The Truth About Investing

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

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

The video from the CFA Society can be accessed below:

Investment Thesis - Pen to Paper

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Its time to start writing … 

Lessons from Valeant

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Highly Acquisitive Company

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

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

High Guidance

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

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

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

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

Win/Lose

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

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

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

Corporate Debt

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

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

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

Position Size

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

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

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

Consistency / Commitment Bias

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

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

Falling In Love

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

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

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

Get Out

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

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

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

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

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

“Quickly identify mistakes and take action.” Charlie Munger

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

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

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

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

The Buffett Series - Buffett on Book Value

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Buffett Series - A Changing Media Landscape

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Buffett Series - Businesses you Know

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

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

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

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

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

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

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

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

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

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

The Buffett Series - Investment Analysis

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

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

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

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

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

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

Buffett expands on the scuttlebutt process… 

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

and on the Apple products ...

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

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

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

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

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

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

The Buffett Series - Look-Through Earnings

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

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

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

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

In his 1991 letter, Buffett advises investors ...

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

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

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

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

In his 1996 letter Buffett once again advised …

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

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

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

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

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

The Buffett Series - A lower Tax Rate?

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

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

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

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

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

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

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

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

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

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

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

The Buffett Series - Thinking about Bonds

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

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

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

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

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

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

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

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

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

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

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

The Buffett Series - Thinking about Competitive Advantage

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

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

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

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

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

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

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

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

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

The Buffett Series - What is Value Investing?

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

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

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

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

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

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

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

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

Daily Journal Meeting 2017

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

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

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

Here are the key points from the meeting ..

On Picking Managers ..

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

On Capex …

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

On Wells Fargo ..

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

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

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

On choosing what to do in life ..

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

About Amex/Payments Systems…

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

On multi-disciplinary learning…

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

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

 On Buffett changing..

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

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

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

On Investing now and the need for change …

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

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

On Indexing with a small index …

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

On funds management and big decisions ..

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

On Books ..

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

Destroying old ideas …

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

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

Ideas …

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

On Valeant..

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

On diversification..

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

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

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

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

On India..

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

 On market declines..

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

On China..

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

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

On adversity..

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

On Manager fees..

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

On being rational ..

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

 On Complex systems..

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

Portfolio Construction - Where is the risk?

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

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

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

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

Here is the portfolio:

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

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

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

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

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

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

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

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

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

Let's assess the subject portfolio on each:

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

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

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

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

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

Buffett noted at the time..

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some additional thoughts ..

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

DISCLAIMER

The Arbitrage Series - Part 3 : Time Arbitrage

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further Reading - 

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

Disclaimer

Learning from the Outsiders

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

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

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

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

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

Some of the common characteristics included:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Arbitrage Series - Part 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further reading - 

The Arbitrage Series - Part 1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further suggested reading:

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

Value - Market, Intrinsic and Private

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Quality Companies, Compounders and Value Traps

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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