedge fund industry, every one of the 10,000+ mutual funds, the passive funds at Vanguard and Blackrock, the most prestigious private equity funds, and the vast majority of venture capital funds in Silicon Valley. We’re talking about many trillions of dollars in all kinds of investment vehicles with all kinds of fees, managed by extremely smart people with unlimited research budgets and super smart employees, who all work extremely hard, and are all highly incentivized to produce great results. And Apple beat nearly every last one of them.”

When it comes to investing mistakes, most people think in terms of what’s been bought, not sold. Yet, selling a stock can be the biggest mistake there is.

“Of our most costly mistakes over the years, almost all have been sell decisions.” Chris Cerrone

"The biggest mistake an investor can make is to sell a stock that goes on to rise ten-fold. It's not from owning something into bankruptcy. But that's what everyone thinks, at least judging by the questions we get from clients." Nick Sleep

"Over time, any honest investor and especially any honest value investor will tell you that their biggest mistakes were what they sold, not what they bought." Chris Davis

"The biggest mistake you can make is not failing to sell something you should have sold, it's selling something that you should have held on to.” Tom Slater

“As the old saying goes: ‘it’s never wrong to take a profit’. But it is often not just wrong but the worst mistake that can be made.” James Anderson

“Selling early is the high blood pressure of the investment business. It’s a silent killer. And you know, people will always talk about the business they bought that went to zero, or the one that went down 50% or 75%. Yes, that’s bad. You want to avoid that but the business that you sold too early, that went on the compound tenfold, or 20-fold after that in my career, has been a real killer.” Peter Keefe

Some of the best track records in investing have come from those investors who’ve identified great companies and ridden them. Whether it’s Li Lu, Terry Smith, Nick Train, Nick Sleep, Chuck Akre, Francois Rochon, Dan Davidowitz, Ted Weschler or Warren Buffett, they’ve chosen a different path to most investors. They view companies through a different lens and have delivered market crushing returns as a result.

Charlie Munger dubbed this approach, ‘Sit On Your Ass’ investing.

A few years ago I penned a piece titled, ‘When to Sell a Great Company?’ The conclusion was, almost never. I enjoyed a recent post by Chris Cerrone of Akre Capital titled ‘The Art of [Not] Selling’, aka ‘Sit on Your Ass’ investing. The article inspired me to finish a post which had been sitting dormant in my ‘drafts’ for the last year. I’ve woven elements of Chris’ article with investing insights from some of the eminent investors mentioned above.

While ‘Sitting On Your Ass’ sounds simple. In practice, it’s not. Ahead are some tips to help you remain seated when everyone else has decided to get out.

Let’s start with some of the attractions of ‘Sit on Your Ass’ Investing:

Availability

As much as I enjoy reading about Jim Simons, Ray Dalio, George Soros, Paul Singer and Howard Marks, their investment style is near impossible for Joe Average to replicate. That’s unless you’ve got a team of code cracking PhD’s, employ a hundred uncorrelated multi-asset strategies, have an intuitive leveraged global macro trading capability, a structurally hedged activist style or deep expertise in distressed assets.

The beauty of ‘Sit of Your Ass’ investing is that it’s available to everyone.

Lower Transaction Costs / Taxes

A benefit of not trading is avoiding short term capital gains tax, meaning less dollar leakage and a larger asset base to compound. Lower turnover also means less frictional costs like commissions and market impact.

“Sit on your ass investing. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.” Charlie Munger

“One of the key roles I’ve played at Peninsula on your behalf over the past 12 years is resisting the temptation to sell - doing nothing can run counter to a serious work ethic, but in the world of investing it can be a very effective strategy in that it: i) minimises transaction costs, ii) minimises taxes, and iii) respects the fact that as a practical manner, market timing is a fool’s errand.” Ted Weschler

“When you sell a stock you’ve got to be right twice. You gotta pay taxes and replace the investment. On a growth stock you just have to right once.” Shad Rowe

Fewer Decisions / Less Re-Investment Risk

A strategy of buying stocks cheaply to sell higher requires a constant supply of new ideas. Not only do you have to get the buy decisions right, but the sells too, and in perpetuity. ‘Sitting on Your Ass’ requires fewer decisions and allows more time to get acquainted with the companies you own.

“What we really like is buying good-sized to very large first-class businesses with first-class management and just sitting there. You don’t have go from flower to flower. You can just sit there and watch them produce more and more every year.” Charlie Munger

“If our firms can successfully grow, and we can resist the temptation to fiddle, then we can meaningfully reduce the reinvestment risk embedded in lots of share buying and selling.” Nick Sleep

Harness Compounding

The human brain is wired to think linearly not exponentially. Chris Cerrone reminds us that a penny doubled everyday for a month turns into $10,737,418.24! Of course, there’s no better investor to demonstrate the extraordinary power of compounding than Warren Buffett, who’s life has been the ‘product of compound interest’. The following table pretty much says it all.

The Power of Compounding - Warren Buffett vs The Market [Source: Visual Capitalist]

“A great company keeps working when you’re not. A great company will eventually earn more and more and more while you’re just sitting and doing nothing. And a mediocre company won’t do that. So you’re harnessing a long range force that will help you. It’s very important.” Charlie Munger

‘Sit on Your Ass’ investing leverages the growth in a business’ intrinsic value. Terry Smith, a dyed-in-the-wool ‘Sit on Your Ass’ investor, touched on this in his recent letter.

“Equities are the only asset in which a portion of your return is automatically reinvested for you. This retention of earnings which are reinvested in the business can be a powerful mechanism for compounding gains.”

Rare Quality Businesses

A multitude of factors impact stock prices in the short term; quarterly earnings, investor sentiment, macro developments, valuation re-ratings, analyst recommendations, etc. As the holding period lengthens, business performance exerts a greater influence on stock prices.

The best businesses for long term investment therefore are those with both ‘enduring’ high returns on capital and attractive reinvestment opportunities.

‘Enduring’ high returns require sustainable competitive advantages to protect the business from the vagaries of capitalism. These businesses are often referred to as ‘Compounding Machines’.

“We endeavour to look past the non-essential details. We want to identify the essence of each business’s competitive advantage.” Chris Cerrone

These businesses are few and far between. As such, businesses worthy of ‘Sit on Your Ass’ investors tend to represent sizable positions in their portfolios.

Long Runway

Growth is an essential element. Businesses that don’t grow are unlikely to be profitable long term investments.

“The real money is going to be made by being in growing businesses, and that’s where the focus should be.” Warren Buffett

“The runway ahead for our businesses may be very long indeed.” Nick Sleep

"In our office we often say, ‘How wide and how long is the runway’?" Chuck Akre

Macro Concerns

Macro issues often spook investors out of positions; trade wars, Fed policy, GDP growth, politics and geopolitical tensions are but a few. These short-lived facts and data points rarely have a bearing on a business’ long term value.

Businesses stress tested by previous economic cycles, with solid balance sheets, good management and sustainable competitive advantages survive.

“We try hard to tune out concerns about politics and the economy. We read the newspapers, and we work just down the road from Washington D.C. However, it has been our experience that we are at our worst as investors when we allow concerns about these issues, including elections, trade wars, and Fed policy, to influence our investment decisions.” Chris Cerrone

“Charlie and I spend essentially no time really thinking about macro factors.” Warren Buffett

Adopting the mindset of a business owner as opposed to a stock trader can help. Would a business owner sell their private company based on a tweet by Trump, a lower GDP print or a strategist forecast?

“Our business owner mentality.. allows us to virtually ignore the constant babble of short term macro noise." Allan Mecham

Destination Analysis

The myopic market focus on the short term provides opportunity for mis-priced opportunities in the long term. Wall Street analysts publish valuations and price targets with scant regard to where a business might be in five or ten years. Armed with a deep understanding of a business’ DNA, an investor can overlook short term operating results and reflect on how a business might be positioned five or ten years hence.

“We always focus on what the business will look like in the very long term.” Zhang Lei

“We patiently build up core expertise that allows us to evaluate the long term prospect of the businesses we are interested in.” Li Lu

“We’re trying to figure out what this businesses is going to look like five years from now and ten years from now, not what’s going to happen in the next quarter or the next year.” Dan Davidowitz

Focusing on the destination can also help an investor stick with a position, even after periods of significant outperformance. Nick Sleep articulated this point with regard to Amazon in his 2007 letter:

‘To those who argue Amazon is large already we ask two questions: What do you think e-commerce will be as a proportion of US retailing in ten years, and what do you think it was last year?

After doubling in the share price and the weighty resultant position in the Partnership it would be easy to claim victory, high five, and sell our shares in Amazon. However, the high weighting makes sense given our understanding of the destination of the business and the probability of reaching that destination. We have argued that the biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of a company’s growth. Mathematically this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records. We wonder, would selling Amazon today be the equivalent mistake of selling Wal-Mart in 1980?”

Valuation

“To the surprise of many, neither valuation nor price targets play a role in our sell decisions.” Chris Cerrone

“Another question we often get from investors concerning valuation: Do you assign price targets for your companies? The answer is no. Price targets strike us as too precise and, as importantly, potentially limiting to total return if one feels compelled to sell once the stock reaches the price target.” Dan Davidowitz

A high multiple doesn’t imply a stock is a poor investment. The power of compounding can render an ‘optically expensive stock’ cheap very quickly.

Valuations are inherently imprecise. Most analysts’ DCF models assume a company’s growth and returns mean revert in time. Businesses with enduring competitive advantages that can resist this reversion are likely to be worth significantly more than typical finance models suggest.

In addition, great management teams have a tendency to enhance value through time.

“The very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.” Chris Cerrone

This suggests valuation should carry less weight in the investment decision.

“We really have a great reluctance to sell businesses where we like both the business and the people. So I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and there are 60 or 70 times earnings, keep an eye on me.” Warren Buffett, 1996

“Selling great companies with large growth potential, even at seemingly rich valuations, is usually a mistake.” Allan Mecham

Position Sizes / Volatility

Not selling a stock that delivers exceptional returns can result in a quality problem; the stock becomes a large part of the portfolio. Ted Weschler’s position in W.R Grace & Co. was almost 50% of his fund before he closed Peninsular to join Berkshire Hathaway in 2011. When Nick Sleep closed Nomad Partners in 2014, Amazon had grown to represent more than thirty percent of assets. Chuck Akre’s position in Speedway had grown to c50% of his portfolio in 1993 despite trimming a third of the position over the previous two years. And when Li Lu delivered a 200%+ fund return in 2009 as BYD skyrocketed 400%, BYD constituted over 50% of his partnership.

When positions get large, future fund returns become increasingly influenced by such positions. Li Lu’s 2009 annual letter noted, “the extreme appreciation [of BYD] has made the stock constitute a very large portion of our portfolio. This will lead to more volatility going forward.”

A large position can also constrain decision making if it leads to commitment bias. Li Lu’s fund struggled in 2010 and 2011 as the BYD share price declined nearly 80% from its 2009 high. By the end of 2012, the position size still represented one third of the fund. By 2014, the position size had been substantially reduced [to c10%] as a result of new investments by limited partners and other portfolio gains. With the benefit of hindsight, Mr Lu questioned his decision regarding the proper sizing of BYD after the market gains became so large. In the end he felt commitment bias [via a prominent association with the company and loyalty to its top leadership] had constrained his decision making.

Aligned Investors

Investor alignment is paramount in light of the potential for outsized positions and volatile returns.

Educating investors and preparing them for an absence of portfolio activity is a sensible strategy.

“One common psychological trap that agents may fall into is that clients expect action, or to be more accurate, fund managers expect their clients to expect action! The investor Seth Klarman was once challenged on whether Buffett’s track record was statistically significant as he traded so little? To which Klarman answered that each day Buffett chose not to do anything was a decision too.” Nick Sleep

"If we were private business owners/investors, long spans of inactivity would raise no eyebrows. No reasonable person would expect a farmer to sell his farm in order to buy a different farm every decade, let alone every year or several times a year. As public -market investors, however, this ‘sitting on our hands’ behaviour is unusual." Clifford Sosin

Patience

Pascal observed, 'The hardest thing for a man to do is sit quietly in a room'. Charlie Munger and Warren Buffett have insurance and operating businesses to occupy them. Over the years I’ve noticed some investors, Warren Buffett included, have played around the edges in different investments while leaving their ‘quality’ companies well alone - a strategy worthy of consideration should it override a temptation to sell.

“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.” Charlie Munger

“Investing is a mind game. If you are in a rut as a concentrated investor, increase your chances of winning and add a couple positions. It also lets you breathe and your positions breathe a bit.” Ian Cassell

Pot Holes

Expect pot holes. Business performance, like stock returns, aren’t linear. Businesses have hiccups. Ensure they are temporary not structural.

“I don’t expect the best companies to show their excellence every quarter.” Li Lu

"Businesses do not meet expectations quarter after quarter and year after year. It just isn’t in the nature of running businesses." Warren Buffett

“It’s in the nature of things that the market is not going to do exactly what you want, when you want it.” Charlie Munger

Many of the great ‘Sit on Your Ass’ investors, Terry Smith, Li Lu, Warren Buffett, Francois Rochon, and Nick Sleep included, look to their companies operating results to judge progress, not stock prices.

“I introduced the concept of viewing our entire portfolio as a single ‘HCI Holding Company” based on the weighted average of our shares in each individual portfolio company. This is a very useful way to understand our activities since we view ourselves primarily as owners of businesses and hold our positions for a very long time with very low turnover.” Li Lu

When To Sell

Mr Cerrone sets out three criteria where Akre Capital may sell a stock; slowing growth, loss of competitive advantage or adverse new management. You’ll note they are all related to the operating characteristics of the business, not the soap opera of the market place or macro considerations.

“We sell really when we think we're re-evaluating the economic characteristics of the business. We probably had one view of the long-term competitive advantage of the company at the time we've bought it, and we may have modified that.” Warren Buffett

“When we become concerned about the strength of a company’s franchise, its competitive advantage, or its balance sheet we will sell immediately.” Dan Davidowitz

The major risk when adopting a ‘Sit on Your Ass’ investment approach is mis-analysis of the business. It’s all about the business and its future.

“What costs us money is when we mis-assess the fundamental economic characteristics of the business.” Warren Buffett

“In our opinion, the biggest risk in investing is the risk of mis-analysis.” Nick Train

Summary

If you’ve been a reader of my posts over the last few years, you will have no doubt noticed the commonality of the world’s best investors and their collective thinking regarding what constitutes a great business. And I have written about this for a reason. ALL of the best investors spend their time finding those outstanding businesses, so that when the urge to sell certain stocks overcomes the collective market and people are running for the hills, these Masters can sit comfortably in the knowledge that the deep understanding of those businesses that they own allows them a certain level of reassurance, and they can choose not to sell, or to Sit On Their Ass.

Selling, as explained above, costs more in the long run and requires an adeptness that most of us lack. When the world’s best state that their biggest mistakes were in selling, not buying, you have to take notice. Outperforming the market is almost impossible for the average investor, yet these Masters do it … ‘Sitting On Their Ass’.

Sources:
‘The Art of (Not) Selling’ - by Chris Cerrone. Akre Capital Management. 2019.
‘When to Sell a Great Company’ by Investment Masters Class. 2017.
‘Quality Companies, Compounders and Value Traps’ by Investment Masters Class. 2016.
‘Hold Discipline,’ Lawrence Burns, Baillie Gifford, 2021.

Follow us on Twitter: @mastersinvest

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Onward - Starbucks’ Howard Schultz

When Howard Schultz opened his first coffee store in Seattle, he strove to replicate the experience of the coffee houses he’d visited in Italy; a place where people would come to meet, in a place that encompassed a welcoming and engaging atmosphere. Starbucks wasn’t to be just about selling a good cup of coffee, in fact it was to be an experience, and it was all about people.

From the beginning, Starbucks took extra care of their staff, which elicited the power of reciprocation and fostered a bond between Starbucks’ employees and their customers. A friendly culture developed which drove repeat business and provided a competitive advantage. A focus on customer experience ensured the stores offered a unique and inviting social gathering place for the communities they served, and a long runway for store roll-outs propelled the company’s earnings and share price.

While Starbucks’ beginning was all about people, over time, unfortunately, it became all about the numbers. Numbers, numbers, numbers. A history of double digit earnings growth allowed the company to neglect it's cost base, all while setting the bar higher for even more growth. And naturally, management and Wall Street obliged.

As a result, a major impetus was placed on growth metrics like new store openings and comp sales. New product offerings unrelated to coffee and inferior store locations drove short term growth all while hurting the brand and the business.

And unfortunately, this is more common an occurrence than you might think.

For more than 25 years, Jim Collins has studied what makes great companies tick. In a recent Farnam Street podcast, he articulated that ‘over-reaching’ and ‘the undisciplined pursuit of more’ was responsible for the downfall of many great companies.

“Almost none of the companies we studied that were great companies that fell, fell because of complacency. They fell because of overreaching, the undisciplined pursuit of more. They became too aggressive, too much growth, firing un-calibrated cannonballs, expanding into areas of which they have no business operating. There’s a certain animus that happens, if we’ve been really successful. Now we just need to have more, and we need to be bigger.” Jim Collins

Once the Financial Crisis hit, Starbucks’ once unstoppable growth reversed. Declining consumer spending laid bare the misjudgments, cost blow-outs and inefficiencies of the business. Starbucks was broken.

It was then that Starbucks’ founder, Howard Schultz, returned to the role of ceo to rectify the company’s woes. While there was no silver bullet, there were many things the company needed to do to return to its core. The retail industry has witnessed very few successful turnarounds, but Starbucks is one. And the book, ‘Onward’, by Mr. Schultz, tells that story.

It’s a tale about how a business came to lose its way, about hubris and the dangers successful businesses face. It’s also a guide for getting back to your core, staying true to your values and innovating for the future. The book distills the essence of Starbucks success through its unique competitive advantages.

I’ve collected some of my favourite extracts below. Once again, you’ll notice many common threads with the other great businesses we’ve covered.

Remove Hierarchy

“Since Starbuck’s earliest days, we have lower-cased all job titles.”

Win-Win

“As a business leader, my quest has never been just about winning or making money; it has also been about building a great, enduring company, which has always meant trying to strike a balance between profit and social conscience.”

“No business can do well for its shareholders without first doing well by all the people its business touches. For us, that means doing our best to treat everyone with respect and dignity, from coffee farmers and baristas to customers and neighbours.”

Value Employees

“We were the first US company to offer both comprehensive healthcare coverage as well as equity in the form of stock options to part-time workers, and we were routinely heralded as a great place to work.”

“Even as we lost money in the early years, Starbucks established two partner benefits that, at the time, were unique: full health-care benefits and equity in the form of stock options for every employee. This was an anomaly.”

“Acting with this level of benevolence helped us build trust with our people and, as a result, long-term value for our shareholders.”

“Owning a piece of the company gave so many of our partners a tremendous sense of pride, demonstrating that we respected our people enough to share our success.”

“Work should be personal. For all of us. Not just for the artist and the entrepreneur. Work should have meaning for the accountant, the construction worker, the technologist, the manager and the clerk.”

“Perhaps the most important step in improving the faltering US business was to re-engage our partners, especially those on the front lines: our baristas and store managers. They are the true ambassadors of our brand, the real merchants of romance and theatre, and as such the primary catalysts for delighting customers.”

“Our turnover rates in stores were too high, and a new generation of baristas had not been effectively trained or inspired by Starbucks’ mission.”

“Our compensation and benefits plans, while generous compared to almost any other retailer, no longer rang revolutionary.”

“Many baristas pen personal notes - ‘Christina rocks!’ - on cups of morning coffee. Our partners’ attitude and actions have such great potential to make our customers feel something. Delighted maybe. Or tickled. Special. Grateful. Connected. Yet the only reason our partners can make our customers feel good is because of how our partners feel about the company. Proud. Inspired. Appreciated. Cared for. Respected. Connected.”

“Franchising would have given us a war chest of cash and significantly increased our return on capital. But if Starbucks ceded ownership of stores to hundreds of individuals, it would be harder for us to maintain the fundamental trust our store partners had in the company, which, in turn, fueled the trust and connection they established with customers. Franchising worked well for other organisations, but would, I believe, create a very different organisation by diluting our unique culture.”

“People will always be our most important asset and Starbucks’ competitive advantage.”

Value Customers

“One of the most important pieces of advice I’d heard upon my return came from a dear Seattle friend and one of the country’s best retail executives, Jim Sinegal, the co founder and CEO of Costco Wholesale Corporation. ‘Protect and preserve your core customers’ he told our marketing team when I invited him to speak to us. ‘The cost of losing your core customers and trying to get them back during a down economy will be much greater than the cost of investing in them and trying to keep them’.”

Owner Mentality

“Part of the problem was that we did not have the proper incentives or the right in-store technology to help store managers operate like owners, taking more control of their stores’ destiny.”

“Knowledge can breed passion. Our company had to do a much better job sharing our coffee knowledge and communicating our mission. Pride in purpose would help give our partners a sense of ownership.”

“Starbucks’ best store managers are coaches, bosses, marketers, entrepreneurs, accountants, community ambassadors, and merchants all at once. The best managers take their jobs personally, treating the store as if it is their very own.”

Misguided Focus on Growth

“By 2007 Starbucks had begun to fail itself. Obsessed with growth, we took our eye off operations and became distracted from the core of our business. The damage was slow and quiet, incremental, like a single loose thread that unravels a sweater inch by inch.”

“We continued to set high bars for ourselves that Wall Street held us to, and every quarter, our people felt more intense pressure to maintain annual revenue and profit increases of at least 20 percent. It was an ambitious, some said unattainable goal that I was admittedly complicit in actively promoting.”

“We had trapped ourselves in a vicious cycle, one that celebrated the velocity of sales instead of what we were selling. We were opening as many as six stores each day, and every quarter our people were under intense pressure from Wall Street - and from within the company - to exceed past performance by showing increased comparative store sales, or comps.”

“We were so intent on building more stores fast to meet each quarter’s projected sales growth that, too often, we picked bad locations or didn’t adequately train newly hired baristas.”

“I liked to say that a partner’s job at Starbucks was to ‘deliver on the unexpected’ for customers. Now, many partners energies seemed to be focused on trying to deliver the expected, mostly for Wall Street.”

“[We needed to] refocus the company on customers instead of breakneck growth.”

"As I saw it, Starbucks had three primary constituencies: partners, customers, and shareholders, in that order, which is not to say that investors are third in order of importance. But to achieve long-term value for shareholders, a company must, in my view, first create value for its employees as well as its customers. Unfortunately, Wall Street does not always see it the same way and too often treats long-term investments as short-term dilution, bringing down the company’s value. Adopting this mentality was, in large part, how Starbucks had become complicit with the Street… We chased the pace of growth by building stores as fast as we could rather than investing in sustainable growth opportunities. The top line grew fast, but in a way that, for a variety of reasons was impossible to sustain.”

“Starbucks had been acting out of fear, mainly a fear of failure. So much of what the company had done was defensive, done to protect itself. Our primary goal had been to avoid missing our earnings projections rather to actively engage our customers.”

“Starbucks, I said, would no longer report its same store sales. Our comps would no longer be made public.”

“There was an even more important reason that I chose to eliminate comps from our quarterly reporting. They were a dangerous enemy in the battle to transform the company. We’d had almost 200 straight months of positive comps, unheard of momentum in retail. And as we grew faster and faster clip during 2006 and 2007 maintaining that positive comp growth history drove poor business decisions that veered us away from our core.”

“The fruits of this ‘comp effect’ could be seen in seemingly small details. Once, I walked into a store and was appalled by a proliferation of stuffed animals for sale. ‘What is this?’ I asked the store manager in frustration, pointing to a pile of wide-eyed cuddly toys that had absolutely nothing to do with coffee. The manager didn’t blink. ‘They’re great for incremental sales and have a big gross margin.’ This was the type of mentality that had become pervasive. And dangerous.'"

“Eliminating comps from the radar was my attempt to send a message to Starbucks partners; We will transform the company internally by being true to our coffee core and by doing what will be best for customers, not what will boost comps.”

Starbucks Vs S&P500 (normalised) 2000-2020 [source:Bloomberg]

“It is difficult to overstate the seductive power that comps had come to have over the organisation, quite literally becoming the reason to exist and overshadowing everything else.”

“We [had] predicated future success on how many stores we opened during a quarter instead of taking the time to determine whether each of those stores would, in fact, be profitable. We thought in terms of millions of customers and thousands of stores instead of one customer, one partner, and one cup of coffee at a time.”

“We had to replace our comps-at-any-cost mind-set with a customer-centric one.”

“From where I sat as ceo, the pieces of our rapid decline were coming together in my mind. Growth had become a carcinogen. When it became our primary operating principle it diverted attention from revenue and cost-saving opportunities, and we did not effectively manage expenses such as rising construction costs and additional monies spent on new equipment, such as warming ovens. Then as customers cut their spending, we faced a lethal combination - rising costs and sinking sales - which meant that Starbucks’ economic model was no longer viable.”

“Success is not sustainable if it’s defined by how big you become. Large numbers that once captivated me - 40,000 stores! - are not what matter. The only number that matters is ‘one’. One cup. One customer. One partner. One experience at a time. We had to get back to what mattered most.”

“As Starbucks now knew all too well, growth for growth’s sake is a losing proposition.”

“Growth, we now know all too well, is not a strategy. It is a tactic. And when undisciplined growth became a strategy for Starbucks, we lost our way.”

Losing Focus

“We also extended our brand beyond our coffee core and into areas like entertainment. Where once we sold a couple of CD’s - artful compilations we played in stores - soon we were displaying kiosks packed with the music of an array of musicians… The business deals looked great on our profit and loss statements. It would be a while before I recognised that Starbucks’ amplified foray into entertainment, while it had its upside, was another sign of hubris born of a sense of invincibility.”

“We were venturing into unrelated businesses like entertainment. And we were pushing products that deviated too far from the core coffee experience.”

Maintain Smallness

“It was all too easy to assume that an almost $10 billion company could not operate with the perspective of a single merchant fighting for its survival. But wasn’t every Starbucks store a single merchant? Yes, was my position, and I was adamant that we should think of ourselves as such.”

Simple Model

“Starbucks’ ability to build and operate profitable stores had succeeded for years because we had adhered to a simple yet ambitious economic model; a sales-to-investment ratio of two to one. During a Starbucks store’s first year in business, it needed to bring in $2 for every $1 invested to build it. If the company spent $400,000 to lease and design a store, for example, we expected and always got at least $800,000 in revenue in the first 12 months of operation. Historically, the average store in the US had bought in about $1m annually. These so-called unit, or store, economics were widely known to be best in class because few, if any, retailers could achieve what Starbucks had accomplished year after year. But in 2008, Starbucks was, for the first time in history, missing that ratio at hundreds of stores... Many of our under performing stores had been opened in the last two years, revealing a lack of discipline in real estate decisions that was, in my opinion, an example of the hubris that had taken hold.”

Love

“There is a word that comes to mind when I think about our company and our people. That word is ‘love’.”

Mistakes

“Celebrate, learn from, and do not hide from mistakes.”

“We have made many mistakes over the years, and we will continue to make them.”

Product

“We are in the people business and always have been.”

“People come to Starbucks for coffee and human connection.”

“Starbucks coffee is exceptional, yes, but emotional connection is our true value proposition. This is a subtle concept, often too subtle for many business-people to replicate or cynics to appreciate. Where is emotion’s return on investment? they want to know. To me, the answer has always been clear. When partners like Sandie feel proud of our company - because of their trust in the company, because of our values, because of how they are treated, because of how they treat others, because of our ethical practices - they willingly elevate the experience for each other and customers, one cup at a time. I could not believe any more passionately than I already do in the power of emotional connection in the Starbucks Experience. It is the ethos of our culture. Our most original and irreplaceable asset.”

“The Starbucks Experience - personal connection - is an affordable necessity. We are all hungry for community.”

“I always say that Starbuck is at its best when we are creating relationships and personal connections. It’s the essence of our brand, but not simple to achieve. Many layers go into eliciting such an emotional response.”

“I strongly believe that if we protect, preserve, and enhance the experience to the point where we really demonstrate that the relationship we have with our customers is not based on a transaction, that we’re not in the fast-food business, and then let the coffee speak for itself, we’re going to win.”

“We would reignite the emotional attachment with customers. Unlike other retailers that sold coffee, the equity of Starbuck’s brand was steeped in the unique experience customers have from the moment they walk into a store.”

“Every little act matters: A store manager’s job is not to oversee millions of customers transactions a week, but one transaction millions of times a week.”

“Our intent to create a unique community inside the company as well as in our stores has, I think, separated us from most other retailers.”

Values

“In business, as in life, people have to stay true to their guiding principles. To their cores. Whatever they may be. Pursuing short-term rewards is always short-sighted.”

Source: Starbucks.com

Tone from the Top

“How leaders embody the values they espouse sets a tone, an expectation, that guides their employees’ behaviour.”

Innovation

“Innovation is in our DNA.”

“Going against conventional wisdom is the foundation of innovation, the basis for Starbucks’ own existence.”

“The best innovations sense and fulfil a need before others realise the need even exists, creating a new mind-set.”

“I remember investors whom I had approached to fund Il Giornale bluntly saying they thought I was selling a crazy idea. That I was out of my mind. Insane! ‘Why on earth do you think this is going to work? Americans are never going to spend a dollar and a half on coffee.”

“Any market [eg instant coffee] that had not seen innovation for decades was ripe for renewal.”

“Innovation, as I had often said, is not only about rethinking products, but also rethinking the nature of relationships. When it came to our customers, connecting them in a store and online did not have to be mutually exclusive.”

“Every company must push for self-renewal and reinvention, constantly challenging the status quo.”

Culture

“The very foundation of Starbucks, our true competitive advantage, is our culture and guiding principles.”

“Creating an engaging, respectful, trusting workplace culture is not the result of any one thing. It’s a combination of intent, process, and heart, a trio that must constantly be fine-tuned.”

“Every small gesture mattered, and so much of what Starbucks achieved was because of partners and the culture they fostered.”

“Starbucks is not a coffee company that serves people. It is a people company that serves coffee, and human behaviour is much more challenging to change than any muffin recipe or marketing strategy. Many of the decisions I was making confounded others because they did not grasp the intangible value of preserving the company’s culture.”

Brand

“A well-built brand is the culmination of intangibles that do not directly flow to the revenue or profitability of the company, but contribute to its texture. Forsaking them can take a subtle, collective toll.”

“Every brand has inherent nuances that, if compromised, will eat away at its equity regardless of short-term returns.”

“Each store’s ambiance is the manifestation of a larger purpose, and at Starbucks each shop’s multidimensional sensory experience has always defined our brand. Our stores and partners are at their best when they collaborate to provide an oasis, an uplifting feeling of comfort, connection, as well as a deep respect for the coffee and communities we serve. Starbucks Coffee Company’s challenge has always been to authentically replicate this experience hundreds upon thousands of times.”

Marketing

“Unlike other brands, Starbucks was not built through marketing and traditional advertising. We succeeded by creating an experience that comes to life, in large part, because of how we treat our people, how we treat our farmers, our customers, and how we give back to communities.”

“I have never embraced traditional advertising for Starbucks. Unlike most consumer brands that are built with hundreds of millions of dollars spent on marketing, our success had been won with millions of daily interactions. Starbucks is the quintessential experiential brand - what happens between our customers and partners inside our stores - and that has defined us for three decades.”

Reinvigorating the Brand

“The only filter to our thinking should be: Will it make our people proud? Will this make the customer experience better? And will this enhance Starbucks in the minds and hearts of our customers?”

No Silver Bullet

“Yes, opportunities to transform Starbucks for profitable, sustainable growth existed everywhere, but no single move, no product, no promotion, and no individual would save the company. Our success would only be won by many. Transforming Starbucks was a complex puzzle we were trying to piece together, where everything we did contributed to the whole. We just had to focus on the right, relevant things for our partners, our customers, for our shareholders, and for our brand.”

Hubris

“Perhaps because we viewed the company as too good to fail, we did not work or operate the business as wisely as we should have. Rarely did we make the effort or take the time to step back and question whether we made the most of our resources.”

Visit Stores

“I prefer to visit stores in person rather than read spreadsheets.”

“I also visited our stores and our roasting plants, and almost daily I made a point of walking the floors of our home office, up and down the stairs multiple times, saying hello to people working at their desks, often stopping to chat.”

Seek Feedback

“Our open forums are brief and unscripted, and anyone can ask any question with no fear of retribution.”

Change

“I had written hundreds of memos during my 26 years at the company, and all had shared a common thread. They were about self-examination in the pursuit of excellence, and a willingness not to embrace the status quo. This is a cornerstone of my leadership philosophy.”

Difficult Choices

“I wasn’t returning to the chief executive post intent on being liked. In fact, I anticipated that many of my decisions would be unpopular with various constituents.”

Know the Customer

“Starbucks was building a rich database that we could use to better understand our customers behaviour and reward them accordingly. The card program was a truly, sustainable, competitive advantage for us in the marketplace.”

Humility

“There is never a finish line.”

Competitive Advantage

“There are companies that operate huge global networks of retail stores, like us. Others distribute their products on grocery shelves all over the world, like us. And a few do an extraordinary job of building emotional connections with their customers, as we have learned to do. But only Starbucks does all three at scale, and we increasingly see a future where each complements the other, forming a virtuous cycle that allows us to go to market and grow the company in a unique way.”

Source: ‘Onward’ by Howard Schultz

Costs

“The work to keep costs in check will never end, and the challenge ahead is to sustain what we have achieved and strive for more while continuing to wisely invest in our people, in growth, and in innovation.”

Summary

A decade of solid growth and share price performance set the stage for Starbucks’ undoing. Past success meant Wall Street demanded more growth, more stores and more comp sales. Starbucks’ management obsessed over meeting the market’s demands and in the process neglected the deep reality of the business.

Jim Collins opined on Wall Street’s obsession with growth in his book, ‘How The Mighty Fall’:

“Public corporations face incessant pressure from the capital markets to grow as fast as possible. But even so, we’ve found in all our research that those who resisted the pressures to succumb to unsustainable short-term growth delivered better long term results by Wall Street’s own definition of success, namely cumulative returns to investors.”

Howard Schultz’s return as ceo refocused the company on the central engine of its success: customer relationships and innovation. Both qualitative factors. To Wall Street’s dismay, he stopped reporting comp sales. He set about re-engaging and re-invigorating the partner/customer relationships. Often such relationships are the key to a company’s success. Nicholas Sleep of Nomad Partners expressed this concept in his investor letters:

‘As time goes by, the performance that you receive, as Partners in Nomad, is the capitalisation of the success of the firms in which we invested. To be precise, the wealth you receive as partners came from the relationship our companies’ employees (using the company as a conduit) have with their customers. It is this relationship that is the source of aggregate wealth created in capitalism.’

Sleep recognised human attributes often are what lead to success, attributes which have ‘hardly changed in a millennia’.

‘When we study truly great businesses we find that very often it has been simple human attributes that have led to their success.’

It’s the reason Sleep focused on the bond between businesses and their customers.

‘There are so many distractions… It is all too easy to make things more complicated than they need to be or, to invert, it is not easy to maintain discipline. One trick we use when sieving the data that passes over our desks is to ask the question: does any of this make a meaningful difference to the relationship our businesses have with their customers? This bond (or not?) between customers and companies is one of the most important factors in determining long term business success. Recognising this can be very helpful to the long-term investor.’

It will be this bond that determines the fate of Starbucks.

Further Reading
‘Learning from Howard Schultz’ - Investment Masters Class. 2017
’Onward - How Starbucks Fought for Its Life without Losing Its Soul’. Howard Schultz. 2011. Rodale.

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Ethical capitalist - Julian Richer

Retailing is hard. Staying on top of the industry for decades is even harder. Particularly when the products you sell are technology based and always changing. Which begs the question, how did a small UK retailer selling Hi-Fi components come to hold the World Record for sales per square foot of any retailer in the world for over twenty five years?

The answer to that question is anything but conventional. Most things about Richer Sounds, the business that holds the record, are unconventional too. In 1978, a nineteen year old hi-fi enthusiast named Julian Richer, opened his first shop on London Bridge Walk. Today that business, Richer Sounds, comprises a successful chain of 52 retail hi-fi stores.

I came across Richer Sounds in a recent article in the Economist titled ‘From Rags to Richer - A Business Success Story Built on Treating People Well.’ Treating people well is a touchstone of Mr Richer’s philosophy. So much so, in May 2019, Mr. Richer handed control of the business over to an Employee Owned Trust, which resulted in Richer Sounds now being controlled and majority owned by the employees.

Mr Richer is an atypical entrepreneur who shared his business philosophy in a book titled ‘The Ethical Capitalist’.

Mr Richer’s approach to business was largely influenced by another book, ‘In Search of Excellence - Lessons from America’s Best Run Companies’ published in 1982 by two McKinsey alumni. The book has been accredited by Warren Buffett as “A landmark book, without question the most important and useful book on what makes organisations effective ever written.” [n.b. an excellent book, which will feature in an upcoming post].

“What really transformed my thinking was reading Tom Peters’ and Robert Waterman’s classic business text ‘In Search of Excellence’, which I first encountered over thirty years ago. The authors identified various factors that they believed made companies successful. Key among them were how they treated their employees and customers. I began to apply ‘In Search of Excellence’ ideas to my own business and found they really produced results.” Julian Richer

Not surprisingly, many of the unconventional attributes of Julian Richer’s business unify many of the other great businesses we have previously covered.

I’ve included some of my favourite extracts from Mr Richer’s book below.

Ethical Capitalism

“My own experiences in the business world suggest that an ethical approach, far from being a potential barrier to profits, is actually the secret to success.”

“Good companies survive. Unethical companies go to the wall.”

“Ethical capitalism is about doing our best to ensure that everybody we work with, from staff to customers to the wider community, feels their lives, and their happiness, are improved by what we offer - both materially and emotionally.”

“What do I mean by ethical? I mean treating staff, customers and suppliers honestly, open and respectfully. I mean taking responsibility for our actions, owning up when things go wrong and setting out to put them right. Seeing ourselves as an integral part of society and paying our dues - and taxes - accordingly. By following this approach I believe we can create a virtuous circle for ourselves: not only can we sleep better at night, but a fair and honest approach to customers and staff leads to a huge competitive advantage that in turn reinforces the need to be fair and honest.”

“The ethical approach must be built into the way the business operates every day.”

“Ethically run businesses are better businesses - there are huge competitive advantages to be gained from creating an honest and open culture, from paying a fair wage to ensuring customers are well treated, and so on.”

“The ruthless pursuit of shareholder value, however, is not actually a company’s legal obligation. What’s more, it is downright dangerous. If managers believe that their duty is only to their shareholders - and not at all to society more generally - they will be prepared to make socially harmful decisions in pursuit of immediate gain.”

“Conscienceless capitalism doesn’t work even for shareholders.”

Source: Richer Sounds [https://www.richersounds.com/information/the_richer_way]

Short Termism

“If you’re directing all your attention to the bottom line for the next quarter, you’re not going to make decisions that serve the long-term interest of your company. Sadly, ‘short-termism’ is now built into the mindset of managers.”

Culture

“Organisations that create cultures based on fairness, honesty and respect reap the rewards. They acquire motivated, hard-working staff who are there for the long haul. It’s no coincidence that many of the world’s most successful companies are those that are also rated as the best to work for (Which is, essentially, the message of ‘In Search of Excellence’.)”

“All the evidence suggests that a bad culture leads to bad behaviour regardless of the business sector in which it is to be found.”

“Fraud and theft are hallmarks of a poor company culture, but they’re not the only ones. Staff turnover and absenteeism are also crucial indicators. Some staff churn is inevitable as people move away or are offered a better or preferable job elsewhere. But high levels of staff turnover are always a sign that something is fundamentally wrong.”

“Businesses may think high staff turnover is not a problem, as long as there is a ready supply of new applicants. But in reality, a constantly changing workforce is a big drag on productivity. Moreover it eats into profits.”

People

“It’s all about people. The key to a successful business lies in managing and motivating the workforce so they give their best to the job.”

“Our focus on treating our staff fairly has given us staying power.”

Share the Success

“To make sure that it’s not just those on the shop floor who benefit from success, we give all our central departments a profit share at the end of the financial year.”

Reciprocation

“I have found that by treating people well, they appreciate it and will almost always reciprocate and treat my business well.”

“What goes around comes around. I always try to deal with people, not only with honestly and fairness, but with generosity too.”

“All the evidence suggests that if employees are badly treated, the company as a whole will suffer: it will attract poor-quality, often unmotivated employees, who may well defraud it or take extended leaves of absence. Yet some companies are prepared to risk all this for short-term gain and profit, not recognising that in the process they are racking up costs and running the risk of forfeiting future success.”

“Disaffected staff offer bad service, and bad service drives away customers. Contented staff, by contrast, encourage repeat business. I’ve invariably found that when people are treated well, the tendency is for them to reciprocate - by working hard, and contributing their enthusiasm and ideas. They feel motivated, morale rises, and productivity and profitability improves as a result.”

Win-Win

“Every transaction should be a reciprocal arrangement that benefits both the seller and the purchaser.”

“In a well run-organisation, the enablers [ie. supply chain drivers, cleaners, lawyers, bankers, external auditors, suppliers etc] are regarded as an integral part of the whole. It is recognised they are essential to the enterprises success as the other two sides of the business triangle [staff & customers]. In badly run concerns, they’re often the people who are most neglected and worst treated.”

“While we negotiate hard, we always make sure we end meetings on good terms with our manufacturers. We make sure we pay on time; sometimes we offer early payment, particularly if we know they’re having a problem with cash flow.”

“At Richer Sounds we’ve actually ended up paying our cleaning agency extra in order to ensure that on our premises their employees earn the Living Wage.”

The Customer

“If a customer can’t find what they want in one of our shops, or aren’t completely sure about the suitability of what is on offer, I don’t want to make a sale. Our trading philosophy as well as our incentive scheme is based on that principle.”

“We should be aiming to keep a customer for life, not for one transaction.”

“Ultimately, I do believe that companies that fail to serve their customers well do not last.”

Empower Staff

“Sales colleagues have the authority to make a decision then and there, rather than having to refer to the manager or head office and so risk a dissatisfied customer feeling they are being fobbed off.”

Incentives

“When incentives are badly constructed, the outcomes will be bad, too.”

“Rewarding people simply for carrying out a transaction, regardless of the wisdom of that transaction, is a recipe for disaster.”

More Than Wages

“In a good company, what motivates people to turn up for work each day is much more than the amount in their wage packet. Their job satisfaction is much more likely to derive from getting on well with their colleagues, feeling part of a team and seeing customers happy.”

“The notion that how you treat people is central to how you conduct your business stayed with me as I built my company and learnt from my mistakes.”

“Of course businesses need to be profitable, or else they will go bust and jobs will be lost. But the pursuit of profit before everything is not the key to business success. If profits are only gained by paying employees and suppliers the bare minimum and giving customers a bad deal, in the long run the business won’t survive.”

Ethics

“The recent global financial crisis - at bottom, this was not about a failure of a particular economic doctrine or approach but of ethics.”

Hard Work & Constant Attention

“Creating an ethically minded company is not something that’s achieved the moment a list of company values has been put together. It’s a process that involves very hard work and requires constant attention. It also has to permeate every action that a company takes, which is why for me this process of creating an ethical company begins right at the very beginning of the job cycle - with the recruitment ad - and not only continues through recruitment, the setting of pay and conditions, ongoing staff welfare, and so on, but also requires regular maintenance and improvement. If one link of this complex chain is weak, or is allowed to become weak, ultimately the chain will break.”

Business Ecosystem

“A business is like a very delicate ecosystem. Every component part of it counts and every part has an impact on everything else. People often ask me whether ultimately it’s the employee or the customer who is more important to commercial success. To my mind it’s not a valid question. In the business ecosystem each element has a vital role and each element is connected to all the others. That’s why creating the right overarching culture is so crucial. Without it, things fall apart.”

Staffing

“If we were simply box-ticking, the logical thing for us to do as retailers would be to seek out red-hot salespeople. But we don’t. The most important quality we look for in a recruit is friendliness: we need staff who can not only talk to customers, but who can listen to what they say. Passion and enthusiasm are important too. We like applicants who are enthusiastic about the products we sell, about dealing with customers, and about life in general. Overall, our policy is to hire for personality and train for skill.”

“No-one is ever hired without having had a trial day.”

“We want to recruit for the long term. We want people who want to be with us. We seek people who are career orientated and who are keen to work their way up. Indeed we do our damnedest to recruit from within. It’s no coincidence that seven out of nine of our directors started working in the shops.”

Wages

“Low wages have bad economic effects. They create a self-perpetuating system in which poor pay leads to low skills, low morale, low productivity, lack of training and high labour turnover, leading back to poor pay.”

“If the people at the top are rewarding themselves while holding pay rises for others at bay, morale suffers.”

“The bonus culture can lead to poor decisions, as senior executives agree on business strategies or company mergers that flatter the share price but damage the long term health of the company.”

Community, Society and Government

“Even the supposedly narrow world of business, with its focus on profitability and the bottom line, relies heavily on the community. It may look to individuals for its customers, but it needs society to provide its employees and to create and maintain the infrastructure without which it cannot possibly survive.”

“Essential commercial activity is possible thanks only to government spending. Roads and railways are the arteries of business. When someone tells me they’re a ‘self-made' millionaire, I’m tempted to ask how they got into work that morning.”

“From maintaining the money supply and issuing banknotes, right through to creating the legal basis for contracts and private property, the state is in the background of every business transaction.”

“No business is an island. However much successful people like to think they are self-made, they would be nowhere without the society that surrounds them, and the support, security and economic stability that society provides.”

“There’s one very obvious way in which businesses can give back to the community. The problem is, they usually put a lot of effort into finding ways to avoid it. I’m talking of course, about tax.”

“Many business leaders have it fixed in their minds that taxation is somehow bad for business (let alone themselves), that they not only fight to have it reduced but believe it’s perfectly legitimate to aggressively avoid it.”

“I would urge businesses to allocate a percentage of their profits to charity - and if they do that, a larger percentage. I give 15% of my company profits to charity, along with a lot of my time.”

Seek Feedback

“We include a short feedback card with every receipt (the incentive to fill it in being entry into a monthly prize draw)”

“[Feedback cards are studied at our quarterly Customer Service Group meetings, helping] us trouble-shoot, plan and refine. They also provide us with an invaluable window into the future, since they often give the first indication that customers’ tastes might be changing and that they might be looking for something new or different.”

“If there’s a complaint, I deal with it personally.”

Repeat Customers

“According to a US study carried out by SumAll in 2013, somewhere between 25% and 40% of the total revenues of the most stable businesses they examined came from returning customers. These customers were also most likely to be the ones who helped sustain the companies they supported in difficult economic times: ‘Businesses with 40% repeat customers generated nearly 50% more revenue than similar businesses with only 10% repeat customers’, the study suggested. It therefore seems totally bizarre to me that some companies would think it clever practice to go out of their way to alienate existing customers. Why would an insurance company offer cover at special price to attract a new customer and yet increase premiums for the same package to an existing one? Why would a bank or phone company offer preferential rates only to the people they don’t already serve? It’s baffling. I know they’re relying on customer inertia, but I suspect that as people become more savvy and it becomes ever easier to find out what rival deals there are out there, customers will defect from such concerns in steadily increasing numbers.”

Capitalism

“I am an absolute believer in capitalism. I think it is the only economic system humans have so far come up with that offers the real promise of personal prosperity and well-being.”

“In societies where free enterprise is stifled, where the system is controlled by the state, or where markets are dominated by corrupt monopolies or oligopolies, the consumer has tended to suffer. Choice dwindles. The quality of products and services sinks lower and lower.”

“Social inequality is actually bad for capitalism. For businesses to thrive, we need people to be in secure jobs and decent homes, able to spend confidently. They should not be condemned to a low wage economy.”

Summary

Julian Richer’s business is a long term success story. He understands business is about people and the practices he implemented share many commonalities with the other great businesses we’ve studied. Many are the familiar mental models covered in previous posts; the power of reciprocation, the importance of culture, the need for a long-term view, the adoption of a win-win mindset. They tend to be qualitative in nature, you won’t necessarily find them in a spreadsheet.

Julian Richer learnt from other great businesses that had come before. He applied those lessons to his own business and turned it into a phenomenal success. He did it without compromising on staff, suppliers or the community.

Studying, understanding and identifying the factors that contributed to the success of Julian Richer’s business can help us identify other potential success stories. And that seems a pretty good recipe for getting Richer.

Source:

‘The Ethical Capitalist’ - Julian Richer. 2018. Penguin Random House.

‘From Rags to Richer - A Business Success Story Built on Treating People Well.’ -The Economist

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Learning From Costco's Jim Sinegal

If there is one stock in America you could buy outside Berkshire Hathaway, Charlie Munger’s advice is to choose Costco. He sits on the board. Not surprising Charlie Munger keeps his portfolio concentrated, he owns just three major investments, Berkshire, Li Lu’s fund and Costco. If you’ve read our recent piece on Sol Price, you’ll be well aware that Costco was founded by Jim Sinegal, who adopted the lessons of his mentor and long-time employer, Sol Price, when he opened a retail warehouse in Seattle in 1983.

Like many of the other great businesses we’ve studied - Home Depot, Aldi, Southwest Airlines and Walmart to name a few - Costco is Unconventional.

“Costco is a different kind of place. It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet.” Charlie Munger

“Jim Sinegal is a fabulous business operator - like a Carnegie, Rockefeller, or James J Hill. I consider him to be one of the top five retailers of the past century. He’s that good.” Charlie Munger

Costco doesn’t advertise, they carry a very limited selection, they have low margins and standard mark-ups, they charge customers to shop, and their employees payslips are almost double their competitors. For this, Costco has been a runaway success. One hundred dollars invested in Costco in 1986 would be worth $11,800 today, a veritable 100-bagger!

Costco vs S&P500 - Normalised [Source: Bloomberg]

Studying successful companies can give us insights into effective business models to help us identify profitable future investments. The best analysis of Costco’s business model I’ve come across is from Nick Sleep of Nomad Investment Partnership who recognised Costco’s virtues almost two decades ago. He saw Costco as a ‘Perpetual Motion Machine’ utilising a business model he termed ‘Scale Economics Shared’. His 2002 Investor Letter articulated the retail concept:

“The retail concept is as follows: customers pay an annual membership fee which provides entry to the stores for a year, and in exchange Costco operates an every-day-low-pricing strategy by marking up 14% on branded goods and 15% on private label with the result that prices are very, very low. This is a very simple and honest consumer proposition in the sense that the membership fee buys the customer’s loyalty (and is almost all profit). and Costco in exchange sells goods while just covering operating costs. In addition by sticking to a standard mark up, savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages. This is retail’s version of perpetual motion and has been widely adopted by Walmart among others.” Nick Sleep, 2002

In his 2004 investor letter, he expanded on the business model:

“In the office we have a white board on which we have listed the (very few) investment models that work and that we can understand. Costco is the best example we can find of one of them: Scale Efficiencies Shared. Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful. But in the centre of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no-one replies ‘give it back to customers’ - how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long term success.” Nick Sleep, 2004

And in 2008 he discussed the power of reciprocation:

“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’ incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.” Nick Sleep, 2008

Charlie Munger makes a similar observation:

“Costco will continue making huge contributions to society. It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success. More of you should look at Costco.” Charlie Munger

Many of the inputs that define Costco’s success won’t be found in a spreadsheet or formula, they are qualitative. They have to do with the mental models that Charlie Munger always talks about; reciprocation, scarcity, scale, leverage, feedback loops, culture, incentives, flywheels, win-win, deferred gratification, simplicity, social proof, pricing power (on member fees) and sunk costs. These factors combine to reinforce each other and amplify results in a non-linear fashion; what Charlie Munger coined 'lollapalooza' effects.

“I can’t give you a formulaic approach, because I don’t use one. And I just mix all the factors and if the gap between value and price is not attractive, I go on to something else. And sometimes it’s just quantitative. For instance, when Costco was selling for 12 or 13 times earnings, I thought that was a ridiculously low value just because the competitive strength of the business was so great and it was so likely to keep doing better and better. But I can’t reduce that to a formula for you. I liked the cheap real estate, I liked the competitive position, I liked the personnel system—I liked everything about it. And I thought even though its three times book or whatever it was then, that it’s worth more. But that’s not a formula. If you want a formula, you should go back to graduate school. They’ll give you lots of formulas that won’t work.” Charlie Munger

It’s often these qualitative factors and their combined impact that the market overlooks. When Nick Sleep was praising the virtues of Costco in 2004, Wall Street analysts were criticizing the company for their low margins and generosity to employees above shareholders. Needless to say they were focusing on the short term at the expense of the long term.

At the time, Jim Sinegal stated:

"The last thing I want people to believe is that I don't care about the shareholder. But I happen to believe that in order to reward the shareholder in the long term, you have to please your customers and workers."

And Nick Sleep opined:

“The consensus has it that Costco is a low-margin retailer with an expensive stock and a cost problem. That is certainly one description. But in our judgment it is a cost-disciplined, intellectually honest, high-product-integrity, perpetual motion machine trading at a discount to value.”

Prescient indeed!

[nb. Nick Sleep’s fund went on to compound at almost 21% per annum over it’s thirteen year life versus the benchmark’s return of 6.5% per annum. The fund closed in 2014.]

Costco vs Walmart vs S&P500 - 2004 - 2019 [Source Bloomberg]

I’ve collected some of my favorite quotes on Costco’s business model from Jim Sinegal’s interviews and public speeches [see sources below]. Once again you’ll find an abundance of common threads with the other Masters CEOs we’ve studied.

Love

“I love it. I’ve been doing it all my life, and it’s my style. That doesn’t mean it’s the right style or the style that works for everybody, but it’s my style.”

“Find something you are really passionate about and you won’t have to work a day in your life. I’m 80 years old and I’m retired and I still go into a Costco every day. Nobody is holding a gun to my head. I do it because I love it. If you can find something you love it will be a great gift for you.”

“If you don't have somebody who is passionate about the business [leading the business], no matter how smart and how creative and how diligent and how much money they have, if they don't have the passion for the business you're not going to see the business driving in the right direction, in my view. I would always look for that.”

Culture

“The three best operating companies I’m aware of are Costco, Kiewit and Glenair.  There is nothing remarkable about the product or field for any of these.  But there is something remarkable about the culture of all three.” Charlie Munger

“There are very few businesses like Costco that have a very extreme culture where everybody’s bought into. And where they stay in one basic business all the way. I love a business like Costco because of the strong culture and how much can be achieved if the culture is right.” Charlie Munger

“Our attitude at Costco is that culture is not the most important thing in a company, it’s the only thing. It dictates every action that you take. We feel we have to work continuously not to lose our culture. The way our employees describe it is ‘do the right thing’.” Jim Sinegal

Keep it Simple

“Our operating mission is very simple, ‘constantly strive to bring goods and services to market at the lowest possible price’. We look at every item and we judge it on that basis. When you have less than 4,000 items you can spend a lot of time doing that. Where a typical retailer might look at an item selling at $29 and say ‘I wonder if I can get $31 for it’, we look at and say, ‘I’m selling it at $20, how do we get it to $18 and then $16’. We really focus on that constantly, everybody works on that.”

Great Value on Great Products

“We look at the history and the evolutionary process of business and we say, "Boy, you'd better recognize why it is that customers shop with you." They don't shop with us because we have a Santa Claus at the front door, or fancy window displays or escalators or piano players. They shop with us because we have great value on great products, and you'd better not forget that.”

Win-Win

“Our code of ethics became a very simple thing and that’s the way it stayed.. We think we have four things we have to do. We have to obey the law, take care of our customers, take care of our employees and respect our suppliers. Pretty much in that order. We think it’s possible to succeed short term by not paying attention to those things, but long term you’ll stub your toe pretty badly. We think if you do those things, what you have to do as a public company will happen, you’ll reward your shareholders.”

“Our view is that you can reward the shareholders in the short term by not paying attention to one of those aspects (law, customers, employees, suppliers), but you can’t do it in a long term. You are either going to have labor problems, or you are going to break the law, or your customers are going to be turned off, or the suppliers are not going to want to do any business with you. Sooner or later you are going to stumble very badly.”

Long Term Mindset

“We never had an exit strategy. We never built this business to sell it. We had lots of opportunities to sell the business dozens of times. We wanted to build an institution that would be here 40 and 50 years from now. We thought we owed that to all the stakeholders.”

“Wall Street is in the business of making money between now and next Thursday. We are in the business of building an organisation that we hope to be here in fifty years from now.”

“We have always loved and viewed our businesses as something that we wanted to build for the long term. We are the company that wants to be here 50 years from now. We want to still be thriving. We want our employees to know that they can build their careers here, that they can count on us being here and that we are not going out of business. For the suppliers likewise, we want them to know they can count on our business into the future. We want the communities where we are doing business to know that our buildings are still going to be around and we still are going to be employing people in the future and those are all commitments that we have.”

Merchandising Strategy

“Our merchandising strategy is very simple, but quite unique. we have a very limited selection, we carry something less than 4,000 items. To put that into perspective, Target or Walmart, that has essentially the same categories of merchandise that we do, they have about 140,000 items. We really preselect the products we’re selling and trying to get the best value that we can in every single category. They are generally high quality national brands augmented by our private label.”

Customers Save on Every Item

“We have to be able to show a savings on everything we sell. If we can’t show a savings we won’t carry it. We’ve had situations, like in Portland, where for about two years we didn’t carry sugar because every supermarket was selling sugar below cost. We couldn’t save our customers any money. Our attitude was if they came in and see we couldn’t save them any money on the sugar, they have every reason to believe that maybe our pricing isn’t so hot on Michelin Tyres or a television. It’s a chink in the armour and we won’t engage in that.”

Efficiencies & Productivity

“If you go into a typical supermarket you would find about 350 SKU’s in the aisle. Various sizes and brands. We go out and we try and find someone who will make the largest box of cereal in the world, put it on a pallet and we simply move it into position with a pallet jack. If you think about the labor involved cutting open cases and hand stacking merchandise on the shelf and ringing through a lower ticket item you start to see the scope of the savings. Costco will have about 12 cereal items compared to 350 at a typical supermarket.”

“We count on very significant productivity. We pay high wages and have a very healthy benefit plan. If you buy into the concept that Costco is the low-cost provider of goods and services and also pay the highest wages in retail and have the richest benefit plan, then we must be getting better productivity, because of every dollar that we spend on our business, $0.70 is on people.”

Membership Model

“We have 87 million people who are running around with a Costco card in their wallet. There are very strong renewals. They are very loyal to us. We have established what’s referred to as ‘absolute pricing authority’. If you see it at a Costco you’ll be pretty sure you are getting the best price you can find.”

No Advertising

“In our business advertising is cost. If you advertise, you have to raise the price of the merchandise—it is that simple. We are working on margins that do not allow us to spend 1 or 2 percent on advertising. Also, advertising becomes like a drug. I use the expression: It’s like heroin, once you start doing it, it is very hard to stop. We feel that the most successful type of advertising is word of mouth. When people are saying good things about you, it is much more important than when you say them about yourself. Word of mouth is the most effective type of advertising.”

Scarcity

“We have created a Treasure Hunt atmosphere. When customers come in they may find at one time we have a Coach handbag, and they come back and we don’t have the Coach handbag but perhaps we have some Levi’s we are selling at a hot price. We try to create a sense of urgency, that if you see the product you’d better buy it because chances are it won’t be there next time. We purposely run out of merchandise to create that sense of urgency in our customers.”

“About 1,000 of the 4,000 items that we carry are what we refer to as the "treasure hunt" items. Those are the items that are constantly changing. Those are the types of things that continue to bring customers in shopping with us. We try to create an attitude in those kinds of products that if you see it you'd better buy it, because chances are it's not going to be there next time - so create an urgency in the customer.”

“Customers love the fact that we're going to save them $0.50 or $0.60 or $0.75 on a jar of peanut butter, and they would never forgive us if we didn't save them that, but that's not enough to bring them out of the hills. What really gets them in there is when they see something like the Under Armour garment that we're selling for $20 that they know is $40 in a department store. Or the Coach handbag that we're selling for $159 that they know is $300 at a department store. That's what really gets the customers really excited. That's what makes them talk about us at cocktail parties.”

Need Revenue Growth

“Costco is a top line company, we don’t do very well if we’re not doing a lot of volume. That’s the key to our business.”

“The economics of our business is pretty simple. High volume - we do well when we generate high volume and high revenues out of our businesses. We don't do nearly as well when the revenues are low.”

Minimum and Maximum Mark-up

“There is a minimum and maximum mark up. Every good deal we bought the customer is going to get. If we made a good deal customers would be the beneficiary.”

Think Small

“We like to think that we are nimble. We like to think like a small company. That’s not easy with 213,000 employees but it is very important because we think that’s the way we can navigate our way through competitive situations.”

Value Employees

“Paying high wages is contrary to conventional wisdom.”

“Someone who works on the floor pushing carts out in the parking lot or stocking the floors is making over $22 per hour compared to our competitors who are paying $11 and $12 an hour. In addition, they have a full benefit package. It’s a very stable workforce. We’ve always felt if you go out and hire good people, and provide good jobs, pay and benefits and career opportunities, then good things will happen in your business.”

“Of all the money we spend on running our business, seventy cents of every dollar we spend is spent on people. It is by far the most significant expense ratio we have. If you are going to spend 70% of everything you spend you better do that well.”

Promote From Within

“We home-grow all of our management. All of the people that are running the Costco’s today are people who have been with us 10 and 12 and 15 years prior to becoming a warehouse manager.”

Lucky Break & Humility

“You have to have a lucky break somewhere along the line. We had a lot of good fortune. If you are in business and successful and don’t recognise that you had some good fortune you are a fool.”

Recognise Change & Innovate

“Everything is changing. We have to be mindful of changes. There is always going to be change. If we are going to be successful in the future we are going to have to be as innovative in the next fifteen years as the last fifteen years. It will be imperative or we won’t survive. The customers vote at the checkout stand. If we aren’t doing our job they won’t be buying the products.”

Controlled Growth and No Grand Plans

“We’re not kamikaze pilots. We want to do things in a sensible fashion. If we can speed up our growth, without outdistancing our management team, and provide a quality product, then we will do so. Aside from the quality issues and wanting to grow the business in a sensible fashion, we don’t have any grand scheme that says, for example, that we have to be in Latin America by the year 2015 or have 1000 Costco’s in ten years.”

Make Mistakes

“You don’t have enough space in your magazine to talk about all the things that we’ve tried that didn’t work out. Some time ago, we tried to get involved in the home-improvement business. We were going to have paint. There are places where you can get thousands of colors of paint. We were going to have four, and three of those were going to be white [laughs]. It’s safe to say we underwhelmed the customer.”

Visit Stores

“I try to approach the visits from the standpoint of a customer. Does the building have the right goods out? Is it well-stocked and clean and safe? Nothing is a bigger turnoff than poor housekeeping, most particularly in a place where you have food. Also, when you have a sloppy building, I can guarantee you’re going to have high shrinkage [pilfering and shoplifting].”

Quarterly Earnings & Stock Price

“One of the follies of American business is that we are all so tied into these quarterly results and having to perform that it’s damaged a lot of businesses.”

“The things that we do are basic and intrinsic to our business and our company. Our reputation for pricing is an example. We have sweated over this for years. Why would we sacrifice that just to make a quarterly target? It wouldn’t make sense — sacrificing everything, risking our whole reputation. We believe our strategy will maximize shareholder value over the long term.”

“Driving stock up from one day to the next is not what we are about. We are about building a good company and performing for the long term. I know everyone says that, that sounds trite when I repeat it that way, but that is and has always been our attitude about our business. If we do the right things, the stock price will take care of itself, and our shareholders will be rewarded.”

Sol Price

“Sol Price was considered the most creative mind in the retail business in the 20th Century. Even the great Sam Walton said I’ve stolen more ideas from Sol Price than any man I’ve ever known. Guys like Sol are not a dime a dozen, you won’t find them on every street corner. I was like a fly on the wall watching Sol. I watched everything he did and I leaned everything from him.”

“When I was in my twenties, if I really worked hard maybe I could make thirty thousand dollars a year. I didn’t have any great goals just a lot of good luck. Sol Price was my mentor and a reporter asked me one time, ‘Gee you worked for Sol for so many years, you must have learned a lot?’, I said ‘No that’s inaccurate, I learned everything’. He was my mentor. He was the smartest man I ever knew, he was also as tough as shoe leather.”

And a final word from Nick Sleep’s 2010 letter ..

“Costco’s advantage is its very low cost base .. from a thousand daily decisions to save money where it need not be spent. This saving is then returned to customers in the form of lower prices, the customer reciprocates and purchases more goods and so begins a virtuous feedback loop. The firm’s advantage starts with 147,000 employees at 566 warehouses making multiple daily decisions regarding US$68b worth of annual costs. Its thousands of people caring about thousands of things a little more, perhaps, than may occur at other retailers. No fig leaf here. When Zak and I met Jim Sinegal, Costco’s CEO, Jim suddenly stopped in mid-sentence, his face lit up, “I must show you this” he said and disappeared into a filing cabinet. He emerged with a memo from 1967 written by Sol Price, Fed-Mart’s founder (the predecessor firm to Costco), “here you can have a copy of this” he said, and that copy is framed on our office wall. The memo says this,

“Although we are all interested in margin, it must never be done at the expense of our philosophy. Margin must be obtained by better buying, emphasis on selling the kind of goods we want to sell, operating efficiencies, lower markdowns, greater turnover, etc. Increasing the retail prices and justifying it on the basis that we are still ‘competitive’ could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there”. [The best summary of the business case for scale economics shared we have come across].

Forty three years later, almost to the day, and Costco is the most valuable retailer of its type in the world.” Nick Sleep, 2010.

Summary

Many of the Investment Masters have recognised the strength of Costco’s model:

“Costco is one of our long-term holdings in the “jam tomorrow” camp. It is highly rated, but its perpetually low margins (and low prices) help it to retain and grow its customer base. This approach helps it continue to win market share even in a very tough retail environment that is competitive and changing.” James Seddon, Hosking Partners, 2018

“Some firms have strengthened their cultures by spending more not less. The classic example is Costco, the discount retailer. Bucking the conventional retail model, Costco pays its staff more than the legal minimum wage – and far more than rivals. The average Costco employee makes in excess of $20 an hour, compared to average US national retail pay of less than $12 an hour. Wall Street is constantly pressuring Costco to cut its wage bill, with the cacophony reaching a peak during the crisis of 2009. Instead, the company raised wages over the following three years. The return for this munificence is that Costco employees stay on longer, thus saving on training costs. Turnover for employees who have been with the company for more than one year is a paltry 5 per cent. Loyal employees are more likely to excel.” Marathon Asset Management, 2015

“We understood, having followed high quality businesses like Walgreens, Walmart and Home Depot for a lot of years, the embedded unit economics of Costco where lots of stores that have been opened recently and don’t reach maturity for six or seven years. Therefore the 11% return on capital when we first bought the stock in 2004 was very much understated by the relative installed base compared to new stores that had been opened. I paid 20x earnings. I was still a classic value guy and value guys don’t pay 20x for things. Fast forward today and Costco trades for over 30x, so you’ve made over 50% on the multiple expansion, but we’ve made over 10x our money on Costco because they’ve grown the store base profitably. I look at the amount of money we made on Costco and we could have paid 35-40x earnings at the time. Everything they do as a retailer is best in class. You just can’t get anchored to classic valuation pricing methods even if you call yourself a value investor. This is probably the most valuable thing I’ve learned.” Chris Bloomstran, 2019

At last year’s Berkshire AGM, Warren Buffett joked that Charlie Munger continues to find things he likes about Costco.

“All the time [Charlie Munger] is finding new virtues in Costco, you know, and he’s right, incidentally. I mean, Costco has an enormous appeal to its constituency. They delight — they surprise and delight their customers. And there is nothing like that in business. If you have delighted customers, you’re a long way home.” Warren Buffett

Understanding and investing in businesses which share their scale economics can be hugely profitable. You’ll find them across industries as diverse as airlines, retail and insurance. Many of these businesses have been around for a long time and we’re likely to see new businesses develop which adopt this ‘Scale Economics Shared’ approach. Being mindful of this powerful business model can also help identify competitive threats to businesses that might already be in your portfolio.

“The business model that built the Ford empire a hundred years ago is the same that built Sam Walton’s (Walmart) in the 1970’s, Herb Kelleher’s (Southwest Airlines) in the 1990s or Jeff Bezos’ (Amazon.com) today. And it will build empires in the future too.” Nick Sleep, 2012

And when you do identify such businesses, it’s imperative you hold onto them. These rare businesses are compounding machines. Provided the competitive outlook hasn’t changed and the valuation isn’t extreme, stay focused on the destination not the short term market noise.

“Keep your eyes on the horizon.. The trick to being a good investor, over the long term, is to maintain your long-term orientated discipline.” Nick Sleep

It’s likely to be a pleasurable experience. Time to go find some Costco’s!

“I’m no good at exits. I don’t like even looking for exits. I’m looking for holds. Think of the pleasure I’ve got from watching Costco march ahead. Such an utter meritocracy and it does so well, why would I trade that experience for a series of transactions? I’d be less rich not more after taxes. The second place is a much less satisfactory life than rooting for people I like and admire. So I say find Costco’s, not good exits.” Charlie Munger

Sources:
Provost Lecture Series Spring 2017 - Jim Sinegal Lecture
LMU's College of Business Administration - Jim Sinegal Lecture
Costco - Perpetual Growth Machine - Value Investor Insight - Nicholas Sleep - Nomad Investment Partnership 2005.
Sacred Heart University - Integrity and Values: Interview with Dr. Jim Sinegal, Costco Wholesale Corporation
Fast Company - CEO Interview: Costco’s Jim Sinegal
Motley Fool - An Interview With Jim Sinegal, Co-Founder of Costco
Ethix - James D. Sinegal: A Long-Term Business Perspective in a Short-Term World - 2003
WSJ - Costco's Dilemma: Be Kind To Its Workers, or Wall Street? 2004
The Resilience of Costco - @minesafety

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TERMS OF USE: DISCLAIMER

Study the Master CEO’s here…

Ray Kroc - McDonalds

Howard Schultz - Starbucks

Ken Iverson - Nucor

Bernie Marcus - Home Depot

Sol Price - The Price Club

Jim Sinegal - Costco

Sam Walton - Walmart

Jeff Bezos - Amazon

Karl Albrecht - Aldi

Arthur Blank - Home Depot

Yvon Chouinard - Patagonia

Bob Iger - Disney Corporation

Herb Kelleher - Southwest Airlines

Charles Koch - Koch Industries

Les Schwab - Les Schwab Tires

Charles Schwab - Charles Schwab Co

Ron Shaich - Panera Bread

Lynsi Snyder - IN-N-OUT Burger

Ed Catmull - Pixar

Leonard Lauder - Estée Lauder

Willis Johnson - Copart

Don Keough - Coca-Cola

Jamie Dimon - JP Morgan

Hunter Harrison - Railroader

Julian Richer - Richer Sounds

Bruce Halle Discount Tire

Dick Erickson - Sun Tires

Learning From Chris Bloomstran

Whilst I’m a long-time avid follower of all of the Investment Masters, and I have to say a veritable devourer of their collected wisdom, there is nothing more valuable to me as an investor than actually speaking with these amazing people. Whether it’s a meeting at Berkshire, the odd telephone dialogue or even an interview, all of these interactions deepen my understanding of their unique views on financial and business matters and for that matter, the investment world.

Recently I had a wonderful opportunity to Interview Chris Bloomstran of Semper Augustus. Chris is a veteran of the Investment Fraternity and a recognised Master; The stocks in his portfolio have compounded at 4.7% above the S&P 500 since launching Semper Augustus more than 20 years ago. I’ve always valued what he has to say and our interview was no exception.

We covered many topics in the few hours in which we spoke, and I am incredibly grateful to Chris for being so open in sharing his knowledge and experience. I have collected the gems from our interview below.

Eclectic Value Investor

“For lack of a better nomenclature you’d put us into the value camp. Value is such a broad brush definition. We simply think of growth as part of the value equation. Growth is important. We are pretty eclectic in our process. We own compounders and we also own some out of favor, high-quality cyclicals; we’ll do the long side of merger-arb here and there. You can’t put us in a style box and I think that’s a big advantage.”

Dual Margin of Safety

“We are trying to find outstanding businesses at low prices to give us a dual margin of safety.”

Investment Time Horizon

“Having invested for 20 years at Semper Augustus and run money for thirty years, our process is very eclectic. We have businesses, such as Berkshire Hathaway, that we’ve owned since early 2000. For the duration of our owning it its been undervalued and it’s become an outsized position in a lot of our accounts. We’ve only sold it when mandate or need for diversification compels a sale. We’ve owned Mercury General and Washington Federal even longer, for the better part of twenty years, and have a history trimming companies like this when they’re rich and adding to the positions when they are cheap. We’ve owned things cyclically where we don’t have a long term horizon such as deep water drilling businesses. Today we own Subsea 7. It’s an engineering and construction company in Norway. We’ve also done things very opportunistically.”

Arbitrage Opportunity

“In 2008 we built a big position in the electrical utility Constellation Energy when it was to be acquired by Berkshire Hathaway. Although we ordinarily don’t like electrical utilities because of mediocre regulated returns, no pricing power and limited growth, we know how to price them. Generally they trade rich because investors are attracted to the dividend yield, which usually consists of most of profits. To us, Constellation was an attractive arbitrage opportunity and we traded the position actively as news broke again and again.

Berkshire offered to buy the business for $26.50 to keep Constellation out of bankruptcy. To effect the deal, Berkshire had to put in a billion dollars to shore up the derivative book of a merchant business Constellation owned in Texas. We had a bit of cash and the market volatility meant an attractive deal spread. EDF, who had a JV with Constellation to develop nuclear plants, ultimately made a counteroffer at $37 and Constellation accepted. As EDF was more of an unknown in the middle of the financial crisis, Constellation’s stock price tanked when Berkshire announced they were out. The stock dropped from $24 to $21 to $19 to $17 then $15 and we bought it at every one of those points except the last, when our final limit didn’t fill. It all happened fast. By the end of 2008 it was our second largest holding. We stayed in it until near the close, actually EDF bought the nuclear assets and the utility was ultimately sold to Exelon in Chicago. We exited in the mid $30’s.”

Position Size

“The businesses at the top of my portfolio are not necessarily going to be the ones that perform the best over the long term but are the ones I know will perform. Generally we’ll start with a 1% or 2% position size. Then as we continue doing our homework, absent some underlying business deterioration, we prefer stock prices to decline which gives us a chance to add to the position size.”

Dealing With Market Turmoil

“Being in the investment business for thirty years and knowing the businesses we own so well, is the best edge to deal with market turmoil. Because we have an anchor in the appraisals of the businesses we own and follow and we’ve done our homework - made accounting adjustments, drilled down to economic earning power and management quality - we don’t have to do a lot of work when price gives us an opportunity. For that reason, we are very non-emotional in times of stress.”

High Quality Companies

“Sustainable returns on equity aligned with very high quality management teams running the businesses is how we define high quality companies. It’s taken a very long time for us to get to that. Leverage is anathema to our thinking. We are running a very unlevered portfolio in terms of the collective balance sheets of the assets we own. Cash largely offsets debt now. Our returns on capital are not far off the underlying returns on equity of the businesses.”

No DCF’s

“We don’t run DCF’s. We think long and hard about the inputs [of a DCF] but we think the model lends itself to assumptions where you can get some crazy results.”

Owning Berkshire

“We’ve bought and still buy Berkshire at 15-20% position size, and it’s grown to 35% in some of our taxable accounts. BRK is unique to us and it’s the only business we would concentrate in that kind of size. We almost use BRK as a bond surrogate, really as our opportunity cost of capital, given a very predictable 10% ROE, which in a worst case could be an 8% ROE. To us, it’s a highly predictable, highly knowable business so for that we are willing to own BRK as a lower return business relative to the balance of the portfolio. It’s the most knowable thing we own. At a 10% unlevered ROE its undervalued by a lot, and if it trades closer to intrinsic we’ll earn something north of 10. If it earns 8 (ROE) for the next 10 or 15 years it’s fairly valued and we’ll likely earn 8.”

Company Issues Provide Opportunity

Investment Master - Chris Bloomstran

“Usually company specific issues provide opportunities. My experience has been that when the whole market sells off and everything gets cheap, it’s hard to want to make changes because we already like what we own. We’ve also proven unwilling to trade down the quality spectrum during a rout like ‘08, even though you’re going to make way more during the recovery. That won’t change.”

Portfolio Turnover

“We’ve had on average about 15% turnover for the last 20 years. Our turnover in 2008 was probably 70%. We had about half of our capital in financials at the end of 2007 which included insurers. None of our holdings failed. In fact, some were rewarded for their conservatism with failed assets more or less given to them at fire sale prices.”

Thinking About Management

“We have learned to think a lot more and spend a lot more time assessing management quality. We are spending a lot more time in the proxy statement than we used to. In our portfolio we only have about 20% of our businesses profits coming back to us in dividends which means management teams are retaining 80% of the profits. It is incumbent on us to work out how those people allocate capital. There are so many levers management can pull and we are very deliberate in assessing how well capital gets invested in the businesses we own.”

The Proxy Statement

“We are spending more time with proxy statements. We try and tie in year to year changes. What we’ve learned by looking at the evolution of proxies over a period of ten or more years, by observing how compensation committees award and incentivise management, is that you can really ferret out underlying changes in the business.

As an example, General Mills’ bonus structure is tied to two yardsticks, none of which are capital related. One is organic sales growth and the other is free cash flow growth. Ten years ago they were using 3-4% organic sales growth as the hurdle for paying half the bonus. Over time that became 3%, then 2%, then 1.4% and in the last couple of years the hurdle has become negative. Think about that! Rev up the acquisition machine. Buy Blue Buffalo. You don’t count a deal in year one but if its a growing business you sure get your organic growth in the out years, regardless of profitability.

Many consumer packaged goods businesses are under-investing in their business and it’s evident in the free cash flow. It’s pretty easy to dial up free cash flow growth by cutting advertising and growth initiatives. I guarantee these people lay awake at night thinking about how to get supremely wealthy in the next five years and not how they are going to grow or protect the business over the next thirty years. If you don’t have a motivation to make decisions based on returns on assets or capital or equity you can get all kinds of nutso behavior. You might as well take a giant pile of money and light it on fire.”

The Macro

“I wish we didn’t have to think about macro. We spend almost all of our time turning over rocks and looking at businesses, but, in my investing lifetime, we’ve seen aggregate debt levels systemically rise to levels we think are unsustainable. And that does enter our thinking. With on-balance sheet debt alone now at 350% of US GDP and 320% of global GDP, we don’t have room for a term structure of interest rates even remotely similar to where it was prior to the financial crisis. The days of 5-7% interest rates don’t work when debt is 350% of GDP.

The notion that debt levels are unsustainable and we are unlikely to grow our way out of what we think is excess leverage, lends to our thinking that interest rates will probably stay far lower for far longer than would be the case in a more normal, unlevered society. For that, you do allow for higher multiples somewhat than would have been the case historically. By contrast, we also think because the debt numbers are unsustainable we very much worry about long term stability in the financial system. The flip side of low rates driving higher multiples is that low rates are reflective of too much debt which goes hand in hand with disallowing growth. Therefore you can’t justify multiples that purely reflect low rates. Paying high prices for no growth won’t work out. Look at Japan for the past 30 years. We have small positions in two gold companies which are really just hedges against central banks doing bad things. Combined they are a mid to high single digit exposure.”

Anchoring - Mistakes of Commission

“Our single biggest error of commission was Ross Stores. We bought the position when small caps were cheap in 2000 for less than 10x earnings and 50% of sales. We loved the business and we loved the unit economics. We bought it as such a discount that during the 2000-2002 downturn which saw the S&P fall 50% we made about two and a half times our money over that period. When it traded for something like 20x we thought we could sell it at what looked like a full valuation and ease back into the shares at some point when valuations were a lot more attractive. I was probably anchored to having bought the stock at 10x earnings. It never traded at 10x again. It traded in the mid teens. After we sold the stock, it went on to be another twenty bagger. A gravely expensive mistake.”

Costco & Growth

“I learnt a lot about the growth component of the value equation by watching Ross Stores. A couple of years after we sold Ross we bought Costco, which has provided an invaluable education about how capital really works. Costco is the same deal as Ross Stores. We love the unit economics, we love the management. Costco had a similar number of stores to Ross when we first bought it. They’d just started paying a dividend. We bought Costco when their gross margin was about 14% and they were earning 11% on capital. We understood, having followed high quality businesses like Walgreens, Walmart and Home Depot for a lot of years, the embedded unit economics of Costco where lots of stores that have been opened recently and don’t reach maturity for six or seven years. Therefore the 11% return on capital was very much understated by the relative installed base compared to new stores that had been opened.

I paid 20x earnings. I was still a classic value guy and value guys don’t pay 20x for things. Fast forward today and Costco trades for over 30x, so you’ve made over 50% on the multiple expansion, but we’ve made over 10x our money on Costco because they’ve grown the store base profitably.

The gross margin has been driven down from 14% to 11%. Wall Street typically kills a company for shaving gross margin, however Costco has taken the scale and purchasing power of the business and they’ve passed their cost savings through to their customers. Returns on capital have gravitated upward towards to the high teens or higher if you account for the cut in tax rates [Costco will likely be one of the first companies to compete away the tax cuts]. Our returns over owning the business for a long time have gravitated toward the underlying return on capital of the business.”

Most Valuable Lesson

“I look at the amount of money we made on Costco and we could have paid 35-40x earnings at the time. Everything they do as a retailer is best in class. You just can’t get anchored to classic valuation pricing methods even if you call yourself a value investor. This is probably the most valuable thing I’ve learned. The extension of that is, if you own a business that really is a true genuine compounder where you have a ramp to grow and particularly for re-investment at high rates of return, don’t sell it, and definitely don’t sell it all. I get cute with a lot of other things that aren’t your classic compounders but any time I’ve sold shares in one of the handful of businesses that I think we can own forever it has proven to be a mistake. ”

When Compounders Mature

“The durability of compounders is really only obvious in arrears. There are very few that are knowable. The risk is when you own a compounder and it matures and starts to face its own competition. Walmart for example, having killed retailers in small towns started facing competition. First from Costco and the like and then internet retailing. Look at Coke for the last 20 years. The core business weakened at the same time it traded for a nosebleed valuation that was awarded because of a glorious past.”

Price Matters

“A great business at the wrong price can be a disaster.”

Long Term Focus

“We have stocks that have some common threads. They have all suffered in one form or another. We’ve been able to look through the short term suffering which is just that, it’s short term. Richemont is a great example. We’ve owned it for a handful of years. Richemont owns Cartier and Van Cleef & Arpels in jewelry. They have ten or so very high end watch brands including Vacheron Constantin, IWC and Jaeger-LeCoultre. Then they own some one-off brands like Peter Millar and Purdey shotguns. The Ruperts, the family that founded the firm had South African tobacco holdings which they sold to BAT probably 30 years ago. Within a holding company structure, they started buying up luxury brands. They’ve done a marvellous job preserving the brands and building them out and growing them intelligently.

Richemont’s watch business, when you count watches sold by Cartier, comprise about half the revenue, experienced a huge growth curve on the back of Asian demand. Richemont grew their distribution by using the store inside a store concept. Retail outlets were located in the best zip codes in Hong Kong, Macau and the rest of the high end world. A few years ago two things happened - the Chinese cracked down on graft and travel visas which really put a dent in high-end watch sales. It gave us the opportunity to buy the stock.

We watched how the CEO, Mr Johann Rupert and the management thought about the long-term viability of the brands they own. Mr Rupert talks about being a temporary steward of Vacheron which was founded in 1855. When sales declined, management recognised an excess of inventory in the retail partner channel. The first thing retailers do when sales slow and they have excess inventory is mark it down. The last thing you want to see happen if your customer just paid $20,000 for a watch is to see it sell six months later on on the grey market for $15,000. Richemont approached their retail partners and bought back a whole bunch of inventory and in some cases physically melted down the precious metal content of the watches.

Richemont is a 65% gross margin manufacturer. Initially I presumed the value of a $20,000 or $200,000 watch was largely in the precious metal or jewel content. Far from it. The higher up the price point, the higher the gross margin. On a $200,000 watch the gross margin can be ninety percent plus. It’s the brand. So to preserve brand they destroyed watches.

They also didn’t want to be in a situation where retail partners could kill the brands so they built out more of their own distribution. They spent a lot of money building out their own bricks and mortar. They sacrificed operating margins for the durability of the brand. The watch business is a good business but will likely only grow 4-6% organically, above nominal GDP, but it’s the fashion jewellery business where the upside lies. Fashion jewellery is very early, it’s maybe 10% of all the jewellery sold and there is a long curve to teach wealthy families about the appeal of high end jewellery lines. Once you’re into a line you’re kind of hooked on it. They’ve now fully bought into the internet. Control of distribution is a common theme across several names in our portfolio.”

Disruption & Change

“Disruption is happening at a much faster pace which makes investing that much harder. What looked to be a durable brand or franchise can get dislocated in a hurry. Things like cutting out wholesalers and middlemen and going direct to consumers, I think we are in the early innings of it.”

“If you get fundamental change on a compounder and you bought it at a high price, the combination of the fundamentals deteriorating and then the multiple revaluation downward can be lethal.”

Understand

“There are reasons we will stop the investment process. We start with either unknowability of industries or industries we don’t like because the economics don’t work for us. They would be the easiest decisions (e.g. Electric utilities without growth and the complexity of pharmaceuticals).

When I think back to the branded pharma companies we’ve owned, despite making a bunch of money, we really didn’t know what we were doing. It’s the unknowability. We’re not scientists and I’m not sure the scientists inside those companies know what’s going to go through the FDA or the EMEA. We don’t have an edge. Being lucky is not a replacement for understanding.”

Business Fundamentals

“Once we get past knowability, it’s onto the blocking and tackling which is the business fundamentals, management quality and how they’re compensated, price & volume, the durability of product lines and all the myriad accounting adjustments we make.

If we have an edge it’s adjusting every business’ GAAP numbers. Most businesses overstate what they earn. We are very good at getting to economic earnings from GAAP or IFRS which is just the starting point.”

Waiting for Price

“We’ve built a working list over the years of c450 companies that we track peripherally. We try and update our thinking on them through the course of the year. We maintain a rough intrinsic value target. When we get a stock trading south of that number we might get interested. It’s a function of sitting around and waiting for price. In the meantime thinking about where you are wrong on the valuation or the fundamentals. Price is then kind of the last thing we look at. When we have done work for 20 years on a business and the price now makes sense it’s very easy for us to put 1-2% to work. To the extent we’ll have to do more work we’ll do it. If we get comfortable we’ll make the position size even larger.”

Circle of Competence

“I would tell my younger self, ‘your circle of competence is way more narrow than you think it is.’”

Independence of Thought

“From a psychological perspective, you need independence of thought, but not to a fault. You need an understanding that the crowd at the extremes is wrong, but for a long time they can be right.”

Client Alignment

“Client expectations are never aligned. Clients expect results and if you’re not racing ahead when markets are, nobody likes to get richer slower. We spend a fair amount of time with process over the years, and telling the same story. It still doesn’t make it any easier. Human nature doesn’t make it any easier. Most people wrongly view the stock market as a casino, and it’s not. It’s a joy and refreshing to find clients who get it, who think about the long term, that are realistic about expected returns and think about what can go wrong and right. It makes way more sense to focus on long-term business performance and not short-term stock price performance, but that’s really hard for most people. It’s easy to see the stock price. You have to work to understand the business.”

Free Cash Flow

“We’re looking for businesses that have an opportunity to invest and build out capacity. We are looking for retail concepts that can grow units over time on an accretive basis and expand returns on capital. Can I build a plant or distribution facility and earn high returns on the investment? Free cash flow in that setting is a terrible concept. It’s a great yardstick if you are in a business that is mature and isn’t going to grow. There are all kinds of flaws with various pricing metrics. It would be easier if maintenance capex was a disclosed number. It’s not. So you’ve got to talk to management and get a sense of what it really takes to replace your capital stock.”

Listen to Transcripts

“We read the transcripts but we might also listen to the transcript to see the nuances, to hear how something is said. The value might be in the Q&A and listening to what was asked and how management has answered the questions.”

Value Line vs Broker Research

“We read and see very little sell side research. We do read Value Line, both the large cap and the small and mid cap editions every week. It allows me to cover the gamut of a lot of companies and industries very efficiently. Thirteen editions. It’s not in-depth but you see each company and industry four times per year.”

Questioning Management

“We don’t want to talk to management about quarterly earnings. We are trying to get to the durability of the business franchise. I want to understand why an insurance company can raise prices by 6.9% but not 7%. That answer is meaningful for me. It’s not something discussed in a SEC filing. But there’s value in knowing that stuff.”

Summary

Chris also suggested some book titles he has read and recommended to others. These include: Sol Price, Merger Masters by Kate Welling, Economics in One Lesson, Freedom’s Forge, The Forgotten Man, Shoe Dog, Railroader, and The Bare Essentials. He gives copies of The Richest Man in Babylon and The Intelligent Investor to lots of students. All of these tomes include fascinating and valuable insights into both business and investment worlds.

Chris is a Master. Even with more than twenty years of my own in investing, Chris still manages to teach me things that add value to my own thinking. He is humble and was very generous with his time, and I am grateful for the opportunity to have spoken with him.

Further Reading:
Chris Bloomstran: The New Super Investors - Investment Masters Class
Chris Bloomstran - Annual Letter [Part II] - Investment Masters Class
Chris Bloomstran – What Makes a Quality Company – Invest Like the Best - Podcast

Semper Augustus - Investor Letters

Join our Investing Community for daily insights on Twitter: @mastersinvest

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Learning From Chuck Akre

One of the traits that sets the Great Investors apart is the ability to be grounded - to remain calm under pressure and sensible when things get hairy. All the Masters have it but none more so than Chuck Akre.

Grounded: Mentally and emotionally stable, admirably sensible, realistic, and unpretentious.

And ‘Grounded’ quite possibly is the perfect word to describe Chuck. If you’ve been an active reader of our blog over the last few years, I’m sure you’ll remember our post on Chuck Akre and his Three Legged Stool. Like Buffett, he prefers to work away from the noise of Wall Street. His office is based in a small Virginian town that boasts a single traffic light. His humility and expertise are synonymous with those we call Master Investors and Chuck has been kind enough to give of his time to us on a number of occasions. He is someone we follow avidly.

Chuck was recently interviewed on one of our favourite Podcast series: ‘Invest Like the Best’ with Patrick O’Shaughnessy. O’Shaughnessy typically has a great line up and as usual, he delivered big time on his recent talk with Chuck. Chuck’s explanations and investment approach are refreshing in their simplicity. Over more than fifty years of investing experience, Chuck has distilled the essence of great investing into three key criteria which he refers to as his ‘Three Legged Stool.’ And while Chuck might be reluctant to disclose insights into his favourite stock positions, he does share a key insight in the Podcast which took him decades to appreciate. The podcast gets to the core of what great investing is all about. The Podcast is replete with pearls of wisdom and anecdotes, all straight from the legend’s mouth. It’s the perfect mental detox to remove the daily noise we get caught up in as investors.

Following are some of our favourite quotes from the Podcast:

Read

“I spend a lot of time reading. That’s how ideas bubble up in my universe. Mostly it is a serendipitous, non-quantitative approach.”

Imagination & Curiosity

“In my career I’ve literally run across thousands of people who were very very bright, but not necessarily good investors. Pure knowledge, in and of itself, is not a ticket to being a good investor. Imagination and curiosity are what’s hugely important. We’ve discovered things over the years purely by being curious and continuing to keep involved in the search process to find these exceptional businesses.”

“I find that curiosity has been useful to me in searching for investments. Relating real life experiences allows me to pursue lines of thought to find a stock that might be interesting.”

“Curiosity and imagination go hand in hand in being creative and identifying businesses.”

Education & Smarts

“I had no background whatsoever in the business world; I was an English major and I’d been a pre-med student and had no courses in business whatsoever. So I had a clean canvas and a willingness and a desire to learn and so my voyage was: ‘What makes a good investor, what makes a good investment?’”

Stocks Outperform Long Term

“I examined early on, and continue to do so, rates of return in all asset categories and made the observation that rates of return in common stocks over a long period of time was higher than anything else on an unlevered basis.”

Compound Returns

“Thomas Phelps, wrote the book, ‘100 to 1 in the stock market’ in 1972, and to this day it remains inspirational to me and fundamental to me in terms of thinking about the issue of compound returns.”

Return on Equity

“A return in an asset will approximate the ROE [FCF return on owners capital] given a constant valuation and given the absence of any distributions. You get that from your quantitative background. There are no constant valuations so you work hard to have a modest starting valuation.”

“If our goal is to have above average outcomes we need businesses to have above average returns."

“We try to identify businesses that have had high returns on the owner’s capital for a long time and we spend a lot of time trying to figure out why that’s so and what caused that. What’s does the runway ahead of them look like? Is it broad and long? Do they still have the opportunity to earn above average returns on capital?”

“Rate of return is what drives us. Did I understand that implicitly thirty years ago or fifty years ago? No! Stuff that is right in front of your face sometimes doesn’t reveal itself in terms of its importance for a long time. I carry a coin in my pocket that says, ‘I am a chartered member of the slow learners.’ And that’s in fact the case.”

‘Three Legged Stool’

“Leg one [of the three-legged stool approach to investing] is the quality of the business enterprise. Leg two is the quality and integrity of the people who run the business and the third leg is, what is their record of reinvestment and what is their opportunity for re-investment? Once we have those in place, we say we’re just not willing to pay very much for these businesses. Those are the three legs of the stool.”

Disclosing Positions

“We try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in and going out.”

In March of 2010, Chuck added their first position to MasterCard. Due to regulatory concerns, MasterCard and Visa were selling at 10 or 11 times. In regards to return on capital, Chuck noted “there isn’t a word in the English language superlative enough to talk about them. You could cut the margins in half twice and you’d still be above average for an American business. So clearly something extraordinary is going on there. It also tells you there is a big target on their back; everybody wants some of that. It tells you they are probably jamming everything they can in the income statement to try to reduce how good the margin is they are showing. We think we know what causes that and we’ve quit talking about it. If you read any research from Wall Street, and we read very little, there is no-one who talks about rates of return they are earning on their capital. Because Wall Street, in general has a completely different business model than we have. Our business model is to compound our capital. Wall Street’s business model, generically, is to create transactions. What is the best way to create transactions? Create false expectations, they are earnings estimates. We call it ‘beat by a penny and miss by a penny.’ That gives us opportunities periodically.”

Keep it Simple

“Everything should be made as simple as possible. Lots of very bright people can build really intriguing complicated ways to find out why something is cheap or expensive. We try to keep things as simple as possible.”

Management

“[The managers we have owned] don’t have a screen in their office showing them the price of their stock. And lots of them do. Sometimes you find it in the lobby of a company and sometimes you find it on the CEO’s desk. That doesn’t interest us. Their focus is on the wrong thing, in our judgement.”

“We have an expression, ‘Our experience is that once a guy sticks his hand in your pocket, he’ll do it again.’ So we just have no reason to go there. We constantly find people’s behaviour which is antithetical to our interests.”

Post-Mortems

“We explore, we learn and we observe; we think a lot about the businesses we have sold. Was that the right decision? We’ve concluded in a number of cases is was not. But who does it perfectly?”

Right Once or Twice + Long Runway

“Here’s an important notion: You only need to be right in your investment decisions once or twice in a career. The challenge is how do you identify that? Typically you want something that’s small.”

Collect Data, Form Judgements

“A pre-med major, an English major, someone involved in the investment business - they’re all the same. They are about collecting data points and forming judgements around them. It’s all the same.”

Not Selling Exceptional Businesses

“If we own exceptional businesses, one of the hardest things in the world is to not sell them. All businesses have hiccups in their business operations and all businesses have things occur that are unplanned for. Nothing is perfect. Not selling maybe is one of the hardest things to do. Maybe one of our greatest assets is our ability to not sell.”

Read Biographies

“Reading business biographies you learn about people’s behaviour. Sometimes you see it through the eyes of a biographer who has a rose tint to the glasses, sometimes you see it through pure actions.”

Career Advice

“Follow your passion. That’s the most important thing. And read like crazy and be curious about everything. It’s relating real life experiences.”

Pricing Power

“I’m always looking for ways to understand pricing power because pricing power is key. What is the source of their pricing power? Think about MasterCard and Visa; we have our notions and we don’t talk about it anymore. And you’ll notice the company never talks about it.”

It’s Not all Quantitative

“If this business was susceptible to purely quantitative approach, they wouldn’t need me and you would just a punch a button and it would solve for all your problems. That hasn’t happened.”

A Question for CEO’s

“One of the questions we like to ask [the CEO particularly] is, how do you measure if you’ve been a success managing this business? As you might expect some say the price of the stocks goes up, or we hit our earnings target, or we delivered on all the things the board asked of us. It’s a rare occasion that the CEO articulates an idea that shows he understands the idea of compounding the economic value per share. Why is that so? Because they’re trained to run businesses. They’re not trained to think about compounding the intrinsic value per share, which is really the single most important thing.”

Learning

Whilst Chuck has continued to out perform the Index for many years, it is interesting to note that his recent above average performance has been done entirely without any of the FAANGS. Many of the Masters cannot say the same; the likes of Google and Apple and Amazon feature in many of their portfolios. Chuck says it was simply because he ‘wasn’t smart enough or quick enough to figure them out.’ Humility indeed. But that said, it doesn’t say he’s not open to considering them.

“Everyday is a learning day and we have to figure out which of those businesses [FAANGS], if any of them are truly attractive, and not subject to rapid changes in technology or governmental intervention or retaliatory issues relating to different countries in different parts of the world.”

Curiosity and Reciprocation

Chuck tells the story of how curiosity, observation and imagination led him to a tyre company with a history of very high returns on capital, a company called ‘Bandag’, which had done well for a long period of time. Chuck arranged a meeting with the company and when he walked into the CEO’s office, the CEO had his feet up on the desk and was eating an apple … “we got a different feel right off the bat,” Chuck noted.

Bandag’s returns were three or four times the competitors. Chuck’s goal was to go meet them and figure out what business they were actually in. Bandag was a tyre company that dealt with independent tyre dealers who retreaded Bus and Truck tyres. Bandag had taken the savings generated when key input costs fell and distributed the windfall to their dealers on the basis the dealers had to use the money in their business, ‘They couldn’t buy new Cadillacs, but they could buy a new store.’

As all the Bandag stores were franchised, each was an independent dealer who worked long hours compared to the competition. In contrast, employee dealers had no share in the profits and worked shorter hours. Bandag very wisely shared the wealth with their dealers instead of passing it all onto their shareholders. As a result they built a huge loyalty network of independent dealers, who continued to use the Bandag products instead of the national tyre companies. This resulted in much higher returns on capital than other tyre companies.

Summary

Just like successful athletes develop strategies to mentally prepare for the emotional rigour of a race or big game, investors can do the same. I find setting aside some time early in the day to re-visit insights from the great investors, be it Akre, Munger, Buffett, Lynch or others, keeps me grounded and mentally prepared for when volatility strikes.

Chuck’s ‘Three Legged Stool’ criteria for identifying great investments is beautiful in its simplicity. His lessons and mental models on other aspects of business and finance are incredibly handy to have at your disposal.

You don’t have to have a major in business to succeed, nor it seems do you need to be the quickest of the mark. It’s Chuck’s innate curiosity and imagination that have allowed him to spot great companies that quite often others have missed. We’re glad to have him in our community of Master Investors and we look forward to many more inspiring lessons.

Berkshire Meeting: Omaha 2019

Source: ‘Invest Like the Best’ Podcast. Chuck Akre interview with Patrick O’Shaugnessy. 2019. Apple Podcasts.

Further Reading: ‘Chuck’s Three Legged Stool’, Investment Masters Class.

Join our Investing Community for daily insights on Twitter: @mastersinvest

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Guesses & Forecasts

If successful investing was as easy as acting on the headlines of the financial press or the latest stockbroker bulletin, we’d all be wealthy indeed. Very wealthy and very successful. Imagine how easy it would be to simply read headlines such as: ‘USD to rise’, ‘Gold to Break $2,000’, ‘Stock Market Crash Imminent’, ‘Company XYZ a BUY, Price Target $152’, and then upon taking action, turn those forecasts into success. Every single time. Sound too good to be true?

Unfortunately it is.

Forecasting is an art, not a science and as such, its incredibly hard to be accurate 100% of the time. Actually, when you think about it, its hard to be right even part of the time. Forecasting, at best, is just a considered guess, and when you look at the actual definitions of those two words, you’ll see there’s actually not much difference:

Forecast: “predict or estimate (a future event or trend)”.

Guess: “estimate or conclude (something) without sufficient information to be sure of being correct.”

In the end, they’re both estimates, yet we’re often led to believe that the person making the estimate must have some foresight we don’t. Unfortunately the truth is, ordinarily they don’t.

“The rules of the investment profession seem to require that its members describe their views about the future using high-sounding terms like “analysis,” “assessment,” “projection,” “prediction” and “forecast.” Rarely do we see the word “guess.”)” Howard Marks

If investors demanded those publishing the forecasts to include their track record, life would be much simpler. I’m not suggesting forecasting is easy, but the confidence and precision portrayed by so-called experts reminds me of the charlatans who peddled their ‘miracle cures’ before medicine became a science.

“We always read ‘I think the stock market's going to go up.’ We never read ‘I think the stock market’s going up, (and 8 out of my last 30 predictions were right) or ‘I think the stock market's going to go up (and by the way I said the same thing last year and was wrong).’ Can you imagine deciding which baseball players to hire without knowing their batting averages? When did you ever see a market forecaster's track record? “ Howard Marks

"The greatest folly is to accept expert statements uncritically" Garrett Hardin

In over a quarter of a century in the finance industry, I’ve pretty much seen it all. Consider this recent forecast in Barron’s … 'Tesla is headed to $10 a share under a bearish case—or $391 under a bullish one, wrote [an] analyst this week’. The stock was around $200 at the time. I thought to myself, $391, that’s rather precise. No rounding required? Maybe $400? And the downside as low as $10? Yet that outcome seemed unlikely. Not because it was too bearish, but a glance at the debt load suggested to me that if the bearish case developed, the light will bypass yellow and go straight to red from green. And the analyst range of $10 to $391? I’m not sure how to make money out of that one, but given the possibility of losing everything, maybe it’s a stock to avoid?

The above statement can be best described as a guess. When we look into the future that’s what we’re all really doing. Guessing.

William Stewart, the founder of Stewart Asset Management, has bettered the S&P500 by a remarkable 4.3%pa net for 40 years! In a recent Graham & Doddesville interview he proffered:

“This is not a science but more of a guessing game. We try to make the best guesses we can.” William Stewart

“What you’re really doing is laying out your decision tree and adjusting it. You can come back saying, I think I got this a little high, or that a little low. It’s not fixed. In essence, we’re always operating with the best guess we can make. If it changes weekly, it changes weekly. It doesn’t usually change weekly, but it could. Nobody’s got a lock on what’s right, a model is only a model and it’s not fixed in stone. Sometimes, nothing’s changed but you changed your mind. That’s good. The purpose of the process is to bring out our best guesses. Everything we do is guessing. I think we all get a little carried away with the science of the matter, because there are lots of formulas, whereas you’re essentially making a guess.” William Stewart

Because we don’t have perfect information and because we can never know the future, a model capable of predicting an exact target price is fiction; even a 5,000 line spreadsheet model! Because businesses are unpredictable, some more so than others, asset price targets or intrinsic values can’t be set in stone; regardless of what their makers and promoters hope to convey.

We won’t know if a stock price was a reasonable reflection of a company’s value until some future date. So today, a stock price is just a fictional analog of the underlying company it represents.

The benefit of approaching investing with a ‘guessing’ mindset is that it removes the shackles of perfection. It provides for the possibility of being wrong and in doing so, it helps avoid confirmation and commitment biases.

"You need humility to say 'I might be wrong'.'' Seth Klarman

"Every day I assume every position I have is wrong." Paul Tudor Jones

William Stewart‘s quote took me back to one of my favourite books, ‘Super-Forecasting’, by Philip Tetlock. Tetlock’s observation about ‘guesses’ is an apt one.

“Probability judgements should be explicit so we can consider whether they are as accurate as they can be. And if they are nothing but a guess, because that’s the best we can do, we should say so. Knowing what we don’t know is better than thinking we know what we don’t.” Philip Tetlock

I’ve included some of my favourite quotes from Tetlock’s book below. I hope they’ll help guide you the next time you’re presented with an ‘expert’ forecast, or even if you’re attempting to develop your own.

Check The Forecasters’ Record

“Every day, the news media deliver forecasts without reporting, or even asking, how good the forecasters who made the forecasts really are.”

“Many have become wealthy peddling forecasting of untested value to corporate executives, government officials, and ordinary people who would never think of swallowing medicine of unknown efficacy and safety but who routinely pay for forecasts that are as dubious as elixirs sold from the back of a wagon.”

“The list of organisations that produce or buy forecasts without bothering to check for accuracy is astonishing.”

“Consumers of forecasting will stop being gulled by pundits with good stories and start asking how their past predictions fared - and reject answers that consist of nothing but anecdotes and credentials.”

“Far too many people treat numbers like sacred totems offering divine insight. The truly numerate know that numbers are tools, nothing more, and their quality can range from wretched to superb.”

Most Forecasts Are Quickly Forgotten

“Old forecasts are like old news - soon forgotten - and pundits are almost never asked to reconcile what they said with what actually happened.”

“More often forecasts are made and then .. nothing. Accuracy is seldom determined after the fact and is almost never done with sufficient regularity and rigor that conclusions can be drawn. The reason? Mostly it’s a demand-side problem: The consumers of forecasting - governments, business, and the public - don’t demand evidence of accuracy. So there is no measurement.”

Forecasting is Often Impossible

“It’s misguided to think anyone can see very far into the future.”

“It’s a rare day when a journalist says, ‘The market rose today for any one of a hundred different reasons, or a mix of them, so no one knows’.”

“Uncertainty is real. It is the dream of total certainty that is an illusion.”

“Limits on predictability are the predictable results of the butterfly dynamics of non-linear systems.”

“If you have to plan for a future beyond the forecasting horizon, plan for a surprise.”

“The past did not have to unfold as it did, the present did not have to be what it is, and the future is wide open. History is a virtually infinite array of possibilities.”

Stay Open-Minded, Curious and Self Critical

“Super-forecasting demands thinking that is open-minded, careful, curious, and - above all - self critical. It also demands facts. The kind of thinking that produces superior judgement does not come effortlessly.”

“The strongest predictor of rising into the ranks of super-forecasters is perpetual beta, the degree to which one is committed to belief updating and self-improvement. It is roughly three times as powerful a predictor as its closest rival; intelligence.”

Seek Dis-Confirming Evidence

“Scientists must be able to answer the question “What would convince me I am wrong?” If they can’t it’s a sign they have grown too attached to their beliefs.”

“We rarely seek out evidence that undercuts our first explanation, and when that evidence is shoved under our noses we become motivated skeptics - finding reasons, however tenuous, to belittle it or throw it out entirely.”

“People can be astonishingly intransigent - and capable of rationalizing like crazy to avoid acknowledging new information.”

“Social psychologists have long known that getting people to publicly commit to a belief is a great way to freeze it in place, making it resistant to change. The stronger the commitment, the greater the resistance.”

“Super forecasters may have a surprising advantage; they’re not experts or professional, so they have little ego invested in each forecast.”

Beware High Confidence

“Declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily the story is true.”

“People trust more confident financial advisers over those who are less confident even when their track records are identical.”

Intuition is Pattern Recognition

“There is nothing mystical about an accurate intuition .. it’s pattern recognition. With training or experience, people can encode patterns deep in their memories in vast numbers and intricate detail - such as the estimated fifty thousand to one hundred thousand chess positions that top players have in their repertoire. If something doesn’t fit a pattern, a competent expert senses it immediately.”

Wrong Outcome Doesn’t Imply Wrong Forecast

“If the forecast said there was a 70% chance of rain and it rains, people think the forecast was right; if it doesn’t rain, they think it was wrong. This simple mistake is extremely common.”

& Vice Versa

“People often assume that when a decision is followed by a good outcome, the decision was good, which isn’t always true, and can be dangerous if it blinds us to the flaws in our thinking.”

Words, Numbers and Time Matter

“Study after study showed people attach very different meanings to probabilistic language like “could”, “might,” and “likely.”

“Forecasts must have clearly defined terms and timelines. They must use numbers.”

“Fuzzy thinking can never be proven wrong. And only when we are proven wrong so clearly that we can no longer deny it to ourselves will we adjust our mental models of the world - producing a clearer picture of reality. Forecast, measure, revise: it is the surest path to seeing better.”

More People ≠ Better Forecasts

“Aggregating the judgments of many people who know nothing produces a lot of nothing.”

Models are Models

“No model captures the richness of human nature. Models are supposed to simplify things, which is why even the best are flawed.”

Forecasts Are To Foresee

“The point of making forecasts is not to tick all the boxes on the ‘how to make forecasts’ checklist. It is to foresee what’s coming.”

Sample Size & Randomness Matter

“Someone beats the market six or seven years in a row, journalists profile the great investor, calculate how unlikely it is to get such results by luck alone, and triumphantly announce that it’s proof of skill. The mistake? They ignore how many people were trying to do what the great man did. If it’s many thousand, the odds of someone getting that lucky shoot up.”

You Can Get Caught by Stories

“It’s natural to be drawn to the inside view. It’s usually concrete and filled with engaging detail we can use to craft a story about what’s going on. The outside view is typically abstract, bare, and doesn’t lend itself so readily to storytelling.”

Test & Debate Views

“Super forecasters constantly look for other views they can synthesis with their own. There are many different ways to obtain new perspectives. What do other forecasters think? What outside and inside views have they come up with? What are the experts saying? You can even train yourself to generate different perspectives.”

“For super forecasters, beliefs are hypotheses to be tested, not treasures to be guarded.”

“If forecasters can keep questioning themselves and their team mates, and welcome vigorous debate, the group can become more than the sum of its parts.”

Assume You’re Forecast is Wrong

“Researchers have found that merely asking people to assume their initial judgement is wrong, to seriously consider why that might be, and then make another judgement, produces a second estimate which, when combined with the first, improves accuracy almost as much as getting a second estimate from another person.”

Practice Forecasting

“Learning to forecast requires trying to forecast. Reading books on forecasting is no substitute for the experience of the real thing.”

“Our expectations of the future are derived from our mental models of how the world works, and every event is an opportunity to learn and improve those models.”

Revisit Forecasts

“To learn from failure, we must know when we fail.”

“Unfortunately, most forecasters do not get high-quality feedback that helps meteorologists and bridge players improve. There are two main reasons why. Ambiguous language is a big one. Vague terms like ‘probably’ and ‘likely’ make it impossible to judge forecasts. The second big barrier to feedback is time lag. When forecasts span months or years, the wait for a result allows the flaws of memory to creep in.”

Hindsight Bias

“Once we know the outcome of something, that knowledge skews our perception of what we thought before we knew the outcome; that’s hindsight bias.”

Stay Humble

“Underlying super-forecasting is a spirit of humility - sense that the complexity of reality is staggering, our ability to comprehend limited, and mistake inevitable.”

Summary

The front pages of yesterday’s financial papers and brokerages bulletins are littered with stock recommendations that resulted in permanent loss of capital. Why? Because for most forecasters, it doesn’t matter. It’s wasted ink not money. New Price target 50% of Old Price Target. Has the model been changed? The old model didn’t work?

When you don’t have a position, you just have an opinion. It’s for this reason I prioritise information from investors with skin-in-the game and long track records of success.

The next time you’re presented with a forecast, take the time to consider the forecasters track record of success, and also why they might be making such claims. Remember, if their guess is right, they’re seen as a guru; if they get it wrong nobody remembers anyway.

I’ll let Morgan Housel have the last word on this topic:

“You don’t get on TV, or invited to industry conferences, or big book deals for predicting average outcomes. Pundits get paid for sitting three standard deviations away from sane analysts.”

Source: ‘Superforecasting: The Art and Science of Prediction’ Philip Tetlock, Dan Gardner, Broadway Books, 2016.

Further Reading: Investment Masters Class Tutorial - ‘Forecasting’

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Learning from Sol Price

Walmart, Costco, Home Depot. You’ve heard of them no doubt? Together, they’re recognised as the world’s largest retail and hardware chains and believe it or not, all three owe a great deal of their legacy to the same man.

Sol Price.

Walmart’s founder, Sam Walton, noted in his biography, "Most everything I've done I've copied from somebody else." Later he divulged, "I guess I've stolen - I actually prefer the word 'borrowed' - as many ideas from Sol Price as from anybody else in the business."

It’s the same story for Costco. It’s founder, Jim Sinegal, had one mission: ‘clone’ Sol Price’s retail business. Jim also had the credentials to do so. At the age of 18, Sinegal started his retail career as an employee of Sol Price and three decades later he left to start Costco. A reporter once asked Jim: “you worked for Sol for so many years, you must have learnt a lot?” To which Jim replied “No, that’s inaccurate, I learned everything from Sol Price.” Sol Price was his mentor and as he put it: ‘The smartest businessman I ever met’.

'Sol Price was a very intelligent man.' Charlie Munger

Similarly, there’s every chance that Home Depot wouldn’t exist today if not for Sol Price. Home Depot’s co-founder, Arthur Blank, went to see his friend Sol after he was fired from a hardware chain called Handy Dan Home Improvement. In that meeting, Sol encouraged Arthur to forget about suing his ex-employee and instead start a retail business. Which he did.

As the son of immigrant parents, Sol Price grew up in the Bronx, before relocating to San Diego, where he met his wife Helen. While pursuing a career as a lawyer, Sol’s father-in-law passed away leaving a property which needed to be dealt with. Sol ended up trading the property for a vacant retail property in need of a new tenant. Sol sought advice from a good friend and client who’d opened a few jewellers stores in San Diego. The friend explained how the jeweller’s highest volume account was a business called Fedco, a membership retail store which catered to federal employees in Los Angeles. As a not-for-profit corporation, Fedco was doing a brisk business with customers coming from as far away as San Diego.

Sol tried to convince Fedco to join with him to open a Fedco at his vacant property. Fedco declined. Henceforth, FedMart was born. Fedmart was started as a ‘membership’ retailer, allowing the business to circumvent the strict Fair Trade Laws applicable at the time; laws which gave manufacturers the right to set minimum selling prices for their products.

Ultimately Sol sold FedMart to a European retailer, and remained in the business. Before long the new owners clashed with Sol and fired him. Sol wasted no time moving on. Sol started a wholesale cash and carry business he named the The Price Club. Unfortunately, it wasn’t all smooth sailing to begin, with initial sales well below budget. In response to lagging sales, Sol decided to open the business to a wider customer base. Sales grew rapidly. The Price Club concept grew into a 94 store enterprise before it merged with Costco.

While you’ll find references to Sol Price in Sam Walton and Arthur Blank’s biographies, Robert Price has written a biography about his father entitled ‘Sol Price - Retail Revolutionary and Social Innovator’. Once again, you’ll find many of the characteristics embodied in Sol in the other Master CEO’s we’ve covered; it’s no surprise, many took a leaf straight out of Sol’s book. Here are some of my favourite insights from the book.

Retail Innovation

‘As a retail revolutionary, Sol’s brilliance changed the way we shop, first with FedMart in 1954, the retail format copied by Walmart, Kmart and Target in 1962; and then, with the Price Club, the warehouse club format adopted by Costco and Sam’s Club in 1983.”

“Fortunately, most of us had backgrounds that were alien to retailing. We didn’t know what wouldn’t work or what we couldn’t do.” Sol Price

Look After Customers

“Our first duty is to our customers. Our second duty is to our employees. Our third duty is to our stockholders.” Sol Price

“[Sol] was never driven by the need to have the most stores or the most money, but by the desire to give the customer the best deal and to provide fair wages and benefits to FedMart’s employees.”

And Employees

“Employees [in San Antonio] were paying their employees 50 cents per hour. Sol knew that people could not live on 50 cents an hour. He decided that the wage rate at FedMart would be $1.00 per hour. Of course, everyone wanted to work at FedMart.”

“Sol’s approach to FedMart employees mirrored the relationship he had with FedMart members. He felt a responsibility -a fiduciary duty - to provide excellent wages, benefits, and working conditions for employees.”

“In a bulletin to FedMart employees, Sol said: ‘We believe that you should be paid the best wages in your community for the job you perform. We believe that you should be provided with an opportunity to invest in the company so you can prosper as it prospers. We believe you should be encouraged to express yourself freely and without fear of recrimination or retaliation.'”

Innovate to Keep Prices Down

“Because Fair Trade Laws impacted so many products, including such staples as Tide detergent and name-brand liquors, FedMart developed a line of private label merchandise. FedMart purchased these products with specifications and standards as nearly equivalent to the national brands as possible and stocked the FM brand to demonstrate the savings.”

“FedMart’s low price merchandise, limited selection, yet breadth of product offerings had a major impact on the retail world.”

“According to Sol, FedMart was not a discount store. He described FedMart as a ‘low margin retailer.’”

“FedMart priced merchandise starting with the cost of the product and taking as small a markup as possible - consistent with covering expenses and a small profit while giving the customer the best price.”

“The trusting relationship with members was reinforced by FedMart’s unique merchandise selection - limited selection and large pack sizes. Sol proved it was possible to do more sales with fewer merchandise items [stock keeping units - SKUs). He pioneered large packing size as a way of lowering prices.”

“The typical grocery or discount store carried about 50,000 different items compared to Price Club’s 3,000 items.”

“Price Club was different from other retailers - charging a $25 annual fee with large package sizes and extremely limited selection.”

“[Product] sampling increased sales both because members liked the products and because of the ‘reciprocity rule’, people’s subconscious desire when receiving something for free.”

‘The Intelligent Loss of Sales’

“One of the intriguing questions is: why does limited selection result in higher sales? Part of the answer lies in what Sol called ‘the intelligent loss of sales.’ Conventional wisdom in retailing is to stock as many items as possible in order to satisfy every customer’s needs and wants. The ‘intelligent loss of sales’ turns that theory on its head, postulating that customer demand is most sensitive to price, not selection. And low prices are possible only if there is integrity in the pricing combined with being the most efficient operator.”

“Because payroll and benefits represent approximately 80% of a retailer’s cost of operations, pricing advantage follows labor productivity. Put simply, the cost to deal with 4,500 items is a lot less than the cost to deal with 50,000 items.”

Empower Staff

“Sol taught by example and he taught by engaging people in challenging discussions, demanding that they use their brains.”

“In return for providing a great workplace for FedMart employees, Sol asked only two things of his employees: that they work hard and that they think.”

A Customer Fiduciary

“Sol’s business philosophy was simple:

1) Provide the best possible value to the customers, excellent quality products at the lowest possible prices.

2) Pay good wages and provide good benefits, including health insurance to employees.

3) Maintain honest business practices.

4) Make money for investors.

Sol believed in building long term relationships with his customers. He described his business philosophy as the professional fiduciary relationship between the retailer and the customer. In his words; ‘If you recognize you’re really a fiduciary for the customer, you shouldn’t make too much money.’

The underpinnings of this fiduciary were consistently high quality merchandise and consistently low prices. Sol infused FedMart’s employees with the belief that they were representing the interests of the customer.”

Refund Policy

“Sol’s sense of duty to FedMart members was punctuated by FedMart’s refund policy: ‘Everything we sell is guaranteed unconditionally. We will give an immediate cash refund to any customer not completely satisfied with a purchase made at FedMart. No questions asked.’”

Pristine Ethics / Tone at The Top

“Sol’s business ethics extended to all facets of his business world. FedMart employees were prohibited from taking any form of gratuity from suppliers, even a free lunch. But suppliers were to be treated fairly.”

“Sol believed that fairness was a moral imperative. He would say that rich people would often think they gained their wealth on their own when, in fact, their success was the product of their teachers, along with government workers, service providers, and the employees in their companies.”

Membership Model Benefits

“There were a number of reasons for charging a membership fee of $25, a significant amount of money compared to the rather nominal $2 membership fee that members of FedMart paid. The most important reason was to use the membership money to lower prices by including the fee in the calculation of gross margins.”

“The $25 membership fee also operated as an incentive for the member to purchase more as a way to leverage the membership fee as a percent of purchases. In addition, the membership concept helped reduce operating expenses for the business because the membership psychologically tied the member to Price Club and eliminated the need to advertise.”

Summary

One of the things I find particularly interesting with Sol is that, as with Warren Buffett, many people have benefited from one man’s insights. Thousands of investors have benefited from all the lessons shared by Warren Buffett. They’ve recognized his success and copied it. Berkshire Hathaway itself has copied others.

“All Berkshire does is copy the right people.” Charlie Munger

The same can be said for Walmart, Costco and Home Depot. Even Jeff Bezos’ Amazon Prime membership model draws on the innovation of Sol Price. If the world’s largest retailers and hardware chains have all been influenced by the one man, and even further have emulated his practices in their own businesses, its hard to refute that the man was a genius.

Sol was a true Master.

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Disclosing Positions

Not many investors have been likened to Warren Buffett in their investment career. Besides numerous other aspects, you would need to have an incredible track record for one, and most of the Investment Masters, despite having enviable track records themselves, have found it difficult to match Buffett and his long history of success.

UK based Neil Woodford has been likened to Buffett in the past, and for a while enjoyed both the financial success and the celebrity that came with it. Right up to the point where he didn’t. The recent demise of The Woodford Fund has been well-publicised and well-analysed, with a lot of reasons for its downfall.

‘The glittering career of Neil Russell Woodford, touted as the UK’s answer to legendary American investor Warren Buffett, lies in tatters. The UK financial regulator has turned on him, long-standing investors have collectively pulled billions of pounds from his funds, and a reputation built over four decades of front-line investment management has been ripped to shreds.” Barrons, June 2019

One factor that likely contributed to the downfall was Mr Woodford’s decision to publicly disclose all his positions. Now it has to be said that taken by itself, his disclosure would not have led to the downfall of the fund, but after the dust settled, it seems disclosure added to its woes.

“Woodford will publish only the top 10 holdings of his three funds while redemptions from the LF Woodford Equity Income Fund are halted, the firm said in a statement on Monday. The move is an abrupt shift from a longstanding commitment to provide transparency about investments; the fund previously disclosed all holdings at the end of each month.” Bloomberg, June 2019

Many managers release their letters publicly. While a letter’s purpose is to inform a fund’s investors, it can also be used to help clarify the manager’s own thinking. In many cases the letters are a marketing tool to help attract new funds. At times, managers use letters to explain how and why the fund’s performance differs from others. Some manager’s hope the information conveyed in their letters will encourage others into the investment, a catalyst to close the gap between an under-priced stock and its fair value.

Despite the many who do disclose, some choose not to publish letters, or if they do, they’re very hard to find. Others choose to disclose little about the positions that make up the fund.

Why is this so?

Front Run - Squeeze

Without doubt, The Woodford Fund’s woes were exacerbated by the market’s knowledge of the positions. For those unfamiliar with what transpired, the ‘star’ UK fund manager stopped redemptions after facing a multitude of problems; a cocktail of illiquid assets, poor performance, riskier assets and questionable management actions. This resulted in a mass exodus by investors. Market knowledge of the stock positions attracted predatory shorts which moved ahead of, or front-ran, the unwind of the fund. The UK’s FT noted:

“Mr Woodford’s ambition for full transparency on his holdings may have been enlightened, but recent weeks have shown the risks of such openness. Short sellers have been able to exploit his difficulties, driving down the prices of investments they know he will be under pressure to sell.”

It’s one reason managers can be reluctant to disclose positions.

“Our Fund is concentrated in relatively few large positions and greater disclosure than that required could make it more difficult to deal when we are building or divesting from positions in the Fund, and enable other market participants to “front run” our dealing activity to the detriment of the prices we can achieve.” Terry Smith

And size positions appropriately.

“Being too large in an activity enables the rest of the market to pick you off or ‘gun’ for you. We once did an option trade that was so compelling that we built much too large a position. We found that as market participants sensed the size of our positions, they ‘ganged up’ on us. The options that we bought at cheap prices just got cheaper and cheaper, people anticipated our ‘rolls’ from one option to another, and every trading action we took seemed to increase our losses. As soon as we unwound the position to stem the losses, prices rebounded to near normal levels. It was quite an expensive lesson for people who were used to trading quietly in the market, rather than being the focal point for attack.” Paul Singer

I suspect Bill Ackman knows that feeling all too well. In 2012, with much fanfare, he announced a $1 billion short position in Herbalife. Ackman opened the attack publicly with a three hour, 342-slide presentation at the New York Sohn Conference. Like a red rag to a bull, hedge funds, including Dan Loeb’s Thirdpoint, piled in on the long side, squeezing Ackman. Soon after, billionaire activist Carl Icahn whaled into a 25% stake, predicting at the time Ackman’s investment could produce the “mother of all short squeezes.” In 2017, when Ackman finally capitulated and closed the position, he’d dusted $500m.

Ackman survived the ordeal. But one of the most infamous funds that faced a ‘run on its positions’ and didn’t survive was Long-Term Capital Management. It almost took the US financial system down with it. Once highly secretive, as liquidity problems emerged, the fund was forced to seek capital, requiring a higher level of disclosure. Roger Lowenstein’s brilliant book, ‘When Genius Failed’, noted:

“As it scavenged for capital, Long-Term had been forced to reveal bits and pieces and even the general outline of its portfolio. Ironically, the secrecy-obsessed hedge fund had become an open book. Markets, as Vinny Mattone might say, conspire against the weak. And thanks to Meriwether’s letter, all Wall Street knew about Long-Term’s troubles. Rival firms began to sell in advance of what they feared would be an avalanche of liquidating by Long-Term. ‘When you bare your secrets, you’re left naked’.”

“Knowledge of Long-Term’s portfolio was, by now commonplace. Salomon was, and had been, pounding the fund’s positions for months. Deutsche Bank was bailing out of swap trades, and American International Group, which hadn’t shown any interest in equity volatility before, was suddenly bidding for it. Why this sudden interest, if not to exploit Long-Term’s distress? Morgan and UBS were buying volatility, too. Some of this activity was clearly predatory. The game, as old as Wall Street itself, was simple: if Long-Term could be made to feel enough pain - could be squeezed - the fund would cry and buy back its shorts. Then anyone who owned those positions would make a bundle.”

It’s little wonder many managers are careful about publicly disclosing positions, especially shorts.

“As you are aware, we are guarded in disclosing our shorts to anyone.” Andreas Halvorsen

"The danger is you get squeezed on that short. Bob Wilson, a very famous short seller, famously said that nobody ever gets rich publicising their shorts. You want to get rich quietly. I don't go on CNBC trying to talk a stock up." Leon Cooperman

Commitment Bias

Ackman’s nemeses in Herbalife weren’t confined to the hedge funds that squeezed him. The enemy was also within. The fact he was on the record in a big way [342 pages!] and had committed tens of millions in research and publicity costs meant he was all-in. While Ackman recognised the ‘commitment bias’ in Wall Street analysts he may have missed his own short comings.

“When one shares an investment thesis publicly, it can be more difficult to change one’s mind because the human mind has a tendency to ignore data that are inconsistent with a firmly held view, and particularly so, when that view is aired publicly. That is likely why Wall Street analysts continued to rate MBIA a buy until it nearly went bankrupt. And, I believe it is why analysts will likely keep their buy ratings until Herbalife is shut down by regulators or the company faces substantial distributor defections.” Bill Ackman

Many of the Investment Masters understand the risks of sharing positions, ideas and thoughts on the record. Talking up a big position can make it harder to change one’s view when contradictory evidence emerges.

“The more public you become with your positions the harder it is for your ego to let go of a position. You can’t let your ego slow you down when the facts change. Don’t talk openly about your positions until you are strong enough to change your mind in front of the crowd.” Ian Cassell

“When you pound out an idea as a good idea, you’re pounding it in.” Charlie Munger

“I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.” Paul Tudor Jones

"I hated discussing ideas with investors - because I then become a Defender of the Idea, and that influences your thought process. Once you became an idea's defender, you had a harder time changing your mind about it.” Michael Burry

Competition

Great ideas are few and far between. Disclosing positions can lead to unwanted competition, meaning higher prices or potentially better performance by a competing fund. Funds management is a competitive industry and most funds are seeking to attract capital, not give their competitors a leg-up.

Despite Buffett’s openness with regards to his investment philosophy, business and industry insights, you won’t find him talking about the specific stocks he’s buying and selling.

“We cannot talk about our current investment operations. Such an “open mouth” policy could never improve our results and in some situations could seriously hurt us.  For this reason, should anyone, including partners, ask us whether we are interested in any security, we must plead the ‘5th Amendment’.” Warren Buffett, Partnership Letter 1964

"Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore, we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation." Warren Buffett 1983

"If we decide to change our position, we will not inform shareholders until long after the change has been completed. (We may be buying or selling as you read this.) The buying and selling of securities is a competitive business, and even a modest amount of added competition on either side can cost us a great deal of money… For this reason, we will not comment about our activities in securities - neither to the press, nor shareholders, nor to anyone else - unless legally required to do so." Warren Buffett 1984

"Our never-comment-even-if-untrue policy in regard to investments may disappoint "piggy-backers" but will benefit owners: Your Berkshire shares would be worth less if we discussed what we are doing." Warren Buffett 1998

Buffett’s not alone in this regard.

“The less definition offered, the less positions revealed, the less statistics applied – all the better for the portfolio that aims for these supra-normal returns. Hence, the fund’s individual positions may not be revealed except at the discretion of the manager.”  Michael Burry

“We will publicly discuss our transactions in marketable securities only when we believe such disclosure will be to your advantage. Good ideas are scarce, and the output of our research efforts is your exclusive property.” Frank Martin

“I follow Buffett’s perspective. He has said that specific investment ideas are rare and valuable and they’re like intellectual property and subject to being lifted. Therefore he only discloses them to the extent required by law. That’s pretty much what we follow.” Mohnish Pabrai

“One reason we don’t disclose our holdings is that we don’t want competition.  If the stock goes lower, which is quite possible, we’ll want to buy more.” Walter Schloss

“While I was at Graham-Newman, a man called up and said he’d like to speak to Mr. Graham. Because he was out of town that day, I asked if there was anything I could do in his stead. He said, “I just wanted to thank him. Every 6 months Graham-Newman publishes their portfolio holdings. And I’ve made so much money on the stocks that he had in his portfolio, I just wanted to come by and thank him. That was one of the reasons I decided never to publish our holdings. We work hard to find our stocks. We don’t want to just give them away. It’s not fair to our partners.” Walter Schloss

“I don’t want to disclose things pertaining to what positions we’re going into and why.” Ray Dalio

"I really don't like to give out ideas." Bruce Berkowitz

“We do not disclose information that would create a competitive disadvantage for the funds unless we are legally required to do so.” Bill Ackman

“We try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in and going out.” Chuck Akre

“If I figure out something really clever, I’m not going to go out and tell anyone, I’m not even going to tell my clients. I’m just going to do it in privacy and tell them later, “Hey, we made a bunch of money.” Maybe I’ll tell them what it was if the opportunity falls over.” David Abrams

“Given our larger AUM and the ease of disseminating our letters across the internet, we think it’s risky to detail our thesis about our scarce ideas. I’ll do my best to provide commentary without tipping our hand or revealing future intentions” Allan Mecham

“I think, as any businessman, you’d rather keep proprietary what you’d like to keep proprietary and only tell you what you have to or choose to. It’s one of the odd paradoxes why the money management industry has not fought back on the SEC’s disclosure rules for long investors who are not in an activist campaign or not in a corporate control campaign because there were all kinds of people that follow investors in their portfolios. And for investors who don’t turn their portfolios over a lot, they’re, in effect, giving away their intellectual property for free.” Jim Chanos

“We have discussed the dysfunctional of disclosing specific investment ideas. The problems are mainly psychological and include the locking in of an idea, the desire to seem consistent, the wish to seem prudent in other people’s eyes and so forth. There is then the effect of copy-cat investing, brokers trading against us and, as Walter Schloss found out, dealing with nervous-Nellies and so on.” Nicholas Sleep

‘Book Talking’

The process of talking up your investments is often referred to as ‘book talking’. Some managers see it as a way to attract interest in a name once it’s purchased, a catalyst to closing the gap between the stock’s trading price and ‘fair value’.

Unsurprisingly Buffett takes an unconventional view on this particular activity. While he doesn’t talk individual stocks, theoretically, he’d be more inclined to talk them down than up.

"We get asked questions about investments we own, and people think we want to talk them up. We have no interest in encouraging other people to buy the investments we own. We or the company are likely to be buying stock in the future. Why would we want the stock to go up if we’re going to be a buyer next year, and the year after, and the year after that?

But the whole mentality of Wall Street is that if you buy something — even if you’re going to buy more of it later on, or if the company is going to buy its own stock in — the people seem to think that they’re better off if it goes up the next day, or the next week, or the next month, and that’s why they talk about “talking your book.”

If we talked our book, from our standpoint, we would say pessimistic things about all four of the biggest holdings we have, because all four of them are repurchasing their shares, and, obviously, the cheaper they repurchase their shares, the better off we are. But people don’t seem to get that point.” Warren Buffett

Conclusion

Without the benefit of the many investor letters I’ve read over the years, I’d be less than half the investor I am today. Notwithstanding this benefit, there are risks that can arise from disclosing too much information. When you combine the market knowledge of a portfolio of illiquid or very large positions with redemption requests, things can quickly turn from manageable to disastrous. Just as telegraphing short positions can be asking for trouble.

It’s important to not let the public disclosure of positions blind you to evidence that you may be wrong. The courage to admit a mistake in the face of public disclosure is quite often difficult if not downright impossible for many investors.

Ultimately, like most things when investing, it really comes down to common sense. Remain open-minded and consider worse case scenarios.

Don’t let your disclosures get the better of you or your fund.

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Learning From David Abrams

What if I told you that there was a guy who has a degree in History, who, when he started his career in investing not only did not know the difference between a stock and a bond but also hadn’t a clue as to what they actually were, has worked in Risk Arbitrage with Seth Klarman and currently runs a fund that has over $9 billion under management. He’s generated consistent returns of at least 15% since the fund’s inception in 1999 and he’s also been labelled ‘The Wealth Machine’ by the Wall Street Journal. Do you know this investor?

His name is David Abrams.

It’s no surprise if you haven’t heard of David Abrams. He keeps a pretty low profile, so I was pleasantly surprised to see a recent interview with him on Columbia Business School’s ‘Value Investing with Legends’ Podcast series. I’ve included some of my favorite quotes below. You’ll notice many of them relate to topics that are common to the Investment Masters, but it was David’s commentary about the need for growth that particularly struck out at me: it’s no accident that Buffett has often stated his preference for businesses with growth:

"It’s pretty hard in a declining business to buy things cheap enough to compensate for the decline." Warren Buffett

Let’s start with that one…

The Need for Growth

“If we buy things with what we call a ‘hard catalyst’, an event that is going to close the gap between where we bought it and what it’s worth, we don’t need that much growth. We need to buy it cheap and get out. Where there is no catalyst, we absolutely need growth. The growth can come in all kinds of ways, it doesn't have to come through increased revenues, although a lot of times it does. It can come from running operations more efficiently, from acquisitions, or from buying back shares cheap. But if there is no catalyst, we absolutely need growth.”

Raising Money

“The best times to invest are the hardest times to raise money and the worst times to invest are when it’s easiest to raise money.”

Understand

“In all cases we do want to understand the fundamental economics because it’s easy to tell what has been, it’s easy to tell what is today, but as an investor we are always trying to deal with what’s going to be tomorrow, in two years or five years from today. To understand the dynamics of what’s going on has a lot to do with who has power in the relationship, what people’s alternatives are, what is the value to the customer or to the employees. So you try to understand that as opposed to just taking historical numbers and projecting them forward.”

Pricing Power

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

Think

“A lot of times the analysis [on companies] is as much just thinking it through. There are plenty of times when there is information and data you can get, but in the end you’re trying to form a judgement about something and I don’t think the judgements are going to be found on an excel spreadsheet. It is about thinking those things through as much as anything.”

Change

“You have to live with qualitative analysis. There’s uncertainty, there’s competition and I think what’s obvious to everyone, particularly in the last ten years, is that capitalism is very competitive and there is a lot of change. And there is change going on every day, all around us.”

Humility

“You always need to approach markets and business with a lot of humility, and as a generalist, even more so.”

People’s Thinking

“We are trying to determine what [other] people think, not by reading reports but really by understanding the economics of the business and by comparing it to the securities prices. And that will really tell you what people are really thinking.”

Consider Alternate Scenarios

“You’re trying to think about the multiple paths that could happen. There is not one path that can happen in the future. When you look back there is one path that happened but that doesn’t mean going forward there is only one path. In the future there’s multiple paths. You need to have the range about what that could be.”

Management Ownership

“We have a bias to liking companies where the management owns a lot of stock and has created value. The idea is fairly simple, people who have created value have a way of figuring out what will do more of it in the future. If you have a management team whose primary economics are coming through salary and bonus you can be at odds versus being a shareholder.”

Unknown

“The hard part about stocks is the future is unknowable. Is a five year track record the beginning or is the end. You won’t know that until you are in year ten.”

Stock List

“We have a list of things that we are always updating, adding and subtracting to it businesses we’d like to buy or people we’d like to invest it with. A lot of our research takes many years, sometimes more than a decade before we first look at something to buying it.”

Ideas

“I try to keep a lot of things coming into the intellectual funnel. I try to have a pretty good screen so I can sort through it. I invest in a wide range of things. Most of my money is invested in the fund. I put small amounts of money into VC funds that got me more in the flow of what’s going on in Silicon Valley. I travel and I try to expose myself to people thinking really differently. Sometimes it’s people with more positive or negative views of the world. Sometimes getting out around the world gives you a different perspective. Even within the US, travelling to different places gives you different perspectives.”

Position Sizes

“We try to put more money into the things that we have more conviction about. We’ll tend to top out stock positions at cost around six or seven percent. We can hold them if they go up but we tend to top them out around that cost. We look at industry concentration. We loosely keep an eye on it. We want to be fairly concentrated. I don’t target industry diversification, I keep an eye on it to make sure we are not getting too concentrated in a particular industry.”

Risk

“I’m not a huge fan of [hedging risk in positions with other instruments], I think sometimes the strategy can make people enter them with the idea they’re reducing risk but they actually maybe increasing risk. I always say, if we’re not comfortable with the risk the best and easiest way [to manage risk] is not taking that risk.”

Leverage

“We don’t use leverage in the portfolio. That is a basic philosophical decision on my part. I don’t want to have to meet a margin call at the wrong time. We try to study financial disasters and when you study all the people who had huge financial issues and you said ‘what was the reason they had those huge issues?’ Leverage was one reason that would probably capture 90% of all the disasters. In that sense, it seems fairly easy and straightforward to stay away from the one thing that causes most of the distress. Buffett said ‘If you’re smart you don’t need it and if you’re dumb you don’t want to use it.’ I think that captures the idea too.”

Win-Win

“Companies are responsible to all their constituents. If you don’t have a good product or good service you won’t have any customers. If you don’t treat you’re employees well, they are going to leave. If you don’t do all of that, you won’t make any money and you won’t attract any capital and you won’t have the investors. It’s not perfect, there are a lot of issues but it works pretty well. It’s better to let people, companies and individuals figure that out than mandating it like they do in Germany with works councils. There is not a lot of new business formations and innovation in Europe and there is a big reason for it. Our country has been a home for risk taking and innovation and if anything it’s picked up speed. But there are proposals out there that could dent that.”

Quant

“We do get closer to the companies and the people and I think it is certain the human relations and the human factor is not something a computer is ever going to dis-intermediate. I’m not overly concerned about quants. You don’t want to be Polyannish about it, or arrogant, nor in denial about these changes as they are really important. People have been looking for black boxes for investing since the day I got on Wall Street and well before. They will always look for it. The reason why its very unlikely to really happen is behind every pool of money there’s people. Whether endowments or foundations, the quants are interesting and shouldn't be ignored but they can only grow in popularity when they are working in the moment. If they haven’t produced good results in the short term people are going to throw them out.”

Summary

What I appreciate about David Abrams and the other Investment Masters is their willingness to teach and share their wisdom. With the plethora of podcasts, videos and investment newsletters that are available from the Investment Masters, it’s possible for all of us to learn new investment precepts from the best in the game. And once you have the new concepts, you can then apply enhanced investment skills to your own money management. I’ve always said I’d much rather learn from those with great long term track records and skin in the game and Abrams, whilst largely unknown, remains one of the best.

Source: ‘Value Investing With Legends Podcast’ with Tano Santos, Columbia Business School.

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How Buffett Manages Risk

Investing involves risk.

No surprise there and virtually every investor will agree. When there’s the chance of losing your capital, and by that I mean permanent loss of capital, then it’s something to be concerned about. You’re exposing yourself to danger and that in essence is the definition of risk. Interestingly though, whilst we’re all on the same page that investing involves risk, if we asked different investors what they actually think risk is, we’d end up with some different answers.

So what is risk to a long term investor?

OK, if your answer is ‘Share Price Volatility’, then you’re incorrect. Risk in investment parlance is not volatility.

Share prices are naturally irrational; emotional participants, and more frequently today, computer algorithms, can drive share prices to nonsensical levels. Of course there is a degree of risk in this, however that risk can be mitigated by two simple factors - the first of which is having a long-term horizon on your investment portfolio, rather than trying to buy this morning and sell this afternoon; and the second is having a deep understanding of the businesses which you own. Too many investors know little about the businesses they invest in, and therefore live or die based on what the stock price does. If you know the company has intrinsic value, a good runway, deep moat, strong management and a healthy culture for example, then the daily rise and fall of the stock price should not be of concern to you. It is not where risk lies for an investor.

Warren Buffett understands this.

For over 60 years he has navigated market cycles, macro forces, technology changes, sharp salesmen and geopolitical currents, and in the process has left a track record of returns few could match. If you want to understand risk, study Buffett.

Prevention

Buffett’s approach to risk management is simple. It’s also common sense. It’s not some esoteric risk management system built with complex formulas, in fact it’s more prevention than anything else.

“Wisdom is prevention but very few people do much about it.” Charlie Munger

“The biggest thing is to have something in the way you’re programmed so that you don’t ever do anything where you can lose a lot. Our best ideas have not been better than other people’s best ideas, but we’ve never had a lot of things that pulled us way back. So we never went two steps forward and one step back. We probably went two steps forward and a fraction of a step back. Avoiding the catastrophes is a very important thing.” Warren Buffett

Before we delve into Buffett’s risk management toolkit, it’s worth taking a step back to understand how Buffett approaches investing. It’s certainly not conventional. But it’s important to understand so we can put his risk management framework into context.

Ever since Buffett picked up Ben Graham’s book, ‘The Intelligent Investor’, Buffett’s defining principle has been that the shares he owns are simply the fractional ownership of the underlying businesses. If he pays a reasonable price for those fractional pieces, and provided the businesses do well, over the long term, the share prices will also do well.

“You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn't pay a totally silly price. That is what it is all about." Warren Buffett

Buffett recognises that in the short term, share prices are often irrational. Given his long term investment horizon he doesn’t concern himself with short term price fluctuations. Buffett has an advantage here, he’s got the luxury of permanent capital, which allows him to take a long term view.

“We do define risk as the possibility of harm or injury. And in that respect we think it’s inextricably wound up in your time horizon for holding an asset. I mean, if your risk is that if you intend to buy XYZ Corporation at 11:30 this morning and sell it out before the close today, in our view that is a very risky transaction. Because we think 50 percent of the time you’re going to suffer some harm or injury. If you have a time horizon on a business, we think the risk of buying something like Coca-Cola at the price we bought it at a few years ago is essentially so close to nil, in terms of our perspective holding period. But if you asked me the risk of buying Coca-Cola this morning and you’re going to sell it tomorrow morning, I say that is a very risky transaction.” Warren Buffett

"We look to business performance, not market performance. If we are correct in expectations regarding the business, the market will eventually follow along."  Warren Buffett

Most people don’t think about risk in this way and it’s certainly not the way it’s taught in most business schools. The typical finance textbook defines risk as ‘share price volatility’. In contrast, Buffett sees heightened volatility as opportunity. He can choose to buy shares at cheaper prices or simply ignore them. Buffett actually rejoices when share prices decline as most of the companies he owns are buying back their own stock, effectively increasing his entitlement to the company’s future earnings without him lifting a finger.

“In business schools, volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEO’s astray." Warren Buffett

Ultimately, Buffett views Risk as that which gets in the way of compounding; the permanent loss of capital. Or more specifically, the permanent loss of purchasing power over the holding period.

"The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period." Warren Buffett

Know What You Own

Buffett doesn’t panic out of stocks he owns if their share prices decline because he understands what he owns, he knows what he’s doing. He doesn’t let share prices tell him whether he’s right or wrong.

"Risk comes from not knowing what you're doing." Warren Buffett

Business Risk

Given Buffett’s objective is to own companies whose earnings will be higher in the future, his primary concern is Business Risk; how will a companies earnings manifest themselves over time?

“Should we conclude that the risk in owning a piece of a company - its stock - is somehow divorced from the long-term risk inherent in its business operations?  We believe [this] conclusion makes [no] sense and that equating beta with investment risk also makes no sense.” Warren Buffett

“When we look at businesses, we try to think of what can go wrong with them. We try to look [for] businesses that are good businesses now, and we think about what can go wrong with them. If we think there’s a lot that can go wrong with them, we just forget it. We are not in the business of assuming a lot of risk in businesses.” Warren Buffett

“We think of business risk in terms of what can happen — say five, 10, 15 years from now — that will destroy, or modify, or reduce the economic strengths that we perceive currently exist in a business.” Warren Buffett

Like all investors, Buffett’s not infallible. And when he has stumbled in the past, it’s usually because he’s mis-assessed the fundamental economic characteristics of the business. Think Dexter Shoes, Blue Stamps, Department Stores and the original Hathaway Textile business.

“What costs us money is when we mis-assess the fundamental economic characteristics of the business.” Warren Buffett

“We’ve made mistakes on judging the future economics of the business[es].” Warren Buffett

Filters, Base Rates and Pattern Recognition

Buffett deploys a concise filtering system when considering investments and he’s collected a huge repertoire of ‘base rates’ he applies to avoid risk. Furthermore Buffett has a well developed pattern recognition system drawing on his accumulated knowledge which he uses to identify potential risks and opportunities.

Filters

One of Buffett’s most powerful risk mitigation and prevention tools are his Filters.

“We do care about being right about the economic characteristics of the business, and that’s one thing we think we’ve got certain filters that tell us in certain cases that we know enough to assess.” Warren Buffett

“We have a bunch of filters we’ve developed in our minds over time. We don’t say they’re perfect filters. We don’t say that those filters don’t occasionally leave things out that should get through. But they’re very efficient.” Warren Buffett

Every investment needs an edge and it’s impossible to have an edge if you don’t understand an investment or other people have a better understanding than you. Buffett’s first filter is understanding what he owns and it relies on a strong appreciation for the boundaries of what he knows and what he doesn’t - his circle of competence.

“Different people understand different businesses. And the important thing is to know which ones you do understand and when you’re operating within what I call your “circle of competence.” Warren Buffett

If a potential investment falls outside of that circle or he won’t be able to get it within that circle it is discarded immediately. Buffett doesn’t venture outside of the circle.

“The first filter we probably put it through is whether we think — and we know instantly — whether it’s a business we’re going to understand, and whether it’s a business that — if it passes through that, it’s whether a company can have a sustainable edge.” Warren Buffett

“We do have filters, and sometimes those filters are very irritating to people who check in with us about businesses, because we really can say in ten seconds or so “no” to 90 percent-plus of all the things that come in, simply because we have these filters. We have some filters in regard to people, too.” Warren Buffett

Buffett doesn’t compromise his filters, they’re black and white. He doesn’t raise his discount rate to overcome his risk concerns, the filters work as a strict go/no-go valve.

“We look at riskiness, essentially, as being sort of a go/no-go valve in terms of looking at the future businesses. In other words, if we think we simply don’t know what’s going to happen in the future, that doesn’t mean it’s necessarily risky, it just means we don’t know. It means it’s risky for us. It might not be risky for someone else who understands the business.” Warren Buffett

"Don't worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us - if it has risk, we just don't go ahead." Warren Buffett

Base rates

Base Rates are one of Buffett’s most useful filters to mitigate risk. An example of a base rate would be the history of successful pharmaceutical drug tests as a percentage of the total population of trials. In this case, it’s a very small number. Needless to say Buffett has weeded out a plethora of investment categories with low base rates such as this.

“People who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.” Daniel Kahneman

Examples of common investment categories with ‘base rates’ too low for Buffett include: start-ups, turnarounds, new issues, declining businesses, highly leveraged entities, low ROE businesses, low quality management, unpredictable or quickly changing industries and/or business with headwinds as opposed to tailwinds.

“If it’s got a lousy past but bright future we’ll miss it.” Warren Buffett

"Start ups are not our game." Warren Buffett

“Charlie and I haven’t bought an IPO since 1955.” Warren Buffett

“If you really think a business is declining, most of the time you should avoid it. The real money is going to be made by being in growing businesses, and that’s where the focus should be.” Warren Buffett

“We have to stay away from businesses that have low returns on equity.” Warren Buffett

"We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business." Warren Buffett

“We favor businesses and industries unlikely to experience major change.” Warren Buffett

"I would say anybody that's investing in something they consider opaque should just walk away" Warren Buffett

“One of the lessons our management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.” Warren Buffett

"We don’t play big trends. We don’t think about demographic trends or anything of the sort.... Big trends, they just don’t mean that much. There’s too much money to be made from year to year to think about things that take decades to manifest themselves." Warren Buffett 

Pattern recognition

Buffett relies on a vast mental database of information which he employs to identify patterns which help him manage risk.

"Pattern recognition is one of [Buffett’s] primary skills and perhaps his greatest skill. So in terms of data points, unlike many people who learn by seeking information on an as-needed basis, Warren is always looking for fuel for pattern recognition before he needs it." Alice Schroeder

Having studied and been exposed to a vast array of businesses and business problems over decades, Buffett utilises his vast filing cabinet of knowledge to identify potential future business risks.

“There is nothing mystical about an accurate intuition .. it’s pattern recognition. With training or experience, people can encode patterns deep in their memories in vast numbers and intricate detail - such as the estimated fifty thousand to one hundred thousand chess positions that top players have in their repertoire. If something doesn’t fit a pattern, a competent expert senses it immediately.” Philip Tetlock

“Charlie and I have seen, and we’re not remotely perfect at this, but we’ve seen patterns. Pattern recognition gets very important in evaluating humans and businesses. And, the pattern recognition isn’t 100 percent, and none of the patterns exactly repeat themselves, but there’re certain things in business and securities markets that we’ve seen over and over, and that frequently come to a bad end, but frequently look extremely good in the short run.” Warren Buffett [on Valeant blow-up]

“If you focus, you do see repetition of certain business patterns and business behavior. And Wall Street tends to ignore those, incidentally. I mean, Wall Street really doesn’t seem to learn, for very long, business lessons.” Warren Buffett

Margin of Safety

In complex adaptive systems like markets and business environments, the future is inherently uncertain. Not all things will work out as expected. One way Buffett mitigates this uncertainty is by seeking a margin of safety in his investments. This means buying at a discount to a conservatively estimated intrinsic value.

"We insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than it's price, we're not interested in buying.  We believe this margin of safety principle, emphasised by Ben Graham, to be the cornerstone of investment success"  Warren Buffett

No Intolerable Outcomes

Buffett always looks down before he looks up. And while an investment may have significant upside, Buffett won’t invest if the consequences of a bad outcome to his entire portfolio are intolerable, no matter how remote those consequences might be. Buffett is happy to compromise upside for the ability to sleep soundly at night.

“If we can’t tolerate a possible consequence, remote though it may be, we steer clear of plantings its seeds.” Warren Buffett

“I put heavy weight on certainty .. if you do that, the whole idea of a risk factor doesn’t make any sense to me. You don’t do it where you take a significant risk.  But it’s not risky to buy securities at a fraction of what they are worth.” Warren Buffett

“I would rather be, you know, a hundred times too cautious than 1 percent too incautious, and that will continue as long as I’m around.” Warren Buffett

“We are perfectly willing to trade away a big payoff for a certain payoff. And that’s the way we’re put together.” Warren Buffett

Think About Worst Case Scenarios

To avoid intolerable outcomes, you need to get a handle on what those may be in the future. Buffett spends his time thinking about what those scenarios may look like. These tend not to be the things that fall out of a spreadsheet model.

“We think in terms of not exposing ourselves to any mistakes that could really hurt our ability to play tomorrow. And so we are always thinking about, you know, worst-case situations … we have to think about whether we’re doing anything really big that could have really terrible consequences.” Warren Buffett

“We don’t have any formula that evaluates risk, but we certainly make our own calculation of risk versus reward in every transaction we do.” Warren Buffett

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

Summary

You can see that Buffett doesn’t follow the daily irrationality of share prices. And he certainly doesn’t view what they teach in most business schools as the correct definition of Risk. He has long talked about being a business owner rather than a stock owner, and the underlying principle of this is that he understands the businesses within which he owns stock. If he doesn’t understand them, then he simply doesn’t own them.

“We will never buy anything we don’t think we understand. And our definition of understanding is thinking that we have a reasonable probability of being able to asses where the business will be in 10 years.” Warren Buffett

He further mitigates risk by ensuring he avoids fundamentally risky ventures. He doesn’t go into IPO’s, he’s not interested in turn-around businesses, and you won’t see him going anywhere near companies with dangerously high leverage or low returns on capital.

Ultimately, Buffett is trying to avoid Business Risk. He does use three simple tools to assist him with all of this. Base Rates, Filtering and Pattern Recognition. True, he’s had a lot longer at this than most of the rest of us, however that simple fact alone, probably coupled with his outstanding track record over those same years makes it very hard to refute his beliefs in all of this.

So who are you going to believe?

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Further Reading:
Investment Masters Class Tutorials: Volatility, Risk, Permanent Loss of Capital, VAR

Merger Masters - The Art of Risk Arb

If you’ve worked in investing for a while, or even if you’re a private investor, I’m sure you will have come across the term Arbitrage. It comes from the French, and in investing its definition is ‘the buying and selling of securities, assets or commodities in different markets to take advantage of differing prices for the same asset.’ Quite simple really.

When we talk about Risk Arbitrage however, we’re referring to something slightly different. Risk Arbitrage, which is also known as Merger Arbitrage, is ‘an investment strategy that speculates on the successful completion of mergers and acquisitions.’ In reality this is not as simple, and as the name suggests it is arbitrage with the added element of RISK. Quite often a lot of it.

“Make the Assumption There Can be No Assumptions”

These profound Eight Words were written in thick black pen on a post-it note which I stuck to my computer monitor sometime in late 2007. At that time my job was advising Global Hedge Funds on risk arbitrage, and the words served as a daily reminder to me right through the Financial Crisis until I left that job to join another bank in 2010. I can’t tell you how much money those words saved my clients along the way, but I can say they helped us avoid recommending plenty of deals that broke. And broke ugly.

In late 2007, the world’s largest commodity company, BHP Billiton, announced it was going to take out its largest rival. China’s massive stimulus program had ignited a frenzied rally in commodity prices and the race was on for commodity companies to lock down more supply. BHP lobbied an audacious scrip-based bid for it’s iron ore arch rival RIO Tinto. The ink had only just dried on RIO’s own acquisition of Alcan, a large aluminium producer. At the time, many saw RIO’s bulking up as a defensive tactic to ward off potential bidders. There had been speculation that RIO was in the cross-hairs of numerous acquirers including the Chinese.

Once the dust had settled and BHP’s bid was live, the common assumptions that surfaced were: BHP would be willing to divest any assets required for competition authority approval; BHP’s initial bid was an opening gambit and given the significant synergies available, was sure to be raised; BHP was taking a long term view and wouldn’t be swayed by weaker commodity prices; a counter-bid from the Chinese or another miner was possible and finally; even should the deal break, BHP and RIO would trade back to the stock price ratio consistent with that prior to the bid.

BHP RIO Share Price Ratio [Source: Bloomberg]

Those assumptions ended up costing the hedge fund industry hundreds of millions of dollars. In actual fact, commodity prices weakened, BHP couldn’t extract the required synergies, debt markets closed and BHP abandoned it’s bid. On the day the deal broke, BHP’s shares rose 15% while RIO’s shares collapsed nearly 40%. The prior ratio did not hold. Expensive assumptions, indeed.

I think you would all agree that learning investment lessons from others is far preferable to doing so with your own money.

Recently I read a wonderful book on Merger Arbitrage entitled, ‘Merger Masters - Tales of Arbitrage’ by Kate Welling and Mario Gabelli. Kate and Mario have done an incredible job of bringing together many excellent tales of merger arbitrage via interviews with the world’s Risk Arbitrage Masters, and have identified the learning insights we can take from each.

The book is a must read if you’re considering adding merger-arb to your investment toolkit and it’s a useful adjunct for all investors. Like the Investment Tutorials that form the Investment Masters Class, you’ll notice some themes common to successful risk-arb practitioners. I have included a number of the pertinent points and quotes raised in the text below.

Free Calls

“Focus on finding a free call. If you were risking a really small sum of money but there was a chance for the bid to be increased, we liked to load up.” Martin Gruss

“What you’re trying to do in a deal is put yourself in a position to win the call option.” Drew Figdor

Market Downturns

“All boats- yachts and rowboats-go down together in a severe market decline. And if you’re highly leveraged, you’ll be carried out.” Martin Gruss

“Arb stocks get pounded in extreme market situations. And that’s true whether it’s your basic cyclical crash, as ‘87 proved to be, or crashes that are actual harbingers of recessions and economic crisis, like more recent examples.” Michael Price

“Sometimes everything is correlated - but that’s not anything you’ll get away from.” Clint Carlson

“I hate a merger agreement with a market escape clause - I hate it.” Karen Fineman

“Almost every long position is correlated, if the downturn is bad enough.” John Bader

Meeting Mario Gabelli at BRK 2019

Leverage

“You can’t always get it right. If you have leverage when you slip, it takes you down.” John Paulson

“If you’re running a very concentrated portfolio, you need to bring the leverage down… The wrong strategy is, ‘My arb spreads are tight so now I’m going to lever up. No, you lever up when arb spreads are wide and the opportunity is really good.” Clint Carlson

Why The Deal?

“My first and most important thought process when a new deal emerges is why is there a deal? Why does this deal make sense?” Michael Price

“The first question is not the obvious, what’s the spread? Or what’s the rate of return? It is why? What’s the motivation, Why are they doing this? Second question, What’s the valuation? Does it make any sense? Is it cheap? Is it expensive? I’d much rather invest in a deal - even if nobody comes in and tops the bid - if it’s on the low side of fair value because (a) there are that many more chances that something good will happen and (b) there’s that much less downside.” John Bader

“There’s one key element that’s going to make or break your investment and you’ve got to focus on getting that one big thing right. That’s why, to this day, my first question is, ‘Does this deal make sense? Should both parties be wanting to do this?’” Clint Carlson

“[We do] lots and lots of fundamental research work on the acquirer and the target, as well as on the industry involved trying to understand why they’re doing the deal, what they see, who the people are, and what the incentives are.” Jamie Zimmerman

“I always try to figure out: What is the industrial logic for this deal? Why are they doing it? Is it accretive, dilutive? I do a lot of valuation work and try to understand the business - because if I didn’t understand them, I wouldn’t know what risks could stand in the way of completion of the deals.” Clint Carlson

“When assessing deals, the most important factor for us - is whether there is strategic merit to the combination. Is there a strategic reason why these people are getting together? Or is it just a financing deal or a tax deal or some other motivation, which is not as strong or not as good?” George Kellner

“A deal should be a big opportunity for the buyer or a big opportunity for the seller.” Michael Price

“I’m always leery of tax-driven deals as opposed to deals driven by real business reasons.. Another red flag is a lot of debt financing. Another is sketchy earnings. You look through the products, you look through the people.” Michael Price

“Avoid politicized deals, which seem to have a tendency not to work out well.” John Bader

“Avoid the spreads where the buyer has a get-out-jail-for-free card.” James Dinan

Deals Break

“There’s risk in even ‘sure things.’” Michael Shannon

“There’s no such thing as a ‘sure thing’ and deals can break for a whole host of reasons - which can’t be foreseen. What’s more, my experiences also taught me that the insiders very often don’t know how it will turn out. Deals get done by human beings, and human beings can be fickle. Attitudes can turn on a dime. So much so that maybe a degree in psychology would be good preparation for merger arbitrage.” Martin Gruss

“There’s no such thing as a safe deal. That’s why it’s called risk arbitrage.” Clint Carlson

“No matter how sure you are that something will happen, there’s always a bit of uncertainty.” James Dinan

“I learned about risk management in the tails by experiencing very real pain.. If there is one thing I have learned - and really learned it in this business - it is that the losers are what kill you in the merger arbitrage space.” James Dinan

“Inevitably there will be broken deals. There will be fraud at a company, there may be a natural disaster - anything can happen… We deal with that by limiting our position sizes and properly diversifying.” Roy Behren

“You always have to be thinking, ‘What could go wrong'?’ Finally you need a high degree of skepticism - bordering on cynicism. You can’t take anything at face value.” Clint Carlson

Broken Deals

“If the deal breaks, you’re not losing a rate of return, you’re going to lose money.” Drew Figdor

“We hold to a general philosophy that making valuation bets on companies is not our business. So, if a deal breaks, we work our way out of related positions, ideally, methodically and carefully.” Michael Shannon

“Hoping is a terrible strategy. I try to be very disciplined about it - as in, ‘I’m here for an event. It didn’t happen. We’re out’. That is a pretty firm rule for me, and it’s painful, but how many times do you see that your first sale was your best sale? My biggest losers always started out as a smaller losses.” Karen Finerman

“There’s often real value to be found in playing the busted arb deals.” James Dinan

“Knowing where intrinsic value is means you can take advantage of the technical selling pressure from arbs unwinding - it can create opportunity. But you have to have done the work first.” Clint Carlson

“You have to have a sense of what you think the risk/reward is for holding or covering.” Jamie Zimmerman

Humility

“Hubris and bravado have no place in arbitrage.” George Kellner

“There’s a set of mind that is an absolute requirement. If’ your’re not a person whose starting point is “What am I missing?” rather than “How frickin’ great am I?” you are missing something essential to survival. “What am I missing?” is like oxygen. If you’re asking, “How great am I?” you’re the Night of the Living Dead.” Paul Singer

“If you think you’re smarter and right on deals, you’re going to go down the tubes too often. My approach is always trying to control risk by not assuming I’m right versus the market.” Drew Figdor

“Being taken to the edge and being forced to look down, it taught me something very important.. I learned that you’re not as smart as you think you are - and bad things can happen totally unexpectedly.” George Kellner

Capital Preservation

“The real key is avoiding losers.” James Dinan

“Capital preservation is the key to the risk-arb business.” Drew Figdor

“I don’t want to lose money, ever, with no excuses. My goal with investors is a combination of under promising and over delivering whenever I can. And I try not to be benchmarked. We just try to make moderate returns - as high as possible - given that our goal is not to lose money.” Paul Singer

“We always spend a lot more time trying to figure out what the downside could be than we do on the upside - and continuously update the downside calculation over time to track how the values are changing.” Clint Carlson

“The way you get really rich in this country is you live a really long time and don’t lose money - keep it compounding.” Joe Gruss

“Any young MBA can do the math. But you need judgement, experience to know when to get involved. Even then, no one is right all the time, so part of risk arb - and all investing - is managing losses, and that goes first to position sizing.” Michael Price

“The downside of the business is that when you’re wrong, it’s very painful. So you can’t be too wrong, too frequently - which makes avoiding busted deals the name of the game. Figuring out what that risk is and the probability of that risk - which is not a science, it’s a little bit of an art - is the key.” George Kellner

Skills

“I actually think the technical skills are secondary. The important stuff is creativity and a little intelligence.” Paul Singer

“The whole business, at least on the senior level, is very much an art form and it pays to be able to draw upon history.” Peter Schoenfeld

Hard Work & Channel Checks

“You’ve got to be 100% focused… The way you get or find things is by 100% focus and constant digging, finding information, and understanding the relevance of that information - because when you look back, there are always clues. You want to find those clues before the event happens.” John Paulson

“We actually go visit companies. They’re like, ‘Why are you here? Why aren’t you just asking questions on the conference call? But risk arbitrage is like the insurance business. We’re taking on the risk the deal won’t close. If you’re writing a life insurance policy on someone, wouldn’t you want to take a look, make sure they’re healthy?” Michael Shannon

“We travel to directly meet with companies, competitors, regulators.” Drew Figdor

“Start with the documents, read the merger agreement, go through the 10-K. There are no short cuts. But don’t get lulled into thinking, as some people do, that nothing else matters ‘if the merger agreement is airtight’… You can’t rely on an ‘airtight’ merger agreement.” Clint Carlson

Cyclicality

“It’s not a business for all seasons.” Paul Gould

Diversify

“We were quite risk-averse and very conscious of avoiding concentrating our positions in industries or sectors or with a specific investment banker.” Paul Gould

“If you only sell ten life insurance policies and one guy dies, it wipes out all the premium. You can’t do it, you have to be more diversified.” Michael Shannon

“Unusual things happen. That’s why you have to diversify” Jeffrey Tarr

Market Neutral

“The important thing for us is to squeeze out any directional exposure. Our goal in managing the merger-arbitrage portfolio is to create a market-neutral vehicle to provide absolute return for our investors.” Roy Behren

“The great thing about these strategies is that you can be market-neutral or uncorrelated to the market.” Jamie Zimmerman

Common Sense

“The core of a good risk-arb strategy has always been and remains, even today, despite all the computers, just common sense about where the risks are and how they correlate and don’t correlate - things that machines can’t necessarily tell you. The analysis of deal dynamics and of people’s motivations.” Paul Gould

Resilience

“As an investor, you need tenacity, resilience. Everybody makes mistakes - sometimes big - and you have to have resilience to come back, survive, make decisions amid ambiguity.” Paul Singer

“You have to remember these are essentially bets; you’re not always going to get them right. What’s more, when you’re wrong about a position, you can’t let it get in your brain so it defeats you. You have to pick yourself up and do the next deal.” Jamie Zimmerman

Low Risk and Last Mile Trades

“Nor will we play what we call ‘Last Mile Trades,’ which involve taking positions in deals that are almost certain to happen - ones with four or five days to closing that you can maybe make a nickel in. To us, the asymmetric optics of buying a position to make a nickel when - God forbid - something could go wrong and you’d lose $8.” Roy Behren

“We’ve always been highly selective. I’m not a fan of investing in vanilla, low risk-mergers. In that game, you get nine right and then you give it all back with the tenth. The merger business we tend to do is stuff that’s complicated; has hair on it.” Paul Singer

“We get involved in deals that have different characteristics, where we can trade effort for risk or complexity for risk - and that’s why our pattern of returns is so different than others.” Paul Singer

“Embrace complexity. Complexity is your friend. For the simple reason it is where you can add value.” James Dinan

“We’re not a buy and hold merger-arb spread shop. Instead we focus on being a complex, trade the events, creative shop.” Drew Figdor

Position Size

“Position sizing in arbitrage really matters because that’s what determines your success. You’ve got to be right, but if you have tiny positions in the deals than happen and a big position in one that doesn’t, you’re done. You’re toast.” Michael Price

“Before you put yourself into a position to get lucky if a bidding war or whatnot breaks out, you first have to decide, ‘How do I size this?’.. Its always tempting to look at the potential rewards but it’s much more disciplined to look at what could go wrong; what do I lose if it goes wrong; The last thing you want to do is kill yourself. You have to live to fight another day. If you size yourself appropriately and something goes wrong, you can go and make the money back somewhere else.” Jamie Zimmerman

“We basically limit our positions to 2 percent of the portfolio. So our basic metric in the worst case we can anticipate, we’re not going to lose more than 2 percent of our capital. Over the many years that worked pretty well for us.” George Kellner

'“The game plan is not to be the Babe Ruth of the business. In other words, I want to have a 0.300 batting average wherever possible, but I don’t need to hit sixty-one home runs, or whatever Roger Maris hit, to break the Babe’s record. Consistently hitting singles and doubles is just fine.” George Kellner

People

“You have to know the cast of characters.” Michael Price

“Its crucial to assess who is pulling the strings and to understand what assumptions they are operating under and to assess whether they are realistic or not.” Peter Schoenfeld

“All the probabilities built into your best models - they don’t apply when it’s just one person, one decision.” James Dinan

“I also care who the lawyers and bankers are. I care if it’s the A-team, because the A-team get deals to the finish line.” Karen Finerman

“We should always want to think about: Does the CEO have his board behind him?” John Bader

“I've long considered management-led leveraged buyouts to potentially be the most egregious form of insider trading. If management participates in a buy-out group, you know they have hidden jewels.” Mario Gabelli

“Watch what the smart guys do. Today, that might be Jeff Immelt or Seth Klarman, Warren Buffett or Charlie Munger.” Michael Price

Summary

You can see that many of the principles of value investing are present in Risk Arbitrage as well. No one has a clean batting record; all of us will, and do, fail from time to time. Acknowledge your mistakes and pick yourself up and get on with it. Spread yourself rather than place all your eggs in one basket. Focus on the downside first.

Mario’s comment that if ‘management are involved in a buy out group, you know they have hidden jewels’ is a valuable insight. Look to the people involved for the real clues as to whether the merger has legs. All the research in the world won’t necessarily give you insight into people’s intentions, and the ‘why’ of the matter is crucial to success in this field. Why are they merging, indeed.

As the name suggests, Risk Arbitrage is fraught with peril. Never make the assumption there are no risks. And while things can go wrong, risk-arb can provide attractive returns if you use common sense, work hard and manage risk appropriately.

“There’s no way anyone could get bored with this business.” Paul Singer

Knowledge is the key, as it is with all investing. The information you glean from reading and meeting and talking and analysing makes all the difference in the world. I’ll let Mario have the last say:

“You don’t have to have good hand-to-eye co-ordination to be a good investor if you have the benefit of accumulated and compounded knowledge.” Mario Gabelli

Further Reading:
Merger Masters: Tales of Arbitrage - Kate Welling & Mario Gabelli. (Columbia Business School Publishing)
Investment Masters Class - The Arbitrage Series - Part 1
Investment Masters Class - The Arbitrage Series - Part 2

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Buffett on Recessions, IPO's, Capitalism & the Media Sector

Knowledge is cumulative.

That’s a known fact. As human beings we accumulate new knowledge every day; from reading and listening, experimenting and exploring and from observing others in what they do. And if you’re interested in learning, then the world has a limitless supply of information ready for you to absorb.

It’s one of the things I’ve always admired about the Investment Masters, and in particular, Warren Buffett. Even at 88, and with more than 70 years of investing experience behind him, you’d think he would have already learnt everything there it to know. But it’s not the case. He still has lessons to give, and I am always on the hunt for any new gems that fall from the fertile tree of his mind.

Warren was recently interviewed by Becky Quick on CNBC. During that interview, he spoke about his thoughts on recessions, investing (or not investing) in IPO’s and about the media landscape. All are topical conversations in the investment world currently and I found his thoughts on each subject compelling.

Here are the highlights from that interview:

Recessions

“[Recessions] are part of a capitalistic system. We will have them and it won’t change anything Berkshire invests in. It may offer us more opportunities in marketable securities or businesses. If we see a good business and everybody in the world is bearish and [thinks the yield curve] inversion is going to 100 basis points, we are going to buy it and buy it enthusiastically.”

Interest Rates and Stock Prices

“The lower interest rates are, basically, the better the option stocks are, because stocks are going to produce whatever they are over the next 20 or 30 or 40 years. But if you buy a 30 year bond, you’re going to get that rate. So when the 30 year is at 2.8-2.9% and the Federal Reserve’s intent is to have 2% a year inflation, and you pay tax on that 2.8-2.9% that you receive, your net is around 2%. Your’e essentially saying ‘I’m willing to go with a profitless investment for 30 years’. I don’t get excited about that. You can buy good businesses that may earn 14-15% on taxable equity and they’ve done it in aggregate for a long, long time. You have to think about these good businesses and how they’ll compound over time. You can start with [stock] yields that are higher than the bonds give you and the odds are that a diversified group [which are effectively] bonds with ascending coupons [will do better]. Because that’s all a stock really is, it’s a bond with a whole bunch of coupons that go out to infinity, you just have to [effectively] print the amount on the coupons yourself [because they are not fixed]. The one thing you know is the numbers on stocks as a whole are going to be way greater than 2.8%. The lower bond yields go, the more attractive stocks are as a long term investment.”

The Auto Industry

“The auto industry is not a static industry and if you keep doing everything the same way you did it in that business, if you aren’t thinking many years ahead, you’re making a very big mistake. Every footprint that an auto company might have had 10 or 30 or 50 years ago is going to be obsolete at some time. And the ones they are putting in now are going to be obsolete. It’s the nature of it.”

Change

“Capitalism is described as creative destruction. Change is part of a capitalist system. If you don’t believe it, you’re going to be doing some very dumb things.”

Free Trade

“I’m 100% for free trade. I think is has benefited this country enormously and will continue to benefit it. But the benefits of free trade are invisible. You don’t think about the fact your shoes or underwear or whatever cost ten percent less. You’re benefiting all the time in ways totally invisible. There’s nothing at Walmart that says you’ve just saved 8% because we bought this somewhere other than an American manufacturer. So you have this huge national benefit, unseen, but you ruin the economic lives of people who are 50 or 55 and are not going to be re-trained or re-located. A rich country can take care of those people if they follow policies that benefit all of us and take care of the relatively few who are dislocated. I think that’s the obligation of a rich country.”

IPO’s and LYFT’s $25b Market Capitalisation

“I certainly wouldn’t buy [the] business for $25b. I always think in terms of buying the whole business. I look at what I’m getting as a part owner of a business and I don’t know why, with all the things you could buy for $25b in this world, that you would pick a business that really has to be earning $2.5-$3b pre-tax in five years [versus losses now] to even be on the same radar screen as things you can buy right now. I’ve never been a big buyer of IPO’s. Charlie and I haven’t bought an IPO since 1955.”

“I don’t think buying new offerings during hot periods in the market is anything the average person should think about at all.”

“[Question from Becky Quick - But IPO’s always could be opportunities, e.g. Google and Amazon?] You can go around making dumb bets and win. It’s not something you want to take as a lifetime policy though. I worry much more about the things I do than I don’t do. I’ve missed all kinds of opportunities in my life. You just want to make sure you’re on the side of the house when you bet, rather than bet against the house.”

Media is Too Tough

“Entertainment is a big game with big players in it and they are playing for keeps. One problem they all have is that everybody has just two eyeballs and they’ve got x hours discretionary time, maybe they have 4 hours a day. Obviously there is disruption going on in delivering various things. People are always going to want to watch sports. They’ll want to watch the Olympics; the question is how much it’s worth. You’ve got some very, very big players who are going to fight for those eyeballs. The eyeballs aren’t going to double. The time isn’t going to double. It’s a relatively fixed market and then you get the size of certain players and disruption from Netflix which no-one predicted ten years ago. We’ll see how it plays out but that’s not an easy game to predict because you have very smart people with lots of resources trying to figure out how to grab another half hour of your time. I would not want to play in that game myself, that’s too tough for me.”

“Ten years from now when we look at entertainment delivery, it will be what people want. It will be in the form they want, it will be whatever the creativity comes up with. It’s going to be a very hotly contested game and the one thing I can guarantee you, is the public will be the winner.”

Companies and Mistakes

“I’d love to see Apple succeed [in media]. That’s a company that can afford a mistake or two. You don’t want to buy stock in a company that has to do everything right. In the mining business, they say any mine being dug should be able to stand a certain amount of bad luck because you get into different things as you get 5,000 feet down. There’s some businesses that are quite predictable. Berkshire’s made lots of mistakes over the years; my mistakes. We started with a textile mill and we had two businesses that failed. You’re gonna make mistakes and you don’t want to make them with too big a portion of your capital and you want to recognise them when you make them. You want to basically hang onto your winners. Apple should do some things that don’t work.”

Addressing Bad Acts

“The only thing I worry about Berkshire Hathaway [is bad acts of one or a few people reflecting on the business]. I don’t worry about our financials or earnings. I recognise we have 390,000 people and somebody’s doing something wrong. Probably fifty or a hundred people are doing something wrong at any given time. The only thing I have to remember is an ounce of prevention isn’t worth a pound of cure; an ounce of prevention is worth a ton of cure. So anytime you have anything unpleasant you’ve got to attack it immediately. It’s so easy just to shove it off or hope somebody down the line solves it. You pay a huge price for that.”

Summary

It’s clear that even after those 70 years, Buffett still thinks in simple terms.

He sees recessions as opportunities, doesn’t invest in hot IPO stocks or businesses he doesn’t understand, but he does want the businesses he invests in to make the odd mistake now and then. That’s how innovation comes about - from stumbling on occasion and learning from the error.

Investing is about connecting the dots. This also is a known fact. But if you want to succeed in investing, its important that you actually have dots to connect. In reality, the dots are information, disparate pieces of knowledge that we accumulate through learning from others, such as Buffett. And I for one am glad that the man still has ‘dots’ that the rest of us can learn from.

Source: ‘Becky Quick interviews Warren Buffett at The Gatehouse” CNBC.

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