Thinking About Margin of Safety

If anything, the past few years has reminded us that the future is unknown and events can take turns you would never expect. Businesses have set-backs, economies have downturns and even the best investors make mistakes. Because of this, leaving some room for error makes eminent sense. Almost a century ago, Ben Graham first proposed the concept of Margin of Safety in his seminal book, ‘Security Analysis.’ Ever since, the term has been indoctrinated into the investing lexicon of the world’s most successful investors.

Like most things investing however, there’s conjecture around what constitutes a ‘Margin of Safety.’ While most investors consider margin of safety in the context of a purchase discount relative to a company’s intrinsic value, others look towards low valuation ratios, avoiding high multiple stocks, seeking a high degree of business quality or a combination thereof.

If you subscribe to Buffett’s first rule of investing, ‘Don’t Lose Money,’ then, ‘Don’t buy without a Margin of Safety,’ would seem sensible advice. But how do you achieve it? Should a ‘Margin of Safety’ be applied to all investments? Or to the portfolio as whole? Is it acceptable to invest without a margin of safety?

Over the years, my views on Margin of Safety have evolved. Here are some thoughts.

Low Ratios

A common misconception is that low stock valuation multiples provide a margin of safety. This line of reasoning assumes bad news is already priced in, rendering share prices indifferent to negative developments.

Over two decades of experience in markets would have me believe otherwise. A stock purchased on a low multiple doesn’t imply a margin of safety. Screening for low multiple stocks is just as likely to get you caught in ‘value traps’; businesses whose best times are behind them.

"If anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we’re looking at a poor business in the first case and a good business in the second case.” Warren Buffett

“Starting with a rank-order valuation screen is more likely to lead you into less than-optimal businesses.” Brian Bares

When you own an inferior business, time is working against you - as the underlying value of the business deteriorates.

“The investor who spots a price discrepancy in an ordinary business hopes that the share price will promptly rise to the intrinsic value he has estimated. The more time passes, the longer they take to realise the forecast return, and the more exposed they are to uncontrollable risks.” IP Capital

If buying low PE stocks were the key to investment success, we’d all be rich. In recent times, limiting yourself to such stocks has meant forgoing many of the best investment opportunities. If you moved to a new city, would you ask the local agent for the names of the cheapest suburbs? Not likely. The same should apply to investing.

High Ratios

All things being equal, the lower the multiple paid for a business, the better; you’re paying less for the business and there’s less room for the multiple to fall should things not pan out as expected. It doesn’t follow however, that purchasing a stock on a high multiple provides no margin of safety. The first question to ask is, ‘is today’s multiple even relevant?’ and the follow up questions are, ‘what will the earnings be in three to five years time?’ and, ‘what will the multiple be in three to five years time?”

Some of the best investment opportunities arise when investors and analysts apply standard industry multiples to near term earnings which are completely anomalous to where a business might be in the future (completely undervaluing the company). In such cases, the near term multiple can be meaningless. Joel Greenblatt made this point in a recent interview:

“One of the big mistakes I made was looking at Walmart, seeing what a good business it was thirty years ago. Think about it this way, if you’re looking at the numbers to do with fifty stores but you can see they can have a thousand or two thousand stores, like any of these new internet businesses with an unlimited growth trajectory, the numbers you’re using at fifty stores aren’t very helpful. You might have a model that can expand, but putting a multiple on whatever you’re earning on fifty stores, if you could have 1000 or 2000, of course they’re meaningless. You really have to make some estimates about what the opportunity set is and what the competition will be over a long period of time. Traditionally these have been some of my biggest mistakes of omission. Missing huge opportunities.”

Stocks that look optically expensive today can actually be cheap on the basis of future earnings. Rather than disregard multiples altogether, it’s worth trying to establish whether the stock might be on a reasonable multiple in the future.

“In 2007, Apple traded at 30x EPS but only 3x 5 years out. The art of growth investing is realising a stock that appears expensive today can be dirt cheap 5-7 years later. Multi-baggers are the source of most outperformance and hide many mistakes.” Philipe Laffonte

"It isn’t a multiple of today’s earnings that is the primary determinate of things. We bought our Coca-Cola at a price of $11 a share. And it’ll earn $2.30-$2.40 this year. So, that’s under five times this year’s earnings, but it was a pretty good size multiple back when we bought it." Warren Buffett

Even businesses that don’t report profits can provide a Margin of Safety - it all comes down to understanding the specifics of the business; how is value defined? how it is created? what are the potential outcomes?

Bill Miller made this point at the 2019 Santa Fe Institute Symposium using Amazon and John Malone’s TCI as examples:

“Probably the best example of a misunderstanding of the valuation of anything has been Amazon over its entire history. It was constantly, you know, Baron’s saying, ‘Amazon.bomb,’ and everybody talking about how they don't make any money, they don't make any money, they don't make any money. CBC did a special on it, and one of the things they interviewed me about was Amazon's finances. They start off with, oh, how can you own this thing that doesn't make any money? And I have two answers to that.

Number one, John Malone, the great cable investor. I said, if you put one dollar in John's TCI when John became the CEO, and you kept it there for the twenty-five years that one dollar is 900 dollars. And he never reported a profit in twenty-five years. So, something else is going on besides profits and the report of profits.

With Amazon, I said, look, there’s a reason that they’re called ‘generally accepted accounting principles,’ and not ‘divinely inspired accounting principles’ or ‘immaculately conceived accounting principles.’ They’re a way to capture a certain type of information for particular kinds of companies that have a particular kind of economics.”

The confidence to underwrite the future requires an understanding of the primary drivers that will help ensure a business reaches the anticipated destination.

Due to the power of compounding, businesses that can sustain success over decades are often undervalued in spite of an ‘optically-high’ PE ratio. With regards to Walmart, Nick Sleep noted you could have paid 150 times the price in the early years and still earned a ten percent annual return. That’s 150 times the prevailing share price not 150 times earnings! Furthermore, ten years later you could have paid a 150X PE and earned ten percent returns. That really is the magic of compounding.

The world’s best investors often confess that selling great businesses because of a high near term multiple has been one of their biggest mistakes. If the destination is intact, stay the course.

Discount To Intrinsic Value

Generally, the most accepted definition of Margin of Safety relates to a company’s Intrinsic Value; the present value of a business’ future cashflows. Purchasing at a discount to one’s estimate of Intrinsic Value provides the Margin of Safety. While highly subjective, the more predictable a company’s earnings over the long term, the less divergent the estimates of intrinsic value will be, and the more reliable the calculation of a margin of safety.

"The concept of a margin of safety is that an investor should purchase a security at a price sufficiently below his estimate of its intrinsic value that he will have protection against permanent loss even if his estimate proves somewhat optimistic.” Ed Wachenheim

"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 its 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

The idea of buying at a discount to intrinsic value is never going to become obsolete. Provided you’ve got the ability to ride out any short term volatility, in time, you’ll be rewarded as the share price converges with intrinsic value.

Quality

‘Quality’ is another investing term that’s hard to define; a conservative balance sheet, aligned management, high returns on capital and a track record of success make a good foundation. As regards the future, it’s often the qualitative characteristics that determine performance; a business’ purpose, management, culture, adaptability, innovativeness and the company’s relationships within its ecosystem.

Margin of Safety is about ensuring survival, both now and in the future. History has shown high-quality companies tend to weather near-term volatility, crises, corporate mishaps and competitive threats better than lower quality businesses - and go on to prosper in time.

“Major capital losses occur mostly when the business suffers irreparable damage. Exceptional companies are, by definition, those best protected against competitors, disruptive technologies, poor governance, and other factors that can destroy value. A portfolio of exceptional companies can be both more concentrated and safer than a portfolio of ordinary companies.” IP Capital

“Bad companies are destroyed by crises; good companies survive them; great companies are improved by them.” Andy Grove, Intel

The best businesses do things differently, they tend to be the leaders in what they do, they thrive in different environments, they fulfil an important customer demand, they take a longer term view and do things right by their customers, employees, suppliers, community and shareholders. They develop new products, grow markets and have a level of control over their destiny. Investors who own them enjoy a Margin of Safety.

“The most important three words in investing, stated by Mr. Graham are: Margin of Safety. What that means to us, is that we are looking at investing in very, very high-quality companies that have great franchises and that have had these great franchises for many years.” David Polen

“The best long term margin of safety comes not from an investment’s price but from the value of a company’s sustained competitive advantage over very long periods of time. That’s what quality investing is all about.” Thomas Russo

“[Ben Graham] gave the world the concept of margin of safety. We utilise that very much and the margin of safety for us is the quality of each business that we are investing in." Jeff Mueller

“The margin of safety is not just in the price you pay, it's also in the quality of the business, it's in the balance sheet of the business and the accounting and also in terms of the quality of top management. When we bought shares of Constellation Software, I don't remember how much we paid but we paid a reasonable valuation, I think 18 or 19 times earnings. To us the real margin of safety was Mark Leonard.” Francois Rochon

“When people talk about margin of safety in investing, they usually talk about things that are financial in nature. They talk about asset value or they talk about sustainable return on equity or whatever. I'm much more focused on the nature of business franchise and the replicability of that, and the quality of the people running it.” Steve Mandel

"A good business model provides the ultimate margin of safety." Jake Rosser

Exceptional businesses compound their capital at high rates over time while inferior businesses tend to compound their disadvantages. Compounding machines are defined by high quality businesses, not cheap price.

Portfolio Margin of Safety

Where I once looked for a margin of safety in every investment, I now consider Margin of Safety in a portfolio context which allows me to relax the requirements for a small portion of the portfolio. I’m an advocate of the idea that markets are complex adaptive systems; they’re unpredictable, the whole is greater than the sum of the parts, and they’re subject to non-linear outcomes. Capturing some of that non-linearity may require you to venture into companies with less margin of safety; perhaps the business is yet to hit an inflection point, hasn’t been stress tested by economic cycles, offers a somewhat binomial outcome or the balance sheet isn’t as pristine as one would ordinarily prefer.

An investment with the potential to be a multi-bagger might be worth considering in a portfolio context despite a limited ‘Margin of Safety.’

“I confess to finding the Margin of Potential Upside more alluring than the classic Margin of Safety.” James Anderson

“If you can lose 100 percent on something, so say an option, that doesn’t mean you shouldn’t ever buy options. Sometimes they’re really interesting and if you can sometimes get to the point of view that even though you can lose 100 percent on a particular investment, it might be an interesting thing to do.” David Abrams

“I will invest in companies where the possibility the equity goes to zero has to be recognised as part of the equation – and my record on that front is not spotless. Charlie Munger has talked about how depending on the probabilities you assign to the up and down case, it may be a perfectly reasonable bet to accept the possibility of a zero if your upside is 5x or more. I agree.” Robert Robotti

Even Messrs Buffett and Munger have recognised as much. Given the nature of their insurance business, this may come as little surprise.

“Charlie and I by nature are pretty risk-averse. But we are very willing to enter into transactions — if we knew it was an honest coin, and someone wanted to give us seven-to-five or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? Well it would sound like a big number to you. It would not be a huge percentage of the net worth, but it would be a significant.” Warren Buffett

"Mostly, Berkshire, in its history, has bought common stocks that practically couldn’t fail. But occasionally, Berkshire just makes an intelligent gamble where there’s plenty of chance of failure, but there’s enough chance of success so the gamble is worth taking." Charlie Munger

A portfolio can provide a Margin of Safety despite a small component having elevated downside risk. An everyday example is index investing. The S&P500 has managed to compound at c.10%pa for the last hundred years in spite of many component companies losing significant value or becoming bankrupt.

Buffett has long analogised investing to baseball, but better. There are no strike-outs. Taking that analogy a step further, it’s been noted .. ‘‘Baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you get is four. In the wider world, every once in a while, when you step up to the plate, you can score 1,000 runs.” That’s certainly true of investing. Baillie Gifford’s James Anderson points to research by Professor Hendrik Bessembinder showing the entire gain in the US stock market since 1926 can be attributable to the best-performing four percent of listed companies (when stated in terms of lifetime dollar wealth creation).

One of the most insightful investment papers I’ve ever read is Charlie Munger’s 1996 discussion of Coca-Cola. Here, Munger presents a case study that asks rhetorically how one would go about producing a $2 trillion business from an initial $2m outlay - the focus is very much on the upside rather than the downside. The story encapsulates the incredible asymmetric opportunities that can exist in markets.

Searching for these outliers and sizing such positions appropriately can enhance portfolio performance while not exposing the portfolio to an undue level of risk.

'To have a few higher-multiple names is very different than having a weighted average price/sales ratio of 6x or even higher at the whole portfolio level. The air begins to get thin at those altitudes!' Rajiv Jain

Dual Margin of Safety

Many of the world’s most successful investors have adopted the concept of a ‘dual’ margin of safety - seeking high quality companies at attractive discounts to intrinsic value.

“We strive to avoid situations without our cherished dual margin of safety – the quality of business and the price. We need both to counter our inevitable mistakes and unforeseen events.” Christopher Bloomstran

“Margin of safety for us comes from the quality of the business and second from buying into it at a substantial discount to our estimate of intrinsic value. Neither is sufficient on its own for us to be interested.” Mark Curnin

"The margin of safety in our investment strategy is to identify fundamentally good businesses and adhere to strict valuation discipline." Jeffrey Ubben

Summary

While a Margin of Safety doesn’t pertain to purchasing low multiple stocks or avoiding high multiple stocks, it can be attained, over the longer term, by holding high quality businesses acquired below their intrinsic value.

Unfortunately, little in investing is clear cut and there are plenty of exceptions to the received dogma. Even investments with a low margin of safety can enhance portfolio results if they offer the prospect of highly asymmetric returns, provided the overall portfolio exhibits an appropriate margin of safety.

Participating in such highly skewed opportunities might require an evolution in thinking beyond the traditional mantra of value investing; applying the concept of margin of safety to the portfolio as a whole, while relaxing that constraint at the individual stock level.

A portfolio comprised primarily of companies exhibiting a dual margin of safety combined with some asymmetric opportunities, appropriately sized, might provide the best of all worlds.

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Learning from Honey Bees

The great investors never stop learning. Warren Buffett, Charlie Munger and John Templeton all continued to learn well past the age of most people’s retirement, and despite decades of investment success, they all had the humility to recognise there was so much more to learn. More recently, the eminently successful practitioners, Howard Marks and Dan Loeb have each acknowledged their continued evolution as investors.

And the information they absorb can come from a multitude of sources. At MastersInvest we have looked at what can be learned from a variety of areas, many of which upon first reflection you would consider to be only tenuously related to investing at best. Interestingly though, often the better learning is to be found in the most unlikely of places.

“Camel's nostrils are miracles of heat exchange and water recovery engineering. We are currently looking at cuttlebone and bird skulls to help design more efficient concrete structures for office buildings. The combustion chamber in the abdomen of a bombardier beetle mixes two high explosives from fuel tanks with valves that open and close 200 times a second—it is being studied in order to develop needle-free medical injections, more efficient fuel injection systems and more effective fire extinguishers.” Michael Pawlyn

This field is called biomimicry; a discipline that looks at nature's best ideas to inspire solutions to human problems. When it comes to continuous innovation and devising strategies for success, nature has a three billion year head start on us humans. While we’ve barely scratched the surface when it comes to understanding the world we live in, it’s no reason to be despondent. The world is just far too complex and ever changing. There’s much to learn and everyday those learnings can help in all facets of life.

A recent article in The Economist titled, ‘The nose knows - Flies, worms and bees could help detect illness’ provides an enlightening example. While everybody knows dogs have a much better sense of smell than us, few would realise they can smell things at concentrations of one part in a trillion. That’s equivalent to a single drop in a pond the size of 20 Olympic swimming pools! While trials have shown that dogs can detect human disease - cancer, diabetes, tuberculosis, and malaria - recent research shows bees have senses just as good. Imagine such an expendable resource providing an economical, easy and non-invasive way of detecting cancer.

“The imagination of nature is far, far greater than the imagination of man. No one who did not have some inkling of this through observations could ever have imagined such a marvel as nature is.” Richard Feynman

Many great investors have found lessons in life within nature itself. The learnings that she can offer us are many and varied, and so upon recommendation by both Michael Mauboussin and James Anderson, I recently delved into an interesting book called, ‘Honeybee Democracy.’

In this fascinating treatise, the world-renowned animal behaviourist Thomas Seeley delves into the life of a honey bee swarm. These tiny creatures face a life-or-death problem when choosing a new home, effectively ‘staking everything on a process that includes collective fact-finding, vigorous debate, and consensus building.’

It all starts with the honey bee colony’s reproduction process. In the late spring and early summer, as a bee colony becomes overcrowded, a third of the hive stays behind and rears a new queen, while a swarm of thousands departs with the old queen to produce a daughter colony. As part of this process, a small percentage [c2%] of the hive’s worker bees, referred to as scouts, will independently search for a new nest site.

Experimental studies have found these scout bees to have an innate sense of what comprises the ideal location; a small entrance, plentiful volume for honey storage to survive winter, a suitable height above the ground, etc. Each scout bee’s job is to independently search for new locations and report them back to the hive. This communication process is achieved through a form of ‘ritual dance’ which signals both the location of the sites and the scout bee’s relative keenness on it.

Upon witnessing the dances, other scout bees will then visit the advertised sites and make their own independent assessment of the location’s merits and once again communicate this to the colony. Over time, each scout gradually reduces their marketing efforts regardless of how suitable the site is. The most keenly marketed sites attract more scouts who then inspect and, if appropriate advertise the site, creating a positive feedback loop. In contrast, lower quality sites are abandoned. When a quorum of bees is reached at the optimum site, the swarm will depart and take up residence in its new home.

An intelligent decision making process emerges from a group of less sophisticated beings; the wisdom of the hive is greater than that of any individual bee. This decision making process, honed over millions of years, almost always leads to the optimal site selection. There is no central decision maker; the queen bee plays no role in the process.

There are lessons in this decision making process that can help improve group decision making. Thomas Seeley recommended four things:

1) make sure the group is sufficiently large for the challenges it faces
2) make sure the group consists of people with diverse backgrounds and perspective
3) foster independent exploratory work by the group’s members
4) create a social environment in which the group’s members feel comfortable about proposing solutions

Every bee in the hive starts with a common purpose. The individuals and the hive’s interests are aligned - to the point where it is a life or death decision. When it comes to human decision making, ensuring a group understands the entities goals, have alignment and are incentivised appropriately, is fundamental.

The scout bees possessed an innate sense of what constitutes an optimal nest site. Extrapolating this to an investment group requires agreement on the attributes of a ‘good investment.’ Defining qualities such as a businesses’ purpose, a good culture, enduring competitive advantages, high returns on capital, management alignment and capability are perhaps, pre-requisites to consider. Filtering out unsuitable opportunities is an important part of the process.

Just as each bee doesn’t compare and contrast every site, but investigates a diverse range of sites, investment analysts should search widely for potential opportunities. Each analyst however, must be discerning in their selection process before reporting back to the group. Other analysts can then independently investigate those companies and a debate can be held about the merits of each.

While it might sound like common sense, collective groups of people have a tendency to make poor decisions. It’s uncanny the extent to which Thomas Seeley’s findings and recommendations parallel with those that the renowned Yale psychologist, Irving Janus described in his famous book, ‘Groupthink.’

Summary

One recurring trait of the great investors is their dedication to continuous learning. And its astounding from how many diverse fields they can draw life’s lessons from. At Mastersinvest we’ve drawn on teachings from great Investors, Businesses, CEO’s, Navy Captains, Psychologists, Physicists, Artists - and now - Honey Bees!

As humans, we understand just a fraction of what there is to know, which should make one optimistic about the amazing things we will achieve in the future. I’ll leave you with one of my all time favourite quotes from Ray Dalio, it connects the concept of nature and humility far better than I ever could.

“While I spend the most time studying how the realities that affect me most work—i.e., those that drive the markets and the people I deal with — I also love to study nature to try to figure out how it works because, to me, nature is both beautiful and practical. Its perfection and brilliance staggers me. When I think about all the flying machines, swimming machines, and billions of other systems that nature created, from the microscopic level to the cosmic level, and how they interact with one another to make a workable whole that evolves through time and through multi-dimensions, my breath is taken away. It seems to me that, in relation to nature, man has the intelligence of a mould growing on an apple—man can’t even make a mosquito, let alone scratch the surface of understanding the universe.” Ray Dalio, Principles 2011.

Source:
‘Honeybee Democracy,' Thomas Seeley, 2010, Princeton University Press.

Further Reading:
‘Avoiding Groupthink,’ Investment Masters Class, 2016.

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The Good Life Podcast

I recently had the pleasure of chatting to Sean Murray from ‘The Good Life.’ We talked about all things investing including quality companies, powerful business models, developing a multi-disciplinary mindset and the common threads evident amongst the very best investors, CEOs and businesses.

I’m a big fan of Sean’s work, be sure to check out his other interviews with the likes of Robert Cialdini, Annie Duke, Michael Abrashoff, Morgan Housel and William Green.

I hope you enjoy the episode…

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Lights Out - Learning from GE

MastersInvest has spent a lot of time studying businesses and business leaders that have been successful, some remarkably so. Those companies that have forged not only stellar reputations in their fields, but also those who have succeeded in industries where success is not a common commodity. And whilst a solid working knowledge of these success stories is vital for any investor to know, its also incredibly valuable to look at the other side of the coin - those businesses that have failed.

Warren Buffett and Charlie Munger have long espoused the benefits of studying failure. Armed with the foresight of what not to do can help an investor avoid the key risk to any investment program - the permanent loss of capital. With this insight in mind, and having read a short synopsis in Bill Gates Summer Reading List, I looked forward to reading the book, ‘Lights Out - Pride, Delusion and the Fall of General Electric’ by Ted Mann and Thomas Gryta. An easy read, the book details the multitude of problems which beset GE coupled with a cornucopia of red flags to look out for in your own investments.

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

Once a storied industrial leader, the last few decades have been nothing short of brutal for GE. While a toxic culture of ‘making the numbers’ seemed ingrained at the time Jack Welch handed the reigns to Jeff Immelt, Immelt’s sixteen year term atop GE earned him a scathing review. Characterised with an incessant focus on the share price, always coveting Wall Street’s admiration, ignorant of tail risks, obstructive to feedback, turning a blind eye to questionable accounting and an absence of humility were the hallmarks of a failed leadership tenure. If the expression, ‘an institution is the lengthened shadow of one man’ rings true, this isn’t a book for Immelt’s trophy cabinet.

Gates Notes - ‘5 Ideas for Summer Reading’ 2021

Perhaps unsurprisingly, the company’s travails were strikingly at odds with the traits that have defined the great businesses we’ve reviewed in the past. Below I’ve called out some red flags and accompanying lessons from GE. Notwithstanding the accounting misconduct, most of the tell-tale signs of trouble are qualitative and behavioural in nature.

S&P500 [grey] vs General Electric [blue] Normalised - 2000 - 2021 [Source: Bloomberg]

Financials Above Purpose

In the superb book, ‘In Search of Excellence,’ Tom Peters noted, “We found that companies whose only articulated goals were financial did not do nearly as well financially as companies that had broader sets of values.”

“The Growth Playbook [was] a grueling annual examination of GE’s eight major business leaders. It was here that GE hammered out targets for sales and profits, setting the underlying assumptions for the financial estimates it would give investors. Under Immelt, the point of the exercise was determining how his executives would get to their financial targets - though not how they would determine what output the business would produce as a starting point. This practice had been ingrained at GE from the days of Welch.” Lights Out

“The problems stemmed not from any single action but from the practices of accountants on staff at the dozen or so plants in the division. They’d reported their numbers by working backward: starting with a profit target and then working out what their sales figures would have to show to get there, rather than simply running the business and reporting their results to headquarters every three months.” Lights Out

The best business leaders have long recognised a company’s share price is a function of long term business performance. Solve for the latter, and in time, the share price will look after itself. At GE the financials dictated strategy.

“Investors and executives need to realise that the creation of shareholder value is an outcome — not an objective.” Terry Smith

“Stock price is an outcome. You can’t manage the outcome. You manage the inputs.” James Gorman

“We want corporate management to solve for value creation, not security price.” Dan Loeb

“Companies that focus on their stock price will eventually lose their customers. Companies that focus on their customers will eventually boost their stock price. This is simple, but forgotten by countless managers.” Morgan Housel

“When it comes to discussing a company’s strategy, it is alarming how frequently one finds confusion about what a strategy actually is. Often a CEO mistakes a short-term target, say an earnings per share target or a return on capital threshold, with a strategy.” Marathon Asset Management

“Some would claim that maximising profits is a business’s ultimate purpose. Yet it is often when companies become exclusively profit orientated – and explicitly define this as their objective - that things go wrong. The end result of what investors seek, good shareholder returns, is invariably better achieved obliquely.” Nick Train

“An annual report with a numbers obsession speaks volumes about what’s important.” Marianne Jennings

Jeff Immelt’s strategy was directed with reference to the share price; providing guidance, smoothing earnings, setting optimistic long term EPS targets, undertaking acquisitions and divestments to appease Wall Street, appealing to big investors and ‘making the numbers’ regardless of cost. All are misguided short cuts.

Focus on Share Price

Of all the books on great businesses I’ve read, I can’t recall one where a company’s share price featured so prominently. Great businesses are all about empowering people, innovating, delighting customers, tolerating mistakes, focusing on the long term, upholding values, embracing change and remaining humble, to name but a few - none of which rated barely a mention.

“The stock market didn’t appreciate what GE was really worth. And it was driving Jeff Immelt crazy. His handlers claimed that he didn’t watch the daily movement in the shares, but his actions betrayed him. The stock market was the ultimate scoreboard tracking his performance.” Lights Out

“‘The stock is currently trading at one of the lowest earnings multiples in a decade,’ Immelt wrote in his annual letter to investors in early 2006. ‘Investors decide the stock price, but we love the way GE is positioned. We know it is time to go big!’ he wrote.” Lights Out

“Always aware of the stock’s reflection on his leadership, Immelt was trapped in a waking nightmare.” Lights Out

“GE’s stock price and its miserable performance were a constant cloud over Immelt’s head.” Lights Out

A management’s obsession with their share price is often a tell for investors; as recognised by some of the world’s best.

“Today, it seems to be regarded as the duty of CEOs to make the stock go up. This leads to all sorts of foolish behaviour.” Charlie Munger

“[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.” Chuck Akre

“We’ve been suspicious of companies that place a whole lot of emphasis on the price of their stock. When we see the price of a stock posted in the lobby of the headquarters or something, things like that make us nervous.” Warren Buffett

“A worrying sign is a CEO with a subscription to Bloomberg as this may indicate an unhealthy interest in stock prices and short-term news flow to the detriment of long-term thinking.” Marathon Asset Management

Quarterly Earnings

The best investors have a long-term orientation, focused on where a business might be in three to five years or more, rather than next quarter’s result. GE spent their time trying to please short-term investors.

“We do not worry about the stock price in the short run, and we do not worry about quarterly earnings. Our mindset is that we consistently build the company — if you do the right things, the stock price will take care of itself.” Jamie Dimon

“The investor wanting maximum results should favour companies with a truly long-range outlook concerning profits.” Phil Fisher

“We really think that an undue focus on quarterly earnings, not only is probably a bad idea for investors, but we think it’s a terrible idea for managers. If I had told our managers that we would earn three dollars and 17 1/2 cents for the quarter, you know, they might do a little fudging in order to make sure that we actually came out at that number.” Warren Buffett

Business Results Aren’t Linear

Smart investors recognise the business environment and economy are not conducive to a perfect earnings trajectory. GE failed to understand this, deploying unethical and in some case illegal short cuts to deliver.

“GE executives have acknowledged that they worked to make sure earnings were growing in a nice smooth trajectory.” Lights Out

“When Fortune’s Carol Loomis once told Welch that the smoothing practice was terrible, he vehemently disagreed with her. ‘What investor would want to buy a conglomerate like GE unless its earnings were predictable?” Lights Out

“The concept of managing earnings, another wonderful numbers term that infiltrates the numbers-pressure culture that leads to ethical collapse. It’s not cooking the books, it is managing earnings. A numbers obsession finds employees and officers not managing strategically but manipulating numbers for results.” Marianne Jennings

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

“Businesses do not meet expectations quarter after quarter and year after year. It just isn’t in the nature of running businesses. And, in our view, people that predict precisely what the future will be are either kidding investors, or they’re kidding themselves, or they’re kidding both.” Warren Buffett

Promoting the Stock

“In the [2015] annual letter, Immelt wrapped up his lecture on the limitless superlatives of GE with an awkward plea to major institutional investors.. ‘We have delivered for you in the last five years. But we are still under-owned by big investors. In this time of uncertainty, why not GE?’ he wrote, like a heartbroken lover begging for reconciliation. ‘We have a ton of cash that can protect you,’ he added.” Lights Out

“[At the annual Electrical Products Group conference for industrial investors and executives] Immelt, as he had done before, argued that investors had GE all wrong and were mispricing a stock that should have been above $30 a share.” Lights Out

“We suspect that business leaders who are busy promoting themselves or their stock are not properly focused on running their companies. We go out of our way to look for management that cares about shareholder value but doesn't hype its stock.” Marathon Asset Management

“People who have a proclivity for announcing how valuable their stock is, are I think, people who you ought to be very cautious of.” Warren Buffett

Fancy Predictions

“As the [2016] year came to an end, Immelt planted a flag that would define the rest of his career: he declared that GE would produce at least $2 of profit per share in 2018. It was an unusually long-term projection, and its meaning was undeniable to Immelt.” Lights Out

“It was wishful thinking at best that GE could deliver the $2 of earnings Immelt had promised.” Lights Out

“Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic – but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.” Warren Buffett

Candor and Bad News

“Faced with the prospect of telling their tempestuous CEO that the new product was a disaster, the managers chose another route. They massaged the numbers.” Lights Out

“There was no market for hard truths or bad news. Not as far as the guy at the top was concerned.” Lights Out

“It was better to figure out a better way to deliver the bad news, or make it go away somehow, than to present it to Immelt straight.” Lights Out

Great businesses are tolerant of mistakes. Great Leadership recognises businesses grow through trial and error. When problems aren’t addressed they fester and the eventual impact on a business can be disastrous.

“Almost every business has problems, and we’d just as soon the manager would tell us about them. We would like that in the businesses we run. In fact, one of the things, we give very little advice to our managers, but one thing we always do say is to tell us the bad news immediately. And I don’t see why that isn’t good advice for the manager of a public company. Over time, you know, I’m positive it’s the best policy.” Warren Buffett

“Bad news concealed over time doesn’t get any better. See those studies again: companies with the most candid disclosures in their financial statements perform better over the long term and have higher share prices.Companies that put their current positions and performance right out there for investors and analysts to study are the companies to put your money in.” Marianne Jennings

A Culture of Making the Numbers

“The pressure to perform inside GE is omnipresent, and missed goals can be fatal, a tradition true at all levels of the company.” Lights Out

“Management expectation about the sales growth and profit they should be able to hit didn’t reflect the dim reality of the market, team members told Steve Bolze [CEO GE Power] and Paul McElhinney, the head of the unit that administers the service contracts. Vocal complaints about management’s view diverging from the reality of the market, or from basic math, were common among lower level Power executives. When the concerns were raised to leaders like McElhinney, they were stopped cold... ‘Get on board,’ McElhinney said. ‘We have to make the numbers.’” Lights Out

“When Immelt took over the Plastics operation, the previous management hadn’t been playing it straight. Under pressure from Welch, the division had stretched to make the numbers, including misreporting inventory figures to reduce the cost of goods sold.” Lights Out

“Welch would argue that he pushed his underlings to produce results, not fraud. But even if the CEO didn’t bend the rules himself, Welch cultivated an environment of pressure that incentivised people to do just that.” Lights Out

“If you couldn’t do the job and hit your targets, they all knew, Jack Welch would get someone else who could.” Lights Out

“Jeff Immelt’s assignment was clear: keep the earnings machine of GE humming steadily along, as it had under Welch.” Lights Out

“GE regularly leaned on [GE Capital] to make sure that profits stayed steady.” Lights Out

“Few fates were worse than missing your numbers at GE. Executives assigned targets to underlings, rather than lower-rung workers passing information up the ladder, so projections were based on market realities.” Lights Out

“Salespeople relied on financing provided by the stub of GE capital to prop up customer demand.” Lights Out

Marianne Jennings wonderful book, ‘The Seven Signs of Ethical Collapse - How to Spot Moral Meltdowns in Companies... Before It's Too Late’ cites ‘Pressure to Maintain Those Numbers’ as the number one sign of ethical collapse; “All companies experience pressure to maintain solid performance. The tension between ethics and the bottom line will al-ways be present. Indeed, such pressure motivates us and keeps us working and striving. But in this first sign of a culture at risk for ethical collapse, there is not just a focus on numbers and results but an unreasonable and unrealistic obsession with meeting quantitative goals. ‘Meet those numbers!’ is the mantra.”

“Charlie and I have been around the culture, sometimes on the board, where the ego of the CEO became very involved in meeting predictions which were impossible and everybody in the organisation knew, because they were very public about it, what these predictions were and they knew that their CEO was going to look bad if they weren’t met. And that can lead to a lot of bad things. You get enough bad things, anyway, but setting up a system that either exerts financial or psychological pressure on the people around you to do things that they probably really don’t even want to do, in order to avoid disappointing you, that’s a terrible mistake. And, you know, we’ll try to avoid it.” Warren Buffett

“We really believe in the power of incentives. And there’s these hidden incentives that we try to avoid. One we have seen more than once, is when really decent people misbehave because they felt that there was a loyalty to their CEO to present certain numbers, to deliver certain numbers, because the CEO went out and made a lot of forecasts about what the company would earn. I’ve seen a lot of misbehaviour that actually doesn’t profit anybody financially, but it’s been done merely because they don’t want to make the CEO look bad, in terms of his forecast.” Warren Buffett

“You really have to be very careful in the messages you send as a CEO. If you tell your managers you never want to disappoint Wall Street, and you want to report X per share, you may find that they start fudging figures to protect your predictions. And we try to avoid all that kind of behaviour at Berkshire. We’ve just seen too much trouble with it.” Warren Buffett

If a culture is broken and toxic the best advice is to steer clear. It’s almost impossible to turn around a poor culture.

“You can’t buy a company that’s got a dishonest culture and turn it into an honest culture." Bradley Jacobs

Cost Cutting

“The Corporate cost cutting program [was'] called ‘Simplification.’ That program had zeroed in on worker pensions and retiree health insurance as a good place to tighten the company belt.” Lights Out

'Whenever I read about some company undertaking a cost-cutting program, I know it's not a company that really knows what costs are all about. Spurts don't work in this area. The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practice breathing.'' Warren Buffett 

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

“Almost every firm engages in bouts of cost cutting. Exceptional firms, however are involved in a permanent revolution against unnecessary expenses.” Marathon Asset Management

Losing Your Competitive Position

“If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s ‘An ounce of prevention is worth a pound of cure.’ But sometimes no amount of cure will overcome the mistakes of the past.” Warren Buffett

“Companies which underinvest in their franchise in order to meet short term targets are not good candidates for compounding wealth.” Terry Smith

Accounting Irregularities

Pressure from the top to hit numbers coupled with an unwarranted focus on the share price, can tempt employees to fudge the numbers. Once again, Marianne Jennings observed, ‘A declining stock price can cause bizarre accounting behaviour. The drive for numbers, number, numbers can take us right to the slippery slope and into ethical collapse.”

“GE Power had sold service guarantees to many of its customers that extended out for decades. By tweaking its estimate of the future cost of fulfilling those contracts, it could boost its profits as needed.” Lights Out

“These reviews [of GE’s service contracts] produced profits that GE could use to hit targets for Wall Street, but they were really future profits, produced by accounting adjustments alone. There was no actual cash coming in… [They] can be red flags to investors… To pad the hole, GE now began selling its receivables - bills its customers owed over time - to GE Capital in order to generate short-term cashflow, making it appear that those newfound profits were matched by cash flowing in the door.” Lights Out

“The SEC concluded its investigations into GE accounting practices, having found multiple instances of misbehaviour in the pursuit of financial targets. The company had overstated its earnings by hundreds of millions of dollars and stretched the accounting rules to their breaking point.” Lights Out

“The SEC described [GE as] a company that lied to investors in its regulatory filings and in its public statements, that ignored growing risks, and that worked to keep those risks hidden.” Lights Out

“Over the years, Charlie and I have seen all sorts of bad corporate behaviour, both accounting and operational, induced by the desire of management to meet Wall Street expectations.” Warren Buffett

Hitting Guidance

“What starts as an ‘innocent’ fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud. Playing with the numbers ‘just this once’ may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalise similar behaviour.” Warren Buffett

Acquisitions & Divestments

Immelt wanted to appease Wall Street and convince them to place a higher multiple on the stock. Historically GE had enjoyed a premium valuation providing the currency for accretive acquisitions. As GE Capital grew, a complex finance business within an industrial company, Wall Street applied a lower multiple. Immelt believed shrinking GE Capital would fix the problem.

“GE could use its unusually high price-to-earnings ratio for an industrial company as high-value currency to pay for deals. By acquiring companies with a lower price-to-earnings ratio, GE was getting an automatic earnings boost.” Lights Out

“Immelt needed to make moves that would finally impress upon Wall Street that he had found a way to lead the old GE into a new economic paradigm.” Lights Out

Capital Management

“GE had been sending cash out the door to repurchase its stock but wasn’t bringing in enough cash from its regular operations to cover its dividend.” Lights Out

“Buybacks were a regular fixture under Immelt, who spent more than $108 billion on them after 2004. At the end of 2018, GE’s entire market value was $67 billion.” Lights Out

Group Think

“The oversight role of the board was minimal.” Lights Out

“The board, made up of current and retired business executives and academics, as a group, liked Immelt and didn’t want to challenge him.” Lights Out

“Top GE executives, including Immelt, would say that they never heard any serious dissent about the Alstom deal.” Lights Out

“The absence of robust opposition [to the Alstom deal] also pointed to the broader problem, long cultivated and growing into a quiet crisis within the company of real candor and self-awareness. When it had come time for lower levels of management to stand up to the ultimate boss and tell him that his legacy play wasn’t going to work - and in fact, had been a clumsy mistake all along - no-one was willing to do so.” Lights Out

“Vice Chair John Krenecki, insiders said, had been forced out by Immelt, in part because he had already seemed a little too prone to disagreeing with the CEO or telling him no.” Lights Out

“GE’s board of directors was unquestionably weakened from having the CEO as the chairman of the Board.” Lights Out

“While Immelt said he encouraged debate, [Board] meetings often lacked critical questioning.” Lights Out

“The seventeen independent directors got a mix of cash, stock, and other perks worth more than $300,000 a year.” Lights Out

“[Board] directors rarely challenged Immelt.” Lights Out

“The [Board] directors had amassed impressive titles in their own career and in many cases undeniable achievement. They had resumes a yard long, most of them had personal fortunes, and they were presumed in all company to have unusually astute minds for business - not least because each one was a highly compensated director of GE. And yet, on their fiduciary watch, with whatever caveats about individual misjudgement and macroeconomic trends, they had done nothing to stop one of the world’s most solid industrial companies from lunging off a commercial cliff.” Lights Out

“Sycophants are the enablers of ethical collapse. Fear and silence are the enemies of an ethical culture.” Marianne Jennings

“If you arrange your organisation so that you basically have a bunch of sycophants who are cloaked in titles, you are going to leave your prior conclusions intact, and you’re going to get whatever you go in with your biases wanting. And the board is not going to be much of a check on that. I’ve seen very, very few boards that can stand up to the CEO on something that’s important to the CEO and just say, you know, ‘You’re not going to get it.’” Warren Buffett

Complexity

“Inside GE’s legendary management machine was a complex mechanism that used [GE Capital’s] deals to help the company meet its profit goals.” Lights Out

“GE Capital was always a problem. It was utterly complex and filled with risk, and its tentacles reached everywhere in the company.” Lights Out

“[The financial services] balance sheets were treacherously complex, and deep risks lurked there and were not always easily spotted in the quarterly profits and losses.” Lights Out

“[GE Capital was] essentially operating a high-powered hedge fund.” Lights Out

“Where you have complexity, by nature you can have fraud and mistakes.. This will always be true of financial companies. If you want accurate numbers from financial companies, you’re in the wrong world.” Charlie Munger

Cyclical Industries

GE ventured into the highly cyclical oil business with optimistic forecasts, little experience and no margin of safety.

“GE was going big into the oil business.” Lights Out

“Now GE became, in a series of high-dollar acquisitions, a player in the oil and gas equipment market virtually overnight.” Lights Out

“While Immelt heard, and was annoyed by, the chirping of some analysts who felt he’d paid a premium to leap into the oil and gas industry several years after his competitors, the company’s leadership was sure that the ensuing years would show the bet payoff.” Lights Out

“GE’s ‘base case’ assumption for all of the rosy pictures it was painting about its oil unit was $100 for a barrel of oil. Brent crude had closed out the previous month at more than $105 a barrel, only a little off its summer peak.” Lights Out

“Afloat on fracking profits during an oil boom, Lufkin had caught GE’s eye and been swallowed up at an expensive price, only to become a casualty when the conglomerate couldn’t abide the hit to earnings that a prolonged dip in the price of oil represented.” Lights Out

Insurance Tail Risks

“Everyone - reporters, analysts, investors - thought that the company had sold the insurance business long ago, significantly de-risking GE Capital. In often highlighting this point, Immelt and his top executives hadn’t minced words: GE was out of insurance.” Lights Out

“The core problem was that GE had made some bad decisions in reinsuring the long-term care policies.” Lights Out

“GE needed $15 billion to cover its liability.” Lights Out

"Virtually all surprises in insurance are unpleasant ones." Warren Buffett

“You can make big mistakes in insurance… You can make mistakes in something like insurance reserving, big time.” Warren Buffett

Bigger than Life CEO

Jeff Immelt almost personified the ‘bigger-than-life’ CEO. It’s a characterisation Marianne Jennings identified as another red flag for investors.

“Immelt knew the power of his influence, and he wasn’t above calling these subordinates [below the divisional heads] to make sure they knew the stakes and urge them to hit their targets.” Lights Out

“The structural component that fuels fear and silence and numbers pressure is the presence of an iconic CEO who is adored by the community, media, and just about anyone at a distance.” Marianne Jennings

Humility & Tone from the Top

“Immelt was required by the board to use only the company’s planes and was barred from flying commercial.” Lights Out

“Immelt, his good cheer notwithstanding, was not interested in hearing his judgement questioned. ‘My job is to make the company perform,’ Immelt told a newspaper reporter, ‘and my job is to make sure that nobody defines this company other than me.” Lights Out

“[Owning GE Capital meant] Immelt enjoyed having the accompanying seat at the table with Wall Street power players.” Lights Out

“Owning NBC gave Immelt and Welch access to red carpets.” Lights Out

“It had taken two corporate jets to take Jeff Immelt around the world. For much of his career [Immelt] often had an empty jet follow his GE-owned Bombardier or Gulfstream to far-flung destinations, just in case there was a mechanical issue that could lead to delays.” Lights Out

“No effort was spared by the staff to ensure that meeting venues were cooled to meat-locker temperatures to accommodate Immelt’s preference, irrespective of whether anyone had ever heard him make such a demand out loud.” Lights Out

“Was a CEO supposed to object that the temperature was not to his liking, or demand that elevators were always open and waiting for him? Or that the cold diet sodas he liked were always present on a sideboard when he entered a room, no matter how far-flung the visit or conference room he walked into?” Lights Out

“But GE has stood for well-bred hubris as well. Under Immelt, the company believed that the will to hit a target could supersede the math, even when hundred of thousands of livelihoods - those of investors, customers, and suppliers, to say nothing of workers, retirees, and their families - hung in the balance." Lights Out

Smart Investors

The emergence of a smart investor on the register is no panacea for investment success. Activist investor Nelson Peltz’s fund emerged with a $2.5 billion stake in 2015. Even the great investors make mistakes.

“Trian’s endorsement was the stamp of approval that Immelt thought would help others realise the full legitimacy of GE’s expected turnaround.” Lights Out

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

Summary

The ‘pressure to maintain those numbers’, a culture of ‘fear and silence’, a bigger-than-life CEO, and a weak board conspired against the investors of General Electric; red flags that stand firmly in the qualitative camp, not to be found in a spreadsheet.

These misdeeds aren’t unique or new to investing. After more than two decades of research and observation, Marianne Jennings identified each of them in her book, ‘The Seven Signs of Ethical Collapse.’ They didn’t go amiss at Berkshire either, given Munger and Buffett’s astute understanding of human behaviour.

History is littered with similar corporate disasters to GE. They serve as a warning for analysts, investors, portfolio managers, boards and CEO’s alike; Forewarned is forearmed. Understanding those qualitative tools that may suggest not all’s right with a company might help you ‘keep the lights on,’ when the next GE turns up.

“I think that many CEOs get carried away into folly. They haven’t studied the past models of disaster enough and they’re not risk-averse enough.” Charlie Munger

Source:
“Lights Out - Pride, Delusion and the Fall of General Electric,” by Ted Mann and Thomas Gryta, Mariner Books, 2020.

Further Suggested Reading:
“The Ten Commandments of Business Failure,” Investment Masters Class, 2016.
“The Seven Signs of Ethical Collapse - How to Spot Moral Meltdowns in Companies... Before It's Too Late,” Marianne Jennings, MacMillan, 2006.
“Avoiding Group Think,” Investment Masters Class, 2016.

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The Beauty of Stock Markets

Step right up, step right up! Welcome to the Stock Market Circus, an unruly bazaar that is absolutely chock full of brazen salespeople, fortune tellers, sham wealth remedies, high-frequency pirates, fallen angels, pigs with lipstick and much, much more. This is a place where crazy things can happen; stocks can take exponential leaps only to then crash and burn, companies that are here today can be gone by tomorrow, and perceived good news that usually brings higher prices might actually trigger shock selling. Its not a place for the faint-hearted; this Circus abounds with metaphors like death spirals, squeezes, collapses and crashes, none of which engenders feelings of security. And if you want to leave, the exits aren’t always big enough. For the uninitiated, this can be a truly scary place.

If you take a step back however, there is beauty to be found in this madness. You just need the right perspective. A few home truths, a grasp of history and an ability to filter out the noise can go a long way to help investors in this respect. Let’s dive in…

Silly Prices

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

Buffett likes to remind us that on occasion you will get silly prices in the stock market. That’s the beauty of it. Silly prices are often the result of emotionally charged behaviour rather than anything fundamental. The market’s ease of access and low cost of transacting encourages quick action, hence turning the psychological short cuts that saved our ancestors on the savannah into an impediment to investment success.

When we’re fearful, we look to other people for guidance. Yet, the truth of the matter is they’re just as likely to be acting on their own fears; reacting emotionally rather than rationally.

When you throw in the dominant quantitative and passive funds of today, who’ve no idea what they own and are triggered by price movements, you’ve got a recipe for significant mis-pricing - stock prices become untethered from business value. For those who are able to keep their cool during these situations, opportunity abounds.

"The stock market will offer you opportunities for profit, percentage-wise, that you’ll never see, in terms of negotiated purchase of business." Warren Buffett

“Research has shown that over the last century, U.S. stock prices have been three times more volatile than fundamentals.” Frank Martin

“We believe that shares spend relatively little time at ‘fair value’. Rather, lengthy periods of overvaluation are followed by lengthy periods of undervaluation… Extreme valuation spreads in the equity market aren’t necessarily rare or short-lived.” Marathon AM

Nick Sleep of Nomad Partners recognised that over time, all businesses can be meaningfully mis-priced.

“We can all observe that stock prices, set in an auction market, are more volatile than business values. Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mis-priced.” Nick Sleep

An analysis by John Huber at Saber Capital highlights this point. Mr Huber shows the average intra-year difference between the high and low of the ten largest stocks in the S&P500 in 2019 was a staggering 44%! [and people talk of an efficient market?]

“Stock prices move much more than true values do even in the largest stocks, which by definition causes mis-pricing at times. This isn’t due to a lack of information, it’s simply good old-fashioned human nature, and unlike the price of semiconductors or the value of information, human behaviour is not going to change. The biggest edge is in understanding this simple concept, and then being prepared to capitalise on it when it’s appropriate.” John Huber

Source: Saber Capital Letter Q3 2019.

The opportunity conferred by extreme price volatility isn’t lost on the Investment Masters. In many ways, the great investors are arbitrageurs of human nature.

Stock Markets Compound

The long-term history of the US stock market is one of rising prices. A key contributing factor to a rising stock market has been the earnings retained by corporates that are re-invested for the benefit of shareholders.

“Equities can compound in value in a way that investments in other asset classes, such as bonds and real estate, cannot. The reason for this is quite simple: companies retain a portion of the profits they generate to re-invest in the business.” Terry Smith

“To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker - John Maynard Keynes, who in 1925 reviewed the book, ‘Common Stocks for Long-Term Investment’, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith's most important point ... and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest operating in favour of a sound industrial investment.’ It was that simple. It wasn't even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn't thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings--and dividends, too.’" Warren Buffett

“In the 1920’s, a brilliant and important book by Edgar Smith, ‘Common Stocks for Long-Term Investment’, became a prime market influence. It was still popular in the fall of 1929, but most people read it too late. Mr. Smith advocated the benefit to corporate growth of the application of retained earnings and depreciation. Thus capital appreciates. The book may have been influential in changing accepted multiples of 10 x earnings to higher multiples of 20 to 30 x earnings.” Roy Neuberger

“Retained earnings have propelled American business throughout our country’s history. What worked for Carnegie and Rockefeller has, over the years, worked its magic for millions of shareholders as well.” Warren Buffett

While markets can be volatile, the returns achieved by corporate America have remained remarkably consistent. Free trade, an entrepreneurial spirit and continuous innovation have been the hallmarks of America’s success.

“Historically, US companies increase their profits by about 6-7% per year and pay a dividend of around 2%. This generates an annual return of 8-9% from simply owning a solid group of companies.” Francois Rochon

“Anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.” Warren Buffett

“The S&P 500 produces 12% or 13% returns on capital and it retains and reinvests about half of its earnings, and so that should generate 6% or 7% earnings growth over the long run. Then the rest of the earnings can be returned to you as dividends and share repurchases. If you can get 6% earnings growth in the long run, plus a couple percent from dividends and buybacks, then you're going to achieve a high single digit rate of return by owning that asset class in the long run. Obviously, it's going to be very lumpy, but if you have a long term, 10-year plus time horizon, that is the rate of internal compounding that I think American business will continue to achieve over time.” John Huber

Attractive Long Term Returns

Over the long haul the stock market has delivered attractive returns. While the Saber Capital table above makes clear the potential for short-term volatility, the potential for loss diminishes with time. Certainly that’s been the case in history.

The chart below highlights that over the last c150 years, investors who’ve taken a twenty year view have earned positive returns 100% of the time.

“The historical odds of making money in U.S. markets are c50/50 over one-day periods, 68% in one-year periods, 88% in 10-year periods, and (so far) 100% in 20 year periods.” Morgan Housel

Source: Collaborativefund.com - Morgan Housel.

Not only have investors been blessed with positive returns a good majority of the time, those returns have ordinarily been pretty solid. For context, in the last one hundred years the worst 25-year return in the market was four times capital. More generally, it’s been twelve times or more.

“You want to remind people that the worst 25-year period in the past 100 years was a 4-times return on their capital. Typically, a 25-year investor gets 12 times return or more. So, to me, being able to share that message with our younger analysts, with our shareholders and potential shareholders helps me keep it together when stocks are behaving differently than we anticipate they would.” Bill Nygren

Even stock market crashes fade over time. The worst percentage fall in stock market history, the 1987 crash, is a blip on the long term chart [see below]. What a wonderful friend compounding has been for the long term investor.

Dow Jones Industrial Average - 1987 Crash [Source; Bloomberg].

Asymmetric

It’s been found that humans find symmetrical patterns more attractive than asymmetrical ones. When it comes to the stock market however, it’s the asymmetry that beautiful. When you invest, the most you can lose is 100% of your capital yet the opportunity exists to make multiples of your investment.

“The asymmetric payoff structure (you can make far more if you’re right about a stock than you can lose if you’re wrong) is the fundamental attraction of investing in equity markets.” James Anderson

“One of the interesting dynamics of buying stock in a company is that our downside is known. In the worst case, we can lose 100% of our investment. In the best case, we can make many multiples of our original investment.” Scott Miller

Long Term Gains

To harness the market’s beauty you need to be invested. Sitting on the sidelines won’t earn returns. While short term market moves can be volatile, history has shown investing in high quality businesses has been a winning strategy over the long term.

“I think that this time would be as good as any other time or as bad as any other time. I have been at this business for 40 years now, so I have been through all kinds of times. That’s a long time to be at one trade, and I have done it every day. I couldn’t tell you that I knew any particular day, whether it was today or 10, 15, 20 or 40 years ago that actually would have been the right day for someone to invest. The right thing to do is to enter the investment scene, whether you are just an individual investor, someone who might be approaching it on a career basis, or a professional investor already working to hone your skill set.” David Polen

“All I can tell you as an increasingly experienced investor, is that I have never known a time when people weren’t worried about the sort of issues that you adduce and those people that spent too much time worrying about those issues, didn’t get invested and missed out on a opportunity to protect their wealth against inflation and indeed, to growth their wealth in real terms. So the rational way to deal with these sports of concerns, it may not be the correct thing, but the rational thing is to ignore them and be invested in fine businesses.” Nick Train

“The stock market goes up over time. Developed markets should increase by around 6% p.a. over long periods of time, implying a double every 12 years, a quadruple every 24 years, and so on. If you have a 40 year plus time horizon and an investment opportunity that will go up 8-fold, how much is there to think about? The smart money is invested, not on the side-lines fretting about what to do.” Robert Vinall

Get Rich Slowly

Compounding’s power reveals itself over time. While short term gains may look small, with time they mushroom. You don’t need to hit the ball out the park every year to build long term wealth. In fact, doing so, may increase the risk of losing capital. And losing capital is what impedes compounding. While everyone wants it all today, the world’s best recognise the beauty in getting rich slowly.

“At the beginning of the AGM of the Berkshire Hathaway Company they show this little video and each year Buffett is asked what’s the main difference between himself and the average investor, and he answers patience. And there is so little of it these days. Has anyone heard of getting rich slowly?” Nick Sleep

“The biggest thing about making money is time. You don’t have to be particularly smart you just have to be patient.” Warren Buffett

"The desire to get rich fast is pretty dangerous.” Charlie Munger

“People would rather be promised a (presumably) winning lottery ticket next week than an opportunity to get rich slowly.” Warren Buffett

“Ninety-nine percent of investors shouldn’t try to get rich too quickly; it’s too risky. Try to get rich slowly.” Sir John Templeton

“Small investors who get into trouble, I think, are those who try to get rich quick. They are in and out of the market in a flash and don’t take the time to learn. That’s a dangerous game.” Roy Neuberger

"In investing, time is your friend. The people who make a lot of money in investing are those that buy great businesses, in our case with expanding moats, and they give them time to work for them over 5, 10 and 15 year pulls. All the people that have created a lot of wealth for themselves didn't do it in a week, or 3 months or 6 months. They did it over a generation." Paul Black

“A good summary of investing history is that stocks pay a fortune in the long run but seek punitive damages when you try to be paid sooner. Virtually all investing mistakes are rooted in people looking at long-term market returns and saying, “That’s nice, but can I have it all faster?” Morgan Housel

Summary

On any given day it’s pretty much a coin toss what markets will do, and because of it you must be able to brace yourself for volatility. It’s a function of human nature and that’s not going to change anytime soon. Discard the received dogma that volatility is risk. While most business schools trumpet this notion, the great investors have recognised the beauty in volatile prices - they can present attractive entry points which ordinarily don’t surface in most markets. Little wonder these Investment Masters consider volatility as the friend of the long-term investor.

While there’s little sense to be made in the daily sound bites and market gyrations, as time expands, the markets longer term beauty reveals itself. Companies values compound and together cause markets to rise. You just have to lengthen your perspective to see it.

Whilst we’ve covered some of the attractive features of the stock market, I’m sure you can think of plenty of others; accessing the world’s best management teams, the ability to work from remote locations, not having a boss - there’s plenty more. Successful investing requires the right attitude, perspective and planning; manage your emotions, recognise and respect the power of compounding and exercise patience.

The market has a history of attractive long term returns; all you need to do is step back to see it’s beauty.

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Beyond Investing

In 2014, the Nomad Investment Partnership was it, and their last few years of returns were nothing short of astonishing. A 2012 return of 39.8% trumped the MSCI’s 15.8%, and a year later, Nomad clocked up a staggering 62.2% return, decimating the MSCI’s 26.7%. Indeed, in four of their last five years Nomad delivered returns of 40% or more. Without a doubt the partnership founders, Nick Sleep and Qais Zakaria were at the top of their game. Still young, in their mid-40’s, they possessed a magnet for capital via their track record of 20%+ annualised returns. The opportunity to raise billions of capital was there for the taking. Yet, after two decades of investing and fourteen years running Nomad, Sleep and Zakaria decided it was time to hang up their boots. They’d achieved their ‘X-amount’. For them, it was time to move beyond investing.

From the early days, Sleep and Zakaria had mused over a concept they referred to as the ‘X-amount’. This was an amount of money they deemed necessary to pay the bills and have a nice lifestyle. Beyond which, they felt the surplus funds could be an anchor, stripping meaning from their lives by distorting relationships with friends and family and encouraging an indulgent existence.

Like many of the Investment Masters, Sleep and Zakaria recognised the good fortune afforded to successful investors, and took it upon themselves to direct their excess gains towards charitable causes. Both established foundations which continue to benefit from their investing prowess; almost six years on from closing Nomad to external capital, the fund has achieved an average twenty percent return for twenty years.

There is certainly more to life than investing. Caring for the environment, supporting society and helping others less fortunate helps make the world a better place. The rewards of investing are often non-linear, rarely are they commensurate with the commitment, dedication and work required to achieve them. They are unique to the world of investing and with thoughtful application they can support the foundations of a better world.

“My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mis-pricing of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.” Warren Buffett

“Investors can think their way to success without seeming to work in the traditional sense and the payoff in capitalism from stock picking can be extraordinary.” Nick Sleep

One of my favourite sayings is, ‘You can’t take a pin with you.’ Money won’t deliver happiness. Meaning will, however, and many of the world's greatest investors have recognised this. Below are some of the random musings I’ve collected over the years.

Giving Pledge

In 2010, Bill and Melinda Gates and Warren Buffett created the Giving Pledge, a movement of philanthropists who’ve committed to giving the majority of their wealth to philanthropy or charitable causes, either during their lifetimes or in their wills. In addition to Buffett, many of the Investment Masters have also signed the pledge, including Ray Dalio, Paul Singer, Paul Tudor Jones, Chris Hohn, Bill Ackman, Jim Simons, Mario Gabelli, Seth Klarman, Jeremy Grantham, Ken Langone, David Rubenstein, Tom Steyer, T. Boone Pickens and Julian Robertson.

It’s quite possible Warren Buffett will be remembered more by his philanthropic endeavours than his investing acumen.

“Gifting to Bill Gates his wealth to take on, that was the greatest achievement of Warren Buffett. He’s respected as an investor, but he should be more respected as a philanthropist.” Chris Hohn

Life Lessons

Studying the world’s greatest investors offers not just lessons in investment but lessons for living a successful and fulfilling life. While Buffett is beyond rich, he chooses to reside in a house purchased in 1958 for $31,500, whose value today reflects less than 0.001% of his wealth. Buffett’s favourite restaurant is the low-key local Omaha steak diner, Gorat’s, while his favorite meal remains a burger washed down with a can of Coke.

“I think it’s also probably surprising to people that the money doesn’t matter to him. He made the money sort of by accident because he was really good at doing what he loved, and when you do that particular thing really well, you end up with a whole bunch of money. But it’s really true that he does not care about having a bunch of money.” Susie Buffett [Warren’s daughter]

“When I look at a bunch of stock certificates in a safe deposit box that were put there 50 years ago or so, they have absolutely no utility to me; zero. They can’t do anything for me in life. I mean they can’t let me consume 7,000 calories a day instead of 3,000. There’s nothing they can do. I’ve got everything in the world I want, and I’ve had it for decades. If I wanted something additionally, I’d go buy it.” Warren Buffett

“I could have 10 houses, but, you know, I could buy a hotel to live in, you know. But would I be happier? It would be crazy. Charlie and I both like fairly simple lives.” Warren Buffett

Purpose

People need purpose and meaning in life. One of my favourite books, ‘Man’s Search For Meaning’ was written by Viktor Frankl, a survivor of the Nazi concentration camps. His experience at Auschwitz reinforced a key idea: life is not a quest for pleasure, but a quest for meaning. The greatest task for any person is to find meaning in his or her life.

Frankl’s insights are echoed in the empowering stories of James Stockdale and Eddie Jaku. Stockdale was a vice admiral in the US Navy who endured seven and a half years as a Prisoner of War - tortured, isolated in solitary confinement and restrained in leg irons - after being shot down above North Vietnam. Eddie Jaku, also a holocaust survivor, endured seven years of unimaginable horrors across Nazi concentration camps in World War II.

While each of their stories was forged in the extremes of terrible suffering, they highlight a common theme - mankind’s need of purpose.

Inheritance

Without purpose, one’s life lacks meaning. Most people cherish the idea of inheriting a fortune, yet there can be a ‘dark side of wealth’. Another favourite book is ‘Fortune’s Children - the Fall of the House of Vanderbilt.’ In 1877, Cornelius Vanderbilt was the richest man in the world. Fifty years after his death, one of his direct descendants died penniless, and no Vanderbilt was counted among the world’s richest people. The story recounts an extravagant lifestyle of spending by his heirs but also the misery, burden and loneliness that inherited wealth can inflict. By his early sixties, Vanderbilt’s son confessed to his family..

“The care of $200,000,000 is too great a load for my brain or back to bear. It is enough to kill a man. I have no son whom I am willing to afflict with the terrible burden. There is no pleasure to be got out of it as an offset - no good of any kind. I have no real gratification or enjoyments of any sort more than my neighbour on the next block who is worth only half a million. So when I lay down this heavy responsibility, I want my sons to divide it, and share the worry which it will cost to keep it.”

This hasn’t gone unrecognised by many of the world’s most successful investors and business owners.

“I think Kay Graham was quoting her father at the time but — some years back as saying, ‘If you’re quite rich, probably the idea of leaving your children enough so they can do anything, but not enough so they can do nothing, is not a bad formula.’” Warren Buffett

“If you have a lot of money, giving all your money to your kids is a mistake which will deprive them of self-achievement. I’ve given my kids a reasonable sum of money. One made it all on his own, one needed it because he’s a scientist, didn’t make a lot of money, but I wouldn’t give all my money to my kids, it’s just so damaging.” Leon Cooperman

“You can always give all your money to your children, but usually people who inherit great sums may not be as productive citizens as people who don’t inherit as much.” David Rubenstein

“I’m not a big fan of inherited wealth. It generally does more harm than good.” T. Boone Pickens

"My children are in a privileged position. I am willing to give them enough help to do something, but I am not willing to give them enough help to do nothing. Because it would destroy them." Terry Smith

“Do you really want your children to be like those who thought themselves your betters while you struggled? Letting them have too much money is really a lot worse than letting them have too little. I've watched family after family destroyed by excessive distributions to descendants, and by family patriarchs' and matriarchs' attempts to be able to control others' behavior from the grave. With wealth comes power. With power comes the ability to damage. Gifts and inheritances influence those you love most. Inheriting too much money at one time destroys initiative, distorts reality, and breeds arrogance. When the money runs out - as it always does - those left bereft of cash can't cope.” Michael Bloomberg

“We will make sure we’ve given most of our money away by the time we die, with the exception of what we leave to our kids. We want to pass along enough for them to live reasonably well, but not so much that they can do anything foolish with it. We want them to have a roof over their heads, but we also want them to have the meaning in their lives that comes from having to make their own way.” Ken Langone

“Why should men leave great fortunes to their children? If this is done from affection, is it not misguided affection? Observation teaches that, generally speaking, it is not well for the children that they should be so burdened.” Andrew Carnegie

“Inherited wealth is as certain a death to ambition as cocaine is to morality.” William Vanderbilt

Possessions

We live in a society that encourages consumption and materialism. Keeping up with the Jones’ has been a long held ambition of many. The sad truth of this matter is that it’s impossible to keep up; when everyone is striving for more, there is no finish line and the race is eternal. Personal possessions will only keep accumulating over time.

“Possession’s don’t bring anybody happiness and most people don’t believe it until you experience it. Your possessions in many ways can become burdens.” James Dinan 

“Money is a wonderful commodity to have, but the more one possesses, the more involved and complicated become his dealings and relationships with people.” John P Getty

“We should have guys like Sir John Templeton, Warren Buffett, Charlie Munger as examples to all of us. The legacy of these men should be the focal point of our lives because it doesn’t take long to realize that money buys nothing of value. Everything that is truly worthy is free. That lesson comes hard to some people, but the sooner it comes, the better.” Frank Martin

“Some material things make my life more enjoyable; many, however, would not… Too often, a vast collection of possessions ends up possessing its owner.” Warren Buffett

“The first thing you could do [with money] is you could pleasure yourself. You could buy a plane, you could buy cars, you could buy homes, you could buy art. If you’re an art collector you never have enough money because you can spend $100 million on one canvas. I don’t collect art and I happen to have a view that material possessions brings with it aggravation. I’m a less is more kind of guy.” Leon Cooperman

Health

This one speaks for itself. There’s no such thing as the richest man in a graveyard, so you better ensure you look after yourself while you’re alive.

“A healthy man wants a thousand things, a sick man only wants one.” Confucius

“Stay fit. You don’t want to get old and feel bad. You’ll also get a lot more accomplished and feel better about yourself if you stay fit. I didn’t make it to 91 by neglecting my health.” T Boone Pickens

"You get exactly one mind & body in this world & you can't start taking care of it when you're 50. By that time you'll have rusted out if you haven't done anything. You should really remember you've got just one mind & body to get through life with & do the most with it." Warren Buffett

Time is Money

Time is one of those rare finite resources. We only get so much of it, and regardless of how much money we have, we can’t buy more. So it becomes infinitely more valuable than any possession or trinket.

“If you asked me to trade away a very significant percentage of my net worth, either for some extra years in life, or being able to do, during those years, what I want to do, you know, I’d do it in a second.” Warren Buffett

“Many times over the years, I was fortunate enough to speak at student commencement ceremonies, and that gave me the chance to look out into a sea of the future and share some of these thoughts with young minds. My favourite of these speeches included my grandchildren in the audience. What I would tell them was this Depression-era baby from tiny Holdenville, Oklahoma — that wide expanse where the pavement ends, the West begins, and the Rock Island crosses the Frisco — lived a pretty good life. In those speeches, I’d always offer these future leaders a deal: I would trade them my wealth and success, my 68,000-acre ranch and private jet, in exchange for their seat in the audience. That way, I told them, I’d get the opportunity to start over, experience every opportunity America has to offer.” T. Boone Pickens

Last year, I was saddened by the loss of Jon Boorman, who died of cancer. I didn’t know Jon but I enjoyed his financial posts on twitter. He seemed to have his priorities right. He wrote this before he was diagnosed with cancer. He was a real stoic.

“When you’re young, you have so much time but never enough money. When you’re old you have money but never enough time. How you perceive and value time and money will change many times throughout your life, but at the end there’s only one you’ll want more of, would give anything for, but it won’t be available at any price. Cherish it while you can.” Jon Boorman

Pleasure

Many of the Investment Masters have chosen to give away their money while they are alive. Helping others gives pleasure and investors can direct the funds where they feel they’re most needed.

I enjoyed a recent Forbes article, ‘The Billionaire Who Wanted To Die Broke . . . Is Now Officially Broke’ which recounts the story of Chuck Feeney, the former billionaire co-founder of retail giant Duty Free Shoppers, who pioneered the ‘Giving While Living’ approach while donating over $8 billion to worthwhile causes.

“I see little reason to delay giving when so much good can be achieved through supporting worthwhile causes. Besides, it’s a lot more fun to give while you live than give while you're dead.” Chuck Feeney

Many of the Investment Masters have chosen a route similar to Chuck Feeney.

“You know, I get a lot of pleasure out of doing these things and if I didn’t do them and I died with more money, would I be a happier person? I don’t think so.” David Rubenstein

“Hopefully, we would live long enough to also see the consequences of our [charitable] actions; we would have to eat our own cooking, as it were. Previous generations that retired in old age and died soon after, have not always had that opportunity.” Nick Sleep

“Over the years, the emotional and psychological returns I have earned from charitable giving have been enormous. The more I do for others, the happier I am. The happiness and optimism I have obtained from helping others are a big part of what keeps me sane.. I get tremendous pleasure from helping others. It's what makes my life worth living.” Bill Ackman

“Philanthropy has had a huge role in my life. It’s brought me great joy. I give money away because I love the joy of watching lives change and being able to shape things. I don’t feel guilty about the money I made but I do think it’s strange that I’ve gotten the financial remuneration I have versus a doctor. If I can take that money and raise the the prospects for the American Dream in underserved neighbourhoods, provide scholarships or work on the environment it just brings great joy.” Stanley Druckenmiller

“When we make charitable gifts, we almost always feel richer, not poorer, for having been given the opportunity to help.” Seth Klarman

“We find the execution of our philanthropic work to be both challenging and deeply satisfying.” Jim Simons

“We think it is true that, once past X-amount, real meaning comes with reinvesting in society through charitable giving, which can also be a thoughtful, challenging, wonderful adventure, but with the added bonus that it feels like the world working properly.” Nick Sleep

A desire to donate through their lifetimes is the recognition that problems can sometimes compound faster than capital.

“Our current expectation is that within the constraints of the vagaries of fate, we will spend down most of our philanthropic assets in our lifetimes. One key observation is that society’s problems seem to be compounding as fast as or faster than wealth can compound, suggesting a greater urgency to current funding.” Seth Klarman

After Life

“I realised how rich I had become and I asked myself, ‘Do I really want to be the richest person in the cemetery?’” David Rubenstein

“There’s no Forbes 400, you know, in the graveyard.” Warren Buffett

Summary

The exponential pay-off unique to the investment industry can afford it’s most successful practitioners the capability to make a difference in the world. While every successful investor takes their own approach, there are lessons that can be drawn that relate to not just investing, but leading a more fulfilling life.

Investing is only a small piece of the pie.

Charlie Munger, with his 97 years of accumulated wisdom, teaches us in his characteristically shrewd way that a successful life requires stretching beyond investing.

“If all you succeed in doing in your life is to get early rich from passive holding of little bits of paper, and you get better and better at only that for all your life, it’s a failed life. Life is more than being shrewd at passive wealth accumulation.” Charlie Munger

“If you’re good at just investing your own money, I hope you’ll morph into doing something more.” Charlie Munger

Leon Cooperman encapsulated this nicely in his letter to the Giving pledge:

“I feel it is our moral imperative to give others the opportunity to pursue the American Dream by sharing our financial success. The case for philanthropy has been stated by others in a most articulate way and in words that have impressed me: In the early 1900's Andrew Carnegie said "He who dies rich, dies disgraced." In the 1930's, Sir Winston Churchill observed that "We make a living by what we get, but we make a life by what we give." In 1961, President John F. Kennedy in his inaugural address stated "Ask not what your country can do for you, ask what you can do for your country." Well before all these gentlemen expressed their thoughts, it was written in the Talmud that "A man's net worth is measured not by what he earns but rather what he gives away." Leon Cooperman

The idea of being able to answer the question of, ‘What’s enough?’ remains anathema to many. But not to these few altruistic investors who like Sleep and Zakaria, have determined their X-amount and chosen to pursue more meaningful lives beyond investing.

Sources/Further Reading:
‘X-Amount’ - The I.G.Y Foundation. Nick Sleep & Qais Zakaria. 2021.
‘The Giving Pledge - A Commitment to Philanthropy.’
‘The Billionaire Who Wanted To Die Broke . . . Is Now Officially Broke.’ Steven Bertoni, Forbes. 2020.
‘The Billionaire Who Wasn’t - How Chuck Feeney Made and Gave Away a Fortune Without Anyone Knowing,’ Conor O’Clery, 2007.

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Founders & Management Alignment

If you’ve ever founded your own business, you’ll know how important they become to you. For many business owners, their companies become like one of their own children; they nurture and guide them and then watch them grow, and feel every triumph and failure far more keenly than others who are not as emotionally invested within the business might. Some few decide to sell their businesses after a while, yet many others choose to stay with them, remaining with their ‘child’ over time to see it grow to maturity.

I’m sure you’ve heard the saying, ‘no one works as hard as the owner’, and this is largely true. No one does. Where other managers and employees might come and go over time, it’s the founder who is there, quite often seven days a week, plugging away at their enterprise, steering and guiding and leading it towards success. And its this commitment to the cause that often leads to remarkable levels of performance.

We’ve covered a lot of different successful businesses in the Investment Masters Class over the last few years: Aldi, Home Depot, Walmart, Copart, Charles Schwab and McDonald’s to name but a few. And interestingly, one of the most striking features of these businesses has been the fact that ninety percent of them have been run by Founders.

You may have also noticed yourself that many of the investors considered ‘Masters’ have quite literally filled their portfolios with companies run by either founders, families or major shareholders who act like such; Berkshire, Nomad, Giverny, Baillie Gifford, Marathon and Gardner Russo are some that come to mind.

“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.” Nick Sleep

“Sixty-plus percent of my investments at the moment and most of the past decades have been invested in family-controlled companies, which is quite unusual, and it has given us a slightly interesting benefit that to most investors, family-controlled companies suggest more risk, not less risk.” Thomas Russo

“Almost ninety percent of the portfolio is invested in firms run by founders or the largest shareholder, and their average investment in the firms is just over twenty percent of shares outstanding.” Nick Sleep

“The attractions of [founding] shareholder structures explain why companies that enjoy them form nearly 60 per cent of the International Alpha portfolio.” Baillie Gifford

And the reason for this is quite simple. Over time, businesses with aligned management have tended to produce some of the best stock market returns. There’s a myriad of explanations for this. Let’s delve a little deeper.

Outperformance

Numerous studies have shown that companies with a long term founder at the helm have outperformed. A 2012 study by the Harvard Business Review titled, ‘What You Can Learn from Family Business’ highlighted, ‘when we looked across business cycles from 1997 to 2009, we found that the average long-term financial performance was higher for family businesses than for non-family businesses in every country we examined.’

“Studies such as the one from the Harvard Business Review conclude that founder-led businesses often outperform professionally managed firms. I would suggest that they do so because the founder's commitment runs far deeper and is often longer-term in nature than that of the professional manager. And commitment and focus is what drives performance." Ron Shaich, Founder, Panera Bread.

The Credit Suisse Research Institute have made similar findings. Using its proprietary ‘Family 1000’ database of more than 1000 publicly listed family or founder-owned companies, Credit Suisse has identified that since 2006, the overall universe of ‘Family-owned businesses’ have outperformed non-family-owned companies by an annual average of 370 basis points.

Research by Baillie Gifford concurs, “Our own research suggested that businesses where a family or founder owned more than 10 per cent outperformed by 3.4 per cent per annum over a fifteen-year period.”

Trust

Money managers effectively pass stewardship of their client’s capital to the management of the companies they invest in. And as it’s never possible to know everything going on inside a company, it’s paramount they trust management. A useful method to help ascertain management integrity is to study the course of a company’s history - reading every company announcement over the last five plus years until today - soon gives you an understanding of management’s achievements versus their goals. You’ll also get a sense of director behaviour through their buying and selling activity.

“When you choose to invest with us on behalf of your clients, you’re subcontracting their capital to us to look after. The reality of this process is we subcontract it to the management of companies. Therefore, seeing they think what we regard as sensible about things is a very important sign.” Terry Smith

“Our job is to pass custody of your investment over at the right price and to the right people.” Nick Sleep

“In effect, we subcontract our portfolio to the boards and managers of the companies in which we invest.” Andy Brown

If you don’t trust management, then don’t invest.

“If there is a serious question of the lack of a strong management sense of trusteeship for stockholders, the investor should never seriously consider participating in such an enterprise.” Phil Fisher

"We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business." Warren Buffett

Incentives

In his 97 years, Charlie Munger has studied incentive-driven behaviour more than most. Yet, even he still feels he under-estimates it.

“I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it.” Charlie Munger

A company founder’s incentives are usually in stark contrast to those of a professional management team. A large ownership stake in the business means a founder’s wealth is far more influenced by longer term valuation improvements than a salary. In contrast, a CEO with little skin-in-the-game may be tempted to undertake accretive short term acquisitions or minimise capex & investments to achieve short term remuneration hurdles, even to the detriment of long term value creation.

"A CEO faced with 4 years at the helm with financial incentives is unlikely to act in the same way as an owner-manager with a multi-generational timescale." Marathon Asset Management

"All else being equal, favour companies in which management has a significant personal investment over companies run by people that benefit only from their salaries." Peter Lynch

"If the CEO owns $1 million worth of stock and gets paid $10 million per year, it’s pretty clear he’ll value his job more than the value of the stock. If he’s paid $1 million per year and owns $50 million in stock, we think that’s predictive of his making better long-term decisions for the company... Where the founder owns 20-30% of the business... they’ll work with Wall Street because they don’t completely control the company, but at the same time they can take a longer-term perspective. CEOs with tons of options rather than actual shares can be prone to adopt Wall Street’s short-term focus, which can cause value to be eroded more quickly than you’d think as one bad decision piles on top of another." Adam Weiss

“Many corporate CEOs have very low levels of genuine ownership in the firms they manage and are incentivised primarily on short-term earnings-per-share targets or share price movements. These sorts of incentive schemes do not engender long-term thinking.” Baillie Gifford

"A guy who rises to the top of a big corporation and owns none of it is much more interested in control than he is in economics. It is just the nature of humanity. A guy who owns his business is used to control. He never has to fight for control. What he has to fight for is economics. But a bunch of entrepreneurs find it much easier to collaborate and create economic value. They have something beyond control—they have economics.” John Malone

Principal-Agency Problem

The incentive misalignment is often referred to as the principal/agency problem; what’s in the best interest of the CEO may be detrimental to the shareholders. The presence of a founder can resolve this dilemma.

“As ownership increases agency costs fall. And like any cost, a sustained fall increases profitability and the value of firm. This effect is born out in our experience and numerous academic studies, dating as far back as the late 1980’s. This relationship between inside ownership and outcomes is not only positive but potentially meaningful. For example, Christoph Kaserer and Benjamin Moldenhauer correlated a 1 per cent increase in inside ownership with ~10 basis points per annum increase in share price performance.” Baillie Gifford

“Insider ownership has always seemed to us as the most direct way to deal with the principal-agent problem, which arises with the separation of corporate management from ownership. Our portfolios have tended to be skewed towards companies where successful entrepreneurs run their companies and retain sizeable shareholdings.” Marathon Asset Management

“The issue of alignment of interests is one of the great challenges of modern-day capitalism. Strong governance structures, well-devised remuneration schemes and large management shareholdings can help, but one of the best ways to overcome this challenge is simply to invest alongside the founders of a business or their descendants. When founders move on, substantial equity ownership by their descendants can still have significant beneficial effects." Baillie Gifford

Passion versus Pay

The most profitable businesses tend to be those focused on delivering a customer outcome, not the most profit-orientated. Founders often bring a passion to the business absent from that of professional managers. They are building a legacy, which requires long term thinking. Buffett himself is a good example; Berkshire pays him a salary of $100,000 a year; he resides in the same house he bought in 1958. Berkshire is his canvas. In the insightful book, Obliquity, John Kay observed, “Many of the businesspeople who talk obsessively about profit are ultimately less successful in creating profit than those who profess love for their business.”

“The best entrepreneurs we know don’t particularly care about the terms of their compensation packages, and some, such as Jeff Bezos and Warren Buffett have substantially and permanently waived their salaries, bonuses, or option packages. We would surmise that the founders of the firms Nomad has invested in are not particularly motivated by the incremental dollar of personal wealth… These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages their compensation committees have devised for them. The point is that financial incentives may be necessary, but they may also not be sufficient in themselves to bring out the best in people.” Nick Sleep

“One thing that Sam Walton and Mrs. B had in common is they had a passion for the business. It isn’t all about the money, at all. It was about winning. Passion counts enormously; you have to really be doing it because you love the results, rather than the money. When we buy businesses, we are looking for people that will not lose an ounce of passion for the business even after their business is sold.” Warren Buffett

“I always look to invest in a manager who has made the company his or her life’s work.” Robert Vinall

“A majority of our managers are financially independent, so that they don’t go to work because they are worried about putting kids through school or putting food on the table. So they have to have some reason to go to work aside from that.” Warren Buffett

“What matters most: passion or competence that was inborn. Berkshire is full of people who have a peculiar passion for their business. I would argue passion is more important than brain power.” Charlie Munger

“We’ve had terrific luck with the entrepreneurs who basically love their businesses the way I love Berkshire.” Warren Buffett

“I’ve spent a lot of time thinking about factors that influence the long-term success of a business, and I think firms (public or private) that are run by the founders often have a huge intangible quality to them - one that is crucial to the firm’s ultimate success. This intangible quality is that the founder is often motivated by much more than money. And that is a driving force that can be incredibly powerful, and incredibly valuable for the owners of those firms.” John Huber

Tone from the Top & Culture

This aspect is really quite simple, yet despite its simplicity, its often underestimated or even overlooked altogether. And it is vastly important to the success of any organisation. Higher management set the tone for any organisation. What this means is that when you think of a company’s culture, in its simplest form it is actually derived from the values and behaviour(s) of either the founder/owner or the combined personality of the management team.

And those behaviours of passion and commitment and love for the business are always going to be far more evident in a company that is run by a Founder, than that run by a professional manager or team.

“A company’s behaviour is an analog of its leadership’s behaviour, much as a marionette’s behaviour is an analog of the puppeteer’s hand motions.” Rajenda Sisodia

“Costco’s founder, Jim Sinegal owned a lot of shares but never made more than $300k a year. How different is that from other company's where the CEO is making $20, $30, $40m or gets fired and gets a $200m golden parachute? That doesn't usually bode well for the long term cultural success of the firm." Paul Black

“We’ve bought business after business because we admire the founders and what they’ve done with their lives. In almost all cases, they’ve stayed on, and our expectations have not been disappointed.” Charlie Munger

Lower Capital Requirements

Investors often give little consideration to the capital required to grow a business. One of the attractions of businesses owned by founders, or in an industry where a founder-led business thrives after decades, is the ability for a company to self-fund growth without calling upon external capital.

“We are the Groucho Marx of investment. Groucho Marx once said he would never join a club that would have him as a member. We would never invest in a company that needs our money. All the companies we invest in are quoted but the companies are not quoted on the stock market because they need our money. Why are they quoted? They are typically quoted because they were once family-owned, and when family’s become dispersed a realization has to happen. When we are looking at a sector and we are thinking of investing in it, we look for a big private company in that sector, that’s been around for many decades, if not longer and has never had to float. Which means we know in that sector companies can grow and prosper and create value without ever ringing up the shareholders and asking for more money. We can’t buy those companies but they give us comfort we are fishing in the right area.” Terry Smith

"We usually tend to be in bed with managements who don't really need the capital markets." Marty Whitman

Long Term Focus / Jam Tomorrow

All the way back in 1958, Phil Fisher understood the benefits of investing in businesses taking a long-term view.

“The investor wanting maximum results should favour companies with a truly long-range outlook concerning profits.” Phil Fisher

‘The Hunt for Europe’s Ten-Baggers’, Baillie Gifford 2019.

Often business decisions that promise long-term value, come at the cost of short-term performance. It might be investing in an overseas expansion which is dilutive to near term earnings, keeping margins low to deter competitors, increasing advertising spend to maximise long-term customer value or increasing R&D spending which has potential long-term benefits.

“Almost all good businesses engage in ‘pain today, gain tomorrow’ activities.” Charlie Munger

Professional CEO’s are often reluctant to disappoint Wall Street expectations over concerns of long-term job stability, short-term earnings implications and concern for short term stock price performance.

“If you owned a business all by yourself, you wouldn’t care at all about maximising reported numbers.”  Tom Russo

“Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long-term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites.” Mark Leonard

“At best, family control can be an elegant solution to the agency problem. Families are better able to withstand short-term profit fluctuations and to invest for the long term benefit of themselves and outside shareholders.” Marathon Asset Management

“Often family controlled companies have the ability to look out beyond quarters and that's valuable.” Thomas Russo

“Our experience suggests founder-led companies show greater propensity to focus on long-term value creation, even when it comes at the expense of short-term pain.” Baillie Gifford

“Family owners typically want their firms to last for generations, so they can make long-term investments without worrying about shareholders looking for short term-profits.” Vicki Tenhaken

A founder is less likely to be seduced by the demands of Wall Street.

“I admire Amazon founder, Jeff Bezos. He has revolutionized the retail industry and has two great qualities: He is patient and persistent, and he doesn’t care to please Wall Street’s quarterly expectations. This last quality is often overlooked but it is seldom found and represents, in my opinion, a true competitive advantage.” Francois Rochon

Summary

Warren Buffett has long espoused the more attractive opportunities in the equities market than the private market. Notwithstanding, he has continued to seek out founder-led businesses for acquisition. In fact, if he had his way, he’d own more.

‘In the stock market, you get a chance to buy businesses at foolish prices, and that is why we end up with a lot of money in marketable securities. If we absolutely had our choice, we would own three times the number of businesses we own outright.’ Warren Buffett

Many of the world’s best investors have applied the benefits of his approach to public equities investing.

“An owner-operator culture is the central idea expressed in our portfolio. Boiled down to our essential raison d'être, that’s it. We invest with talented people who have skin the game. In other words, we invest in businesses where management and/or the board own a significant amount of stock.” Chris Mayer

“We seek companies with owner-oriented management.” Fred Liu

“I follow the philosophy, have your money where the owners are.” Mario Gabelli

“We look for managers who are owners.” Chuck Akre

"I invest almost exclusively in companies with active and engaged owners. Very occasionally, you find managers who think and act like owners even if no owner is present but this is the exception rather than the rule. If a restaurant has an absentee owner, over time the service quality will slip and the waiters will have their hand in the till. With large companies, it is no different.” Robert Vinall

"We love owner-operators.” Mason Hawkins

"We want to invest with management teams 'that think and act like owners.’" David Herro

“If we recognise that portfolio performance is usually driven by a relatively small number of long-term winners, and that these winners most often are run by passionate managers, often founders or a second-generation with a deep-rooted interest in the success of their offspring, we must then redouble our efforts to find more of this type of company.” David Poppe

"I want to invest with people who have at-risk skin in the game, ideally founder capital. I like knowing that I and the person calling the shots are in parity in terms of risk." Frank Martin

“I try to stuff our portfolio with management teams that ‘get it’. Founders run 45% of our companies; the average tenure of management is fifteen years.” Ryan Krafft

One of my favourite quotes from Charlie Munger is ‘Fish where the fish are.’ The starting point is finding the right pond. And ultimately, this is profound advice. It’s clear that a great starting place in your search for great investments might be the pond of companies run by Founders.

Sources:
‘The Hunt For Europe’s Ten Baggers’, Baillie Gifford. 2019
‘Owner Operators’, Horizon Kinetics, 2014.
‘What You Can Learn from Family Business,’ Kachaner, Stalk, Bloch. Harvard Business Review. 2012.
‘Family-owned businesses show resilience through pandemic,’ Credit Suisse Research. 2020.
‘Founder-Led Companies Outperform the Rest — Here’s Why,’ Chris Zook, Harvard Business Review, 2016.
‘Business In The Blood - Companies controlled by Founding Families remain surprisingly important and look set to stay so.’ The Economist, 2014.

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Fight the Fade - Round 2

Businesses Fade; its a fact. Market saturation, new competitors, management complacency and poor capital allocation all conspire against business growth. Today, corporate moats are being filled faster than ever as new technologies disrupt and challenge the prospects of what were once unassailable businesses. This process isn’t new. If you look back at the leading stocks of the S&P500 twenty years ago, few companies still hold those positions today. Given enough time, capitalism guarantees the demise of virtually all businesses.

Most analysts and investors understand this, correctly assuming a business’ growth will FADE.

“Investors tend not to believe in “longevity of compound.” Conventional thinking has it that good things do not last, and indeed, on average that’s right! Empirical Research Partners, an investment research boutique, discovered that the chance of a growth stock keeping its status as a growth stock for five years is one in five, and for ten years just one in ten. On average, companies fail.” Nick Sleep

However, when the ‘mental model’ of mean reversion is applied to those rare FADE-defying companies, the estimate of value can not only be incorrect, but in the wrong ballpark. Both Nick Sleep and Terry Smith have drawn on examples to make this point. Nomad’s 2009 letter contained the following chart:

Sleep observed, “If, in 1972, upon reading that year’s twelve page annual report (!) an investor chose to make a purchase of shares, he could have paid over one hundred and fifty times the prevailing share price (a price to earnings ratio of over fifteen-hundred times, a ratio far in excess of what professional fund managers would consider prudent. They would be mistaken, as it turns out) and he would have still earned a ten percent return on his investment through to today. If, instead, the investor thought about it for a while and decided to purchase shares ten years later he could still have paid over two hundred times earnings for his shares (beware heuristics) and still earned ten percent on his investment. And ten years after that could also have paid a premium over the prevailing Wal-Mart share price and done well subsequently. The market struggled to appreciate the magnitude and longevity of the business’ success.”

Terry Smith makes the following point in his new book, ‘Investing For Growth,’ “.. the level of valuation which may represent good value at which to buy shares in a high-quality company may surprise you. The following chart shows the “justified” PEs (price-to-earnings ratios) of a group of stocks of the sort we invest in. What does that mean? It looks at the period 1973 to 2019 when the MSCI World Index produced an annual return of 6.2% and works out what PE an investor could have paid at the outset for those stocks and still returned 7% p.a. over the period, so beating the index. You could have paid 281 times earnings for L’Oréal in 1973 and beaten the index return. Or a PE of 126 for Colgate. A PE of 63 for Coca-Cola. Clearly this approach would not fit the mutation of value investing in which the rating must simply be low. Yet it is hard to argue with the fact that these stocks would have been good value even on some eye-watering valuation metrics.”

While neither Smith nor Sleep advocate paying such extreme multiples for a business, their analysis highlights both the value that accrues to a business able to compound for extended periods of time and the disservice a simple price earnings multiple can afford great businesses.

Holding a variant perception on the sustainability of growth and resultant business worth can equip an investor with the fortitude to remain invested in these ‘compounding machines’. The unique characteristics misunderstood by the investing community often come in the form of business models, industry structures or the individual culture of the business. While by no means exhaustive, below we review four of these: ‘Scale Economics Shared’, ‘Increasing Returns’, ‘Market Dynamics’ and ‘Culture’.

Scale Economics Shared

‘Scale Economics Shared,’ a term coined by Nick Sleep, describes a business which shares the benefits of scale with it’s customers; ‘increased revenues begets scale savings begets lower costs begets lower prices begets increased revenues’.

These businesses optimise for longevity - not short term profitability. Persistent low prices attract customers, leading to increased turnover that drives scale benefits which are then returned to the customer in the form of even lower prices; a virtuous feedback loop. As the business grows, the moat gets wider.

“There are very few business models where growth begets growth. Scale economics turns size into an asset. Companies that follow this path are at a huge advantage.” Nick Sleep

It’s not new. Cornelius Vanderbilt, America’s first tycoon, built the greatest fortune America had ever seen employing this business model over two centuries ago. Buffett too, recognised this model decades ago. Berkshire’s 1993 letter touched on Nebraska Furniture Mart.

“They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners."

Berkshire’s 1996 letter discussed Geico:

“There's nothing esoteric about GEICO's success: The company's competitive strength flows directly from its position as a low-cost operator. Low costs permit low prices, and low prices attract and retain good policyholders. The final segment of a virtuous circle is drawn when policyholders recommend us to their friends… the economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle. We do best on costs in geographical areas in which we enjoy high market penetration. As our policy count grows, concurrently delivering gains in penetration, we expect to drive costs materially lower.”

Companies across diverse industries, Ford, Costco, Walmart, Southwest Airlines, Aldi, Amazon and Geico, have all delivered exponential wealth to their shareholders employing this business model.

“The business model that built the Ford empire a hundred years ago is the same that built Sam Walton’s (Wal-Mart) in the 1970’s, Herb Kelleher’s (Southwest Airlines) in the 1990’s or Jeff Bezos’s (Amazon.com) today. And it will build empires in the future, too.” Nick Sleep

Increasing Returns

Over the last decade, many tech giants have defied the fade. They’ve grown stronger and more profitable as they have evolved; first mover advantages have morphed into huge network effects. The Santa Fe Institute’s theoretical economist, W. Brian Arthur, recognised this potential in a groundbreaking paper published almost 25 years ago. ‘Increasing Returns and the New World of Business,’ presented a roadmap for what would become today’s tech titans.

“Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate—within markets, businesses, and industries—to reinforce that which gains success or aggravate that which suffers loss. Increasing returns generate not equilibrium but instability: If a product or a company or a technology—one of many competing in a market—gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market.” W. Brian Arthur

Arthur recognised the capital-light nature of technology businesses meant they could become entrenched in a winner-take-most scenario. High upfront costs (‘The first disk of Windows to go out the door cost Microsoft $50 million; the second and subsequent disks cost $3. Unit costs fall as sales increase’), network effects and customer lock-in all serve to increase business sustainability over time.

“Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology—from processing of resources to processing of information, from application of raw energy to application of ideas. As this shift has occurred, the underlying mechanisms that determine economic behaviour have shifted from ones of diminishing to ones of increasing returns.” W. Brian Arthur

Charlie Songhurst, a Microsoft alumni and prolific investor, recognised the limitation of applying typical fade metrics to ‘increasing returns’-type businesses.

“I think one thing that's very interesting is the way you model companies in Excel with a DCF, there's this sort of set of cultural norms, like trending down the growth rate to a terminal value over time that obviously we collect for industrial era companies. It's obviously the right concept [for industrial era companies]. Maybe that's just not right for network effects businesses because instead, literally, how do you model in Excel the concept of in year six, something becomes a standard and therefore gets sustained to accelerating growth? There was some sort of joke in the eighties that you'd never get fired for buying IBM. Well maybe in 2006, it suddenly became you never got fired for buying salesforce.com. How do you model in that as a concept? Suddenly kicking into revenue growth, maybe what you should actually be doing is writing a 3,000 word essay on revenue growth drivers, as opposed to sort of trending down over time as an automatic default.” Charlie Songhurst

Addressable Market / Market Opportunity

It’s obvious that a business starting from a smaller base has a much bigger runway for growth; the law of large numbers makes it hard for businesses to grow at high rates for long periods. Even with this understanding, investors and analysts often misjudge a potential market opportunity. When Southwest Airlines enters a new market they liberate a new class of customers by dramatically cutting fares and increasing frequency; market size can rise by a factor of eight.

“When evaluating market size, it’s also critical to try to account for how lower costs and product improvements can expand markets by appealing to new customers, in addition to seizing market share from existing players.” Reid Hoffman

“When you materially improve an offering, and create new features, functions, experiences, price points, and even enable new use cases, you can materially expand the market in the process. The past can be a poor guide for the future if the future offering is materially different than the past.” Bill Gurley

Often an adjacent market can be tapped by an enterprising business. The obvious example is Amazon’s move beyond books. Uber and food delivery, Airbnb and hotels, Nike and casual wear are further examples.

“When Amazon listed at the height of the dot.com boom in the late 1990’s, even the most bullish analysts thought that the total addressable market for Amazon was $26 billion, which equated to the total size of the book market in the US.” Helen Xiong

“We didn't really foresee back 20 years ago that the sport shoe business could get so big.” Phil Knight

“We should ban all talk of TAMs – the total addressable market – these are spot numbers in any other guise and useless in my view. Ten years ago, did anyone imagine the success of Amazon Web Services or YouTube? The supposed experts had no conception of how large cloud computing might become or how many smartphones would be sold. Tesla’s potential in the mass market today looks rather different than when the company produced the first Roadsters, etc. The point here is not to constrain ourselves to a point in time – great companies innovate to create new areas of opportunity and by doing so help to prolong their corporate life.” Mark Urquhart

“In the tech space, investors repeatedly made the mistake of assuming that the size of the market opportunity for growing companies was capped by the size of the market they were disrupting. Many examples spring to mind where this was the case. For example, Google’s and Facebook’s market opportunity was thought to be capped by the size of the advertising market (the largest part of which historically was TV advertising in which only the largest 100 or so companies in any country could participate). Facebook today has over ten million advertisers.” Robert Vinall

“Newer companies are opening up new markets and it’s easy to undersize size the TAM. Is Uber or Lyft replacing taxis or reinventing car ownership?” Philippe Laffonte

Deriving the scope for a market from an incumbent can seriously under-estimate the addressable market. I recall when realtor ads first moved on-line, analysts dampened their growth expectations for a listed company which achieved winner-take-all status. The analysts failed to appreciate the opportunity to take a greater share of the customer’s wallet by monetising on-line video tours, which weren’t possible with newsprint.

“Sizing the market for a disruptor based on an incumbent’s market size is like sizing a car industry off how many horses there were in 1910.” Aaron Levie

Management & Culture

Everyday businesses face competitive challenges, threats and opportunities; capitalism is a brutal force and change is constant. If a business is to survive and prosper it must adapt and evolve. It’s the company’s management and people that ultimately determine the long term success of a business.

Businesses sustainability is enhanced in the presence of a culture of continuous learning, trial and error, accepting of mistakes, innovation, quality and customer focus. Respect and care for a business’ ecosystem - employees, customers, shareholders, suppliers, the community and environment - is critical to long term success. The management team must set the right example, be aligned with shareholders and focus on the long term.

“A business’s product differentiation is not an enduring moat. If the differentiation has any merit, it will eventually be copied and advantages will soon be frittered away. Xerox, Kodak, BlackBerry and countless other businesses once held product dominance and fell to this fate. The only moat that is not fleeting, and conversely the only moat that is truly enduring, is culture.” Christopher Begg

“Culture trumps everything else in the long term. What do I mean by culture? Simplistically, it’s where companies are genuinely run for the long term.” Helen Xiong

Summary

When it come’s to long term business success, sharing scale benefits with the customer, grasping increased returns, optimising your market and ensuring an enduring culture can go a long way to fight the FADE that inflicts typical businesses. The companies that benefit from a few of these are likely to be long-term success stories. Those that utilise all may become tomorrow’s titans. Amazon is a case in point.

And for those investors who recognise and incorporate these characteristics in their investment process, the rewards can be lucrative. It’s time to search out those businesses where the ‘mental model’ of mean reversion is unbefitting - then all you have to do is simply sit on your ass.

“It’s a simple statement of fact that there have been great growth companies that have defied the skepticism of Graham and the mantra of mean reversion. They have endured for decades even at massive scale. I don’t see this as a contention but as an observation. Ironically they’ve altered the patterns of stock market return sufficiently that the very utility of the ‘mean’ has been undermined. The mean is now so far above the median stock that our entire notion of the distribution of returns has to be reviewed. The first chance to reassess came with Microsoft over 30 years ago. The investment community has been slow indeed. We can react to economic data or quarterly earnings in seconds but adjusting our world view has proven far harder.” James Anderson

Further Suggested Reading:
“What Goes Up Must Come Down: Must It Not?” - Nick Train, Lindsell Train 2012
“Graham or Growth - Concluding Thoughts.” - James Anderson, Baillie Gifford, 2020
“Increasing Returns and the New World of Business.” - Brian Arthur, HBR, 1996.
“How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size.” - Bill Gurley, Above the Crowd. 2014.

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Fight The Fade - Round 1

Every great investor has an edge. Jim Simons employs a code cracking team, Ray Dalio demands radical transparency while Paul Singer deploys no-holds-barred activist attacks. One of the most common and lucrative edges I’ve seen exploited in markets is ‘Fighting the Fade’. It’s in this niche many of the world’s most successful investors have cemented their track records; Munger & Buffett, Akre, Sleep, Smith, Polen, Lone Pine, Lindsell Train, WCM and Baillie Gifford.

At the heart of all successful investing is compounding and when it comes to this exponential function, two things matter - high rates of return and longevity. Over the long run just a few percentage points differential in annual returns translate to staggering differences in financial outcomes. It’s right here you find the edge in ‘Fighting the Fade’.

Let me explain.

It’s a well known fact that few businesses can defy capitalism’s onslaught. Business success attracts attention, copycats emerge and so called ‘super-returns’ and high growth get competed away - they FADE. And while most businesses FADE, not all do. A few rare companies have defied competition’s mean reverting forces to sustain growth over the longer term. They possess some unique or idiosyncratic features that help them fight the FADE, delivering and maintaining those extra percentage points that drive the huge return differentials we discussed above.

Investors and analysts who misjudge the longevity of a company’s success will do so at the detriment of valuation. The typical discounted cash flow [DCF] model will specify financial outputs for a company over five or ten years. In the early years investors often apply high growth rates, after which forecasts assume capitalism’s brutality forces returns to a lower perpetual growth rate; usually a rate consistent with GDP (2-3%). This is the FADE and in a general sense, it’s appropriate. Just as no trees grow to the sky, no business can be larger than the economy they’re in. Compound at a rate much faster than the economy over a very long period of time and you eventually end up bigger than the economy.

The non-linear effect of compounding means those businesses that can sustain success over decades, who ‘Fight the Fade,’ are worth substantially more than a typical DCF model would suggest. These businesses deliver those extra percentage points of return that get neglected in the valuation and can render companies on ‘optically high’ price-earning ratios as actually under-valued.

“Investors presume regression to the mean starts at the time of their analysis or, as CFA students may recognize, in year three or five of a DCF analysis! Investors use valuation heuristics rather than assess the real value of the business.” Nick Sleep

“It would seem that the unwillingness of many analysts to forecast strong growth out beyond 18 months to two years in the future is a significant factor in the valuation differences. The durability and longevity of extraordinary growth drastically changes what one might be willing to pay for a company. It can mean that we are willing to pay for growth at what seems like ‘an unreasonable price’ based on near term price multiples etc.” James Anderson

“Our ability to identify businesses that have the market opportunity, product distinction, competitive advantage and management skill to grow earnings and cash flow for longer than is factored into consensus expectations has distinguished our investment effort over the years.” Steve Mandel

“Since stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean, businesses whose returns do not do this can become undervalued. Therein lies our opportunity as investors.” Terry Smith

“From what is misleadingly labelled the ‘growth’ universe, we search for businesses whose returns are believed to be more sustainable than most investors expect.” Marathon Asset Management

“We are explicitly hunting the 3% of securities that do not mean revert, and the absence of mean reversion is our variant perception. Typically our expectations over the first year for these companies isn’t much different from consensus. What can be vastly different is what happens over two, five or ten years. The market in general will fade growth rates, earnings power and the multiple. We try to underwrite businesses we think can maintain growth and high returns for long periods of time.” Yen Liow

“We do not spend a lot of time building discounted cash flow models, but many people do. In these models, after five or ten years, the idea is to take the growth rate down to GDP. But we believe that doesn’t happen with great companies. Great companies can compound at over GDP growth rates for decades usually. So, the ‘market’ has a hard time pricing that. Essentially, we seek to buy companies at a discount to their intrinsic value. It may not appear that way when you pay 20-30X earnings. But the strength of earnings growth and length of time that a company compounds that growth is how we achieve our results.” Dan Davidowitz

“Most sell-side models go out a couple of years and then assume some sort of step-function down in growth or a terminal growth rate of some kind. Doing that might overly discount growth prospects that are more than a couple years out.” Rajiv Jain

“In out-year estimates, market participants tend to apply a generic fade rate to growth that is in line with industry base rates. If that assumption is wrong, it can create an investment opportunity.” Scott Management LLC

“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 periods of time, the optically high multiple, when in hindsight that was a smoking deal five years ago.” Jeff Mueller

“One of the hallmarks of the unique, competitively-advantaged businesses that comprise our portfolios is that we think they all possess the ability to grow their earnings base at a much greater rate, and for much longer, than the market typically expects.” Dan Davidowitz

“It’s rational to assume that the good times won’t last forever. As such, prudent analysts will assume some amount of ROIC decay in their terminal assumptions. But, again, the billion-dollar question is, ‘How long will it take for ROIC to decay to WACC?’ Assume the decay is too rapid and you’re undervaluing the business; assume it’s too slow and you’re overvaluing the business.” Ensemble Capital

“The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.” Terry Smith

The investor’s quoted above have all exploited this wrinkle in accepted financial theory. They’ve done so by identifying and seeking the unique characteristics that allows a business to ‘Fight the Fade’; maybe it’s an exceptional business model, a special culture, adaptability, or capital allocation prowess. These rare great businesses not only don’t succumb to capitalism’s mean reverting forces, but in many cases become stronger as they grow. The key is where can they be found? Freshen up for Round 2.

“Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. Mis-pricing stems from a number of sources. One is the under-estimation of the durability of barriers to entry. Another is the under-appreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked.” Marathon Asset Management

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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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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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The First Investment Primer

People like to make investing complicated. And the more complicated they can make it sound, the smarter some people think they are. If you stop and think about it, the investment strategies that are marketed today could make anyone’s head spin; Value, Deep Value, Relative Value, Growth, Core Growth, Aggressive Growth, Growth at a Reasonable Price, Alpha Overlays, Quantitative, Momentum etc - they’re all complicated terms that when used can make the dumbest investor sound very smart indeed.

But let’s get back to basics. What is investing really all about? Mostly, it’s about simple common-sense; you outlay money today with the expectation you’re going to get more returned in the future.

So the value of an investment then is the value of the future cash-flows you will receive in the future.

As a dollar in your hand today is worth more than a dollar in the future [because you could invest that dollar today and earn interest on it versus, say a dollar received in a year’s time] you need to discount those future cash-flows back into today’s dollars. The total amount of those discounted dollars is effectively a company’s ‘Intrinsic value’. And Warren Buffett says that this is what businesses and investing is all about.

“The intrinsic value of any business, if you could foresee the future perfectly, is the present value of all cash that will be ever distributed for that business between now and judgment day. And we’re not perfect at estimating that, obviously. But that’s what an investment or a business is all about. You put money in and you take money out.”

While most people think of Buffett as a ‘value investor’, the concept of value is often misinterpreted. Buffett uses the term ‘value’ in reference to a company’s ‘intrinsic value’. In short, Buffett wants back more than he puts in.

“I just cringe when I hear people talk about, “Now it’s time to move from growth stocks to value stocks,” or something like that, because it just doesn’t make any sense.” Warren Buffett

"Anybody that tells you, “You ought to have your money in growth stocks or value stocks,” really does not understand investing." Warren Buffett

Among his many skills as an investor, one is keeping things simple. At the Berkshire meeting in 2000, Buffett noted the laws of investing were set out a long long time ago...

“It’s very simple. The first investment primer, when would you guess it was written? The first investment primer that I know of, and it was pretty good advice, was delivered in about 600 B.C. by Aesop. And Aesop, you’ll remember, said, “A bird in the hand is worth two in the bush.”

Buffett noted Aesop was smart, but there were a few more questions that need to be answered to identify an attractive investment ..

“Now, Aesop was onto something, but he didn’t finish it, because there’s a couple of other questions that go along with that.”

And the other things you need to know are; when do you get the other birds? How certain are you that you will get them? And: What are interest rates?

“[Aesop] He forgot to say exactly when you were going to get the two in the bush — and he forgot to say what interest rates were that you had to measure this against.

But if he’d given those two factors, he would have defined investment for the next 2,600 years. Because a bird in the hand is — you know, you will trade a bird in the hand, which is investing. You lay out cash today.

And then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush, or three birds in the bush, and you have to decide when they’re going to come out, and when you’re going to acquire them.”

A nice summary of Investing. Buffett appropriated the analogy of buying the bushes for modern day investment.

“A bird in the hand is worth two in the bush. Now our question is, when do we get the two? How long do we wait? How sure are we that there are two in the bush? Could there be more, you know? What’s the right discount rate?

And we measure one against the other that way. I mean, we are looking at a whole bunch of businesses, how many birds are they going to give us, when are they going to give them to us, and we try to decide which ones — basically, which bushes — we want to buy out in the future.

It’s all about evaluating future — the future ability — to distribute cash, or to reinvest cash at high rates if it isn’t distributed.”

What that means is you need to work out what cashflows you as an investor will receive from the company you own. When do they arrive, and how certain are you you’ll get them? What can the company do to grow those cash flows? But use conservative forecasts; if you’re uncertain, it may be best to avoid the investment. Then use an appropriate discount rate to discount those cash flows back to a present value.

The key criteria then is, can I buy the stock at an attractive discount to my estimate of intrinsic value? And finally, how does this investment compare to all the other investment choices I have? The latter of course includes, doing nothing.

“When you say a bird in the hand is worth two in the bush, you’re comparing it — you’ve got to compare that to every other bush that’s available.” Warren Buffett

Aesop didn’t use terms like Deep Value or Alpha Overlays. He simply stated that what you hold in your hand today should be be worth more in the future. He kept it simple, and without over-complicating his theory. And Buffett says much the same thing; he even used Aesop’s theory, rather than develop a new one of his own. Which sounds pretty smart to me. It’s a time tested equation that was as relevant 500 years ago as it’s likely to be be 500 years in the future.

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Your Investment Style

Everybody is different. Each and every one of us. We all have unique personalities which we apply to our everyday actions and beliefs, which in turn denote our individual style. Authors have different styles, as do coaches, business people and even musicians. And naturally, because of this, every investors' style is also different. 

While all of the Investment Masters have great track records of long term success, they naturally all have their own styles. Whether it's running highly concentrated portfolios, focusing on a select type of asset or having a different time horizon, each has had their own path to success. As Buffett likes to say, there's more than one way to get to investment heaven. 

"I’ve said in investing, in the past, there’s more than one way to get to heaven." Warren Buffett

"There are many, many different ways to make money in the investment business and the one I describe as ours, its not necessarily the only right one but it's the one we like." Howard Marks

"Looking at the careers of the great investors, it is clear that there are many different, often contradictory, ways to succeed. Each has been highly successful in his own way" Roy Neuberger

Buffett, for example, often says his style is a combination of Ben Graham and Phil Fisher. He's taken elements from both and combined them.

“I think I’d rather think of myself as being a sort of a hundred percent Ben Graham and a hundred percent Phil Fisher in the points where they don’t — and they really don’t — contradict each other. It’s just that they had a vastly different emphasis.” Warren Buffett

As a student of Graham, Buffett started out with a focus on buying companies whose underlying asset values exceeded their share prices. As his asset base grew, he leaned more towards Fisher, seeking wonderful businesses. But Buffett never forgot the three key tenets of Graham's approach. 

"The three basic ideas that underlie successful investing — look at stocks as businesses; have the proper attitude toward the market [use it to serve you and not to instruct you], and to operate with a margin of safety." Warren Buffett

And while all of the Investment Masters have their own unique style, those three ideas underpin the majority of their investment philosophies; Karman, Greenblatt, Akre, Pabrai and many more.

"With those three sort of philosophical benchmarks, the exact — the evaluation technique you use is not really that important. Because you’re not going to go way off the track, whether you use Walter’s approach — Walter Schloss’s — or mine, or whatever. Phil Carret has a slightly different approach. But it’s got those three cornerstones to it, I will guarantee. And believe me, he’s done very well." Warren Buffett

And while we should learn from the Masters, we must also recognise we aren't them. Each of us have different knowledge bases and different skill sets; we all have a unique circle of competence.

More importantly, each us are wired differently. It is because of our different psychological make-up that we must find a style that suits us.

"My advice is to learn from the great investors - not follow them. You can benefit from mistakes and successes, and you can adapt what fits your temperament and circumstances. Your resources and your needs are bound to be different from anyone you may want to emulate." Roy Neuberger

Buffett touched on this in 1994 when he was asked about Peter Lynch:

"There’s certainly a fair amount of overlap. There’s some difference. Peter [Lynch], obviously, likes to diversify a lot more than I do. He owns more stocks than the names of companies I can remember. I mean, but that’s Peter.  And, you know, I’ve said in investing, in the past, that there’s more than one way to get to heaven. And there isn’t a true religion in this, but there’s some very useful religions. And Peter’s got one, and I think we’ve got one that’s useful, too. And there is a lot of overlap. But I would not do as well if I tried to do it the way Peter does it, and he probably wouldn’t do as well if he tried to do it exactly the way I’d do it." Warren Buffett

From my own observations, I'd say Charlie and Warren's tolerance for volatility is higher than most investors. Share price volatility doesn't scare them. Munger has often said that if you can't stomach a 50% fall in a stock price, the markets are no place for you. 

"If you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations." Charlie Munger

Many shareholders can't stomach such returns.

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

For the last decade or more I've run 'alpha funds' for some of the world's largest hedge funds and long-only investors. Each of these funds have different requirements and risk tolerances; some of these clients want you to manage only long positions, others let you choose your long/short and net/gross exposure, while some want a market-neutral portfolio and others beta-hedge all positions. One commonality is they all want limited losses or drawdowns [usually sub 5%]. This happens to suit my style; a low tolerance for loss, even if it is just quotational [i.e. not permanent loss of capital].

While my tolerance for loss hasn't changed over the years, my style has evolved. I've extended my time horizon, looking out three to five years, to try and establish what a company might be earning. I've shifted from advocating stocks on undemanding multiples to preferring high quality companies with competitive advantages that are getting stronger. I now structure the portfolios I run around companies that meet these criteria. I'll build smaller positions in other opportunities like mis-pricings, takeovers etc, around the core positions.

Once a big advocate for short selling and maintaining a short book, I've found it far less fruitful over the years than spending time finding quality mis-priced companies to buy. (I sometimes wonder if that's a sign we are late in the market cycle). While I focus on individual stocks I spend a lot of time constructing a portfolio which is likely to perform under alternative scenarios. Come what may, I've got a pretty good idea how the portfolio will perform under different scenarios.

While Buffett's core positions since the 1970's have been 'franchise businesses,' he's also invested in silver, oil, takeovers, distressed bonds and preferred stock. Before Berkshire, the Buffett Partnership operated like a multi-strategy hedge fund. Buffett has since evolved.

For example, we know Buffett's always had an aversion to technology stocks. At the Berkshire 2012 meeting Buffett said he wouldn't buy Apple. In years gone by Buffett swore himself off airlines and jokingly enrolled himself in AA ['Airlines Anonymous']. More recently, he's taken large  positions in both. 

"I would not be at all surprised to see them [Apple and Google] be worth a lot more money ten years from now, but I wouldn’t want to buy either one of them. I do not get to the level of conviction that would cause me to buy them. But I sure as hell wouldn’t short them, either." Warren Buffett 2012

And that's a key lesson: Markets change and you need to adapt. A set and forget approach does not work when investing. 

"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.  He can earn them only by carefully evaluating facts and continuously exercising discipline.” Warren Buffett

“Investors who adhere to one particular style are likely to end up in trouble, sooner or later.” Marathon Asset Management

"It is dangerous to rely on a single strategy in a doctrinaire fashion. Strategies and disciplines ought always to be tempered by intelligence and intuition." Peter Cundill

"An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed." Howard Marks

"Never adopt permanently any type of asset or any selection method. Try to stay flexible, open-minded, and skeptical." Sir John Templeton

So find an investment style that suits your personality. One that matches your temperament and lets you sleep at night.

“If you fit your nature with your investment style and it makes economic sense, you’ll probably do pretty well.” Shad Rowe

“You have to invest the way that’s comfortable for you.” Walter Schloss

“You need a method that suits your personality.” Colm O’Shea

“Every investor has to gear their strategy according to their own talents and their own psyche. George Soros has been successful for a long time in dealing with extremely large, unbalanced risks. But I’m a completely different type of investor and trader.” Paul Singer

“You have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size fits all investment strategy that I can give you.”  Charlie Munger

“If you are going to be a great investor, you have to fit the style to who you are. At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.”  Michael Burry

“Part of the game of investing is to come into your own. You must find some way that perfectly fits your personality.” Li Lu

“You have to adapt what you learn to what fits your own personality. A lot of times people try to mimic blindly somebody else. That will not work.” Rajiv Jain

“Everyone has to understand what type of investor they are. I know that I am not George Soros. I don’t have a temperament to be constantly flitting in and out of positions in order to gain a short-term edge or best position the portfolio for macro events.” Jake Rosser

“There is no single correct way to be successful in capital markets. There a multiplicity of approaches and each and every one of them offers the prospect of success. The most likely requirement of success is finding the investment approach that is most emotionally satisfying for you.” Nick Train

“There are lots of ways to make money, but it is really important to find one that fits well with the way that you are built emotionally. You have to discover it as early as you can.” Yen Liow

“My father had this saying, he said, ‘Investing is like painting, there are all different styles’. It’s one thing to imitate someone’s style when you are learning, just like a painter would go to a museum and copy great works, but at some point, they find what resonates with them.” Chris Davis

"If you are pursuing a style that doesn't fit your temperament, you won't be happy. Show me an unhappy investor and I'll show you an unsuccessful investor." Ralph Wanger

And if you're managing money for others, make sure those investors are aligned with your style. If not, you risk having to liquidate the portfolio at exactly the wrong time.

“We care less about volatility than others and try to find limited partners who are like-minded.” David Abrams

“[It’s critical to] correctly align the interests and time horizons of the manager with those of their end clients.” James Anderson

"To perform the task of money management properly, there must be a true partnership and understanding between investors and their managers. The partnership does not mean that investors are sitting in the kitchen watching the sausage being made. Rather, it means that investors should have rational expectations based on past performance and current market conditions, and should give managers a strong leeway for the inevitable range of their (the manager's) brilliant and not-so-brilliant decisions within the overall boundaries of trust and confidence." Paul Singer

“People say, “Do you want individual owners? You want institutional owners?” What we want are informed owners who are in sync with our objectives, our measurements, our time horizons, all of that sort of thing.” Warren Buffett

“People ask for advice and I say, ‘The first and most important thing is make sure that you choose your clients carefully.’ Most people either look at me like I had three heads, like ‘You’ve got to be kidding me’, like ‘That’s quaint.’” Seth Klarman

“It’s important how you choose your clients. I threw every fund of fund out of Duquesne in 1993. It was the smartest thing I ever did. It’s very important that you educate your clients to whatever your investment philosophy is.” Stanley Druckenmiller

You can see that all investor's styles differ. Warren Buffett is not Peter Lynch. Neither is he Ben Graham or Phil Fisher. And nor are they he. But Buffett has elements of his style which are common to all three. And you'll find that while no two of the Masters investment styles are the same, there are common threads that run through all of them; if you've read any of the Investment Masters tutorials you will have noticed as much. You'll do well to learn from the Masters and adopt some of their approaches, but in the end you must find both a style and investor clients that you're comfortable with, that ultimately suit your personality. 

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TERMS OF USE: DISCLAIMER

Stock Prices Follow Earnings

More than 50 years ago, Benjamin Graham, the 'Father of Value Investing', observed "In the short run the market is a voting machine, but in the long run, it is a weighing machine". That one quote contains as much wisdom today as it did then and it's implications have been long recognised by those we consider Investment Masters. 

What Graham was referring to were the two forces acting on securities, namely human psychology and business fundamentals. In the short run, human psychology can overwhelm fundamentals. However, over the long term it's a securities earnings that determines returns. 

Stocks are more than just pieces of paper. When you invest in stocks you are investing in the underlying businesses; management prowess, business culture, competitive advantages, re-investment opportunities and the like. The ultimate determinant of the price of the stock will be the underlying business' performance. Buffett once again reiterated this in his 2017 annual letter.. 

"Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well."

The key to long term market beating results then is to identify quality businesses whose earnings will grow, buy them at a reasonable price and stick with them. It is the sticking with them where most investors come undone. Adopting the mindset of a business owner as opposed to a stock trader can help.

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

"People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business..  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

There are some good reasons a focus on earnings works. Firstly, share prices are volatile, and far more so than corporate profits. Share prices are influenced by the emotions of the crowd. And even more relevant today, they can be driven by the flows of indexing, ETF's and momentum strategies. 

“Research has shown that over the last century, U.S. stock prices have been three times more volatile than fundamentals. In part due to financial innovation, volatility has accelerated since 1990, with stock prices fluctuating at 6–10 times the rate of change in fundamentals.” Frank Martin

"Securities prices rise and fall much more than profit ... Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychology” Howard Marks

“When an S&P 500 ETF is purchased, its underlying securities are not bought for their individual value, earnings potential, financial health, or any other metric. Those securities are purchased simply because they are on the ETF’s shopping list. This process is without regard to the price/value relationship. As a result, serious distortions in price have accumulated.” Frank Martin

"As a youthful analyst I used to have a notice on my desk that read, ‘Share prices are more volatile than corporate cash flow, which is more volatile than asset replacement cost’. It was a reminder to concentrate on non-transitory items. Today I would update such a notice to read, ‘share prices are more volatile than business values’, but the gist is the same: a reminder to focus on lasting value, not transitory prices." Nick Sleep

Consequently, short term share prices can do almost anything. The record amount of money in passive funds today, means you can and should, expect irrational prices. There is no price too high for an index fund to BUY and there is no price too low for an index fund to SELL. Prices get set by flow not fundamentals. 

Secondly, a business' value is a function of its future earnings, often estimated using a multiple of earnings approach. 

“Business value is rooted in long-term earnings.” Allan Mecham

"Investors own a claim to the current and future profits of a company." Christopher Bloomstran

“Past profits only rewards past investors not today’s buyers. And it is future earnings that make up intrinsic value.” Francois Rochon

“Behind all the smoke and noise on the market’s surface, it’s important to remember that companies — small, medium, and large — make up the market’s backbone. And corporate earnings drive stock prices.” Peter Lynch

“We own shares for multi-year periods and so our continued investment success has far more to do with the economics of the underlying businesses than it has to do with their last share price quote.” Nick Sleep

If you buy a business whose earnings are higher in the future, it's likely the share price will be as well. Consider a simple example: You buy a $100 stock earning $10, ie an undemanding P/E of 10X. If its earnings grow at 12%pa, in ten years it will be earning almost $28. Providing the P/E's unchanged, it will be trading at $280. If it is still trading at $100, the P/E would be just 3.6X, an unlikely scenario.

“There are only two things that matter in investing. What are they going to earn, and what multiple are people going to put on that.  Let’s not make our business any more complicated than this.” Larry Robbins

The good news for investors with a long term investment horizon is that in the long run, earnings and shares prices do converge.

“If the business does well, the stock eventually follows.” Warren Buffett

“Ultimately the market does reflect value, even if it may seem to lose its marbles for unbearably long periods.” Leon Levy

“Stock prices often move in opposite directions from fundamentals but long term, the direction and sustainability of profits will prevail.” Peter Lynch

"Over time, earnings determine a stock's value." Joel Tillinghast

"Our investment philosophy is that, in the long run, corporate earnings drive returns." Dan Davidowitz

"We believe that earnings growth is the primary driver of investment returns over the long run." Rajiv Jain

“We believe that the market performance of a share of common stock, over an extended period of time, is likely to follow the business performance of the underlying company.” Lou Simpson

"Market performance and corporate performance are rarely synchronized over the course of a calendar year. But as more time passes, the synchronization between the two inevitably begins to reveal itself.” Francois Rochon

“We recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses.” Chuck Akre

“Over the intermediate to long-term in the stock market, business performance has been inexorably reflected in share price performance.” Bill Ackman

“We believe when one pays a fair price for quality businesses and holds them for the long term, share prices and, thus, the aggregate return of the portfolio will follow the underlying earnings growth over time.” Jeff Mueller

"On any given day, market prices are driven almost 100% by sentiment. As one's investment horizon lengthens, however sentiment matters less and returns are more dominated by cash flows." Andy Redleaf

“One central premise we believe is that over time, the compounding of our long portfolio will revert to the underlying earnings power growth of the businesses we own.” Yen Liow

"For the most part, it is short-term trades that prices are driven by emotion. Mid-term and long-term investments are usually influenced more by fundamentals." James Rogers

“Long-term gains in the intrinsic value of a company are more important than short-term gains in stock prices. The market has a way of fairly pricing stocks over long periods. Provided a company performs well, its stock price will invariably reflect the performance.” Christopher Bloomstran

“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or a few years. In the long term, there is 100 percent correlation between the success of the company and the success of its stock .” Peter Lynch

“As a bottom up investor, our investments over the long haul will largely mirror the performance of the underlying companies we invest in.” Li Lu

“A continuous focus on share price movements to the exclusion of the underlying fundamental economics of the companies is neither healthy nor useful. In the long term one will follow the other, and it is not the fundamentals which will follow the share price.” Terry Smith

Likewise, markets themselves follow earnings over the long run.

"In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share." Sir John Templeton

Maintaining your focus on a company's earnings rather than the share price can give you the fortitude to hold-on when share prices maybe telling you to sell.

"Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it...  The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate." Warren Buffett

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

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

“We prefer to judge our investments by what is happening in their financial statements than by the share price.” Terry Smith

And by thinking about future earnings you're also less likely to overpay for a stock or get caught in a value trap. 

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

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

“The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Warren Buffett

“Wild swings in market prices far above and below business value, do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains.” Warren Buffett

It's time to look for businesses which offer the potential for sustainable earnings growth. Buy them at reasonable share prices and the returns will follow!

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now ...  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.” Warren Buffett

Investment Models - Need to Know

Over the last 20 years or so I've studied the world's greatest investors and I've tried to unpick the characteristics that have made them successful. While business schools all over the world focus an inordinate amount of time on teaching students how to model, I'm yet to find an Investment Master whose made his name by having the most detailed financial models. Consider a few of these gems ...

"I don't use a computer or a calculator. If you need to use a computer or calculator to make the calculation, you shouldn't buy it...It should scream at you...we do not sit down with spreadsheets and do all that sort of thing. We just see something that obviously is better than anything else around that we understand — and then we act." Warren Buffett

"We never sit down, run the numbers out and discount them back to net present value ... The decision should be obvious." Charlie Munger

"In general, I haven't run spreadsheets and I find that, if there is a need to run a spreadsheet, that is a red flag to take a pass." Mohnish Pabrai

“Everybody wants a formal model. And it’s encouraged by computers. Berkshire Hathaway has gotten to its present place with zero in the way of formal models. Or have you been hiding them from me [Warren]?” Charlie Munger

"I'd say some of the worst business decisions I've ever seen are those that are done with a lot of formal projections and discounts back" Charlie Munger

Sure it's important to be able to navigate around a balance sheet, cash flow statement and income statement, but the really great investors spend their time reading, thinking, focusing on the qualitative data and testing ideas. I've not once heard an Investment Master say "All I do is sit and model all day."

So why don't the Investment Masters spend their time building 5,000 line spreadsheet models like most Wall Street analysts do? In part it's because models have their limitations including:

Stuck in the Rear-View Mirror

Typically an analyst will build a spreadsheet model by plugging in the last five years financials for a company and then building out the future years from there. The problem is historic data is just that, historic. A company is worth the discounted value of its earnings in the future, not the past. The historic data may provide a useful insight into a company's revenue trends, the quality of the balance sheet and how attractive margins are, as well as provide a basis to compare the company with competitors. But problems can arise because the future may look a lot different to the past. Models are good for extrapolating, but dangerous when it comes to changing circumstances. This is as relevant today as ever given the rapid technological changes taking place.

"The qualitative analysis is even more important than the quantitative analysis because quantitative is always a lagging indicator. By the time you see it in the numbers, it's often too late." C.T Fitzpatrick

"One cannot analyse events until they have already happened. Numbers, the 'oxygen' of analysis, lag behind reality. Analytic methodology is ineffective in identifying change in the early stages and thus contributes to what Marshall McLuhan refers to as man's tendency to walk into the future looking in the rear-view mirror." Bennett Goodspeed

"Data is backward looking and it is the future that will determine our returns." Jake Rosser

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid." Ed Wachenheim

"Typically, analysts evaluating the future prospects of a company look at its past. Where else can they look, after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future" Leon Levy

Over-Confidence and Anchoring

Studies show that the more information someone has the more likely they are to become over-confident. And more information doesn't necessarily mean more profits. Remember, humility is a key ingredient to investment success. An analyst or investor with a detailed model risks becoming over committed to an idea,"I've built a 5,000 line spreadsheet, I must be right!";or becoming anchored to the outcome of a spreadsheet, "The model says it's worth $x, it must be true."

“Having more information doesn’t necessarily improve decision-making. We know from studies of horse racing than when handicappers receive more information about horses and riders, they become proportionately more confident even though they are no more likely to pick the winner. When analysts have too much data, there’s a danger they won’t see the wood for the trees.” Marathon Asset Management

"I’m reminded of a study which showed that as the number of variables requiring analysis increase, the odds of success decline, yet the confidence of participants soar due to extensive time and energy invested." Allan Mecham

"The harder you work, the more confidence you get. But you may be working on something that is false" Charlie Munger

"[Computer] models can lull decision makers into a false sense of security and thereby increase their chances of making a really huge mistake" Warren Buffett

"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" Philip Tetlock

"I think an enormous false precision gets into things when you program computers to make forward projections for a long period of time" Charlie Munger

"Investors like modelling because it appears scientific (the more spreadsheet tabs, the greater the effect). Investment models, however, encourage anchoring. Most models are calibrated to produce a current value for a company within a reasonable range of the current price" Marathon Asset Management

"When forecasters have too much information, they often become even more inaccurate than when there is too little. Research on horse handicappers and other studies indicate that only early information affects one's decisions. Once the decision is made, additional information, even when contradictory, will not cause the person to change his mind. In fact, as more and more information becomes available, it only reinforces his belief. Additional information does not increase the quality of decision making, only the certainty of conviction. It only adds a false sense of security.” Bennett Goodspeed

Difficult To Model

Einstein famously said "Not everything that counts can be counted, and not everything that can be counted counts." It's an apt quote for investing. The brain and financial models tend to operate in a linear fashion. But it's often the case that the best and worst investment outcomes are derived from non-linear situations. Charlie Munger often talks about 'Lollapalooza' effects where a number of forces combine to greatly amplify a positive outcome - more than simple addition. Alternatively, a credit crunch is an example of a non-linear event that can decimate a business but won't show up in a model.

There are plenty of other qualitative factors that are critical drivers of investment success but are hard to model. Corporate culture and innovation, management quality, capital allocation prowess and incentives would be some examples. Networks effects, product obsolescence, scalability, first-mover-advantages, industry developments, winner-takes-all, etc are also challenging to model.

"When we analyze a business, we pay close attention to the qualitative and intangible variables –such factors are often difficult to ‘model’. We are uneasy with fancy numerical models .. which have almost ubiquitous acceptance by the high priests of modern finance. We believe one is susceptible to gaining a false sense of security, which can result in mental slothfulness and neglect. In the case of models, analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers. The ‘model’ behind our largest investment required nothing more than sixth grade math, and a napkin – not a sophisticated spreadsheet capable of more numbers than I’m capable of counting." Allan Mecham

"You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important and there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers. Well practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and doesn’t mix in the hard-to-measure stuff that may be more important.” Charlie Munger

"In our evolution as investors, one of the things we have discovered is that it is often the things that don’t get measured that have a greater magnitude on investment returns than what is measured. That is to say, the numbers don’t provide all the clues. It is often qualitative factors such as company culture, management’s approach toward capital allocation, or customer service, that can yield critical insights into a company’s sources of competitive advantage. In fact, an advantage premised upon qualitative factors can often be more enduring." Jake Rosser

“Much of what investing is has an important qualitative element to it as well. It’s about using your judgment when evaluating leadership and managerial skills—something you can do only by synthesizing information in a way that often does not lend itself to computation. It’s about the judgment needed to reconcile data points that support diametrically opposed conclusions.” Paul Hilal

Missing the Forest for The Trees

Successful investing ordinarily requires determining the few key variables that drive a business' performance. By focusing on collecting all the data to build a more realistic model, the investor risks overlooking those key variables. 

“Every company has 100 things about them you could study and learn. But you have to understand the differences between data and knowledge, and between knowledge and wisdom. Warren Buffett is remarkable in his ability to cut right through. He sees very clearly the three or four or five critical factors that determine whether a company succeeds or fails. It’s not about encyclopedic knowledge, it’s about zeroing in on what truly matters and assessing that. There’s no substitute for that in this business." Howard Marks

"Our approach stresses the importance of wisdom by subtraction. We endeavour to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers, first with Danaher and second with Colfax, been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?" Chris Cerrone

"Are there dangers in getting too caught up in the minutiae of using a computer so that you miss the organised common sense? There are huge dangers. There'll always be huge dangers. People calculate too much and think too little" Charlie Munger

“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.” Jeff Mueller

“I think if somebody is terribly interested in the details, they really are missing the whole picture. Because you could have known every detail of our textile business in 1965, and we could give you the information as to how much we made from linings and how much we made from handkerchiefs, and you’d be in a different world. I mean, the important thing was how we looked at running money and what we would do about things over time… But going into a whole lot of detail that might be very interesting to an analyst, but really for the shareholder, they’ve got to make a decision as to who’s running their money, and how they’re running it, and what they’ve done over time, and what they hope to do in the future, and how to measure that.” Warren Buffett

Models Aren't Reality

A model is only as good as its inputs and it can never truly reflect reality. The inherent simplification of a model is one of its pitfalls. If the model is missing critical information or the key factors for success or failure, the output will be next to worthless. A good example of this was during the Financial Crisis when the bank analyst where I worked had a buy rating on an Investment Bank. The model and the analysts 'buy' rating went over the cliff when the stock went bust. Critically, the business relied on credit markets remaining open. That wasn't in the model.

"I have seen so many cases where there is a complex model that is exactly wrong. This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own." Glenn Greenberg

"Models are supposed to simplify things, which is why even the best models are flawed.” Philip Tetlock

“Nobody’s got a lock on what’s right, a model is only a model and it’s not fixed in stone.” Bill Stewart

“Just like the map is not the terrain, the spreadsheet is not the business.” Ben Horowitz

“Investors must always remember that a spreadsheet, no matter how good, is not business reality. The numbers laid out in a spreadsheet tell a precise story, but sometimes it’s not the right story.” Todd Combs

"This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail." Andy Redleaf

Instead of spending their days building financial models, the Investment Masters read, think, focus on qualitative data and test ideas. They keep stock valuations simple. If they do work on models, it's more likely to be mental models as an aid to investment success. Let's cover off on a few of those...

Reading & Thinking

The Investment Masters spend their time reading and thinking about investments and asking themselves questions - Why is this opportunity available? Do I have an edge? Is this a good business? Do I understand the business? What is the business' competitive advantages? Will the business continue to thrive? What could kill the business? Will technology enhance or destroy the business? Could the business be replicated? What is the right price for the business? What don't I know about the business? etc.

“I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking." Warren Buffett

"I just spend all my time thinking, reading, and adapting as best as I can." Thomas Gayner

“We read and think.” Ed Wachenheim

“Warren and I do more reading and thinking and less doing than most people in business.” Charlie Munger

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

Focus on Qualitative Factors

Successful investors spend more time understanding the qualitative aspects of their investments. This often involves channel checks with customers, competitors, suppliers, ex-employees and anyone else who might affect the company.

"Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel

“Interesting enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a 'high probability insight'. This is what causes the cash register to really sing. So the really big money tends to be made by investors who are right on qualitative decisions, at least in my opinion.” Warren Buffett

"The quantitative side of what we do is easy, to be honest with you. You don't have to have much more than a sixth-grade mathematics education to spot a potentially interesting investment proposition.... I would say the qualitative side of what we do consumes 95% of our time because that's the hard part." John Harris

"[My] only evolution .. in my own framework of looking at businesses, is that I pay more attention to the qualitative factors around a business than the quantitative. In the past I used to be much more focused on the quantitative." Mohnish Pabrai

"While we can run spreadsheets with the best of them, we really emphasize understanding the qualitative factors that drive the numbers. Market shares. Competitive advantages. The secular and cyclical impacts on the industry. Management’s skill in allocating capital. The goal is to identify companies in which we have a great deal of confidence that their values are going to continue to compound as we own them." C.T Fitzpatrick

"It's tempting when you start out to think your knowledge about finance and valuation will lead you to all the answers, but I now put more emphasis on qualitative than quantitative analysis" Jake Rosser

“We are qualitative. We’re qualitative because the determinants of value over time are qualitative.” Brian Bares

“Our process is very qualitative. What we’re trying to think about are what are the drivers? Where will the revenues of this company be 5 or 10 years from now? What are the competitive advantages which is really getting into questions about profitability and margins? But what is the corporate culture? What is it that makes this business special? Why can’t somebody else do it? And we think if we can answer some of these more causative questions, I think it gets you to broadly correct answers. The left of the decimal point, if you will. And I see much more value in this.” Tom Slater

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

"It is easy to drown in the ocean of available facts while underestimating the few important qualitative aspects of a business that should enable it to do well going forward." Larry Pitkowski

“I think the most common tendency of young investment professionals is to rely almost entirely on quantitative skills and ignore qualitative positives or negatives of businesses and their managers. I was no exception. It is really just natural because fresh graduates have better quantitative skills than their bosses. And if you’ve got the biggest hammer, you want everything to look like a nail. But I can’t think of one investment we’ve made where we developed an advantage over other investors by ‘outmodeling’ them. With experience comes an appreciation for the qualitatives that are hard to incorporate in a model. Our most successful stocks typically include a differentiated point of view on the quality of management or the quality of the business.” Bill Nygren

"I started out very influenced by Graham, so I emphasized quantitative factors. Charlie came along and said I was all wrong, and that he’d learned more in law than I’d learned in financial studies and everything, and that I should think more about qualitative factors, and he was right. And Phil Fisher said the same thing.” Warren Buffett

While building a simple financial model can help us better understand a company, it's clear that the people we refer to as the Investment Masters do not rely on 5,000 line spreadsheets for their ideas. Qualitative investment relies on knowledge, which can be gained from reading and thinking and talking with people. And then pulling all that information together into an idea that is valuable. It's also clear that an over reliance on financial modelling can leave you blind to certain risks. So the question remains as to why people still continue to both create them and then follow them? If the Masters don't use them, and they have the track records to prove their method as the right one, which will you follow? For me, I'll choose qualitative investing over quantitative every day of the week and twice on Sunday, and any investment thesis predicated on a 5,000 line spreadsheet will end up in the trash where it belongs.

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What Farming can teach us about Investing

Many inferences have been drawn over time between the Market and Business. This is nothing new to any of us and we have seen it often. The analogies are always simple, clean and relevant and offer practical value to our investing activities. At the same time, many of the Investment Masters have espoused the value in not only being capable in both arenas, but also in keeping up to date on your knowledge of both. It makes sense right? Sure it does.

But there are also other comparisons out there, ones which might not be as obvious at first glance. If I told you there was also value to be gained from comparing Investing to Farming, what would you say?

Hopefully you would agree with me.

Good ol' farming. It's been there forever, through good times and bad. And the inferences that can be drawn between it and Investing are many. 

Let's start with those good and bad times, because they happen to all of us whether you are digging in the dirt or investing in the market. The last two weeks drop in global markets is solid enough evidence of that, as is the freakish weather conditions in different parts of the world that have had a negative impact on the farming sector. The actual lesson though lies in how we react to the market tanking or when a farmer's crops fail. 

In situations like we have just witnessed in the market, prices dropped and investors rushed to get out, causing a significant level of volatility. But every farmer expects the unexpected and recognises that despite his best efforts, nature doesn't always deliver optimal outcomes - pests descend, rains don't come, commodity prices fall.

But if we were working a farm and had one bad year because of say, adverse weather conditions, would you immediately cut the value of your farm in half? Of course not. The value of the farm is the future value of many many years of crops, one bad season just doesn't have that much impact. In contrast, the stock market often over reacts to poor earnings and slashes good companies prices when the unexpected happens.

“You would not cut the value of a good farm in half just because bad weather conditions caused a crop failure in a single year.” Phil Fisher

Farmers exhibit patience. They hold onto good farm property even when they have a bad crop. Farmers don't and aren't expected to trade their paddocks and no-one raises eyebrows when they don't. 

"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

And the value of farm land remains pretty constant. The absence of minute by minute pricing for farmers to obsess over means farmers tend to set prices by analysing what the farm will earn over a long period of time. Contrast that to stock prices which tend to be set by the whim of the most emotional participant watching the constant gyrations of the market. That's a gift for the rational investor.

“Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behaviour? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.” Warren Buffett

"Nobody buys a farm to make a lot of money next week or next month, or they buy, you know, an apartment house. They buy it based on what they think the long-term future is. And if they make a reasoned calculation of that and the purchase price looks attractive, they buy it and then they don’t get a quote on it every day or every week or every month or even every year, and that’s probably a better way to look at stocks." Warren Buffett

Stock prices go up or down responding to any number of psychological biases as opposed to fundamental developments. Yet, while those prices change, they generally don't impact what a company will earn.

“If Investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behaviour would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.” Warren Buffett

And farmers don't respond to what other farmers are doing like investors do. If a farm a few paddocks away sells for less than the farmer paid, he's not going to rush to sell his property too.

"Instead of focusing on what businesses will do in the years ahead, many prestigious
money managers now focus on what they expect other money managers to do in the days ahead.  For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.... an extreme example of what their attitude leads to is "portfolio insurance," a money-management strategy that many leading investment advisors embraced in 1986-1987 ... After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighbouring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely
because at 9:30 a similar house sold for less than it would have brought on the previous day?" Warren Buffett 1987

Per the lessons gained from the Fingers of Instability posts, learning from this farming analogy is just as important. We know that many investors react to market conditions without really knowing or understanding the intrinsic worth of the stocks they hold. Farming is a long term game and investing should be considered the same way. We should not expect great yields every year from either, rather sometimes we can expect to have to 'weather a storm', and in doing so we can expect a bumper crop.

Betting Against America?

“Remember, my son, that any man who is a bear on the future of this country will go broke.” JP Morgan, 1908.

In the history of mankind, no single nation has developed, grown and innovated like the United States of America. No other country on Earth can boast what American’s have achieved; either over long or short time spans, through good times and adverse, war and prosperity, no other empire, kingdom or republic has been able to match their level of industrious activity or ingenuity. And in more modern times this phenomenon has only been exacerbated.

Its an amazing story if you look back at it. A civil war, two world wars and other conflicts, political upheavals, corporate scandals, energy crises, and a plethora of asset bubbles; despite all of this and more, American industry has prospered and the US equity market has delivered attractive long-term returns. 

"One US dollar in stocks, after discounting for inflation, experienced an appreciation of 1 million times the original value over the past 200 years! Its value today would be 1.03MN US dollars. Even the remainder of this number is bigger than the return on every other class of assets." Li Lu

Source: ‘The Prospect of Value Investing in China’, Li Lu, 2015.

Of course, its nice to be able to view historical data on a market going back 200 years. The opportunity to review historical performance on that scale doesn't come about that often. But remember, history aside, investing involves outlaying money today in the expectation you will receive more back in the future. And whilst it's true that the stock market has delivered attractive returns in the past, as an investor your returns are determined by the future, not the past. If you think the future will be less prosperous than today, it follows that stock market returns are likely to be less favourable also. So in addition to studying the past, having a general view on what the future might look like is an important foundation for investment. The Investment Master, Li Lu, summed it up nicely...

"In order to understand stock performance in the past 200 years, and the next 20 years, we must be able to understand and explain the basic trajectory of human civilization. Otherwise, it will be hard for us to remain rational when a stock market crash occurs. We will think the world is coming to an end whenever we encounter a crisis similar to that of 2008 and 2009. Predicting the future lies at the heart of investing." Li Lu

The theme of the latest Time magazine, edited by Bill Gates, focuses on the fact the world is getting better. Much better. In the present day we are blessed by an unprecedented level of peaceful co-existence, prosperity and health. 

"All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do." Warren Buffett

Yet despite the growth and prosperity available to us now, people today remain pessimistic. But why? If ingenuity and innovation have delivered prosperity and longer life spans for example, why is it that we can only see the bad? The answer is that we are surrounded by drama. And I mean totally surrounded. You cannot pick up a newspaper, turn on the news, watch a TV show or talk with other people these days without regularly hearing the bad stuff that happens in the world. Microsoft's Bill Gates noted the media's tendency to focus on the negatives.

"So why does it feel like the world is in decline? I think it is partly the nature of news coverage. Bad news arrives as drama, while good news is incremental—and not usually deemed newsworthy. A video of a building on fire generates lots of views, but not many people would click on the headline “Fewer buildings burned down this year.” It’s human nature to zero in on threats: evolution wired us to worry about the animals that want to eat us." Bill Gates

As Gates recognises, in the first instance humans have evolved to feel fear above any other emotion; it's all about survival.. 'noise in the bush, you better run or risk being eaten by a tiger.'

Humans have also evolved to think visually, not in numbers. We are wired to believe more in a story than we are in statistics. Stories carry much more impact, negative stories even more so. Steven Pinker, an American cognitive psychologist and linguist also points out... 

“You can’t get an accurate picture of the world by looking at media headlines. The headlines are about things that happen, they’re not about things that don’t happen. As long as the rate of violence hasn’t fallen to zero, there are always going to be enough violent instances to fill the news. And we can lose sight of the vast amounts of the world that are at peace.”

The latest Time edition contains an article entitled, 'Warren Buffett Shares the Secrets to Wealth in America.' Buffett has long espoused the dangers of betting against America. He's not alone. Throughout time, many of the Investment Masters have recognized the same dangers.

"America is America and it’s always wrong to bet against her.” Barton Biggs

"You don't see any Fifth Avenue mansions built by bears." Bernard Baruch

"Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see." Warren Buffett

"One of the things I think that's really important is we should never underestimate the resilience of the US economy. It's very powerful. And no matter how much the politicians try and screw it up, there's an underlying strength there. And I never want to bet against that." David Swenson

“The American spirit is a factor which no quantitative model can properly account for, yet it has been such an important factor throughout our history. My closing comments today are that in the midst of all our problems; do not underestimate the American people.” Chuck Akre 2009

“Yes, for better or for worse, we are faced with cyclical swings in our economy, periodic recessions, and even rare depressions. But American capitalism has demonstrated remarkable resilience, plugging along steadily even as times change, driving growth in earnings and paying dividends that have risen apace over time, in step with our growing economy.” John C Bogle

And despite the negativity that abounds today, over the last few hundred years America has experienced a growth rate unprecedented in the history of mankind.

“It is important to remember, the American system is a six-sigma event like the world has never seen. In the last 100 years America has enjoyed a 7-fold increase in productivity – unprecedented in modern history. What is new and cutting edge in one’s youth is outdated and obsolete by the time one reaches middle age, if not sooner – a development that was unheard of before the mid 1800’s." Allan Mecham

"When we examine the past 200 years, we see a continuous upward trajectory [in US GDP]. If we take a year as the unit of measurement, GDP grew almost every year. This is real, long-term, cumulative and compounding growth... The economic pattern of sustained, long-term compounding growth is a modern phenomenon, which had never previously occurred in the recorded human history of the past 16,000 years." Li Lu

In many ways, the characteristics that make a great country are the same characteristics that define successful companies and investors. After all, a large company is essentially a small society. In previous blogs we've recognised those parallels that exist between great businesses and great investors. And given this, it's worth spending some time understanding how America evolved from an agrarian society to a flourishing modern economy.

It started with free trade and specialization.

"The division of labor is responsible for the world's greatly increased standard of living, despite its huge population growth." Charles Koch

“So long as human exchange and specialisation are allowed to thrive somewhere, then culture evolves whether leaders help it or hinder it, and the result is that prosperity spreads, technology progresses, poverty declines, disease retreats, fecundity falls, happiness increases, violence atrophies, freedom grows, knowledge flourishes, the environment improves and wilderness expands.” Matt Ridley

“It is irrefutable that billions of people around the world, including most Americans, have benefitted from the massive increases in global trade over decades. An ever expanding upward spiral of innovation, entrepreneurship, production, exports, imports and exchange of goods and services has produced massive accretions of wealth, together with billions of new consumers, producers and increasingly skilled workers.” Paul Singer

“Adam Smith identified that when men and women specialize their skills, and also importantly “trade” with one another, the end result is a rise in productivity and standard of living for everyone. In 1817, David Ricardo expanded upon Smith’s work in developing the theory of comparative advantage. What Ricardo proved mathematically, is that if one country has simply a comparative advantage (not even an absolute one), it still is in everyone’s best interest to embrace specialization and free trade. In the end, everyone ends up in a better place. First and foremost, you need free and open trade. It is quite bizarre to see modern day politicians throw caution to the wind and ignore these fundamental tenants of economic science. Time and time again, the fact patterns show that when countries open borders and freely trade, the end result is increased economic prosperity.” Bill Gurley

In addition, America benefited from knowledge sharing. 

"In the age of the modern civilisation, the value created by the division of labor and by exchange is further increased because human knowledge can be accumulated. Compared to goods and services, human knowledge is easier to accumulate. Exchanges of ideas often result in a 1+1>4 equation. When different ideas are exchanged, the parties not only retain their own ideas, they also obtain the ideas of others. Moreover, sparks can fly during exchanges, creating entirely new ideas. When ideas are having sex with each other, they become very productive." Li Lu

The US Declaration of Independence provided a constitutional and limited government, whose fundamental goal was to protect property rights and whose legitimacy came from empowerment by the people.

“This country is unique. Why is this country unique? For many different reasons. We have a Constitution put together in a four month period of time by 55 white males who came to Philadelphia. While the constitution has had 27 amendments or so, it has stood the test of time, and over 240 years has become a role model as a way of government to work as it has problems. It has been a stable government and been an incredible opportunity." David Rubenstein

The American Constitution led to political unification; it set the framework for a large unified population. Prior to this, it was medieval China that had led the world in technology, with a long list of major technological firsts including cast iron, the compass, gun powder, paper, and printing. But it lost that position. Jared Diamond, in 'Guns, Germs and Steel,’ posits that once China unified in 221 BC, “No other independent state ever had a chance of arising and persisting for long in China”. However China’s connectedness eventually became a disadvantage, because a major decision by one despot could, and repeatedly did, halt innovation.

This was in contrast to Europe which resisted unification by determined conquerors such as Charlemagne, Napoleon and Hitler. Jared Diamond notes, “even the Roman Empire at its peak never controlled more than half of Europe’s area.” While “Europe’s geographic balkanisation resulted in dozens or hundreds of independent, competing statelets and centres of innovation. If one state did not pursue some particular innovation, another did, forcing neighbouring states to do likewise or else be conquered or left economically behind. Europe’s barriers were sufficient to prevent political unification, but insufficient to halt the spread of technology and ideas.”

Abundent resources and geographic protection certainly provided an economic advantage.

“It might sound silly, but having a ton of land endowed with tons of natural resources buffered from long-time foes by the world’s biggest oceans on both coasts is responsible for more of our prosperity than we think. I don’t know how much. But if you know the history of countries who are just as capable as Americans but have been ravaged by battle every few generations you know how devastating the after-effects of war are, in both infrastructure and culture. Things could change, of course. But it is reasonable to assume America will indefinitely have an economic advantage over other nations because of its structural advantages in geography and natural resources?” Morgan Housel

“America is still the most prosperous nation the world has ever seen. We are blessed with the natural gifts of land; all the food, water and energy we need; the Atlantic and Pacific oceans as natural borders; and wonderful neighbors in Canada and Mexico. And we are blessed with the extraordinary gifts from our Founding Fathers, which are still unequaled: freedom of speech, freedom of religion, freedom of enterprise, the sanctity of the individual, and the promise of equality and opportunity for all. These gifts have led to a bold and dynamic economy – one that nurtures vibrant businesses large and small.” Jamie Dimon

The American Constitution's design was intended to expand and maintain order in the free market, provide freedom of speech, safeguard individual liberties and protects business interests. 

“[Throughout history] a large, interconnected population meant faster cumulative invention – a surprising truth even to this day, as Hong Kong and Manhattan islands demonstrate.” Matt Ridley

“An open economy always delivers a more prosperous future. This has been one of America’s chief advantages for several centuries.” Michael Mandel

"Societies are most prosperous when knowledge is most plentiful, accessible, relevant, and inexpensive. These conditions are best bought about by freedom of speech and association, and trade based on mutual gain." Charles Koch

America also offered the prospect of wealth and a new beginning to immigrants. America was unencumbered by social classes, operated with a common language and had an incentive system based on meritocracy.

"America is the great equalizer. You can come from nothing, you can come with no pedigree, you can be the son or daughter of immigrants, and you have the opportunity to be successful. There's no other country that doesn't require some kind of birth heritage, or inheritance, or ingrown advantage. Here, everybody has a shot at being the lead dog." Sam Zell

"America's strengths include [the fact it is a] society that attracts talent from around the world and assimilates them comfortably as Americans; and a language that is the equivalent of an open system that is clearly the lingua franca of the leaders in science, technology, invention, business, education, diplomacy and those who rise to the top of their own societies around the world." Lee Kuan Yew

"Another thing that is unique is we had a melting pot; the country has welcomed people from all over the world and many people have bought different talents. There has also been a sense you can rise from the bottom. Now there is a problem today in income inequality and social mobility, maybe its getting worse. But there is no doubt the American dream is one I believed in. You can, in this country, make a difference. Your life outcome isn’t determined by who you were born to, but what you do on your own merits. No doubt you have a chance to rise up." David Rubenstein

America's open society drives an entrepreneurial culture of risk taking, is accepting of failure, leading to creativity and innovation. Characteristics necessary for companies to succeed also. 

"America loves the entrepreneur who failed. I kid you not. Because they will back that person again in a heartbeat. And it’s one of the great things about America; you can fail in America time and time again; it’s a country that forgives. And each time you go through a failure, there’s a valuable life experience you will carry your entire life. I remember some of the early things I did at Citadel where abysmal failures.” Ken Griffin

“It is no exaggeration to say that much of the reason for America’s extraordinary economic greatness is that it has nurtured an environment in which a small entrepreneur can flourish.” Bruce Kovner

"America's asset is, simply risk taking and the use of optionality, this remarkable ability to engage in rational forms of trial and error, with no comparative shame in failing, starting again, and repeating failure. In modern Japan, by contrast, shame comes with failure, which causes people to hide risks under the rug, financial or nuclear, making small benefits while sitting on dynamite, an attitude that strangely contrasts with their traditional respect for fallen heroes and the so-called nobility of failure." Nicholas Nassim Taleb

"What has made the U.S. economy pre-eminent is its entrepreneurial culture. Entrepreneurs and investors alike see risk and failure as natural and necessary for success. When they fail, they pick themselves up and start afresh. The Europeans and the Japanese now have the task of adopting these practices to increase their efficiency and competitiveness. But many American practices go against the grain of the more comfortable and communitarian cultural systems of their own societies - the Japanese with life-long employment for their workers, the Germans with their unions having a say in management under co-determination, and the French with their government supporting the right of unions to pressure business from retrenching, by requiring large compensation to be paid to laid-off workers." Lee Kuan Yew

“It is the ever increasing exchange of ideas that causes the ever-increasing rate of innovation in the modern world.” Matt Ridley

"The wealth of this country over the last 240 years is due to the economic wealth created by entrepreneurs, businesses, skills and talents that have come together to create the envy of the world in various parts of our country - Silicon Valley and Wall Street.” David Rubenstein

And the future looks bright. The characteristics that contributed to the America's success remain it's competitive advantage.

"The US has endured all kinds of difficulties in the past and ultimately prospered – I believe the future will be similar." Allan Mecham

"Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." Warren Buffett

"The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead." Warren Buffett

“The same factors that have served the U.S. well in the past are the same that factors I believe will lead us to future prosperity, namely: 1) America is the home of the entrepreneur. 2) The U.S. is the most open/flexible society the world has ever seen. 3) The brightest minds from around the world dream of coming to the U.S. 4) English is the universal language. 5) Americanization remains a powerful and growing — albeit often resented — economic and social trend globally. (To quote my friend, the advertising/marketing giant WPP Group’s CEO, Sir Martin Sorrell, ‘‘Globalization’ is a misnomer. The better word is ‘Americanization.)’’ Shad Rowe

With the advent and broad-scale adoption of the internet, America and the world are on the cusp of a potential massive leap in productive potential. The world has never been so connected.

“Human cultural progress is a collective enterprise and it needs a dense collective brain.” Matt Ridley

“The secret of the modern world is its gigantic inter-connectedness.” Matt Ridley

“Every generation has perceived the limits of growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has under-estimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered.” Paul Romer

“There is not even a theoretical possibility of exhausting the supply of ideas, discoveries and inventions. This is the biggest cause for all my optimism.” Matt Ridley

“It will be hard to snuff out the flame of innovation because it is such an evolutionary, bottom-up, phenomenon in such a networked world.” Matt Ridley

The potential of new technologies is far from exhausted..

"With the arrival of powerful new technologies, we stand on the verge of a productivity boom. Just as networking computers accelerated productivity and growth in the 1990s, innovations in mobility, sensors, analytics, and artificial intelligence promise to quicken the pace of growth and create myriad new opportunities for innovators, entrepreneurs, and consumers." Michael Mandel

While America's best days no doubt lie ahead, foreign governments need to adapt to promote creativity, innovation and productivity. It's little wonder the powerhouses of the last 20 years like Amazon, Facebook and Google have all developed in the US.

“When you have freedom of speech and freedom of expression and don’t get thrown in jail by criticizing a bad idea, it’s more likely bad ideas will get exposed, and it’s not a coincidence oppressive regimes are also oppressive in clamping down on free speech.” Steven Pinker

"Societies with beneficial incentives - those that reward creating the most value in society - have tended to enjoy the greatest and most widespread well-being. Societies with perverse incentives have suffered from waste and corruption, and the vast majority of their citizens have languished in poverty." Charles Koch

“When you have ideas being brought together and people debating them and arguing over them, bad ideas tend to get filtered out.” Steven Pinker

"China will inevitably catch up to the US in absolute GDP. But its creativity may never match America's, because its culture does not permit a free exchange and contest of ideas. How else to explain how a country with four times as many people as America and presumably four times as many talented people not come up with technological breakthroughs?" Lee Kuan Yew

“A nationalised industry stagnates: monopoly rewards caution and discourages experiment, the income is gradually captured by the interests of the producers at the expense of the interests of consumers and so on. The list of innovations achieved by the pharaohs is as thin as the list of innovations achieved by British Rail or the US Postal Service.” Matt Ridley

It's little wonder, most of the Investment Masters either don't short or they run long-biased portfolios. They also focus on stocks, not bonds [That's a post for another time!].

"We're always long. You guys should know one thing: the markets go up over time. If you try to play the short game at the wrong time, you'll lose money. You don't want to be short markets over a long period of time." Craig Effron

"The 9.5% long term upward bias of the stock market is one reason that shorting stocks generally is a bad business." Ed Wachenheim

"[We] maintain net long exposure typically between 30% and 60%.…. Shorting is more challenging for several reasons, one of which is that the market tends to appreciate over time." Lee Ainslee

“In practice, we have more long exposure than short exposure... the market tends to rise over time and we wish to participate. It is psychologically challenging to manage a portfolio that outperforms only a falling market, I have no desire to spend my life hoping for a market crash.” David Einhorn

"The economy overall has been really growing at a compounding rate for 200-300 years, ever since the modern science technology era. So, naturally, the economic trend favors long positions rather than short." Li Lu

“We are always long-biased, such that our long exposure is typically at least three times our short exposure." Zeke Ashton

So why is betting against America likely to prove a dumb trade?

Despite the numerous challenges that America has faced, it consistently demonstrates resilience. Much like the legendary Phoenix, it repeatedly emerges stronger from adversity. Beyond the apparent drama and negativity, one can discern the nation's enduring industriousness and innovative spirit, which define its success. With over 200 years of outstanding performance, and the best years yet to come, it is hard to even contemplate placing a long term bet against those odds. 

Further Reading:
The Rational Optimist - How Prosperity Evolves - Matt Ridley
Guns, Germs & Steel - The Fates of Human Societies - Jared Diamond
A Discussion on Modernization - Li Lu
The Prospect of Value Investing in China - Li Lu
Media and The Market - Mastersinvest
The Coming Productivity Boom - Michael Mandel/Bret Swanson

Seeking Perfection

Perfection is an aspiration. It is something to strive for, an ideal so high that its nigh on impossible to achieve. Perfectionists are those that seek flawless outcomes, sublime achievements and impeccable results. And the reality is that if you're seeking perfection in Investment, you'll never get there.

The stock market is a complex system where an almost infinite number of variables can influence stock prices in any multitude of ways. Information is often ambiguous, participants are often irrational and those variables are in a state of flux. The future is unknown. In this environment you can’t possibly expect to know all the information that will impact a company or it's share price.

“Complex systems are full of interdependencies—hard to detect—and nonlinear responses. In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events.” Nassim Nicholas Taleb

"The stock market, at least in the short run, responds to many factors besides profits and dividends. Inflation and interest rates, the supply of new stock underwritings, the money supply, investor confidence, government actions, and international events are all factors that interact with one another in subtle, changing and unpredictable ways. What we have, really, is a complex system with lags and multiple feedback loops. All such systems share certain characteristics that hinder predictive accuracy." Ralph Wange

Even the CEO of a company cannot be aware of every detail within the organization. Moreover, even if they were, leveraging this information for profit would require an understanding of how it will affect market participants.

"First, no matter how much research is performed, some information always remains elusive: investors have to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.” Seth Klarman

I recall collaborating with a remarkably astute junior analyst who consistently sought additional information regarding the companies under our scrutiny. Hailing from a corporate finance background, he was accustomed to having ample data at his disposal to craft corporate documents and forecasts—ranging from company budgets and management accounts to debt schedules and contracts. However, when it came to delving into market dynamics and stock insights, he found himself grappling with a scarcity of readily available information. Consequently, he became immobilized by the absence of data, unable to formulate recommendations based on probabilistic assessments.

And this is a common trend. Yet, accepting that we cannot know everything is an essential psychological mindset for successful investment.

“One thing I’ve learned is, people can be unbelievably smart. But if they're very linear thinkers, it will never work as an analyst. We are always dealing in shades of gray, probabilities. If somebody has to know the answer to a math problem or whatever, if they have to know the answer, there is never the answer in our world. Those people can be incredibly smart and might be winning Nobel prizes or whatever, but they can't work in our world because our world is all about probabilities and weighing outcomes. If that makes you uncomfortable, it's just not going to work.” Steve Mandel

One of my favourite books “The Art of Learning” by the US Chess Master, Josh Waitzkin, highlights the need to be able to operate without perfection.

“We must be prepared for imperfection. If we rely on having no nerves, on not being thrown off by a big miss, or on the exact replication of a certain mindset, then when the pressure is high enough, or when the pain is too piercing to ignore, our ideal state will shatter.” Josh Waitzkin

The current breed of 'Rocket Scientists' created by the Financial Industry want to set standards for Investment that are impossibly high. They want to have a 'clean sheet,' an investment record so perfect that the Masters of the Finance Game bow in homage to it. But they're focusing on 'doing things right', rather than 'knowing the right things'; even the Investment Masters understand that striving for perfection is a futile exercise..

“Perfection doesn’t exist in this world. All of my choices involve various degrees of compromise and tradeoffs.” Thomas Gayner

"This is not a perfect game." Steve Cohen

"There is never perfect knowledge about the world. Simply put, we don't know what we don't know." Leon Levy

"Trying to be right 100% of the time leads to paralysis." Sam Zell

“You can’t be 100% certain but try to look for weaknesses in your thinking.” Walter Schloss

"I’ve never been 100% certain and I’m never seeking to be stubborn. There are many possible outcomes, and there’s a large range of profitable outcomes." Bruce Berkowitz

“Investing is about predicting the future, and the future is inherently unpredictable. Therefore the only way you can do better is to assess all the facts and truly know what you know and know what you don’t know. That’s your probability edge. Nothing is 100%, but if you always swing when you have an overwhelming better edge, then over time, you will do very well.” Li Lu

“I am always searching for the underlying truth, based on insufficient information.. it’s simply not possible to have a complete understanding of anything. We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences.” Guy Spier

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

“I don't know any certain way of arriving at the 'correct' value of any asset. What I do know though is that I've been asking the right questions about the attraction of any equity asset.” Nick Train

“The more you know, you start to realise there is a lot more than 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

“Any time you’re investing, pretty much any style of investing, there is no such thing as a 100% sure bet. You can always have the asteroid come and take everything out – everything is probabilities.” Mohnish Pabrai

“I’ve always thought it was important to remember that there is no absolute truth. Everything is a working hypothesis, and from there it’s about reacting to data points.” Rajiv Jain

“My conclusions are the result of my reasoning, applied with the benefit of my experience, but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation.” Howard Marks

Many investors and analysts rely on financial and mental models to understand and predict how a company operates and how it may perform in the future. But models are exactly that, models - they are not reality. Even the best models are imperfect.

“All models are wrong, some are useful.” George Box

“Every scientific law, every scientific principle, every statement of the results of an observation is some kind of a summary which leaves out details, because nothing can be stated precisely.” Richard Feynman

"No model captures the richness of human nature. Models are supposed to simplify things, which is why even the best models are flawed.” Philip Tetlock

"All models have an inherent limitation on their validity." Ralph Wanger

“Models, including financial models, work only because they shed certain information in order to highlight or analyze other information. This is necessarily true. A great physicist once summed up the situation: "To build a perfect model of the universe would require all the matter and energy in the universe because the only perfect model, the only model that sheds no information and made no compromises in order to achieve its object, would be the universe itself." This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail. If the model fails in a critical situation, and the people using the model cannot recover or even identify the critical lost information, they may not be able to react rationally to events; they may panic.” Andy Redleaf

While models can’t possibly include all the variables that may impact a company, what's important is that they do consider the limited number of critical factors that are key to a company’s performance.

"In my early years, I ended up too much in the weeds. I had to know everything about a company and its industry. I’ve since learned that knowing less is okay as long as you have identified the one to three things that will drive the company. We believe exactness offers little so we prefer to establish a potential range of outcomes instead. We’d rather be directionally right rather than precisely wrong." Steven Romick

"I believe that there's no need to know every detail, rather there's a need to understand the three, four or five factors affecting the company." Charles De Vaulx

"If you are an investment analyst or investment manager, to be successful and to do well, a couple of things have to happen. Number one, in most businesses, the results are driven by three or four factors that control let’s say 80 percent of the outcome and most entrepreneurs are honed in on those three or four factors. They understand those factors and they focus on those factors. If the factors you focus on do not match the factors that the guy running the business is focused on, you’ve not understood the business and there’s a problem over there." Mohnish Pabrai

“Every company has 100 things about them you could study and learn. But you have to understand the differences between data and knowledge, and between knowledge and wisdom. Warren Buffett is remarkable in his ability to cut right through. He sees very clearly the three or four or five critical factors that determine whether a company succeeds or fails. It’s not about encyclopedic knowledge, it’s about zeroing in on what truly matters and assessing that. There’s no substitute for that in this business." Howard Marks

Investment errors typically stem from shortcomings in analysis rather than deficiencies in data collection. Rather than allocating excessive time gathering every possible piece of information, it is more beneficial to focus on critical thinking and reasoning processes. Is the collected information genuinely practical? Are there underlying psychological biases influencing the interpretation? Have consultations been conducted with competitors, customers, and suppliers? Has the concept been thoroughly tested? What assumptions underpin the analysis, and can they be challenged? Are alternative scenarios considered? What potential oversights exist? What gaps in knowledge need to be addressed?

"There are only a few things you have to get right about a company for it to be successful investment. Our view is that if you can get 85% of the way there by answering the big questions, don't waste your time on the last 15% because the marginal utility isn't worth it." Steve Morrow

“The value of in-depth fundamental analysis is subject to diminishing marginal returns.” Seth Klarman

By focusing on the things that matter as opposed to seeking every last detail means you’re less prone to over-confidence and confirmation bias. 

“Information tends to beget information, as users become addicts. “Perfect information”, the saying goes, “leads to perfect decisions.” But more and more information gathered in the name of the wrong context leads to worse and worse decisions.” ‘CEO’s and the CIA: Lessons Learned’ Inferential Focus 1998

“Investment experts continue to be convinced that their major problems could have been handled if only those extra few necessary facts had been available. They thus tend to overload themselves with information, which usually does not improve their decisions but only makes them more confident and more vulnerable to serious errors.” Dave Dreman

"Conventional wisdom suggests that, for investors, more information these days is a blessing and more competition is a curse. I'd say the opposite is true. Coping with so much information runs the risk of distracting attention from the few variables that really matter." John Neff

"When forecasters have too much information, they often become even more inaccurate than when there is too little." Bennett Goodspeed

"Once an experienced analyst has the minimum information necessary to make an informed judgement, obtaining additional information generally does not improve the accuracy of his or her forecasts. Additional information does, however, lead the analyst to become more confident in the judgement, to the point of over-confidence." Richards Heuer

Although the ability to collect all the information will always remain elusive, investors can still achieve solid returns even if mistakes are made. You don’t need a perfect batting average.

“I am a professional mistake maker. One third of my trades are probably wrong.” Ray Dalio

“If you’re terrific in this business, you’re right six out of 10.” Peter Lynch

“If an investor is right 2 out of 3 times in the investment decisions they make, they would hit the ball so far out of the park, it would be amazing.” Mohnish Pabrai

The important thing is not to dwell on mistakes. Learn from them and move on.

“To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” George Soros

“Since actual perfection and 100% satisfaction with a position are impossible, we must learn from results and not dwell on past outcomes, either good or bad. Moving forward, even from large errors, is required.” Paul Singer

“I may try to minimise my errors, but I'm not one to dwell on them. It isn't worth it. You have to put mistakes behind you and not look back. Tomorrow is another day. Just go on to the next thing and strive to do your best." Warren Buffett

Remaining open-minded, accepting and learning from mistakes and adopting a sense of humility by acknowledging you can't know everything will improve investment results in an environment of impossible perfection. 

“The humility required for good judgment is not self-doubt—the sense that you are untalented, unintelligent, or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.” Philip Tetlock

"The more you learn, the more you will realize how little you know - and armed with this humility, you will never lose sight of the distance that separates self-confidence and self-importance." Jim Rogers

Even the Investment Masters make mistakes. It's human nature. And whilst perfectionism is also a fundamental human behaviour, striving for it in Investment is a mistake. We can learn from our mistakes, whereas if we are always seeking that perfect 'batting average', the chances of learning and adapting are minimal indeed. So before you buy your next stock, keep open the possibility you may be wrong ... 

TURN-AROUNDS AND RETAIL

If, you, like me have been observing many of the great investors over time, no doubt you will have noticed that most prefer to invest in businesses that have been operating with long track records of success. Consistent profitability, excellent brands and market share and products and processes that require little in the way of constant management intervention. These types of businesses are likely to be doing the same thing in ten years that they are doing now.  

While its inevitable that many businesses will hit bumps in the road along the way - product launches may not go quite as expected, management unexpectedly changes, competitors gain a short-term edge, etc. - most of the Investment Masters stay well away from those businesses that need to be 'turned around'. These are organisations that need significant management input and skilful execution to return them to profitability.

“Both our operating and investment experience cause us to conclude that 'turn-arounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than a poor business at a bargain price”  Warren Buffett

“There’s more safety and optionality in businesses that don’t need to be rescued.” Vinson Walden

“We generally don’t invest in broken businesses that need to be straightened out .. It’s just not what we do.” Chuck Akre

"We require strong balance sheets and a long record of profitability, so we’re not usually investing in classic turnarounds." Alexander Roepers

"We actually don’t do turnarounds. What attracts us to the whole concept of value investing is the idea of having a margin of safety, in terms of value over price. That margin of safety only exists if values are stable and it only improves if value increases. With turnarounds, you’re making a bet – maybe a very intelligent one, but still a bet – that something broken can be fixed. Even in the best case, you may be looking at years when value declines or stagnates. Our experience is that we’re better off investing in a good business that is constantly compounding value from the beginning of our ownership, without what to us is the unacceptable risk that the turnaround doesn’t work. We just don’t think we need to take that kind of risk to earn strong returns.” CT Fitzpatrick

“Companies rarely go through a transformational improvement (a phrase involving leopards and spots springs to mind) and these events are also difficult to predict. But in our view the main problem with this investment strategy, other than the fact that we have no expectation we could make it work, is that whilst fund managers await the kiss that will turn their corporate frogs into princes, they steadily erode value.” Terry Smith

“I’ve got a friend who always wants to buy lousy companies with the idea he’s going to change them into wonderful companies. And I just ask him, you know, “Where in the last hundred years have you seen it happen?” Warren Buffett

Some management teams are well-known for their capabilities in rescuing businesses. Inevitably though, the return to successful operations is a painstaking and often frustratingly long exercise with no guarantee of success. Whilst they initially may look like a very attractive bargain at the beginning, the road to rescue can often cost a lot more than was anticipated.

“Managements of weak companies often announce plans to improve earnings and other fundamentals, but my experience is that turning around entire companies usually is a difficulty process that rarely meets with satisfactory success.” Ed Wachenheim

“Turnarounds are exceedingly rare and bargain stocks often wind up costing a good deal.”  Scott Fearon

Many Investment Masters cut their teeth on turn around companies. Very few can show the benefits from what they initially saw as a wise investment. Most have learnt their lesson.

“I was tempted in my youth by turnaround stories or betting on new product or service offers, where you could hit the ball out of the park if things got fixed or the new product took off. But I’ve had enough failures pursuing those types of ideas that I’ve for the most part lost the stomach for them. From a performance standpoint, I’m more focused on what something is than what it can be.” Thomas Gayner

“After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.” Warren Buffett

Businesses that require significant capital expenditure to get back to profitability require a leap of faith that is often too far. Unless the business has a strong competitive advantage, the benefits of additional capital ordinarily end up with the customers and not the shareholders.

"We react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures.  The projections will be dazzling, and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.” Warren Buffett

One area the Investment Masters are particularly cautious about is poor performing retailers that need turning around.  Even at the best of times retailing is a tough business .. consumer tastes can be fickle, competition is usually intense, barriers to entry are low, margins are thin and fixed costs are high. The industry has a history of significant disruption and is a wasteland of corporate bankruptcies.

"Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail, the Sears, the Montgomery Wards, the Woolworth's, the Grants, the Kresges. I mean, over the years, a lot of giants have been toppled." Warren Buffett

“Warren [Buffett] is super smart and highly disciplined, but he has made lots of mistakes in other industries. Berkshire has bought many loser retail operations over the years. Other than Nebraska Furniture Mart and Borsheim’s, most of the rest of them have not worked out so well.” Mohnish Pabrai

“I don’t do retail because you have to recreate the demand every day.” Jeffrey Ubben

"Charlie and I try and distinguish between businesses where you have to have been smart once and businesses where you have to stay smart. And, I mean, retailing is a good case of a business where you have to stay smart. You are under attack all of the time. People are in your store. If you’re doing something successful, they’re in your store the next day trying to figure out what it is about your success that they can transplant and maybe add a little something on in their own situation. So, you cannot coast in retailing." Warren Buffett

“Retail is a tougher place to make money than most people realise.” Guy Spier

"I think Warren and I can match anybody's failures in retail." Charlie Munger

“Retailing is a difficult business. It involves large investments for a thin margin.” Marathon Asset Management

“Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.  In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.” Warren Buffett

In retailing good management is essential  ...

“Buying a retailer without good management is like buying the Eiffel Tower without an elevator.” Warren Buffett

But sometimes even that isn't enough ..

"Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day. Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1996 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it." Warren Buffett

And turning around a poor performing retailer rarely works...

“Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme." Warren Buffett

“In general I don’t like retailers, and I have a bias against turnaround of struggling retailers. Those are very hard things to pull off.” Mohnish Pabrai

"How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers." Warren Buffett

It's easier, less risky and likely more profitable to find other things to do...

"We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money." Warren Buffett

Particularly with the arrival of Amazon...

"[Amazon is] one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important." Warren Buffett

In 2016, Buffett sold his position in Walmart .. he decided to look for an easier game.. 

".. Amazon in particular is an entity that’s gonna have everybody in their sights. And they’ve got delighted customers. And it’s extraordinary what they’ve accomplished. And a lot of people, the delivery, you know, and that is a tough, tough, tough, competitive force. Now, Walmart’s pushing forward online themselves and they’ve got all kinds of strengths. But I just decided that I’d look for a little easier game.”

Turn around business situations, particularly those in retail are hard going. Lots of capital, lots of hard work and almost constant management intervention are required. Is it really worth it, though? The Investment Masters have determined there are far easier fish to fry out there....

Conservative Forecasts - Masters Thoughts

Forecasting, or more importantly, accurate Forecasting is an art which has long been considered akin to crystal ball gazing. Many think they can do it well, but when you really get down to it you'll often find that those self professed 'seers' are no better at it than anyone else.

Our opinions on the worth of certain investments are also affected by the intellectual biases we have been talking about in recent blogs. Basically, if you want an investment that you really like to perform, then naturally, your belief is that it will. And if you are attempting to forecast that business' future results, invariably it will have significant upside potential.

In realistic terms, the value of an investment is determined by the future cash flows a business will generate, not what it has earned in the past. Given no-one knows what's going to happen in the future, determining a company's worth requires making an estimate of what those future cashflows may be. This of course, is where it gets hard.

Given the number one rule of investing is not losing money, the Investment Masters manage this difficulty by focusing on buying stocks with a 'margin of safety.' Should future events unfold in a manner you weren't expecting, a margin of safety will help minimise the downside.

"Investing is inherently about predicting the future. But predictions can never reach 100% accuracy; they can only fall between zero and something approaching 100%. So when we make a judgement, we need a large buffer. This is called margin of safety.  Because there is no way to ever be sure, you must always remember the margin of safety no matter how many other things you grasp." Li Li

“The best investments have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vissitudes of the business cycle won’t derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive ten-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly, every assumption proving accurate, every break going your way.” Seth Klarman

To build this margin of safety, you'll find the Investment Masters take a conservative approach to forecasting future earnings. Simply assuming a company can grow earnings at high rates into the future, and then relying on a valuation based on those optimistic forecasts, exposes the investor to undue capital risk should those optimistic forecasts not be met.

“How do value investors deal with analytical necessity to predict the unpredictable?  The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded.  Investors are well advised to make only conservative projections and then invest only at a substantial discount from valuations derived there from.” Seth Klarman

“Typically, when I’m making investments, I’m not making them with assumptions in terms of futures, which are anything more than conservative. I am not banking on massive amounts of demand or any growth rates. I want to make them in a manner where, in virtually any circumstance that I can think of, the odds are heavily in our favour.” Mohnish Pabrai

“.. take all of the variables and calculate ‘em reasonably conservatively .. don’t focus too much on extreme conservatism on each variable in terms of the discount rate and the growth rate and so on; but try to be as realistic as you can on these numbers, with any errors being on the conservative side. And then when you get all through, you apply the margin of safety.” Warren Buffett

“Over the years, we have always positioned ourselves so that if we err, it will generally be on the side of excessive conservatism.” Frank Martin

“These situations are dynamic, so you make the best guess you can and try to be more on the conservative side when figuring out what all these things are likely to be worth.” Bill Stewart

“When weighing whether or not to purchase a security, we usually make assumptions that hopefully will prove conservative.” Ed Wachenheim

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative.” Warren Buffett

“We strive to be conservative and realistic in assessing opportunities, paying close attention to our own limitations.” Allan Mecham

“We only want to buy when we can pay less than 60% of a conservative appraisal of a company’s value .…. trying to create a big margin of safety.” Mason Hawkins

It's important to recognise that very few companies are actually able to grow at very high rates over the long term. Not only that, it's also very difficult to estimate which companies will be the fast growers ahead of time. While analysts and investors sometimes have a tendency to project double-digit growth for years into the future, in reality this rarely eventuates. Companies become too large and succumb to the 'law of large numbers': competition is attracted by the high growth rates, or they get disrupted by new technology. The Investment Masters recognise few companies can grow at double-digit rates over the medium to long term.

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends; a high growth rate eventually forges its own anchor." Warren Buffett

"As well as being difficult to manage and also attracting competition, high rates of growth are, in any case, unsustainable. Eventually, even the most successful business models must face the law of large numbers - all markets are of finite size (even Coca-Cola's despite it's mid-90's slogan: "The closer we get to infinity, the better it looks!"). Empirically, very few companies can sustain anything like double-digit growth for a decade or more." Marathon Asset Management

"Once a fast grower gets too big, it faces the same dilemma as Gulliver and Lilliput. There's simply no place for it to stretch out." Peter Lynch

"Since analysts consistently overestimate growth rates, disasters happen all the time.  A 20% growth rate is a nice round number, easy for an analyst to pencil in, and that gets people excited. It should, because 20% growth over time would be spectacular. And at some point impossible to sustain." Ralph Wanger

“It’s unrealistic to expect companies to grow at 15% for extended periods. Most great companies can’t do it.” Chris Davis

“The notion that any business can grow at 20% per year forever is a fallacy. It doesn’t happen. In fact, if you go back in time. Let’s say I go back 50 years and I look at the best businesses of the era 50 years back, the bluest of blue chips which were the Amex of the time. Most of them are not around today. They don’t even exist. They have gone bankrupt or they have been acquired or gone.  You cannot get long, long runs on most of these businesses.” Mohnish Pabrai

"Examine the record of, say, the 200 highest earnings companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates.  You will find only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings per-share over the next 20 years." Warren Buffett

"Over time, the growth rate of almost all technologies, products, and services slow because of saturation, obsolescence, or competition. Many investors tend to project high growth rates far into the future without fully considering forces that eventually will lead to slower growth.” Ed Wachenheim

Over time companies change and naturally, so industries also change. It's important therefore that when considering the future, we must ask ourselves what the economic and competitive landscape may look like.

"Everything is in a constant state of change, and the wise investor recognises that success is a process of continually seeking answers to new questions." Sir John Templeton

Simply predicting the future by looking into the past is one of the most dangerous pitfalls of investing. Even though this fact is largely known, many people still practice this approach. Because forecasting the future is so inaccurate, they feel the only safe way to predict what will happen is to look at past results. Successful investing requires that you think about the factors that will impact upon a business in the future. 

"The investor of today does not profit from yesterday's growth." Warren Buffett

“Typically, analysts evaluating the future prospects of a company look at its past. Where else can you look after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future.” Leon Levy

"Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do."  Howard Marks

Over time I've witnessed many analysts change their earnings forecasts and tweak their price targets for companies by minuscule amounts. Yet, in the case of most companies, its almost impossible to predict future earnings with any level of precision. Rather than spending the time labouring over precise forecasts, time is better spent thinking about, and understanding the key quantitative and qualitative factors that are likely to impact on the business in the future.

“It is better to be approximately right, than precisely wrong.” Warren Buffett

"The cost of obsessing on precision is to often miss the forest for the trees." Frank Martin

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid. We need numbers and models, but their utility should be paired with judgment and common sense." Ed Wachenheim

Talking to customers, suppliers and competitors is likely to be more fruitful than burying yourself in a 5,000 line spreadsheet model.

"Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them." Phil Fisher

One method I find useful in analysing a company is inverting the analytical process. Rather than forecasting how fast a company's earnings will grow, look to estimate the growth rates that are implied by the current share price. This can be done by building a basic discounted cash flow model of the company's earnings.  If you use the current EPS and a growth rate of 'n' for future years, you can calculate future annual EPS estimates and a terminal EPS estimate for the year beyond the forecast period [say 3-6 years]. You can then apply an appropriate PE ratio to the terminal EPS to calculate a notional terminal value. You can then discount the annual EPS estimates and the future terminal value back to the present value by using an appropriate discount rate.  If you solve for 'n' such that the present value of the cash flows is equal to the share price you get an indication of the growth rate implied in the stock price.  This can then be considered in terms of reasonableness.  

“Reverse engineering the expectations embedded in a stock price is usually more fruitful than trying to foretell the future.”  Marathon Asset Management

“If you are wedded to the use of discounted cash flow valuations, then you may well benefit from turning the process in its head. Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth.”  James Montier

“We do a lot of what we call reverse DCF where we actually take the price today and instead of a typical discounted cash flow where you make projections about what the cash flows will be and you discount them back and say this is what it is worth. A reverse is, you actually try to figure out what’s priced in to today’s stock and what would have to happen for it to be worth this." Jason Karp

Successful investment decisions are made through a combination of using conservative forecasts, thinking about the future and understanding that high-growth rates tend to be unsustainable in the medium to longer term. So how do your forecasts look?