Best Performers: Microcap Stocks

(Image:  Zen Buddha Silence by Marilyn Barbone.)

November 20, 2022

Are you a long-term investor?  If so, are you interested in maximizing long-term results without taking undue risk?

Warren Buffett, arguably the best investor ever, has repeatedly said that most people should invest in a low-cost broad market index fund.  Such an index fund will allow you to do better than 80% to 90% of all investors, net of costs, after several decades.

Buffett has also said that you can do better than an index fund by investing in microcap stocks – as long as you have a sound method.  Take a look at this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2020:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2020) Mean Firm Size (in millions)
1 9.67% 9.47% 179 145,103
2 10.68% 10.63% 173 25,405
3 11.38% 11.17% 187 12,600
4 11.53% 11.29% 203 6,807
5 12.12% 12.03% 217 4,199
6 11.75% 11.60% 255 2,771
7 12.01% 11.99% 297 1,706
8 12.03% 12.33% 387 888
9 11.55% 12.51% 471 417
10 12.41% 17.27% 1,023 99
9+10 11.71% 15.77% 1,494 199

(CRSP is the Center for Research in Security Prices at the University of Chicago.  You can find the data for various deciles here:  http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)

The smallest two deciles – 9+10 – comprise microcap stocks, which typically are stocks with market caps below $500 million.  What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2020:

Microcap equal weighted returns = 15.8% per year

Large-cap equal weighted returns = ~10% per year

In practice, the annual returns from microcap stocks will be 1-2% lower because of the difficulty (due to illiquidity) of entering and exiting positions.  So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2020, versus 10% per year for an equal weighted large-cap approach.

Still, if you can do 4% better per year than the S&P 500 Index (on average) – even with only a part of your total portfolio – that really adds up after a couple of decades.

  • Most professional investors ignore micro caps as too small for their portfolios.  This causes many micro caps to get very cheap.  And that’s why an equal weighted strategy – applied to micro caps – tends to work well.

 

VALUE SCREEN: +2-3%

By systematically implementing a value screen—e.g., low EV/EBITDA or low P/E—to a microcap strategy, you can add 2-3% per year.

 

IMPROVING FUNDAMENTALS: +2-3%

You can further boost performance by screening for improving fundamentals.  One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps.  See:  http://boolefund.com/joseph-piotroski-value-investing/

 

BOTTOM LINE

If you invest in microcap stocks, you can get about 14% a year.  If you also use a simple screen for value, that adds at least 2% a year.  If, in addition, you screen for improving fundamentals, that adds at least another 2% a year.  So that takes you to 18% a year, which compares quite well to the 10% a year you could get from an S&P 500 index fund.

What’s the difference between 18% a year and 10% a year?  If you invest $50,000 at 10% a year for 30 years, you end up with $872,000, which is good.  If you invest $50,000 at 18% a year for 30 years, you end up with $7.17 million, which is much better.

Please contact me if you would like to learn more.

    • My email: jb@boolefund.com.
    • My cell: 206.518.2519

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

 

Walter Schloss: Cigar-Butt Specialist

November 6, 2022

Walter Schloss generated one of the best investment track records of all time—close to 21% (gross) annually over 47 years—by investing exclusively in cigar butts (deep value stocks).  Cigar-butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).

The highest returning cigar butt strategy comes from Ben Graham, the father of value investing.  It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.

  • The main trouble with net nets today is that many of them are tiny microcap stocks—below $50 million in market cap—that are too small even for most microcap funds.
  • Also, many net nets exist in markets outside the United States.  Some of these markets have had problems periodically related to the rule of law.

Schloss used net nets in the early part of his career (1955 to 1960).  When net nets became too scarce (1960), Schloss started buying stocks at half of book value.  When those became too scarce, he went to buying stocks at two-thirds of book value.  Eventually he had to adjust again and buy stocks at book value.  Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.

(Photo by Sky Sirasitwattana)

One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career.  (At any given time, his portfolio had about 100 stocks.)  Warren Buffett commented:

Following a strategy that involved no real risk—defined as permanent loss of capital—Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500.  It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type.  A few big winners did not account for his success.  It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

Schloss was aware that a concentrated portfolio—e.g., 10 to 20 stocks—could generate better long-term returns.  However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.

Most investors are best off investing in low-cost index funds or in quantitative value funds.  For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:

It is important to know what you like and what you are good at and not worry that someone else can do it better.  If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.

I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital: https://www.walterschloss.com/

Here’s the outline for this blog post:

  • Stock is Part Ownership;  Keep It Simple
  • Have Patience;  Don’t Sell on Bad News
  • Have Courage
  • Buy Assets Not Earnings
  • Buy Based on Cheapness Now, Not Cheapness Later
  • Boeing:  Asset Play
  • Less Downside Means More Upside
  • Multiple Ways to Win
  • History;  Honesty;  Insider Ownership
  • You Must Be Willing to Make Mistakes
  • Don’t Try to Time the Market
  • When to Sell
  • The First 10 Years Are Probably the Worst
  • Stay Informed About Current Events
  • Control Your Emotions;  Be Careful of Leverage
  • Ride Coattails;  Diversify

 

STOCK IS PART OWNERSHIP;  KEEP IT SIMPLE

A share of stock represents part ownership of a business and is not just a piece of paper or a blip on the computer screen.

Try to establish the value of the company.  Use book value as a starting point.  There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value.  Intrinsic value is what a company is worth—i.e., what a private buyer would pay for it.  Book value—assets minus liabilities—is also called “net worth.”

Follow Buffett’s advice: keep it simple and don’t use higher mathematics.

(Illustration by Ileezhun)

Some kinds of stocks are easier to analyze than others.  As Buffett has said, usually you don’t get paid for degree of difficulty in investing.  Therefore, stay focused on businesses that you can fully understand.

  • There are thousands of microcap companies that are completed neglected by most professional investors.  Many of these small businesses are simple and easy to understand.

 

HAVE PATIENCE;  DON’T SELL ON BAD NEWS

Hold for 3 to 5 years.  Schloss:

Have patience.  Stocks don’t go up immediately.

Schloss again:

Things usually take longer to work out but they work out better than you expect.

(Illustration by Marek)

Don’t sell on bad news unless intrinsic value has dropped materially.  When the stock drops significantly, buy more as long as the investment thesis is intact.

Schloss’s average holding period was 4 years.  It was less than 4 years in good markets when stocks went up more than usual.  It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.

 

HAVE COURAGE

Have the courage of your convictions once you have made a decision.

(Courage concept by Travelling-light)

Investors shun companies with depressed earnings and cash flows.  It’s painful to own stocks that are widely hated.  It can also be frightening.  As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

A related worry is that if a company is burning through its cash, it will gradually destroy net asset value.  Ben Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock.  But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world—such as bear markets and recessions.

Schloss discussed an example: Cleveland Cliffs, an iron ore producer.  Buffett owned the stock at $18 but then sold at about that level.  The steel industry went into decline.  The largest shareholder sold out because he thought the industry wouldn’t recover.

Schloss bought a lot of stock at $6.  Nobody wanted it.  There was talk of bankruptcy.  Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.

Soon thereafter, the company sold some assets and bought back some stock.  After the stock increased a great deal from the lows, then it started getting attention from analysts.

In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks.  Investors avoid stocks when they’re having problems, which is why they get so cheap.  Investors overreact to negative news.

 

BUY ASSETS NOT EARNINGS

(Illustration by Teguh Jati Prasetyo)

Schloss:

Try to buy assets at a discount [rather] than to buy earnings.  Earnings can change dramatically in a short time.  Usually assets change slowly.  One has to know much more about a company if one buys earnings.

Not only can earnings change dramatically; earnings can easily be manipulated—often legally.  Schloss:

Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.

 

BUY BASED ON CHEAPNESS NOW, NOT CHEAPNESS LATER

Buy things based on cheapness now.  Don’t buy based on cheapness relative to future earnings, which are hard to predict.

Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:

  • Net asset value
  • Current and past earnings

Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.

  • As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets.  The true economic value of the assets is the cost of reproducing them at current prices.
  • Another way to determine intrinsic value is to figure out earnings power—also called normalized earnings—or how much the company should earn on average over the business cycle.  Earnings power typically corresponds to a market level return on the reproduction value of the assets.  In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.

In some cases, earnings power may exceed a market level return on the reproduction value of the assets.  This means that the ROIC (return on invested capital) exceeds the cost of capital.  It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return.  Often it’s a question of how long some competitive advantage can be maintained.  How long can a high ROIC be sustained?

As Buffett remarked:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A moat is a sustainable competitive advantage.  Schloss readily admits he can’t determine which competitive advantages are sustainable.  That requires unusual insight.  Buffett can do it, but very few investors can.

As far as franchises or good businesses—companies worth more than adjusted book value—Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value.  As a result, Schloss usually buys mediocre and bad businesses at book value or below.  Schloss buys “difficult businesses” at clearly cheap prices.

Buying a high-growing company on the expectation that growth will continue can be quite dangerous.  First, growth only creates value if the ROIC exceeds the cost of capital.  Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably.  Schloss:

If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20.  You can lose half your money just because the earnings fell out of bed.

If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8.  It’s not great, but it’s not terrible either.  On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.

Basically, we like protection on the downside.  A $10 stock with a $15 book can offer pretty good protection.  By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.

Also, I think the person who buys earnings has got to follow it all the darn time.  They’re constantly driven by earnings, they’re driven by timing.  I’m amazed.

 

BOEING:  ASSET PLAY

(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)

Cigar butts—deep value stocks—are characterized by two things:

  • Poor past performance;
  • Low expectations for future performance, i.e., low multiples (low P/B, low P/E, etc.)

Schloss has pointed out that Graham would often compare two companies.  Here’s an example:

One was a very popular company with a book value of $10 selling at $45.  The second was exactly the reverse—it had a book value of $40 and was selling for $25.

In fact, it was exactly the same company, Boeing, in two very different periods of time.  In 1939, Boeing was selling at $45 with a book of $10 and earning very little.  But the outlook was great.  In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.

If you’d bought Boeing in 1939 at $45, you would have done rather badly.  But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.

Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves.  For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment.  If the initial purchase is below true book value—based on the replacement cost of the assets—then you have downside protection in case earnings don’t recover.

 

LESS DOWNSIDE MEANS MORE UPSIDE

If you buy stocks that are protected on the downside, the upside takes care of itself.

The main way to get protection on the downside is by paying a low price relative to book value.  If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.

If the stock is well below probable intrinsic value, then you should buy more on the way down.  The lower the price relative to intrinsic value, the less downside and the more upside.  As risk decreases, potential return increases.  This is the opposite of what modern finance theory teaches.  According to theory, your expected return only increases if your risk also increases.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward.  Sometimes risk and reward are positively correlated.  Buffett gives the example of Russian roulette.  Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive.  Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive.  Clearly that would be a positive correlation between risk and reward.  Buffett continues:

The exact opposite is true with value investing.  If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.  The greater the potential for reward in the value portfolio, the less risk there is.

One quick example:  The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.  The company owned the Post, Newsweek, plus several television stations in major markets.  Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Link: https://bit.ly/2jBezdv

Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling.  In other words, most investors focus on price instead of intrinsic value.

 

MULTIPLE WAYS TO WIN

A stock trading at a low price relative to book value—a low P/B stock—is usually distressed and is experiencing problems.  But there are several ways for a cigar-butt investor to win, as Schloss explains:

The thing about buying depressed stocks is that you really have three strings to your bow:  1) Earnings will improve and the stocks will go up;  2) somebody will come in and buy control of the company;  or 3) the company will start buying its own stock and ask for tenders.

Schloss again:

But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does—because it’s cheap.

 

HISTORY;  HONESTY;  INSIDER OWNERSHIP

Look at the history of the company.  Value line is helpful for looking at history 10-15 years back.  Also, read the annual reports.  Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.

It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:

When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.

That said, try to ensure that management is honest.  Honesty is more important than brilliance, says Schloss:

…we try to get in with people we feel are honest.  That doesn’t mean they’re necessarily smart—they may be dumb.

But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.

Finally, insider ownership is important.  Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.

Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed.  You should prefer investment managers who, like the Schlosses, eat their own cooking.

 

YOU MUST BE WILLING TO MAKE MISTAKES

(Illustration by Lkeskinen0)

You have to be willing to make mistakes if you want to succeed as an investor.  Even the best value investors tend to be right about 60% of the time and wrong 40% of the time.  That’s the nature of the game.

You can’t do well unless you accept that you’ll make plenty of mistakes.  The key, again, is to try to limit your downside by buying well below probable intrinsic value.  The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.

 

DON’T TRY TO TIME THE MARKET

No one can predict the stock market.  Ben Graham observed:

If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

(Illustration by Maxim Popov)

Or as value investor Seth Klarman has put it:

In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:

I don’t believe all this nonsense about market timing.  Just buy very good value and when the market is ready that value will be recognized.

Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s.  Fourteen of these years—1968 to 1982—were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974).  But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach.  Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.

Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work.  However, bear markets create many bargains.  As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).

In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high.  Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.

Both Buffett and Schloss ignored the advice.  In hindsight, both Buffett and Schloss made great decisions.  Of course, Singleton would have made the same decision as Buffett and Schloss.  Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.

Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.

 

WHEN TO SELL

Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.

Selling is hard.  Schloss readily admits that many stocks he sold later increased a great deal.  But he doesn’t dwell on that.

The basic criterion for selling is whether the stock price is close to estimated intrinsic value.  For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling.  (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)

If stock A is cheaper than stock B, some value investors will sell A and buy B.  Schloss doesn’t do that.  It often takes four years for one of Schloss’s investments to work.  If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move.  Also, it’s very difficult to compare the relative cheapness of stocks in different industries.

Instead, Schloss makes an independent buy or sell decision for every stock.  If B is cheap, Schloss simply buys B without selling anything else.  If A is no longer cheap, Schloss sells A without buying anything else.

 

THE FIRST 10 YEARS ARE PROBABLY THE WORST

John Templeton’s worst ten years as an investor were his first ten years.  The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.

 

STAY INFORMED ABOUT CURRENT EVENTS

(Photo by Juan Moyano)

Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc.  Edwin Schloss said:

If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us—like John Templeton says in his book about being open to new ideas and new experiences.

 

CONTROL YOUR EMOTIONS;  BE CAREFUL OF LEVERAGE

Try not to let your emotions affect your judgment.  Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.

Quantitative investing is a good way to control emotion.  This is what Graham suggested and practiced.  Graham just looked at the numbers to make sure they were below some threshold—like 2/3 of current assets minus all liabilities (the net-net method).  Graham typically was not interested in what the business did.

On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:

One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks.  If you don’t shoot a hole-in-one, you owe us $10.”

Warren thought about it and said, “I’m not taking the bet.”

The others said, “Why don’t you?  The most you can lose is $10. You can make $10,000.”

Warren replied, If you’re not disciplined in the little things, you won’t be disciplined in the big things.”

Be careful of leverage.  It can go against you.  Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap.  Companies with high leverage can occasionally become especially cheap compared to book value.  But often the risk of bankruptcy is too high.

Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company.  If the probability of success is high enough and if the upside is great enough, it may not be a difficult decision.  Often the upside can be 10x or 20x your investment, which implies a positive expected return even when the odds of success are 10%.

 

RIDE COATTAILS;  DIVERSIFY

Sometimes you can get good ideas from other investors you know or respect.  Even Buffett did this.  Buffett called it “coattail riding.”

Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing.  Have at least 15-20 stocks in your portfolio.  A few investors can do better by being more concentrated.  But most investors will do better over time by using a quantitative, diversified approach.

Schloss tended to have about 100 stocks in his portfolio:

…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out.  Now I can’t tell you which ones, so I buy a hundred of them.  Of course, it doesn’t mean you own the same amount of each stock.  If we like a stock we put more money in it.  Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.

Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.

Schloss emphasized that it’s important to know what you know and what you don’t know.  Warren Buffett and Charlie Munger call this a circle of competence.  Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.

(Image by Wilma64)

The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence.  Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow.  By humbly defining your circle of competence, you can limit the impact of overconfidence.  Part of this humility comes from making mistakes.

The best choice for most investors is either an index fund or a quantitative value fund.  It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Business Adventures

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 30, 2022

In 1991, when Bill Gates met Warren Buffett, Gates asked him to recommend his favorite business book.  Buffett immediately replied, “It’s Business Adventures, by John Brooks.  I’ll send you my copy.”  Gates wrote in 2014:

Today, more than two decades after Warren lent it to me—and more than four decades after it was first published—Business Adventures remains the best business book I’ve ever read.  John Brooks is still my favorite business writer.

It’s certainly true that many of the particulars of business have changed.  But the fundamentals have not.  Brooks’s deeper insights about business are just as relevant today as they were back then.  In terms of its longevity, Business Adventures stands alongside Benjamin Graham’s The Intelligent Investor, the 1949 book that Warren says is the best book on investing that he has ever read.

See:  https://www.gatesnotes.com/Books/Business-Adventures

I’ve had the enormous pleasure of reading Business Adventures twice.  John Brooks is quite simply a terrific business writer.

Each chapter of the book is a separate business adventure.  Outline:

  • The Fluctuation
  • The Fate of the Edsel
  • A Reasonable Amount of Time
  • Xerox Xerox Xerox Xerox
  • Making the Customers Whole
  • The Impacted Philosophers
  • The Last Great Corner
  • A Second Sort of Life
  • Stockholder Season
  • One Free Bite

 

THE FLUCTUATION

Brooks recounts J.P. Morgan’s famous answer when an acquaintance asked him what the stock market would do:  “It will fluctuate.”  Brooks then writes:

Apart from the economic advantages and disadvantages of stock exchanges – the advantage that they provide a free flow of capital to finance industrial expansion, for instance, and the disadvantage that they provide an all too convenient way for the unlucky, the imprudent, and the gullible to lose their money – their development has created a whole pattern of social behavior, complete with customs, language, and predictable responses to given events.

Brooks explains that the pattern emerged fully at the first important stock exchange in 1611 in Amsterdam.  Brooks mentions that Joseph de la Vega published, in 1688, a book about the first Dutch stock traders.  The book was aptly titled, Confusion of Confusions.

And the pattern persists on the New York Stock Exchange.  (Brooks was writing in the 1960’s, but many of his descriptions still apply.)  Brooks adds that a few Dutchmen haggling in the rain might seem to be rather far from the millions of participants in the 1960’s.  However:

The first stock exchange was, inadvertently, a laboratory in which new human reactions were revealed.  By the same token, the New York Stock Exchange is also a sociological test tube, forever contributing to the human species’ self-understanding.

On Monday, May 28, 1962, the Dow Jones Average dropped 34.95 points, or more than it had dropped on any day since October 28, 1929.  The volume was the seventh-largest ever.  Then on Tuesday, May 29, after most stocks opened down, the market reversed itself and surged upward with a large gain of 27.03.  The trading volume on Tuesday was the highest ever except for October 29, 1929.  Then on Thursday, May 31, after a holiday on Wednesday, the Dow rose 9.40 points on the fifth-greatest volume ever.

Brooks:

The crisis ran its course in three days, but needless to say, the post-mortems took longer.  One of de la Vega’s observations about the Amsterdam traders was that they were ‘very clever in inventing reasons’ for a sudden rise or fall in stock prices, and the Wall Street pundits certainly needed all the cleverness they could muster to explain why, in the middle of an excellent business year, the market had suddenly taken its second-worst nose dive ever up to that moment.

Many rated President Kennedy’s April crackdown on the steel industry’s planned price increase as one of the most likely causes.  Beyond that, there were comparisons to 1929.  However, there were more differences than similarities, writes Brooks.  For one thing, margin requirements were far higher in 1962 than in 1929.  Nonetheless, the weekend before the May 1962 crash, many securities dealers were occupied sending out margin calls.

In 1929, it was not uncommon for people to have only 10% equity, with 90% of the stock position based on borrowed money.  (The early Amsterdam exchange was similar.)  Since the crash in 1929, margin requirements had been raised to 50% equity (leaving 50% borrowed).

Brooks says the stock market had been falling for most of 1962 up until crash.  But apparently the news before the May crash was good.  Not that news has any necessary relationship with stock movements, although most financial reporting services seem to assume otherwise.  After a mixed opening – some stocks up, some down – on Monday, May 28, volume spiked as selling became predominant.  Volume kept going up thereafter as the selling continued.  Brooks:

Evidence that people are selling stocks at a time when they ought to be eating lunch is always regarded as a serious matter.

One problem in this crash was that the tape – which records the prices of stock trades – got delayed by 55 minutes due to the huge volume.  Some brokerage firms tried to devise their own systems to deal with this issue.  For instance, Merrill Lynch floor brokers – if they had time – would shout the results of trades into a floorside telephone connected to a “squawk box” in the firm’s head office.

Brooks remarks:

All that summer, and even into the following year, security analysts and other experts cranked out their explanations of what had happened, and so great were the logic, solemnity, and detail of these diagnoses that they lost only a little of their force through the fact that hardly any of the authors had had the slightest idea what was going to happen before the crisis occurred.

Brooks then points out that an unprecedented 56.8 percent of the total volume in the crash had been individual investors.  Somewhat surprisingly, mutual funds were a stabilizing factor.  During the Monday sell-off, mutual funds bought more than they sold.  And as stocks surged on Thursday, mutual funds sold more than they bought.  Brooks concludes:

In the last analysis, the cause of the 1962 crisis remains unfathomable;  what is known is that it occurred, and that something like it could occur again.

 

THE FATE OF THE EDSEL

1955 was the year of the automobile, writes Brooks.  American auto makers sold over 7 million cars, a million more than in any previous year.  Ford Motor Company decided that year to make a new car in the medium-price range of $2,400 to $4,000.  Brooks continues:

[Ford] went ahead and designed it more or less in comformity with the fashion of the day, which was for cars that were long, wide, low, lavishly decorated with chrome, liberally supplied with gadgets… Two years later, in September, 1957, Ford put its new car, the Edsel, on the market, to the accompaniment of more fanfare than had attended the arrival of any new car since the same company’s Model A, brought out thirty years earlier.  The total amount spent on the Edsel before the first specimen went on sale was announced as a quarter of a billion dollars;  its launching… was more costly than any other consumer product in history.  As a starter toward getting its investment back, Ford counted on selling at least 200,000 Edsels the first year.

There may be an aborigine somewhere in a remote rainforest who hasn’t yet heard that things failed to turn out that way… on November 19, 1959, having lost, according to some outside estimates, around $350 million on the Edsel, the Ford Company permanently discontinued its production.

Brooks asks:

How could this have happened?  How could a company so mightily endowed with money, experience, and, presumably, brains have been guilty of such a monumental mistake?

Many claimed that Ford had paid too much attention to public-opinion polls and the motivational research it conducted.  But Brooks adds that some non-scientific elements also played a roll.  In particular, after a massive effort to come up with possible names for the car, science was ignored at the last minute and the Edsel was named for the father of the company’s president.  Brooks:

As for the design, it was arrived at without even a pretense of consulting the polls, and by the method that has been standard for years in the designing of automobiles – that of simply pooling the hunches of sundry company committees.

The idea for the Edsel started years earlier.  The company noticed that owners of cars would trade up to the medium-priced car as soon as they could.  The problem was that Ford owners were not trading up to the Mercury, Ford’s medium-priced car, but to the medium-priced cars of its rivals, General Motors and Chrysler.

Late in 1952, a group called the Forward Product Planning Committee gave much of the detailed work to the Lincoln-Mercury Division, run by Richard Krafve (pronounced “Kraffy”).  In 1954, after two years’ work, the Forward Product Planning Committee submitted to the executive committee a six-volume report.  In brief, the report predicted that there would be seventy million cars in the U.S. by 1965, and more than 40 percent of all cars sold would be in the medium-price range.  Brooks:

On the other hand, the Ford bosses were well aware of the enormous risks connected with putting a new car on the market.  They knew, for example, that of the 2,900 American makes that had been introduced since the beginning of the automobile age… only about twenty were still around.

But Ford executives felt optimistic.  They set up another agency, the Special Products Division, again with Krafve in charge.  The new car was referred to as the “E”-Car among Ford designers and workers.  “E” for Experimental.  Roy A. Brown was in charge of the E-car’s design.  Brown stated that they sought to make a car that was unique as compared to the other nineteen cars on the road at the time.

Brooks observes that Krafve later calculated that he and his associates would make at least four thousand decisions in designing the E-Car.  He thought that if they got every decision right, they could create the perfectly designed car.  Krafve admitted later, however, that there wasn’t really enough time for perfection.  They would make modifications, and then modifications of those modifications.  Then time would run out and they had to settle on the most recent modifications.

Brooks comments:

One of the most persuasive and frequently cited explanations of the Edsel’s failure is that it was a victim of the time lag between the decision to produce it and the act of putting it on the market.  It was easy to see a few years later, when smaller and less powerful cars, euphemistically called “compacts,” had become so popular as to turn the old automobile status-ladder upside down, that the Edsel was a giant step in the wrong direction, but it far from easy to see that in fat, tail-finny 1955.

As part of the marketing effort, the Special Products Division tapped David Wallace, director of planning for market research.  Wallace:

‘We concluded that cars are a means to a sort of dream fulfillment.  There’s some irrational factor in people that makes them want one kind of car rather than another – something that has nothing to do with the mechanism at all but with the car’s personality, as the customer imagines it.  What we wanted to do, naturally, was to give the E-Car the personality that would make the greatest number of people want it.’

Wallace’s group decided to get interviews of 1,600 car buyers.  The conclusion, in a nutshell, was that the E-Car could be “the smart car for the younger executive or professional family on its way up.”

As for the name of the car, Krafve had suggested to the members of the Ford family that the new car be named the Edsel Ford – the name of their father.  The three Ford brothers replied that their father probably wouldn’t want the car named after him.  Therefore, they suggested that the Special Products Division look for another name.

The Special Products Division conducted a large research project regarding the best name for the E-Car.  At one point, Wallace interviewed the poet Marianne Moore about a possible name.  A bit later, the Special Products Division contacted Foote, Cone & Belding, an advertising agency, to help with finding a name.

The advertising agency produced 18,000 names, which they then carefully pruned to 6,000.  Wallace told them that was still way too many names from which to pick.  So Foote, Cone & Belding did an all-out three-day session to cut the list down to 10 names.  They divided into two groups for this task.  By chance, when each group produced its list of 10 names, 4 of the names were the same:  Corsair, Citation, Pacer, and Ranger.

Wallace thought that Corsair was clearly the best name.  However, the Ford executive committee had a meeting at a time when all three Ford brothers were away.  Executive vice-president Ernest R. Breech, chairman of the board, led the meeting.  When Breech saw the final list of 10 names, he said he didn’t like any of them.

So Breech and the others were shown another list of names that hadn’t quite made the top 10.  The Edsel had been kept on this second list – despite the three Ford brothers being against it – for some reason, perhaps because it was the originally suggested name.  When the group came to the name “Edsel,” Breech firmly said, “Let’s call it that.”  Breech added that since there were going to be four models of the E-Car, the four favorite names – Corsair, Citation, Pacer, and Ranger – could still be used as sub-names.

Brooks writes that Foote, Cone & Belding presumably didn’t react well to the chosen name, “Edsel,” after their exhaustive research to come up with the best possible names.  But the Special Products Division had an even worse reaction.  However, there were a few, including Krafve, would didn’t object to the name.

Krafve was named Vice-President of the Ford Motor Company and General Manager, Edsel Division.  Meanwhile, Edsels were being road-tested.  Brown and other designers were already working on the subsequent year’s model.  A new set of retail dealers was already being put together.  Foote, Cone & Belding was hard at work on strategies for advertising and selling Edsels.  In fact, Fairfax M. Cone himself was leading this effort.

Cone decided to use Wallace’s idea of “the smart car for the younger executive or professional family on its way up.”  But Cone amended it to: “the smart car for the younger middle-income family or professional family on its way up.”  Cone was apparently quite confident, since he described his advertising ideas for the Edsel to some reporters.  Brooks notes with amusement:

Like a chess master that has no doubt that he will win, he could afford to explicate the brilliance of his moves even as he made them.

Normally, a large manufacturer launches a new car through dealers already handling some of its other makes.  But Krafve got permission to go all-out on the Edsel.  He could contact dealers for other car manufacturers and even dealers for other divisions of Ford.  Krafve set a goal of signing up 1,200 dealers – who had good sales records – by September 4, 1957.

Brooks remarks that Krafve had set a high goal, since a dealer’s decision to sell a new car is major.  Dealers typically have one hundred thousand dollars – more than 8x that in 2019 dollars – invested in their dealerships.

J. C. (Larry) Doyle, second to Krafve, led the Edsel sales effort.  Doyle had been with Ford for 40 years.  Brooks records that Doyle was somewhat of a maverick in his field.  He was kind and considerate, and he didn’t put much stock in the psychological studies of car buyers.  But he knew how to sell cars, which is why he was called on for the Edsel campaign.

Doyle put Edsels into a few dealerships, but kept them hidden from view.  Then he went about recruiting top dealers.  Many dealers were curious about what the Edsel looked like.  But Doyle’s group would only show dealers the car if they listened to a one-hour pitch.  This approach worked.  It seems that quite a few dealers were so convinced by the pitch that they signed up without even looking at the car in any detail.

C. Gayle Warnock, director of public relations at Ford, was in charge of keeping public interest in the Edsel – which was already high – as strong as possible.  Warnock told Krafve that public interest might be too strong, to the extent that people would be disappointed when they discovered that the Edsel was a car.  Brooks:

It was agreed that the safest way to tread the tightrope between overplaying and underplaying the Edsel would be to say nothing about the car as a whole but to reveal its individual charms a little at a time – a sort of automotive strip tease…

Brooks continues:

That summer, too, was a time of speechmaking by an Edsel foursome consisting of Krafve, Doyle, J. Emmet Judge, who was Edsel’s director of merchandise and product planning, and Robert F. G. Copeland, its assistant general sales manager for advertising, sales promotion, and training.  Ranging separately up and down and across the nation, the four orators moved around so fast and so tirelessly, that Warnock, lest he lost track of them, took to indicating their whereabouts with colored pins on a map in his office.  ‘Let’s see, Krafve goes from Atlanta to New Orleans, Doyle from Council Bluffs to Salt Lake City,’ Warnock would muse of a morning in Dearborn, sipping his second cup of coffee and then getting up to yank the pins out and jab them in again.

Needless to say, this was by far the largest advertising campaign ever conducted by Ford.  This included a three-day press preview, with 250 reporters from all over the country.  On one afternoon, the press were taken to the track to see stunt drivers in Edsels doing all kinds of tricks.  Brooks quotes the Foote, Cone man:

‘You looked over this green Michigan hill, and there were those glorious Edsels, performing gloriously in unison.  It was beautiful.  It was like the Rockettes.  It was exciting.  Morale was high.’

Brooks then writes about the advertising on September 3 – “E-Day-minus-one”:

The tone for Edsel Day’s blizzard of publicity was set by an ad, published in newspapers all over the country, in which the Edsel shared the spotlight with the Ford Company’s President Ford and Chairman Breech.  In the ad, Ford looked like a dignified young father, Breech like a dignified gentleman holding a full house against a possible straight, the Edsel just looked like an Edsel.  The accompanying text declared that the decision to produce the car had been ‘based on what we knew, guessed, felt, believed, suspected – about you,’ and added, ‘YOU are the reason behind the Edsel.’  The tone was calm and confident.  There did not seem to be much room for doubt about the reality of that full house.

The interior of the Edsel, as predicted by Krafve, had an almost absurd number of push-buttons.

The two larger models – the Corsair and the Citation – were 219 inches long, two inches longer than the biggest of the Oldsmobiles.  And they were 80 inches wide, “or about as wide as passenger cars ever get,” notes Brooks.  Each had 345 horsepower, making it more powerful than any other American car at the time of launching.

Brooks records that the car received mixed press after it was launched.  In January, 1958, Consumer Reports wrote:

The Edsel has no important basic advantage over other brands.  The car is almost entirely conventional in construction…

Three months later, Consumer Reports wrote:

[The Edsel] is more uselessly overpowered… more gadget bedecked, more hung with expensive accessories than any other car in its price class.

This report gave the Corsair and the Citation the bottom position in its competitive ratings.

Brooks says there were several factors in the downfall of the Edsel.  It wasn’t just that the design fell short, nor was it simply that the company relied too much on psychological research.  For one, many of the early Edsels suffered from a surprising variety of imperfections.  It turned out that only about half the early Edsels functioned properly.

Brooks recounts:

For the first ten days of October, nine of which were business days, there were only 2,751 deliveries – an average of just over three hundred cars a day.  In order to sell the 200,000 cars per year that would make the Edsel operation profitable the Ford Motor Company would have to move an average of between six and seven hundred each business day – a good many more than three hundred a day.  On the night of Sunday, October 13th, Ford put on a mammoth television spectacular for Edsel, pre-empting the time ordinarily allotted to the Ed Sullivan show, but though the program cost $400,000 and starred Bing Crosby and Frank Sinatra, it failed to cause any sharp spurt in sales.  Now it was obvious that things were not going well at all.

Among the former executives of the Edsel Division, opinions differ as to the exact moment when the portents of doom became unmistakable… The obvious sacrificial victim was Brown, whose stock had gone through the roof at the time of the regally accoladed debut of his design, in August, 1955.  Now, without having done anything further, for either better or worse, the poor fellow became the company scapegoat…

Ford re-committed to selling the Edsel in virtually every way that it could.  Sales eventually increased, but not nearly enough.  Ultimately, the company had to stop production.  The net loss for Ford was roughly $350 million.

Krafve rejects that the Edsel failed due to a poor choice of the name.  He maintains that it was a mistake of timing.  Had they produced the car two years earlier, when medium-sized cars were still highly popular, the Edsel would have been a success.  Brown agrees with Krafve that it was a mistake of timing.

Doyle says it was a buyers’ strike.  He claims not to understand at all why the American public suddenly switched its taste from medium-sized cars to smaller-sized cars.

Wallace argued that the Russian launch of the sputnik had caused many Americans to start viewing Detroit products as bad, especially medium-priced cars.

Brooks concludes by noting that Ford did not get hurt by this setback, nor did the majority of people associated with the Edsel.  In 1958, net income per share dropped from $5.40 to $2.12, and Ford stock dropped from a 1957 high of $60 to a low of $40.  However, by 1959, net income per-share jumped to $8.24 and the stock hit $90.

The Ford executives associated with the Edsel advanced in their careers, for the most part.  Moreover, writes Brooks:

The subsequent euphoria of these former Edsel men did not stem entirely from the fact of their economic survival;  they appear to have been enriched spiritually.  They are inclined to speak of their Edsel experience – except for those still with Ford, who are inclined to speak of it as little as possible – with the verve and garrulity of old comrades-in-arms hashing over their most thrilling campaign.

 

A REASONABLE AMOUNT OF TIME

Brooks:

Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading…

Not until 1934 did Congress pass the Securities Exchange Act, which forbids insider trading.  Later, a 1942 rule 10B-5 held that no stock trader could “make any untrue statement of a material fact or… omit to state a material fact.”  However, observes Brooks, this rule had basically been overlooked for the subsequent couple of decades.  It was argued that insiders needed the incentive of being able to profit in order to bring forth their best efforts.  Further, some authorities said that insider trading helped the markets function more smoothly.  Finally, it was held that most stock traders “possess and conceal information of one sort or another.”

In short, the S.E.C. seemed to be refraining from doing anything regarding insider trading.  But this changed when a civil complaint was made against Texas Gulf Sulphur Company.  The case was tried in the United States District Court in Foley Square May 9 to June 21, 1966.  The presiding judge was Dudley J. Bonsal, says Brooks, who remarked at one point, “I guess we all agree that we are plowing new ground here to some extent.”

In March 1959, Texas Gulf, a New York-based company and the world’s leader producer of sulphur, began conducting aerial surveys over a vast area of eastern Canada.  They weren’t looking for sulphur or gold, but for sulphides – sulphur in combination with other useful minerals such as zinc and copper.  Texas Gulf wanted to diversify its production.

These surveys took place over two years.  Many areas of interest were noted.  The company concluded that several hundred areas were most promising, including a segment called Kidd-55, which was fifteen miles north of Timmins, Ontario, an old gold-mining town several hundred miles northwest of Toronto.

The first challenge was to get title to do exploratory drilling on Kidd-55.  It wasn’t until June, 1963, that Texas Gulf was able to begin exploring on the northeast quarter of Kidd-55.  After Texas Gulf engineer, Richard H. Clayton, completed a ground electromagnetic survey and was convinced the area had potential, the company decided to drill.  Drilling began on November 8.  Brooks writes:

The man in charge of the drilling crew was a young Texas Gulf geologist named Kenneth Darke, a cigar smoker with a rakish gleam in his eye, who looked a good deal more like the traditional notion of a mining prospector than that of the organization man that he was.

A cylindrical sample an inch and a quarter in diameter was brought out of the earth.  Darke studied it critically inch by inch using only his eyes and his knowledge.  On November 10, Darke telephoned his immediate superior, Walter Holyk, chief geologist of Texas Gulf, to report the findings at that point.

The same night, Holyk called his superior, Richard D. Mollison, a vice president of Texas Gulf.  Mollison then called his superior, Charles F. Fogarty, executive vice president and the No. 2 man at the company.  Further reports were made the next day.  Soon Holyk, Mollison, and Fogarty decided to travel to Kidd-55 to take a look for themselves.

By November 12, Holyk was on site helping Darke examine samples.  Holyk was a Canadian in his forties with a doctorate in geology from MIT.  The weather had turned bad.  Also, much of the stuff came up covered in dirt and grease, and had to be washed with gasoline.  Nonetheless, Holyk arrived at an initial estimate of the core’s content.  There seemed to be average copper content of 1.15% and average zinc content of 8.64%.  If true and if it was not just in one narrow area, this appeared to be a huge discovery.  Brooks:

Getting title would take time if it were possible at all, but meanwhile there were several steps that the company could and did take.  The drill rig was moved away from the site of the test hole.  Cut saplings were stuck in the ground around the hole, to restore the appearance of the place to a semblance of its natural state.  A second test hole was drilled, as ostentatiously as possible, some distance away, at a place where a barren core was expected – and found.  All of these camouflage measures, which were in conformity with long-established practice among miners who suspect that they have made a strike, were supplemented by an order from Texas Gulf’s president, Claude O. Stephens, that no one outside the actual exploration group, even within the company, should be told what had been found.  Late in November, the core was shipped off, in sections, to the Union Assay Office in Salt Lake City for scientific analysis of its contents.  And meanwhile, of course, Texas Gulf began discreetly putting out feelers for the purchase of the rest of Kidd-55.

Brooks adds:

And meanwhile other measures, which may or may not have been related to the events of north of Timmins, were being taken.  On November 12th, Fogarty bought three hundred shares of Texas Gulf stock;  on the 15th he added seven hundred more shares, on November 19th five hundred more, and on November 26th two hundred more.  Clayton bought two hundred on the 15th, Mollison one hundred on the same day; and Mrs. Holyk bought fifty on the 29th and one hundred more on December 10th.  But these purchases, as things turned out, were only the harbingers of a period of apparently intense affection for Texas Gulf stock among certain of its officers and employees, and even some of their friends.

The results of the sample test confirmed Holyk’s estimates.  Also found were 3.94 ounces of silver per ton.  In late December, while in the Washington, D.C. area, Darke recommended Texas Gulf stock to a girl he knew there and her mother.  They later became known as “tippees,” while a few people they later told naturally became “sub-tippees.”  Between December 30 and February 17, Darke’s tippees and sub-tippees purchased 2,100 shares of Texas Gulf stock and also bought calls on another 1,500 shares.

In the first three months of 1964, Darke bought 300 shares of Texas Gulf stock, purchased calls on 3,000 more shares, and added several more persons to his burgeoning list of tippees.  Holyk and his wife bought a large number of calls on Texas Gulf stock.  They’d hardly heard of calls before, but calls “were getting to be quite the rage in Texas Gulf circles.”

Finally in the spring, Texas Gulf had the drilling rights it needed and was ready to proceed.  Brooks:

After a final burst of purchases by Darke, his tippees, and his sub-tippees on March 30th and 31st (among them all, six hundred shares and calls on 5,100 more shares for the two days), drilling was resumed in the still-frozen muskeg at Kidd-55, with Holyk and Darke both on the site this time.

While the crew stayed on site, the geologists almost daily made the fifteen-mile trek to Simmins.  With seven-foot snowdrifts, the trip took three and a half to four hours.

At some stage – later a matter of dispute – Texas Gulf realized that it had a workable mine of large proportions.  Vice President Mollison arrived on site for a day.  Brooks:

But before going he issued instructions for the drilling of a mill test hole, which would produce a relatively large core that could be used to determine the amenability of the mineral material to routine mill processing.  Normally, a mill test hole is not drilled until a workable mine is believed to exist.  And so it may have been in this case;  two S.E.C. mining experts were to insist later, against contrary opinions of experts for the defense, that by the time Mollison gave his order, Texas Gulf had information on the basis of which it could have calculated that the ore reserves at Kidd-55 had a gross assay value of at least two hundred million dollars.

Brooks notes:

The famous Canadian mining grapevine was humming by now, and in retrospect the wonder is that it had been relatively quiet for so long.

On April 10, President Stephens had become concerned enough to ask a senior member of the board – Thomas S. Lamont of Morgan fame – whether Texas Gulf should issue a statement.  Lamont told him he could wait until the reports were published in U.S. papers, but then he should issue a statement.

The following day, April 11, the reports poured forth in the U.S. papers.  The Herald Tribune called it “the biggest ore strike since gold was discovered more than 60 years ago in Canada.”  Stephens instructed Fogarty to begin preparing a statement to be issued on Monday, April 13.  Meanwhile, the estimated value of the mine seemed to be increasing by the hour as more and more copper and zinc ore was brought to the surface.  Brooks writes:

However, Fogarty did not communicate with Timmins after Friday night, so the statement that he and his colleagues issued to the press on Sunday afternoon was not based on the most up-to-the-minute information.  Whether because of that or for some other reason, the statement did not convey the idea that Texas Gulf thought it had a new Comstock Lode.  Characterizing the published reports as exaggerated and unreliable, it admitted that recent drilling on ‘one property near Timmins’ had led to ‘preliminary indications that more drilling would be required for proper evaluation of the prospect;’  went on to say that ‘the drilling done to date has not been conclusive;’  and then, putting the same thought in what can hardly be called another way, added that ‘the work done to date has not been sufficient to reach definitive conclusions.’

The wording of this press release was sufficient to put a damper on any expectations that may have arisen due to the newspaper stories the previous Friday.  Texas Gulf stock had gone from around $17 the previous November to around $30 just before the stories.  On Monday, the stock went to $32, but then came back down and even dipped below $29 in the subsequent two days.

Meanwhile, at Kidd-55, Mollison, Holyk, and Darke talked with a visiting reporter who had been shown around the place.  Brooks:

The things they told the reporter make it clear, in retrospect, that whatever the drafters of the release may have believed on Sunday, the men at Kidd-55 knew on Monday that they had a mine and a big one.  However, the world was not to know it, or at least not from that source, until Thursday morning, when the next issue of the Miner would appear in subscribers’ mail and on newstands.

Mollison and Holyk flew to Montreal Tuesday evening for the annual convention of the Canadian Institute of Mining and Metallurgy.  They had arranged for that Wednesday, in the company of the Minister of Mines of the Province of Ontario and his deputy, to attend the convention.  En route, they briefed the minister on Kidd-55.  The minister decided he wanted to make an announcement as soon as possible.  Mollison helped the minister draft the statement.

According to the copy Mollison kept, the announcement stated that “the information now in hand… gives the company confidence to allow me to announce that Texas Gulf Sulphur has a mineable body of zinc, copper, and silver ore of substantial dimensions that will be developed and brought to production as soon as possible.”  Mollison and Holyk believed that the minister would make the announcement that evening.  But for some reason, the minister didn’t.

Texas Gulf was to have a board of directors meeting that Thursday.  Since better and better news had been coming in from Kidd-55, the company officers decided they should write a new press release, to be issued after the Thursday morning board meeting.  This statement was based on the very latest information and it read, in part, “Texas Gulf Sulphur Company has made a major strike of zinc, copper, and silver in the Timmins area… Seven drill holes are now essentially complete and indicate an ore body of at least 800 feet in length, 300 feet in width, and having a vertical depth of more than 800 feet.  This is a major discovery.  The preliminary data indicate a reserve of more than 25 million tons of ore.”

The statement also noted that “considerably more data has been accumulated,” in order to explain the difference between this statement and the previous one.  Indeed, the value of the ore was not the two hundred million dollars alleged to have been estimable a week earlier, but many times that.

The same day, engineer Clayton and company secretary Crawford bought 200 and 300 shares, respectively.  The next morning, Crawford doubled his order.

The directors’ meeting ended at ten o’clock.  Then 22 reporters entered the room.  President Stephens read the new press release.  Most reporters rushed out before he was finished to report the news.

The actions of two Texas Gulf directors, Coates and Lamont, during the next half hour were later to lead to the most controversial part of the S.E.C.’s complaint.  As Brooks writes, the essence of the controversy was timing.  The Texas Gulf news was released by the Dow Jones News Service, the well-known spot-news for investors.  In fact, a piece of news is considered to be public the moment it crosses “the broad tape.”

The morning of April 16, 1964, a Dow Jones reporter was among those who attended the Texas Gulf press conference.  He left early and called in the news around 10:10 or 10:15, according to his recollection.  Normally, a news item this important would be printed on the Dow Jones machines two or three minutes after being phoned in.  But for reasons unknown, the Texas Gulf story did not appear on the tape until 10:54.  This delay was left unexplained during the trial based on irrelevance, says Brooks.

Coates, the Texan, around the end of the press conference, called his son-in-law, H. Fred Haemisegger, a stockbroker in Houston.  Coates told Haemisegger about the Texas Gulf discovery, also saying that he waited to call until “after the public announcement” because he was “too old to get in trouble with the S.E.C.”  Coates next placed an order for 2,000 shares of Texas Gulf stock for four family trusts.  He was a trustee, but not a beneficiary.  The stock had opened at $30.  Haemisegger, by acting quickly, was able to buy a bit over $31.

Lamont hung around the press conference area for 20 minutes or so.  He recounts that he “listened to chatter” and “slapped people on the back.”  Then at 10:39 or 10:40, he called a friend at Morgan Guaranty Trust Company – Longstreet Hinton, the bank’s executive vice president and head of its trust department.  Hinton had asked Lamont earlier in the week if he knew anything about the rumors of an ore discovery made by Texas Gulf.  Lamont had said no then.

But during this phone call, Lamont told Hinton that he had some news now.  Hinton asked whether it was good.  Lamont replied either “pretty good” or “very good.”  (Brooks notes that they mean the same thing in this context.)  Hinton immediately called the bank’s trading department, got a quote on Texas Gulf, and placed an order for 3,000 shares for the account of the Nassau Hospital, of which he was treasurer.  Hinton never bothered to look at the tape – despite being advised to do so by Lamont – because Hinton felt he already had the information he needed.  (Lamont didn’t know about the inexplicable forty minute delay before the Texas Gulf news appeared on the tape.)

Then Hinton went to the office of the Morgan Guaranty officer in charge of pension trusts.  Hinton recommended buying Texas Gulf.  In less than half an hour, the bank had ordered 7,000 shares for its pension fund and profit-sharing account.

An hour after that – at 12:33 – Lamont purchased 3,000 shares for himself and his family, paying $34 1/2 for them.  The stock closed above $36.  It hit a high of over $58 later that month.  Brooks:

…and by the end of 1966, when commercial production of ore was at last underway at Kidd-55 and the enormous new mine was expected to account for one-tenth of Canada’s total annual production of copper and one-quarter of its total annual production of zinc, the stock was selling at over 100.  Anyone who had bought Texas Gulf between November 12th, 1963 and the morning (or even the lunch hour) of April 16th, 1964 had therefore at least tripled his money.

Brooks then introduces the trial:

Perhaps the most arresting aspect of the Texas Gulf trial – apart from the fact that a trial was taking place at all – was the vividness and variety of the defendants who came before Judge Bonsal, ranging as they did from a hot-eyed mining prospector like Clayton (a genuine Welchman with a degree in mining from the University of Cardiff) through vigorous and harried corporate nabobs like Fogarty and Stephens to a Texas wheeler-dealer like Coates and a polished Brahmin of finance like Lamont.

Darke did not appear at the trial, claiming his Canadian nationality.  Brooks continues:

The S.E.C., after its counsel, Frank E. Kennamer Jr. had announced his intention to “drag to light and pillory the misconduct of these defendants,” asked the court to issue a permanent injunction forbidding Fogarty, Mollison, Clayton, Holyk, Darke, Crawford, and several other corporate insiders who had bought stock or calls between November 8th, 1963 and April 15th, 1964, from ever again “engaging in any act… which operates or would operate as a fraud or deceit upon any person in connection with purchase or sale of securities”;  further – and here it was breaking entirely new ground – it prayed that the court order the defendants to make restitution to the persons they had allegedly defrauded by buying stock or calls from them on the basis of inside information.  The S.E.C. also charged that the pessimistic April 12th press release was deliberately deceptive, and asked that because of it Texas Gulf be enjoined from “making any untrue statement of material fact or omitting to state a material fact.”  Apart from any question of loss of corporate face, the nub of the matter here lay in the fact that such a judgment, if granted, might well open the way for legal action against the company by any stockholder who had sold his Texas Gulf stock to anybody in the interim between the first press release and the second one, and since the shares that had changed hands during that period had run into the millions, it was a nub indeed.

Regarding the November purchases, the defense argued that a workable mine was far from a sure thing based only on the first drill hole.  Some even argued that the hole could have turned out to be a liability rather than an asset for Texas Gulf, based on what was known then.  The people who bought stock or calls during the winter claimed that the hole had little or nothing to do with their decision.  They stated that they thought Texas Gulf was a good investment in general.  Clayton said his sudden appearance as a large investor was because he had just married a well-to-do wife.  Brooks:

The S.E.C. countered with its own parade of experts, maintaining that the nature of the first core had been such as to make the existence of a rich mine an overwhelming probability, and that therefore those privy to the facts about it had possessed a material fact.

The S.E.C. also made much of the fact that Fogarty based the initial press release on information that was two days old.  The defense countered that the company had been in a sensitive position.  If it had issued an optimistic report that later turned out to be false, it could well be accused of fraud for that.

Judge Bonsal concluded that the definition of materiality must be conservative.  He therefore decided that up until April 9th, when three converging drill holes positively established the three-dimensionality of the ore deposit, material information had not been in hand.  Therefore, the decisions of insiders to buy stock before that date, even if based on initial drilling results, were legal “educated guesses.”

Case was thus dismissed against all educated guessers who had bought stock or calls, or recommended others do so, before the evening of April 9th.  Brooks:

With Clayton and Crawford, who had been so injudicious as to buy or order stock on April 15th, it was another matter.  The judge found no evidence that they had intended to deceive or defraud anyone, but they had made their purchases with the full knowledge that a great mine had been found and that it would be announced the next day – in short, with material private information in hand.  Therefore they were found to have violated Rule 10B-5, and in due time would presumably be enjoined from doing such a thing again and made to offer restitution to the persons they bought their April 15th shares from – assuming, of course, that such persons can be found…

On the matter of the April 12th press release, the judge found that it was not false or misleading.

Still to be settled was the matter of Coates and Lamont making their purchases.  The question was when it can be said that the information has officially been made public.  This was the most important issue and would likely set a legal precedent.

The S.E.C. argued that the actions of Coates and Lamont were illegal because they occurred before the ore strike news had crossed the Dow Jones broad tape.  The S.E.C. argued, furthermore, that even if Coates and Lamont had acted after the “official” announcement, it still would be illegal unless enough time had passed so that those who hadn’t attended the press conference, or even those who hadn’t seen the initial news cross the broad tape, had enough time to absorb the information.

Defense argued first that Coates and Lamont had every reason to believe that the news was already out, since Stephens said it had been released by the Ontario Minister of Mines the previous evening.  So Coates and Lamont acted in good faith.  Second, counsel argued that for all practical purposes, the news was out, via osmosis and The Northern Miner.  Brokerage offices and the Stock Exchange had been buzzing all morning.  Lamont’s lawyers also argued that Lamont had merely told Hinton to look at the tape, not to buy any stock.  Defense argued that the S.E.C. was asking the court to write new rules and then apply them retroactively, while the plaintiff was merely asking that an old rule 10B-5, be applied broadly.

As for Lamont’s waiting for two hours, until 12:33, before buying stock for himself, the S.E.C. took issue, as Brooks records:

‘It is the Commission’s position that even after corporate information has been published in the news media, insiders, are still under a duty to refrain from securities transactions until there had elapsed a reasonable amount of time in which the securities industry, the shareholders, and the investing public can evaluate the development and make informed investment decisions… Insiders must wait at least until the information is likely to have reached the average investor who follows the market and he has had some opportunity to consider it.’

In the Texas Gulf case, the S.E.C. argued that one hour and thirty-nine minutes was not “a reasonable amount of time.”  What, then, is “a reasonable amount of time,” the S.E.C. was asked?  The S.E.C.’s counsel, Kennamer, said it “would vary from case to case.”  Kennamer added that it would be “a nearly impossible task to formulate a rigid set of rules that would apply in all situations of this sort.”

Brooks sums it up with a hint of irony:

Therefore, in the S.E.C.’s canon, the only way an insider could find out whether he had waited long enough before buying his company’s stock was by being hauled into court and seeing what the judge would decide.

Judge Bonsal rejected this argument by the S.E.C.  Moreover, he took a narrower view that, based on legal precedent, the key moment was when the press release was read.  The judge admitted that a better rule might be formulated according to which insiders had to wait at least some amount time after the initial press release so that other investors could absorb it.  However, he didn’t think he should write such a rule.  Nor should this matter be left up to the judge on a case-by-base basis.  Thus, the complaints against Coates and Lamont were dismissed.

The S.E.C. appealed all the dismissals.  Brooks concludes:

…in August, 1968, the U.S. Court of Appeals for the Second Circuit handed down a decision which flatly reversed Judge Bonsal’s findings on just about every score except the findings against Crawford and Clayton, which were affirmed.  The Appeals Court found that the original November drill hole had provided material evidence of a valuable ore deposit, and that therefore Fogarty, Mollison, Darke, Holyk, and all other insiders who had bought Texas Gulf stock or calls on it during the winter were guilty of violations of the law;  that the gloomy April 12th press release had been ambiguous and perhaps misleading;  and that Coates had improperly and illegally jumped the gun in placing his orders right after the April 16th press conference.  Only Lamont – the charges against whom had been dropped following his death shortly after the lower court decision – and a Texas Gulf office manager, John Murray, remained exonerated.

 

XEROX XEROX XEROX XEROX

There was no economical and practical way of making copies until after 1950.  Brooks writes that the 1950’s were the pioneering years for mechanized office copying.  Although people were starting to show a compulsion to make copies, the early copying machines suffered from a number of problems.  Brooks:

…What was needed for the compulsion to flower into a mania was a technological breakthrough, and the breakthrough came at the turn of the decade with the advent of a machine that worked on a new principle, known as xerography, and was able to make dry, good-quality, permanent copies on ordinary paper with a minimum of trouble.  The effect was immediate.  Largely as a result of xerography, the estimated number of copies (as opposed to duplicates) made annually in the United States sprang from some twenty million in the mid-fifties to nine and a half billion in 1964, and to fourteen billion in 1966 – not to mention billions more in Europe, Asia, and Latin America.  More than that, the attitude of educators towards printed textbooks and of business people toward written communication underwent a discernable change;  avant-garde philosophers took to hailing xerography as a revolution comparable in importance to the invention of the wheel;  and coin-operated copy machines began turning up in candy stores and beauty parlors…

The company responsible for the great breakthrough and the one on whose machines the majority of these billions of copies were made was of course, the Xerox Corporation, of Rochester, New York.  As a result, it became the most spectacular big-business success of the nineteen-sixties.  In 1959, the year the company – then called Haloid Xerox, Inc. – introduced its first automatic xerographic office copier, its sales were thirty-three million dollars.  In 1961, they were sixty-six million, in 1963 a hundred and seventy-six million, and in 1966 over half a billion.

The company was extremely profitable.  It ranked two hundred and seventy-first in Fortune’s ranking in 1967.  However, in 1966 the company ranked sixty-third in net profits and probably ninth in the ratio of profits to sales and fifteenth in terms of market value.  Brooks continues:

…Indeed, the enthusiasm the investing public showed for Xerox made its shares the stock market Golconda of the sixties.  Anyone who bought its stock toward the end of 1959 and held on to it until early 1967 would have found his holding worth about sixty-six times its original price, and anyone who was really fore-sighted and bought Haloid in 1955 would have seen his original investment grow – one might almost say miraculously – a hundred and eighty times.  Not surprisingly, a covey of “Xerox millionaires” sprang up – several hundred of them all told, most of whom either lived in the Rochester area or had come from there.

The Haloid company was started in Rochester in 1906.  It manufactured photographic papers.  It survived OK.  But after the Second World War, due to an increase in competition and labor costs, the company was looking for new products.

More than a decade earlier, in 1938, an obscure thirty-two year-old inventor, Chester F. Carlson, was spending his spare time trying to invent an office copying machine.  Carlson had a degree in physics from the California Institute of Technology.  Carlson had hired Otto Kornei, a German refugee physicist, to help him.  Their initial copying machine was unwieldy and produced much smoke and stench.  Brooks:

The process, which Carlson called electrophotography, had – and has – five basic steps:  sensitizing a photoconductive surface to light by giving it an electrostatic charge (for example, by rubbing it with fur);  exposing this surface to a written page to form an electrostatic image;  developing the latest image by dusting the surface with a powder that will adhere only to the charged areas;  transferring the image to some sort of paper;  and fixing the image by the application of heat.

Although each individual step was already used in other technologies, this particular combination of steps was new.  Carlson carefully patented the process and began trying to sell it.  Over the ensuing five years, Carlson tried to sell the rights to every important office-equipment company in the country.  He was turned down every time.  In 1944, Carlson finally convinced Battelle Memorial Institute to conduct further development work on the process in exchange for three-quarters of any future royalties.

In 1946, various people at Haloid, including Joseph C. Wilson – who was about to become president – had noticed the work that Battelle was doing.  Wilson asked a friend of his, Sol M. Linowitz, a smart, public-spirited lawyer just back from service in the Navy, to research the work at Battelle as a “one-shot” job.  The result was an agreement giving Haloid the rights to the Carlson process in exchange for royalties for Battelle and Carlson.

At one point in the research and development process, the Haloid people got so discouraged that they considered selling most of their xerography rights to International Business Machines.  The research process became quite costly.  But Haloid committed itself to seeing it through.  It took full title of the Carlson process and assumed the full cost of development in exchange for shares in Haloid (for Battelle and Carlson).  Brooks:

…The cost was staggering.  Between 1947 and 1960, Haloid spent about seventy-five million dollars [over $800 million in 2019 dollars] on research in xerography, or about twice what it earned from its regular operations during that period;  the balance was raised through borrowing and through the wholesale issuance of common stock to anyone who was kind, reckless, or prescient enough to take it.  The University of Rochester, partly out of interest in a struggling local industry, bought an enormous quantity for its endowment fund at a price that subsequently, because of stock splits, amounted to fifty cents a share.  ‘Please don’t be mad at us if we have to sell our Haloid stock in a couple of years to cut our losses on it,’ a university official nervously warned Wilson.  Wilson promised not to be mad.  Meanwhile, he and other executives of the company took most of their pay in the form of stock, and some of them went as far as to put up their savings and the mortgages on their houses to help the cause along.

In 1961, the company changed its name to Xerox Corporation.  One unusual aspect to the story is that Xerox became rather public-minded.  Brooks quotes Wilson:

‘To set high goals, to have almost unattainable aspirations, to imbue people with the belief that they can be achieved – these are as important as the balance sheet, perhaps more so.’

This rhetoric is not uncommon.  But Xerox followed through by donating one and a half percent of its profits to educational and charitable institutions in 1965-1966.  In 1966, Xerox committed itself to the “one-per-cent program,” also called the Cleveland Plan, according to which the company gives one percent of its pre-tax income annually to educational institutions, apart from any other charitable activities.

Furthermore, President Wilson said in 1964, “The corporation cannot refuse to take a stand on public issues of major concern.”  As Brooks observes, this is “heresy” for a business because it could alienate customers or potential customers.  Xerox’s chief stand was in favor of the United Nations.  Brooks:

Early in 1964, the company decided to spend four million dollars – a year’s advertising budget – on underwriting a series of network-television programs dealing with the U.N., the programs to be unaccompanied by commercials or any other identification of Xerox apart from a statement at the beginning and end of each that Xerox had paid for it.

Xerox was inundated with letters opposing the company’s support of the U.N.  Many said that the U.N. charter had been written by American Communists and that the U.N. was an instrument for depriving Americans of their Constitutional rights.  Although only a few of these letters came from the John Birch Society, it turned out later that most of the letters were part of a meticulously planned Birch campaign.  Xerox officers and directors were not intimidated.  The U.N. series appeared in 1965 and was widely praised.

Furthermore, Xerox consistently committed itself to informing the users of its copiers of their legal responsibilities.  It took this stand despite their commercial interest.

Brooks visited Xerox in order to talk with some of its people.  First he spoke with Dr. Dessauer, a German-born engineer who had been in charge of the company’s research and engineering since 1938.  It was Dessauer who first brought Carlson’s invention to the attention of Joseph Wilson.  Brooks noticed a greeting card from fellow employees calling Dessauer the “Wizard.”

Dr. Dessauer told Brooks about the old days.  Dessauer said money was the main problem.  Many team members gambled heavily on the xerox project.  Dessauer himself mortgaged his house.  Early on, team members would often say the damn thing would never work.  Even if it did work, the marketing people said there was only a market for a few thousand of the machines.

Next Brooks spoke with Dr. Harold E. Clark, who had been a professor of physics before coming to Haloid in 1949.  Dr. Clark was in charge of the xerography-development program under Dr. Dessauer.  Dr. Clark told Brooks that Chet Carlson’s invention was amazing.  Also, no one else invented something similar at the same time, unlike the many simultaneous discoveries in scientific history.  The only problem, said Dr. Clark, was that it wasn’t a good product.

The main trouble was that Carlson’s photoconductive surface, which was coated with sulphur, lost its qualities after it had made a few copies and became useless.  Acting on a hunch unsupported by scientific theory, the Battelle researchers tried adding to the sulphur a small quantity of selenium, a non-metallic element previously used chiefly in electrical resistors and as a coloring material to redden glass.  The selenium-and-sulphur surface worked a little better than the all-sulphur one, so the Battelle men tried adding a little more selenium.  More improvement.  They gradually kept increasing the percentage until they had a surface consisting entirely of selenium – no sulphur.  That one worked best of all, and thus it was found, backhandedly, that selenium and selenium alone could make xerography practical.

Dr. Clark went on to tell Brooks that they basically patented one of the elements, of which there are not many more than one hundred.  What is more, they still don’t understand how it works.  There are no memory effects – no traces of previous copies are left on the selenium drum.  A selenium-coated drum in the lab can last a million processes, or theoretically an infinite number.  They don’t understand why.  Dr. Clark concluded that they combined “Yankee tinkering and scientific inquiry.”

Brooks spoke with Linowitz, who only had a few minutes because he had just been appointed U.S. Ambassador to the Organization of American States.  Linowitz told him:

…the qualities that made for the company’s success were idealism, tenacity, the courage to take risks, and enthusiasm.

Joseph Wilson told Brooks that his second major had been English literature.  He thought he would be a teacher or work in administration at a university.  Somehow he ended up at Harvard Business School, where he was a top student.  After that, he joined Haloid, the family business, something he’d never planned on doing.

Regarding the company’s support of the U.N., Wilson explained that world cooperation was the company’s business, because without it there would be no world and thus no business.  He went on to explain that elections were not the company’s business.  But university education, civil rights, and employment of African-Americans were their business, to name just a few examples.  So far, at least, Wilson said there hadn’t been a conflict between their civic duties and good business.  But if such a conflict arose, he hoped that the company would honor its civic responsibilities.

 

MAKING THE CUSTOMERS WHOLE

On November 19th, 1963, the Stock Exchange became aware that two of its member firms – J. R. Williston & Beane, Inc., and Ira Haupt & Co. – were in serious financial trouble.  This later became a crisis that was made worse by the assassination of JFK on November 22, 1963.  Brooks:

It was the sudden souring of a speculation that these two firms (along with various brokers not members of the Stock Exchange) had become involved in on behalf of a single customer – the Allied Crude Vegetable Oil & Refining Co., of Bayonne, New Jersey.  The speculation was in contracts to buy vast quantities of cotton-seed oil and soybean oil for future delivery.

Brooks then writes:

On the two previous business days – Friday the fifteenth and Monday the eighteenth – the prices had dropped an average of a little less than a cent and a half per pound, and as a result Haupt had demanded that Allied put up about fifteen million dollars in cash to keep the account seaworthy.  Allied had declined to do this, so Haupt – like any broker when a customer operating on credit has defaulted – was faced with the necessity of selling out the Allied contracts to get back what it could of its advances.  The suicidal extent of the risk that Haupt had undertaken is further indicated by the fact that while the firm’s capital in early November had amounted to only about eight million dollars, it had borrowed enough money to supply a single customer – Allied – with some thirty-seven million dollars to finance the oil speculations.  Worse still, as things turned out it had accepted as collateral for some of these advances enormous amounts of actual cottonseed oil and soybean oil from Allied’s inventory, the presence of which in tanks at Bayonne was attested to by warehouse receipts stating the precise amount and kind of oil on hand.  Haupt had borrowed the money it supplied Allied from various banks, passing along most of the warehouse receipts to the banks as collateral.  All this would have been well and good if it had not developed later that many of the warehouse receipts were forged, that much of the oil they attested to was not, and probably never had been, in Bayonne, and that Allied’s President, Anthony De Angelis (who was later sent to jail on a whole parcel of charges), had apparently pulled off the biggest commercial fraud since that of Ivar Kreuger, the match king.

What began to emerge as the main issue was that Haupt had about twenty thousand individual stock-market customers, who had never heard of Allied or commodity trading.  Williston & Beane had nine thousand individual customers.  All these accounts were frozen when the two firms were suspended by the Stock Exchange.  (Fortunately, the customers of Williston & Beane were made whole fairly rapidly.)

The Stock Exchange met with its member firms.  They decided to make the customers of Haupt whole.  G. Keith Funston, President of the Stock Exchange, urged the member firms to take over the matter.  The firms replied that the Stock Exchange should do it.  Funston replied, “If we do, you’ll have to repay us the amount we pay out.”  So it was agreed that the payment would come out of the Exchange’s treasury, to be repaid later by the member firms.

Funston next led the negotiations with Haupt’s creditor banks.  Their unanimous support was essential.  Chief among the creditors were four local banks – Chase Manhattan, Morgan Guaranty Trust, First National City, and Manufacturers Hanover Trust.  Funston proposed that the Exchange would put up the money to make the Haupt customers whole – about seven and a half million dollars.  In return, for every dollar the Exchange put up, the banks would agree to defer collection on two dollars.  So the banks would defer collection on about fifteen million.

The banks agreed to this on the condition that the Exchange’s claim to get back any of its contribution would come after the banks’ claims for their loans.  Funston and his associates at the Exchange agreed to that.  After more negotiating, there was a broad agreement on the general plan.

Early on Saturday, the Exchange’s board met and learned from Funston what was proposed.  Almost immediately, several governors rose to state that it was a matter of principle.  And so the board agreed with the plan.  Later, Funston and his associates decided to put the Exchange’s chief examiner in charge of the liquidation of Haupt in order to ensure that its twenty thousand individual customers were made whole as soon as the Exchange had put up the cash.  (The amount of cash would be at least seven and a half million, but possibly as high as twelve million.)

Fortunately, the American banks eventually all agreed to the final plan put forth by the Exchange.  Brooks notes that the banks were “marvels of cooperation.”  But agreement was still needed from the British banks.  Initially, Funston was going to make the trip to England, but he couldn’t be spared.

Several other governors quickly volunteered to go, and one of them, Gustave L. Levy, was eventually selected, on the ground that his firm, Goldman, Sachs & Co., had had a long and close association with Kleinwort, Benson, one of the British banks, and that Levy himself was on excellent terms with some of the Kleinwort, Benson partners.

The British banks were very unhappy.  But since their loans to Allied were unsecured, they didn’t have any room to negotiate.  Still, they asked for time to think the matter over.  This gave Levy an opportunity to meet with this Kleinwort, Benson friends.  Brooks:

The circumstances of the reunion were obviously less than happy, but Levy says that his friends took a realistic view of their situation and, with heroic objectivity, actually helped their fellow-Britons to see the American side of the question.

The market was closed Monday for JFK’s funeral.  Funston was still waiting for the call from Levy.  After finally getting agreement from all the British banks, Levy placed the call to Funston.

Funston felt at this point that the final agreement had been wrapped up, since all he needed was the signatures of the fifteen Haupt general partners.  The meeting with the Haupt partners ended up taking far longer than expected.  Brooks:

One startling event broke the even tenor of this gloomy meeting… someone noticed an unfamiliar and strikingly youthful face in the crowd and asked its owner to identify himself.  The unhesitating reply was, ‘I’m Russell Watson, a reporter for the Wall Street Journal.’  There was a short, stunned silence, in recognition of the fact that an untimely leak might still disturb the delicate balance of money and emotion that made up the agreement.  Watson himself, who was twenty-four and had been on the Journal for a year, has since explained how he got into the meeting, and under what circumstances he left it.  ‘I was new on the Stock Exchange beat then,’ he said afterward.  ‘Earlier in the day, there had been word that Funston would probably hold a press conference sometime that evening, so I went over to the Exchange.  At the main entrance, I asked a guard where Mr. Funston’s conference was.  The guard said it was on the sixth floor, and ushered me into an elevator.  I suppose he thought I was a banker, a Haupt partner, or a lawyer.  On the sixth floor, people were milling around everywhere.  I just walked off the elevator and into the office where the meeting was – nobody stopped me.  I didn’t understand much of what was going on.  I got the feeling that whatever was at stake, there was general agreement but still a lot of haggling over details to be done.  I didn’t recognize anybody there but Funston.  I stood around quietly for about five minutes before anybody noticed me, and then everybody said, pretty much at once, “Good God, get out of here!”  They didn’t exactly kick me out, but I saw it was time to go.’

At fifteen minutes past midnight, finally all the parties signed an agreement.

As soon as the banks opened on Tuesday, the Exchange deposited seven and a half million dollars in an account on which the Haupt liquidator – James P. Mahony – could draw.  The stock market had its greatest one-day rise in history.  A week later, by December 2, $1,750,000 had been paid out to Haupt customers.  By December 12, it was $5,400,000.  And by Christmas, it was $6,700,000.  By March 11, the pay-out had reached nine and a half million dollars and all the Haupt customers had been made whole.

  • Note:  $9.5 million in 1963 would be approximately $76 million dollars today (in 2018), due to inflation.

Brooks describes the reaction:

In Washington, President Johnson interrupted his first business day in office to telephone Funston and congratulate him.  The chairman of the S.E.C., William L. Cary, who was not ordinarily given to throwing bouquets at the Stock Exchange, said in December that it had furnished ‘a dramatic, impressive demonstration of its strength and concern for the public interest.’

Brooks later records:

Oddly, almost no one seems to have expressed gratitude to the British and American banks, which recouped something like half of their losses.  It may be that people simply don’t thank banks, except in television commercials.

 

THE IMPACTED PHILOSOPHERS

Brooks opens this chapter by observing that communication is one of the biggest problems in American industry.  (Remember he was writing in the 1960’s).  Brooks:

This preoccupation with the difficulty of getting a thought out of one head and into another is something the industrialists share with a substantial number of intellectuals and creative writers, more and more of whom seemed inclined to regard communication, or the lack of it, as one of the greatest problems not just of industry, but of humanity.

Brooks then adds:

What has puzzled me is how and why, when foundations sponsor one study of communication after another, individuals and organizations fail so consistently to express themselves understandably, or how and why their listeners fail to grasp what they hear.

A few years ago, I acquired a two-volume publication of the United States Government Printing Office entitled Hearings Before the Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, United States Senate, Eighty-Seventh Congress, First Session, Pursuant to S. Res. 52, and after a fairly diligent perusal of its 1,459 pages I thought I could begin to see what the industrialists are talking about.

The hearings were conducted in April, May, and June of 1961 under the chairmanship of Senator Estes Kefauver of Tennessee.  They concerned price-fixing and bid-rigging in conspiracies in the electrical-manufacturing industry.  Brooks:

…Senator Kefauver felt that the whole matter needed a good airing.  The transcript shows that it got one, and what the airing revealed – at least within the biggest company involved – was a breakdown in intramural communication so drastic as to make the building of the tower of Babel seem a triumph of organizational rapport.

Brooks explains a bit later:

The violations, the government alleged, were committed in connection with the sale of large and expensive pieces of apparatus of a variety that is required chiefly by public and private electric-utility companies (power transformers, switchgear assemblies, and turbine-generator units, among many others), and were the outcome of a series of meetings attended by executives of the supposedly competing companies – beginning at least as early as 1956 and continuing into 1959 – at which noncompetitive price levels were agreed upon, nominally sealed bids on individual contracts were rigged in advance, and each company was allocated a certain percentage of the available business.

Brooks explains that in an average year at the time of the conspiracies, about $1.75 billion – $14 billion in 2019 dollars – was spent on the sorts of machines in question, with nearly a quarter of that local, state, and federal government spending.  Brooks gives a specific example, a 500,000-kilowatt turbine-generator, which sold for about $16 million (nearly $130 million in 2019 dollars), but was often discounted by 25 percent.  If the companies wanted to, they could effectively charge $4 million extra (nearly $32 million extra in 2019 dollars).  Any such additional costs as a result of price-fixing would, in the case of government purchases, ultimately fall on the taxpayer.

Brooks again:

To top it all off, there was a prevalent suspicion of hypocrisy in the very highest places.  Neither the chairman of the board nor the president of General Electric, the largest of the corporate defendants, had been caught on the government’s dragnet, and the same was true of Westinghouse Electric, the second-largest;  these four ultimate bosses let it be known that they had been entirely ignorant of what had been going on within their commands right up to the time the first testimony on the subject was given to the Justice Department.  Many people, however, were not satisfied by these disclaimers, and, instead, took the position that the defendant executives were men in the middle, who had broken the law only in response either to actual orders or to a corporate climate favoring price-fixing, and who were now being allowed to suffer for the sins of their superiors.  Among the unsatisfied was Judge Ganey himself, who said at the time of the sentencing, ‘One would be most naive indeed to believe that these violations of the law, so long persisted in, affecting so large a segment of the industry, and, finally, involving so many millions upon millions of dollars, were facts unknown to those responsible for the conduct of the corporation… I am convinced that in the great number of these defendants’ cases, they were torn between conscience and approved corporate policy, with the rewarding objectives of promotion, comfortable security, and large salaries.’

General Electric got most of the attention.  It was, after all, by far the largest of those companies involved.  General Electric penalized employees who admitted participation in the conspiracy.  Some saw this as good behavior, while others thought it was G.E. trying to save higher-ups by making a few sacrifices.

G.E. maintained that top executives didn’t know.  Judge Ganey thought otherwise.  But Brooks realized it couldn’t be determined:

…For, as the testimony shows, the clear waters of moral responsibility at G.E. became hopelessly muddied by a struggle to communicate – a struggle so confused that in some cases, it would appear, if one of the big bosses at G.E. had ordered a subordinate to break the law, the message would somehow have been garbled in its reception, and if the subordinate had informed the boss that he was holding conspiratorial meetings with competitors, the boss might well have been under the impression that the subordinate was gossiping idly about lawn parties or pinochle lessons.

G.E., for at least eight years, has had a rule, Directive Policy 20.5, which explicitly forbids price-fixing, bid-rigging, and similar anticompetitive practices.  The company regularly reissued 20.5 to new executives and asked them to sign their names to it.

The problem was that many, including those who signed, didn’t take 20.5 seriously.  They thought it was just a legal device.  They believed that meeting illegally with competitors was the accepted and standard practice.  They concluded that if a superior told them to comply with 20.5, he was actually ordering him to violate it.  Brooks:

Illogical as it might seem, this last assumption becomes comprehensible in light of the fact that, for a time, when some executives orally conveyed, or reconveyed, the order, they were apparently in the habit of accompanying it with an unmistakable wink.

Brooks gives an example of just such a meeting of sales managers in May 1948.  Robert Paxton, an upper-level G.E. executive who later became the company’s president, addressed the group and gave the usual warnings about antitrust violations.  William S. Ginn, a salesman under Paxton, interjected, “We didn’t see you wink.”  Paxton replied, “There was no wink.  We mean it, and these are the orders.”

Senator Kefauver asked Paxton how long he had known about such winks.  Paxton said that in 1935, he saw his boss do it following an order.  Paxton recounts that he became incensed.  Since then, he had earned a reputation as an antiwink man.

In any case, Paxton’s seemingly unambiguous order in 1948 failed to get through to Ginn, who promptly began pricing-fixing with competitors.  When asked about it thirteen years later, Ginn – having recently gotten out of jail and having lost his $135,000 a year job at G.E. – said he had gotten a contrary order from two other superiors, Henry V. B. Erben and Francis Fairman.  Brooks:

Erben and Fairman, Ginn said, had been more articulate, persuasive, and forceful in issuing their order than Paxton had been in issuing his;  Fairman, especially, Ginn stressed, had proved to be ‘a great communicator, a great philosopher, and, frankly, a great believer in stability of prices.’  Both Erben and Fairman had dismissed Paxton as naive, Ginn testified, and, in further summary of how he had been led astray, he said that ‘the people who were advocating the Devil were able to sell me better than the philosophers that were selling me the Lord.’

Unfortunately, Erben and Fairman had passed away before the hearing.  So we don’t have their testimonies.  Ginn consistently described Paxton as a philosopher-salesman on the side of the Lord.

In November, 1954, Ginn was made general manager of the transformer division.  Ralph J. Cordiner, chairman of the board at G.E. since 1949, called Ginn down to New York to order him to comply strictly with Directive 20.5.  Brooks:

Cordiner communicated this idea so successfully that it was clear enough to Ginn at the moment, but it remained so only as long as it took him, after leaving the chairman, to walk to Erben’s office.

Erben, Ginn’s direct superior, countermanded Cordiner’s order.

Erben’s extraordinary communicative prowess carried the day, and Ginn continued to meet with competitors.

At the end of 1954, Paxton took over Erben’s job and was thus Ginn’s direct superior.  Ginn kept meeting with competitors, but he didn’t tell Paxton about it, knowing his opposition to the practice.

In January 1957, Ginn became general manager of G.E.’s turbine-generator division.  Cordiner called him down again to instruct him to follow 20.5.  This time, however, Ginn got the message.  Why?  “Because my air cover was gone,” Ginn explained to the Subcommittee.  Brooks:

If Erben, who had not been Ginn’s boss since late in 1954, had been the source of his air cover, Ginn must have been without its protection for over two years, but, presumably, in the excitement of the price war he had failed to notice its absence.

In any case, Ginn apparently had reformed.  Ginn circulated copies of 20.5 among all his division managers.  He then instructed them not to even socialize with competitors.

It appears that Ginn had not been able to impart much of his shining new philosophy to others, and that at the root of his difficulty lay that old jinx, the problem of communicating.

Brooks quotes Ginn:

‘I have got to admit that I made a communication error.  I didn’t sell this thing to the boys well enough… The price is so important in the complete running of a business that, philosophically, we have got to sell people not only just the fact that it is against the law, but… that it shouldn’t be done for many, many reasons.  But it has got to be a philosophical approach and a communication approach…’

Frank E. Stehlik was general manager of the low-voltage-switchgear department from May, 1956 to February, 1960.  Stehlik not only heard 20.5 directly from his superiors in oral and written communications.  But, in addition, Stehlik was open to a more visceral type of communication he called “impacts.”  Brooks explains:

Apparently, when something happened within the company that made an impression on him, he would consult an internal sort of metaphysical voltmeter to ascertain the force of the jolt he had received, and, from the reading he got, would attempt to gauge the true drift of company policy.

In 1956, 1957, and for most of 1958, Stehlik believed that company policy clearly required compliance with 20.5.  But in the fall of 1958, Stehlik’s immediate superior, George E. Burens, told him that Paxton had told him (Burens) to have lunch with a competitor.  Paxton later testified that he categorically told Burens not to discuss prices.  But Stehlik got a different impression.

In Stehlik’s mind, this fact made an “impact.”  He felt that company policy was now in favor of disobeying 20.5.  So, late in 1958, when Burens told him to begin having price meetings with a competitor, he was not at all surprised.  Stehlik complied.

Brooks next describes the communication problem from the point of view of superiors.  Raymond W. Smith was general manager of G.E.’s transformer division, while Arthur F. Vinson was vice-president in charge G.E.’s apparatus group.  Vinson ended up becoming Smith’s immediate boss.

Smith testified that Cordiner gave him the usual order on 20.5.  But late in 1957, price competition for transformers was so intense that Smith decided on his own to start meeting with competitors to see if prices could be stabilized.  Smith thought company policy and industry practice both supported his actions.

When Vinson became Smith’s boss, Smith felt he should let him know what he was doing.  So on several occasions, Smith told Vinson, “I had a meeting with the clan this morning.”

Vinson, in his testimony, said he didn’t even recall Smith use the phrase, “meeting of the clan.”  Vinson only recalled that Smith would say things like, “Well, I am going to take this new plan on transformers and show it to the boys.”  Vinson testified that he thought Smith meant the G.E. district salespeople and the company’s customers.  Vinson claimed to be shocked when he learned that Smith was referring to price-fixing meetings with competitors.

But Smith was sure that his communication had gotten through to Vinson.  “I never got the impression that he misunderstood me,” Smith testified.

Senator Kefauver asked Vinson if he was so naive as to not know to whom “the boys” referred.  Vinson replied, “I don’t think it is too naive.   We have a lot of boys… I may be naive, but I am certainly telling the truth, and in this kind of thing I am sure I am naive.”

Kefauver pressed Vinson, asking how he could have become vice-president at $200,000 a year if he were naive.  Vinson:  “I think I could well get there by being naive in this area.  It might help.”

Brooks asks:

Was Vinson really saying to Kefauver what he seemed to be saying – that naivete about antitrust violations might be a help to a man in getting and holding a $200,000-a-year job at General Electric?  It seems unlikely.  And yet what else could he have meant?

Vinson was also implicated in another part of the case.  Four switchgear executives – Burens, Stehlik, Clarence E. Burke, and H. Frank Hentschel – testified before the grand jury (and later before the Subcommittee) that in mid-1958, Vinson had lunch with them in Dining Room B of G.E.’s switchgear works in Philadelphia, and that Vinson told them to hold price meetings with competitors.

This led the four switchgear executives to hold a series of meetings with competitors.  But Vinson told prosecutors that the lunch never took place and that he had had no knowledge at all of the conspiracy until the case broke.  Regarding the lunch, Burens, Stehlik, Burke, and Hentschel all had lie-detector tests, given by the F.B.I., and passed them.

Brooks writes:

Vinson refused to take a lie-detector test, at first explaining that he was acting on advice of counsel and against his personal inclination, and later, after hearing how the four other men had fared, arguing that if the machine had not pronounced them liars, it couldn’t be any good.

It was shown that there were only eight days in mid-1958 when Burens, Stehlik, Burke, and Hentschel all had been together at the Philadelphia plant and could have had lunch together.  Vinson produced expense accounts showing that he had been elsewhere on each of those eight days.  So the Justice Department dropped the case against Vinson.

The upper level of G.E. “came through unscathed.”  Chairman Cordiner and President Paxton did seem to be clearly against price-fixing, and unaware of all the price-fixing that had been occurring.  Paxton, during his testimony, said that he learned from his boss, Gerard Swope, that the ultimate goal of business was to produce more goods for people at lower cost.  Paxton claimed to be deeply impacted by this philosophy, explaining why he was always strongly against price-fixing.

Brooks concludes:

Philosophy seems to have reached a high point at G.E., and communication a low one.  If executives could just learn to understand one another, most of the witnesses said or implied, the problem of antitrust violations would be solved.  But perhaps the problem is cultural as well as technical, and has something to do with a loss of personal identity that comes with working in a huge organization.  The cartoonist Jules Feiffer, contemplating the communication problem in a nonindustrial context, has said, ‘Actually, the breakdown is between the person and himself.  If you’re not able to communicate successfully between yourself and yourself, how are you supposed to make it with the strangers outside?’  Suppose, purely as a hypothesis, that the owner of a company who orders his subordinates to obey the antitrust laws has such poor communication with himself that he does not really know whether he wants the order to be complied with or not.  If his order is disobeyed, the resulting price-fixing may benefit his company’s coffers;  if it is obeyed, then he has done the right thing.  In the first instance, he is not personally implicated in any wrongdoing, while in the second he is positively involved in right doing.  What, after all, can he lose?  It is perhaps reasonable to suppose that such an executive will communicate his uncertainty more forcefully than his order.

 

THE LAST GREAT CORNER

Piggly Wiggly Stores – a chain of retail self-service markets mostly in the South and West, and headquartered in Memphis – was first listed on the New York Stock Exchange in June, 1922.  Clarence Saunders was the head of Piggly Wiggly.  Brooks describes Saunders:

…a plump, neat, handsome man of forty-one who was already something of a legend in his home town, chiefly because of a house he was putting up there for himself.  Called the Pink Palace, it was an enormous structure faced with pink Georgia marble and built around an awe-inspiring white-marble Roman atrium, and, according to Saunders, it would stand for a thousand years.  Unfinished though it was, the Pink Palace was like nothing Memphis had ever seen before.  Its grounds were to include a private golf course, since Saunders liked to do his golfing in seclusion.

Brooks continues:

The game of Corner – for in its heyday it was a game, a high-stakes gambling game, pure and simple, embodying a good many of the characteristics of poker – was one phase of the endless Wall Street contest between bulls, who want the price of a stock to go up, and bears, who want it to go down.  When a game of Corner was underway, the bulls’ basic method of operation was, of course, to buy stock, and the bears’ was to sell it.

Since most bears didn’t own the stock, they would have to conduct a short sale.  This means they borrow stock from a broker and sell it.  But they must buy the stock back later in order to return it to the broker.  If they buy the stock back at a lower price, then the difference between where they initially sold the stock short, and where they later buy it back, represents their profit.  If, however, they buy the stock back at a higher price, then they suffer a loss.

There are two related risks that the short seller (the bear) faces.  First, the short seller initially borrows the stock from the broker in order to sell it.  If the broker is forced to demand the stock back from the short seller – either because the “floating supply” needs to be replenished, or because the short seller has insufficient equity (due to the stock price moving to high) – then the short seller can be forced to take a loss.  Second, technically there is no limit to how much the short seller can lose because there is no limit to how high a stock can go.

The danger of potentially unlimited losses for a short seller can be exacerbated in a Corner.  That’s because the bulls in a Corner can buy up so much of the stock that there is very little supply of it left.  As the stock price skyrockets and the supply of stock shrinks, the short seller can be forced to buy the stock back – most likely from the bulls – at an extremely high price.  This is precisely what the bulls are trying to accomplish in a Corner.

On the other hand, if the bulls end up owning most of the publicly available stock, and if the bears can ride out the Corner, then to whom can the bulls sell their stock?  If there are virtually no buyers, then the bulls have no chance of selling most of their holding.  In this case, the bulls can get stuck with a mountain of stock they can’t sell.  The achievable value of this mountain can even approach zero in some extreme cases.

Brooks explains that true Corners could not happen after the new securities legislation in the 1930’s.  Thus, Saunders was the last intentional player of the game.

Saunders was born to a poor family in Amherst County, Virginia, in 1881.  He started out working for practically nothing for a local grocer.  He then worked for a wholesale grocer in Clarksville, Tennessee, and then for another one in Memphis.  Next, he organized a retail food chain, which he sold.  Then he was a wholesale grocer before launching the retail self-service food chain he named Piggly Wiggly Stores.

By the fall of 1922, there were over 1,200 Piggly Wiggly Stores.  650 of these were owned outright by Saunders’ Piggly Wiggly Stores, Inc.  The rest were owned independently, but still paid royalties to the parent company.  For the first time, customers were allowed to go down any aisle and pick out whatever they wanted to buy.  Then they paid on their way out of the store.  Saunders didn’t know it, but he had invented the supermarket.

In November, 1922, several small companies operating Piggly Wiggly Stores in New York, New Jersey, and Connecticut went bankrupt.  These were independently owned, having nothing to do with Piggly Wiggly Stores, Inc.  Nonetheless, several stock-market operators saw what they believed was a golden opportunity for a bear raid.  Brooks:

If individual Piggly Wiggly stores were failing, they reasoned, then rumors could be spread that would lead the uninformed public to believe that the parent firm was failing, too.  To further this belief, they began briskly selling Piggly Wiggly short, in order to force the price down.  The stock yielded readily to their pressure, and within a few weeks its price, which earlier in the year had hovered around fifty dollars a share, dropped to below forty.

Saunders promptly announced to the press that he was going to “beat the Wall Street professionals at their own game” through a buying campaign.  At that point, Saunders had no experience at all with owning stock, Piggly Wiggly being the only stock he had ever owned.  Moreover, there is no reason to think Saunders was going for a Corner at this juncture.  He merely wanted to support his stock on behalf of himself and other stockholders.

Saunders borrowed $10 million dollars – about $140 million in 2019 dollars – from bankers in Memphis, Nashville, New Orleans, Chattanooga, and St. Louis.  Brooks:

Legend has it that he stuffed his ten million-plus, in bills of large denomination, into a suitcase, boarded a train for New York, and, his pockets bulging with currency that wouldn’t fit in the suitcase, marched on Wall Street, ready to do battle.

Saunders later denied this, saying he conducted his campaign from Memphis.  Brooks continues:

Wherever he was at the time, he did round up a corp of some twenty brokers, among them Jesse L. Livermore, who served as his chief of staff.  Livermore, one of the most celebrated American speculators of this century, was then forty-five years old but was still occasionally, and derisively, referred to by the nickname he had earned a couple of decades earlier – the Boy Plunger of Wall Street.  Since Saunders regarded Wall Streeters in general and speculators in particular as parasitic scoundrels intent only on battering down his stock, it seemed likely that his decision to make an ally of Livermore was a reluctant one, arrived at simply with the idea of getting the enemy chieftain into his own camp.

Within a week, Saunders had bought 105,000 shares – more than half of the 200,000 shares outstanding.  By January 1923, the stock hit $60 a share, its highest level ever.  Reports came from Chicago that the stock was cornered.  The bears couldn’t find any available supply in order to cover their short positions by buying the stock back.  The New York Stock Exchange immediately denied the rumor, saying ample amounts of Piggly Wiggly stock were still available.

Saunders then made a surprising but exceedingly crafty move.  The stock was pushing $70, but Saunders ran advertisements offering to sell it for $55.  Brooks explains:

One of the great hazards in Corner was always that even though a player might defeat his opponents, he would discover that he had won a Pyrrhic victory.  Once the short sellers had been squeezed dry, that is, the cornerer might find that the reams of stock he had accumulated in the process were a dead weight around his neck;  by pushing it all back into the market in one shove, he would drive its price down close to zero.  And if, like Saunders, he had had to borrow heavily to get into the game in the first place, his creditors could be expected to close in on him and perhaps not only divest him of his gains but drive him into bankruptcy.  Saunders apparently anticipated this hazard almost as soon as a corner was in sight, and accordingly made plans to unload some of his stock before winning instead of afterward.  His problem was to keep the stock he sold from going right back into the floating supply, thus breaking his corner;  and his solution was to sell his fifty-five-dollar shares on the installment plan.

Crucially, the buyers on the installment plan wouldn’t receive the certificates of ownership until they had paid their final installment.  This meant they couldn’t sell their shares back into the floating supply until they had finished making all their installment payments.

By Monday, March 19, Saunders owned nearly all of the 200,000 shares of Piggly Wiggly stock.  Livermore had already bowed out of the affair on March 12 because he was concerned about Saunders’ financial position.  Nonetheless, Saunders asked Livermore to spring the bear trap.  Livermore wouldn’t do it.  So Saunders himself had to do it.

On Tuesday, March 20, Saunders called for delivery all of his Piggly Wiggly stock.  By the rules of the Exchange, stock so called for had to be delivered by 2:15 the following afternoon.  There were a few shares around owned in small amounts by private investors.  Short sellers were frantically trying to find these folks.  But on the whole, there were basically no shares available outside of what Saunders himself owned.

This meant that Piggly Wiggly shares had become very illiquid – there were hardly any shares trading.  A nightmare, it seemed, for short sellers.  Some short sellers bought at $90, some at $100, some at $110.  Eventually the stock reached $124.  But then a rumor reached the floor that the governors of the Exchange were considering a suspension of trading in Piggly Wiggly, as well as an extension of the deadline for short sellers.  Piggly Wiggly stock fell to $82.

The Governing Committee of the Exchange did, in fact, made such an announcement.  They claimed that they didn’t want to see a repeat of the Northern Pacific panic.  However, many wondered whether the Exchange was just helping the short sellers, among whom were some members of the Exchange.

Saunders still hadn’t grasped the fundamental problem he now faced.  He still seemed to have several million in profits.  But only if he could actually sell his shares.

Next, the Stock Exchange announced a permanent suspension of trading in Piggly Wiggly stock and a full five day extension for short sellers to return their borrowed shares.  Short sellers had until 2:15 the following Monday.

Meanwhile, Piggly Wiggly Stores, Inc., released its annual financial statement, which revealed that sales, profits, and assets had all sharply increased from the previous year.  But everyone ignored the real value of the company.  All that mattered at this point was the game.

The extension allowed short sellers the time to find shareholders in a variety of locations around the country.  These shareholders were of course happy to dig out their stock certificates and sell them for $100 a share.  In this way, the short sellers were able to completely cover their short positions by Friday evening.  And instead of paying Saunders cash for some of his shares, the short sellers gave him more shares to settle their debt, which is the last thing Saunders wanted just then.  (A few short sellers had to pay Saunders directly.)

The upshot was that all the short sellers were in the clear, whereas Saunders was stuck owning nearly every single share of Piggly Wiggly stock.  Saunders, who had already started complaining loudly, repeated his charge that Wall Street had changed its own rule in order to let “a bunch of welchers” off the hook.

In response, the Stock Exchange issued a statement explaining its actions:

‘The enforcement simultaneously of all contracts for the return of stock would have forced the stock to any price that might be fixed by Mr. Saunders, and competitive bidding for the insufficient supply might have brought about conditions illustrated by other corners, notably the Northern Pacific corner in 1901.’

Furthermore, the Stock Exchange pointed out that its own rules allowed it to suspend trading in a stock, as well as to extend the deadline for the return of borrowed shares.

It is true that the Exchange had the right to suspend trading in a stock.  But it is unclear, to say the least, about whether the Exchange had any right to postpone the deadline for the delivery of borrowed shares.  In fact, two years after Saunders’ corner, in June, 1925, the Exchange felt bound to amend its constitution with an article stating that “whenever in the opinion of the Governing Committee a corner has been created in a security listed on the Exchange… the Governing Committee may postpone the time for deliveries on Exchange contracts therein.”

 

A SECOND SORT OF LIFE

According to Brooks, other than FDR himself, perhaps no one typified the New Deal better than David Eli Lilienthal.  On a personal level, Wall Streeters found Lilienthal a reasonable fellow.  But through his association with Tennessee Valley Authority from 1933 to 1946, Lilienthal “wore horns.”  T.V.A. was a government-owned electric-power concern that was far larger than any private power corporation.  As such, T.V.A. was widely viewed on Wall Street as the embodiment of “galloping Socialism.”

In 1946, Lilienthal became the first chairman of the United States Atomic Energy Commission, which he held until February, 1950.

Brooks was curious what Lilienthal had been up to since 1950, so he did some investigating.  He found that Lilienthal was co-founder and chairman of Development & Resources Corporation.  D. & R. helps governments set up programs similar to the T.V.A.  Brooks also found that as of June, 1960, Lilienthal was a director and major shareholder of Minerals & Chemicals Corporation of America.

Lastly, Brooks discovered Lilienthal had published his third book in 1953, “Big Business: A New Era.”  In the book, he argues that:

  • the productive superiority of the United States depends on big business;
  • we have adequate safeguards against abuses by big business;
  • big businesses tend to promote small businesses, not destroy them;
  • and big business promotes individualism, rather than harms it, by reducing poverty, disease, and physical insecurity.

Lilienthal later agreed with his family that he hadn’t spent enough time on the book, although its main points were correct.  Also, he stressed that he had conceived of the book before he ever decided to transition from government to business.

In 1957, Lilienthal and his wife Helen Lamb Lilienthal had settled in a house in Princeton.  It was a few years later, at this house, that Brooks went to interview Lilienthal.  Brooks was curious to hear about how Lilienthal thought about his civic career as compared to his business career.

Lilienthal had started out as a lawyer in Chicago and he done quite well.  But he didn’t want to practice the law.  Then – in 1950 – his public career over, he was offered various professorship positions at Harvard.  He didn’t want to be a professor.  Then various law firms and businesses approached Lilienthal.  He still had no interest in practicing law.  He also rejected the business offers he received.

In May, 1950, Lilienthal took a job as a part-time consultant for Lazard Freres & Co., whose senior partner, Andre Meyer, he had met through Albert Lasker, a mutual friend.  Through Lazard Freres and Meyer, Lilienthal became a consultant and then an executive of a small company, the Minerals Separation North American Corporation.  Lazard Freres had a large interest in the concern.

The company was in trouble, and Meyer thought Lilienthal was the man to solve the case.  Through a series of mergers, acquisitions, etc., the firm went through several name changes ending, in 1960, with the name, Minerals & Chemicals Philipp Corporation.  Meanwhile, annual sales for the company went from $750,000 in 1952 to more than $274,000,000 in 1960.  (In 2019 dollars, this would be a move from $6,750,000 to $2,466,000,000.)  Brooks writes:

For Lilienthal, the acceptance of Meyer’s commission to look into the company’s affairs was the beginning of a four-year immersion in the day-to-day problems of managing a business;  the experience, he said decisively, turned out to be one of his life’s richest, and by no means only in the literal sense of that word.

Minerals Separation North American, founded in 1916 as an offshoot from a British company, was a patent firm.  It held patents on processes used to refine copper ore and other nonferrous minerals.  In 1952, Lilienthal became the president of the company.  In order to gain another source of revenue, Lilienthal arranged a merger between Minerals Separation and Attapulgus Clay Company, a producer of a rare clay used in purifying petroleum products and also a manufacturer of various household products.

The merger took place in December, 1952, thanks in part to Lilienthal’s work to gain agreement from the Attapulgus people.  The profits and stock price of the new company went up from there.  Lilienthal managed some of the day-to-day business.  And he helped with new mergers.  One in 1954, with Edgar Brothers, a leading producer of kaolin for paper coating.  Two more in 1955, with limestone firms in Ohio and Virginia.  Brooks notes that the company’s net profits quintupled between 1952 and 1955.

Lilienthal received stock options along the way.  Because the stock went up a great deal, he exercised his options and by August, 1955, Lilienthal had 40,000 shares.  Soon the stock hit $40 and was paying a $0.50 annual dividend.  Lilienthal’s financial worries were over.

Brooks asked Lilienthal how all of this felt.  Lilienthal:

‘I wanted an entrepreneurial experience.  I found a great appeal in the idea of taking a small and quite crippled company and trying to make something of it.  Building.  That kind of building, I thought, is the central thing in American free enterprise, and something I’d missed in all my government work.  I wanted to try my hand at it.  Now, about how it felt.  Well, it felt plenty exciting.  It was full of intellectual stimulation, and a lot of my old ideas changed.  I conceived a great new respect for financiers – men like Andre Meyer.  There’s a correctness about them, a certain high sense of honor, that I’d never had any conception of.  I found that business life is full of creative, original minds – along with the usual number of second-guessers, of course.  Furthermore, I found it seductive.  In fact, I was in danger of becoming a slave… I found that the things you read – for instance, that acquiring money for its own sake can become an addiction if you’re not careful – are literally true.  Certain good friends helped keep me on track… Oh, I had my problems.  I questioned myself at every step.  It was exhausting.’

A friend of Lilienthal’s told Brooks that Lilienthal had a marvelous ability to immerse himself totally in the work.  The work may not always be important.  But Lilienthal becomes so immersed, it’s as if the work becomes important simply because he’s doing it.

On the matter of money, Lilienthal said it doesn’t make much difference as long as you have enough.  Money was something he never really thought about.

Next Brooks describes Lilienthal’s experience at Development & Resources Corporation.  The situation became ideal for Lilienthal because it combined helping the world directly with the possibility of also earning a profit.

In the spring of 1955, Lilienthal and Meyer had several conversations.  Lilienthal told Meyer that he knew dozens of foreign dignitaries and technical personnel who had visited T.V.A. and shown strong interest.  Many of them told Lilienthal that at least some of their own countries would be interested in starting similar programs.

The idea for D. & R. was to accomplish very specific projects and, incidentally, to make a profit.  Meyer liked the idea – although he expected no profit – so they went forward, with Lazard Freres owning half the firm.  The executive appointments for D.& R. included important alumni from T.V.A., people with deep experience and knowledge in management, engineering, dams, electric power, and related areas.

In September, 1955, Lilienthal was at a World Bank meeting in Istanbul and he ended up speaking with Abolhassan Ebtehaj, head of a 7-year development plan in Iran.  Iran had considerable capital with which to pay for development projects, thanks to royalties from its nationalized oil industry.  Moreover, what Iran badly needed was technical and professional guidance.  Lilienthal and a colleague later visited Iran as guests of the Shah to see what could be done about Khuzistan.

Lilienthal didn’t know anything about the region at first.  But he learned that Khuzistan was in the middle of the Old Testament Elamite kingdom and later of the Persian Empire.  The ruins of Persepolis are close by.  The ruins of Susa, where King Darius had a winter palace, are at the center of Khuzistan.  Brooks quotes Lilienthal (in the 1960’s):

Nowadays, Khuzistan is one of the world’s richest oil fields  – the famous Abadan refinery is at its southern tip – but the inhabitants, two and a half million of them, haven’t benefited from that.  The rivers have flowed unused, the fabulously rich soil has lain fallow, and all but a tiny fraction of the people have continued to live in desperate poverty.

D. & R. signed a 5-year agreement with the Iranian government.  Once the project got going, there were 700 people working on it – 100 Americans, 300 Iranians, and 300 others (mostly Europeans).  In addition, 4,700 Iranian-laborers were on the various sites.  The entire project called for 14 dams on 5 different rivers.  After D. & R. completed its first 5-year contract, they signed a year-and-a-half extension including an option for an additional 5 years.

Brooks records:

While the Iranian project was proceeding, D. & R. was also busy lining up and carrying out its programs for Italy, Colombia, Ghana, the Ivory Coast, and Puerto Rico, as well as programs for private business groups in Chile and the Philippines.  A job that D. & R. had just taken on from the United States Army Corps of Engineers excited Lilienthal enormously – an investigation of the economic impact of power from a proposed dam on the Alaskan sector of the Yukon, which he described as ‘the river with the greatest hydroelectric potential remaining on this continent.’  Meanwhile, Lazard Freres maintained its financial interest in the firm and now very happily collected its share of a substantial annual profit, and Lilienthal happily took to teasing Meyer about his former skepticism as to D. & R. financial prospects.

Lilienthal wrote in his journal about the extreme poverty in Ahwaz, Khuzistan:

…visiting villages and going into mud ‘homes’ quite unbelievable – and unforgettable forever and ever.  As the Biblical oath has it:  Let my right hand wither if I ever forget how some of the most attractive of my fellow human beings live – are living tonight, only a few kilometres from here, where we visited them this afternoon…

And yet I am as sure as I am writing these notes that the Ghebli area, of only 45,000 acres, swallowed in the vastness of Khuzistan, will become as well known as, say, the community of Tupelo… became, or New Harmony or Salt Lake City when it was founded by a handful of dedicated men in a pass of the great Rockies.

 

STOCKHOLDER SEASON

The owners of public businesses in the United States are the stockholders.  But many stockholders don’t pay much attention to company affairs when things are going well.  Also, many stockholders own small numbers of shares, making it not seem worthwhile to exercise their rights as owners of the corporations.  Furthermore, many stockholders don’t understand or follow business, notes Brooks.

Brooks decided to attend several annual meetings in the spring of 1966.

What particularly commended the 1966 season to me was that it promised to be a particularly lively one.  Various reports of a new “hard-line approach” by company managements to stockholders had appeared in the press.  (I was charmed by the notion of a candidate for office announcing his new hard-line approach to voters right before an election.)

Brooks first attended the A. T. & T. annual meeting in Detroit.  Chairman Kappel came on stage, followed by eighteen directors who sat behind him, and he called the meeting to order.  Brooks:

From my reading and from annual meetings that I’d attended in past years, I knew that the meetings of the biggest companies are usually marked by the presence of so-called professional stockholders… and that the most celebrated members of this breed were Mrs. Wilma Soss, of New York, who heads an organization of women stockholders and votes the proxies of its members as well as her own shares, and Lewis D. Gilbert, also of New York, who represents his own holdings and those of his family – a considerable total.

Brooks learned that, apart from prepared comments by management, many big-company meetings are actually a dialogue between the chairman and a few professional stockholders.  So professional stockholders can come to represent, in a way, many other shareholders who might otherwise not be represented, whether because they own few shares, don’t follow business, or other reasons.

Brooks notes that occasionally some professional stockholders get boorish, silly, on insulting.  But not Mrs. Soss or Mr. Gilbert:

Mrs. Soss, a former public-relations woman who has been a tireless professional stockholder since 1947, is usually a good many cuts above this level.  True, she is not beyond playing to the gallery by wearing bizarre costumes to meetings;  she tries, with occasional success, to taunt recalcitrant chairmen into throwing her out;  she is often scolding and occasionally abusive;  and nobody could accuse her of being unduly concise.  I confess that her customary tone and manner set my teeth on edge, but I can’t help recognizing that, because she does her homework, she usually has a point.  Mr. Gilbert, who has been at it since 1933 and is the dean of them all, almost invariably has a point, and by comparison with his colleagues he is the soul of brevity and punctilio as well as of dedication and diligence.

At the A. T. & T. meeting, after the management-sponsored slate of directors had been duly nominated, Mrs. Soss got up to make a nomination of her own, Dr. Frances Arkin, a psychoanalyst.  Mrs. Soss said A. T. & T. ought to have a woman on its board and, moreover, she thought some of the company’s executives would have benefited from periodic psychiatric examinations.  (Brooks comments that things were put back into balance at another annual meeting when the chairman suggested that some of the firm’s stockholders should see a psychiatrist.)  The nomination of Dr. Arkin was seconded by Mr. Gilbert, but only after Mrs. Soss nudged him forcefully in the ribs.

A professional stockholder named Evelyn Y. Davis complained about the meeting not being in New York, as it usually is.  Brooks observed that Davis was the youngest and perhaps the best-looking, but “not the best-informed or the most temperate, serious-minded, or worldly-wise.”  Davis’ complaint was met with boos from the largely local crowd in Detroit.

After a couple of hours, Mr. Kappel was getting testy.  Soon thereafter, Mrs. Soss was complaining that while the business affiliations of the nominees for director were listed in the pamphlet handed out at the meeting, this information hadn’t been included in the material mailed to stockholders, contrary to custom.  Mrs. Soss wanted to know why.  Mrs. Soss adopted a scolding tone and Mr. Kappel an icy one, says Brooks.  “I can’t hear you,” Mrs. Soss said at one point.  “Well, if you’d just listen instead of talking…”, Mr. Kappel replied.  Then Mrs. Soss said something (Brooks couldn’t hear it precisely) that successfully baited the chairman, who got upset and had the microphone in front of Mrs. Soss turned off.  Mrs. Soss marched towards the platform and was directly facing Mr. Kappel.  Mr. Kappel said he wasn’t going to throw her out of the meeting as she wanted.  Mrs. Soss later returned to her seat and a measure of calm was restored.

Later, Brooks attended the annual meeting of Chas. Pfizer & Co., which was run by the chairman, John E. McKeen.  After the company announced record highs on all of its operational metrics, and predicted more of the same going forward, “the most intransigent professional stockholder would have been hard put to it to mount much of a rebellion at this particular meeting,” observes Brooks.

John Gilbert, brother of Lewis Gilbert, may have been the only professional stockholder present.  (Lewis Gilbert and Mrs. Davis were at the U.S. Steel meeting in Cleveland that day.)

John Gilbert is the sort of professional stockholder the Pfizer management deserves, or would like to think it does.  With an easygoing manner and a habit of punctuating his words with self-deprecating little laughs, he is the most ingratiating gadly imaginable (or was on this occasion; I’m told he isn’t always), and as he ran through what seemed to be the standard Gilbert-family repertoire of questions – on the reliability of the firms’s auditors, the salaries of its officers, the fees of its directors – he seemed almost apologetic that duty called on him to commit the indelicacy of asking such things.

The annual meeting of Communications Satellite Corporation had elements of farce, recounts Brooks.  (Brooks refers to Comsat as a “glamorous space-age communications company.”)  Mrs. Davis, Mrs. Soss, and Lewis Gilbert were in attendance.  The chairman of Comsat, who ran the meeting, was James McCormack, a West Point graduate, former Rhodes Scholar, and retired Air Force General.

Mrs. Soss made a speech which was inaudible because her microphone wasn’t working.  Next, Mrs. Davis rose to complain that there was a special door to the meeting for “distinguished guests.”  Mrs. Davis viewed this as undemocratic.  Mr. McCormack responded, “We apologize, and when you go out, please go by any door you want.”  But Mrs. Davis went on speaking.  Brooks:

And now the mood of farce was heightened when it became clear that the Soss-Gilbert faction had decided to abandon all efforts to keep ranks closed with Mrs. Davis.  Near the height of her oration, Mr. Gilbert, looking as outraged as a boy whose ball game is being spoiled by a player who doesn’t know the rules or care about the game, got up and began shouting, ‘Point of order!  Point of order!’  But Mr. McCormack spurned this offer of parliamentary help;  he ruled Mr. Gilbert’s point of order out of order, and bade Mrs. Davis proceed.  I had no trouble deducing why he did this.  There were unmistakable signs that he, unlike any other corporate chairman I had seen in action, was enjoying every minute of the goings on.  Through most of the meeting, and especially when the professional stockholders had the floor, Mr. McCormack wore the dreamy smile of a wholly bemused spectator.

Mrs. Davis’ speech increased in volume and content, and she started making specific accusations against individual Comsat directors.  Three security guards appeared on the scene and marched to a location near Mrs. Davis, who then suddenly ended her speech and sat down.

Brooks comments:

Once, when Mr. Gilbert said something that Mrs. Davis didn’t like and Mrs. Davis, without waiting to be recognized, began shouting her objection across the room, Mr. McCormack gave a short irrepressible giggle.  That single falsetto syllable, magnificently amplified by the chairman’s microphone, was the motif of the Comsat meeting.

 

ONE FREE BITE

Brooks writes about Donald W. Wohlgemuth, a scientist for B. F. Goodrich Company in Akron, Ohio.

…he was the manager of Goodrich’s department of space-suit engineering, and over the past years, in the process of working his way up to that position, he had had a considerable part in the designing and construction of the suits worn by our Mercury astronauts on their orbital and suborbital flights.

Some time later, the International Latex Corporation, one of Goodrich’s three main competitors in the space-suit field, contacted Wohlgemuth.

…Latex had recently been awarded a subcontract, amounting to some three-quarters of a million dollars, to do research and development on space suits for the Apollo, or man-on-the-moon, project.  As a matter of fact, Latex had won this contract in competition with Goodrich, among others, and was thus for the moment the hottest company in the space-suit field.

Moreover, Wohlgemuth was not particularly happy at Goodrich for a number of reasons.  His salary was below average.  His request for air-conditioning had been turned down.

Latex was located in Dover, Delaware.  Wohlgemuth went there to meet with company representatives.  He was given a tour of the company’s space-suit-development facilities.  Overall, he was given “a real red-carpet treatment,” as he later desribed.  Eventually he was offered the position of manager of engineering for the Industrial Products Division, which included space-suit development, at an annual salary of $13,700 (over $109,000 in 2019 dollars) – solidly above his current salary.  Wohlgemuth accepted the offer.

The next morning, Wohlgemuth informed his boss at Goodrich, Carl Effler, who was not happy.  The morning after that, Wohlgemuth told Wayne Galloway – with whom he had worked closely – of his decision.

Galloway replied that in making the move Wohlgemuth would be taking to Latex certain things that did not belong to him – specifically, knowledge of the processes that Goodrich used in making space suits.

Galloway got upset with Wohlgemuth.  Later Effler called Wohlgemuth to his office and told him he should leave the Goodrich offices as soon as possible.  Then Galloway called him and told him the legal department wanted to see him.

While he was not bound to Goodrich by the kind of contract, common in American industry, in which an employee agrees not to do similar work for any competing company for a stated period of time, he had, on his return from the Army, signed a routine paper agreeing ‘to keep confidential all information, records, and documents of the company of which I may have knowledge because of my employment’ – something Wohlgemuth had entirely forgotten until the Goodrich lawyer reminded him.  Even if he had not made that agreement, the lawyer told him now, he would be prevented from going to work on space suits for Latex by established principles of trade-secrets law.  Moreover, if he persisted in his plan, Goodrich might sue him.

To make matters worse, Effler told Wohlgemuth that if he stayed at Goodrich, this incident could not be forgotten and might well impact his future.  Wohlgemuth then informed Latex that he would be unable to accept their offer.

That evening, Wohlgemuth’s dentist put him in touch with a lawyer.  Wohlgemuth talked with the lawyer, who consulted another lawyer.  They told Wohlgemuth that Goodrich was probably bluffing and wouldn’t sue him if he went to work for Latex.

The next morning – Thursday – officials of Latex called him back to assure him that their firm would bear his legal expenses in the event of a lawsuit, and, furthermore, would indemnify him against any salary losses.

Wohlgemuth decided to work for Latex, after all, and left the offices of Goodrich late that day, taking with him no documents.

The next day, R. G. Jeter, general counsel of Goodrich, called Emerson P. Barrett, director of industrial relations for Latex.  Jeter outlined Goodrich’s concern for its trade secrets.  Barrett replied that Latex was not interested in Goodrich trade secrets, but was only interested in Wohlgemuth’s “general professional abilities.”

That evening, at a farewell dinner given by forty or so friends, Wohlgemuth was called outside.  The deputy sheriff of Summit County handed him two papers.

One was a summons to appear in the Court of Common Pleas on a date a week or so off.  The other was a copy of a petition that had been filed in the same court that day by Goodrich, praying that Wohlgemuth be permanently enjoined from, among other things, disclosing to any unauthorized person any trade secrets belonging to Goodrich, and ‘performing any work for any corporation… other than plaintiff, relating to the design, manufacture and/or sale of high-altitude pressure suits, space suits and/or similar protective garments.’

For a variety of reasons, says Brooks, the trial attracted much attention.

On one side was the danger that discoveries made in the course of corporate research might become unprotectable – a situation that would eventually lead to the drying up of private research funds.  On the other side was the danger that thousands of scientists might, through their very ability and ingenuity, find themselves permanently locked in a deplorable, and possibly unconstitutional, kind of intellectual servitude – they would be barred from changing jobs because they knew too much.

Judge Frank H. Harvey presided over the trial, which took place in Akron from November 26 to December 12.  The seriousness with which Goodrich took this case is illustrated by the fact that Jeter himself, who hadn’t tried a case in 10 years, headed Goodrich’s legal team.  The chief defense counsel was Richard A. Chenoweth, of Buckingham, Doolittle & Burroughs – an Akron law firm retained by Latex.

From the outset, the two sides recognized that if Goodrich was to prevail, it had to prove, first, that it possessed trade secrets;  second, that Wohlgemuth also possessed them, and that a substantial peril of disclosure existed;  and, third, that it would suffer irreparable injury if injunctive relief was not granted.

Goodrich attorneys tried to establish that Goodrich had a good number of space-suit secrets.  Wohlgemuth, upon cross-examination from his counsel, sought to show that none of these processes were secrets at all.  Both companies brought their space suits into the courtroom.  Goodrich wanted to show what it had achieved through research.  The Latex space suit was meant to show that Latex was already far ahead of Goodrich in space-suit development, and so wouldn’t have any interest in Goodrich secrets.

On the second point, that Wohlgemuth possessed Goodrich secrets, there wasn’t much debate.  But Wohlgemuth’s lawyers did argue that he had taken no papers with him and that he was unlikely to remember the details of complex scientific processes, even if he wanted to.

On the third point, seeking injunctive relief to prevent irreparable injury, Jeter argued that Goodrich was the clear pioneer in space suits.  It made the first full-pressure flying suit in 1934.  Since then, it has invested huge amounts in space suit research and development.  Jeter characterized Latex as a newcomer intent on profiting from Goodrich’s years of research by hiring Wohlgemuth.

Furthermore, even if Wohlgemuth and Latex had the best of intentions, Wohlgemuth would inevitably give away trade secrets.  But good intentions hadn’t been demonstrated, since Latex deliberately sought Wohlgemuth, who in turn justified his decision in part on the increase in salary.  The defense disagreed that trade secrets would be revealed or that anyone had bad intentions.  The defense also got a statement in court from Wohlgemuth in which he pledged not to reveal any trade secrets of B. F. Goodrich Company.

Judge Harvey reserved the decision for a later date.  Meanwhile, the lawyers for each side fought one another in briefs intended to sway Judge Harvey.  Brooks:

…it became increasingly clear that the essence of the case was quite simple.  For all practical purposes, there was no controversy over facts.  What remained in controversy was the answer to two questions:  First, should a man be formally restrained from revealing trade secrets when he has not yet committed any such act, and when it is not clear that he intends to?  And, secondly, should a man be prevented from taking a job simply because the job presents him with unique temptations to break the law?

The defense referred to “Trade Secrets,” written by Ridsdale Ellis and published in 1953, which stated that usually it is not until there is evidence that the employee has not lived up to the contract, written or implied, that the former employer can take action.  “Every dog has one free bite.”

On February 20, 1963, Judge Harvey delivered his decision in a 9-page essay.  Goodrich did have trade secrets.  And Wohlgemuth could give these secrets to Latex.  Furthermore, there’s no doubt Latex was seeking to get Wohlgemuth for his specialized knowledge in space suits, which would be valuable for the Apollo contract.  There’s no doubt, wrote the judge, that Wohlgemuth would be able to disclose confidential information.

However, the judge said, in keeping with the one-free-bite principle, an injunction against disclosure of trade secrets cannot be issued before such disclosure has occurred unless there is clear and substantial evidence of evil intent on the part of the defendant.  In the view of the court, Wohlgemuth did not have evil intent in this case, therefore the injunction was denied.

On appeal, Judge Arthur W. Doyle partially reversed the decision.  Judge Doyle granted an injunction against Wohlgemuth from disclosing to Latex any trade secrets of Goodrich.  On the other hand, Wohlgemuth had the right to take a job in a competitive industry, and he could use his knowledge and experience – other than trade secrets – for the benefit of his employer.  Wohlgemuth was therefore free to work on space suits for Latex, provided he didn’t reveal any trade secrets of Goodrich.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Common Stocks and Common Sense

(Image:  Zen Buddha Silence by Marilyn Barbone)

October 23, 2022

It’s crucial in investing to have the proper balance of confidence and humility.  Overconfidence is very deep-seated in human nature.  Nearly all of us tend to believe that we’re above average across a variety of dimensions, such as looks, smarts, academic ability, business aptitude, driving skill, and even luck (!).

Overconfidence is often harmless and it even helps in some areas.  But when it comes to investing, if we’re overconfident about what we know and can do, eventually our results will suffer.

(Image by Wilma64)

The simple truth is that the vast majority of us should invest in broad market low-cost index funds.  Buffett has maintained this argument for a long time: http://boolefund.com/warren-buffett-jack-bogle/

The great thing about investing in index funds is that you can outperform most investors, net of costs, over the course of several decades.  This is purely a function of costs.  A Vanguard S&P 500 index fund costs 2-3% less per year than the average actively managed fund.  This means that, after a few decades, you’ll be ahead at least 80% (or more) of all active investors.

You can do better than a broad market index fund if you invest in a solid quantitative value fund.  Such a fund can do at least 1-2% better per year, on average and net of costs, than a broad market index fund.

But you can do even better—at least 8% better per year than the S&P 500 index—by investing in a quantitative value fund focused on microcap stocks.

  • At the Boole Microcap Fund, our mission is to help you do at least 8% better per year, on average, than an S&P 500 index fund.  We achieve this by implementing a quantitative deep value approach focused on cheap micro caps with improving fundamentals.  See: http://boolefund.com/best-performers-microcap-stocks/

 

I recently re-read Common Stocks and Common Sense (Wiley, 2016), by Edgar Wachenheim III.  It’s a wonderful book.  Wachenheim is one of the best value investors.  He and his team at Greenhaven Associates have produced 19% annual returns for over 25 years.

Wachenheim emphasizes that, due to certain behavioral attributes, he has outperformed many other investors who are as smart or smarter.  As Warren Buffett has said:

Success in investing doesn’t correlate with IQ once you’re above the level of 125.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

That’s not to say IQ isn’t important.  Most of the finest investors are extremely smart.  Wachenheim was a Baker Scholar at Harvard Business School, meaning that he was in the top 5% of his class.

The point is that—due to behavioral factors such as patience, discipline, and rationality—top investors outperform many other investors who are as smart or smarter.  Buffett again:

We don’t have to be smarter than the rest; we have to be more disciplined than the rest.

Buffett himself has always been extraordinarily patient and disciplined.  There have been several times in Buffett’s career when he went for years on end without making a single investment.

Wachenheim highlights three behavioral factors that have helped him outperform others of equal or greater talent.

The bulk of Wachenheim’s book—chapters 3 through 13—is case studies of specific investments.  Wachenheim includes a good amount of fascinating business history, some of which is mentioned here.

Outline for this blog post:

  • Approach to Investing
  • Being a Contrarian
  • Probable Scenarios
  • Controlling Emotions
  • IBM
  • Interstate Bakeries
  • U.S. Home Corporation
  • Centex
  • Union Pacific
  • American International Group
  • Lowe’s
  • Whirlpool
  • Boeing
  • Southwest Airlines
  • Goldman Sachs

(Photo by Lsaloni)

 

APPROACH TO INVESTING

From 1960 through 2009 in the United States, common stocks have returned about 9 to 10 percent annually (on average).

The U.S. economy grew at roughly a 6 percent annual rate—3 percent from real growth (unit growth) and 3 percent from inflation (price increases).  Corporate revenues—and earnings—have increased at approximately the same 6 percent annual rate.  Share repurchases and acquisitions have added 1 percent a year, while dividends have averaged 2.5 percent a year.  That’s how, on the whole, U.S. stocks have returned 9 to 10 percent annually, notes Wachenheim.

Even if the economy grows more slowly in the future, Wachenheim argues that U.S. investors should still expect 9 to 10 percent per year.  In the case of slower growth, corporations will not need to reinvest as much of their cash flows.  That extra cash can be used for dividends, acquisitions, and share repurchases.

Following Warren Buffett and Charlie Munger, Wachenheim defines risk as the potential for permanent loss.  Risk is not volatility.

Stocks do fluctuate up and down.  But every time the market has declined, it has ultimately recovered and gone on to new highs.  The financial crisis in 2008-2009 is an excellent example of large—but temporary—downward volatility:

The financial crisis during the fall of 2008 and the winter of 2009 is an extreme (and outlier) example of volatility.  During the six months between the end of August 2008 and end of February 2009, the [S&P] 500 Index fell by 42 percent from 1,282.83 to 735.09.  Yet by early 2011 the S&P 500 had recovered to the 1,280 level, and by August 2014 it had appreciated to the 2000 level.  An investor who purchased the S&P 500 Index on August 31, 2008, and then sold the Index six years later, lived through the worst financial crisis and recession since the Great Depression, but still earned a 56 percent profit on his investment before including dividends—and 69 percent including the dividends that he would have received during the six-year period.  Earlier, I mentioned that over a 50-year period, the stock market provided an average annual return of 9 to 10 percent.  During the six-year period August 2008 through August 2014, the stock market provided an average annual return of 11.1 percent—above the range of normalcy in spite of the abnormal horrors and consequences of the financial crisis and resulting deep recession.

(Photo by Terry Mason)

Wachenheim notes that volatility is the friend of the long-term investor.  The more volatility there is, the more opportunity to buy at low prices and sell at high prices.

Because the stock market increases on average 9 to 10 percent per year and always recovers from declines, hedging is a waste of money over the long term:

While many investors believe that they should continually reduce their risks to a possible decline in the stock market, I disagree.  Every time the stock market has declined, it eventually has more than fully recovered.  Hedging the stock market by shorting stocks, or by buying puts on the S&P 500 Index, or any other method usually is expensive, and, in the long run, is a waste of money.

Wachenheim describes his investment strategy as buying deeply undervalued stocks of strong and growing companies that are likely to appreciate significantly due to positive developments not yet discounted by stock prices.

Positive developments can include:

  • a cyclical upturn in an industry
  • an exciting new product or service
  • the sale of a company to another company
  • the replacement of a poor management with a good one
  • a major cost reduction program
  • a substantial share repurchase program

If the positive developments do not occur, Wachenheim still expects the investment to earn a reasonable return, perhaps close to the average market return of 9 to 10 percent annually.  Also, Wachenheim and his associates view undervaluation, growth, and strength as providing a margin of safety—protection against permanent loss.

Wachenheim emphasizes that at Greenhaven, they are value investors not growth investors.  A growth stock investor focuses on the growth rate of a company.  If a company is growing at 15 percent a year and can maintain that rate for many years, then most of the returns for a growth stock investor will come from future growth.  Thus, a growth stock investor can pay a high P/E ratio today if growth persists long enough.

Wachenheim disagrees with growth investing as a strategy:

…I have a problem with growth-stock investing.  Companies tend not to grow at high rates forever.  Businesses change with time.  Markets mature.  Competition can increase.  Good managements can retire and be replaced with poor ones.  Indeed, the market is littered with once highly profitable growth stocks that have become less profitable cyclic stocks as a result of losing their competitive edge.  Kodak is one example.  Xerox is another.  IBM is a third.  And there are hundreds of others.  When growth stocks permanently falter, the price of their shares can fall sharply as their P/E ratios contract and, sometimes, as their earnings fall—and investors in the shares can suffer serious permanent loss.

Many investors claim that they will be able to sell before a growth stock seriously declines.  But very often it’s difficult to determine whether a company is suffering from a temporary or permanent decline.

Wachenheim observes that he’s known many highly intelligent investors—who have similar experiences to him and sensible strategies—but who, nonetheless, haven’t been able to generate results much in excess of the S&P 500 Index.  Wachenheim says that a key point of his book is that there are three behavioral attributes that a successful investor needs:

In particular, I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties.  These three behavioral attributes are so important that they merit further analysis.

 

BEING A CONTRARIAN

(Photo by Marijus Auruskevicius)

Most investors are not contrarians because they nearly always follow the crowd:

Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors.  Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position—a position that is unpopular and often is very lonely.  Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media.  Most individuals and most investors simply end up being followers, not leaders.

In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait.  I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favored fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.

Wachenheim mentions a fellow investor he knows—Danny.  He notes that Danny has a high IQ, attended an Ivy League university, and has 40 years of experience in the investment business.  Wachenheim often describes to Danny a particular stock that is depressed for reasons that are likely temporary.  Danny will express his agreement, but he never ends up buying before the problem is fixed.

In follow-up conversations, Danny frequently states that he’s waiting for the uncertainty to be resolved.  Value investor Seth Klarman explains why it’s usually better to invest before the uncertainty is resolved:

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.  Yet high uncertainty is frequently accompanied by low prices.  By the time the uncertainty is resolved, prices are likely to have risen.  Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.  The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

 

PROBABLE SCENARIOS

(Image by Alain Lacroix)

Many (if not most) investors tend to extrapolate recent trends into the future.  This usually leads to underperforming the market.  See:

The successful investor, by contrast, is a contrarian who can reasonably estimate future scenarios and their probabilities of occurrence:

Investment decisions seldom are clear.  The information an investor receives about the fundamentals of a company usually is incomplete and often is conflicting.  Every company has present or potential problems as well as present or future strengths.  One cannot be sure about the future demand for a company’s products or services, about the success of any new products or services introduced by competitors, about future inflationary cost increases, or about dozens of other relevant variables.  So investment outcomes are uncertain.  However, when making decisions, an investor often can assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities.  Investing is probabilistic.

Because investing is probabilitistic, mistakes are unavoidable.  A good value investor typically will have at least 33% of his or her ideas not work, whether due to an error, bad luck, or an unforeseeable event.  You have to maintain equanimity despite inevitable mistakes:

If I carefully analyze a security and if my analysis is based on sufficiently large quantities of accurate information, I always will be making a correct decision.  Granted, the outcome of the decision might not be as I had wanted, but I know that decisions always are probabilistic and that subsequent unpredictable changes or events can alter outcomes.  Thus, I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.  An analogy might be my putting game in golf.  Before putting, I carefully try to assess the contours and speed of the green.  I take a few practice strokes.  I aim the putter to the desired line.  I then putt and hope for the best.  Sometimes the ball goes in the hole…

 

CONTROLLING EMOTION

(Photo by Jacek Dudzinski)

Wachenheim:

I have observed that when the stock market or an individual stock is weak, there is a tendency for many investors to have an emotional response to the poor performance and to lose perspective and patience.  The loss of perspective and patience often is reinforced by negative reports from Wall Street and from the media, who tend to overemphasize the significance of the cause of the weakness.  We have an expression that aiplanes take off and land every day by the tens of thousands, but the only ones you read about in the newspapers are the ones that crash.  Bad news sells.  To the extent that negative news triggers further selling pressures on stocks and further emotional responses, the negativism tends to feed on itself.  Surrounded by negative news, investors tend to make irrational and expensive decisions that are based more on emotions than on fundamentals. This leads to the frequent sale of stocks when the news is bad and vice versa.  Of course, the investor usually sells stocks after they already have materially decreased in price.  Thus, trading the market based on emotional reactions to short-term news usually is expensive—and sometimes very expensive.

Wachenheim agrees with Seth Klarman that, to a large extent, many investors simply cannot help making emotional investment decisions.  It’s part of human nature.  People overreact to recent news.

I have continually seen intelligent and experienced investors repeatedly lose control of their emotions and repeatedly make ill-advised decisions during periods of stress.

That said, it’s possible (for some, at least) to learn to control your emotions.  Whenever there is news, you can learn to step back and look at your investment thesis.  Usually the investment thesis remains intact.

 

IBM

(IBM Watson by Clockready, Wikimedia Commons)

When Greenhaven purchases a stock, it focuses on what the company will be worth in two or three years.  The market is more inefficient over that time frame due to the shorter term focus of many investors.

In 1993, Wachenheim estimated that IBM would earn $1.65 in 1995.  Any estimate of earnings two or three years out is just a best guess based on incomplete information:

…having projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

The positive development Wachenheim expected was that IBM would announce a concrete plan to significantly reduce its costs.  On July 28, 1993, the CEO Lou Gerstner announced such a plan.  When IBM’s shares moved up from $11½ to $16, Wachenheim sold his firm’s shares since he thought the market price was now incorporating the expected positive development.

Selling IBM at $16 was a big mistake based on subsequent developments.  The company generated large amounts of cash, part of which it used to buy back shares.  By 1996, IBM was on track to earn $2.50 per share.  So Wachenheim decided to repurchase shares in IBM at $24½.  Although he was wrong to sell at $16, he was right to see his error and rebuy at $24½.  When IBM ended up doing better than expected, the shares moved to $48 in late 1997, at which point Wachenheim sold.

Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right.  To err is human—and I make plenty of errors.  My judgment to sell IBM’s shares in 1993 at $16 was an expensive mistake.  I try not to fret over mistakes.  If I did fret, the investment process would be less enjoyable and more stressful.  In my opinion, investors do best when they are relaxed and are having fun.

Finding good ideas takes time.  Greenhaven rejects the vast majority of its potential ideas.  Good ideas are rare.

 

INTERSTATE BAKERIES

(Photo of a bakery by Mohylek, Wikimedia Commons)

Wachenheim discovered that Howard Berkowitz bought 12 percent of the outstanding shares of Interstate Bakeries, became chairman of the board, and named a new CEO.  Wachenheim believed that Howard Berkowitz was an experienced and astute investor.  In 1967, Berkowitz was a founding partner of Steinhardt, Fine, Berkowitz & Co., one of the earliest and most successful hedge funds.  Wachenheim started analyzing Interstate in 1985 when the stock was at about $15:

Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company.  When studying a balance sheet, I look for signs of financial and accounting strengths.  Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and ‘hidden’ assets and liabilities all are among common considerations, with their relative importance depending on the situation.  If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.  

Wachenheim looks at management after he is done analyzing the balance sheet.  He admits that he is humble about his ability to assess management.  Also, good or bad results are sometimes due in part to chance.

Next Wachenheim examines the business fundamentals:

We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.  Because we believe that information reduces uncertainty, we try to gather as much information as possible.  We read and think—and we sometimes speak to customers, competitors, and suppliers.  While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased.

Wachenheim reveals that the actual process of analyzing a company is far messier than you might think based on the above descriptions:

We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict.  While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental.  And we need to decide when to cease our analysis and make decisions.  In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions.

Wachenheim indicates a couple of lessons learned.  First, it can often pay off when you follow a capable and highly incentivized business person into a situation.  Wachenheim made his bet on Interstate based on his confidence in Howard Berkowitz.  Interstate’s shares were not particularly cheap.

Years later, Interstate went bankrupt because they took on too much debt.  This is a very important lesson.  For any business, there will be problems.  Working through difficulties often takes much longer than expected.  Thus, having low or no debt is essential.

 

U.S. HOME CORPORATION

(Photo by Dwight Burdette, Wikimedia Commons)

Wachenheim describes his use of screens:

I frequently use Bloomberg’s data banks to run screens.  I screen for companies that are selling for low price-to-earnings (PE) ratios, low prices to revenues, low price-to-book values, or low prices relative to other relevant metrics.  Usually the screens produce a number of stocks that merit additional analyses, but almost always the additional analyses conclude that there are valid reasons for the apparent undervaluations. 

Wachenheim came across U.S. Home in mid-1994 based on a discount to book value screen.  The shares appeared cheap at 0.63 times book and 6.8 times earnings:

Very low multiples of book and earnings are adrenaline flows for value investors.  I eagerly decided to investigate further.

Later, although U.S. Home was cheap and produced good earnings, the stock price remained depressed.  But there was a bright side because U.S. Home led to another homebuilder idea…

 

CENTEX CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

After doing research and constructing a financial model of Centex Corporation, Wachenheim had a startling realization:  the shares would be worth about $63 a few years in the future, and the current price was $12.  Finally, a good investment idea:

…my research efforts usually are tedious and frustrating.  I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between.  Maybe only 1 percent or so of the companies we study ends up being part of our portfolios—making it much harder for a stock to enter our portfolio than for a student to enter Harvard.  However, when I do find an exciting idea, excitement fills the air—a blaze of light that more than compensates for the hours and hours of tedium and frustration.

Greenhaven typically aims for 30 percent annual returns on each investment:

Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return.  Thus, we have very high expectations for each investment.

In late 2005, Wachenheim grew concerned that home prices had gotten very high and might decline.  Many experts, including Ben Bernanke, argued that because home prices had never declined in U.S. history, they were unlikely to decline.  Wachenheim disagreed:

It is dangerous to project past trends into the future.  It is akin to steering a car by looking through the rearview mirror…

 

UNION PACIFIC

(Photo by Slambo, Wikimedia Commons)

After World War II, the construction of the interstate highway system gave trucks a competitive advantage over railroads for many types of cargo.  Furthermore, fewer passengers took trains, partly due to the interstate highway system and partly due to the commercialization of the jet airplane.  Excessive regulation of the railroadsin an effort to help farmersalso caused problems.  In the 1960s and 1970s, many railroads went bankrupt.  Finally, the government realized something had to be done and it passed the Staggers Act in 1980, deregulating the railroads:

The Staggers Act was a breath of fresh air.  Railroads immediately started adjusting their rates to make economic sense.  Unprofitable routes were dropped.  With increased profits and with confidence in their future, railroads started spending more to modernize.  New locomotives, freight cars, tracks, automated control systems, and computers reduced costs and increased reliability.  The efficiencies allowed the railroads to reduce their rates and become more competitive with trucks and barges….

In the 1980s and 1990s, the railroad industry also enjoyed increased efficiencies through consolidating mergers.  In the west, the Burlington Northern merged with the Santa Fe, and the Union Pacific merged with the Southern Pacific.  

Union Pacific reduced costs during the 2001-2002 recession, but later this led to congestion on many of its routes and to the need to hire and train new employees once the economy had picked up again.  Union Pacific experienced an earnings shortfall, leading the shares to decline to $14.86.

Wachenheim thought that Union Pacific’s problems were temporary, and that the company would earn about $1.55 in 2006.  With a conservative multiple of 14 times earnings, the shares would be worth over $22 in 2006.  Also, the company was paying a $0.30 annual dividend.  So the total return over a two-year period from buying the shares at $14½ would be 55 percent.

Wachenheim also thought Union Pacific stock had good downside protection because the book value was $12 a share.

Furthermore, even if Union Pacific stock just matched the expected return from the S&P 500 Index of 9½ percent a year, that would still be much better than cash.

The fact that the S&P 500 Index increases about 9½ percent a year is an important reason why shorting stocks is generally a bad business.  To do better than the market, the short seller has to find stocks that underperform the market by 19 percent a year.  Also, short sellers have limited potential gains and unlimited potential losses.  On the whole, shorting stocks is a terrible business and often even the smartest short sellers struggle.

Greenhaven sold its shares in Union Pacific at $31 in mid-2007, since other investors had recognized the stock’s value.  Including dividends, Greenhaven earned close to a 24 percent annualized return.

Wachenheim asks why most stock analysts are not good investors.  For one, most analysts specialize in one industry or in a few industries.  Moreover, analysts tend to extrapolate known information, rather than define future scenarios and their probabilities of occurrence:

…in my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes that 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.

Also, I believe it is difficult for securities analysts to embrace companies and industries that currently are suffering from poor results and impaired reputations.  Often, securities analysts want to see tangible proof of better results before recommending a stock.  My philosophy is that life is not about waiting for the storm to pass.  It is about dancing in the rain.  One usually can read a weather map and reasonably project when a storm will pass.  If one waits for the moment when the sun breaks out, there is a high probability others already will have reacted to the improved prospects and already will have driven up the price of the stock—and thus the opportunity to earn large profits will have been missed.

Wachenheim then quotes from a New York Times op-ed piece written on October 17, 2008, by Warren Buffett:

A simple rule dictates my buying:  Be fearful when others are greedy, and be greedy when others are fearful.  And most certainly, fear is now widespread, gripping even seasoned investors.  To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.  But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.  These businesses will indeed suffer earnings hiccups, as they always have.  But most major companies will be setting new profit records 5, 10, and 20 years from now.  Let me be clear on one point:  I can’t predict the short-term movements of the stock market.  I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now.  What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.  So if you wait for the robins, spring will be over.

 

AMERICAN INTERNATIONAL GROUP

(AIG Corporate, Photo by AIG, Wikimedia Commons)

Wachenheim is forthright in discussing Greenhaven’s investment in AIG, which turned out to be a huge mistake.  In late 2005, Wachenheim estimated that the intrinsic value of AIG would be about $105 per share in 2008, nearly twice the current price of $55.  Wachenheim also liked the first-class reputation of the company, so he bought shares.

In late April 2007, AIG’s shares had fallen materially below Greenhaven’s cost basis:

When shares of one of our holdings are weak, we usually revisit the company’s longer-term fundamentals.  If the longer-term fundamentals have not changed, we normally will continue to hold the shares, if not purchase more.  In the case of AIG, it appeared to us that the longer-term fundamentals remained intact.

When Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, all hell broke loose:

The decline in asset values caused financial institutions to mark down the carrying value of their assets, which, in turn, caused sharp reductions in their credit ratings.  Sharp reductions in credit ratings required financial institutions to raise capital and, in the case of AIG, to post collateral on its derivative contracts.  But the near freezing of the financial markets prevented the requisite raising of capital and cash and thus caused a further deterioration in creditworthiness, which further increased the need for new capital and cash, and so on… On Tuesday night, September 16, the U.S. government agreed to provide the requisite cash in return for a lion’s share of the ownership of AIG.  As soon as I read the agreement, it was clear to me that we had a large permanent loss in our holdings of AIG.

Wachenheim defends the U.S. government bailouts.  Much of the problem was liquidity, not solvency.  Also, the bailouts helped restore confidence in the financial system.

Wachenheim asked himself if he would make the same decision today to invest in AIG:

My answer was ‘yes’—and my conclusion was that, in the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments.  It comes with the territory.  So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks.  However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities.  One should not invest with the precept that the next 100-year storm is around the corner.

Wachenheim also points out that when Greenhaven learns of a flaw in its investment thesis, usually the firm is able to exit the position with only a modest loss.  If you’re right 2/3 of the time and if you limit losses as much as possible, the results should be good over time.

 

LOWE’S

(Photo by Miosotis Jade, Wikimedia Commons)

In 2011, Wachenheim carefully analyzed the housing market and reached an interesting conclusion:

I was excited that we had a concept about a probable strong upturn in the housing market that was not shared by most others.  I believed that the existing negativism about housing was due to the proclivity of human beings to uncritically project recent trends into the future and to overly dwell on existing problems.  When analyzing companies and industries, I tend to be an optimist by nature and a pragmatist through effort.  In terms of the proverbial glass of water, it is never half empty, but always half full—and, as a pragmatist, it is twice as large as it needs to be.

Next Wachenheim built a model to estimate normalized earnings for Lowe’s three years in the future (in 2014).  He came up with normal earnings of $3 per share.  He thought the appropriate price-to-earnings ratio was 16.  So the stock would be worth $48 in 2014 versus its current price (in 2011) of $24.  It looked like a bargain.

After gathering more information, Wachenheim revised his earnings model:

…I revise models frequently because my initial models rarely are close to being accurate.  Usually, they are no better than directional.  But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

Wachenheim now thought that Lowe’s could earn close to $4.10 in 2015, which would make the shares worth even more than $48.  In August 2013, the shares hit $45.

In late September 2013, after playing tennis, another money manager asked Wachenheim if he was worried that the stock market might decline sharply if the budget impasse in Congress led to a government shutdown:

I answered that I had no idea what the stock market would do in the near term.  I virtually never do.  I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good.  I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time.  Thus, one would do just as well by flipping a coin.

I feel the same way about predicting the short-term direction of the economy, interest rates, commodities, or currencies.  There are too many variables that need to be identified and weighed.

As for Lowe’s, the stock hit $67.50 at the end of 2014, up 160 percent from what Greenhaven paid.

 

WHIRLPOOL CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

Wachenheim does not believe in the Efficient Market Hypothesis:

It seems to me that the boom-bust of growth stocks in 1968-1974 and the subsequent boom-bust of Internet technology stocks in 1998-2002 serve to disprove the efficient market hypothesis, which states that it is impossible for an investor to beat the stock market because stocks always are efficiently priced based on all the relevant and known information on the fundamentals of the stocks.  I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders.  As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly.  Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend.  Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.

Many investors focus on the shorter term, which generally harms their long-term performance:

…so many investors are too focused on short-term fundamentals and investment returns at the expense of longer-term fundamentals and returns.  Hunter-gatherers needed to be greatly concerned about their immediate survival—about a pride of lions that might be lurking behind the next rock… They did not have the luxury of thinking about longer-term planning… Then and today, humans often flinch when they come upon a sudden apparent danger—and, by definition, a flinch is instinctive as opposed to cognitive.  Thus, over years, the selection process resulted in a subconscious proclivity for humans to be more concerned about the short term than the longer term.

By far the best thing for long-term investors is to do is absolutely nothing.  The investors who end up performing the best over the course of several decades are nearly always those investors who did virtually nothing.  They almost never checked prices.  They never reacted to bad news.

Regarding Whirlpool:

In the spring of 2011, Greenhaven studied Whirlpool’s fundamentals.  We immediately were impressed by management’s ability and willingness to slash costs.  In spite of a materially subnormal demand for appliances in 2010, the company was able to earn operating margins of 5.9 percent.  Often, when a company is suffering from particularly adverse industry conditions, it is unable to earn any profit at all.  But Whirlpool remained moderately profitable.  If the company could earn 5.9 percent margins under adverse circumstances, what could the company earn once the U.S. housing market and the appliance market returned to normal?

Not surprisingly, Wall Street analysts were focused on the short term:

…A report by J. P. Morgan dated April 27, 2011, stated that Whirlpool’s current share price properly reflected the company’s increased costs for raw materials, the company’s inability to increase its prices, and the current soft demand for appliances…

The J. P. Morgan report might have been correct about the near-term outlook for Whirlpool and its shares.  But Greenhaven invests with a two- to four-year time horizon and cares little about the near-term outlook for its holdings.

The bulk of Greenhaven’s returns has been generated by relatively few of its holdings:

If one in five of our holdings triples in value over a three-year period, then the other four holdings only have to achieve 12 percent average annual returns in order for our entire portfolio to achieve its stretch goal of 20 percent.  For this reason, Greenhaven works extra hard trying to identify potential multibaggers.  Whirlpool had the potential to be a multibagger because it was selling at a particularly low multiple of its potential earnings power.  Of course, most of our potential multibaggers do not turn out to be multibaggers.  But one cannot hit a multibagger unless one tries, and sometimes our holdings that initially appear to be less exciting eventually benefit from positive unforeseen events (handsome black swans) and unexpectedly turn out to be a complete winner.  For this reason, we like to remain fully invested as long as our holdings remain reasonably priced and free from large risks of permanent loss.

 

BOEING

(Photo by José A. Montes, Wikimedia Commons)

Wachenheim likes to read about the history of each company that he studies.

On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation.  On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations.  After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators.  One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer.  Boeing was so exhilarated by the flight that he completely caught the aviation bug—a bug that was to be with him for the rest of his life.

Boeing launched Pacific Aero Products (renamed the Boeing Airplane Company in 1917).  In late 1916, Boeing designed an improved floatplane, the Model C.  The Model C was ready by April 1917, the same month the United States entered the war.  Boeing thought the Navy might need training aircraft.  The Navy bought two.  They performed well, so the Navy ordered 50 more.

Boeing’s business naturally slowed down after the war.  Boeing sold a couple of small floatplanes (B-1’s), then 13 more after Charles Lindberg’s 1927 transatlantic flight.  Still, sales of commercial planes were virtually nonexistent until 1933, when the company started marketing its model 247.

The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane.  It had a capacity to carry 10 passengers and a crew of 3.  It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled.

Boeing sold seventy-five 247’s before making the much larger 307 Stratoliner, which would have sold well were it not for the start of World War II.

Boeing helped the Allies defeat Germany.  The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary.  More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity).

Boeing prospered during the war, but business slowed down again after the war.  In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, the first use of a jet engine.  The Comet started carrying passengers in 1952.  In response, Boeing started developing its 707 jet.  Commercial flights for the 707 began in 1958.

The 707 was a hit and soon became the leading commercial plane in the world.

Over the next 30 years, Boeing grew into a large and highly successful company.  It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems.  Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas.

In late 2012, after several years of delays on its new, more fuel-efficient plane—the 787—Wall Street and the media were highly critical of Boeing.  Wachenheim thought that the company could earn at least $7 per share in 2015.  The stock in late 2012 was at $75, or 11 times the $7.  Wachenheim believed that this was way too low for such a strong company.

Wachenheim estimated that two-thirds of Boeing’s business in 2015 would come from commercial aviation.  He figured that this was an excellent business worth 20 times earnings (he used 19 times to be conservative).  He reckoned that defense, one-third of Boeing’s business, was worth 15 times earnings.  Therefore, Wachenheim used 17.7 as the multiple for the whole company, which meant that Boeing would be worth $145 by 2015.

Greenhaven established a position in Boeing at about $75 a share in late 2012 and early 2013.  By the end of 2013, Boeing was at $136.  Because Wall Street now had confidence that the 787 would be a commercial success and that Boeing’s earnings would rise, Wachenheim and his associates concluded that most of the company’s intermediate-term potential was now reflected in the stock price.  So Greenhaven started selling its position.

 

SOUTHWEST AIRLINES

(Photo by Eddie Maloney, Wikimedia Commons)

The airline industry has had terrible fundamentals for a long time.  But Wachenheim was able to be open-minded when, in August 2012, one of his fellow analysts suggested Southwest Airlines as a possible investment.  Over the years, Southwest had developed a low-cost strategy that gave the company a clear competitive advantage.

Greenhaven determined that the stock of Southwest was undervalued, so they took a position.

The price of Southwest’s shares started appreciating sharply soon after we started establishing our position.  Sometimes it takes years before one of our holdings starts to appreciate sharply—and sometimes we are lucky with our timing.

After the shares tripled, Greenhaven sold half its holdings since the expected return from that point forward was not great.  Also, other investors now recognized the positive fundamentals Greenhaven had expected.  Greenhaven sold the rest of its position as the shares continued to increase.

 

GOLDMAN SACHS

(Photo of Marcus Goldman, Wikimedia Commons)

Wachenheim echoes Warren Buffett when it comes to recognizing how much progress the United States has made:

My experience is that analysts and historians often dwell too much on a company’s recent problems and underplay its strengths, progress, and promise.  An analogy might be the progress of the United States during the twentieth century.  At the end of the century, U.S. citizens generally were far wealthier, healthier, safer, and better educated than at the start of the century.  In fact, the century was one of extraordinary progress.  Yet most history books tend to focus on the two tragic world wars, the highly unpopular Vietnam War, the Great Depression, the civil unrest during the Civil Rights movement, and the often poor leadership in Washington.  The century was littered with severe problems and mistakes.  If you only had read the newspapers and the history books, you likely would have concluded that the United States had suffered a century of relative and absolute decline.  But the United States actually exited the century strong and prosperous.  So did Goldman exit 2013 strong and prosperous.

In 2013, Wachenheim learned that Goldman had an opportunity to gain market share in investment banking because some competitors were scaling back in light of new regulations and higher capital requirements.  Moreover, Goldman had recently completed a $1.9 billion cost reduction program.  Compensation as a percentage of sales had declined significantly in the past few years.

Wachenheim discovered that Goldman is a technology company to a large extent, with a quarter of employees working in the technology division.  Furthermore, the company had strong competitive positions in its businesses, and had sold or shut down sub-par business lines.  Wachenheim checked his investment thesis with competitors and former employees.  They confirmed that Goldman is a powerhouse.

Wachenheim points out that it’s crucial for investors to avoid confirmation bias:

I believe that it is important for investors to avoid seeking out information that reinforces their original analyses.  Instead, investors must be prepared and willing to change their analyses and minds when presented with new developments that adversely alter the fundamentals of an industry or company.  Good investors should have open minds and be flexible.

Wachenheim also writes that it’s very important not to invent a new thesis when the original thesis has been invalidated:

We have a straightforward approach.  When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course.  We do not seek new theories that will justify our original decision.  We do not let errors fester and consume our attention.  We sell and move on.

Wachenheim loves his job:

I am almost always happy when working as an investment manager.  What a perfect job, spending my days studying the world, economies, industries, and companies;  thinking creatively;  interviewing CEOs of companies… How lucky I am.  How very, very lucky.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Heads, I win; tails, I don’t lose much!

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 9, 2022

Value investor Mohnish Pabrai wrote The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007).  It’s an excellent book that captures the essence of value investing:

The lower the price you pay relative to the probable intrinsic value of the business, the higher your returns will likely be if you’re right and the lower your losses will likely be if you’re wrong.

If you have a good investment process as a value investor—whether it’s quantitative and statistical, or it involves stock-picking—then typically you’ll be right on about 60 percent of the positions.  Because losses are minimized on the other 40 percent, the portfolio is likely to do well over time.

Mohnish sums up the Dhandho approach as:

Heads, I win;  tails, I don’t lose much!

There is one very important additional idea that Mohnish focused on in his recent (October 2016) lecture at Peking University (Guanghua School of Management):

10-BAGGERS TO 100-BAGGERS

A 10-bagger is an investment that goes up 10x after you buy it.  A 100-bagger is an investment that goes up 100x after you buy it.  Mohnish gives many examples of stocks—a few of which he kept holding and many of which he sold—that later became 10-baggers, 20-baggers, up to a few 100-baggers.  If you own a stock that has already been a 2-bagger, 3-bagger, 5-bagger, etc., and you sell and the stock later turns out to be a 20-bagger, 50-bagger, or 100-bagger, often you have made a huge mistake by selling too soon.

Link to Mohnish’ lecture at Peking University:  https://www.youtube.com/watch?v=Jo1XgDJCkh4

Here’s the outline for this blog post:

    • Patel Motel Dhandho
    • Manilal Dhandho
    • Virgin Dhandho
    • Mittal Dhandho
    • The Dhandho Framework
    • Dhandho 101: Invest in Existing Businesses
    • Dhandho 102: Invest in Simple Businesses
    • Dhandho 201: Invest in Distressed Businesses in Distressed Industries
    • Dhandho 202: Invest in Businesses with Durable Moats
    • Dhandho 301: Few Bets, Big Bets, Infrequent Bets
    • Dhandho 302: Fixate on Arbitrage
    • Dhandho 401: Margin of Safety—Always!
    • Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses
    • Dhandho 403: Invest in the Copycats rather than the Innovators
    • A Short Checklist
    • Be Generous

 

PATEL MOTEL DHANDHO

(Mohnish published the book in 2007.  I will use the present tense in this blog post.)

Mohnish notes that Asian Indians make up about 1 percent of the population of the United States.  Of these three million, a small subsection hails from the Indian state of Gujarat—the birthplace of Mahatma Gandhi.  The Patels are from a tiny area in Southern Gujarat.  Mohnish:

Less than one in five hundred Americans is a Patel.  It is thus amazing that over half of all the motels in the entire country are owned and operated by Patels… What is even more stunning is that there were virtually no Patels in the United States just 35 years ago.  They started arriving as refugees in the early 1970s without much in the way of capital or education.  Their heavily accented, broken-English speaking skills didn’t improve their prospects either.  From that severely handicapped beginning, with all the odds stacked against them, the Patels triumphed.  Patels, as a group, today own over $40 billion in motel assets in the United States, pay over $725 million a year in taxes, and employ nearly a million people.  How did this small, impoverished ethnic group come out of nowhere and end up controlling such vast resources?  There is a one word explanation:  Dhandho.

Dhandho means a low-risk, high-return approach to business.  It means the upside is much larger than the downside, which is the essence of value investing.

Dhandho is all about the minimization of risk while maximizing the reward… Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.

Mohnish gives a brief history of the Patels.  Some Patels had gone to Uganda and were doing well there as entrepreneurs.  But when General Idi Amin came to power as a dictator in 1972, things changed.  The Ugandan state seized all of the businesses held by Patels and other non-natives.  These businesses were nationalized, and the previous owners were paid nothing.

Because India was already dealing with a severe refugee crisis in 1972-1973, the Indian-origin population that had been tossed out of Uganda was not allowed back into India.  Many Patels settled in England and Canada, and a few thousand were accepted in the United States.

In 1973, many nondescript motels were being foreclosed and then sold at distressed prices.  “Papa Patel” realized that a motivated seller or bank might finance 90% of the purchase.  If Papa Patel could put $5,000 down, he could get a motel on the cheap.  The Patel family would run things and also live there.  So they had no salaries to pay, and no rent to pay.  With rock-bottom expenses, they could then offer the lowest nightly rates.  This would lead to higher occupancy and high profits over time, given the very low cost structure.

As long as the motel didn’t fail, it would likely be a highly profitable venture relative to the initial $5,000 investment.  If the motel did fail, Papa Patel reasoned that he and his wife could bag groceries and save close to $5,000 in a couple of years.  Then Papa Patel could find another cheap motel and make the same bet.  If the probability of failure is 10%, then the odds of two failures in a row would be 1%, while nearly every other scenario would involve a high return on investment.  Once the first motel was solidly profitable, Papa Patel could let his oldest son take over and look for the next one to buy.

The Patels kept repeating this basic approach until they owned over half the motels in the United States.

 

MANILAL DHANDHO

The Patel formula is repeatable.  It’s not just a one-time opportunity based on unique circumstances.  Consider Manilal Chaudhari, also from Gujarat, says Mohnish.

Manilal had worked hard as an accountant in India.  In 1991, with sponsorship from his brother, he migrated to the United States.  His English was not good, and he couldn’t find a job in accounting.

His first job was working 112 hours a week at a gas station at minimum wage.  Later, he got a job at a power supply manufacturing company, Cherokee International, owned by a Patel.  Manilal worked full-time at Cherokee, and kept working at the gas station as much as possible.  The Persian owner of the gas station, recognizing Manilal’s hard work, gave him a 10 percent stake in the business.

In 1998, Manilal decided he wanted to buy a business.  One of the employees at Cherokee (a Patel) told Manilal that he wanted to invest with him in whatever business he found.  In 2001, the travel industry went into a slump and motel occupancy and prices plummeted.  Manilal found a Best Western motel on sale at a terrific location.  Since everyone in the extended family had been working non-stop and saving, Manilal – along with a few Patels from Cherokee – were able to buy the Best Western.

Four years later, the Best Western had doubled in value to $9 million.  The $1.4 million invested by Manilal and a few Patels was now worth $6.7 million, an annualized return of 48 percent.  This doesn’t include annual free cash flow.  Mohnish concludes:

Now, that’s what I’d call Manilal Dhandho.  He worked hard, saved all he could, and then bet it all on a single no-brainer bet.  Reeling from the severe impact of 9/11 on travel, the motel industry was on its knees.  As prices and occupancy collapsed, Manilal stepped in and made his play.  He was on the hunt for three years.  He patiently waited for the right deal to materialize.  Classically, his story is all about Few Bets, Big Bets, Infrequent Bets.  And it’s all about only participating in coin tosses where:

Heads, I win;  tails, I don’t lose much!

 

VIRGIN DHANDHO

The year was 1984 and Richard Branson knew nothing about the airline business.  He started his entrepreneurial journey at 15 and was very successful in building an amazing music recording and distribution business.

Somebody sent Branson a business plan about starting an all business class airline flying between London and New York.  Branson noted that when an executive in the music business received a business plan to start an airline involving a 747 jumbo jet, he knew that the business plan had been turned down in at least three thousand other places before landing on his desk…

Branson decided to offer a unique dual-class service.  But when he presented the idea to his partners and senior executives at the music business, they told him he was crazy.  Branson persisted and discovered that he could lease a 747 jumbo jet from Boeing.  Branson calculated that Virgin Atlantic Airlines, if it failed, would cost $2 million.  His record company was going to earn $12 million that year and about $20 million the following year.

Branson also realized that tickets get paid about 20 days before the plane takes off.  But fuel is paid 30 days after the plane lands.  Staff wages are paid 15 to 20 days after the plane lands.  So the working capital needs of the business would be fairly low.

Branson had found a service gap and Virgin Atlantic ended up doing well.  Branson would repeat this formula in many other business opportunities:

Heads, I win;  tails, I don’t lose much!

 

MITTAL DHANDHO

Mohnish says Rajasthan is the most colorful state of India.  Marwar is a small district in the state, and the Marwaris are seen as excellent businesspeople.  Lakshmi Mittal, a Marwari entrepreneur, went from zero to a $20 billion net worth in about 30 years.  And he did it in an industry with terrible economics:  steel mills.

Take the example of the deal he created to take over the gigantic Karmet Steel Works in Kazakhstan.  The company had stopped paying its workforce because it was bleeding red ink and had no cash.  The plant was on the verge of closure with its Soviet-era managers forced to barter for steel food for its workers.  The Kazakh government was glad to hand Mr. Mittal the keys to the plant for nothing.  Not only did Mr. Mittal retain the entire workforce and run the plant, he paid all the outstanding wages and within five years had turned it into a thriving business that was gushing cash.  The workers and townsfolk literally worship Mittal as the person who saved their town from collapse.

…The same story was repeated with the Sidek Steel plant in Romania, and the Mexican government handed him the keys to the Sibalsa Mill for $220 million in 1992.  It had cost the Mexicans over $2 billion to build the plant.  Getting dollar bills at 10 cents—or less—is Dhandho on steroids.  Mittal’s approach has always been to get a dollar’s worth of assets for far less than a dollar.  And then he has applied his secret sauce of getting these monolith mills to run extremely efficiently.

Mohnish recounts a dinner he had with a Marwari friend.  Mohnish asked how Marwari businesspeople think about business.  The friend replied that they expect their entire investment to be returned as dividends within three years, with the principal still being worth at least the initial amount invested.

 

THE DHANDHO FRAMEWORK

Mohnish lays out the Dhando framework, including:

  • Invest in existing businesses.
  • Invest in simple businesses.
  • Invested in distressed businesses in distressed industries.
  • Invest in businesses with durable moats.
  • Few bets, big bets, and infrequent bets.
  • Fixate on arbitrage.
  • Margin of safety—always.
  • Invest in low-risk, high-uncertainty businesses.
  • Invest in the Copycats rather than the Innovators.

Let’s look at each point.

 

DHANDHO 101: INVEST IN EXISTING BUSINESSES

Over a long period of time, owning parts of good businesses via the stock market has been shown to be one of the best ways to preserve and grow wealth.  Mohnish writes that there are six big advantages to investing in stocks:

  • When you buy stock, you become a part owner of an existing business. You don’t have to do anything to create the business or to make the business run.
  • You can get part ownership of a compounding machine. It is simple to buy your stake, and the business is already fully staffed and running.
  • When people buy or sell entire businesses, both buyer and seller typically have a good idea of what the business is worth. It’s hard to find a bargain unless the industry is highly distressed.  In the public stock market, however, there are thousands and thousands of businesses.  Many stock prices change by 50% or more in any given year, but the intrinsic value of most businesses does not change by 50% in a given year.  So a patient investor can often find opportunities.
  • Buying an entire business usually takes serious capital. But buying part ownership via stock costs very little by comparison.  In stocks, you can get started with a tiny pool of capital.
  • There are likely over 100,000 different businesses in the world with public stock available.
  • For a long-term value investor, the transaction costs are very low (especially at a discount broker) over time.

 

DHANDHO 102: INVEST IN SIMPLE BUSINESSES

As Warren Buffett has noted, you generally do not get paid extra for degree of difficulty in investing.  There is no reason, especially for smaller investors, not to focus on simple businesses.  By patiently looking at hundreds and hundreds of microcap stocks, eventually you can find a 10-bagger, 20-bagger, or even a 100-bagger.  And the small business in question is likely to be quite simple.  With such a large potential upside, there is no reason, if you’re a small investor, to look at larger or more complicated businesses.  (The Boole Microcap Fund that I manage focuses exclusively on micro caps.)

It’s much easier to value a simple business because it usually is easier to estimate the future free cash flows.  The intrinsic value of any business—what the business is worth—is the sum of all future free cash flows discounted back to the present.  This is called the discounted cash flow (DCF) approach.  (Intrinsic value could also mean liquidation value in some cases.)

You may need to have several scenarios in your DCF analysis—a low case, a mid case, and a high case.  (What you’re really looking for is a high case that involves a 10-bagger, 20-bagger, or 100-bagger.)  But you’re still nearly always better off limiting your investments to simple businesses.

Only invest in businesses that are simple—ones where conservative assumptions about future cash flows are easy to figure out.

 

DHANDHO 201: INVEST IN DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES

The stock market is usually efficient, meaning that stock prices are usually accurate representations of what businesses are worth.  It is very difficult for an investor to do better than the overall stock market, as represented by the S&P 500 Index or another similar index.

Stock prices, in most instances, do reflect the underlying fundamentals.  Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time.  The market is mostly efficient.  However, there is a huge difference between mostly and fully efficient.

Because the market is not always efficient, value investors who patiently examine hundreds of different stocks eventually will find a few that are undervalued.  Because public stock markets are highly liquid, if an owner of shares becomes fearful, he or she can quickly sell those shares.  For a privately held business, however, it usually takes months for an owner to sell the position.  Thus, a fearful owner of public stock is often more likely to sell at an irrationally low price because the sale can be completed right away.

Where can you find distressed businesses or industries?  Mohnish offers some suggestions:

  • Business headlines often include articles about distressed businesses or industries.
  • You can look at prices that have dropped the most in the past 52 weeks. You can also look at stocks trading at low price-to-earnings ratios (P/Es), low price-to-book ratios (P/Bs), high dividend yields, and so on.  Not every quantitatively cheap stock is undervalued, but some are.  There are various services that offer screening such as Value Line.
  • You can follow top value investors by reading 13-F Forms or through different services. I would only note that the vast majority of top value investors are not looking at microcap stocks.  If you’re a small investor, your best opportunities are very likely to be found among micro caps.  Very few professional investors ever look there, causing microcap stocks to be much more inefficiently priced than larger stocks.  Also, micro caps tend to be relatively simple, and they often have far more room to grow.  Most 100-baggers start out as micro caps.
  • Value Investors Club (valueinvestorsclub.com) is a club for top value investors. You can get free guest access to all ideas that are 45 days old or older.  Many cheap stocks stay cheap for a long time.  Often good ideas are still available after 45 days have elapsed.

 

DHANDHO 202: INVEST IN BUSINESSES WITH DURABLE MOATS

A moat is a sustainable competitive advantage.  Moats are often associated with capital-light businesses.  Such businesses (if successful) tend to have sustainably high ROIC (return on invested capital)—the key attribute of a sustainable competitive advantage.  Yet sometimes moats exist elsewhere and sometimes they are hidden.

Sometimes the moat is hidden.  Take a look at Tesoro Corporation.  It is in the oil refining business—which is a commodity.  Tesoro has no control over the price of its principle raw material, crude oil.  It has no control [of the price] over its principal finished good, gasoline.  Nonetheless, it has a fine moat.  Tesoro’s refineries are primarily on the West Coast and Hawaii.  Refining on the West Coast is a great business with a good moat.  There hasn’t been a refinery built in the United States for the past 20 years.  Over that period, the number of refineries has gone down from 220 to 150, while oil demand has gone up about 2 percent a year.  The average U.S. refinery is operating at well over 90 percent of capacity.  Anytime you have a surge in demand, refining margins escalate because there is just not enough capacity.

…How do we know when a business has a hidden moat and what that moat is?  The answer is usually visible from looking at its financial statements.  Good businesses with good moats… generate high returns on capital deployed in the business.  (my emphasis)

But the nature of capitalism is that any company that is earning a high return on invested capital will come under attack by other businesses that want to earn a high return on invested capital.

It is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat is, no matter how many sharks or piranhas are in that moat, eventually it is going to fall to the marauding invaders.

Mohnish quotes Charlie Munger:

Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are.  Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.

Mohnish adds:

There is no such thing as a permanent moat.  Even such invincible businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.

…It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500… it typically takes many blue chips less than 20 years after they get on the list to cease to exist.  The average Fortune 500 business is already past its prime by the time it gets on the list.

If you’re a small investor, searching for potential 10-baggers or 100-baggers among microcap stocks makes excellent sense.  You want to find tiny companies that much later reach the Fortune 500.  You don’t want to look at companies that are already on the Fortune 500 because the potential returns are far more likely to be mediocre going forward.

 

DHANDHO 301: FEW BETS, BIG BETS, INFREQUENT BETS

Claude Shannon was a fascinating character—he often rode a unicycle while juggling, and his house was filled with gadgets.  Shannon’s master’s thesis was arguably the most important and famous master’s thesis of the twentieth century.  In it, he proposed binary digit or bit, as the basic unit of information.  A bit could have only two values—0 or 1, which could mean true or false, yes or no, or on or off.  This allowed Boolean algebra to represent any logical relationship.  This meant that the electrical switch could perform logic functions, which was the practical foundation for all digital circuits and computers.

The mathematician Ed Thorp, a colleague of Shannon’s at MIT, had discovered a way to beat the casinos at blackjack.  But Thorp was trying to figure out how to size his blackjack bets as a function of how favorable the odds were.  Someone suggested to Thorp that he talk to Shannon about it.  Shannon recalled a paper written by a Bell Labs colleague of his, John Kelly, that dealt with this question.

The Kelly criterion can be written as follows:

  • F = p – [q/o]

where

  • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital, assuming that you’re going to make a long series of bets.  Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Thorp proceeded to use the Kelly criterion to win quite a bit of money at blackjack, at least until the casinos began taking countermeasures such as cheating dealers, frequent reshuffling, and outright banning.  But Thorp realized that the stock market was also partly inefficient, and it was a far larger game.

Thorp launched a hedge fund that searched for little arbitrage situations (pricing discrepancies) involving warrants, options, and convertible bonds.  In order to size his positions, Thorp used the Kelly criterion.  Thorp evolved his approach over the years as previously profitable strategies were copied.  His multi-decade track record was terrific.

Ed Thorp examined Buffett’s career and concluded that Buffett has used the essential logic of the Kelly criterion by concentrating his capital into his best ideas.  Buffett’s concentrated value approach has produced an outstanding, unparalleled 65-year track record.

Thorp has made several important points about the Kelly criterion as it applies to long-term value investing.  The Kelly criterion was invented to apply to a very long series of bets.  Value investing differs because even a concentrated value investing approach will usually have at least 5-8 positions in the portfolio at the same time.  Thorp argues that, in this situation, the investor must compare all the current and prospective investments simultaneously on the basis of the Kelly criterion.

Mohnish gives an example showing how you can use the Kelly criterion on your top 8 ideas, and then normalize the position sizes.

Say you look at your top 8 investment ideas.  You use the Kelly criterion on each idea separately to figure out how large the position should be, and this is what you conclude about the ideal bet sizes:

  • Bet 1 – 80%
  • Bet 2 – 70%
  • Bet 3 – 60%
  • Bet 4 – 55%
  • Bet 5 – 45%
  • Bet 6 – 35%
  • Bet 7 – 30%
  • Bet 8 – 25%

Of course, that adds up to 400%.  Yet for a value investor, especially running a concentrated portfolio of 5-8 positions, it virtually never makes sense to buy stocks on margin.  Leverage cannot make a bad investment into a good investment, but it can turn a good investment into a bad investment.  So you don’t need any leverage.  It’s better to compound at a slightly lower rate than to risk turning a good investment into a bad investment because you lack staying power.

So the next step is simply to normalize the position sizes so that they add up to 100%.  Since the original portfolio adds up to 400%, you just divide each position by 4:

  • Bet 1 – 20%
  • Bet 2 – 17%
  • Bet 3 – 15%
  • Bet 4 – 14%
  • Bet 5 – 11%
  • Bet 6 – 9%
  • Bet 7 – 8%
  • Bet 8 – 6%

(These percentages are rounded for simplicity.)

As mentioned earlier, if you truly know the odds of each bet in a long series of bets, the Kelly criterion tells you exactly how much to bet on each bet in order to maximize your long-term compounded rate of return.  Betting any other amount will lead to lower compound returns.  In particular, if you repeatedly bet more than what the Kelly criterion indicates, you eventually will destroy your capital.

It’s nearly always true when investing in a stock that you won’t know the true odds or the true future scenarios.  You usually have to make an estimate.  Because you never want to bet more than what the Kelly criterion says, it is wise to bet one half or one quarter of what the Kelly criterion says.  This is called half-Kelly or quarter-Kelly betting.  What is nice about half-Kelly betting is that you will earn three-quarters of the long-term returns of what full Kelly betting would deliver, but with only half the volatility.

So in practice, if there is any uncertainty in your estimates, you want to bet half-Kelly or quarter-Kelly.  In the case of a concentrated portfolio of 5-8 stocks, you will frequently end up betting half-Kelly or quarter-Kelly because you are making 5-8 bets at the same time.  In Mohnish’s example, you end up betting quarter-Kelly in each position once you’ve normalized the portfolio.

Mohnish quotes Charlie Munger again:

The wise ones bet heavily when the world offers them that opportunity.  They bet big when they have the odds.  And the rest of the time, they don’t.  It’s just that simple.

When running the Buffett Partnership, Warren Buffett invested 40% of the partnership in American Express after the stock had been cut in half following the salad oil scandal.  American Express had to announce a $60 million loss, a huge hit given its total market capitalization of roughly $150 million at the time.  But Buffett determined that the essential business of American Express—travelers’ checks and charge cards—had not been permanently damaged.  American Express still had a very valuable moat.

Buffett explained his reasoning in several letters to limited partners, as quoted by Mohnish here:

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.

We are obviously only going to go to 40% in very rare situations—this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity.  We probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25%.  Any such situations are going to have to promise very significant superior performance… They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal…

There’s virtually no such thing as a sure bet in the stock market.  But there are situations where the odds of winning are very high or where the potential upside is substantial.

One final note:  In constructing a concentrated portfolio of 5-8 stocks, if at least some of the positions are non-correlated or even negatively correlated, then the volatility of the overall portfolio can be reduced.  Some top investors prefer to have about 15 positions with low correlations.

Once you get to at least 25 positions, specific correlations typically tend not to be an issue, although some investors may end up concentrating on specific industries.  In fact, it often may make sense to concentrate on industries that are deeply out-of-favor.

Mohnish concludes:

…It’s all about the odds.  Looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth.  It’s all about letting the Kelly Formula dictate the upper bounds of these large bets.  Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio.

In sum, top value investors like Warren Buffett, Charlie Munger, and Mohnish Pabrai—to name just a few out of many—naturally concentrate on their best 5-8 ideas, at least when they’re managing a small enough amount of money.  (These days, Berkshire’s portfolio is massive, which makes it much more difficult to concentrate, let alone to find hidden gems among micro caps.)

You have to take a humble look at your strategy and your ability before deciding on your level of concentration.  The Boole Microcap Fund that I manage is designed to focus on the top 15-25 ideas.  This is concentrated enough so that the best performers—whichever stocks they turn out to be—can make a difference to the portfolio.  But it is not so concentrated that it misses the best performers.  In practice, the best performers very often turn out to be idea #9 or idea #17, rather than idea #1 or idea #2.  Many top value investors—including Peter Cundill, Joel Greenblatt, and Mohnish Pabrai—have found this to be true.

 

DHANDHO 302: FIXATE ON ARBITRAGE

The example often given for traditional commodity arbitrage is that gold is selling for $1,500 in London and $1,490 in New York.  By buying gold in New York and selling it in London, the arbitrageur can make an almost risk-free profit.

In merger arbitrage, Company A offers to buy Company B at, say, $20 per share.  The stock of Company B may move from $15 to $19.  Now the arbitrageur can buy the stock in Company B at $19 in order to capture the eventual move to $20.  By doing several such deals, the arbitrageur can probably make a nice profit, although there is a risk for each individual deal.

In what Mohnish calls Dhandho arbitrage, the entrepreneur risks a relatively small amount of capital relative to the potential upside.  Just look at the earlier examples, including Patel Motel Dhandho, Virgin Dhandho, and Mittal Dhandho.

Heads, I win;  tails, I don’t lose much!

 

DHANDHO 401: MARGIN OF SAFETY—ALWAYS!

Nearly every year, Buffett has hosted over 30 groups of business students from various universities.  The students get to ask questions for over an hour before going to have lunch with Buffett.  Mohnish notes that students nearly always ask for book or reading recommendations, and Buffett’s best recommendation is always Ben Graham’s The Intelligent Investor.  As Buffett told students from Columbia Business School on March 24, 2006:

The Intelligent Investor is still the best book on investing.  It has the only three ideas you really need:

  • Chapter 8—The Mr. Market analogy.  Make the stock market serve you.  The C section of the Wall Street Journal is my business broker—it quotes me prices every day that I can take or leave, and there are no called strikes.
  • Chapter 8—A stock is a piece of a business.  Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.
  • Chapter 20—Margin of Safety.  Make sure that you are buying a business for way less than you think it is conservatively worth.

The heart of value investing is an idea that is directly contrary to economic and financial theory:

  • The bigger the discount to intrinsic value, the lower the risk.
  • The bigger the discount to intrinsic value, the higher the return.

Economic and financial theory teaches that higher returns always require higher risk.  But Ben Graham, the father of value investing, taught just the opposite:  The lower the price you pay below intrinsic value, the lower your risk and the higher your potential return.

Mohnish argues that the Dhandho framework embodies Graham’s margin of safety idea.  Papa Patel, Manilal, and Branson all have tried to minimize the downside while maximizing the upside.  Again, most business schools, relying on accepted theory, teach that low returns come from low risk, while high returns require high risk.

Mohnish quotes Buffett’s observations about Berkshire’s purchase of Washington Post stock in 1973:

We bought all of our [Washington Post (WPC)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise.  Calculating the price/value ratio required no unusual insights.  Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did.  And its $100 million stock market valuation was published daily for all to see.  Our advantage, rather, was attitude:  we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business value.

…Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew.  Nevertheless, by year-end 1974 our WPC holding showed a loss of about 25%, with a market value of $8 million against our cost of $10.6 million.  What we had bought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

As of 2007 (when Mohnish wrote his book), Berkshire’s stake in the Washington post had grown over 33 years from the original $10.6 million to a market value of over $1.3 billion—more than 124 times the original investment.  Moreover, as of 2007, the Washington Post was paying a modest dividend (not included in the 124 times figure).  The dividend alone (in 2007) was higher than what Berkshire originally paid for its entire position.  Buffett:

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell.  This now seems hard to believe.  However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory:  the stock market was totally efficient, and therefore calculations of business value—and even thought, itself—were of no importance in investment activities.  (We are enormously indebted to those academics:  what could be more advantageous in an intellectual contest—whether it be bridge, chess, or stock selection—than to have opponents who have been taught that thinking is a waste of energy?)

At any given time, a business is in either of two states:  it has problems or it will have problems.  Virtually every week there are companies or whole industries where stock prices collapse.  Many business problems are temporary and not permanent.  But stock investors on the whole tend to view business problems as permanent, and they mark down the stock prices accordingly.

You may be wondering:  Due to capitalist competition, nearly all businesses eventually fail, so how can many business problems be temporary?  When we look at businesses experiencing problems right now, many of those problems will be solved over the next three to five years.  Thus, considering the next three to five years, many business problems are temporary.  But the fate of a given business over several decades is a different matter entirely.

 

DHANDHO 402: INVEST IN LOW-RISK, HIGH-UNCERTAINTY BUSINESSES

The future is always uncertain.  And that’s even more true for some businesses.  Yet if the stock price is low enough, high uncertainty can create a good opportunity.

Papa Patel, Manilal, Branson, and Mittal are all about investing in low-risk businesses.  Nonetheless, most of the businesses they invested in had a very wide range of possible outcomes.  The future performance of these businesses was very uncertain.  However, these savvy Dhandho entrepreneurs had thought through the range of possibilities and drew comfort from the fact that very little capital was invested and/or the odds of a permanent loss of capital were extremely low… Their businesses had a common unifying characteristic—they were all low-risk, high-uncertainty businesses.

In essence, says Mohnish, these were all simple bets:

Heads, I win;  tails, I don’t lose much!

Wall Street usually hates high uncertainty, and often does not distinguish between high uncertainty and high risk.  But there are several distinct situations, observes Mohnish, where Wall Street tends to cause the stock price to collapse:

  • High risk, low uncertainty
  • High risk, high uncertainty
  • Low risk, high uncertainty

Wall Street loves the combination of low risk and low uncertainty, but these stocks nearly always trade at high multiples.  On the other hand, Dhandho entrepreneurs and value investors are only interested in low risk and high uncertainty.

Mohnish discusses an example of a company he was looking at in the year 2000:  Stewart Enterprises (STEI), a funeral service business.  Leading companies such as Stewart Enterprises, Loewen, Service Corp. (SRV), and Carriage Services (CSV) had gone on buying sprees in the 1990s, acquiring mom-and-pop businesses in their industry.  These companies all ended up with high debt as a result of the acquisitions.  They made the mistake of buying for cash—using debt—rather than buying using stock.

Loewen ended up going bankrupt.  Stewart had $930 million of long-term debt with $500 million due in 2002.  Wall Street priced all the funeral service giants as if they were going bankrupt.  Stewart’s price went from $28 to $2 in two years.  Stewart kept coming up on the Value Line screen for lowest price-to-earnings (P/E) ratios.  Stewart had a P/E of less than three, a rarity.  Mohnish thought that funeral services must be a fairly simple business to understand, so he started doing research.

Mohnish recalled reading an article in the mid-1990s in the Chicago Tribune about the rate of business failure in various industries.  The lowest rate of failure for any type of business was funeral homes.  This made sense, thought Mohnish.  It’s not the type of business that aspiring entrepreneurs would dream about, and pre-need sales often make up about 25 percent of total revenue.  It’s a steady business that doesn’t change much over time.

Stewart had roughly $700 million in annual revenue and owned around 700 cemeteries and funeral homes.  Most of its business was in the United States.  Stewart’s tangible book value was $4 per share, and book value was probably understated because hard assets like land were carried at cost.  At less than $2 per share, Stewart was trading at less than half of stated tangible book value.  By the time the debt was due, the company would generate over $155 million in free cash flow, leaving a shortfall of under $350 million.

Mohnish thought through some scenarios and estimated the probability for each scenario:

  • 25% probability: The company could sell some funeral homes.  Selling 100 to 200 might take care of the debt.  Equity value > $4 per share.
  • 35% probability: Based on the company’s solid and predictable cash flow, Stewart’s lenders or bankers might decide to extend the maturities or refinance the debt—especially if the company offered to pay a higher interest rate.  Equity value > $4 per share.
  • 20% probability: Based on Stewart’s strong cash flows, the company might find another lender—especially if it offered to pay a higher interest rate.  Equity value > $4 per share.
  • 19% probability: Stewart enters bankruptcy.  Even assuming distressed asset sales, equity value > $2 per share.
  • 1% probability: A 50-mile meteor comes in or Yellowstone blows or some other extreme event takes place that destroys the company.  Equity value = $0.

The bottom line, as Mohnish saw it, was that the odds were less than 1% that he would end up losing money if he invested in Stewart at just under $2 per share.  Moreover, there was an 80% chance that the equity would be worth at least $4 per share.  So Mohnish invested 10 percent of Pabrai Funds in Stewart Enterprises at under $2 per share.

A few months later, Stewart announced that it had begun exploring sales of its international funeral homes.  Stewart expected to generate $300 to $500 million in cash from this move.  Mohnish:

The amazing thing was that management had come up with a better option than I had envisioned.  They were going to be able to eliminate the debt without any reduction in their cash flow.  The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable.

Soon the stock hit $4 and Mohnish exited the position with more than 100% profit.

It’s worth repeating what investor Lee Ainslee has said:  Good management tends to surprise on the upside, while bad management tends to surprise on the downside.

Frontline

In 2001, Mohnish noticed two companies with a dividend yield of more than 15 percent.  Both were crude oil shippers:  Knightsbridge (VLCC) and Frontline (FRO).  Mohnish started reading about this industry.

Knightsbridge had been formed a few years earlier when it ordered several tankers from a Korean shipyard.  A very large crude carrier (VLCC) or Suezmax at the time cost $60 to $80 million and would take two to three years to be built and delivered.  Knightsbridge would then lease the ships to Shell Oil under long-term leases.  Shell would pay Knightsbridge a base lease rate (perhaps $10,000 a day per tanker) regardless of whether it used the ships or not.  On top of that, Shell paid Knightsbridge a percentage of the difference between a base rate and the spot market price for VLCC rentals, notes Mohnish.  So if the spot price for a VLCC was $30,000 per day, Knightsbridge might receive $20,000 a day.  If the spot was $50,000, it would get perhaps $35,000 a day.  Mohnish:

At the base rate, Knightbridge pretty much covered its principal and interest payments for the debt it took on to pay for the tankers.  As the rates went above $10,000, there was positive cash flow;  the company was set up to just dividend all the excess cash out to shareholders, which is marvelous…

Because of this unusual structure and contract, when tanker rates go up dramatically, this company’s dividends go through the roof.

Mohnish continues:

In investing, all knowledge is cumulative.  I didn’t invest in Knightsbridge, but I did get a decent handle on the crude oil shipping business.  In 2001, we had an interesting situation take place with one of these oil shipping companies called Frontline.  Frontline is the exact opposite business model of Knightsbridge.  It has the largest oil tanker fleet in the world, among all the public companies.  The entire fleet is on the spot market.  There are very few long-term leases.

Because it rides on the spot market on these tankers, there is no such thing as earnings forecasts or guidance.  The company’s CEO himself doesn’t know what the income will be quarter to quarter.  This is great, because whenever Wall Street gets confused, it means we likely can make some money.  This is a company that has widely gyrating earnings.

Oil tanker rates have ranged historically from $6,000 a day to $100,000 a day.  The company needs about $18,000 a day to breakeven… Once [rates] go above $30,000 to $35,000, it is making huge profits.  In the third quarter of 2002, oil tanker rates collapsed.  A recession in the United States and a few other factors caused a drop in crude oil shipping volume.  Rates went down to $6,000 a day.  At $6,000 a day Frontline was bleeding red ink, badly.  The stock went from $11 a share to around $3, in about three months.

Mohnish notes the net asset value of Frontline:

Frontline had about 70 VLCCs at the time.  While the daily rental rates collapsed, the price per ship hadn’t changed much, dropping about 10 percent or 15 percent.  There is a fairly active market in buying and selling oil tankers.  Frontline had a tangible book value of about $16.50 per share.  Even factoring in the distressed market for ships, you would still get a liquidation value north of $11 per share.  The stock price had gone from $15 to $3… Frontline was trading at less than one-third of liquidation value.

Keep in mind that Frontline could sell a ship for about $60 million, and the company had 70 ships.  Frontline’s annual interest payments were $150 million.  If it sold two to three ships a year, Frontline could sustain the business at the rate of $6,000 a day for several years.

Mohnish also discovered that Frontline’s entire fleet was double hull tankers.  All new tankers had to be double hull after 2006 due to regulations following the Exxon Valdez spill.  Usually single hull tankers were available at cheaper day rates than double hull tankers.  But this wasn’t true when rates dropped to $6,000 a day.  Both types of ship were available at the same rate.  In this situation, everyone would rent the double hull ships and no one rented the single hull ships.

Owners of the single hull ships were likely get jittery and to sell the ships as long as rates stayed at $6,000 a day.  If they waited until 2006, Mohnish explains, the ability to rent single hull ships would be much lower.  And by 2006, scrap rates might be quite low if a large number of single hull ships were scrapped at the same time.  The net result is that there is a big jump in scrapping for single hulled tankers whenever rates go down.  Mohnish:

It takes two to three years to get delivery of a new tanker.  When demand comes back up again, inventory is very tight because capacity has been taken out and it can’t be added back instantaneously.  There is a definitive cycle.  When rates go as low as $6,000 and stay there for a few weeks, they can rise to astronomically high levels, say $60,000 a day, very quickly.  With Frontline, for about seven or eight weeks, the rates stayed under $10,000 a day and then spiked to $80,000 a day in fourth quarter 2002.  The worldwide fleet of VLCCs in 2002 was about 400 ships.  Over the past several decades, worldwide oil consumption has increased by 2 percent to 4 percent on average annually.  This 2 percent to 4 percent is generally tied to GDP growth.  Usually there are 10 to 12 new ships added each year to absorb this added demand.  When scrapping increases beyond normal levels, the fleet is no longer increasing by 2 percent to 4 percent.  When the demand for oil rises, there just aren’t enough ships.  The only thing that’s adjustable is the price, which skyrockets.

Pabrai Funds bought Frontline stock in the fall of 2002 at $5.90 a share, about half of liquidation value of $11 to $12.  When the stock moved up to $9 to $10, Mohnish sold the shares.  Because he bought the stock at roughly half liquidation value, this was a near risk-free bet:  Heads, I win a lot;  tails, I win a little!

Mohnish gives a final piece of advice:

Read voraciously and wait patiently, and from time to time amazing bets will present themselves.

Important Note:  Had Mohnish kept the shares of Frontline, they would have increased dramatically.  The shares approached $120 within a few years, so Mohnish would have made 20x his initial investment at $5.90 per share had he simply held on for a few years.

As noted earlier, Mohnish recently gave a lecture at Peking University (Guanghua School of Management) about 10-baggers to 100-baggers, giving many examples of stocks like Frontline that he had actually owned but sold way too soon.  Link:  https://www.youtube.com/watch?v=Jo1XgDJCkh4

 

DHANDHO 403: INVEST IN THE COPYCATS RATHER THAN THE INNOVATORS

What Mohnish calls copycats are businesses that simply copy proven innovations.  The first few Patels figured out the economics of motel ownership.  The vast majority of Patels who came later simply copied what the first Patels had already done successfully.

Mohnish writes:

Most entrepreneurs lift their business ideas from other existing businesses or from their last employer.  Ray Kroc loved the business model of the McDonald brothers’ hamburger restaurant in San Bernardino, California.  In 1954, he bought the rights to the name and know-how, and he scaled it, with minimal change.  Many of the subsequent changes or innovations did not come from within the company with its formidable resources—they came from street-smart franchisees and competitors.  The company was smart enough to adopt them, just as they adopted the entire concept at the outset.

 

A SHORT CHECKLIST

Mohnish gives a list of good questions to ask before buying a stock:

  • Is it a business I understand very well—squarely within my circle of competence?
  • Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
  • Is the business priced at a large discount to its intrinsic value today and in two to three years?  Over 50 percent?
  • Would I be willing to invest a large part of my net worth into this business?
  • Is the downside minimal?
  • Does the business have a moat?
  • Is it run by able and honest managers?

If the answers to these questions are yes, buy the stock.  Furthermore, writes Mohnish, hold the stock for at least two to three years before you think about selling.  This gives enough time for conditions to normalize and thus for the stock to approach intrinsic value.  One exception:  If the stock increases materially in less than two years, you can sell, but only after you have updated your estimate of intrinsic value.

In any scenario, you should always update your estimate of intrinsic value.  If intrinsic value is much higher than the current price, then continuing to hold is almost always the best decision.  One huge mistake to avoid is selling a stock that later becomes a 10-bagger, 20-bagger, or 100-bagger.  That’s why you must always update your estimate of intrinsic value.  And don’t get jittery just because a stock is hitting new highs.

A few more points:

  • If you have a good investment process, then about 2/3 of the time the stock will approach intrinsic value over two to three years.  1/3 of the time, the investment won’t work as planned—whether due to error, bad luck, or unforeseeable events—but losses should be limited due to a large margin of safety having been present at the time of purchase.
  • In the case of distressed equities, there may be much greater potential upside as well as much greater potential downside.  A few value investors can use this approach, but it’s quite difficult and typically requires greater diversification.
  • For most value investors, it’s best to stick with companies with low or no debt.  You may grow wealth a bit more slowly this way, but as Buffett and Munger always ask, what’s the rush?  Buffett and Munger had a friend Rick Guerin who owned a huge number of Berkshire Hathaway shares, but many of the shares were on margin.  When Berkshire stock got cut in half—which will happen occasionally to almost any stock, no matter how good the company—Guerin was forced to sell much of his position.  Had Guerin not been on margin, his non-margined shares in Berkshire would later have been worth a fortune (approaching $1 billion).
  • Your own mistakes are your best teachers, explains Mohnish.  You’ll get better over time by studying your own mistakes:

While it is always best to learn vicariously form the mistakes of others, the lessons that really stick are ones we’ve stumbled through ourselves.

 

BE GENEROUS

Warren Buffett and Bill Gates are giving away most of their fortune to help many people who are less fortunate.  Bill and Melinda Gates devote much of their time and energy (via the Gates Foundation) to saving or improving as many human lives as possible.

Mohnish Pabrai and his wife started the Dakshana Foundation in 2005.  Mohnish:

I do urge you to leverage Dhandho techniques fully to maximize your wealth.  But I also hope that… you’ll use some time and some of that Dhandho money to leave this world a little better place than you found it.  We cannot change the world, but we can improve this world for one person, ten people, a hundred people, and maybe even a few thousand people.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

There’s Always Something to Do

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 2, 2022

There’s Always Something to Do:  The Peter Cundill Investment Approach, by Christopher Risso-Gill (2011), is an excellent book.  Cundill was a highly successful deep value investor whose chosen method was to buy stocks below their liquidation value.

Here is an outline for this blog post:

  • Peter Cundill
  • Getting to First Base
  • Launching a Value Fund
  • Value Investment in Action
  • Going Global
  • A Decade of Success
  • Investments and Stratagems
  • Learning From Mistakes
  • Entering the Big League
  • There’s Always Something Left to Learn
  • Pan Ocean
  • Fragile X
  • What Makes a Great Investor?
  • Glossary of Terms with Cundill’s Comments

 

PETER CUNDILL

It was December in 1973 when Peter Cundill first discovered value investing.  He was 35 years old at the time.  Up until then, despite a great deal of knowledge and experience, Cundill hadn’t yet discovered an investment strategy.  He happened to be reading George Goodman’s Super Money on a plane when he came across chapter 3 on Benjamin Graham and Warren Buffett.  Cundill wrote about his epiphany that night in his journal:

…there before me in plain terms was the method, the solid theoretical back-up to selecting investments based on the principle of realizable underlying value.  My years of apprenticeship were over:  ‘THIS IS WHAT I WANT TO DO FOR THE REST OF MY LIFE!’

What particularly caught Cundill’s attention was Graham’s notion that a stock is cheap if it sells below liquidation value.  The farther below liquidation value the stock is, the higher the margin of safety and the higher the potential returns.  This idea is at odds with modern finance theory, according to which getting higher returns always requires taking more risk.

Peter Cundill became one of the best value investors in the world.  He followed a deep value strategy based entirely on buying companies below their liquidation values.

We do liquidation analysis and liquidation analysis only.

 

GETTING TO FIRST BASE

One of Cundill’s first successful investments was in Bethlehem Copper.  Cundill built up a position at $4.50, roughly equal to cash on the balance sheet and far below liquidation value:

Both Bethlehem and mining stocks in general were totally out of favour with the investing public at the time.  However in Peter’s developing judgment this was not just an irrelevance but a positive bonus.  He had inadvertently stumbled upon a classic net-net:  a company whose share price was trading below its working capital, net of all its liabilities.  It was the first such discovery of his career and had the additional merit of proving the efficacy of value theory almost immediately, had he been able to recognize it as such.  Within four months Bethlehem had doubled and in six months he was able to start selling some of the position at $13.00.  The overall impact on portfolio performance had been dramatic.

Riso-Gill describes Cundill as having boundless curiosity.  Cundill would not only visit the worst performing stock market in the world near the end of each year in search of bargains.  But he also made a point of total immersion with respect to the local culture and politics of any country in which he might someday invest.

 

LAUNCHING A VALUE FUND

Early on, Cundill had not yet developed the deep value approach based strictly on buying below liquidation value.  He had, however, concluded that most models used in investment research were useless and that attempting to predict the general stock market was not doable with any sort of reliability.  Eventually Cundill immersed himself in Graham and Dodd’s Security Analysis, especially chapter 41, “The Asset-Value Factor in Common-Stock Valuation,” which he re-read and annotated many times.

When Cundill was about to take over an investment fund, he wrote to the shareholders about his proposed deep value investment strategy:

The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favourable investment opportunities.  Although a large number of holdings might be held, performance was invariably established by concentrating in a few holdings.  In essence, the fund invested in companies that, as a result of detailed fundamental analysis, were trading below their ‘intrinsic value.’  The intrinsic value was defined as the price that a private investor would be prepared to pay for the security if it were not listed on a public stock exchange.  The analysis was based as much on the balance sheet as it was on the statement of profit and loss.

Cundill went on to say that he would only buy companies trading below book value, preferably below net working capital less long term debt (Graham’s net-net method).  Cundill also required that the company be profitable—ideally having increased its earnings for the past five years—and dividend-paying—ideally with a regularly increasing dividend.  The price had to be less than half its former high and preferably near its all time low.  And the P/E had to be less than 10.

Cundill also studied past and future profitability, the ability of management, and factors governing sales volume and costs.  But Cundill made it clear that the criteria were not always to be followed precisely, leaving room for investment judgment, which he eventually described as an art form.

Cundill told shareholders about his own experience with the value approach thus far.  He had started with $600,000, and the portfolio increased 35.2%.  During the same period, the All Canadian Venture Fund was down 49%, the TSE industrials down 20%, and the Dow down 26%.  Cundill also notes that 50% of the portfolio had been invested in two stocks (Bethlehem Copper and Credit Foncier).

About this time, Irving Kahn became a sort of mentor to Cundill.  Kahn had been Graham’s teaching assistant at Columbia University.

 

VALUE INVESTMENT IN ACTION

Having a clearly defined set of criteria helped Cundill to develop a manageable list of investment candidates in the decade of 1974 to 1984 (which tended to be a good time for value investors).  The criteria also helped him identify a number of highly successful investments.

For example, the American Investment Company (AIC), one of the largest personal loan companies in the United States, saw its stock fall from over $30.00 to $3.00, despite having a tangible book value per share of $12.00.  As often happens with good contrarian value candidates, the fears of the market about AIC were overblown.  Eventually the retail loan market recovered, but not before Cundill was able to buy 200,000 shares at $3.00.  Two years later, AIC was taken over at $13.00 per share by Leucadia.  Cundill wrote:

As I proceed with this specialization into buying cheap securities I have reached two conclusions.  Firstly, very few people really do their homework properly, so now I always check for myself.  Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.

…I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market beaviour using a disparate, and almost certainly incomplete, set of statistical variables.  It makes me wonder what might be accomplished if all this time, energy, and money were to be applied to endeavours with a better chance of proving reliable and practically useful.

Meanwhile, Cundill had served on the board of AIC, which brought some valuable experience and associations.

Cundill found another highly discounted company in Tiffany’s.  The company owned extremely valuable real estate in Manhattan that was carried on its books at a cost much lower than the current market value.  Effectively, the brand was being valued at zero.  Cundill accumulated a block of stock at $8.00 per share.  Within a year, Cundill was able to sell it at $19.00.  This seemed like an excellent result, except that six months later, Avon Products offered to buy Tiffany’s at $50.00.  Cundill would comment:

The ultimate skill in this business is in knowing when to make the judgment call to let profits run.

Sam Belzberg—who asked Cundill to join him as his partner at First City Financial—described Cundill as follows:

He has one of the most important attributes of the master investor because he is supremely capable of running counter to the herd.  He seems to possess the ability to consider a situation in isolation, cutting himself off from the mill of general opinion.  And he has the emotional confidence to remain calm when events appear to be indicating that he’s wrong.

 

GOING GLOBAL

Partly because of his location in Canada, Cundill early on believed in global value investing.  He discovered that just as individual stocks can be neglected and misunderstood, so many overseas markets can be neglected and misunderstood.  Cundill enjoyed traveling to these various markets and learning the legal accounting practices.  In many cases, the difficulty of mastering the local accounting was, in Cundill’s view, a ‘barrier to entry’ to other potential investors.

Cundill also worked hard to develop networks of locally based professionals who understood value investing principles.  Eventually, Cundill developed the policy of exhaustively searching the globe for value, never favoring domestic North American markets.

 

A DECADE OF SUCCESS

Cundill summarized the lessons of the first 10 years, during which the fund grew at an annual compound rate of 26%.  He included the following:

  • The value method of investing will tend at least to give compound rates of return in the high teens over longer periods of time.
  • There will be losing years; but if the art of making money is not to lose it, then there should not be substantial losses.
  • The fund will tend to do better in slightly down to indifferent markets and not to do as well as our growth-oriented colleagues in good markets.
  • It is ever more challenging to perform well with a larger fund…
  • We have developed a network of contacts around the world who are like-minded in value orientation.
  • We have gradually modified our approach from a straight valuation basis to one where we try to buy securities selling below liquidation value, taking into consideration off-balance sheet items.
  • THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE.  THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.

 

INVESTMENTS AND STRATAGEMS

Buying at a discount to liquidation value is simple in concept.  But in practice, it is not at all easy to do consistently well over time.  Peter Cundill explained:

None of the great investments come easily.  There is almost always a major blip for whatever reason and we have learnt to expect it and not to panic.

Although Cundill focused exclusively on discount to liquidation value when analyzing equities, he did develop a few additional areas of expertise, such as distressed debt.  Cundill discovered that, contrary to his expectation of fire-sale prices, an investor in distressed securities could often achieve large profits during the actual process of liquidation.  Success in distressed debt required detailed analysis.

 

LEARNING FROM MISTAKES

1989 marked the fifteenth year in a row of positive returns for Cundill’s Value Fund.  The compound growth rate was 22%.  But the fund was only up 10% in 1989, which led Cundill to perform his customary analysis of errors:

…How does one reduce the margin of error while recognizing that investments do, of course, go down as well as up?  The answers are not absolutely clear cut but they certainly include refusing to compromise by subtly changing a question so that it shapes the answer one is looking for, and continually reappraising the research approach, constantly revisiting and rechecking the detail.

What were last year’s winners?  Why?—I usually had the file myself, I started with a small position and stayed that way until I was completely satisfied with every detail.

For most value investors, the investment thesis depends on a few key variables, which should be written down in a short paragraph.  It’s important to recheck each variable periodically.  If any part of the thesis has been invalidated, you must reassess.  Usually the stock is no longer a bargain.

It’s important not to invent new reasons for owning the stock if one of the original reasons has been falsified.  Developing new reasons for holding a stock is usually misguided.  However, you need to remain flexible.  Occasionally the stock in question is still a bargain.

 

ENTERING THE BIG LEAGUE

In the mid 1990’s, Cundill made a large strategic shift out of Europe and into Japan.  Typical for a value investor, he was out of Europe too early and into Japan too early.  Cundill commented:

We dined out in Europe, we had the biggest positions in Deutsche Bank and Paribas, which both had big investment portfolios, so you got the bank itself for nothing.  You had a huge margin of safety—it was easy money.  We had doubles and triples in those markets and we thought we were pretty smart, so in 1996 and 1997 we took our profits and took flight to Japan, which was just so beaten up and full of values.  But in doing so we missed out on some five baggers, which is when the initial investment has multiplied five times, and we had to wait at least two years before Japan started to come good for us.

This is a recurring problem for most value investors—that tendency to buy and to sell too early.  The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time.  What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.

As for Japan, Cundill had long ago learned the lesson that cheap stocks can stay cheap for “frustratingly long” periods of time.  Nonetheless, Cundill kept loading up on cheap Japanese stocks in a wide range of sectors.  In 1999, his Value Fund rose 16%, followed by 20% in 2000.

 

THERE’S ALWAYS SOMETHING LEFT TO LEARN

Although Cundill had easily avoided Nortel, his worst investment was nevertheless in telecommunications: Cable & Wireless (C&W).  In the late 1990’s, the company had to give up many of its networks in newly independent former British colonies.  The shares dropped from 15 pounds per share to 6 pounds.

A new CEO, Graham Wallace, was brought in.  He quickly and skillfully negotiated a series of asset sales, which dramatically transformed the balance sheet from net debt of 4 billion pounds to net cash of 2.6 billion pounds.  Given the apparently healthy margin of safety, Cundill began buying shares in March 2000 at just over 4 pounds per share.  (Net asset value was 4.92 pounds per share.)  Moreover:

[Wallace was] generally regarded as a relatively safe pair of hands unlikely to be tempted into the kind of acquisition spree overseen by his predecessor.

Unfortunately, a stream of investment bankers, management consultants, and brokers made a simple but convincing pitch to Wallace:

the market for internet-based services was growing at three times the rate for fixed line telephone communications and the only quick way to dominate that market was by acquisition.

Wallace proceeded to make a series of expensive acquisitions of loss-making companies.  This destroyed C&W’s balance sheet and also led to large operating losses.  Cundill now realized that the stock could go to zero, and he got out, just barely.  As Cundill wrote later:

… So we said, look they’ve got cash, they’ve got a valuable, viable business and let’s assume the fibre optic business is worth zero—it wasn’t, it was worth less than zero, much, much less!

Cundill had invested nearly $100 million in C&W, and they lost nearly $59 million.  This loss was largely responsible for the fund being down 11% in 2002.  Cundill realized that his investment team needed someone to be a sceptic for each potential investment.

 

PAN OCEAN

In late 2002, oil prices began to rise sharply based on global growth.  Cundill couldn’t find any net-net’s among oil companies, so he avoided these stocks.  Some members of his investment team argued that there were some oil companies that were very undervalued.  Finally, Cundill announced that if anyone could find an oil company trading below net cash, he would buy it.

Cundill’s cousin, Geoffrey Scott, came across a neglected company:  Pan Ocean Energy Corporation Ltd.  The company was run by David Lyons, whose father, Vern Lyons, had founded Ocelot Energy.  Lyons concluded that there was too much competition for a small to medium sized oil company operating in the U.S. and Canada.  The risk/reward was not attractive.

What he did was to merge his own small Pan Ocean Energy with Ocelot and then sell off Ocelot’s entire North American and other peripheral parts of the portfolio, clean up the balance sheet, and bank the cash.  He then looked overseas and determined that he would concentrate on deals in Sub-Saharan Africa, where licenses could be secured for a fraction of the price tag that would apply in his domestic market.

Lyons was very thorough and extremely focused… He narrowed his field down to Gabon and Tanzania and did a development deal with some current onshore oil production in Gabon and a similar offshore gas deal in Tanzania.  Neither was expensive.

Geoffrey Scott examined Pan Ocean, and found that its share price was almost equal to net cash and the company had no debt.  He immediately let Cundill know about it.  Cundill met with David Lyons and was impressed:

This was a cautious and disciplined entrepreneur, who was dealing with a pool of cash that in large measure was his own.

Lyons invited Cundill to see the Gabon project for himself.  Eventually, Cundill saw both the Gabon project and the Tanzania project.  He liked what he saw.  Cundill’s fund bought 6% of Pan Ocean.  They made six times their money in two and a half years.

 

FRAGILE X

As early as 1998, Cundill had noticed a slight tremor in his right arm.  The condition worsened and affected his balance.  Cundill continued to lead a very active life, still reading and traveling all the time, and still a fitness nut.  He was as sharp as ever in 2005.  Risso-Gill writes:

Ironically, just as Peter’s health began to decline an increasing number of industry awards for his achievements started to come his way.

For instance, he received the Analyst’s Choice award as “The Greatest Mutual Fund Manager of All Time.”

In 2009, Cundill decided that it was time to step down, as his condition had progressively worsened.  He continued to be a voracious reader.

 

WHAT MAKES A GREAT INVESTOR?

Risso-Gill tries to distill from Cundill’s voluminous journal writings what Cundill himself believed it took to be a great value investor.

INSATIABLE CURIOSITY

Curiosity is the engine of civilization.  If I were to elaborate it would be to say read, read, read, and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts.  Keep the reading broad, beyond just the professional.  This helps to develop one’s sense of perspective in all matters.

PATIENCE

Patience, patience, and more patience…

CONCENTRATION

You must have the ability to focus and to block out distractions.  I am talking about not getting carried away by events or outside influences—you can take them into account, but you must stick to your framework.

ATTENTION TO DETAIL

Never make the mistake of not reading the small print, no matter how rushed you are.  Always read the notes to a set of accounts very carefully—they are your barometer… They will give you the ability to spot patterns without a calculator or spreadsheet.  Seeing the patterns will develop your investment insights, your instincts—your sense of smell.  Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in a crisis.

CALCULATED RISK

… Either [value or growth investing] could be regarded as gambling, or calculated risk.  Which side of that scale they fall on is a function of whether the homework has been good enough and has not neglected the fieldwork.

INDEPENDENCE OF MIND

I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call ‘the natural order of things.’  If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition toward lateral thinking—making important connections intuitively.

HUMILITY

I have no doubt that a strong sense of self belief is important—even a sense of mission—and this is fine as long as it is tempered by a sense of humour, especially an ability to laugh at oneself.  One of the greatest dangers that confront those who have been through a period of successful investment is hubris—the conviction that one can never be wrong again.  An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.

ROUTINES

Routines and discipline go hand in hand.  They are the roadmap that guides the pursuit of excellence for its own sake.  They support proper professional ambition and the commercial integrity that goes with it.

SCEPTICISM

Scepticism is good, but be a sceptic, not an iconoclast.  Have rigour and flexibility, which might be considered an oxymoron but is exactly what I meant when I quoted Peter Robertson’s dictum ‘always change a winning game.’  An investment framework ought to include a liberal dose of scepticism both in terms of markets and of company accounts.

PERSONAL RESPONSIBILITY

The ability to shoulder personal responsibility for one’s investment results is pretty fundamental… Coming to terms with this reality sets you free to learn from your mistakes.

 

GLOSSARY OF TERMS WITH CUNDILL’S COMMENTS

Here are some of the terms.

ANALYSIS

There’s almost too much information now.  It boggles most shareholders and a lot of analysts.  All I really need is a company’s published reports and records, that plus a sharp pencil, a pocket calculator, and patience.

Doing the analysis yourself gives you confidence buying securities when a lot of the external factors are negative.  It gives you something to hang your hat on.

ANALYSTS

I’d prefer not to know what the analysts think or to hear any inside information.  It clouds one’s judgment—I’d rather be dispassionate.

BROKERS

I go cold when someone tips me on a company.  I like to start with a clean sheet: no one’s word.  No givens.  I’m more comfortable when there are no brokers looking over my shoulder.

They really can’t afford to be contrarians.  A major investment house can’t afford to do research for five customers who won’t generate a lot of commissions.

EXTRA ASSETS

This started for me when Mutual Shares chieftain Mike Price, who used to be a pure net-net investor, began talking about something called the ‘extra asset syndrome’ or at least that is what I call it.  It’s taking, you might say, net-net one step farther, to look at all of a company’s assets, figure the true value.

FORECASTING

We don’t do a lot of forecasting per se about where markets are going.  I have been burned often enough trying.

INDEPENDENCE

Peter Cundill has never been afraid to make his own decisions and by setting up his own fund management company he has been relatively free from external control and constraint.  He doesn’t follow investment trends or listen to the popular press about what is happening on ‘the street.’  He has travelled a lonely but profitable road.

Being willing to be the only one in the parade that’s out of step.  It’s awfully hard to do, but Peter is disciplined.  You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.’ – Ross Southam

INVESTMENT FORMULA

Mostly Graham, a little Buffett, and a bit of Cundill.

I like to think that if I stick to my formula, my shareholders and I can make a lot of money without much risk.

When I stray out of my comfort zone I usually get my head handed to me on a platter.

I suspect that my thinking is an eclectic mix, not pure net-net because I couldn’t do it anyway so you have to have a new something to hang your hat on.  But the framework stays the same.

INVESTMENT STRATEGY

I used to try and pick the best stocks in the fund portfolios, but I always picked the wrong ones.  Now I take my own money and invest it with that odd guy Peter Cundill.  I can be more detached when I treat myself as a normal client.

If it is cheap enough, we don’t care what it is.

Why will someone sell you a dollar for 50 cents?  Because in the short run, people are irrational on both the optimistic and pessimistic side.

MANTRAS

All we try to do is buy a dollar for 40 cents.

In our style of doing things, patience is patience is patience.

One of the dangers about net-net investing is that if you buy a net-net that begins to lose money your net-net goes down and your capacity to be able to make a profit becomes less secure.  So the trick is not necessarily to predict what the earnings are going to be but to have a clear conviction that the company isn’t going bust and that your margin of safety will remain intact over time.

MARGIN OF SAFETY

The difference between the price we pay for a stock and its liquidation value gives us a margin of safety.  This kind of investing is one of the most effective ways of achieving good long-term results.

MARKETS

If there’s a bad stock market, I’ll inevitably go back in too early.  Good times last longer than we think but so do bad times.

Markets can be overvalued and keep getting expensive, or undervalued and keep getting cheap.  That’s why investing is an art form, not a science.

I’m agnostic on where the markets will go.  I don’t have a view.  Our task is to find undervalued global securities that are trading well below their intrinsic value.  In other words, we follow the strict Benjamin Graham approach to investing.

NEW LOWS

Search out the new lows, not the new highs.  Read the Outstanding Investor Digest to find out what Mason Hawkins or Mike Price is doing.  You know good poets borrow and great poets steal.  So see what you can find.  General reading—keep looking at the news to see what’s troubled.  Experience and curiosity is a really winning combination.

What differentiates us from other money managers with a similar style is that we’re comfortable with new lows.

NOBODY LISTENING

Many people consider value investing dull and as boring as watching paint dry.  As a consequence value investors are not always listened to, especially in a stock market bubble.  Investors are often in too much of a hurry to latch on to growth stocks to stop and listen because they’re afraid of being left out…

OSMOSIS

I don’t just calculate value using net-net.  Actually there are many different ways but you have to use what I call osmosis—you have got to feel your way.  That is the art form, because you are never going to be right completely; there is no formula that will ever get you there on its own.  Osmosis is about intuition and about discipline and about all the other things that are not quantifiable.  So can you learn it?  Yes, you can learn it, but it’s not a science, it’s an art form.  The portfolio is a canvas to be painted and filled in.

PATIENCE

When times aren’t good I’m still there.  You find bargains among the unpopular things, the things that everybody hates.  The key is that you must have patience.

RISK

We try not to lose.  But we don’t want to try too hard.  The losses, of course, work against you in establishing decent compound rates of return.  And I hope we won’t have them.  But I don’t want to be so risk-averse that we are always trying too hard not to lose.

STEADY RETURNS

All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering.  But a lot of investors want excitement, not steady returns.  Most people don’t see making money as grinding it out, doing it as efficiently as possible.  If we have a strong market over the next six months and the fund begins to drop behind and there isn’t enough to do, people will say Cundill’s lost his touch, he’s boring.

TIMING: “THERE’S ALWAYS SOMETHING TO DO”

…Irving Kahn gave me some advice many years ago when I was bemoaning the fact that according to my criteria there was nothing to do.  He said, ‘there is always something to do.  You just need to look harder, be creative and a little flexible.’

VALUE INVESTING

I don’t think I want to become too fashionable.  In some ways, value investing is boring and most investors don’t want a boring life—they want some action: win, lose, or draw.

I think the best decisions are made on the basis of what your tummy tells you.  The Jesuits argue reason before passion.  I argue reason and passion.  Intellect and intuition.  It’s a balance.

We do liquidation analysis and liquidation analysis only.

Ninety to 95% of all my investing meets the Graham tests.  The times I strayed from a rigorous application of this philosophy I got myself into trouble.

But what do you do when none of these companies is available?  The trick is to wait through the crisis stage and into the boredom stage.  Things will have settled down by then and values will be very cheap again.

We customarily do three tests: one of them asset-based—the NAV, using the company’s balance sheet.  The second is the sum of the parts, which I think is probably the most important part that goes into the balance sheet I’m creating.  And then a future NAV, which is making a stab (which I am always suspicious about) at what you think the business might be doing in three years from now.

WORKING LIFE

I’ve been doing this for thirty years.  And I love it.  I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch.  I have no idea whether I’m working or whether I’m playing.

My wife says I’m a workaholic, but my colleagues say I haven’t worked for twenty years.  My work is my play.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Buffett’s Best: Microcap Cigar Butts

(Image:  Zen Buddha Silence by Marilyn Barbone)

September 18, 2022

Warren Buffett, the world’s greatest investor, earned the highest returns of his career from microcap cigar butts.  Buffett wrote in the 2014 Berkshire Letter:

My cigar-butt strategy worked very well while I was managing small sums.  Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO.  Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.  Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices.  Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:  Cigar-butt investing was scalable only to a point.  With large sums, it would never work well…

Before Buffett led Berkshire Hathaway, he managed an investment partnership from 1957 to 1970 called Buffett Partnership Ltd. (BPL).  While running BPL, Buffett wrote letters to limited partners filled with insights (and humor) about investing and business.  Jeremy C. Miller has written a great book— Warren Buffett’s Ground Rules (Harper, 2016)—summarizing the lessons from Buffett’s partnership letters.

This blog post considers a few topics related to microcap cigar butts:

  • Net Nets
  • Dempster: The Asset Conversion Play
  • Liquidation Value or Earnings Power?
  • Mean Reversion for Cigar Butts
  • Focused vs. Statistical
  • The Rewards of Psychological Discomfort
  • Conclusion

 

NET NETS

Here Miller quotes the November 1966 letter, in which Buffett writes about valuing the partnership’s controlling ownership position in a cigar-butt stock:

…Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…

Ben Graham’s primary cigar-butt method was net nets.  Take net current asset value minus ALL liabilities, and then only buy the stock at 2/3 (or less) of that level.  If you buy a basket (at least 20-30) of such stocks, then given enough time (at least a few years), you’re virtually certain to get good investment results, predominantly far in excess of the broad market.

A typical net-net stock might have $30 million in cash, with no debt, but have a market capitalization of $20 million.  Assume there are 10 million shares outstanding.  That means the company has $3/share in net cash, with no debt.  But you can buy part ownership of this business by paying only $2/share.  That’s ridiculously cheap.  If the price remained near those levels, you could effectively buy $1 million in cash for $667,000—and repeat the exercise many times.

Of course, a company that cheap almost certainly has problems and may be losing money.  But every business on the planet, at any given time, is in either one of two states:  it is having problems, or it will be having problems.  When problems come—whether company-specific, industry-driven, or macro-related—that often causes a stock to get very cheap.

The key question is whether the problems are temporary or permanent.  Statistically speaking, many of the problems are temporary when viewed over the subsequent 3 to 5 years.  The typical net-net stock is so extremely cheap relative to net tangible assets that usually something changes for the better—whether it’s a change by management, or a change from the outside (or both).  Most net nets are not liquidated, and even those that are still bring a profit in many cases.

The net-net approach is one of the highest-returning investment strategies ever devised.  That’s not a surprise because net nets, by definition, are absurdly cheap on the whole, often trading below net cash—cash in the bank minus ALL liabilities.

Buffett called Graham’s net-net method the cigar-butt approach:

…I call it the cigar-butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.

Link: http://intelligentinvestorclub.com/downloads/Warren-Buffett-Florida-Speech.pdf

(Photo by Sky Sirasitwattana)

When running BPL, Buffett would go through thousands of pages of Moody’s Manuals (and other such sources) to locate just one or a handful of microcap stocks trading at less than liquidation value.  Other leading value investors have also used this technique.  This includes Charlie Munger (early in his career), Walter Schloss, John Neff, Peter Cundill, and Marty Whitman, to name a few.

The cigar-butt approach is also called deep value investing.  This normally means finding a stock that is available below liquidation value, or at least below net tangible book value.

When applying the cigar-butt method, you can either do it as a statistical group approach, or you can do it in a focused manner.  Walter Schloss achieved one of the best long-term track records of all time—near 21% annually (gross) for 47 years—using a statistical group approach to cigar butts.  Schloss typically had a hundred stocks in his portfolio, most of which were trading below tangible book value.

At the other extreme, Warren Buffett—when running BPL—used a focused approach to cigar butts.  Dempster is a good example, which Miller explores in detail in his book.

 

DEMPSTER: THE ASSET CONVERSION PLAY

Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.  Buffett slowly bought shares in the company over the course of five years.

(Photo by Digikhmer)

Dempster had a market cap of $1.6 million, about $13.3 million in today’s dollars, says Miller.

  • Note:  A market cap of $13.3 million is in the $10 to $25 million range—among the tiniest micro caps—which is avoided by nearly all investors, including professional microcap investors.

Buffett’s average price paid for Dempster was $28/share.  Buffett’s estimate of liquidation value early on was near $35/share, which is intentionally conservative.  Miller quotes one of Buffett’s letters:

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

To estimate liquidation value, Buffett followed Graham’s method, as Miller explains:

  • cash, being liquid, doesn’t need a haircut
  • accounts receivable are valued at 85 cents on the dollar
  • inventory, carried on the books at cost, is marked down to 65 cents on the dollar
  • prepaid expenses and “other” are valued at 25 cents on the dollar
  • long-term assets, generally less liquid, are valued using estimated auction values

Buffett’s conservative estimate of liquidation value for Dempster was $35/share, or $2.2 million for the whole company.  Recall that Buffett paid an average price of $28/share—quite a cheap price.

Even though the assets were clearly there, Dempster had problems.  Stocks generally don’t get that cheap unless there are major problems.  In Dempster’s case, inventories were far too high and rising fast.  Buffett tried to get existing management to make needed improvements.  But eventually Buffett had to throw them out.  Then the company’s bank was threatening to seize the collateral on the loan.  Fortunately, Charlie Munger—who later became Buffett’s business partner—recommended a turnaround specialist, Harry Bottle.  Miller:

Harry did such an outstanding job whipping the company into shape that Buffett, in the next year’s letter, named him “man of the year.”  Not only did he reduce inventories from $4 million to $1 million, alleviating the concerns of the bank (whose loan was quickly repaid), he also cut administrative and selling expenses in half and closed five unprofitable branches.  With the help of Buffett and Munger, Dempster also raised prices on their used equipment up to 500% with little impact to sales volume or resistance from customers, all of which worked in combination to restore a healthy economic return in the business.

Miller explains that Buffett rationally focused on maximizing the return on capital:

Buffett was wired differently, and he achieves better results in part because he invests using an absolute scale.  With Dempster he wasn’t at all bogged down with all the emotional baggage of being a veteran of the windmill business.  He was in it to produce the highest rate of return on the capital he had tied up in the assets of the business.  This absolute scale allowed him to see that the fix for Dempster would come by not reinvesting back into windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

With profits and proceeds raised from converting inventory and other assets to cash, Buffett started buying stocks he liked.  In essence, he was converting capital that was previously utilized in a bad (low-return) business, windmills, to capital that could be utilized in a good (high-return) business, securities.

Bottle, Buffett, and Munger maximized the value of Dempster’s assets.  Buffett took the further step of not reinvesting cash in a low-return business, but instead investing in high-return stocks.  In the end, on its investment of $28/share, BPL realized a net gain of $45 per share.  This is a gain of a bit more than 160% on what was a very large position for BPL—one-fifth of the portfolio.  Had the company been shut down by the bank, or simply burned through its assets, the return after paying $28/share could have been nothing or even negative.

Miller nicely summarizes the lessons of Buffett’s asset conversion play:

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business.  The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.  This is true for each and every business and they are interrelated…

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales.  The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value.  These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster…

 

LIQUIDATION VALUE OR EARNINGS POWER?

For most of the cigar butts that Buffett bought for BPL, he used Graham’s net-net method of buying at a discount to liquidation value, conservatively estimated.  However, you can find deep value stocks—cigar butts—on the basis of other low “price-to-a-fundamental” ratio’s, such as low P/E or low EV/EBITDA.  Even Buffett, when he was managing BPL, used a low P/E in some cases to identify cigar butts.  (See an example below: Western Insurance Securities.)

Tobias Carlisle and Wes Gray tested various measures of cheapness from 1964 to 2011.  Quantitative Value (Wiley, 2012)—an excellent book—summarizes their results.  James P. O’Shaughnessy has conducted one of the broadest arrays of statistical backtests.  See his results in What Works on Wall Street (McGraw-Hill, 4th edition, 2012), a terrific book.

(Illustration by Maxim Popov)

  • Carlisle and Gray found that low EV/EBIT was the best-performing measure of cheapness from 1964 to 2011.  It even outperformed composite measures.
  • O’Shaughnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
  • But O’Shaughnessy also discovered that a composite measure—combining low P/B, P/E, P/S, P/CF, and EV/EBITDA—outperformed low EV/EBITDA.

Assuming relatively similar levels of performance, a composite measure is arguably better because it tends to be more consistent over time.  There are periods when a given individual metric might not work well.  The composite measure will tend to smooth over such periods.  Besides, O’Shaughnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaughnessy, didn’t include Graham’s net-net method in their reported results.  Carlisle wrote another book, Deep Value (Wiley, 2014)—which is fascinating—in which he summarizes several tests of net nets:

  • Henry Oppenheimer found that net nets returned 29.4% per year versus 11.5% per year for the market from 1970 to 1983.
  • Carlisle—with Jeffrey Oxman and Sunil Mohanty—tested net nets from 1983 to 2008.  They discovered that the annual returns for net nets averaged 35.3% versus 12.9% for the market and 18.4% for a Small Firm Index.
  • A study of the Japanese market from 1975 to 1988 uncovered that net nets outperformed the market by about 13% per year.
  • An examination of the London Stock Exchange from 1981 to 2005 established that net nets outperformed the market by 19.7% per year.
  • Finally, James Montier analyzed all developed markets globally from 1985 to 2007.  He learned that net nets averaged 35% per year versus 17% for the developed markets on the whole.

Given these outstanding returns, why didn’t Carlisle and Gray, as well as O’Shaughnessy, consider net nets?  Primarily because many net nets are especially tiny microcap stocks.  For example, in his study, Montier found that the median market capitalization for net nets was $21 million.  Even the majority of professionally managed microcap funds do not consider stocks this tiny.

  • Recall that Dempster had a market cap of $1.6 million, or about $13.3 million in today’s dollars.
  • Unlike the majority of microcap funds, the Boole Microcap Fund does consider microcap stocks in the $10 to $25 million market cap range.

In 1999, Buffett commented that he could get 50% per year by investing in microcap cigar butts.  He was later asked about this comment in 2005, and he replied:

Yes, I would still say the same thing today.  In fact, we are still earning those types of returns on some of our smaller investments.  The best decade was the 1950s;  I was earning 50% plus returns with small amounts of capital.  I would do the same thing today with smaller amounts.  It would perhaps even be easier to make that much money in today’s environment because information is easier to access.  You have to turn over a lot of rocks to find those little anomalies.  You have to find the companies that are off the map—way off the map.  You may find local companies that have nothing wrong with them at all.  A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!!  I tried to buy up as much of it as possible.  No one will tell you about these businesses.  You have to find them.

Although the majority of microcap cigar butts Buffett invested in were cheap relative to liquidation value—cheap on the basis of net tangible assets—Buffett clearly found some cigar butts on the basis of a low P/E.  Western Insurance Securities is a good example.  It had a P/E of 0.15.

 

MEAN REVERSION FOR CIGAR BUTTS

Warren Buffett commented on high quality companies versus statistically cheap companies in his October 1967 letter to partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.  At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.”  On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.”  As is so often the pleasant result in the securities world, money can be made with either approach.  And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school… the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”.  This is what causes the cash register to really sing.  However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.  So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Buffett and Munger acquired See’s Candies for Berkshire Hathaway in 1972.  See’s Candies is the quintessential high quality company because of its sustainably high ROIC (return on invested capital) of over 100%.

Truly high quality companies—like See’s—are very rare and difficult to find.  Cigar butts are much easier to find by comparison.

Furthermore, it’s important to understand that Buffett got around 50% annual returns from cigar butts because he took a focused approach, like BPL’s 20% position in Dempster.

The vast majority of investors, if using a cigar-butt approach like net nets, should implement a group—or statistical—approach, and regularly buy and hold a basket of cigar butts (at least 20-30).  This typically won’t produce 50% annual returns.  But net nets, as a group, clearly have produced very high returns, often 30%+ annually.  To do this today, you’d have to look globally.

As an alternative to net nets, you could implement a group approach using one of O’Shaughnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Still excellent results.  And much easier to apply consistently.

You may think that you can find some high quality companies.  But that’s not enough.  You have to find a high quality company that can maintain its competitive position and high ROIC.  And it has to be available at a reasonable price.

Most high quality companies are trading at very high prices, to the extent that you can’t do better than the market by investing in them.  In fact, often the prices are so high that you’ll probably do worse than the market.

Consider this observation by Charlie Munger:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market.  Everybody goes there and bets and the odds change based o­n what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.  The prices have changed in such a way that it’s very hard to beat the system.

(Illustration by Nadoelopisat)

A horse with a great record (etc.) is much more likely to win than a horse with a terrible record.  But—whether betting on horses or betting on stocks—you don’t get paid for identifying winners.  You get paid for identifying mispricings.

The statistical evidence is overwhelming that if you systematically buy stocks at low multiples—P/B, P/E, P/S, P/CF, EV/EBITDA, etc.—you’ll almost certainly do better than the market over the long haul.

A deep value (cigar-butt) approach has always worked, given enough time.  Betting on “the losers” has always worked eventually, whereas betting on “the winners” hardly ever works.

Classic academic studies showing “the losers” doing far better than “the winners” over subsequent 3- to 5-year periods:

That’s not to say deep value investing is easy.  When you put together a basket of statistically cheap companies, you’re buying stocks that are widely hated or neglected.  You have to endure loneliness and looking foolish.  Some people can do it, but it’s important to know yourself before using a deep value strategy.

In general, we extrapolate the poor performance of cheap stocks and the good performance of expensive stocks too far into the future.  This is the mistake of ignoring mean reversion.

When you find a group of companies that have been doing poorly for at least several years, those conditions typically do not persist.  Instead, there tends to be mean reversion, or a return to “more normal” levels of revenues, earnings, or cash flows.

Similarly for a group of companies that have been doing exceedingly well.  Those conditions also do not continue in general.  There tends to be mean reversion, but in this case the mean—the average or “normal” conditions—is below recent activity levels.

Here’s Ben Graham explaining mean reversion:

It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided.  The converse would be assumed, of course, for those with superior records.  But this conclusion may often prove quite erroneous.  Abnormally good or abnormally bad conditions do not last forever.  This is true of general business but of particular industries as well.  Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

With his taste for literature, Graham put the following quote from Horace’s Ars Poetica at the beginning of Security Analysis—the bible for value investors:

Many shall be restored that now are fallen and many shall fall than now are in honor.

Tobias Carlisle, while discussing mean reversion in Deep Value, smartly (and humorously) included this image of Albrecht Durer’s Wheel of Fortune:

(Albrecht Durer’s Wheel of Fortune from Sebastien Brant’s Ship of Fools (1494) via Wikimedia Commons)

 

FOCUSED vs. STATISTICAL

We’ve already seen that there are two basic ways to do cigar-butt investing: focused vs. statistical (group).

Ben Graham usually preferred the statistical (group) approach.  Near the beginning of the Great Depression, Graham’s managed accounts lost more than 80 percent.  Furthermore, the economy and the stock market took a long time to recover.  As a result, Graham had a strong tendency towards conservatism in investing.  This is likely part of why he preferred the statistical approach to net nets.  By buying a basket of net nets (at least 20-30), the investor is virtually certain to get the statistical results of the group over time, which are broadly excellent.

Graham also was a polymath of sorts.  He had wide-ranging intellectual interests.  Because he knew net nets as a group would do quite well over the long term, he wasn’t inclined to spend much time analyzing individual net nets.  Instead, he spent time on his other interests.

Warren Buffett was Graham’s best student.  Buffett was the only student ever to be awarded an A+ in Graham’s class at Columbia University.  Unlike Graham, Buffett has always had an extraordinary focus on business and investing.  After spending many years learning everything about virtually every public company, Buffett took a focused approach to net nets.  He found the ones that were the cheapest and that seemed the surest.

Buffett has asserted that returns can be improved—and risk lowered—if you focus your investments only on those companies that are within your circle of competence—those companies that you can truly understand.  Buffett also maintains, however, that the vast majority of investors should simply invest in index funds: http://boolefund.com/warren-buffett-jack-bogle/

Regarding individual net nets, Graham admitted a danger:

Corporate gold dollars are now available in quantity at 50 cents and less—but they do have strings attached.  Although they belong to the stockholder, he doesn’t control them.  He may have to sit back and watch them dwindle and disappear as operating losses take their toll.  For that reason the public refuses to accept even the cash holdings of corporations at their face value.

Graham explained that net nets are cheap because they “almost always have an unsatisfactory trend in earnings.”  Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors.  Ongoing business losses can, however, quickly erode net-net working capital.  Investors must therefore always consider the state of a company’s current operations before buying.

Even Buffett—nearly two decades after closing BPL—wrote the following in his 1989 letter to Berkshire shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the “cigar butt” approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original “bargain” price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.  For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.  But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost…

Based on these objections, you might think that Buffett’s focused approach is better than the statistical (group) method.  That way, the investor can figure out which net nets are more likely to recover instead of burn through their assets and leave the investor with a low or negative return.

However, Graham’s response was that the statistical or group approach to net nets is highly profitable over time.  There is a wide range of potential outcomes for net nets, and many of those scenarios are good for the investor.  Therefore, while there are always some individual net nets that don’t work out, a group or basket of net nets is nearly certain to work well eventually.

Indeed, Graham’s application of a statistical net-net approach produced 20% annual returns over many decades.  Most backtests of net nets have tended to show annual returns of close to 30%.  In practice, while around 5 percent of net nets may suffer a terminal decline in stock price, a statistical group of net nets has done far better than the market and has experienced fewer down years.  Moreover, as Carlisle notes in Deep Value, very few net nets are actually liquidated or merged.  In the vast majority of cases, there is a change by management, a change from the outside, or both, in order to restore earnings to a level more in line with net asset value.  Mean reversion.

 

THE REWARDS OF PSYCHOLOGICAL DISCOMFORT

We noted earlier that it’s far more difficult to find a company like See’s Candies, at a reasonable price, than it is to find statistically cheap stocks.  Moreover, if you buy a basket of statistically cheap stocks, you don’t have to possess an ability to analyze individual businesses in great depth.

That said, in order to use a deep value strategy, you do have to be able to handle the psychological discomfort of being lonely and looking foolish.

(Illustration by Sangoiri)

John Mihaljevic, author of The Manual of Ideas (Wiley, 2013), writes:

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations….

…Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude…

Mihaljevic explains:

If we owned nothing but a portfolio of Ben Graham-style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously.  We might look at the portfolio and conclude that every investment could be worth zero.  After all, we could have a mediocre business run by mediocre management, with assets that could be squandered.  Investing in deep value equities therefore requires faith in the law of large numbers—that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.  This conceptually sound view becomes seriously challenged in times of distress…

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

Deep value investors often find some of the best investments in cyclical areas.  A company at a cyclical low may have multi-bagger potential—the prospect of returning 300-500% (or more) to the investor.

Mihaljevic comments on a central challenge of deep value investing in cyclical companies:

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a “this time is different” attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

Consider the following industries that have been pronounced permanently impaired in the past, only to rebound strongly in subsequent years:  Following the financial crisis of 2008-2009, many analysts argued that the banking industry would be permanently negatively affected, as higher capital requirements and regulatory oversight would compress returns on equity.  The credit rating agencies were seen as impaired because the regulators would surely alter the business model of the industry for the worse following the failings of the rating agencies during the subprime mortgage bubble.  The homebuilding industry would fail to rebound as strongly as in the past, as overcapacity became chronic and home prices remained tethered to building costs.  The refining industry would suffer permanently lower margins, as those businesses were capital-intensive and driven by volatile commodity prices.

 

CONCLUSION

Buffett has made it clear, including in his 2014 letter to shareholders, that the best returns of his career came from investing in microcap cigar butts.  Most of these were mediocre businesses (or worse).  But they were ridiculously cheap.  And, in some cases like Dempster, Buffett was able to bring about needed improvements when required.

When Buffett wrote about buying wonderful businesses in his 1989 letter, that’s chiefly because investable assets at Berkshire Hathaway had grown far too large for microcap cigar butts.

Even in recent years, Buffett invested part of his personal portfolio in a group of cigar butts he found in South Korea.  So he’s never changed his view that an investor can get the highest returns from microcap cigar butts, either by using a statistical group approach or by using a more focused method.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Ten Attributes of Great Investors

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 11, 2022

Michael Mauboussin is the author of several excellent books, including More Than You Know and Think Twice.  I wrote about these books here:

He has also written numerous papers, including Thirty Years: Reflections on the Ten Attributes of Great Investorshttps://bit.ly/2zlaljc

When it comes to value investing, Mauboussin is one of the best writers in the world.  Mauboussin highlights market efficiency, competitive strategy analysis, valuation, and decision making as chief areas of focus for him the past couple of decades.  Mauboussin:

What we know about each of these areas today is substantially greater than what we did in 1986, and yet we have an enormous amount to learn.  As I like to tell my students, this is an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.

(Image by magele-picture)

Here are the Ten Attributes of Great Investors:

  • Be numerate (and understand accounting).
  • Understand value (the present value of free cash flow).
  • Properly assess strategy (or how a business makes money).
  • Compare effectively (expectations versus fundamentals).
  • Think probabilistically (there are few sure things).
  • Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
  • Beware of behavioral biases (minimizing constraints to good thinking).
  • Know the difference between information and influence.
  • Position sizing (maximizing the payoff from edge).
  • Read (and keep an open mind).

 

BE NUMERATE (AND UNDERSTAND ACCOUNTING)

Mauboussin notes that there are two goals when analyzing a company’s financial statements:

  • Translate the financial statements into free cash flow.
  • Determine how the competitive strategy of the company creates value.

The value of any business is the future free cash flow it will produce discounted back to the present.

(Photo by designer491)

Free cash flow is cash earnings minus investments that must be made to grow future earnings.  Free cash flow represents what owners of the business receive.  Warren Buffett refers to free cash flow as owner earnings.

Earnings alone cannot give you the value of a company.  You can grow earnings without growing value.  Whether earnings growth creates value depends on how much money the company invests to generate that growth.  If the ROIC (return on invested capital) of the company’s investment is below the cost of capital, then the resulting earnings growth destroys value rather than creates it.

After calculating free cash flow, the next goal in financial statement analysis is to figure out how the company’s strategy creates value.  For the company to create value, the ROIC must exceed the cost of capital.  Analyzing the company’s strategy means determining precisely how the company can get ROIC above the cost of capital.

Mauboussin writes that one way to analyze strategy is to compare two companies in the same business.  If you look at how the companies spend money, you can start to understand competitive positions.

Another way to grasp competitive position is by analyzing ROIC.

Photo by stanciuc

You can break ROIC into two parts:

  • profitability (net operating profit after tax / sales)
  • capital velocity (sales / invested capital)

Companies with high profitability but low capital velocity are using a differentiation strategy.  Their product is positioned in such a way that the business can earn high profit margins.  (For instance, a luxury jeweler.)

Companies with high capital velocity but low profitability have adopted a cost leadership strategy.  These businesses may have very thin profit margins, but they still generate high ROIC because their capital velocity is so high.  (Wal-Mart is a good example.)

Understanding how the company makes money can lead to insight about how long the company can maintain a high ROIC (if ROIC is high) or what the company must do to improve (if ROIC is low).

 

UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)

Mauboussin:

Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.  Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.

It’s worth repeating: The value of any business (or any financial asset) is the future free cash flow it will produce discounted back to the present.  Successful investors understand the variables that impact free cash flow.

Illustration by OpturaDesign

 

PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)

Mauboussin says this attribute has two elements:

  • How does the company make money?
  • Does the company have a sustainable competitive advantage, and if so, how durable is it?

To see how a business makes money, you have to figure out the basic unit of analysis.  Mauboussin points out that the basic unit of analysis for a retailer is store economics:  How much does it cost to build a store?  What revenues will it generate?  What are the profit margins?

Regarding sustainable competitive advantage, Warren Buffett famously said:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

If a company has a sustainable competitive advantage, then ROIC (return on invested capital) is above the cost of capital.  To assess the durability of that advantage, you have to analyze the industry and how the company fits in.  Looking at the five forces that determine industry attractiveness is a common step.  You should also examine potential threats from disruptive innovation.

Mauboussin:

Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors.  The size and longevity of the moat are significant inputs into any thoughtful valuation.

Bodiam Castle, Photo by valeryegorov

Buffett popularized the term economic moat to refer to a sustainable competitive advantage.  Here’s what Buffett said at the Berkshire annual meeting in 2000:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.  And we tell our managers we want the moat widened every year.  That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes.  However, if the moat is widened every year, the business will do very well.

 

COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)

Mauboussin:

Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations.  Fundamentals capture a sense of a company’s future financial performance.  Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals.  Expectations reflect the financial performance implied by the stock price.

Mauboussin mentions pari-mutuel betting, specifically horse racing.

(Photo by Elshaneo)

Fundamentals are how fast the horse will run, while expectations are the odds.

  • If a company has good fundamentals, but the stock price already reflects that, then you can’t expect to beat the market by investing in the stock.
  • If a company has bad fundamentals, but the stock price is overly pessimistic, then you can expect to beat the market by investing in the stock.

The best business in the world will not bring excess returns if the stock price already fully reflects the high quality of the business.  Similarly, a terrible business can produce excess returns if the stock price indicates that investors have overreacted.

To make money by investing in a stock, you have to have what great investor Michael Steinhardt calls a variant perception—a view at odds with the consensus view (as reflected in the stock price).  And you have to be right.

Mauboussin observes that humans are quick to compare but aren’t good at it.  This includes reasoning by analogy, e.g., asking whether a particular turnaround is similar to some other turnaround.  However, it’s usually better to figure out the base rate:  What percentage of all turnarounds succeed?  (Not a very high number, which is why Buffett quipped, “Turnarounds seldom turn.”)

Another limitation of humans making comparisons is that people tend to see similarities when they’re looking for similarities, but they tend to see differences when they’re looking for differences.  For instance, Amos Tversky did an experiment in which the subjects were asked which countries are more similar, West Germany and East Germany, or Nepal and Ceylon?  Two-thirds answered West Germany and East Germany.  But then the subjects were asked which countries seemed more different.  Logic says that they would answer Nepal and Ceylon, but instead subjects again answered West Germany and East Germany.

 

THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)

Great investors are always seeking an edge, where the price of an asset misrepresents the probabilities or the outcomes.  By similar logic, great investors evaluate each investment decision based on the process used rather than based on the outcome.

  • A good investment decision is one that if repeatedly made would be profitable over time.
  • A bad investment decision is one that if repeatedly made would lead to losses over time.

However, a good decision will sometimes lead to a bad outcome, while a bad decision will sometimes lead to a good outcome.  Investing is similar to other forms of betting in that way.

Photo by annebel146

Furthermore, what matters is not how often an investor is right, but rather how much the investor makes when he is right versus how much he loses when he is wrong.  In other words, what matters is not batting average but slugging percentage.  This is hard to put into practice due to loss aversion—the fact that as humans we feel a loss at least twice as much as an equivalent gain.

There are three ways of determining probabilities.  Subjective probability is a number that corresponds with your state of knowledge or belief.  Mauboussin gives an example:  You might come up with a probability that two countries will go to war.  Propensity is usually based on the physical properties of the system.  If a six-sided die is a perfect cube, then you know that the odds of a particular side coming up must be one out of six.  Frequency is the third approach.  Frequency—also called the base rate—is measured by looking at the outcomes of a proper reference class.  How often will a fair coin land on heads?  If you gather all the records you can of a fair coin being tossed, you’ll find that it lands on heads 50 percent of the time.  (You could run your own trials, too, by tossing a fair coin thousands or millions of times.)

Often subjective probabilities are useful as long as you remain open to new information and properly adjust your probabilities based on that information.  (The proper way to update such beliefs is using Bayes’s theorem.)  Subjective probabilities are useful when there’s no clear reference class—no relevant base rate.

When you’re looking at corporate performance—like sales or profit growth—it’s usually best to look at frequencies, i.e., base rates.

An investment decision doesn’t have to be complicated.  In fact, most good investment decisions are simple.  Mauboussin quotes Warren Buffett:

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.  That is what we’re trying to do.  It’s imperfect, but that’s what it’s all about.

Buffett again:

Investing is simple, but not easy.

 

UPDATE YOUR VIEWS EFFECTIVELY (BELIEFS ARE HYPOTHESES TO BE TESTED, NOT TREASURES TO BE PROTECTED)

We have a strong preference for consistency when it comes to our own beliefs.  And we expect others to be consistent.  The problem is compounded by confirmation bias, the tendency to look for and see only information that confirms our beliefs, and the tendency to interpret ambiguous information in a way that supports our beliefs.  As long as we feel like our beliefs are both consistent and correct—and, as a default psychological setting, most of us feel this way most of the time—we’ll feel comfortable and we won’t challenge our beliefs.

Illustration by intheskies

Great investors seek data and arguments that challenge their views.  Great investors also update their beliefs when they come across evidence that suggests they should.  The proper way to update beliefs is using Bayes’s theorem.  To see Bayes’s theorem and also a clear explanation and example, see: http://boolefund.com/the-signal-and-the-noise/

Mauboussin:

The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous.  They actively seek varied points of view and update their beliefs as new information dictates.  The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio.  Others, including your clients, may view this mental flexibility as unsettling.  But good thinking requires maintaining as accurate a view of the world as possible.

 

BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)

Mauboussin:

Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions.  His claim is that the overlap between these abilities is much lower than most people think.  Importantly, you can cultivate your RQ.

Rationality is only partly genetic.  You can train yourself to be more rational.

Great investors relentlessly train themselves to be as rational as possible.  Typically they keep an investment journal in which they write down the reasoning for every investment decision.  Later they look back on their decisions to analyze what they got right and where they went wrong.

Great investors also undertake a comprehensive study of cognitive biases.  For a list of cognitive biases, see these two blog posts:

It’s rarely enough just to know about cognitive biases.  Great investors take steps—like using a checklist—designed to mitigate the impact that innate cognitive biases have on investment decision-making.

Photo by Kenishirotie

 

KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE

A stock price generally represents the collective wisdom of investors about how a given company will perform in the future.  Most of the time, the crowd is more accurate than virtually any individual investor.

(Illustration by Marrishuanna)

However, periodically a stock price can get irrational.  (If this weren’t the case, great value investors could not exist.)  People regularly get carried away with some idea.  For instance, as Mauboussin notes, many investors got rich on paper by investing in dot-com stocks in the late 1990’s.  Investors who didn’t own dot-com stocks felt compelled to jump on board when they saw their neighbor getting rich (on paper).

Mauboussin mentions the threshold model from Mark Granovetter, a professor of sociology at Stanford University.  Mauboussin:

Imagine 100 potential rioters milling around in a public square.  Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot.  Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99.  This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen.  The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold.  Substitute “buy dotcom stocks” for “join the riot” and you get the idea.

The point is that very few of the individuals, save the instigator, think that rioting is a good idea.  Most would probably shun rioting.  But once the number of others rioting reaches a threshold, they will jump in.  This is how the informational value of stocks is set aside and the influential component takes over.

Great investors are not influenced much at all by the behavior of other investors.  Great investors know that the collective wisdom reflected in a stock price is usually right, but sometimes wrong.  These investors can identify the occasional mispricing and then make an investment while ignoring the crowd.

 

POSITION SIZING (MAXIMIZING THE PAYOFF FROM EDGE)

Great investors patiently wait for situations where they have an edge, i.e., where the odds are in their favor.  Many investors understand the need for an edge.  However, fewer investors pay much attention to position sizing.

If you know the odds, there’s a formula—the Kelly criterion—that tells you exactly how much to bet in order to maximize your long-term returns.  The Kelly criterion can be written as follows:

  • F = p – [q/o]

where

  • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital.  (This assumes that you’re going to make a long series of bets.)  Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Mauboussin adds:

Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage).   Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.

In brief, most investors are ineffective at position sizing, but great investors are good at it.

 

READ (AND KEEP AN OPEN MIND)

Great investors generally read a ton.  They also read widely across many disciplines.  Moreover, as noted earlier, great investors seek to learn about the arguments of people who disagree with them.  Mauboussin:

Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.”  Reading is an activity that tends to foster all of those qualities.

(Photo by Lapandr)

Mauboussin continues:

Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time—none, zero.”  This may be hyperbolic, but seems to be true in the investment world as well.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

The Outsiders: Radically Rational CEOs

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 14, 2022

William Thorndike is the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Harvard Business Review Press, 2012).  It’s an excellent book profiling eight CEOs who compounded shareholder value at extraordinary rates over decades.

Through this book, value investors can improve their understanding of how to identify CEOs who maximize long-term returns to shareholders.  Also, investors can become better businesspeople, while businesspeople can become better investors.

I am a better investor because I am a businessman and a better businessman because I am an investor. – Warren Buffett

Thorndike explains that you only need three things to evaluate CEO performance:

  • the compound annual return to shareholders during his or her tenure
  • the return over the same period for peer companies
  • the return over the same period for the broader market (usually measured by the S&P 500)

Thorndike notes that 20 percent returns is one thing during a huge bull market—like 1982 to 1999.  It’s quite another thing if it occurs during a period when the overall market is flat—like 1966 to 1982—and when there are several bear markets.

Moreover, many industries will go out of favor periodically.  That’s why it’s important to compare the company’s performance to peers.

Thorndike mentions Henry Singleton as the quintessential outsider CEO.  Long before it was popular to repurchase stock, Singleton repurchased over 90% of Teledyne’s stock.  Also, he emphasized cash flow over earnings.  He never split the stock.  He didn’t give quarterly guidance.  He almost never spoke with analysts or journalists.  And he ran a radically decentralized organization.  Thorndike:

If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180.  That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500.  Remarkably, Singleton outperformed the index by over twelve times.

Thorndike observes that rational capital allocation was the key to Singleton’s success.  Thorndike writes:

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity.  Think of these options collectively as a tool kit.  Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.  Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Warren Buffett has noted that most CEOs reach the top due to their skill in marketing, production, engineering, administration, or even institutional politics.  Thus most CEOs have not been prepared to allocate capital.

Thorndike also points out that the outsider CEOs were iconoclastic, independent thinkers.  But the outsider CEOs, while differing noticeably from industry norms, ended up being similar to one another.  Thorndike says that the outsider CEOs understood the following principles:

  • Capital allocation is a CEO’s most important job.
  • What counts in the long run is the increase in per share value, not overall growth or size.
  • Cash flow, not reported earnings, is what determines long-term value.
  • Decentralized organizations release entrepreneurial energy and keep both costs and ‘rancor’ down.
  • Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
  • Sometimes the best investment opportunity is your own stock.
  • With acquisitions, patience is vital… as is occasional boldness.

(Illustration by yiorgosgr)

Here are the sections in the blog post:

  • Introduction
  • Tom Murphy and Capital Cities Broadcasting
  • Henry Singleton and Teledyne
  • Bill Anders and General Dynamics
  • John Malone and TCI
  • Katharine Graham and The Washington Post Company
  • Bill Stiritz and Ralston Purina
  • Dick Smith and General Cinema
  • Warren Buffett and Berkshire Hathaway
  • Radical Rationality

 

INTRODUCTION

Only two of the eight outsider CEOs had MBAs.  And, writes Thorndike, they did not attract or seek the spotlight:

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness.  They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate plans, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press.  They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them.  Ben Franklin would have liked these guys.

Thorndike describes how the outsider CEOs were iconoclasts:

Like Singleton, these CEOs consistently made very different decisions than their peers did.  They were not, however, blindly contrarian.  Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions.

Thorndike compares the outsider CEOs to Billy Beane as described by Michael Lewis in Moneyball.  Beane’s team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job.  Beane had discovered newand unorthodoxmetrics that were more correlated with team winning percentage.

Thorndike mentions a famous essay about Leo Tolstoy written by Isaiah Berlin.  Berlin distinguishes between a “fox” who knows many things and a “hedgehog” who knows one thing extremely well.  Thorndike continues:

Foxes… also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes.  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.

(Photo by mbridger68)

 

TOM MURPHY AND CAPITAL CITIES BROADCASTING

When Murphy became CEO of Capital Cities in 1966, CBS’ market capitalization was sixteen times than that of Capital Cities.  Thirty years later, Capital Cities was three times as valuable as CBS.  Warren Buffett has said that in 1966, it was like a rowboat (Capital Cities) against QE2 (CBS) in a trans-Atlantic race.  And the rowboat won decisively!

Bill Paley, who ran CBS, used the enormous cash flow from its network and broadcast operations and undertook an aggressive acquisition program of companies in entirely unrelated fields.  Paley simply tried to make CBS larger without paying attention to the return on invested capital (ROIC).

Without a sufficiently high ROIC, growth destroys shareholder value instead of creating it.  But, like Paley, many business leaders at the time sought growth for its own sake.  Even if growth destroys value (due to low ROIC), it does make the business larger, bringing greater benefits to the executives.

Murphy’s goal, on the other hand, was to make his company as valuable as possible.  This meant maximizing profitability and ROIC:

…Murphy’s goal was to make his company more valuable… Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well.  Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS’s rival broadcast network ABC.

(Capital Cities/ABC, Inc. logo, via Wikimedia Commons)

Burke excelled in operations, while Murphy excelled in making acquisitions.  Together, they were a great team—unmatched, according to Warren Buffett.  Burke said his ‘job was to create free cash flow and Murphy’s was to spend it.’

During the mid-1970s, there was an extended bear market.  Murphy aggressively repurchased shares, mostly at single-digit price-to-earnings (P/E) multiples.

Thorndike writes that in January 1986, Murphy bought the ABC Network and its related broadcasting assets for $3.5 billion with financing from his friend Warren Buffett.  Thorndike comments:

Burke and Murphy wasted little time in implementing Capital Cities’ lean, decentralized approach—immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed.  They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan…

In the nine years after the transaction, revenues and cash flows grew significantly in every major ABC business line, including the TV stations, the publishing assets, and ESPN.  Even the network, which had been in last place at the time of the acquisition, was ranked number one in prime time ratings and was more profitable than either CBS or NBC.

In 1993, Burke retired.  And in 1995, Murphy, at Buffett’s suggestion, met with Michael Eisner, the CEO of Disney.  Over a few days, Murphy sold Capital Cities/ABC to Disney for $19 billion, which was 13.5 times cash flow and 28 times net income.  Thorndike:

He left behind an ecstatic group of shareholders—if you had invested a dollar with Tom Murphy as he became CEO in 1966, that dollar would have been worth $204 by the time he sold the company to Disney.  That’s a remarkable 19.9 percent internal rate of return over twenty-nine years, significantly outpacing the 10.1 percent return for the S&P 500 and 13.2 percent return for an index of leading media companies over the same period.

Thorndike points out that decentralization was one of the keys to success for Capital Cities.  There was a single paragraph on the inside cover of every Capital Cities annual report:

‘Decentralization is the cornerstone of our philosophy.  Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs.  All decisions are made at the local level… We expect our managers… to be forever cost conscious and to recognize and exploit sales potential.’

Headquarters had almost no staff.  There were no vice presidents in marketing, strategic planning, or human resources.  There was no corporate counsel and no public relations department.  The environment was ideal for entrepreneurial managers.  Costs were minimized at every level.

Burke developed an extremely detailed annual budgeting process for every operation.  Managers had to present operating and capital budgets for the coming year, and Burke (and his CFO, Ron Doerfler) went through the budgets line-by-line:

The budget sessions were not perfunctory and almost always produced material changes.  Particular attention was paid to capital expenditures and expenses.  Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as ‘a form of report card.’  Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.

High margins resulted not only from cost minimization, but also from Murphy and Burke’s focus on revenue growth and advertising market share.  They invested in their properties to ensure leadership in local markets.

When it came to acquisitions, Murphy was very patient and disciplined.  His benchmark ‘was a double-digit after-tax return over ten years without leverage.’  Murphy never won an auction as a result of his discipline.  Murphy also had a unique negotiating style.

Murphy thought that, in the best transactions, everyone comes away happy.  He believed in ‘leaving something on the table’ for the seller.  Murphy would often ask the seller what they thought the property was worth.  If Murphy thought the offer was fair, he would take it.  If he thought the offer was high, he would counter with his best price.  If the seller rejected his counter-offer, Murphy would walk away.  He thought this approach saved time and avoided unnecessary friction.

Thorndike concludes his discussion of Capital Cities:

Although the focus here is on quantifiable business performance, it is worth noting that Murphy built a universally admired company at Capital Cities with an exceptionally strong culture and esprit de corps (at least two different groups of executives still hold regular reunions).

 

HENRY SINGLETON AND TELEDYNE

Singleton earned bachelor’s, master’s, and PhD degrees in electrical engineering from MIT.  He programmed the first student computer at MIT.  He won the Putnam Medal as the top mathematics student in the country in 1939.  And he was 100 points away from being a chess grandmaster.

Singleton worked as a research engineer at North American Aviation and Hughes Aircraft in 1950.  Tex Thornton recruited him to Litton Industries in the late 1950s, where Singleton invented an inertial guidance system—still in use—for commercial and military aircraft.  By the end of the decade, Singleton had grown Litton’s Electronic Systems Group to be the company’s largest division with over $80 million in revenue.

Once he realized he wouldn’t succeed Thornton as CEO, Singleton left Litton and founded Teledyne with his colleague George Kozmetzky.  After acquiring three small electronics companies, Teledyne successfully bid for a large naval contract.  Teledyne became a public company in 1961.

(Photo of Teledyne logo by Piotr Trojanowski)

In the 1960’s, conglomerates had high price-to-earnings (P/E) ratios and were able to use their stock to buy operating companies at relatively low multiples.  Singleton took full advantage of this arbitrage opportunity.  From 1961 to 1969, he purchased 130 companies in industries from aviation electronics to specialty metals and insurance.  Thorndike elaborates:

Singleton’s approach to acquisitions, however, differed from that of other conglomerateurs.  He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets… Singleton was a very disciplined buyer, never paying more than twelve times earnings and purchasing most companies at significantly lower multiples.  This compares to the high P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.

In mid-1969, Teledyne was trading at a lower multiple, while acquisition prices were increasing.  So Singleton completely stopped acquiring companies.

Singleton ran a highly decentralized company.  Singleton also did not report earnings, but instead focused on free cash flow (FCF)—what Buffett calls owner earnings.  The value of any business is all future FCF discounted back to the present.

FCF = net income + DDA – capex

(There are also adjustments to FCF based on changes in working capital.  DDA is depreciation, depletion, and amortization.)

At Teledyne, bonus compensation for all business unit managers was based on the maximization of free cash flow.  Singleton—along with his roommate from the Naval Academy, George Roberts—worked to improve margins and significantly reduce working capital.  Return on assets at Teledyne was greater than 20 percent in the 1970s and 1980s.  Charlie Munger calls these results from Teledyne ‘miles higher than anybody else… utterly ridiculous.’  This high profitability generated a great deal of excess cash, which was sent to Singleton to allocate.

Starting in 1972, Singleton started buying back Teledyne stock because it was cheap.  During the next twelve years, Singleton repurchased over 90 percent of Teledyne’s stock.  Keep in mind that in the early 1970s, stock buybacks were seen as a lack of investment opportunity.  But Singleton realized buybacks were far more tax-efficient than dividends.  And buybacks done when the stock is noticeably cheap create much value.  Whenever the returns from a buyback seemed higher than any alternative use of cash, Singleton repurchased shares.  Singleton spent $2.5 billion on buybacks—an unbelievable amount at the time—at an average P/E multiple of 8.  (When Teledyne issued shares, the average P/E multiple was 25.)

In the insurance portfolios, Singleton invested 77 percent in equities, concentrated on just a few stocks.  His investments were in companies he knew well that had P/E ratios at or near record lows.

In 1986, Singleton started going in the opposite direction:  deconglomerating instead of conglomerating.  He was a pioneer of spinning off various divisions.  And in 1987, Singleton announced the first dividend.

From 1963 to 1990, when Singleton stepped down as chairman, Teledyne produced 20.4 percent compound annual returns versus 8.0 percent for the S&P 500 and 11.6 percent for other major conglomerates.  A dollar invested with Singleton in 1963 would have been worth $180.94 by 1990, nearly ninefold outperformance versus his peers and more than twelvefold outperformance versus the S&P 500.

 

BILL ANDERS AND GENERAL DYNAMICS

In 1989, the Berlin Wall came down and the U.S. defense industry’s business model had to be significantly downsized.  The policy of Soviet containment had become obsolete almost overnight.

General Dynamics had a long history selling major weapons to the Pentagon, including the B-29 bomber, the F-16 fighter plane, submarines, and land vehicles (such as tanks).  The company had diversified into missiles and space systems, as well as nondefense business including Cessna commercial planes.

(General Dynamics logo, via Wikimedia Commons)

When Bill Anders took over General Dynamics in January 1991, the company had $600 million in debt and negative cash flow.  Revenues were $10 billion, but the market capitalization was just $1 billion.  Many thought the company was headed into bankruptcy.  It was a turnaround situation.

Anders graduated from the Naval Academy in 1955 with an electrical engineering degree.  He was an airforce fighter pilot during the Cold War.  In 1963 he earned a master’s degree in nuclear engineering and was chosen to join NASA’s elite astronaut corps.  Thorndike writes:

As the lunar module pilot on the 1968 Apollo 8 mission, Anders took the now-iconic Earthrise photograph, which eventually appeared on the covers of Time, Life, and American Photography.

Anders was a major general when he left NASA.  He was made the first chairman of the Nuclear Regulatory Commission.  Then he served as ambassador to Norway.  After that, he worked at General Electric and was trained in their management approach.  In 1984, Anders was hired to run the commercial operations of Textron Corporation.  He was not impressed with the mediocre businesses and the bureaucratic culture.  In 1989, he was invited to join General Dynamics as vice-chairman for a year before becoming CEO.

Anders realized that the defense industry had a great deal of excess capacity after the end of the Cold War.  Following Welch’s approach, Anders concluded that General Dynamics should only be in businesses where it was number one or two.  General Dynamics would stick to businesses it knew well.  And it would exit businesses that didn’t meet these criteria.

Anders also wanted to change the culture.  Instead of an engineering focus on ‘larger, faster, more lethal’ weapons, Anders wanted a focus on metrics such as return on equity (ROE).  Anders concluded that maximizing shareholder returns should be the primary business goal.  To help streamline operations, Anders hired Jim Mellor as president and COO.  In the first half of 1991, Anders and Mellor replaced twenty-one of the top twenty-five executives.

Anders then proceeded to generate $5 billion in cash through the sales of noncore businesses and by a significant improvement in operations.  Anders and Mellor created a culture focused on maximizing shareholder returns.  Anders sold most of General Dynamics’ businesses.  He also sought to grow the company’s largest business units through acquisition.

When Anders went to acquire Lockheed’s smaller fighter plane division, he met with a surprise:  Lockheed’s CEO made a high counteroffer for General Dynamics’ F-16 business.  Because the fighter plane division was a core business for General Dynamics—not to mention that Anders was a fighter pilot and still loved to fly—this was a crucial moment for Anders.  He agreed to sell the business on the spot for a very high price of $1.5 billion.  Anders’ decision was rational in the context of maximizing shareholder returns.

With the cash pile growing, Anders next decided not to make additional acquisitions, but to return cash to shareholders.  First he declared three special dividends—which, because they were deemed ‘return of capital,’ were not subject to capital gains or ordinary income taxes.  Next, Anders announced an enormous $1 billion tender offer for 30 percent of the company’s stock.

A dollar invested when Anders took the helm would have been worth $30 seventeen years later.  That same dollar would have been worth $17 if invested in an index of peer companies and $6 if invested in the S&P.

 

JOHN MALONE AND TCI

While at McKinsey, John Malone came to realize how attractive the cable television business was.  Revenues were very predictable.  Taxes were low.  And the industry was growing very fast.  Malone decided to build a career in cable.

Malone’s father was a research engineer and his mother a former teacher.  Malone graduated from Yale with degrees in economics and electrical engineering.  Then Malone earned master’s and PhD degrees in operations research from Johns Hopkins.

Malone’s first job was at Bell Labs, the research arm of AT&T.  After a couple of years, he moved to McKinsey Consulting.  In 1970, a client, General Instrument, offered Malone the chance to run its cable television equipment division.  He jumped at the opportunity.

After a couple of years, Malone was sought by two of the largest cable companies, Warner Communications and Tele-Communications Inc. (TCI).  Malone chose TCI.  Although the salary would be 60 percent lower, he would get more equity at TCI.  Also, he and his wife preferred Denver to Manhattan.

(TCI logo, via Wikimedia Commons)

The industry had excellent tax characteristics:

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction.  These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows.  If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.

Just after Malone took over as CEO of TCI in 1973, the 1973-1974 bear market left TCI in a dangerous position.  The company was on the edge of bankruptcy due to its very high debt levels.  Malone spent the next few years meeting with bankers and lenders to keep the company out of bankruptcy.  Also during this time, Malone instituted new discipline in operations, which resulted in a frugal, entrepreneurial culture.  Headquarters was austere.  Executives stayed together in motels while on the road.

Malone depended on COO J. C. Sparkman to oversee operations, while Malone focused on capital allocation.  TCI ended up having the highest margins in the industry as a result.  They earned a reputation for underpromising and overdelivering.

In 1977, the balance sheet was in much better shape.  Malone had learned that the key to creating value in cable television was financial leverage and leverage with suppliers (especially programmers).  Both types of leverage improved as the company became larger.  Malone had unwavering commitment to increasing the company’s size.

The largest cost in a cable television system is fees paid to programmers (HBO, MTV, ESPN, etc.).  Larger cable operators can negotiate lower programming costs per subscriber.  The more subscribers the cable company has, the lower its programming cost per subscriber.  This led to a virtuous cycle:

[If] you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on… no one else at the time pursued scale remotely as aggressively as Malone and TCI.

Malone also focused on minimizing reported earnings (and thus taxes).  At the time, this was highly unconventional since most companies focused on earnings per share.  TCI gained an important competitive advantage by minimizing earnings and taxes.  Terms like EBITDA were introduced by Malone.

Between 1973 and 1989, the company made 482 acquisitions.  The key was to maximize the number of subscribers.  (When TCI’s stock dropped, Malone repurchased shares.)

By the late 1970s and early 1980s, after the introduction of satellite-delivered channels such as HBO and MTV, cable television went from primarily rural customers to a new focus on urban markets.  The bidding for urban franchises quickly overheated.  Malone avoided the expensive urban franchise wars, and stayed focused on acquiring less expensive rural and suburban subscribers.  Thorndike:

When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost.

Malone also established various joint ventures, which led to a number of cable companies in which TCI held a minority stake.  Over time, Malone created a great deal of value for TCI by investing in young, talented entrepreneurs.

From 1973 to 1998, TCI shareholders enjoyed a compound annual return of 30.3 percent, compared to 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500.  A dollar invested in TCI at the beginning was worth over $900 by mid-1998.  The same dollar was worth $180 if invested in other publicly traded cable companies and $22 if invested in the S&P 500.

Malone never used spreadsheets.  He looked for no-brainers that could be understood with simple math.  Malone also delayed capital expenditures, generally until the economic viability of the investment had been proved.  When it came to acquisitions—of which there were many—Malone would only pay five times cash flow.

 

KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY

Katharine Graham was the daughter of financier Eugene Meyer.  In 1940, she married Philip Graham, a brilliant lawyer.  Meyer hired Philip Graham to run The Washington Post Company in 1946.  He did an excellent job until his tragic suicide in 1963.

(The Washington Post logo, via Wikimedia Commons)

Katharine was unexpectedly thrust into the CEO role.  At age forty-six, she had virtually no preparation for this role and she was naturally shy.  But she ended up doing an amazing job.  From 1971 to 1993, the compound annual return to shareholders was 22.3 percent versus 12.4 percent for peers and 7.4 percent for the S&P 500.  A dollar invested in the IPO was worth $89 by the time she retired, versus $5 for the S&P and $14 for her peer group.  These are remarkable margins of outperformance.

After a few years of settling into the new role, she began to take charge.  In 1967, she replaced longtime editor in chief Russ Wiggins with the brash Ben Bradlee, who was forty-four years old.

In 1971, she took the company public to raise capital for acquisitions.  This was what the board had recommended.  At the same time, the newspaper encountered the Pentagon Papers crisis.  The company was going to publish a highly controversial (and negative) internal Pentagon opinion of the war in Vietnam that a court had barred the New York Times from publishing.  The Nixon administration threatened to challenge the company’s broadcast licenses if it published the report:

Such a challenge would have scuttled the stock offering and threatened one of the company’s primary profit centers.  Graham, faced with unclear legal advice, had to make the decision entirely on her own.  She decided to go ahead and print the story, and the Post’s editorial reputation was made.  The Nixon administration did not challenge the TV licenses, and the offering, which raised $16 million, was a success.

In 1972, with Graham’s full support, the paper began in-depth investigations into the Republican campaign lapses that would eventually become the Watergate scandal.  Bradlee and two young investigative reporters, Carl Bernstein and Bob Woodward, led the coverage of Watergate, which culminated with Nixon’s resignation in the summer of 1974.  This led to a Pulitzer for the Post—one of an astonishing eighteen during Bradlee’s editorship—and established the paper as the only peer of the New York Times.  All during the investigation, the Nixon administration threatened Graham and the Post.  Graham firmly ignored them.

In 1974, an unknown investor eventually bought 13 percent of the paper’s shares.  The board advised Graham not to meet with him.  Graham ignored the advice and met the investor, whose name was Warren Buffett.  Buffett quickly became Graham’s business mentor.

In 1975, the paper faced a huge strike led by the pressmen’s union.  Graham, after consulting Buffett and the board, decided to fight the strike.  Graham, Bradlee, and a very small crew managed to get the paper published for 139 consecutive days.  Then the pressmen finally agreed to concessions.  These concessions led to significantly improved profitability for the paper.  It was also the first time a major city paper had broken a strike.

Also on advice from Buffett, Graham began aggressively buying back stock.  Over the next few years, she repurchased nearly 40 percent of the company’s stock at very low prices (relative to intrinsic value).  No other major papers did so.

In 1981, the Post’s rival, the Washington Star, ceased publication.  This allowed the Post to significantly increase circulation.  At the same time, Graham hired Dick Simmons as COO.  Simmons successfully lowered costs and improved profits.  Simmons also emphasized bonus compensation based on performance relative to peer newspapers.

In the early 1980s, the Post spent years not acquiring any companies, even though other major newspapers were making more deals than ever.  Graham was criticized, but stuck to her financial discipline.  In 1983, however, after extensive research, the Post bought cellular telephone businesses in six major markets.  In 1984, the Post acquired the Stanley Kaplan test prep business.  And in 1986, the paper bought Capital Cities’ cable television assets for $350 million.  All of these acquisitions would prove valuable for the Post in the future.

In 1988, Graham sold the paper’s telephone assets for $197 million, a very high return on investment.  Thorndike continues:

During the recession of the early 1990s, when her overleveraged peers were forced to the sidelines, the company became uncharacteristically acquisitive, taking advantage of dramatically lower prices to opportunistically purchase cable television systems, underperforming TV stations, and a few education businesses.

When Kay Graham stepped down as chairman in 1993, the Post Company was by far the most diversified among its major newspaper peers, earning almost half its revenues and profits from non-print sources.  This diversification would position the company for further outperformance under her son Donald’s leadership.

 

BILL STIRITZ AND RALSTON PURINA

Bill Stiritz was at Ralston seventeen years before becoming CEO at age forty-seven.

This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent.  When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries.

(Purina logo, via Wikimedia Commons)

Stiritz attended the University of Arkansas for a year but then joined the navy for four years.  While in the navy, he developed his poker skills enough so that poker eventually would pay for his college tuition.  Stiritz completed his undergraduate degree at Northwestern, majoring in business.  (In his mid-thirties, he got a master’s degree in European history from Saint Louis University.)

Stiritz first worked at the Pillsbury Company as a field rep putting cereal on store shelves.  He was promoted to product manager and he learned about consumer packaged goods (CPG) marketing.  Wanting to understand advertising and media better, he started working two years later at the Gardner Advertising agency in St. Louis.  He focused on quantitative approaches to marketing such as the new Nielsen ratings service, which gave a detailed view of market share as a function of promotional spending.

In 1964, Stiritz joined Ralston Purina in the grocery products division (pet food and cereals).  He became general manager of the division in 1971.  While Stiritz was there, operating profits increased fiftyfold due to new product introductions and line extensions.  Thorndike:

Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry.  For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament.

Thorndike continues:

On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company.  He fully appreciated the exceptionally attractive economics of the company’s portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements.  He immediately began to remove the underpinnings of his predecessor’s strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns.

After a number of divestitures, Ralston was a pure branded products company.  In the early 1980s, Stiritz began repurchasing stock aggressively.  No other major branded products company was repurchasing stock at that time.

Stiritz then bought Continental Baking, the maker of Twinkies and Wonder Bread.  He expanded distribution, cut costs, introduced new products, and increased cash flow materially, creating much value for shareholders.

Then in 1986, Stiritz bought the Energizer Battery division from Union Carbide for $1.5 billion.  The business had been a neglected operation at Union Carbide.  Stiritz thought it was undermanaged and also part of a growing duopoly market.

By the late 1980s, almost 90 percent of Ralston’s revenues were from consumer packaged goods.  Pretax profit margins increased from 9 to 15 percent.  ROE went from 15 to 37 percent.  Since the share base was reduced by aggressive buybacks, earnings and cash flow per share increased dramatically.  Stiritz continued making very careful acquisitions and divestitures, with each decision based on an in-depth analysis of potential returns for shareholders.

Stiritz also began spinning off some businesses he thought were not receiving the attention they deserved—either internally or from Wall Street.  Spin-offs not only can highlight the value of certain business units.  Spin-offs also allow the deferral of capital gains taxes.

Finally, Stiritz sold Ralston itself to Nestle for $10.4 billion, or fourteen times cash flow.  This successfully concluded Stiritz’ career at Ralston.  A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later.  The compound return was 20.0 percent versus 17.7 percent for peers and 14.7 percent for the S&P 500.

Stiritz didn’t like the false precision of detailed financial models.  Instead, he focused only on the few key variables that mattered, including growth and competitive dynamics.  When Ralston bought Energizer, Stiritz and his protégé Pat Mulcahy, along with a small group, took a look at Energizer’s books and then wrote down a simple, back of the envelope LBO model.  That was it.

Since selling Ralston, Stiritz has energetically managed an investment partnership made up primarily of his own capital.

 

DICK SMITH AND GENERAL CINEMA

In 1922, Phillip Smith borrowed money from friends and family, and opened a theater in Boston’s North End.  Over the next forty years, Smith built a successful chain of theaters.  In 1961, Phillip Smith took the company public to raise capital.  But in 1962, Smith passed away.  His son, Dick Smith, took over as CEO.  He was thirty-seven years old.

(General Cinema logo, via Wikimedia Commons)

Dick Smith demonstrated a high degree of patience in using the company’s cash flow to diversify away from the maturing drive-in movie business.

Smith would alternate long periods of inactivity with the occasional very large transaction.  During his tenure, he would make three significant acquisitions (one in the late 1960s, one in the mid-1980s, and one in the early 1990s) in unrelated businesses:  soft drink bottling (American Beverage Company), retailing (Carter Hawley Hale), and publishing (Harcourt Brace Jovanovich).  This series of transactions transformed the regional drive-in company into an enormously successful consumer conglomerate.

Dick Smith later sold businesses that he had earlier acquired.  His timing was extraordinarily good, with one sale in the late 1980s, one in 2003, and one in 2006.  Thorndike writes:

This accordion-like pattern of expansion and contraction, of diversification and divestiture, was highly unusual (although similar in some ways to Henry Singleton’s at Teledyne) and paid enormous benefits for General Cinema’s shareholders.

Smith graduated from Harvard with an engineering degree in 1946.  He worked as a naval engineer during World War II.  After the war, he didn’t want an MBA.  He wanted to join the family business.  In 1956, Dick Smith’s father made him a full partner.

Dick Smith recognized before most others that suburban theaters were benefitting from strong demographic trends.  This led him to develop two new practices.

First, it had been assumed that theater owners should own the underlying land.  But Smith realized that a theater in the right location could fairly quickly generate predictable cash flow.  So he pioneered lease financing for new theaters, which significantly reduced the upfront investment.

Second, he added more screens to each theater, thereby attracting more people, who in turn bought more high-margin concessions.

Throughout the 1960s and into the early 1970s, General Cinema was getting very high returns on its investment in new theaters.  But Smith realized that such growth was not likely to continue indefinitely.  He started searching for new businesses with better long-term prospects.

In 1968, Smith acquired the American Beverage Company (ABC), the largest, independent Pepsi bottler in the country.  Smith knew about the beverage business based on his experience with theater concessions.  Smith paid five times cash flow and it was a very large acquisition for General Cinema at the time.  Thorndike notes:

Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands.  Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends.  He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second- and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a smaller number of large independents).  Because Pepsi was the number two brand, its franchises often traded at lower valuations than Coke’s.

ABC was a platform companyother companies could be added easily and efficiently.  Smith could buy new franchises at seemingly high multiples of the seller’s cash flow and then quickly reduce the effective price through reducing expenses, minimizing taxes, and improving marketing.  So Smith acquired other franchises.

Due to constant efforts to reduce costs by Smith and his team, ABC had industry-leading margins.  Soon thereafter, ABC invested $20 million to launch Sunkist.  In 1984, Smith sold Sunkist to Canada Dry for $87 million.

Smith sought another large business to purchase.  He made a number of smaller acquisitions in the broadcast media business.  But his price discipline prevented him from buying very much.

Eventually General Cinema bought Carter Hawley Hale (CHH), a retail conglomerate with several department store and specialty retail chains.  Woody Ives, General Cinema’s CFO, was able to negotiate attractive terms:

Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH…

Eventually General Cinema would exchange its 40 percent ownership in CHH shares for a controlling 60 percent stake in the company’s specialty retail division, whose primary asset was the Neiman Marcus chain.  The long-term returns on the company’s CHH investment were an extraordinary 51.2 percent.  The CHH transaction moved General Cinema decisively into retailing, a new business whose attractive growth prospects were not correlated with either the beverage or the theater businesses.

In the late 1980s, Smith noticed that a newly energetic Coke was attacking Pepsi in local markets.  At the same time, beverage franchises were selling for much higher prices as their good economics were more widely recognized.  So Smith sold the bottling business in 1989 to Pepsi for a record price.  After the sale, General Cinema was sitting on $1 billion in cash.  Smith started looking for another diversifying acquisition.

It didn’t take him long to find one.  In 1991, after a tortuous eighteen-month process, Smith made his largest and last acquisition, buying publisher Harcourt Brace Jovanovich (HBJ) in a complex auction process and assembling General Cinema’s final third leg.  HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm.  Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich.  In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders.

General Cinema management concluded, after examining the business, that HBJ would fit their acquisition criteria.  Moreover, General Cinema managers thought HBJ’s complex balance sheet would probably deter other buyers.  Thorndike writes:

After extensive negotiations with the company’s many debt holders, Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time—an enormous bet.  This price equaled a multiple of six times cash flow for HBJ’s core publishing assets, an attractive price relative to comparable transactions (Smith would eventually sell those businesses for eleven times cash flow).

Thorndike continues:

Following the HBJ acquisition in 1991, General Cinema spun off its mature theater business into a separate publicly traded entity, GC Companies (GCC), allowing management to focus its attention on the larger retail and publishing businesses.  Smith and his management team proceeded to operate both the retail and the publishing businesses over the next decade.  In 2003, Smith sold the HBJ publishing assets to Reed Elsevier, and in 2006 he sold Neiman Marcus, the last vestige of the General Cinema portfolio, to a consortium of private equity buyers.  Both transactions set valuation records within their industries, capping an extraordinary run for Smith and General Cinema shareholders.

From 1962 to 1991, Smith had generated 16.1 percent compound annual return versus 9 percent for the S&P 500 and 9.8 percent for GE.  A dollar invested with Dick Smith in 1962 would be worth $684 by 1991.  The same dollar would $43 if invested in the S&P and $60 if invested in GE.

 

WARREN BUFFETT AND BERKSHIRE HATHAWAY

Buffett was first attracted to the old textile mill Berkshire Hathaway because its price was cheap compared to book value.  Thorndike tells the story:

At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization.  From this undistinguished start, unprecedented returns followed;  and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs.  These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares.  Buffett bought his first share of Berkshire for $7;  today it trades for over $120,000 share.  [Value of Berkshire share as of 10/21/18:  $517.2 billion market capitalization, or $314,477 a share]

(Company logo, by Berkshire Hathaway Inc., via Wikimedia Commons)

Buffett was born in 1930 in Omaha, Nebraska.  His grandfather ran a well-known local grocery store.  His father was a stockbroker in downtown Omaha and later a congressman.  Starting at age six, Buffett started various entrepreneurial ventures.  He would buy a 6-pack of Coke for 25 cents and resell each one for 5 cents.  He later had several paper routes and then pinball machines, too.  Buffett attended Wharton, but didn’t feel he could learn much.  So he returned to Omaha and graduated from the University of Nebraska at age 20.

He’d always been interested in the stock market.  But it wasn’t until he was nineteen that he discovered The Intelligent Investor, by Benjamin Graham.  Buffett immediately realized that value investing—as explained by Graham in simple terms—was the key to making money in the stock market.

Buffett was rejected by Harvard Business School, which was a blessing in that Buffett attended Columbia University where Graham was teaching.  Buffett was the star in Graham’s class, getting the only A+ Graham ever gave in more than twenty years of teaching.  Others in that particular course said the class was often like a conversation between Graham and Buffett.

Buffett graduated from Columbia in 1952.  He applied to work for Graham, but Graham turned him down.  At the time, Jewish analysts were having a hard time finding work on Wall Street, so Graham only hired Jewish people.  Buffett returned to Omaha and worked as a stockbroker.

One idea Buffett had tried to pitch while he was a stockbroker was GEICO.  He realized that GEICO had a sustainable competitive advantage:  a permanently lower cost structure because GEICO sold car insurance direct, without agents or branches.  Buffett had trouble convincing clients to buy GEICO, but he himself loaded up in his own account.

Meanwhile, Buffett regularly mailed investment ideas to Graham.  After a couple of years, in 1954, Graham hired Buffett.

In 1956, Graham dissolved the partnership to focus on other interests.  Buffett returned to Omaha and launched a small investment partnership with $105,000 under management.  Buffett himself was worth $140,000 at the time (over $1 million today).

Over the next thirteen years, Buffett crushed the market averages.  Early on, he was applying Graham’s methods by buying stocks that were cheap relative to net asset value.  But in the mid-1960s, Buffett made two large investments—in American Express and Disney—that were based more on normalized earnings than net asset value.  This was the beginning of a transition Buffett made from buying statistically cheap cigar butts to buying higher quality companies.

  • Buffett referred to deep value opportunities—stocks bought far below net asset value—as cigar butts. Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.”  Such a cigar butt is disgusting, but that one puff is “all profit.”

Buffett started acquiring shares in Berkshire Hathaway—a cigar butt—in 1965.  In the late 1960s, Buffett was having trouble finding cheap stocks, so he closed down the Buffett partnership.

After getting control of Berkshire Hathaway, Buffett put in a new CEO, Ken Chace.  The company generated $14 million in cash as Chace reduced inventories and sold excess plants and equipment.  Buffett used most of this cash to acquire National Indemnity, a niche insurance company.  Buffett invested National Indemnity’s float quite well, buying other businesses like the Omaha Sun, a weekly newspaper, and a bank in Rockford, Illinois.

During this period, Buffett met Charlie Munger, another Omaha native who was then a brilliant lawyer in Los Angeles.  Buffett convinced Munger to run his own investment partnership, which he did with excellent results.  Later on, Munger became vice-chairman at Berkshire Hathaway.

Partly by reading the works of Phil Fisher, but more from Munger’s influence, Buffett realized that a wonderful company at a fair price was better than a fair company at a wonderful price.  A wonderful company would have a sustainably high ROIC, which meant that its intrinsic value would compound over time.  In order to estimate intrinsic value, Buffett now relied more on DCF (discounted cash flow) and private market value—methods well-suited to valuing good businesses (often at fair prices)—rather than an estimate of liquidation value—a method well-suited to valuing cigar butts (mediocre businesses at cheap prices).

In the 1970s, Buffett and Munger invested in See’s Candies and the Buffalo News.  And they bought large stock positions in the Washington Post, GEICO, and General Foods.

In the first half of the 1980s, Buffett bought the Nebraska Furniture Mart for $60 million and Scott Fetzer, a conglomerate of niche industrial businesses, for $315 million.  In 1986, Buffett invested $500 million helping his friend Tom Murphy, CEO of Capital Cities, acquire ABC.

Buffett then made no public market investments for several years.  Finally in 1989, Buffett announced that he invested $1.02 billion, a quarter of Berkshire’s investment portfolio, in Coca-Cola, paying five times book value and fifteen times earnings.  The return on this investment over the ensuing decade was 10x.

(Coca-Cola Company logo, via Wikimedia Commons)

Also in the late 1980s, Buffett invested in convertible preferred securities in Salomon Brothers, Gillette, US Airways, and Champion Industries.  The dividends were tax-advantaged, and he could convert to common stock if the companies did well.

In 1991, Salomon Brothers was in a major scandal based on fixing prices in government Treasury bill auctions.  Buffett ended up as interim CEO for nine months.  Buffett told Salomon employees:

“Lose money for the firm and I will be understanding.  Lose even a shred of reputation for the firm, and I will be ruthless.”

In 1996, Salomon was sold to Sandy Weill’s Travelers Corporation for $9 billion, which was a large return on investment for Berkshire.

In the early 1990s, Buffett invested—taking large positions—in Wells Fargo (1990), General Dynamics (1992), and American Express (1994).  In 1996, Berkshire acquired the half of GEICO it didn’t own.  Berkshire also purchased the reinsurer General Re in 1998 for $22 billion in Berkshire stock.

In the late 1990s and early 2000s, Buffett bought a string of private companies, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes.  He also invested in the electric utility industry through MidAmerican Energy.  In 2006, Berkshire announced its first international acquisition, a $5 billion investment in Iscar, an Israeli manufacturer of cutting tools and blades.

In early 2010, Berkshire purchased the nation’s largest railroad, the Burlington Northern Santa Fe, for $34.2 billion.

From June 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company’s shares increased at a compound rate of 20.7 percent compared to 9.3 percent for the S&P 500.  A dollar invested in Berkshire was worth $6,265 forty-five years later.  The same dollar invested in the S&P 500 was worth $62.

The Nuts and Bolts

Having learned from Murphy, Buffett and Munger created Berkshire to be radically decentralized.  Business managers are given total autonomy over everything except large capital allocation decisions.  Buffett makes the capital allocation decisions, and Buffett is an even better investor than Henry Singleton.

Another key to Berkshire’s success is that the insurance and reinsurance operations are profitable over time, and meanwhile Buffett invests most of the float.  Effectively, the float has an extremely low cost (occasionally negative) because the insurance and reinsurance operations are profitable.  Buffett always reminds Berkshire shareholders that hiring Ajit Jain to run reinsurance was one of the best investments ever for Berkshire.

As mentioned, Buffett is in charge of capital allocation.  He is arguably the best investor ever based on the longevity of his phenomenal track record.

Buffett and Munger have always believed in concentrated portfolios.  It makes sense to take very large positions in your best ideas.  Buffett invested 40 percent of the Buffett partnership in American Express after the salad oil scandal in 1963.  In 1989, Buffett invested 25 percent of the Berkshire portfolio—$1.02 billion—in Coca-Cola.

Buffett and Munger still have a very concentrated portfolio.  But sheer size requires them to have more positions than before.  It also means that they can no longer look at most companies, which are too small to move the needle.

Buffett and Munger also believe in holding their positions for decades.  Over time, this saves a great deal of money by minimizing taxes and transaction costs.

Thorndike:

Buffett’s approach to investor relations is also unique and homegrown.  Buffett estimates that the average CEO spends 20 percent of his time communicating with Wall Street.  In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance.  He prefers to communicate with his investors through detailed annual reports and meetings, both of which are unique.

… The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship.

 

 

RADICAL RATIONALITY:  THE OUTSIDER’S MINDSET

You’re neither right nor wrong because other people agree with you.  You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right.  And if your facts and reasoning are right, you don’t have to worry about anybody else. – Warren Buffett

Thorndike sums up the outsider’s mindset:

  • Always Do the Math
  • The Denominator Matters
  • A Feisty Independence
  • Charisma is Overrated
  • A Crocodile-Like Temperament That Mixes Patience with Occasional Bold Action
  • The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
  • A Long-Term Perspective

Always Do the Math

The outsider CEOs always focus on the ROIC for any potential investment.  They do the analysis themselves just using the key variables and without using a financial model.  Outsider CEOs realize that it’s the assumptions about the key variables that really matter.

The Denominator Matters

The outsider CEOs focus on maximizing value per share.  Thus, the focus is not only on maximizing the numerator—the value—but also on minimizing the denominator—the number of shares.  Outsider CEOs opportunistically repurchase shares when the shares are cheap.  And they are careful when they finance investment projects.

A Feisty Independence

The outsider CEOs all ran very decentralized organizations.  They gave people responsibility for their respective operations.  But outsider CEOs kept control over capital allocation decisions.  And when they did make decisions, outsider CEOs didn’t seek others’ opinions.  Instead, they liked to gather all the information, and then think and decide with as much independence and rationality as possible.

Charisma Is Overrated

The outsider CEOs tended to be humble and unpromotional.  They tried to spend the absolute minimum amount of time interacting with Wall Street.  Outsider CEOs did not offer quarterly guidance and they did not participate in Wall Street conferences.

A Crocodile-Like Temperament That Mixes Patience With Occasional Bold Action

The outsider CEOs were willing to wait very long periods of time for the right opportunity to emerge.

Like Katharine Graham, many of them created enormous shareholder value by simply avoiding overpriced ‘strategic’ acquisitions, staying on the sidelines during periods of acquisition feeding frenzy.

On the rare occasions when there was something to do, the outsider CEOs acted boldly and aggressively.  Tom Murphy made an acquisition of a company (ABC) larger than the one he managed (Capital Cities).  Henry Singleton repeatedly repurchased huge amounts of stock at cheap prices, eventually buying back over 90 percent of Teledyne’s shares.

The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small

The total value that any company creates over time is the cumulative difference between ROIC and the cost of capital.  The outsider CEOs made every capital allocation decision in order to maximize ROIC over time, thereby maximizing long-term shareholder value.

These CEOs knew precisely what they were looking for, and so did their employees.  They didn’t overanalyze or overmodel, and they didn’t look to outside consultants or bankers to confirm their thinking—they pounced.

A Long-Term Perspective

The outsider CEOs would make investments in their business as long as they thought that it would contribute to maximizing long-term ROIC and long-term shareholder value.  The outsiders were always willing to take short-term pain for long-term gain:

[They] disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.

Thorndike notes that the advantage the outsider CEOs had was temperament, not intellect (although they were all highly intelligent).  They understood that what mattered was rationality and patience.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

A Few Lessons from Sherlock Holmes

(Image:  Zen Buddha Silence by Marilyn Barbone.)

July 31, 2022

Peter Bevelin is the author of the great book, Seeking Wisdom: From Darwin to Munger.  I wrote about this book here: http://boolefund.com/seeking-wisdom/

Bevelin also wrote a shorter book, A Few Lessons from Sherlock Holmes.  I’m a huge fan of Sherlock Holmes.  Robert Hagstrom has written an excellent book on Holmes called The Detective and the Investor.  Here’s my summary of Hagstrom’s book: http://boolefund.com/invest-like-sherlock-holmes/

I highly recommend Hagstrom’s book.  But if you’re pressed for time, Bevelin’s A Few Lessons from Sherlock Holmes is worth reading.

Belevin’s book is a collection of quotations.  Most of the quotes are from Holmes, but there are also quotes from others, including:

    • Joseph Bell, a Scottish professor of clinical surgery who was Arthur Conan Doyle’s inspiration for Sherlock Holmes
    • Dr. John Watson, Holmes’s assistant
    • Dr. John Evelyn Thorndike, a fictional detective and forensic scientist  in stories by R. Austin Freeman
    • Claude Bernard, a French physiologist
    • Charles Darwin, the English naturalist
    • Thomas McRae, an American professor of medicine and colleague of Sir William Osler
    • Michel de Montaigne, a French statesman and philosopher
    • William Osler, a Canadian physician
    • Oliver Wendell Holmes, Sr., an American physician and author

Sherlock Holmes:

Life is infinitely stranger than anything which the mind of man could invent.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Here’s an outline for this blog post:

    • Some Lessons
    • On Solving a Case—Observation and Inference
    • Observation—Start with collecting facts and follow them where they lead
    • Deduction—What inferences can we draw from our observations and facts?
    • Test Our Theory—If it disagrees with the facts it is wrong
    • Some Other Tools

 

SOME LESSONS

Bevelin quotes the science writer Martin Gardner on Sherlock Holmes:

Like the scientist trying to solve a mystery of nature, Holmes first gathered all the evidence he could that was relevant to his problem.  At times, he performed experiments to obtain fresh data.  He then surveyed the total evidence in the light of his vast knowledge of crime, and/or sciences relevant to crime, to arrive at the most probable hypothesis.  Deductions were made from the hypothesis; then the theory was further tested against new evidence, revised if need be, until finally the truth emerged with a probability approaching certainty.

Bevelin quotes Holmes on the qualities needed to be a good detective:

He has the power of observation and that of deduction.  He is only wanting in knowledge, and that may come in time.

It’s important to take a broad view.  Holmes:

One’s ideas must be as broad as Nature if they are to interpret Nature.

However, focus only on what is useful.  Bevelin quotes Dr. Joseph Bell:

He [Doyle] created a shrewd, quick-sighted, inquisitive man… with plenty of spare time, a retentive memory, and perhaps with the best gift of all—the power of unloading the mind of all burden of trying to remember unnecessary details.

Knowledge of human nature is obviously important.  Holmes:

Human nature is a strange mixture, Watson.  You see that even a villain and murderer can inspire such affection that his brother turns to suicide when he learns his neck is forfeited.

Holmes again:

Jealousy is a strange transformer of characters.

Bevelin writes that the most learned are not the wisest.  Knowledge doesn’t automatically make us wise.  Bevelin quotes Montaigne:

Judgment can do without knowledge but not knowledge without judgment.

Learning is lifelong.  Holmes:

Like all other arts, the Science of Deduction and Analysis is one which can only be acquired by long and patient study, nor is life long enough to allow any mortal to attain the highest possible perfection in it.

Interior view of the famous The Sherlock Holmes Museum on Nov. 14, 2015 in London

 

ON SOLVING A CASE—Observation and Inference

Bevelin quotes Dr. John Evelyn Thorndyke, a fictional detective in stories by R. Austin Freeman:

…I make it a rule, in all cases, to proceed on the strictly classical lines on inductive inquiry—collect facts, make hypotheses, test them and seek for verification.  And I always endeavour to keep a perfectly open mind.

Holmes:

We approached the case… with an absolutely blank mind, which is always an advantage.  We had formed no theories.  We were there simply to observe and to draw inferences from our observations.

Appearances can be deceiving.  If someone is likeable, that can cloud one’s judgment.  If someone is not likeable, that also can be misleading.  Holmes:

It is of the first importance… not to allow your judgment to be biased by personal qualities… The emotional qualities are antagonistic to clear reasoning.  I can assure you that the most winning woman I ever knew was hanged for poisoning three little children for their insurance-money, and the most repellant man of my acquaintence is a philanthropist who has spent nearly a quarter of a million on the London poor.

Holmes talking to Watson:

You remember that terrible murderer, Bert Stevens, who wanted us to get him off in ’87?  Was there ever a more mild-mannered, Sunday-school young man?

 

OBSERVATION—Start with collecting facts and follow them where they lead

Bevelin quotes Thomas McCrae, an American professor of medicine and colleague of Sir William Osler:

More is missed by not looking than not knowing.

That said, to conduct an investigation one must have a working hypothesis.  Bevelin quotes the French physiologist Claude Bernard:

A hypothesis is… the obligatory starting point of all experimental reasoning.  Without it no investigation would be possible, and one would learn nothing:  one could only pile up barren observations.  To experiment without a preconceived idea is to wander aimlessly.

(Charles Darwin, Photo by Maull and Polyblank (1855), via Wikimedia Commons)

Bevelin also quotes Charles Darwin:

About thirty years ago there was much talk that geologists ought only to observe and not theorise; and I well remember someone saying that at this rate a man might as well go into a gravel-pit and count the pebbles and describe the colors.  How odd it is that anyone should not see that all observation must be for or against some view if it is to be of any service!

Holmes:

Let us take that as  a working hypothesis and see what it leads us to.

It’s crucial to make sure one has the facts clearly in mind.  Bevelin quotes the French statesman and philosopher Montaigne:

I realize that if you ask people to account for “facts,” they usually spend more time finding reasons for them than finding out whether they are true…

Deception, writes Bevelin, has many faces.  Montaigne again:

If falsehood, like truth, had only one face, we would be in better shape.  For we would take as certain the opposite of what the liar said.  But the reverse of truth has a hundred thousand shapes and a limitless field.

Consider why someone might be lying.  Holmes:

Why are they lying, and what is the truth which they are trying so hard to conceal?  Let us try, Watson, you and I, if we can get behind the lie and reconstruct the truth.

It’s often not clear—especially near the beginning of an investigation—what’s relevant and what’s not.  Nonetheless, it’s vital to try to focus on what’s relevant because otherwise one can get bogged down by unnecessary detail.  Holmes:

The principal difficulty in your case… lay in the fact of their being too much evidence.  What was vital was overlaid and hidden by what was irrelevant.  Of all the facts which were presented to us we had to pick just those which we deemed to be essential, and then piece them together in order, so as to reconstruct this very remarkable chain of events.

Holmes again:

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital.  Otherwise your energy and attention must be dissipated instead of being concentrated.

Bevelin quotes the Canadian physician William Osler:

The value of experience is not in seeing much, but in seeing wisely.

Observation is a skill one must develop.  Most of us are not observant.  Holmes:

The world is full of obvious things which nobody by any chance ever observes.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Holmes again:

I see no more than you, but I have trained myself to notice what I see.

Small things can have the greatest importance.  Several quotes from Holmes:

    • The smallest point may be the most essential.
    • It has long been an axiom of mine that the little things are infinitely the most important.
    • What seems strange to you is only so because you do not follow my train of thought or observe the small facts upon which large inferences may depend.
    • It is just these very simple things which are extremely liable to be overlooked.
    • Never trust general impressions, my boy, but concentrate yourself upon details.

Belevin also quotes Dr. Joseph Bell:

I always impressed over and over again upon all my scholars—Conan Doyle among them—the vast importance of little distinctions, the endless significance of trifles.

Belevin points out that it’s easy to overlook relevant facts.  It’s important always to ask if one has overlooked something.

 

DEDUCTION—What inferences can we draw from our observations and facts?

Most people reason forward, predicting what will happen next.  But few people reason backward, inferring the causes of the effects one has observed.  Holmes:

Most people, if you describe a chain of events to them, will tell you what the result would be.  They can put those events together in their minds, and argue from them that something will come to pass.  There are few people, however, who, if you told them a result, would be able to evolve from their own inner consciousness what the steps were which led up to that result.  This power is what I mean when I talk of reasoning backward, or analytically.

Often the solution is simple.  Holmes:

The case has been an interesting one… because it serves to show very clearly how simple the explanation may be of an affair which at first sight seems to be almost inexplicable.

History frequently repeats.  Holmes:

They lay all the evidence before me, and I am generally able, by the help of my knowledge of the history of crime, to set them straight.  There is a strong family resemblance about misdeeds, and if you have all the details of a thousand at your finger ends, it is odd if you can’t unravel  the thousand and first.

Holmes:

There is nothing new under the sun.  It has all been done before.

That said, some cases are unique and different to an extent.  But bizarre cases tend to be easier to solve.  Holmes:

As a rule… the more bizarre a thing is the less mysterious it proves to be.  It is your commonplace, featureless crimes which are really puzzling, just as a commonplace face is the most difficult to identify.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Holmes again:

It is a mistake to confound strangeness with mystery.  The most commonplace crime is often the most mysterious, because it presents no new or special features from which deductions may be drawn.

If something we expect to see doesn’t happen, that in itself can be a clue.  There was one case of a race horse stolen during the night.  When Holmes gathered evidence, he learned that the dog didn’t bark.  This means the midnight visitor must have been someone the dog knew well.

Moreover, many seemingly isolated facts could provide a solution if they are taken together.  Holmes:

You see all these isolated facts, together with many minor ones, all pointed in the same direction.

After enough facts have been gathered, then one can consider each possible hypothesis one at a time.  In practice, there are many iterations:  new facts are discovered along the way, and new hypotheses are constructed.  By carefully excluding each hypothesis that is not possible, eventually one can deduce the hypothesis that is true.  Holmes:

That process… starts upon the supposition that when you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.  It may well be that several explanations remain, in which case one tries test after test until one or other of them has a convincing amount of support.

 

TEST OUR THEORY—If it disagrees with the facts it is wrong

What seems obvious can be very misleading.  Holmes:

There is nothing more deceptive than an obvious fact.

“Truth is stranger than fiction,” said Mark Twain.  Holmes:

Life is infinitely stranger than anything which the mind of many could invent.

Holmes again:

One should always look for a possible alternative and provide against it.  It is the first rule of criminal investigation.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

It’s vital to take time to think things through.  Watson:

Sherlock Holmes was a man… who, when he had an unsolved problem upon his mind, would go for days, and even for a week, without rest, turning it over, rearranging his facts, looking at it from every point of view until he had either fathomed it or convinced himself that his data were insufficient.

Sometimes doing nothing—or something else—is best when one is waiting for more evidence.  Holmes:

I gave my mind a thorough rest by plunging into a chemical analysis.  One of our greatest statesmen has said that a change of work is the best rest.  So it is.

 

SOME OTHER TOOLS

Bevelin observes the importance of putting oneself in another’s shoes.  Holmes:

You’ll get results, Inspector, by always putting yourself in the other fellow’s place, and thinking what you would do yourself.  It takes some imagination, but it pays.

Others may be of help.  Holmes:

If you will find the facts, perhaps others may find the explanation.

Watson was a great help to Holmes.  Watson:

I was a whetstone for his mind.  I stimulated him.  He liked to think aloud in my presence.  His remarks could hardly be said to be made to me—many of them would have been as appropriately addressed to his bedstead—but nonetheless, having formed the habit, it had become in some way helpful that I should register and interject.  If I irritated him by a certain methodical slowness in my mentality, that irritation served only to make his own flame-like intuitions and impressions flash up the more vividly and swiftly.  Such was my humble role in our alliance.

(Illustration of Sherlock Holmes and John Watson by Sidney Paget, via Wikimedia Commons)

Different lines of thought can approximate the truth.  Bevelin quotes Dr. Joseph Bell:

There were two of us in the hunt, and when two men set out to find a golf ball in the rough, they expect to come across it where the straight lines marked in their minds’ eye to it, from their original positions, crossed.  In the same way, when two men set out to investigate a crime mystery, it is where their researches intersect that we have a result.

Holmes makes the same point:

Now we will take another line of reasoning.  When you follow two separate chains of thought, Watson, you will find some point of intersection which should approximate to the truth.

It’s essential to be open to contradictory evidence.  Bevelin quotes Charles Darwin:

I have steadily endeavoured to keep my mind free so as to give up any hypothesis, however much beloved… as soon as facts are shown to be opposed to it.

Mistakes are inevitable.  Holmes:

Because I made a blunder, my dear Watson—which is, I am afraid, a more common occurrence than anyone would think who only knew me through your memoirs.

Holmes remarks that every mortal makes mistakes.  But the best are able to recognize their mistakes and take corrective action:

Should you care to add the case to your annals, my dear Watson… it can only be as an example of that temporary eclipse to which even the best-balanced mind may be exposed.  Such slips are common to all mortals, and the greatest is he who can recognize and repair them.

Bevelin quotes the physician Oliver Wendell Holmes, Sr.:

The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins.

(Oliver Wendell Holmes, Sr., via Wikimedia Commons)

In the investment world, the great investors Warren Buffett and Charlie Munger use the term circle of competence.  Here’s Buffett:

What an investor needs is the ability to correctly evaluate selected businesses.  Note that word “selected”:  You don’t have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.

Buffett again:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Munger:

Knowing what you don’t know is more useful than being brilliant.

Finally, here’s Tom Watson, Sr., the founder of IBM:

I’m no genius.  I’m smart in spots—but I stay around those spots.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.