Buffett’s Best: Microcap Cigar Butts

March 19, 2023

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.

There’s Always Something to Do

March 5, 2023

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.

The Outsiders: Radically Rational CEOs

February 26, 2023

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.

The Best Way to Build Wealth

February 12, 2023

The best way to build wealth is through long-term investing.  The more wealth you have, the more freedom you have to achieve your goals in life.

A smart long-term investment for many investors is an S&P 500 index fund.  It’s just basic arithmetic, as Jack Bogle and Warren Buffett frequently point out: http://boolefund.com/warren-buffett-jack-bogle/

But you can get much higher returns—at least 18% per year (instead of 10% per year)—by investing in cheap, solid microcap stocks.

Because most professional investors have large assets under management, they cannot even consider investing in microcap stocks.  That’s why there continues to be a wonderful opportunity for enterprising investors.  Microcaps are ignored, which causes most of them to become significantly undervalued from time to time.

Warren Buffett obtained the highest returns of his career when he invested primarily in microcap stocks.  Buffett says that he could get 50 percent a year today if he were managing a small enough sum so that he could focus on microcap stocks: http://boolefund.com/buffetts-best-microcap-cigar-butts/

Check out 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—are microcap stocks, which are stocks with market caps below $500 million.  What jumps 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 actuality, the annual returns from microcap stocks will be 1-2% lower because of the cost of entering and exiting positions.  So it’s better to 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.

 

VALUE SCREEN: +2-3%

By consistently applying a value screen—e.g., low EV/EBITDA, low P/E, low P/S, etc.—to a microcap strategy, you can add 2-3% per year.

 

IMPROVING FUNDAMENTALS: +2-3%

You can further increase performance by screening for improving fundamentals.  One powerful 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 implement a simple screen for value, that adds at least 2% a year.  If you then screen for improving fundamentals, that boosts performance by at least another 2% a year.

In brief, if you invest systematically in undervalued microcap stocks with improving fundamentals, you can get at least 18% a year.  That compares quite well to the 10% a year you could get from an S&P 500 index fund.

What’s the difference between 10% a year and 18% a year?  If you invest $100,000 at 10% a year for 30 years, you end up with $1.7 million, which is quite good.  If you invest $100,000 at 18% a year for 30 years, you end up with $14.3 million, which is significantly better.

Please contact me with any questions or comments.

    • 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.  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.

 

 

 

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.

One Up On Wall Street

February 5, 2023

Peter Lynch is one of the great investors.  When Lynch managed Fidelity Magellan from 1977 to 1990, the fund averaged 29.2% per year—more than doubling the annual return of the S&P 500 Index—making it the best performing mutual fund in the world.

In One Up On Wall Street: How to Use What You Already Know to Make Money in the Market (Fireside, 1989 and 2000), Lynch offers his best advice to individual investors.

Lynch explains how to find tenbaggers—stocks that increase by 10x—by looking among stocks that are too small for most professionals.  Lynch also suggests that you pay attention to small businesses you may come across in your daily life.  If you notice a company that seems to be doing well, then you should research its earnings prospects, financial condition, competitive position, and so forth, in order to determine if the stock is a bargain.

Moreover, Lynch notes that his biggest winners—tenbaggers, twentybaggers, and even a few hundredbaggers—typically have taken at least three to ten years to play out.

The main idea is that a stock tracks the earnings of the underlying company over time.  If you can pay a cheap price relative to earnings, and if those earnings increase over subsequent years, then you can get some fivebaggers, tenbaggers, and even better as long as you hold the stock while the story is playing out.

Lynch also writes that being right six out of ten times on average works well over time.  A few big winners will overwhelm the losses from stocks that don’t work out.

Don’t try to time the market.  Focus on finding cheap stocks.  Some cheap stocks do well even when the market is flat or down.  But over the course of many years, the economy grows and the market goes higher.  If you try to dance in and out of stocks, eventually you’ll miss big chunks of the upside.

Here are the sections in this blog post:

    • Introduction: The Advantages of Dumb Money
    • The Making of a Stockpicker
    • The Wall Street Oxymorons
    • Is This Gambling, or What?
    • Personal Qualities It Takes to Succeed
    • Is This a Good Market? Please Don’t Ask
    • Stalking the Tenbagger
    • I’ve Got It, I’ve Got It—What Is It?
    • The Perfect Stock, What a Deal!
    • Stocks I’d Avoid
    • Earnings, Earnings, Earnings
    • The Two-Minute Drill
    • Getting the Facts
    • Some Famous Numbers
    • Rechecking the Story
    • The Final Checklist
    • Designing a Portfolio
    • The Best Time to Buy and Sell

 

INTRODUCTION:  THE ADVANTAGES OF DUMB MONEY

Lynch writes that two decades as a professional investor have convinced him that the ordinary individual investor can do just as well as—if not better than—than the average Wall Street expert.

Dumb money is only dumb when it listens to the smart money.

Lynch makes it clear that if you’ve already invested in a mutual fund with good long-term performance, then sticking with it makes sense.  His point is that if you’ve decided to invest in stocks directly, then it’s possible to do as well as—if not better than—the average professional investor.  This means ignoring hot tips and doing your own research on companies.

There are at least three good reasons to ignore what Peter Lynch is buying:  (1) he might be wrong!  (A long list of losers from my own portfolio constantly reminds me that the so-called smart money is exceedingly dumb about 40 percent of the time);  (2) even if he’s right, you’ll never know when he’s changed his mind about a stock and sold;  and (3) you’ve got better sources, and they’re all around you…

If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them… and if you work in the industry, so much the better.  This is where you’ll find the tenbaggers.  I’ve seen it happen again and again from my perch at Fidelity.

You can find tenbaggers even in weak markets, writes Lynch.  If you have ten positions at 10% each, then one tenbagger will cause your total portfolio to increase 90% if the other nine positions are flat.  If the other nine positions collectively lose 50% (perhaps in weak market), then your overall portfolio will still be up 45% if you have one tenbagger.

Most often, tenbaggers are in companies like Dunkin’ Donuts rather than in penny stocks that depend on a scientific breakthrough.  Lynch also mentions La Quinta Motor Inns—a tenbagger from 1973 to 1983.  (La Quinta modeled itself on Holiday Inn, but with 30% lower costs and 30% lower prices.  If you’ve attended a Berkshire Hathaway Annual Shareholders meeting in the past decade, you may have stayed at La Quinta along with a bunch of other frugal Berkshire shareholders.)

  • Note: When considering examples Lynch gives in his book, keep in mind that he first wrote the book in 1989.  The examples are from that time period.

Lynch says he came across many of his best investment ideas while he was out and about:

Taco Bell, I was impressed with the burrito on a trip to California;  La Quinta Motor Inns, somebody at the rival Holiday Inn told me about it;  Volvo, my family and friends drive this car;  Apple Computer, my kids had one at home and then the systems manager bought several for the office;  Service Corporation International, a Fidelity electronics analyst… found on a trip to Texas;  Dunkin’ Donuts, I loved the coffee…

Many individual investors think the big winners must be technology companies, but very often that’s not the case:

Among amateur investors, for some reason it’s not considered sophisticated practice to equate driving around town eating donuts with the initial phase of an investigation into equities.  People seem more comfortable investing in something about which they are entirely ignorant.  There seems to be an unwritten rule on Wall Street:  If you don’t understand it, then put your life savings into it.  Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product.

Lynch is quick to point out that finding a promising company is only the first step.  You then must conduct the research.

 

THE MAKING OF A STOCKPICKER

Lynch describes his experience at Boston College:

As I look back on it now, it’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics.  Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.

Granted, since Lynch first wrote this book in 1989, more quantitative investors—using computer-based models—have come along.  But when it comes to picking stocks that can do well if held for many years, the majority of successful investors still follow a much more traditional process:  gathering information through observation, massive reading, and scuttlebutt, and then making investment decisions that are often partly qualitative in nature.  Here is a partial list of successful stockpickers:

  • Bill Ackman, David Abrams, Lee Ainslie, Chuck Akre, Bruce Berkowitz, Christopher Browne, Warren Buffett, Michael Burry, Leon Cooperman, Christopher Davis, David Einhorn, Jean-Marie Eveillard, Thomas Gayner, Glenn Greenberg, Joel Greenblatt, Mason Hawkins, Carl Icahn, Seth Klarman, Stephen Mandel, Charlie Munger, Bill Nygren, Mohnish Pabrai, Michael Price, Richard Pzena, Robert Rodriguez, Stephen Romick, Thomas Russo, Walter Schloss, Lou Simpson, Guy Spier, Arnold Van Den Berg, Prem Watsa, Wallace Weitz, and Donald Yacktman.

 

THE WALL STREET OXYMORONS

Lynch observes that professional investors are typically not able to invest in most stocks that become tenbaggers.  Perhaps the most important reason is that most professional investors never invest in microcap stocks, stocks with market caps below $500 million.  Assets under management (AUM) for many professional investors are just too large to be able to invest in microcap companies.  Moreover, even smaller funds usually focus on small caps instead of micro caps.  Often that’s a function of AUM, but sometimes it’s a function of microcap companies being viewed as inherently riskier.

There are thousands of microcap companies.  And many micro caps are good businesses with solid revenues and earnings, and with healthy balance sheets.  These are the companies you should focus on as an investor.  (There are some microcap companies without good earnings or without healthy balance sheets.  Simply avoid these.)

If you invest in a portfolio of solid microcap companies, and hold for at least 10 years, then the expected returns are far higher than would you get from a portfolio of larger companies.  There is more volatility along the way, but if you can just focus on the long-term business results, then shorter term volatility is generally irrelevant.  Real risk for value investors is not volatility, or a stock that goes down temporarily.  Real risk is the chance of suffering a permanent loss—when the whole portfolio declines and is unable to bounce back.

Fear of volatility causes many professional investors only to look at stocks that have already risen a great deal, so that they’re no longer micro caps.  You’ll miss a lot of tenbaggers and twentybaggers if you can’t even look at micro caps.  That’s a major reason why individual investors have an advantage over professional investors.  Individual investors can look at thousands of microcap companies, many of which are in very good shape.

Furthermore, even if a professional investor could look at microcap stocks, there are still strong incentives not to do so.  Lynch explains:

…between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter.  Success is one thing, but it’s more important not to look bad if you fail.

As Lynch says, if you’re a professional investor and you invest in a blue chip like General Electric which doesn’t work, clients and bosses will ask, ‘What is wrong with GE?’  But if you invest in an unknown microcap company and it doesn’t work, they’ll ask, ‘What is wrong with you?’

Lynch sums it up the advantages of the individual investor:

You don’t have to spend a quarter of your waking hours explaining to a colleague why you are buying what you are buying.  [Also, you can invest in unknown microcap companies…]  There’s nobody to chide you for buying back a stock at $19 that you earlier sold at $11—which may be a perfectly sensible move.

 

IS THIS GAMBLING, OR WHAT?

In general, stocks have done better than bonds over long periods of time.

Historically, investing in stocks is undeniably more profitable than investing in debt.  In fact, since 1927, common stocks have recorded gains of 9.8 percent a year on average, as compared to 5 percent for corporate bonds, 4.4 percent for government bonds, and 3.4 percent for Treasury bills.

The long-term inflation rate, as measured by the Consumer Price Index, is 3 percent a year, which gives common stocks a real return of 6.8 percent a year.  The real return on Treasury bills, known as the most conservative and sensible of all places to put money, has been nil.  That’s right.  Zippo.

Many people get scared out of stocks whenever there is a large drop of 20-40% (or more).  But both the U.S. economy and U.S. stocks are very resilient and have always bounced back quickly.  This is especially true since the Great Depression, which was a prolonged period of deep economic stagnation caused in large part by policy errors.  A large fiscal stimulus and/or a huge program of money-printing (monetary stimulus) would have significantly shortened the Great Depression.

Lynch defines good investing as a system of making bets when the odds are in your favor.  If you’re right 60% of the time and you have a good system, then you should do fine over time.  Lynch compares investing to stud poker:

You can never be certain what will happen, but each new occurrence—a jump in earnings, the sale of an unprofitable subsidiary, the expansion into new markets—is like turning up another card.  As long as the cards suggest favorable odds of success, you stay in the hand.

…Consistent winners raise their bets as their position strengthens, and they exit the game when the odds are against them…

Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush.  They accept their fate and go on to the next hand, confident that their basic method will reward them over time.  People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences.  Calamitous drops do not scare them out of the game… They realize the stock market is not pure science, and not like chess, where the superior position always wins.  If seven out of ten of my stocks perform as expected, then I’m delighted.  If six out of ten of my stocks perform as expected, then I’m thankful.  Six out of ten is all it takes to produce on enviable record on Wall Street.

Lynch concludes the chapter by saying that investing is more like 70-card poker than 7-card poker.  If you have ten positions, it’s like playing ten 70-card hands at once.

 

PERSONAL QUALITIES IT TAKES TO SUCCEED

Lynch writes:

It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic…

It’s also important to be able to make decisions without complete or perfect information.  Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them.  The scientific mind that needs to know all the data will be thwarted here.

And finally, it’s crucial to be able to resist your human nature and your ‘gut feelings.’  It’s the rare investor who doesn’t secretly harbor the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, in spite of the fact that most of us have been proven wrong again and again.  It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs.  This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments.

According to information published by Investor’s Intelligence, which tracks investor sentiment via the newsletters, at the end of 1972, when stocks were about to tumble, optimism was at an all-time high, with only 15 percent of the advisors bearish.  At the beginning of the stock market rebound in 1974, investor sentiment was at an all-time low, with 65 percent of the advisors fearing the worst was yet to come…. At the start of the 1982 sendoff into a great bull market, 55 percent of the advisors were bears, and just prior to the big gulp of October 19, 1987, 80 percent of the advisors were bulls again.

…Does the success of Ravi Batra’s book The Great Depression of 1990 almost guarantee a great national prosperity?

Lynch summarizes:

…The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them.  Stand by your stocks as long as the fundamental story of the company hasn’t changed.

 

IS THIS A GOOD MARKET?  PLEASE DON’T ASK

Lynch:

There’s another theory that we have recessions every five years, but it hasn’t happened that way so far… Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio.  But the odds of my figuring it out are nil.  Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market.  The trouble is the bells never go off.  Remember, things are never clear until it’s too late.

… No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next.  This penultimate preparedness is our way of making up for the fact that we didn’t see the last thing coming along in the first place.

Lynch continues:

I don’t believe in predicting markets.  I believe in buying great companies—especially companies that are undervalued and/or underappreciated.

Lynch explains that the stock market itself is irrelevant.  What matters is the current and future earnings of the individual business you’re considering.  Lynch:

Several of my favorite tenbaggers made their biggest moves during bad markets.  Taco Bell soared through the last two recessions.

Focus on specific companies rather than the market as a whole.  Because you’re not restricted as an individual investor—you can look at microcap companies and you can look internationally—there are virtually always bargains somewhere.

A few good quotes from Warren Buffett on forecasting:

Market forecasters will fill your ear but never fill your wallet.

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.

 

STALKING THE TENBAGGER

If you work in a particular industry, this can give you an edge:

If you work in the chemical industry, then you’ll be among the first to realize that demand…is going up, prices are going up, and excess inventories are going down.  You’ll be in a position to know that no new competitors have entered the market and no new plants are under construction, and that it takes two to three years to build one.

Lynch also argues that if you’re a consumer of particular products, then you may be able to gain insight into companies that sell those products.  Again, you still need to study the financial statements in order to understand earnings and the balance sheet.  But noticing products that are doing well is a good start.

 

I’VE GOT IT, I’VE GOT IT—WHAT IS IT?

Most of the biggest moves—from tenbaggers to hundredbaggers—occur in smaller companies.  Microcap companies are the best place to look for these multi-baggers, while small-cap companies are the second best place to look.

Lynch identifies six general categories:  slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds.  (Slow growers and stalwarts tend to be larger companies.)

Slow Growers

Many large companies grow slowly, but are relatively dependable and may pay dividends.  A conservative investor may consider this category.

Stalwarts

These companies tend to grow annual earnings at 10 to 12 percent a year.  If you buy the stock when it’s a bargain, you can make 30 to 50 percent, then sell and repeat the process.  This is Lynch’s approach to Stalwarts.  Also, Stalwarts can offer decent protection during weak markets.

Fast Growers

Some small, aggressive new companies can grow at 20 to 25 percent a year:

If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers.

Of course, you have to be careful to identify the risks.  Many younger companies may grow too quickly or be underfinanced.  So look for the fast growers with good balance sheets and good underlying profitability.

Cyclicals

A cyclical is a company whose sales and profits rise and fall regularly.  If you can buy when the company and the industry are out of favor—near the bottom of the cycle—then you can do well with a cyclical.  (You also need to sell when the company and the industry are doing well again unless you think it’s a good enough company to hold for a decade or longer.)

Some cyclical stocks—like oil stocks—tend to have a low level of correlation with the broader stock market.  This can help a portfolio, especially when the broader stock market offers few bargains.

Turnarounds

Lynch:

Turnaround stocks make up lost ground very quickly… The best thing about investing in successful turnarounds is that of all the categories of stocks, their ups and downs are least related to the general market.

Again, a low correlation with the broader market is especially an advantage when the broader market is overvalued.  You do have to be careful with turnarounds, though.  As Buffett has said, ‘Turnarounds seldom turn.’

Asset Plays

A company may have something valuable that the market has overlooked.  It may be as simple as a pile of cash.  Sometimes it’s real estate.  It may be unrecognized intellectual property.  Or it could be resources in the ground.

 

THE PERFECT STOCK, WHAT A DEAL!

Similar to Warren Buffett, Lynch prefers simple businesses:

Getting the story on a company is a lot easier if you understand the basic business.  That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics.  The simpler it is, the better I like it.  When somebody says, ‘Any idiot could run this joint,’ that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.

… For one thing, it’s easier to follow.  During a lifetime of eating donuts or buying tires, I’ve developed a feel for the product line that I’ll never have with laser beams or microprocessors.

Lynch then names thirteen attributes that are important to look for:

It Sounds Dull—Or, Even Better, Ridiculous

Lynch says a boring name is a plus, because that helps a company to stay neglected and overlooked, often causing the stock to be cheap.  Bob Evans Farms is an example of a perfect name.

It Does Something Dull

Crown, Cork, and Seal makes cans and bottle caps, says Lynch.  The more boring the business, the better.  Again, this will help keep the stock neglected, often causing the stock to be cheap.

It Does Something Disagreeable

Safety-Kleen provides gas stations with a machine that washes greasy auto parts.  Gas stations love it.  But it’s a bit disgusting, which can cause the stock to be neglected and thus possibly cheap.

It’s a Spinoff

Large companies tend to make sure that divisions they spin off are in good shape.  Generally spinoffs are neglected by most professional investors, often because the market cap of the spinoff is too small for them to consider.

The Institutions Don’t Own It, and the Analysts Don’t Follow It

With no institutional ownership, the stock may be neglected and possibly cheap.  With no analyst coverage, the chance of neglect and cheapness is even higher.  It’s not only microcap companies that are neglected.  When popular stocks fall deeply out of favor, they, too, can become neglected.

Rumors Abound: It’s Involved with Toxic Waste

Waste Management, Inc. was a hundredbagger.  People are so disturbed by sewage and waste that they tend to neglect such stocks.

There’s Something Depressing About It

Funeral home companies tend to be neglected and the stocks can get very cheap at times.

It’s a No-Growth Industry

In a no-growth industry, there’s much less competition.  This gives companies in the industry room to grow.

It’s Got a Niche

The local rock pit has a niche.  Lynch writes that if you have the only rock pit in Brooklyn, you have a virtual monopoly.  A rival two towns away is not going to transport rocks into your territory because the mixed rocks only sell for $3 a ton.

People Have to Keep Buying It

Drugs, soft drinks, razor blades, etc., are products that people need to keep buying.

It’s a User of Technology

A company may be in a position to benefit from ongoing technological improvements.

The Insiders Are Buyers

Insider buying usually means the insiders think the stock is cheap.

Also, you want insiders to own as much stock as possible so that they are incentivized to maximize shareholder value over time.  If executive salaries are large compared to stock ownership, then executives will focus on growth instead of on maximizing shareholder value (i.e., profitability).

The Company Is Buying Back Shares

If the shares are cheap, then the company can create much value through buybacks.

 

STOCKS I’D AVOID

Lynch advises avoiding the hottest stock in the hottest industry.  Usually a stock like that will be trading at an extremely high valuation, which requires a great deal of future growth for the investor just to break even.  When future growth is not able to meet lofty expectations, typically the stock will plummet.

Similarly, avoid the next something.  If a stock is touted as the next IBM, the next Intel, or the next Disney, avoid it because very probably it will not be the next thing.

Avoid diworseifications:  Avoid the stock of companies that are making foolish acquisitions of businesses in totally different industries.  Such diworseifications rarely work out for shareholders.  Two-thirds of all acquisitions do not create value.  This is even more true when acquisitions are diworseifications.

Beware whisper stocks, which are often technological long shots or whiz-bang stories such as miracle drugs.  Lynch notes that he’s lost money on every single whisper stock he’s ever bought.

One trick to avoiding whisper stocks is to wait until they have earnings.  You can still get plenty of tenbaggers from companies that have already proven themselves.  Buying long shots before they have earnings rarely works.  This is a good rule for buying microcap stocks in general:  Wait until the company has solid earnings and a healthy balance sheet.

 

EARNINGS, EARNINGS, EARNINGS

Lynch writes that a stock eventually will track the earnings of the business:

Analyzing a company’s stock on the basis of earnings and assets is no different from analyzing a local Laundromat, drugstore, or apartment building that you might want to buy.  Although it’s easy to forget sometimes, a share of stock is not a lottery ticket.  It’s part ownership of a business.

Lynch gives an example:

And how about Masco Corporation, which developed the single-handle ball faucet, and as a result enjoyed thirty consecutive years of up earnings through war and peace, inflation and recession, with the earnings rising 800-fold and the stock rising 1,300-fold between 1958 and 1987?  What would you expect from a company that started out with the wonderfully ridiculous name of Masco Screw Products?

Lynch advises not to invest in companies with high price-to-earnings (p/e) ratios:

If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones.  You’ll save yourself a lot of grief and a lot of money if you do.  With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.

Future earnings may not be predictable, but you can at least check how the company plans to increase future earnings.  Lynch:

There are five basic ways a company can increase earnings:  reduce costs;  raise prices;  expand into new markets;  sell more of its product in the old markets;  or revitalize, close, or otherwise dispose of a losing operation.  These are the factors to investigate as you develop the story.  If you have an edge, this is where it’s going to be most helpful.

 

THE TWO-MINUTE DRILL

Warren Buffett has said that he would have been a journalist if he were not an investor.  Buffett says his job as an investor is to write the story for the company in question.  Lynch has a similar view.  He explains:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path.  The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot.  Once you’re able to tell the story of a stock to your family, your friends, or the dog… and so that even a child could understand it, then you have a proper grasp of the situation.

Usually there are just a few key variables for a given investment idea.  As value investor Bruce Berkowitz has said:

We’ve always done very well when we can use sixth-grade math on the back of a postcard to show how inexpensive something is relative to its free cash.

One good way to gain insight is to ask the executive of a company what he or she thinks the competition is doing right.  Lynch discovered La Quinta Motor Inns while he was talking to the vice president of United Inns, a competitor.

Lynch later learned that La Quinta’s strategy was simple:  to have both costs and prices that are 30% lower than Holiday Inn.  La Quinta had everything exactly the same as at a Holiday Inn—same size rooms, same size beds, etc.  However:

La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs.  La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels.  La Quinta didn’t even have to own the Denny’s.  Somebody else could worry about the food.  Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point…  It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.

 

GATHERING THE FACTS

If it’s a microcap business, then you may be able to speak with a top executive simply by calling the company.  For larger companies, often you will only reach investor relations.  Either way, you want to check the story you’ve developed—your investment thesis—against the facts you’re able to glean through conversation (and through reading the financial statements, etc.).

If you don’t have a story developed enough to check, there are two general questions you can always ask, notes Lynch:

  • What are the positives this year?
  • What are the negatives?

Often your ideas will not be contradicted.  But occasionally you’ll learn something unexpected, that things are either better or worse than they appear.  Such unexpected information can be very profitable because it is often not yet reflected in the stock price.  Lynch says he comes across something unexpected in about one out of every ten phone calls he makes.

Lynch also often will visit headquarters.  The goal, he says, is to get a feel for the place.  What Lynch really appreciates is when headquarters is obviously shabby, indicating that the executives are keeping costs as low as possible.  When headquarters is very nice and fancy, that’s generally a bad signal about management.

Kicking the tires can help.  It’s not a substitute for studying the financial statements or for asking good questions.  But it can help you check out the practical side of the investment thesis.  Lynch used to make a point of checking out as many companies as possible this way.

Finally, in addition to reading the financial statements, Lynch recommends Value Line.

 

SOME FAMOUS NUMBERS

If you’re looking at a particular product, then you need to know what percent of sales that particular product represents.

Lynch then notes that you can compare the p/e and the growth rate:

If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc.  But if the p/e ratio is less than the growth rate, you may have found yourself a bargain.  A company, say, with a growth rate of 12 percent a year… and a p/e of 6 is a very attractive prospect.  On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

In general, a p/e that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.

You can do a similar calculation by taking earnings, adding dividends, and comparing that sum to the growth rate.

High debt-to-equity is something to avoid.  Turnarounds with high debt tend to work far less often than turnarounds with low debt.

Free cash flow is important.  Free cash flow equals net income plus depreciation, depletion, and amortization, minus capital expenditures.  (There may also be adjustments for changes in working capital.)

The important point is that some companies and some industries—such as steel or autos—are far more capital-intensive than others.  Some companies have to spend most of their incoming cash on capital expenditures just to maintain the business at current levels.  Other companies have far lower reinvestment requirements; this means a much higher return on invested capital.  The value that any given company creates over time is the cumulative difference between the return on invested capital and the cost of capital.

Another thing to track is inventories.  If inventories have been piling up recently, that’s not a good sign.  When inventories are growing faster than sales, that’s a red flag.  Lynch notes that if sales are up 10 percent, but inventories are up 30 percent, then you should be suspicious.

Like Buffett, Lynch observes that a company that can raise prices year after year without losing customers can make for a terrific investment.  Such a company will tend to have high free cash flow and high return on invested capital over time.

A last point Lynch makes is about the growth rate of earnings:

All else being equal, a 20-percent grower selling as 20 times earnings (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10).  This may sound like an esoteric point, but it’s important to understand what happens to the earnings of the faster growers that propels the stock price.

Lynch gives an example.  Assume Company A and Company B both start with earnings of $1.00 per share.  But assume that Company A grows at 20 percent a year while Company B grows at 10 percent a year.  (So the stock of Company A starts at $20, while the stock of Company B is at $10.)  What happens after 10 years, assuming the growth rates stay the same?  Company A will be earning $6.19 while Company B will be earning $2.59.

If the multiples haven’t changed, then the stock of Company A will be at $123.80, while the stock of Company B will only be at $26.  Even if the p/e for Company A falls to 15 instead of 20, the stock will still be at $92.  Going from $20 to $92 (or $123.80) is clearly better than going from $10 to $26.

One last point.  In the case of a successful turnaround, the stock of a relatively low-profit margin (and perhaps also high debt) company will do much better than the stock of a relatively high-profit margin (and low debt) company.  It’s just a matter of leverage.

For a long-term stock that you’re going to hold through good times and bad, you want high profit margins and low debt.  If you’re going to invest in a successful turnaround, then you want low profit margins and high debt, all else equal.  (In practice, most turnarounds don’t work, and high debt should be avoided unless you want to specialize in equity stubs.)

 

RECHECKING THE STORY

Every few months, you should check in on the company.  Are they on track?  Have they made any adjustments to their plan?  How are sales?  How are the earnings?  What are industry conditions?  Are their products still attractive?  What are their chief challenges?  Et cetera.  Basically, writes Lynch, have any new cards been turned over?

In the case of a growth company, Lynch holds that there are three phases.  In the start-up phase, the company may still be working the kinks out of the business.  This is the riskiest phase because the company isn’t yet established.  The second phase is rapid expansion.  This is generally the safest phase, and also where you can make the most money as an investor.  The third phase is the mature phase, or the saturation phase, when growth has inevitably slowed down.  The third phase can be the most problematic, writes Lynch, since it gets increasingly difficult to grow earnings.

 

THE FINAL CHECKLIST

Lynch offers a brief checklist.

  • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry.
  • The percentage of institutional ownership. The lower the better.
  • Whether insiders are buying and whether the company itself is buying back its own shares.  Both are positive signs.
  • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.)
  • Whether the company has a strong balance sheet or a weak balance sheet (high debt-to-equity ratio) and how it’s rated for financial strength.
  • The cash position.  With $16 in net cash, I know Ford is unlikely to drop below $16 a share.

Lynch also gives a checklist for each of the six categories.  Then he gives a longer checklist summarizes all the main points (which have already been mentioned in the previous sections).

 

DESIGNING A PORTFOLIO

Some years you’ll make 30 percent, other years you’ll make 2 percent, and occasionally you’ll lose 20 or 30 percent.  It’s important to stick to a disciplined approach and not get impatient.  Stick with the long-term strategy through good periods and bad.  (Even great investors have periods of time when their strategy trails the market, often even several years in a row.)

Regarding the number of stocks to own, Lynch mentions a couple of stocks in which he wouldn’t mind investing his entire portfolio.  But he says you need to analyze each stock one at a time:

…The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.

In my view it’s best to own as many stocks as there are situations in which:  (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research.  Maybe it’s a single stock, or maybe it’s a dozen stocks.  Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those;  or perhaps you happen to know something special about a single turnaround or a single asset play.  There’s no use diversifying into unknown companies just for the sake of diversity.  A foolish diversity is the hobgoblin of small investors.

Lynch then recommends, for small portfolios, owning between 3 and 10 stocks.  It makes sense to concentrate on your best ideas and on what you understand best.  At the same time, it often happens that the tenbagger comes—unpredictably—from your 8th or 9th best idea.  The value investor Mohnish Pabrai has had this experience.

  • Important Note:  One of the best edges you can have as an individual investor—in addition to being able to focus on microcap companies—is that you can have at least a 3- to 5-year holding period.  Because so many investors focus on shorter periods of time, very often the best bargains are stocks that are cheap relative to earnings in 3 to 5 years.

Lynch advises against selling winners and holding on to losers, which is like pulling out the flowers and watering the weeds.  But Lynch’s real point is that price movements are often random.  Just because a stock has gone up or down doesn’t mean the fundamental value of the business has changed.

If business value has increased—or if fundamentals have improved—then it often makes sense to add to a stock even if it’s gone from $11 to $19.

If business value has not declined, or has improved, then it often makes sense to add to a stock that has declined.  On the other hand, if business value has decreased—or if fundamentals have deteriorated—then it often makes sense to sell, regardless of whether the stock has gone up or down.

In general, as long as the investment thesis is intact and business value is sufficiently high, you should hold a stock for at least 3 to 5 years:

If I’d believed in ‘Sell when it’s a double,’ I would never have benefited from a single big winner, and I wouldn’t have been given the opportunity to write a book.  Stick around to see what happens—as long as the original story continues to make sense, or gets better—and you’ll be amazed at the results in several years.

 

THE BEST TIME TO BUY AND SELL

Often there is tax loss selling near the end of the year, which means it can be a good time to buy certain stocks.

As mentioned, you should hold for at least 3 to 5 years as long as the investment thesis is intact and normalized business value is sufficiently high.  Be careful not to listen to negative nellies who yell ‘Sell!’ way before it’s time:

Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell ‘Sell’ before it’s time to sell.  I ought to know.  I’ve been talked out of a few tenbaggers myself.

Lynch took a big position in Toys ‘R’ Us in 1978.  He had done his homework, and he loaded up at $1 per share:

…By 1985, when Toys ‘R’ Us hit $25, it was a 25-bagger for some.  Unfortunately, those some didn’t include me, because I sold too soon.  I sold too soon because somewhere along the line I’d read that a smart investor named Milton Petrie, one of the deans of retailing, had bought 20 percent of Toys ‘R’ Us and that his buying was making the stock go up.  The logical conclusion, I thought, was that when Petrie stopped buying, the stock would go down.  Petrie stopped buying at $5.

I got in at $1 and out at $5 for a fivebagger, so how can I complain?  We’ve all been taught the same adages:  ‘Take profits when you can,’ and ‘A sure gain is always better than a possible loss.’  But when you’ve found the right stock and bought it, all the evidence tells you it’s going higher, and everything is working in your direction, then it’s a shame if you sell.

Lynch continues by noting that individual investors are just as susceptible to selling early as are professional investors:

Maybe you’ve received the ‘Congratulations: Don’t Be Greedy’ announcement.  That’s when the broker calls to say:  ‘Congratulations, you’ve doubled your money on ToggleSwitch, but let’s not be greedy.  Let’s sell ToggleSwitch and try KinderMind.’  So you sell ToggleSwitch and it keeps going up, while KinderMind goes bankrupt, taking all of your profits with it.

One major problem for all investors is that there are so many market, economic, and political forecasts.  Market forecasts and economic forecasts can be very expensive if you follow them, as Buffett has often noted.  The only thing you can really know is the individual company in which you’ve invested, and what its long-term business value is.  Everything else is noise that can only interfere with your ability to focus on long-term business value.

I quoted Buffett earlier.  Now let’s quote the father of value investing, Buffett’s teacher and mentor, Ben Graham:

… if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

Of course, there could be a bear market and/or recession at any time.  But even then, there will be at least a few stocks somewhere in the world that perform well if bought cheaply enough.

The main point made by Graham and Buffett is that repeatedly buying stocks at bargain levels relative to business value can work very well over time if you’re patient and disciplined.  Market forecasting can only distract you from what works.

What works is investing in businesses you can understand at sensible prices, and holding each one for at least 3 to 5 years, if not 10 years or longer, as long as the thesis is intact.  Lynch:

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold.  I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised.  The success of a company isn’t the surprise, but what the shares bring often is.  I remember buying Stop & Shop as a conservative, dividend-paying stock, and then the fundamentals kept improving and I realized I had a fast grower on my hands.

It’s important to note that sometimes years can go by while the stock does nothing.  That, in itself, doesn’t tell you anything.  If the business continues to make progress, and long-term business value is growing (or is sufficiently high), then you should stick with it or perhaps add to the position:

Here’s something else that’s certain to occur:  If you give up on a stock because you’re tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it.  I call this the postdiverstiture flourish.

…Most of the money I make is in the third or fourth year that I’ve owned something… If all’s right with the company, and whatever attracted me in the first place hasn’t changed, then I’m confident that sooner or later my patience will be rewarded.

…It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore.  You begin to think everybody else is right and you are wrong.  But where the fundamentals are promising, patience is often rewarded…

Lynch again later:

… my biggest winners continue to be stocks I’ve held for three and even four years.

Lynch offers much commentary on a long list of macro concerns that are going to sink stocks.  (Remember he was writing in 1989.)  Here is a snipet:

I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in.  Whoops.  Make that the strong dollar will do us in.  They tell me real estate prices are going to collapse.  Last month people started worrying about that.  This month they’re worrying about the ozone layer.  If you believe the old investment adage that the stock market climbs a ‘wall of worry,’ take note that the worry wall is fairly good-sized now and growing every day.

Like Buffett, Lynch is very optimistic about America and long-term investing in general.  Given the strengths of America, and all the entrepreneurial and scientific energy creating ongoing innovation, it seems to me that Buffett and Lynch are right to be long-term optimists.  That’s not to say there won’t be setbacks, recessions, bear markets, and other problems.  But such setbacks will be temporary.  Over the long term, innovation will amaze, profits will grow, and stocks will follow profits higher.

 

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.

More Than You Know

January 29, 2023

To boost our productivity—including our ability to think and make decisions—nothing beats continuous learning.  Broad study makes us better people.  See: http://boolefund.com/lifelong-learning/

Michael Mauboussin is a leading expert in the multidisciplinary study of businesses and markets.  His book—More Than You Know: Finding Financial Wisdom in Unconventional Places—has been translated into eight languages.

Each chapter in Mauboussin’s book is meant to stand on its own.  I’ve summarized most of the chapters below.

Here’s an outline:

  • Process and Outcome in Investing
  • Risky Business
  • Are You an Expert?
  • The Hot Hand in Investing
  • Time is on my Side
  • The Low Down on the Top Brass
  • Six Psychological Tendencies
  • Emotion and Intuition in Decision Making
  • Beware of Behavioral Finance
  • Importance of a Decision Journal
  • Right from the Gut
  • Weighted Watcher
  • Why Innovation is Inevitable
  • Accelerating Rate of Industry Change
  • How to Balance the Long Term with the Short Term
  • Fitness Landscapes and Competitive Advantage
  • The Folly of Using Average P/E’s
  • Mean Reversion and Turnarounds
  • Considering Cooperation and Competition Through Game Theory
  • The Wisdom and Whim of the Collective
  • Vox Populi
  • Complex Adaptive Systems
  • The Future of Consilience in Investing

(Photo: Statue of Leonardo da Vinci in Italy, by Raluca Tudor)

 

PROCESS AND OUTCOME IN INVESTING

(Image by Amir Zukanovic)

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs.  But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Robert Rubin made this remark in his Harvard Commencement Address in 2001.  Mauboussin points out that the best long-term performers in any probabilistic field—such as investing, bridge, sports-team management, and pari-mutuel betting—all emphasize process over outcome.

Mauboussin also writes:

Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.

If you don’t understand why your view differs from the consensus, and why the consensus is likely to be wrong, then you cannot reasonably expect to beat the market.  Mauboussin quotes horse-race handicapper Steven Crist:

The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory… This may sound elementary, and many players may think that they are following this principle, but few actually do.  Under this mindset, everything but the odds fades from view.  There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.

Robert Rubin’s four rules for probabilistic decision-making:

  • The only certainty is that there is no certainty.  It’s crucial not to be overconfident, because inevitably that leads to big mistakes.  Many of the biggest hedge fund blowups resulted when people were overconfident about particular bets.
  • Decisions are a matter of weighing probabilities.  Moreover, you also have to consider payoffs.  Probabilities alone are not enough if the payoffs are skewed.  A high probability of winning does not guarantee that it’s a positive expected value bet if the potential loss is far greater than the potential gain.
  • Despite uncertainty, we must act.  Often in investing and in life, we have to make decisions based in imperfect or incomplete information.
  • Judge decisions not only on results, but also on how they were made.  If you’re making decisions under uncertainty—probabilistic decisions—you have to focus on developing the best process you can.  Also, you must accept that some good decisions will have bad outcomes, while some bad decisions will have good outcomes.

Rubin again:

It’s not that results don’t matter.  They do.  But judging solely on results is a serious deterrent to taking risks that may be necessary to making the right decision.  Simply put, the way decisions are evaluated affects the way decisions are made.

 

RISKY BUSINESS

(Photo by Shawn Hempel)

Mauboussin:

So how should we think about risk and uncertainty?  A logical starting place is Frank Knight’s distinction: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like.  Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like.  So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain.  Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.

Mauboussin highlights three ways to get a probability, as suggested by Gerd Gigerenzer in Calculated Risks:

  • Degrees of belief.  Degrees of belief are subjective probabilities and are the most liberal means to translate uncertainty into a probability.  The point here is that investors can translate even onetime events into probabilities provided they satisfy the laws of probability—the exhaustive and exclusive set of alternatives adds up to one.  Also, investors can frequently update probabilities based on degrees of belief when new, relevant information becomes available.
  • Propensities.  Propensity-based probabilities reflect the properties of the object or system.  For example, if a die is symmetrical and balanced, then you have a one-in-six probability of rolling any particular side… This method of probability assessment does not always consider all the factors that may shape an outcome (such as human error).
  • Frequencies.  Here the probability is based on a large number of observations in an appropriate reference class.  Without an appropriate reference class, there can be no frequency-based probability assessment.  So frequency users would not care what someone believes the outcome of a die roll will be, nor would they care about the design of the die.  They would focus only on the yield of repeated die rolls.

When investing in a stock, we try to figure out the expected value by delineating possible scenarios along with a probability for each scenario.  This is the essence of what top value investors like Warren Buffett strive to do.

 

ARE YOU AN EXPERT?

In 1996, Lars Edenbrandt, a Lund University researcher, set up a contest between an expert cardiologist and a computer.  The task was to sort a large number of electrocardiograms (EKGs) into two piles—heart attack and no heart attack.

(Image by Johannes Gerhardus Swanepoel)

The human expert was Dr. Hans Ohlin, a leading Swedish cardiologist who regularly evaluated as many as 10,000 EKGs per year.  Edenbrandt, an artificial intelligence expert, trained his computer by feeding it thousands of EKGs.  Mauboussin describes:

Edenbrandt chose a sample of over 10,000 EKGs, exactly half of which showed confirmed heart attacks, and gave them to machine and man.  Ohlin took his time evaluating the charts, spending a week carefully separating the stack into heart-attack and no-heart-attack piles.  The battle was reminiscent of Garry Kasparov versus Deep Blue, and Ohlin was fully aware of the stakes.

As Edenbrandt tallied the results, a clear-cut winner emerged: the computer correctly identified the heart attacks in 66 percent of the cases, Ohlin only in 55 percent.  The computer proved 20 percent more accurate than a leading cardiologist in a routine task that can mean the difference between life and death.

Mauboussin presents a table illustrating that expert performance depends on the problem type:

Domain Description (Column) Expert Performance Expert Agreement Examples
Rules based: Limited Degrees of Freedom Worse than computers High (70-90%)
  • Credit scoring
  • Simple medical diagnosis
Rules based: High Degrees of Freedom Generally better than computers Moderate (50-60%)
  • Chess
  • Go
Probabilistic: Limited Degrees of Freedom Equal to or worse than collectives Moderate/ Low (30-40%)
  • Admissions officers
  • Poker
Probabilistic: High Degrees of Freedom Collectives outperform experts Low (<20%)
  • Stock market
  • Economy

For rules-based systems with limited degrees of freedom, computers consistently outperform individual humans; humans perform well, but computers are better and often cheaper, says Mauboussin.  Humans underperform computers because humans are influenced by suggestion, recent experience, and how information is framed.  Also, humans fail to weigh variables well.  Thus, while experts tend to agree in this domain, computers outperform experts, as illustrated by the EKG-reading example.

In the next domain—rules-based systems with high degrees of freedom—experts tend to add the most value.  However, as computing power continues to increase, eventually computers will outperform experts even here, as illustrated by Chess and Go.  Eventually, games like Chess and Go are “solvable.”  Once the computer can check every single possible move within a reasonable amount of time—which is inevitable as long as computing power continues to increase—no human will be able to match such a computer.

In probabilistic domains with limited degrees of freedom, experts are equal to or worse than collectives.  Overall, the value of experts declines compared to rules-based domains.

(Image by Marrishuanna)

In probabilistic domains with high degrees of freedom, experts do worse than collectives.  For instance, stock market prices aggregate many guesses from individual investors.  Stock market prices typically are more accurate than experts.

 

THE HOT HAND IN INVESTING

Sports fans and athletes believe in the hot hand in basketball.  A player on a streak is thought to be “hot,” or more likely to make his or her shots.  However, statistical analysis of streaks shows that the hot hand does not exist.

(Illustration by lbreakstock)

Long success streaks happen to the most skillful players in basketball, baseball, and other sports.  To illustrate this, Mauboussin asks us to consider two basketball players, Sally Swish and Allen Airball.  Sally makes 60 percent of her shot attempts, while Allen only makes 30 percent of his shot attempts.

What are the probabilities that Sally and Allen make five shots in a row?  For Sally, the likelihood is (0.6)^5, or 7.8 percent.  Sally will hit five in a row about every thirteen sequences.  For Allen, the likelihood is (0.3)^5, or 0.24 percent.  Allen will hit five straight once every 412 sequences.  Sally will have far more streaks than Allen.

In sum, long streaks in sports or in money management indicate extraordinary luck imposed on great skill.

 

TIME IS ON MY SIDE

The longer you’re willing to hold a stock, the more attractive the investment.  For the average stock, the chance that it will be higher is (almost) 100 percent for one decade, 72 percent for one year, 56 percent for one month, and 51 percent for one day.

(Illustration by Marek)

The problem is loss aversion.  We feel the pain of a loss 2 to 2.5 times more than the pleasure of an equivalent gain.  If we check a stock price daily, there’s nearly a 50 percent chance of seeing a loss.  So checking stock prices daily is a losing proposition.  By contrast, if we only check the price once a year or once every few years, then investing in a stock is much more attractive.

A fund with a high turnover ratio is much more short-term oriented than a fund with a low turnover ratio.  Unfortunately, most institutional investors have a much shorter time horizon than what is needed for the typical good strategy to pay off.  If portfolio managers lag over shorter periods of time, they may lose their jobs even if their strategy works quite well over the long term.

 

THE LOW DOWN ON THE TOP BRASS

(Illustration by Travelling-light)

It’s difficult to judge leadership, but Mauboussin identifies four things worth considering:

  • Learning
  • Teaching
  • Self-awareness
  • Capital allocation

Mauboussin asserts:

A consistent thirst to learn marks a great leader.  On one level, this is about intellectual curiosity—a constant desire to build mental models that can help in decision making.  A quality manager can absorb and weigh contradictory ideas and information as well as think probabilistically…

Another critical facet of learning is a true desire to understand what’s going on in the organization and to confront the facts with brutal honesty.  The only way to understand what’s going on is to get out there, visit employees and customers, and ask questions and listen to responses.  In almost all organizations, there is much more information at the edge of the network—the employees in the trenches dealing with the day-to-day issues—than in the middle of the network, where the CEO sits.  CEOs who surround themselves with managers seeking to please, rather than prod, are unlikely to make great decisions.

A final dimension of learning is creating an environment where everyone in the organization feels they can voice their thoughts and opinions without the risk of being rebuffed, ignored, or humiliated.  The idea here is not that management should entertain all half-baked ideas but rather that management should encourage and reward intellectual risk taking.

Teaching involves communicating a clear vision to the organization.  Mauboussin points out that teaching comes most naturally to those leaders who are passionate.  Passion is a key driver of success.

Self-awareness implies a balance between confidence and humility.  We all have strengths and weaknesses.  Self-aware leaders know their weaknesses and find colleagues who are strong in those areas.

Finally, capital allocation is a vital leadership skill.  Regrettably, many consultants and investment bankers give poor advice on this topic.  Most acquisitions destroy value for the acquirer, regardless of whether they are guided by professional advice.

Mauboussin quotes Warren Buffett:

The heads of many companies are not skilled in capital allocation.  Their inadequacy is not surprising.  Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities.  They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.  To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.  CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers.  Charlie and I have frequently observed the consequences of such “help.”  On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America.  (That’s why you hear so much about “restructuring.”)

 

SIX PSYCHOLOGICAL TENDENCIES

(Image by Andreykuzmin)

The psychologist Robert Cialdini, in his book Influence: The Psychology of Persuasion, mentions six psychological tendencies that cause people to comply with requests:

  • Reciprocation.  There is no human society where people do not feel the obligation to reciprocate favors or gifts.  That’s why charitable organizations send free address labels and why real estate companies offer free house appraisals.  Sam Walton was smart to forbid all of his employees from accepting gifts from suppliers, etc.
  • Commitment and consistency.  Once we’ve made a decision, and especially if we’ve publicly committed to that decision, we’re highly unlikely to change.  Consistency allows us to stop thinking and also to avoid further action.
  • Social validation.  One of the chief ways we make decisions is by observing the decisions of others.  In an experiment by Solomon Asch, eight people in a room are shown three lines of clearly unequal lengths.  Then they are shown a fourth line that has the same length as one of the three lines.  They are asked to match the fourth line to the one with equal length.  The catch is that only one of the eight people in the room is the actual subject of the experiment.  The other seven people are shills who have been instructed to choose an obviously incorrect answer.  About 33 percent of the time, the subject of the experiment ignores the obviously right answer and goes along with the group instead.
  • Liking.  We all prefer to say yes to people we like—people who are similar to us, who compliment us, who cooperate with us, and who we find attractive.
  • Authority.  Stanley Milgram wanted to understand why many seemingly decent people—including believing Lutherans and Catholics—went along with the great evils perpetrated by the Nazis.  Milgram did a famous experiment.  A person in a white lab coat stands behind the subject of the experiment.  The subject is asked to give increasingly severe electric shocks to a “learner” in another room whenever the learner gives an incorrect answer to a question.  (Unknown to the subject, the learner in the other room is an actor and the electric shocks are not really given.)  Roughly 60 percent of the time, the subject of the experiment gives a fatal shock of 450 volts to the learner.  This is a terrifying result.  See: https://en.wikipedia.org/wiki/Milgram_experiment
  • Scarcity.  Items or data that are scarce or perceived to be scarce automatically are viewed as more attractive.  That’s why companies frequently offer services or products for a limited time only.

These innate psychological tendencies are especially powerful when they operate in combination.  Charlie Munger calls this lollapalooza effects.

Mauboussin writes that investors are often influenced by commitment and consistency, social validation, and scarcity.

Psychologists discovered that after bettors at a racetrack put down their money, they are more confident in the prospects of their horses winning than immediately before they placed their bets.  After making a decision, we feel both internal and external pressure to remain consistent to that view even if subsequent evidence questions the validity of the initial decision.

So an investor who has taken a position in a particular stock, recommended it publicly, or encouraged colleagues to participate, will feel the need to stick with the call.  Related to this tendency is the confirmation trap: postdecision openness to confirming data coupled with disavowal or denial of disconfirming data.  One useful technique to mitigate consistency is to think about the world in ranges of values with associated probabilities instead of as a series of single points.  Acknowledging multiple scenarios provides psychological shelter to change views when appropriate.

There is a large body of work about the role of social validation in investing.  Investing is an inherently social activity, and investors periodically act in concert…

Finally, scarcity has an important role in investing (and certainly plays a large role in the minds of corporate executives).  Investors in particular seek informational scarcity.  The challenge is to distinguish between what is truly scarce information and what is not.  One means to do this is to reverse-engineer market expectations—in other words, figure out what the market already thinks.

 

EMOTION AND INTUITION IN DECISION MAKING

(Photo by Marek Uliasz)

Humans need to be able to experience emotions in order to make good decisions.  Mauboussin writes about an experiment conducted by Antonio Damasio:

…In one experiment, he harnessed subjects to a skin-conductance-response machine and asked them to flip over cards from one of four decks; two of the decks generated gains (in play money) and the other two were losers.  As the subjects turned cards, Damasio asked them what they thought was going on.  After about ten turns, the subjects started showing physical reactions when they reached for a losing deck.  About fifty cards into the experiment, the subjects articulated a hunch that two of the four decks were riskier.  And it took another thirty cards for the subjects to explain why their hunch was right.

This experiment provided two remarkable decision-making lessons.  First, the unconscious knew what was going on before the conscious did.  Second, even the subjects who never articulated what was going on had unconscious physical reactions that guided their decisions.

 

BEWARE OF BEHAVIORAL FINANCE

Individual agents can behave irrationally but the market can still be rational.

…Collective behavior addresses the potentially irrational actions of groups.  Individual behavior dwells on the fact that we all consistently fall into psychological traps, including overconfidence, anchoring and adjustment, improper framing, irrational commitment escalation, and the confirmation trap.

Here’s my main point: markets can still be rational when investors are individually irrational.  Sufficient investor diversity is the essential feature in efficient price formation.  Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices.  Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency.

Mauboussin continues:

In case after case, the collective outperforms the individual.  A full ecology of investors is generally sufficient to assure that there is no systematic way to beat the market.  Diversity is the default assumption, and diversity breakdowns are the notable (and potentially profitable) exceptions.

(Illustration by Trueffelpix)

Mauboussin writes about an interesting example of how the collective can outperform individuals (including experts).

On January 17, 1966, a B-52 bomber and a refueling plane collided in midair while crossing the Spanish coastline.  The bomber was carrying four nuclear bombs.  Three were immediately recovered.  But the fourth was lost and its recovery became a national security priority.

Assistant Security of Defense Jack Howard called a young naval officer, John Craven, to find the bomb.  Craven assembled a diverse group of experts and asked them to place bets on where the bomb was.  Shortly thereafter, using the probabilities that resulted from all the bets, the bomb was located.  The collective intelligence in this example was superior to the intelligence of any individual expert.

 

IMPORTANCE OF A DECISION JOURNAL

In investing and in general, it’s wise to keep a journal of our decisions and the reasoning behind them.

(Photo by Leerobin)

We all suffer from hindsight bias.  We are unable to recall what we actually thought before making a decision or judgment.

  • If we decide to do something and it works out, we tend to underestimate the uncertainty that was present when we made the decision.  “I knew I made the right decision.”
  • If we decide to do something and it doesn’t work, we tend to overestimate the uncertainty that was present when we made the decision.  “I suspected that it wouldn’t work.”
  • If we judge that event X will happen, and then it does, we underestimate the uncertainty that was present when we made the judgment.  “I knew that would happen.”
  • If we judge that event X will happen, and it doesn’t, we overestimate the uncertainty that was present when we made the judgment.  “I was fully aware that it was unlikely.”

See: https://en.wikipedia.org/wiki/Hindsight_bias

As Mauboussin notes, keeping a decision journal gives us a valuable source of objective feedback.  Otherwise, we won’t recall with any accuracy the uncertainty we faced or the reasoning we used.

 

RIGHT FROM THE GUT

Robert Olsen has singled out five conditions that are present in the context of naturalistic decision making.

  • Ill-structured and complex problems.  No obvious best procedure exists to solve a problem.
  • Information is incomplete, ambiguous, and changing.  Because stock picking relates to future financial performance, there is no way to consider all information.
  • Ill-defined, shifting, and competing goals.  Although long-term goals may be clearer, goals can change over shorter horizons.
  • Stress because of time constraints, high stakes, or both.  Stress is clearly a feature of investing.
  • Decisions may involve multiple participants.  

Mauboussin describes three key characteristics of naturalistic decision makers.  First, they rely heavily on mental imagery and simulation in order to assess a situation and possible alternatives.  Second, they excel at pattern matching.  (For instance, chess masters can glance at a board and quickly recognize a pattern.)

(Photo by lbreakstock)

Third, naturalistic decision makers reason through analogy.  They can see how seemingly different situations are in fact similar.

 

WEIGHTED WATCHER

Mauboussin describes how we develop a “degree of belief” in a specific hypothesis:

Our degree of belief in a particular hypothesis typically integrates two kinds of evidence: the strength, or extremeness, of the evidence and the weight, or predictive validity.  For instance, say you want to test the hypothesis that a coin in biased in favor of heads.  The proportion of heads in the sample reflects the strength, while the sample size determines the weight.

Probability theory describes rules for how to combine strength and weight correctly.  But substantial experimental data show that people do not follow the theory.  Specifically, the strength of evidence seems to dominate the weight of evidence in people’s minds.

This bias leads to a distinctive pattern of over- and underconfidence.  When the strength of evidence is high and the weight is low—which accurately describes the outcome of many Wall Street-sponsored surveys—people tend to be overconfident.  In contrast, when the strength is low and the evidence is high, people tend to be underconfident.

(Photo by Michele Lombardo)

Does survey-based research lead to superior stock selection?  Mauboussin responds that the answer is ambiguous.  First, the market adjusts to new information rapidly.  It’s difficult to gain an informational edge, especially when it comes to what is happening now or what will happen in the near future.  In contrast, it’s possible to gain an informational edge if you focus on the longer term.  That’s because many investors don’t focus there.

The second issue is that understanding the fundamentals about a company or industry is very different from understanding the expectations built into a stock price.  The question is not just whether the information is new to you, but whether the information is also new to the market.  In the vast majority of cases, the information is already reflected in the current stock price.

Mauboussin sums it up:

Seeking new information is a worthy goal for an investor.  My fear is that much of what passes as incremental information adds little or no value, because investors don’t properly weight new information, rely on unsound samples, and fail to recognize what the market already knows.  In contrast, I find that thoughtful discussions about a firm’s or an industry’s medium- to long-term competitive outlook extremely rare.

 

WHY INNOVATION IS INEVITABLE

(Image: Innovation concept, by Daniil Peshkov)

Mauboussin quotes Andrew Hargadon’s How Breakthroughs Happen:

All innovations represent some break from the past—the lightbulb replaced the gas lamp, the automobile replaced the horse and cart, the steamship replaced the sailing ship.  By the same token, however, all innovations are built from pieces of the past—Edison’s system drew its organizing principles from the gas industry, the early automobiles were built by cart makers, and the first steam ships added steam engines to existing sailing ships.

Mauboussin adds:

Investors need to appreciate the innovation process for a couple of reasons.  First, our overall level of material well-being relies heavily on innovation.  Second, innovation lies at the root of creative destruction—the process by which new technologies and businesses supersede others.  More rapid innovation means more rapid success and failure for companies.

Mauboussin draws attention to three interrelated factors that continue to drive innovation at an accelerating rate:

  • Scientific advances
  • Information storage capacity
  • Gains in computing power

 

ACCELERATING RATE OF INDUSTRY CHANGE

(Photo: Drosophila Melanogaster, by Tomatito26)

Mauboussin mentions the common fruit fly, Drosophila melanogaster, which geneticists and other scientists like to study because its life cycle is only two weeks.

Why should businesspeople care about Drosophila?  A sound body of evidence now suggests that the average speed of evolution is accelerating in the business world.  Just as scientists have learned a great deal about evolutionary change from fruit flies, investors can benefit from understanding the sources and implications of accelerated business evolution.

The most direct consequence of more rapid business evolution is that the time an average company can sustain a competitive advantage—that is, generate an economic return in excess of its cost of capital—is shorter than it was in the past.  This trend has potentially important implications for investors in areas such as valuation, portfolio turnover, and diversification.

Mauboussin refers to research by Robert Wiggins and Timothy Ruefli on the sustainability of economic returns.  They put forth four hypotheses.  The first three were supported by the data, while the fourth one was not:

  • Periods of persistent superior economic performance are decreasing in duration over time.
  • Hypercompetition is not limited to high-technology industries but will occur through most industries.
  • Over time, firms increasingly seek to sustain competitive advantage by concatenating a series of short-term competitive advantages.
  • Industry concentration, large market share, or both are negatively correlated with chance of loss of persistent superior economic performance in an industry.

Mauboussin points out that faster product and process life cycles means that historical multiples are less useful for comparison.  Also, the terminal valuation in discounted cash-flow models in many cases has to be adjusted to reflect shorter periods of sustainable competitive advantage.

(Image by Marek Uliasz)

Furthermore, while portfolio turnover on average is too high, portfolio turnover could be increased for those investors who have historically had a portfolio turnover of 20 percent (implying a holding period of 5 years).  Similarly, shorter periods of competitive advantage imply that some portfolios should be more diversified.  Lastly, faster business evolution means that investors must spend more time understanding the dynamics of organizational change.

 

HOW TO BALANCE THE LONG TERM WITH THE SHORT TERM

(Photo by Michael Maggs, via Wikimedia Commons)

Mauboussin notes the lessons emphasized by chess master Bruce Pandolfini:

  • Don’t look too far ahead.  Most people believe that great players strategize by thinking far into the future, by thinking 10 or 15 moves ahead.  That’s just not true.  Chess players look only as far into the future as they need to, and that usually means looking just a few moves ahead.  Thinking too far ahead is a waste of time: The information is uncertain.
  • Develop options and continuously revise them based on the changing conditions: Great players consider their next move without playing it.  You should never play the first good move that comes into your head.  Put that move on your list, and then ask yourself if there’s an even better move.  If you see a good idea, look for a better one—that’s my motto.  Good thinking is a matter of making comparisons.
  • Know your competition: Being good at chess also requires being good at reading people.  Few people think of chess as an intimate, personal game.  But that’s what it is.  Players learn a lot about their opponents, and exceptional chess players learn to interpret every gesture that their opponents make.
  • Seek small advantages: You play for seemingly insignificant advantages—advantages that your opponent doesn’t notice or that he dismisses, thinking, “Big deal, you can have that.”  It could be slightly better development, or a slightly safer king’s position.  Slightly, slightly, slightly.  None of those “slightlys” mean anything on their own, but add up seven or eight of them, and you have control.

Mauboussin argues that companies should adopt simple, flexible long-term decision rules.  This is the “strategy as simple rules” approach, which helps us from getting caught in the short term versus long term debate.

Moreover, simple decision rules help us to be consistent.  Otherwise we will often reach different conclusions from the same data based on moods, suggestion, recency bias, availability bias, framing effects, etc.

 

FITNESS LANDSCAPES AND COMPETITIVE ADVANTAGE

(Image: Fitness Landscape, by Randy Olsen, via Wikimedia Commons)

Mauboussin:

What does a fitness landscape look like?  Envision a large grid, with each point representing a different strategy that a species (or a company) can pursue.  Further imagine that the height of each point depicts fitness.  Peaks represent high fitness, and valleys represent low fitness.  From a company’s perspective, fitness equals value-creation potential.  Each company operates in a landscape full of high-return peaks and value-destructive valleys.  The topology of the landscape depends on the industry characteristics.

As Darwin noted, improving fitness is not about strength or smarts, but rather about becoming more and more suited to your environment—in a word, adaptability.  Better fitness requires generating options and “choosing” the “best” ones.  In nature, recombination and mutation generate species diversity, and natural selection assures that the most suitable options survive.  For companies, adaptability is about formulating and executing value-creating strategies with a goal of generating the highest possible long-term returns.

Since a fitness landscape can have lots of peaks and valleys, even if a species reaches a peak (a local optimum), it may not be at the highest peak (a global optimum).  To get a higher altitude, a species may have to reduce its fitness in the near term to improve its fitness in the long term.  We can say the same about companies…

Mauboussin remarks that there are three types of fitness landscape:

  • Stable.  These are industries where the fitness landscape is reasonably stable.  In many cases, the landscape is relatively flat, and companies generate excess economic returns only when cyclical forces are favorable.  Examples include electric and telephone utilities, commodity producers (energy, paper, metals), capital goods, consumer nondurables, and real estate investment trusts.  Companies within these sectors primarily improve their fitness at the expense of their competitors.  These are businesses that tend to have structural predictability (i.e., you’ll know what they look like in the future) at the expense of limited opportunities for growth and new businesses.
  • Coarse.  The fitness landscape is in flux for these industries, but the changes are not so rapid as to lack predictability.  The landscape here is rougher.  Some companies deliver much better economic performance than do others.  Financial services, retail, health care, and more established parts of technology are illustrations.  These industries run a clear risk of being unseated (losing fitness) by a disruptive technology.
  • Roiling.  This group contains businesses that are very dynamic, with evolving business models, substantial uncertainty, and ever-changing product offerings.  The peaks and valleys are constantly changing, ever spastic.  Included in this type are many software companies, the genomics industry, fashion-related sectors, and most start-ups.  Economic returns in this group can be (or can promise to be) significant but are generally fleeting.

Mauboussin indicates that innovation, deregulation, and globalization are probably causing the global fitness landscape to become even more contorted.

Companies can make short, incremental jumps towards a local maximum.  Or they can make long, discontinuous jumps that may lead to a higher peak or a lower valley.  Long jumps include investing in new potential products or making meaningful acquisitions in unrelated fields.  The proper balance between short jumps and long jumps depends on a company’s fitness landscape.

Mauboussin adds that the financial tool for valuing a given business depends on the fitness landscape that the business is in.  A business in a stable landscape can be valued using discounted cash-flow (DCF).  A business in a course landscape can be valued using DCF plus strategic options.  A business in a roiling landscape can be valued using strategic options.

 

THE FOLLY OF USING AVERAGE P/E’S

Bradford Cornell:

For past averages to be meaningful, the data being averaged have to be drawn from the same population.  If this is not the case—if the data come from populations that are different—the data are said to be nonstationary.  When data are nonstationary, projecting past averages typically produces nonsensical results.

Nonstationarity is a key concept in time-series analysis, such as the study of past data in business and finance.  If the underlying population changes, then the data are nonstationary and you can’t compare past averages to today’s population.

(Image: Time Series, by Mike Toews via Wikimedia Commons)

Mauboussin gives three reasons why past P/E data are nonstationary:

  • Inflation and taxes
  • Changes in the composition of the economy
  • Shifts in the equity-risk premium

Higher taxes mean lower multiples, all else equal.  And higher inflation also means lower multiples.  Similarly, low taxes and low inflation both cause P/E ratios to be higher.

The more companies rely on intangible capital rather than tangible capital, the higher the cash-flow-to-net-income ratio.  Overall, the economy is relying increasingly on intangible capital.  Higher cash-flow-to-net-income ratios, and higher returns on capital, mean higher P/E ratios.

 

MEAN REVERSION AND TURNAROUNDS

Growth alone does not create value.  Growth creates value only if the return on invested capital exceeds the cost of capital.  Growth actually destroys value if the return on invested capital is less than the cost of capital.

(Illustration by Teguh Jati Prasetyo)

Over time, a company’s return on capital moves towards its cost of capital.  High returns bring competition and new capital, which drives the return on capital toward the cost of capital.  Similarly, capital exits low-return industries, which lifts the return on capital toward the cost of capital.

Mauboussin reminds us that a good business is not necessarily a good investment, just as a bad business is not necessarily a bad investment.  What matters is the expectations embedded in the current price.  If expectations are overly low for a bad business, it can represent a good investment.  If expectations are too high for a good business, it may be a poor investment.

On the other hand, some cheap stocks deserve to be cheap and aren’t good investments.  And some expensive-looking stocks trading at high multiples may still be good investments if high growth and high return on capital can persist long enough into the future.

 

CONSIDERING COOPERATION AND COMPETITION THROUGH GAME THEORY

(Illustration: Concept of Prisoner’s Dilemma, by CXJ Jensen via Wikimedia Commons)

Mauboussin quotes Robert Axelrod’s The Complexity of Cooperation:

What the Prisoner’s Dilemma captures so well is the tension between the advantages of selfishness in the short run versus the need to elicit cooperation from the other player to be successful over the longer run.  The very simplicity of the Prisoner’s Dilemma is highly valuable in helping us to discover and appreciate the deep consequences of the fundamental processes involved in dealing with this tension.

The Prisoner’s Dilemma shows that the rational response for an individual company  is not necessarily optimal for the industry as a whole.

If the Prisoner’s Dilemma game is going to be repeated many times, then the best strategy is tit-for-tat.  Whatever your competitor’s latest move was, copy that for your next move.  So if your competitor deviates one time and then cooperates, you deviate one time and then cooperate.  Tit-for-tat is both the simplest strategy and also the most effective.

When it comes to market pricing and capacity decisions, competitive markets need not be zero sum.  A tit-for-tat strategy is often optimal, and by definition it includes a policing component if your competitor deviates.

 

THE WISDOM AND WHIM OF THE COLLECTIVE

Mauboussin quotes Robert D. Hanson’s Decision Markets:

[Decision markets] pool the information that is known to diverse individuals into a common resource, and have many advantages over standard institutions for information aggregation, such as news media, peer review, trials, and opinion polls.  Speculative markets are decentralized and relatively egalitarian, and can offer direct, concise, timely, and precise estimates in answer to questions we pose.

Mauboussin then writes about bees and ants, ending with this comment:

What makes the behavior of social insects like bees and ants so amazing is that there is no central authority, no one directing traffic.  Yet the aggregation of simple individuals generates complex, adaptive, and robust results.  Colonies forage efficiently, have life cycles, and change behavior as circumstances warrant.  These decentralized individuals collectively solve very hard problems, and they do it in a way that is very counterintuitive to the human predilection to command-and-control solutions.

(Illustration: Swarm Intelligence, by Farbentek)

Mauboussin again:

Why do decision markets work so well?  First, individuals in these markets think they have some edge, so they self-select to participate.  Second, traders have an incentive to be right—they can take money from less insightful traders.  Third, these markets provide continuous, real-time forecasts—a valuable form of feedback.  The result is that decision markets aggregate information across traders, allowing them to solve hard problems more effectively than any individual can.

 

VOX POPULI

(Painting: Sir Francis Galton, by Charles Wellington Furse, via Wikimedia Commons)

Mauboussin tells of an experiment by Francis Galton:

Victorian polymath Francis Galton was one of the first to thoroughly document this group-aggregation ability.  In a 1907 Nature article, “Vox Populi,” Galton describes a contest to guess the weight of an ox at the West of England Fat Stock and Poultry Exhibition in Plymouth.  He collected 787 participants who each paid a sixpenny fee to participate.  (A small cost to deter practical joking.)  According to Galton, some of the competitors were butchers and farmers, likely expert at guessing the weight.  He surmised that many others, though, were guided by “such information as they might pick up” or “by their own fancies.”

Galton calculated the median estimate—the vox populi—as well as the mean.  He found that the median guess was within 0.8 percent of the correct weight, and that the mean of the guesses was within 0.01 percent.  To give a sense of how the answer emerged, Galton showed the full distribution of answers.  Simply stated, the errors cancel out and the result is distilled information.

Subsequently, we have seen the vox populi results replicated over and over.  Examples include solving a complicated maze, guessing the number of jellybeans in a jar, and finding missing bombs.  In each case, the necessary conditions for information aggregation to work include an aggregation mechanism, an incentive to answer correctly, and group heterogeneity.

 

COMPLEX ADAPTIVE SYSTEMS

(Illustration by Acadac, via Wikimedia Commons)

Complex adaptive systems exhibit a number of essential properties and mechanisms, writes Mauboussin:

  • Aggregation.  Aggregation is the emergence of complex, large-scale behavior from the collective interactions of many less-complex agents.
  • Adaptive decision rules.  Agents within a complex adaptive system take information from the environment, combine it with their own interaction with the environment, and derive decision rules.  In turn, various decision rules compete with one another based on their fitness, with the most effective rules surviving.
  • Nonlinearity.  In a linear model, the whole equals the sum of the parts.  In nonlinear systems, the aggregate behavior is more complicated than would be predicted by totaling the parts.
  • Feedback loops.  A feedback system is one in which the output of one iteration becomes the input of the next iteration.  Feedback loops can amplify or dampen an effect.

Governments, many corporations, and capital markets are all examples of complex adaptive systems.

Humans have a strong drive to invent a cause for every effect.  This has been biologically advantageous for the vast majority of human history.  In the past, if we heard a rustling in the grass, we immediately sought safety.  There was always some cause for the noise.  It virtually never made sense to wait around to see if it was a predator or not.

However, in complex adaptive systems like the stock market, typically there is no simple cause and effect relationship that explains what happens.

For many big moves in the stock market, there is no identifiable cause.  But people have such a strong need identify a cause that they make up causes.  The press delivers to people what they want: explanations for big moves in the stock market.  Usually these explanations are simply made up.  They’re false.

 

THE FUTURE OF CONSILIENCE IN INVESTING

(Painting: Galileo Galilei, by Justus Sustermans, via Wikimedia Commons)

Mauboussin, following Charlie Munger, argues that cross-disciplinary research is likely to produce the deepest insights into the workings of companies and markets.  Here are some examples:

  • Decision making and neuroscience.  Prospect theory—invented by Daniel Kahneman and Amos Tversky—describes how people suffer from cognitive biases when they make decisions under uncertainty.  Prospect theory is extremely well-supported by countless experiments.  But prospect theory still doesn’t explain why people make the decisions they do.  Neuroscience will help with this.
  • Statistical properties of markets—from description to prediction?  Stock price changes are not normally distributed—along a bell-shaped curve—but rather follow a power law.  The statistical distribution has fat tails, which means there are more extreme moves than would occur under a normal distribution.  Once again, a more accurate description is progress.  But the next step involves a greater ability to explain and predict the phenomena in question.
  • Agent-based models.  Individual differences are important in market outcomes.  Feedback mechanisms are also central.
  • Network theory and information flows.  Network research involves epidemiology, psychology, sociology, diffusion theory, and competitive strategy.  Much progress can be made.
  • Growth and size distribution.  There are very few large firms and many small ones.  And all large firms experience significantly slower growth once they reach a certain size.
  • Flight simulator for the mind?  One of the biggest challenges in investing is that long-term investors don’t get nearly enough feedback.  Statistically meaningful feedback for investors typically takes decades to produce.

 

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.

How the Greatest Economist Defied Convention and Got Rich

January 22, 2023

John Maynard Keynes is one of the greatest economists of all time.  But when he tried to invest on the basis of macroeconomic predictions, he failed.  Twice.  When he embraced focused value investing, he was wildly successful.

It is well known that Warren Buffett and Charlie Munger are two of the greatest value investors, and that they both favor a focused approach.  What is not as well known is that the world’s most famous economist, John Maynard Keynes, independently embraced a value investing approach similar to that used by Buffett and Munger.

The story of Keynes’ evolution as an investor has been told many times.  One book in particular – Justyn Walsh’s Keynes and the Market (Wiley, 2008) – does a great job.

Keynes did very well over decades as a focused value investor.  His best advice:

  • Buy shares when they are cheap in relation to probable intrinsic value;
  • Ignore macro and market predictions, and stay focused on a few individual businesses that you understand and whose management you believe in;
  • Hold those businesses for many years as long as the investment theses are intact;
  • Try to have negatively correlated investments (for example, the stock of a gold miner, says Keynes).

Now for a brief summary of the book.

 

INTELLECTUAL BEGINNINGS

Keynes was born in 1883 in the university town of Cambridge, where his father was an economics fellow and his mother was one of its first female graduates.  After attending Eton, in 1902 Keynes won a scholarship to King’s College at Cambridge.  There, he became a member of a secret society known as “the Apostles,” which included E. M. Forster, Bertrand Russell, and Wittgenstein.  The group was based on principles expressed in G. E. Moore’s Principia Ethica.  Moore believed the following:

By far the most valuable things, which we know or can imagine, are certain states of consciousness, which may be roughly described as the pleasures of human intercourse and the enjoyment of beautiful objects.

Upon graduation, Keynes decided to become a Civil Servant, and ended up as a junior clerk in the India Office in 1906.  Keynes was also part of the Bloomsbury group, which included artists, writers, and philosophers who met at the house of Virginia Woolf and her siblings.  Walsh quotes a Bloomsbury:

We found ourselves living in the springtime of a conscious revolt against the social, political, moral, intellectual, and artistic institutions, beliefs, and standards of our fathers and grandfathers.

 

WORLD WAR I – PEACE TERMS

Keynes strongly disagreed with the proposed peace terms following the conclusion of World War I.  He wrote The Economic Consequences of the Peace, which was translated into eleven languages.  Keynes predicted that the vengeful demands of France (and others) against their enemies would inevitably lead to another world war far worse than the first one.  Unfortunately, Keynes was ignored and his prediction turned out to be roughly correct.

 

KEYNES THE SPECULATOR

After resigning from Treasury, Keynes needed a source of income.  Given his background in economics and government, he decided that he could make money by speculating on currencies (and later commodities).  After a couple of large ups and downs, Keynes ended up losing more than 80% of his net worth in 1928 to 1929 – from 44,000 pounds to 8,000 pounds.  His speculative bets on rubber, corn, cotton, and tin declined massively in 1928.  Eventually he realized that value investing was a much better way to succeed as an investor.

Keynes made a clear distinction between speculation and value investing.  He described speculation as like the newspaper competitions where one had to pick out the faces that the average would pick as the prettiest:

It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice fourth, fifth and higher degrees.

 

KEYNES THE ECONOMIST

Another famous economist, Irving Fisher, who had also done well in business, made his famous prediction in mid-October 1929:

Stock prices have reached what looks like a permanently high plateau…. I expect to see the stock market a good deal higher… within a few months.

After the initial crash that began in late October 1929, Fisher continued to predict a recovery.

Keynes, on the other hand, was quick to recognize both the deep problems posed by the economic downturn and the necessity for aggressive fiscal policy (contrary to the teachings of classical economics).  Keynes said:

The fact is – a fact not yet recognized by the great public – that we are now in the depths of a very severe international slump, a slump which will take its place in history amongst the most acute ever experienced.  It will require not merely passive movements of bank rates to lift us out of a depression of this order, but a very active and determined policy.

Keynes argued that the economy was at an underemployment equilibrium, with a large amount of wasted resources.  Only aggressive fiscal policy could increase aggregate demand, thereby bringing the economy back to a healthy equilibrium.  Classical economists at the time – who disagreed forcefully with Keynes – thought that the economy was like a household: when income declines, one must spend less until the situation corrects itself.  Keynes referred to the classical economists as “liquidationists,” because their position implied that everything should be liquidated (at severely depressed and irrational prices) until the economy corrected itself.

Franklin Delano Roosevelt seemed to agree with Keynes.  Roosevelt said “this Nation asks for action, and action now.”  Roosevelt argued that, if necessary, he would seek “broad Executive power… as great as the power that would be given to me if we were in fact invaded by a foreign foe.”

In The General Theory of Employment, Interest and Money, Keynes disagreed with the conventional doctrine that free markets always produce optimal results.  Much later, even Keynes’ opponents agreed with him and admitted that “we are all Keynesians now.”

In the 1970’s, however, when stagflation (slow growth and rising prices) reared its ugly head, neoclassical economics was revived and Keynesian economics became less popular.  But by the late 1970’s, another part of Keynes’ views – “animal spirits” – became important in the new field of behavioral economics.

 

KEYNES THE VALUE INVESTOR

Keynes held that there is an irreducible uncertainty regarding most of the future.  In the face of great uncertainty, “animals spirits” – or “the spontaneous urge to action rather than inaction” – leads people to make decisions and move forward.

Because the future is so uncertain, many investors extrapolate the recent past into the future, which often causes them to make investment mistakes.  Moreover, many investors overweight the near term, leading to stock price volatility far in excess of the long-term earnings and dividends produced by the underlying companies.  Keynes remarked:

Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.

Keynes lamented the largely random daily price fluctuations upon which so many investors uselessly focus.  Of these fluctuating daily prices, Keynes said that they gave:

… a frequent opportunity to the individual… to revise his commitments.  It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.

Warren Buffett has often quoted this statement by Keynes.  Indeed, in discussing speculators as opposed to long-term value investors, Keynes sounds a lot like Ben Graham and Warren Buffett.  Keynes:

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself.  It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise.  For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.

Keynes also noted:

… it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.  For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion.  If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

Because many fund managers are judged over shorter periods of time – even a few months – they typically worry more about not underperforming than they do about outperforming.  With so many investors – both professional and non-professional – focused on short-term price performance, it’s no surprise that the stock market often overreacts to new information – especially if it’s negative.  (The stock market can often underreact to positive information.)  Nor is it a surprise that the typical stock price moves around far more than the company’s underlying intrinsic value – asset value or earnings power.

In a nutshell, investor psychology can cause a stock to be priced almost anywhere in the short term, regardless of the intrinsic value of the underlying company.  Keynes held that value investors should usually simply ignore these random fluctuations and stay focused on the individual businesses in which they have invested.  As Ben Graham, the father of value investing, said in The Intelligent Investor:

Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Graham also wrote:

The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.  Thus we have what appear to be two major sources of undervaluation:  (1) currently disappointing results and (2) protracted neglect or unpopularity.

Or as Buffett said:

Fear is the foe of the faddist, but the friend of the fundamentalist.

Buffett later observed that Keynes “began as a market-timer… and converted, after much thought, to value investing.”  Whereas the speculator attempts to predict price swings, the value investor patiently waits until irrational price swings have made a stock unusually cheap with respect to probable future earnings.  Keynes:

… I am generally trying to look a long way ahead and am prepared to ignore immediate fluctuations, if I am satisfied that the assets and earnings power are there.

 

MARGIN OF SAFETY

Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, wrote the following in Chapter 20 of The Intelligent Investor:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’  Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

Keynes used the phrase “safety first” instead of “margin of safety.”  Moreover, he had a similar definition of intrinsic value: an estimate based on the probable earnings power of the assets.  Keynes realized that a lower price paid relative to intrinsic value simultaneously reduces risk and increases probable profit.  The notion that a larger margin of safety means larger profits in general is directly opposed to what is still taught in modern finance: higher investment returns are only achievable through higher risk.

Moreover, Keynes emphasized the importance of non-quantitative factors relevant to investing.  Keynes is similar to Graham, Buffett, and Munger in this regard.  Munger:

… practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important.

Or as Ben Graham stated:

… the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes… in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom.

 

UNCERTAINTY AND PESSIMISM CREATE BARGAINS

The value investor often gains an advantage by having a 3- to 5-year investment time horizon.  Because the future is always uncertain, and because so many investors are focused on the next 6 months, numerous bargains become available for long-term investors.  As Keynes mentioned:

Very few American investors buy any stock for the sake of something which is going to happen more than six months hence, even though its probability is exceedingly high; and it is out of taking advantage of this psychological peculiarity that most money is made.

Pessimism also creates bargains.  During the 1973-1974 bear market, many stocks became ridiculously cheap relative to asset value or earnings power.  Buffett has explained the case of The Washington Post Company:

In ’74 you could have bought The Washington Post when the whole company was valued at $80 million.  Now at that time the company was debt free, it owned The Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington, D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot.  If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million.

 

MARKET LEADERS OR HIGHER QUALITY COMPANIES

Keynes had a policy of buying the best within each chosen investment category:

It is generally a good rule for an investor, having settled on the class of security he prefers – … bank shares or oil shares, or investment trusts, or industrials, or debentures, preferred or ordinary, whatever it may be – to buy only the best within that category.

Buffett, partly through the influence of Charlie Munger, evolved from an investor in quantitatively cheap stocks to an investor in higher quality companies.  Munger explains the logic:

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.  If the business earns 6 percent on capital over 40 years and you hold if for… 40 years, you’re not going to make much different than 6 percent return – even if you originally buy it at a huge discount.  Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

 

FOCUSED AND PATIENT

Keynes was a “focused” value investor in the sense of believing in a highly concentrated portfolio.  This is similar to Buffett and Munger (especially when they were managing smaller amounts of money).

Keynes was criticized for taking large positions in his best ideas.  Here is one of his responses:

Sorry to have gone too large in Elder Dempster… I was… suffering from my chronic delusion that one good share is safer than ten bad ones, and I am always forgetting that hardly anyone else shares this particular delusion.

If you can understand specific businesses – which is easier to do if you focus on tiny microcap companies – Keynes, Buffett, and Munger all believed that you should take large positions in your best ideas.  Keynes called these opportunities “ultra favourites” or “stunners,” while Buffett called them “superstars” and “grand-slam home runs.”  As Keynes concluded late in his career:

… it is out of these big units of the small number of securities about which one feels absolutely happy that all one’s profits are made… Out of the ordinary mixed bag of investments nobody ever makes anything.

One way that the best ideas of Keynes, Buffett, and Munger become even larger positions in their portfolios over time is if the investment theses are essentially correct, which eventually leads the stocks to move much higher.  Many investors ask: if your best idea becomes an even larger part of the portfolio, shouldn’t you rebalance?  Here is Buffett’s response:

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

The decision about whether to hold a stock should depend only upon your current investment thesis about the company.  It doesn’t matter what you paid for it, or whether the stock has increased or decreased recently.  What matters is how much free cash flow you think the company will produce over time, and how cheap the stock is now relative to that future free cash flow.  What also matters is how cheap the stock is relative to your other ideas.

Keynes again on concentration:

To suppose that safety-first consists in having a small gamble in a large number of different directions…, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.

As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.  It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.

Conducting research on a relatively short list of candidates and then concentrating your portfolio on the best ideas, is a form of specialization.  Often the stocks in a specific sector will get very cheap when that sector is out of favor.  If you’re willing to invest the time to understand the stocks in that sector, you may be able to gain an edge.

Moreover, if you’re an individual investor, it makes sense to focus on tiny microcap companies, which are generally easier to understand and can get extremely cheap because most investors completely ignore them.

Ben Graham often pointed out that patience and courage are essential for contrarian value investing.  Cheap stocks are usually neglected or hated because they have terrible short-term problems affecting their earnings and cash flows.  Similarly, Keynes held that huge short-term price fluctuations are often irrational with respect to long-term earnings and dividends.  Keynes:

… the modern organization of the capital market requires for the holder of quoted equities much more nerve, patience, and fortitude than from the holder of wealth in other forms.

 

SUMMARY

Keynes’ experiences on the stock market read like some sort of morality play – an ambitious young man, laboring under the ancient sin of hubris, loses almost everything in his furious pursuit of wealth; suitably humbled, our protagonist, now wiser for the experience, applies his considerable intellect to the situation and discovers what he believes to be the one true path to stock market success.

Keynes realized that focused value investing is the best way to compound wealth over time.  Ignore market and macro predictions, and focus on a few businesses that you can understand and in whose management you believe.

In 1938, in a memorandum written for King’s College Estates Committee, Keynes gave a concise summary of his investment philosophy:

  • A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
  • A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
  • A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g., a holding of gold shares amongst other equities, since they are likely to move in opposite directions when there are general fluctuations).

Walsh writes that Keynes followed six key investment rules:

  1. Focus on the estimated intrinsic value of a stock – as represented by the projected earnings of the particular security – rather than attempt to divine market trends.
  2. Ensure that a sufficiently large margin of safety – the difference between a stock’s assessed intrinsic value and price – exists in respect of purchased stocks.
  3. Apply independent judgment in valuing stocks, which may often imply a contrarian investment policy.
  4. Limit transaction costs and ignore the distractions of constant price quotation by maintaining a steadfast holding of stocks.
  5. Practice a policy of portfolio concentration by committing relatively large sums of capital to stock market “stunners.”
  6. Maintain the appropriate temperament by balancing “equanimity and patience” with the ability to act decisively.

The importance of temperament and the ability to maintain inner peace should not be overlooked.  As Buffett points out:

Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Walsh summarizes Keynes’ performance as a value investor:

Taking 1931 as the base year – admittedly a relatively low point in the Fund’s fortunes, but also on the assumption that Keynes’ value investment style began around this time – the Chest Fund recorded a roughly tenfold increase in value in the fifteen years to 1945, compared with a virtual nil return for the Standard & Poor’s 500 Average and a mere doubling of the London industrial index over the same period.

What’s even more impressive is that this performance does not include the income generated by the Chest Fund, all of which was spent on college building works and repayment of loans.

One small mistake Keynes made was holding his “stunners” even when they were overvalued.  Keynes made this mistake because he was an optimist.  (Buffett made a similar mistake in the late 1990’s.)  Here is Keynes (sounding like Buffett) on the future:

There is nothing to be afraid of.  On the contrary.  The future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered.

 

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.

Best Performers: Microcap Stocks

January 15, 2023

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.

 

The Most Important Thing

January 8, 2023

Howard Marks is one of the great value investors.  The Most Important Thing is a book Marks created based on his memos to clients.  Marks noticed that in his meetings with clients, he would often say, “The most important thing is X,” and then a bit later say, “The most important thing is Y,” and so on.  So the book, The Most Important Thing, has many “most important things,” all of which truly are important according to Marks.

Outstanding books are often worth reading at least four or five times.  The Most Important Thing is clearly outstanding, and is filled with investment wisdom.  As a result, this blog post is longer than usual.  It’s worth spending time to absorb the wisdom of Howard Marks.

 

INTRODUCTION

Marks writes:

Where does an investment philosophy come from?  The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed.  A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources.  One cannot develop an effective philosophy without having been exposed to life’s lessons.  In my life I’ve been quite fortunate in terms of both rich experiences and powerful lessons.

Marks adds:

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk.  The most valuable lessons are learned in tough times.

 

SECOND-LEVEL THINKING

Marks first points out how variable the investing landscape is:

No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.  Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

The goal for an investor is to do better than the market over time.  Otherwise, the best option for most investors is simply to buy and hold low-cost broad market index funds.  Doing better than the market requires an identifiable edge:

Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have.  You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won’t be sufficient.  You must be more right than others… which by definition means your thinking has to be different.

Marks gives some examples of second-level thinking:

    • First-level thinking says, ‘It’s a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’
    • First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’   Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’
    • First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’

Marks explains that first-level thinking is generally simplistic.  By contrast, second-level thinking requires thinking of the full range of possible future outcomes, along with estimating probabilities for each possible outcome.  Second-level thinking means understanding what the consensus thinks, why one has a different view, and the likelihood that one’s contrarian view is correct.  Marks observes that second-level thinking is far more difficult than first-level thinking, thus few investors truly engage in second-level thinking.  First-level thinkers cannot expect to outperform the market.  Marks:

To outperform the average investor, you have to be able to outthink the consensus.  Are you capable of doing so?  What makes you think so?

Marks again:

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate.  That’s not easy.

 

UNDERSTANDING MARKET EFFICIENCY

Marks holds a view of market efficiency similar to that of Buffett:  The market is usually efficient, but it is far from always efficient.  Marks says that the market reflects the consensus view, but the consensus is not always right:

In January 2000, Yahoo sold at $237.  In April 2001 it was $11.  Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.  But that doesn’t mean many investors were able to detect and act on the market’s error.

Marks summarizes his view:

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct.  That’s what makes the mainstream markets awfully hard to beat – even if they aren’t always right.

Marks makes an important point about riskier investments:

Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise.  Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments.  But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

Marks notes that inefficient prices imply that for each investor who buys at a cheap price, another investor must sell at that cheap price.  Inefficiency essentially implies that each investment that beats the market implies another investment that trails the market by an equal amount.

Generally it is exceedingly difficult to beat the market.  To highlight this fact, Marks asks a series of questions:

    • Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
    • If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
    • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
    • Do you really know more about the asset than the seller does?
    • If it’s such a great proposition, why hasn’t someone else snapped it up?

Market inefficiency alone, argues Marks, is not a sufficient condition for outperformance:

All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high.  You still have to be more insightful than others in order to regularly buy more of the former than the latter.  Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.

Marks ends this section by saying that a key turning point in his career was when he concluded that he should focus on relatively inefficient markets.  (Note:  micro-cap stocks is one area that is relatively inefficient, which is why I created the Boole Microcap Fund.)

A few notes about deep value (contrarian value) investing:

In order to buy a stock that is very cheap in relation to its intrinsic value, some other investor must be willing to sell the stock at such an irrationally low price.  Sometimes such sales happen due to forced selling.  The rest of the time, the seller must be making a mistake in order for the value investor to make a market-beating investment.

Many deep value approaches are fully quantitative, however.  (Deep value is also called contrarian value.)  The quantitative deep value investor is not necessarily making an exceedingly detailed judgment on each individual deep value stock – a judgment which would imply that the value investor is correct in this particular case, and that the seller is wrong.  Rather, the quantitative deep value investor forms a portfolio of the statistically cheapest 20 or more stocks.  All of the studies have shown that a basket of quantitatively cheap stocks does better than the market over time, and is less risky (especially during down markets).

One of the best papers on quantitative deep value investing is Lakonishok, Shleifer, and Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

A concentrated deep value approach, by contrast, typically involves the effort to select the most promising and the cheapest stocks available.  Warren Buffett and Charlie Munger both followed this approach when they were managing smaller amounts of capital.  They would typically have between 3 and 8 positions making up nearly the entire portfolio.  (Joel Greenblatt also used this approach when he was managing smaller amounts.  Greenblatt produced a ten-year record of 50.0% gross per year using a concentrated value approach focused on special situations.  See Greenblatt’s book, You Can Be a Stock Market Genius.)

 

VALUE

Marks begins by saying that “buy low; sell high” is one of the oldest rules in investing.  But since selling will occur in the future, how can one figure out a price today that will be lower than some future price?  What’s needed is an ability to accurately assess the intrinsic value of the asset.  The intrinsic value of a stock can be derived from the price that an informed buyer would pay for the entire company, based on the net asset value or the earnings power of the company.  Writes Marks:

The quest in value investing is for cheapness.  Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases.  The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

Marks also notes that successful value investing requires an estimate of current net asset value, or the current earnings power, that is unrecognized by the consensus.  Successful growth investing, by contrast, requires an estimate of future earnings that is higher than what the consensus currently thinks.  Often the rewards for successful growth investing are higher, but a successful value investing approach is much more repeatable and achievable.

Buying assets below fair value, however, does not mean those assets will outperform right away.  Thus value investing requires having a firmly held view, because quite often after buying, cheap assets will continue to underperform the market.  Marks elaborates:

If you liked it at 60, you should like it more at 50… and much more at 40 and 30.  But it’s not that easy.  No one’s comfortable with losses, and eventually any human will wonder, ‘Maybe it’s not me who’s right.  Maybe it’s the market.’…”

Thus, successful value investing requires not only the consistent ability to identify assets available at cheap prices; it also requires the ability to ignore various signals (many of which are subconscious) flashing the message that one is wrong.  As Marks writes:

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.  Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong.  Oh yes, there’s a third: you have to be right.

 

THE RELATIONSHIP BETWEEN PRICE AND VALUE

Many investors make the mistake of thinking that a good company is automatically a good investment, while a bad company is automatically a bad investment.  But what really matters for the value investor is the relationship between price and value:

For a value investor, price has to be the starting point.  It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.  And there are few assets so bad that they can’t be a good investment when bought cheaply enough.

In the 1960’s, there was a group of stocks called the Nifty Fifty – companies that were viewed as being so good that all one had to do was buy at any price and then hold for the long term.  But it turned out not to be true for many stocks in the basket.  Moreover, the early 1970’s led to huge declines:

Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.  People may have bought into great companies, but they paid the wrong price.

Marks explains the policy at his firm Oaktree:

‘Well bought is half sold.’

By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or to whom, or though what mechanism.  If you’ve bought it cheap, eventually those questions will answer themselves.  If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Marks, similar to Warren Buffett and Charlie Munger, holds that psychology plays a central role in value investing:

Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship – and the outlook for it – lies largely in insight into other investor’s minds.  Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

The safest and most potentially profitable thing is to buy something when no one likes it.  Given time, its popularity, and thus its price, can only go one way: up.

A successful value investor must build systems or rules for self-protection because all investors – all humans – suffer from psychological biases, which often operate subconsciously.  For more on cognitive biases, see the following two blog posts:

Cognitive Biases

The Psychology of Misjudgment

Marks continues:

Of all the possible routes to investment profit, buying cheap is clearly the most reliable.  Even that, however, isn’t sure to work.  You can be wrong about the current value.  Or events can come along that reduce value.  Or deterioration in attitudes or markets can make something sell even further below its value.  Or the convergence of price and intrinsic value can take more time than you have…

Trying to buy below value isn’t infallible, but it’s the best chance we have.

 

UNDERSTANDING RISK

As Buffett frequently observes, the future is always uncertain.  Prices far below probable intrinsic value usually only exist when the future is highly uncertain.  When there is not much uncertainty, asset prices will be much higher than otherwise.  So high uncertainty about the future is the friend of the value investor.

On the other hand, in general, assets that promise higher returns always entail higher risk.  If a potentially higher-returning asset was obviously as low risk as a U.S. Treasury, then investors would rush to buy the higher-returning asset, thereby pushing up its price to the point where it would promise returns on par with a U.S. Treasury.

A successful value investor has to determine whether the potential return on an ostensibly cheap asset is worth the risk.  High risk is not necessarily bad as long as it is properly controlled and as long as the potential return is high enough.  But if the risk is too high, then it’s not the type of repeatable bet that can produce long-term success for a value investor.  Repeatedly taking too much risk – by sizing positions too large relative to risk-reward – virtually guarantees long-term failure.

Consider the Kelly criterion.  If the probability of success and the returns from a potential investment can be quantified, then the Kelly criterion tells one exactly how much to bet in order to maximize the long-term compound returns from a long series of such bets.  Betting any other amount than what the Kelly criterion says will inevitably lead to less than the maximum potential returns.  Most importantly, betting more than what the Kelly criterion says guarantees zero or negative long-term returns.  Repeatedly overbetting guarantees long-term failure.  For more about the Kelly criterion, see:  http://boolefund.com/the-dhandho-investor/

This is why Howard Marks, Warren Buffett, Charlie Munger, and other great value investors often point out that minimizing big mistakes is more important for long-term investing success than hitting home runs.  Buffett and Munger apply the same logic to life itself:  avoiding big mistakes is more important than trying to hit home runs.  Buffett:  “You have to do very few things right in life so long as you don’t do too many things wrong.”

Again, Marks points out, while riskier investments promise higher returns, those higher returns are not guaranteed, otherwise riskier investments wouldn’t be riskier!  The probability distribution of potential returns is wider for riskier investments, typically including some large potential losses.  A certain percentage of future outcomes will be zero or negative for riskier investments.

Marks agrees with Buffett and Munger that the best definition of risk is the potential to experience loss.

Of course, as John Templeton, Ray Dalio, and other great investors observe, even the best investors are typically only right two-thirds of the time, while they are wrong one-third of the time.  Thus, following a successful long-term value investing framework where one consistently and carefully pays cheap prices for assets still entails being wrong roughly one-third of the time.  Being wrong often means that the lower probability future negative scenarios do in fact occur a certain percentage of the time.  Back luck does happen a certain percentage of the time.  (Mistakes in analysis or psychology also happen.)

It’s important to bet big when the odds are heavily in one’s favor.  But one should be psychologically prepared to be wrong roughly one-third of the time, whether due to bad luck or to mistakes.  The overall portfolio should be able to withstand at least a 33% error rate.

More Notes on Deep Value

Investors are systematically too pessimistic about companies that have been doing poorly, and systematically too optimistic about companies that have been doing well.  This is why a deep value (contrarian value) approach, if applied systematically, is very likely to produce market-beating returns over a long enough period of time.

Marks explains:

Dull, ignored, possibly tarnished and beaten-down securities – often bargains exactly because they haven’t been performing well – are often ones value investors favor for high returns…. Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets.  That’s something the risk-conscious value investor is willing to live with.

Measuring Risk-Adjusted Returns

Marks mentions the Sharpe ratio – or excess return compared to the standard deviation of the return.  While not perfect, the Sharpe ratio is a solid measure of risk-adjusted return for many public market securities.

It’s important to point out again that risk can no more be objectively measured after an investment than it can be objectively measured before the investment.  Marks:

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed.  Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa.  With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)?  And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed?  That’s another good questions that’s hard to answer.  Need a model?  Think of the weatherman.  He says there’s a 70 percent chance of rain tomorrow.  It rains; was he right or wrong?  Or it doesn’t rain; was he right or wrong?  It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.

Marks believes (as do Buffett, Munger, and other top value investors) that there is some merit to the expected value framework whereby one attempts to identify possible future scenarios and the probabilities of their occurrence:

If we have a sense for the future, we’ll be able to say which outcome is most likely, what other outcomes also have a good chance of occurring, how broad the range of possible outcomes is and thus what the ‘expected result’ is.  The expected result is calculated by weighing each outcome by its probability of occurring; it’s a figure that says a lot – but not everything – about the likely future.

Again, though, having a reasonable estimate of the future probability distribution is not enough.  One must also make sure that one’s portfolio can withstand a run of bad luck; and one must recognize when one has experienced a run of good luck.  Marks quotes his friend Bruce Newberg (with whom he has played cards and dice):

There’s a big difference between probability and outcome.  Probable things fail to happen – and improbable things happen – all the time.

This is one of the most important lessons to know about investing, asserts Marks.

Marks defines investment performance:

… investment performance is what happens when a set of developments – geopolitical, macro-economic, company-level, technical and psychological – collide with an extant portfolio.  Many futures are possible, to paraphrase Dimson, but only one future occurs.  The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.  The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.

A portfolio can be set up to withstand 99 percent of all scenarios but succumb because it’s the remaining 1 percent that materializes.  Based on the outcome, it may seem to have been risky, whereas the investor might have been quite cautious.

Another portfolio may be structured so that it will do very well in half the scenarios and very poorly in the other half.  But if the desired environment materializes and it prospers, onlookers can conclude that it was a low-risk portfolio.

The success of a third portfolio can be entirely contingent on one oddball development, but if it occurs, wild aggression can be mistaken for conservatism and foresight.

Marks again:

Risk can be judged only by sophisticated, experienced second-level thinkers.

The past seems very definite: for every evolving set of possible scenarios, only one scenario happened at each point along the way.  But that does not at all mean that the scenarios that actually occurred were the only scenarios that could have occurred.

Furthermore, most people assume that the future will be like the past, especially the more recent past.  As Ray Dalio says, the biggest mistake most investors make is to assume that the recent past will continue into the future.

Marks also reminds us that the “worst-case” assumed by most investors is typically not negative enough.  Marks relates a funny story his father told about a gambler who bet everything on a race with only one horse in it.  How could he lose?

Halfway around the track, the horse jumped over the fence and ran away.  Invariably things can get worse than people expect.

Taking more risk usually leads to higher returns, but not always.

And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.

 

RECOGNIZING RISK

The main source of risk, argues Marks, is high prices.  When stock prices move higher, for instance, most investors feel more optimistic and less concerned about downside risk.  But value investors have the opposite point of view: risk is typically very low when stock prices are very low, while risk tends to increase significantly when stock prices have increased significantly.

Most investors are not value investors:

So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether.  That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.

Marks emphasizes that recognizing risk – which comes primarily from high prices – has nothing to do with predicting the future, which cannot be done with any sort of consistency when it comes to the overall stock market or the economy.

Marks also highlights, again, how the psychology of eager buyers – who are unworried about risk – is precisely what creates greater levels of risk as they drive prices higher:

Thus, the market is not a static arena in which investors operate.  It is responsive, shaped by investors’ own behavior.  Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk.  I call this the ‘perversity of risk.’

In a nutshell:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.  Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk they usually bid it up to the point where it’s enormously risky.  No risk is feared, and thus no reward for risk bearing – no ‘risk premium’ – is demanded or provided.  That can make the thing that’s most esteemed the riskiest.

Marks again:

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.  But high quality assets can be risky, and low quality assets can be safe.  It’s just a matter of the price paid for them…

 

CONTROLLING RISK

Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

Great investors generate high returns with moderate risk, or moderate returns with low risk.  If they generate high returns with “high risk,” but they do so consistently for many years, then perhaps the high risk “either wasn’t really high or was exceptionally well-managed.”  Mark says that great investors such as Buffett or Peter Lynch tend to have very few losing years over a relatively long period of time.

It’s important, notes Marks, to see that risk leads to loss only when lower probability negative scenarios occur:

… loss is what happens when risk meets adversity.  Risk is the potential for loss if things go wrong.  As long as things go well, loss does not arise.  Risk gives rise to loss only when negative events occur in the environment.

We must remember that when the environment is salutary, that is only one of the environments that could have materialized that day (or that year).  (This is Nassim Nicholas Taleb’s idea of alternative histories…)  The fact that the environment wasn’t negative does not mean that it couldn’t have been.  Thus, the fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though – as things turned out – it wasn’t needed at that time.

The absence of losses does not mean that there was no risk.  Only a skilled investor can look at a portfolio during good times and tell how much risk has been taken.

Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

Marks says that an investment manager adds value by generating higher than market returns for a given level of risk.  Achieving the same return as the market, but with less risk, is adding value.  Achieving better than market returns without undue risk is also adding value.

Many value investors, such as Marks and Buffett, somewhat underperform during up markets, but far outperform during down markets.  The net result over a long period of time is market-beating performance with very little incremental risk.  But it does take some time in order to see the value-added.

Controlling the risk in your portfolio is a very important and worthwhile pursuit.  The fruits, however, come only in the form of losses that don’t happen.  Such what-if calculations are difficult in placid times.

Marks:

On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments – even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.

Marks’ firm Oaktree invests in high yield bonds.  High yield bonds can be good investments over time if the prices are low enough:

I’ve said for years that risky assets can make for good investments if they’re cheap enough.  The essential element is knowing when that’s the case.  That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Risk bearing per se is neither wise nor unwise, says Marks.  Investing in the more aggressive niches with risk properly controlled is ideal.  But controlling risk always entails being prepared for bad scenarios.

Extreme volatility and loss surface only infrequently.  And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative.  Thus, it becomes tempting to relax rules and increase leverage.  And often this is done just before the risk finally rears its head…

Marks quotes Nassim Taleb:

Reality is far more vicious than Russian roulette.  First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six.  After a few dozen tries, one forgets about the existence of the bullet, under a numbing false sense of security… Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality… One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative ‘low risk’ name.

A good example, which Marks does mention, is large financial institutions in 2004-2007.  Virtually no one thought that home prices could decline on a nationwide scale, since they had never done so before.

Of course, it’s also possible to be too conservative.  You can’t run a business on the  basis of worst-case assumptions.  You wouldn’t be able to do anything.  And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss.  Now, we know the quants shouldn’t have assumed there couldn’t be a nationwide decline in home prices.  But once you grant that such a decline can happen… what should you prepare for?  Two percent?  Ten?  Fifty?

Marks continues:

If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used.  Is that a reasonable reaction?

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so.  Once in a while, a ‘black swan’ will materialize.  But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,’ we’d be frozen in inaction.

… It’s by bearing risk when we’re well paid to do so – and especially by taking risks toward which others are averse in the extreme – that we strive to add value for our clients.

 

BEING ATTENTIVE TO CYCLES

    • Rule number one: most things will prove to be cyclical.
    • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks explains:

… processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.  The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions.  But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.

Marks continues:

Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring.  Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down.  Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good.

Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.

 

AWARENESS OF THE PENDULUM

Marks holds that there are two risks in investing:

the risk of losing money and the risk of missing opportunity.

Most investors consistently do the wrong things at the wrong time:  when prices are high, most investors rush to buy; when prices are low, most investors rush to sell.  Thus, the value investor can profit over time by following Warren Buffett’s advice:

Be fearful when others are greedy.  Be greedy when others are fearful.

Marks:

Stocks are cheapest when everything looks grim.  The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions.

 

COMBATING NEGATIVE INFLUENCES

Marks writes as follows:

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.  To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.  The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.  Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions.  Much of this falls under the heading of ‘human nature.’

Cognitive Biases

As humans, we all have psychological tendencies or cognitive biases that were mostly helpful to us during much of our evolutionary history, but that often lead us to make bad judgments in many areas of modern life.

Marks writes about the following psychological tendencies:

    • Greed
    • Fear
    • Self-deception
    • Conformity to the crowd
    • Envy
    • Ego or overconfidence
    • Capitulation

How might these psychological tendencies have been useful in our evolutionary history?  

When food was often scarce, being greedy by hoarding food (whether at the individual or community level) made sense.  When a movement in the grass occasionally meant the presence of a dangerous predator, immediate fear (this fear is triggered by the amygdala even before the conscious mind is aware of it) was essential for survival.  When hunting for food was dangerous, often with low odds of success, self-deception – accompanied by various naturally occurring chemicals – helped hunters to persevere over long periods of time, regardless of high danger and often regardless of injury.  (Chemical reactions could often cause an injured hunter not to feel the pain much.)  If everyone in one’s hunting group, or in one’s community, was running away as fast as possible, following the crowd was usually the most rational response.  If a starving hunter saw another person with a huge pile of food, envy would trigger a strong desire to possess such a large pile of food, whether by trying to take it or by going on a hunting expedition with a heightened level of determination.  When hunting a dangerous prey, with low odds of success, ego or overconfidence would cause the hunter to be convinced that he would succeed.  From the point of view of the community, having self-deceiving and overconfident hunters was a net benefit because the hunters would persevere despite often low odds of success, and despite inevitable injuries and deaths among individual hunters.

How do these psychological tendencies cause people to make errors in modern activities such as investing?

Greed causes people to follow the crowd by paying high prices for stocks in the hope that there will be even higher prices in the future.  Fear causes people to sell or to avoid ugly stocks – stocks trading at low multiples because the businesses in question are facing major difficulties.

As humans, we have an amazingly strong tendency towards self-deception:

    • The first principle is that you must not fool yourself, and you are the easiest person to fool. – Richard Feynman
    • Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true. – Demosthenes, as quoted by Charlie Munger

There have been many times in history when self-deception was probably crucial for the survival of a given individual or community.  I’ve mentioned hunters pursuing dangerous prey.  A much more recent example might be Winston Churchill, who was firmly convinced – even when virtually all the evidence was against it – that England would defeat Germany in World War II.  Churchill’s absolute belief helped sustain England long enough for both good luck and aid to arrive:  the Germans ended up overextended in Russia, and huge numbers of American troops (along with mass amounts of equipment) arrived in England.

Like other psychological tendencies, self-deception not only was important in evolutionary history, but it still often plays a constructive role.  Yet when it comes to investing, self-deception is clearly harmful, especially as the time horizon is extended so that luck evens out.

Conformity to the crowd is another psychological tendency that many (if not most) investors seem to display.  Marks notes the famous experiment by Solomon Asch.  The subject is shown lines of obviously different lengths.  But in the same room with the subject are shills, who unbeknownst to the subject have already been instructed to say that two lines of obviously different lengths actually have the same length.  So the subject of the experiment has to decide between the obvious evidence of his eyes – the two lines are clearly different lengths – and the opinion of the crowd.  A significant number (36.8 percent) ignored their own eyes and went with the crowd, saying that the two lines had equal length, despite the obvious fact that they didn’t.

(The experiment involved a control group in which there were no shills.  Almost every subject – over 99 percent – gave the correct answer under these circumstances.)

Greed, conformity, and envy together operate powerfully on the brain of many investors:

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.

A good example from history is the tulip mania in Holland, during which otherwise rational people ended up paying exorbitant sums for colorful tulip bulbs.  The South Sea Bubble is another example, during which even the extremely intelligent Isaac Newton, after selling out early for a solid profit, could not resist buying in again as prices seemed headed for the stratosphere.  Newton and many others lost huge sums when prices inevitably returned to earth.

Envy has a very powerful and often negative effect on most human brains.  And as Charlie Munger always points out, envy is particularly stupid because it’s a sin that, unlike many other sins, is not any fun at all.  There are many people who could easily learn to be very happy – grateful for blessings, grateful for the wonders of life itself, etc. – who become miserable because they fixate on other people who have more of something, or who are doing better in some way.  Envy is fundamentally irrational and stupid, but it is powerful enough to consume many people.  Buffett: “It’s not greed that drives the world, but envy.”  Envy and jealousy have for a very long time caused the downfall of human beings.  This certainly holds true in investing.

Ego is another powerful psychological tendency humans have.  As with the other potential pitfalls, many of the best investors – from Warren Buffett to Ray Dalio – are fundamentally humble.  Overconfidence (closely related to ego) is a very strong bias that humans have, and if it is not overcome by learning humility and objectivity, it will kill any investor eventually.  Marks writes:

In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad years.  They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check.  This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short run.  It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control.  Of course, investing shouldn’t be about glamour, but often it is.

Capitulation is a final phenomenon that Marks emphasizes.  In general, people become overly negative about a stock that is deeply out of favor because the business in question is going through hard times.  Moreover, when overly negative investors are filled with fear and when they see everyone selling in a panic, they themselves often sell near the very bottom.  Often these investors know analytically that the stock is cheap, but their emotions (fear of loss, conformity to the crowd, etc.) are too strong, so they disbelieve their own sound logic.  The rational, contrarian, long-term value investor does just the opposite:  he or she buys near the point of maximum pessimism (to use John Templeton’s phrase).

Similarly, most investors become overly optimistic when a stock is near its all-time highs.  They see many other investors who have done well with the sky-high stock, and so they tend to buy at a price that is near the all-time highs.  Again, many of these investors – like Isaac Newton – know analytically that buying a stock when it is near its all-time highs is often not a good idea.  But greed, envy, self-deception, crowd conformity, etc. (fear of missing out, dream of a sure thing), overwhelm their own sound logic.  By contrast, the rational, long-term value investor does the opposite:  he or she sells near the point of maximum optimism.

Marks gives a marvelous example from the tech bubble of 1998-2000:

From the perspective of psychology, what was happening with IPOs is particularly fascinating.  It went something like this: The guy next to you in the office tells you about an IPO he’s buying.  You ask what the company does.  He says he doesn’t know, but his broker told him its going to double on the day of issue.  So you say that’s ridiculous.  A week later he tells you it didn’t double… it tripled.  And he still doesn’t know what it does.  After a few more of these, it gets hard to resist.  You know it doesn’t make sense, but you want protection against continuing to feel like an idiot.  So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO… and the bonfire grows still higher on the buying from new converts like you.

 

CONTRARIANISM

To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit. – Sir John Templeton

Superior value investors buy when others are selling, and sell when others are buying.  Value investing is simple in concept, but it is very difficult in practice.

Of course, it’s not enough just to be contrarian.  Your facts and your reasoning also have to be right:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are 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

Or, as Seth Klarman puts it:

Value investing is at its core the marriage of a contrarian streak with a calculator.

Only by being right about the facts and the reasoning can a long-term value investor hold (or add to) a position when everyone else continues to sell.  Getting the facts and reasoning right still involves being wrong roughly one-third of the time, often due to bad luck but also sometimes due to mistakes in analysis or psychology.  But getting the facts and reasoning right leads to ‘being right’ roughly two-third of the time.

‘Being right’ usually means a robust process correctly followed – both analytically and psychologically – and the absence of bad luck.  But sometimes good luck plays a role.  Either way, a robust process correctly followed should produce positive results (on both an absolute and relative basis) over most rolling five-year periods, and over nearly all rolling ten-year periods.

It’s never easy to consistently follow a careful, contrarian value investing approach.  Marks quotes David Swensen:

Investment success requires sticking with positions made uncomfortable by their variance with popular opinion… Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

… Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

Marks puts it in his own words:

The most profitable investment actions are by definition contrarian:  you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).  These actions are lonely and… uncomfortable.

Marks writes about the paradoxical nature of investing:

The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.

The best bargains are typically only available when pessimism and uncertainty are high.  Many investors say, ‘We’re not going to try to catch a falling knife; it’s too dangerous… We’re going to wait until the dust settles and the uncertainty is resolved.’  But waiting until uncertainty gets resolved usually means missing the best bargains, as Marks says:

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.  When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.  Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

It’s our job as contrarians to catch falling knives, hopefully with care and skill.  That’s why the concept of intrinsic value is so important.  If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.

 

FINDING BARGAINS

It cannot be too often repeated:

A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.

What is the process by which some assets become cheap relative to intrinsic value?  Marks explains:

    • Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
    • Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
    • Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
    • Usually its price has been falling, making the first-level thinker as, ‘Who would want to own that?’ (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean.  First-level thinkers tend to view price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
    • As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.

Where is the best place to look for underpriced assets?  Marks observes that a good place to start is among things that are:

    • little known and not fully understood;
    • fundamentally questionable on the surface;
    • controversial, unseemly or scary;
    • deemed inappropriate for ‘respectable’ portfolios;
    • unappreciated, unpopular and unloved;
    • trailing a record of poor returns; and
    • recently the subject of disinvestment, not accumulation.

Marks:

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.  That means the best opportunities are usually found among things most others won’t do.  After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

Marks started a fund for high yield bonds – junk bonds – in 1978.  One rating agency described high yield bonds as “generally lacking the characteristics of a desirable investment.”  Marks points out the obvious: “if nobody owns something, demand for it (and thus the price) can only go up and…. by going from taboo to even just tolerated, it can perform quite well.”

In 1987, Marks formed a fund to invest in distressed debt:

Who would invest in companies that already had demonstrated their lack of financial viability and the weakness of their management?  How could anyone invest responsibly in companies in free fall?  Of course, given the way investors behave, whatever asset is considered worst at a given point in time has a good likelihood of being the cheapest.  Investment bargains needn’t have anything to do with high quality.  In fact, things tend to be cheaper if low quality has scared people away.

 

PATIENT OPPORTUNISM

Marks makes the same point that Warren Buffett and Charlie Munger often make: Most of the time, by far the best thing to do is absolutely nothing.  Finding one good idea a year is enough to get outstanding returns over time.  Writes Marks:

So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them.  You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own.  An opportunist buys things because they’re offered at bargain prices.  There’s nothing special about buying when prices aren’t low.

Marks took five courses in Japanese studies as an undergraduate business major in order to fulfill his requirement for a minor.  He learned the Japanese value of mujo:

mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control.  Thus we must recognize, accept, cope and respond.  Isn’t that the essence of investing?

… What’s past is past and can’t be undone.  It has led to the circumstances we now face.  All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.

Marks quotes Buffett, who notes that there are no called strikes in investing:

Investing is the greatest business in the world because you never have to swing.  You stand at the plate; the pitcher throws you General Motors at 47!  U.S. steel at 39!  And nobody calls a strike on you.  There’s no penalty except opportunity.  All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

It’s dumb to invest when the opportunities are not there.  But when the overall market is high, there are still a few ways to do well as a long-term value investor.  If one is able to ignore short-term volatility and focus on the next five to ten years, then one can invest in undervalued stocks.

If one’s assets under management are small enough, then there can be certain parts of the market where one can still find excellent bargains.  An example would be micro-cap stocks, since very few professional investors look there.  (This is the focus of the Boole Microcap Fund.)

Another example of potentially cheap (albeit volatile) stocks in an otherwise expensive stock market is old-related companies.  Energy companies recently were as cheap as they’ve ever been.  See: https://www.gmo.com/americas/research-library/resource-equities/?utm_source=linkedin&utm_medium=social&utm_campaign=insights_resource_equities

 

KNOWING WHAT YOU DON’T KNOW

We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know. – John Kenneth Galbraith

Marks, like Buffett, Munger, and most other top value investors, thinks that financial forecasting simply cannot be done with any sort of consistency.  But Marks has two caveats:

    • The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies.  Thus, I suggest people try to ‘know the knowable.’
    • An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums. That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.

 

Marks has tracked (in a limited way) many macro predictions, including U.S. interest rates, the U.S. stock market, and the yen/dollar exchange rate.  He found quite clearly that most forecasts were not correct.

I can elaborate on two examples that I spent much time on (when I should have stayed focused on finding individual companies available at cheap prices):

    • the U.S. stock market
    • the yen/dollar exchange

A secular bear market for U.S. stocks began (arguably) in the year 2000, when the 10-year Graham-Shiller P/E – also called the CAPE (cyclically adjusted P/E) – was over 30, its highest level in U.S. history.  The long-term average CAPE is around 16.  Based on over one hundred years of history, the pattern for U.S. stocks in a secular bear market would be relatively flat or lower until the CAPE approached 10.  However, ever since Greenspan started running the Fed in the 1980’s, the Fed has usually had a policy of stimulating the economy and stocks by lowering rates or keeping rates as low as possible.  This has caused U.S. stocks to be much higher than otherwise.  For instance, with rates today staying near zero, U.S. stocks could easily be twice as high as or three times as high as “normal” indefinitely, assuming the Fed decides to keep rates low for many more years.  As Buffett has noted, near-zero rates for many decades would eventually mean price/earnings ratios on stocks of 100.

In any case, in the year 2012 to 2013, some of the smartest market historians (including Russell Napier, author of Anatomy of the Bear) started predicting that the S&P 500 Index would fall towards a CAPE of 10 or lower, which is how every previous U.S. secular bear market concluded.  It didn’t happen in 2012, or in 2013, or in 2014, or in 2015, or in 2016, or in 2017, or in 2018, or in 2019.  (Also, the stock market decline in early 2020 was a temporary response to the coronavirus.)  Eventually the U.S. stock market will experience another major bear market.  But by the time that happens, it may start from a level over 4,000 or 4,500 in the next year or two, and it may not decline below 2000, which is actually far above the level from which the smartest forecasters (such as Russell Napier) said the decline would begin.

Robert Shiller, the Nobel Prize-winning economist who perfected the CAPE (Shiller P/E), said in 1996 that U.S. stocks were high.  But if an investor had gone to cash in 1996, they wouldn’t have had any chance of being ahead of the stock market until 2008 to 2009, more than 10 years later during the biggest financial crisis since the Great Depression.

Shiller has recently explained the CAPE with more clarity: http://www.businessinsider.com/robert-shiller-on-stocks-2013-1

When the CAPE is high, as it is today, the long-term investor should still have a large position in U.S. stocks.  But the long-term investor should expect fairly low ten-year returns, a few percent per annum, and they also should some investments outside of U.S. stocks.  Shiller also has observed that certain sectors in the U.S. economy can be cheap (low CAPE).  Many oil-related stocks, for example, are very probably quite cheap today (mid 2021) relative to their long-term normalized earnings power.

The main point here, though, is that forecasting the next bear market or the next recession with any precision is generally impossible.  Another example would be the Economic Cycle Research Institute (https://www.businesscycle.com/), which predicted a U.S. recession around 2011-2012 based on its previously quite successful set of leading economic indicators.  But they were wrong, and they later admitted that the Fed printing so much money not only may have kept the U.S. barely out of recession, but also may have led to distortions in the economic data, making ECRI’s set of leading economic indicators no longer as reliable.

As for the yen/dollar exchange, the story begins in a familiar way:  some of the smartest macro folks around predicted (in 2010 and later) that shorting the yen vs. the U.S. dollar would be the “trade of the decade,” and that the yen/dollar exchange would exceed 200.  But it’s not 2021, and the yen/dollar exchange rate has come nowhere near 200.

The “trade of the decade argument” was the following:  the debt-to-GDP in Japan has reached stratospheric levels, , government deficits have continued to widen, and the Japanese population is actually shrinking.  Since long-term GDP growth is a function of population growth plus innovation, it should become mathematically impossible for the Japanese government to pay back its debt without a significant devaluation of their currency.  If the BOJ could devalue the yen by 67% – which would imply a yen/dollar exchange rate of well over 200 – then Japan could repay the government debt in seriously devalued currency.  In this scenario – a yen devaluation of 67% – Japan effectively would only have to repay 33% of the government debt.  Currency devaluation – inflating away the debts – is what most major economies throughout history have done.

The bottom line as regards the yen is the following:  Either Japan must devalue the Yen by 67% – implying a yen/dollar exchange rate of well over 200 – or Japan will inevitably reach the point where it is quite simply impossible for it to repay a large portion of the government debt.  That’s the argument.  There could be other solutions, however.  The human economy is likely to be much larger in the future, and there may be some way to help the Japanese government with its debts.  After all, the situation wouldn’t seem so insurmountable if Japan could grow its population.  But this might happen in some indirect way if the human economy becomes more open in the future, perhaps involving the creation of a new universal currency.

In any case, for the past five to ten years, and even longer, it has been argued that either the yen/dollar would eventually exceed 200 (thus inflating away as much as 67% of the debt), or the Japanese government would inevitably default on JGB’s (Japanese government bonds).  In either case, the yen should collapse relative to the U.S. dollar, meaning a yen/dollar of well over 200.  This has been described as “the trade of the decade,” but it may not happen for several decades.

In the end, one could have spent decades trying to short the Yen or trying to short JGB’s, without much to show for it.  Or one could have spent those decades doing value investing:  finding and buying cheap stocks, year in and year out.  Decades later, value investing would almost certainly have produced a far better result, and with a relatively low level of risk.

The same logic applies to market timing, or trying to profit on the basis of predicting bull markets, bear markets, recessions, etc.  For the huge majority of investors, they would get much better profits, at relatively low risk, by following a value investing approach (whether by investing in a value fund, or by applying the value approach directly to stocks) or simply investing in low-cost broad market index funds.

In Sum

In sum, financial forecasting cannot be done with any sort of consistency.  Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few will be correct in a given year.  But the ones correct this year are almost never the ones correct the next time around, because what they’re trying to predict can’t be predicted with any consistency.  Marks writes thus:

I am not going to try to prove my contention that the future is unknowable.  You can’t prove a negative, and that certainly includes this one.  However, I have yet to meet anyone who consistently knows what lies ahead macro-wise…

One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later.  And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did.  But that doesn’t mean your forecasts are regularly of any value…

It’s possible to be right about the macro-future once in a while, but not on a regular basis.  It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are.  And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.

Marks gives one more example: How many predicted the crisis of 2007-2008?  Of those who did predict it – there was bound to be some from pure chance alone – how many of those then predicted the recovery starting in 2009 and continuing until early 2020?  The answer is “very few.”  The reason, observes Marks, is that those who got 2007-2008 right “did so at least in part because of a tendency toward negative views.”  They probably were negative well before 2007-2008, and more importantly, they probably stayed negative afterwards, during which the U.S. stock market increased (from the low) more than 400% as the U.S. economy expanded from 2009 to early 2020.

 

Marks has a description for investors who believe in the value of forecasts.  They belong to the “I know” school, and it’s easy to identify them:

    • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
    • They’re confident it can be achieved.
    • They know they can do it.
    • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
    • They’re comfortable investing based on their opinions regarding the future.
    • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
    • They rarely look back to rigorously assess their record as forecasters.

Marks contrasts the confident “I know” folks with the guarded “I don’t know” folks.  The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities.  Marks points out that if you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going.

You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture.  On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.

Marks continues by noting that no one likes investing on the assumption that the future is unknowable.  But if the future IS largely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.

Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):

    • when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
    • when they assume the most likely outcome is the one that will happen,
    • when they assume the expected result accurately represents the actual result, or
    • perhaps most important, when they ignore the possibility of improbable outcomes.

Marks sums it up:

Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing.  Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.

 

HAVING A SENSE FOR WHERE WE STAND

Marks believes that market cycles – inevitable ups and downs – cannot be predicted as to extent and (especially) as to timing, but have a profound influence on us as investors.  The only thing we can predict is that market cycles are inevitable.

Marks holds that as investors, we can have a rough idea of market cycles.  We can’t predict what will happen exactly or when.  But we can at least develop valuable insight into various future events.

So look around, and ask yourself: Are investors optimistic or pessimistic?  Do the media talking heads say the markets should be piled into or avoided?  Are novel investment schemes readily accepted or dismissed out of hand?  Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls?  Has the credit cycle rendered capital readily available or impossible to obtain?  Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?  All of these things are important, and yet none of them entails forecasting.  We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.

Marks likens the process of assessing the current cycle with “taking the temperature” of the market.  Again, one can never precisely time market turning points, but one can at least become aware of when markets are becoming overheated, or when they’ve become unusually cheap.

It may be more difficult today to take the market’s temperature because of the policy of near-zero (or negative) interest rates in many of the world’s major economies.  This obviously distorts all asset prices.  As Buffett remarked recently, if U.S. rates were going to stay near zero for many decades into the future, U.S. stocks would eventually be much higher than they are today.  Zero rates indefinitely would easily mean price/earnings ratios of 100 (or even 200).

Stanley Druckenmiller, one of the most successful macro investors, has consistently said that the stock market is driven in large part not by earnings, but by central bank liquidity.

In any case, timing the next major bear market is virtually impossible, as acknowledged by the majority of great investors such as Howard Marks, Warren Buffett, Charlie Munger, Seth Klarman, Bill Ackman, and others.

What Marks, Buffett, and Munger stress is to focus on finding cheap stocks.  Pay cheap enough prices so that, on average, one can make a profit over the next five years or ten years.  At some point – no one knows precisely when – the U.S. stock market is likely to drop roughly 30-50%.  One must be psychologically prepared for this.  And one’s portfolio must also be prepared for this.

If one is able to buy enough cheap stocks, while maintaining a focus on the next five years or ten years, and if one is psychologically prepared for a big drop at some point, which always happens periodically, then one will be in good position.

Note:  Cheap stocks (whether oil-related or otherwise) typically have lower correlation than usual with the broader stock market.  Even if the broader market declines, some cheap stocks may do much better on both a relative and absolute basis.

Finally, some percentage in cash may seem like a wise position to have in the event of a major (or minor) bear market.  The tricky part, again, is what percentage to have in cash and when.  Many excellent value investors have had 50% or more in cash since 2012 or 2013. Since 2012, the market has more than doubled.  So cash has been a significant drag on the performance of investors who have had large cash positions.

For these reasons, many great value investors – including Marks, Buffett, Munger, and many others – simply never try to time the market.  Many of these value investors essentially stay fully invested in the cheapest stocks they can find.  Over a very long period of time, many studies have shown that hedges, short positions, and cash lower the volatility of the portfolio, but also lower the long-term returns.  Given how many smart people have been hedging since 2012,  the eight or so years up until early 2020 have provided yet another clear example of why market timing is impossible to do with any consistency.

Henry Singleton, described by both Buffett and Munger as being the best capital allocator (among CEO’s) in U.S. history, compounded business value at Teledyne at incredible rates for decades by buying stocks (including Teledyne) when they were cheap.  Singleton’s amazing track record included the 1970’s, when the broader U.S. stock market went virtually nowhere.  Singleton was a genius (100 points away from being a chess grandmaster).  On the subject of market timing, Singleton has said:

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.

 

APPRECIATING THE ROLE OF LUCK

Luck – chance or randomness – influences investment outcomes.  Marks considers Nassim Taleb’s Fooled by Randomness to be essential reading for investors.  Writes Marks:

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.

Marks quotes Taleb:

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win.  They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history.

A central concept from Taleb is that of “alternative histories.”  What actually has happened in history is merely a small subset of all the things that could have happened, at least as far as we know.  As long as there is a component of indeterminacy in human behavior (not to mention the rest of reality), one must usually assume that many “alternative histories” were possible.  From the practical point of view of investing, given a future that is currently unknowable in many respects, one must develop a reasonable set of scenarios along with estimated probabilities for each scenario.  And, when judging the quality of past decisions, one must think carefully about various possible (“alternative”) histories, of which what actually happened appears to be a small subset.

Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove that the decision behind it was wise.

 

Marks says he agrees with all of Taleb’s important points:

    • Investors are right (and wrong) all the time for the ‘wrong reason.’ Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).
    • The correctness of a decision can’t be judged from the outcome. Neverthelss, that’s how people assess it.  A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown.  Thus, correct decisions are often unsuccessful, and vice versa.
    • Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof).  But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
    • For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone.  Few of these “geniuses” are right more than once or twice in a row.
    • Thus, it’s essential to have a large number of observations – lots of years of data – before judging a given manager’s ability.

Over the long run, the rational investor learns, refines, and sticks with a robust investment process that reliably produces good results.  In the short run, when a good process sometimes leads to bad outcomes (often due to bad luck but sometimes due to a mistake), one must simply be stoic and patient.

Marks continues:

The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.  My ‘I don’t know’ school thinks of future events in terms of a probability distribution.  That’s a big difference.  In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

Marks concludes:

    • We should spend our time trying to find value among the knowable – industries, companies and securities – rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
    • Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
    • We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
    • To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
    • Given the highly indeterminate nature of outcomes, we must view strategies and their results – both good and bad – with suspicion until proved over a large number of trials.

 

INVESTING DEFENSIVELY

Unlike professional tennis, where a successful outcome depends on which player hits the most winners, successful investing generally depends on minimizing mistakes more than it does on finding winners.

… investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time.  The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment.  Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe.

Marks argues that successful investing is a balance between offense and defense, and that this balance often differs for each individual investor.  What’s important is to stick with an investment process that works over the long term:

… Few people (if any) have the ability to switch tactics to match market conditions on a timely basis.  So investors should commit to an approach – hopefully one that will serve them through a variety of scenarios.  They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers.  They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times.  Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.

And by the way, there’s no right choice between offense and defense.  Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.

Marks argues that defense can be viewed as aiming for higher returns, but through the avoidance of mistakes and through consistency, rather than through home runs and occasional flashes of brilliancy.

Avoiding losses first involves buying assets at cheap prices (well below intrinsic value).  Another element to avoiding losses is to ensure that one’s portfolio can survive a bear market.  If the five-year or ten-year returns appear to be high enough, an investor still may choose to play more offense than defense, even when he or she knows that a bear market is likely within five years or less.  But one must be fully prepared – psychologically and in one’s portfolio – for many already very cheap stocks to get cut in half or worse during a bear market.

Again, some investors can accept higher volatility in exchange for higher long-term returns.  One must know oneself.  One must know one’s clients.  One must really think through all the possible scenarios, because things can get much worse than one can imagine during bear markets.  And bear markets are inevitable.

There is always a trade-off between potential return and potential downside.  Choosing to aim for higher long-term returns means accepting higher downside volatility over shorter periods of time.

But it’s important to keep in mind that many investors fail not due to lack of home runs, but due to having too many strikeouts.  Overbetting is thus a common cause of failure for long-term investors.  We know from the Kelly criterion that overbetting guarantees zero or negative long-term returns.  Therefore, it’s wise for most investors to aim for consistency – a high batting average based on many singles and doubles – rather than to aim for the maximum number of home runs.

Put differently, it is easier for most investors to minimize losses than it is to hit a lot of home runs.  Thus, most investors are much more likely to achieve long-term success by minimizing losses and mistakes, than by hitting a lot of home runs.

Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate.  You may hit fewer home runs than another investor… but you’re also likely to have fewer strikeouts and fewer inning-ending double plays.

Defensive investing sounds very erudite, but I can simplify it: Invest scared!  Worry about the possibility of loss.  Worry that there’s something you don’t know.  Worry that you can make high-quality decisions but still be hit by bad luck or surprise events.  Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong.  And if nothing does go wrong, surely the winners will take care of themselves.

 

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 goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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.

CASE STUDY: Harbor Diversified (HRBR)

December 18, 2022

Harbor Diversified (HRBR) is the parent company of Air Wisconsin, a major U.S. regional airline.  HRBR just signed a new five-year agreement with American Airlines to provide regional airline services starting in early 2023.

Regional airlines are crucial partners to major global airlines and are cost-effective.  Regional airlines can hire pilots and crews at lower rates.  Regional airlines operate specialized fleets and save on repairs by having dedicated hangars and maintenance crews.

Regional airlines are like a captive supplier somewhat protected from fluctuations in consumer demand by their global airline partners.  Regional airlines operate 41% of all scheduled flights in the U.S. and did better than global airlines during the pandemic because regional airlines don’t rely as much on international or business-class fares.

Here are the current multiples:

    • EV/EBITDA = 0.48
    • P/E = 3.18
    • P/B = 0.44
    • P/CF = 2.27
    • P/S = 0.47

Insider ownership is 43.8%, which is excellent.  TL/TA (total liabilities/total assets) is 52.7%, which is good.  ROE is 19.2%, which is also good.

The Piotroski F_score is 8, which is very good.

Here’s a good writeup on Value Investors Club: https://valueinvestorsclub.com/idea/Harbor_Diversified_Air_Wisconsin/1643658552

Here’s another good writeup on MicroCapClub.com (subscription required): https://microcapclub.com/forums/topic/3093-harbor-diversified-inc-hrbr

Intrinsic value scenarios:

    • Low case: Book value per share is $4.94.  In the worse case scenario, the stock may be worth half of book value.  Half of book value is $2.47 per share.  That is 15% higher than today’s $2.15.
    • Mid case: Under normal circumstances, the stock is worth at least book value per share, which is $4.94.  That is 130% higher than today’s $2.15.
    • High case: The stock is probably worth at least 14x normalized earnings, which are about $20 million.  14 x $20 million comes to $280 million.  Then we add net cash of $67.7 million plus $20 million owed by United.  The total value of HRBR comes to $367.7 million, or $6.70 per share.  That is over 210% higher than today’s $2.15.

Risks

The main risk is that HRBR’s only customer will be American Airlines.  (HRBR’s current contract with United expires in early 2023.)  But the contract starts in early 2023 and lasts for five years.  Also, HRBR has worked with American in the past.  It is likely HRBR will get a new contract five years from now, if not from American than from another airline.

 

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.