Virtually all of the historical evidence shows that quantitative deep value investing–systematically buying stocks at low multiples (low P/B, P/E, P/S, P/CF, and EV/EBITDA)–does better than the market over time.
Deep value investing means investing in ugly stocks that are doing terribly–with low- or no-growth–and that are trading at low multiples. Quantitative deep value investing means that the portfolio of deep value stocks is systematically constructed based solely on quantitative factors including cheapness. (It’s a process that can easily be automated.)
Buffett has called deep value investing thecigar buttapproach:
…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.
(Photo by Sensay)
Outline for this blog post:
Rare Temperament
Early Buffett: Deep Value Investor
Investors Much Prefer Income Over Assets
Companies at Cyclical Lows
RARE TEMPERAMENT
Many value investors prefer to invest in higher-quality companies rather than deep value stocks. A high-quality company has a sustainable competitive advantage that allows it to earn a high ROIC (return on invested capital) for a long time. When you invest in such a company, you can simply hold the position for years as it compounds intrinsic value. Assuming you’ve done your homework and gotten the initial buy decision right, you typically don’t have to worry much.
Investing in cigar butts (deep value stocks), however, means that you’re investing in many mediocre or bad businesses. These are companies that have terrible recent performance. Some of these businesses won’t survive over the longer term, although even the non-survivors often survive many years longer than is commonly supposed.
Deep value investing can work quite well, but it takes a certain temperament not to care about various forms of suffering–such as being isolated and looking foolish. As Bryan Jacoboski puts it:
The very reason price and value diverge in predictable and exploitable ways is because people are emotional beings. That’s why the distinguishing attribute among successful investors is temperament rather than brainpower, experience, or classroom training. They have the ability to be rational when others are not.
(Photo by Nikki Zalewski)
In The Manual of Ideas (Wiley, 2013),John Mihaljevic explains the difficulty of deep value investing:
It turns out that Graham-style investing may be appropriate for a relatively small subset of the investment community, as it requires an unusual willingness to stand alone, persevere, and look foolish.
On more than one occasion, we have heard investors respond as follows to a deep value investment thesis: ‘The stock does look deeply undervalued, but I just can’t get comfortable with it.’ When pressed on the reasons for passing, many investors point to the uncertainty of the situation, the likelihood of negative news flow, or simply a bad gut feeling. Most investors also find it less rewarding to communicate to their clients that they own a company that has been in the news for the wrong reasons.
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.
Many investors will look at a list of statistically cheap stocks and conclude that most of them would be awful investments. But in practice, a basket of deep value stocks tends to outperform, given enough time. And typically some of the big winners include stocks that looked the worst prior to being included in the portfolio.
EARLY BUFFETT: DEEP VALUE INVESTOR
Warren Buffett started out as a cigar-butt investor. That was the method he learned from his teacher and mentor, Ben Graham, the father of value investing. When Buffett ran his partnership, he generated exceptional performance using a deep value strategy focused on microcap stocks:https://boolefund.com/buffetts-best-microcap-cigar-butts/
(Early Buffett teaching at the University of Nebraska, via Wikimedia Commons)
One reason Buffett transitioned from deep value to buying high-quality companies (and holding them forever) was simply that the assets he was managing at Berkshire Hathaway became much too large for deep value. But in his personal account, Buffett recently bought a basket of South Korean cigar butts and ended up doing very well.
Buffett has made it clear that if your assets under management are relatively small, then deep value investing–especially when focused on microcap stocks–can do better than investing in high-quality companies. Buffett has said he could make 50% a year by investing in deep value microcap stocks:https://boolefund.com/buffetts-best-microcap-cigar-butts/
In the microcap world, since most professional investors don’t look there, if you turn over enough rocks you can find some exceptionally cheap companies. If you don’t have sufficient time and interest to find the most attractive individual microcap stocks, using a quantitative approach is an excellent alternative. A good quantitative value fund focused on microcaps is likely to do much better than the S&P 500 over time. That’s the mission of the Boole Fund.
INVESTORS MUCH PREFER INCOME OVER ASSETS
Outside of markets, people naturally assess the value of possessions or private businesses in terms of net asset value–which typically corresponds with what a buyer would pay. But in markets, when the current income of an asset-rich company is abnormally low, most investors fixate on the low income even when the best estimate of the company’s value is net asset value. (Mihaljevic makes this point.)
If an investor is considering a franchise (high-quality) business like Coca-Cola or Johnson & Johnson, then it makes sense to focus on income, since most of the asset value involves intangible assets (brand value, etc).
But for many potential investments, net asset value is more important than current income. Most investors ignore this fact and stay fixated on current income. This is a major reason why stock prices occasionally fall far below net asset value, which creates opportunities for deep value investors.
(Illustration byTeguh Jati Prasetyo)
Over a long period of time, the income of most businesses does relate to net asset value. Bruce Greenwald, in his book Value Investing (Wiley, 2004), explains the connection. For most businesses, the best way to estimate intrinsic value is to estimate the reproduction cost of the assets. And for most businesses–because of competition–earnings power over time will not be more than what is justified by the reproduction cost of the assets.
Only franchise businesses like Coca-Cola–with a sustainable competitive advantage that allows it to earn more than its cost of capital–are going to have normalized earnings that are higher than is justified by the reproduction cost of the assets.
Because most investors view cigar butts as unattractive investments–despite the overwhelming statistical evidence–there are always opportunities for deep value investors. For instance, when cyclical businesses are at the bottom of the cycle, and current earnings are far below earnings power, investors’ fixation on current earnings can create very cheap stocks.
A key issue is whether the current low income reflects a permanently damaged business or a temporary–or cyclical–decline in profitability.
COMPANIES AT CYCLICAL LOWS
Although you can make money by buying cheap businesses that are permanently declining, you can usually make more money by buying stocks at cyclical lows.
(Illustration by Prairat Fhunta)
Mihaljevic:
Assuming a low enough entry price, money can be made in both cheap businesses condemned to permanent fundamental decline and businesses that may benefit from mean reversion as their industry moves through the cycle. We much prefer companies that find themselves at a cyclical low, as they may restore much, if not all, of their earning power, providing multi-bagger upside potential. Meanwhile, businesses likely to keep declining for a long time have to be extremely cheap and keep returning cash to shareholders to generate a positive investment outcome.
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.
If you can stay calm and rational while being isolated and looking foolish, then you can buy deeply out of favor cyclical stocks, which often have multi-bagger upside potential.
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: https://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 approachesintrinsic 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.
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.
Capitalism without Capital: The Rise of the Intangible Economy, by Jonathan Haskel and Stian Westlake, is an excellent book that everyone should read.
Historically most assets were tangible rather than intangible. Houses, castles, temples, churches, farms, farm animals, equipment, horses, weapons, jewels, precious metals, art, etc. These types of tangible assets tended to hold their value, and naturally they were included on accountants’ balance sheets.
(Photo by W. Scott McGill)
Intangible assets are different. It’s harder to account for investing in intangibles. But intangible investment is important. Haskel and Westlake explain why:
Investment is what builds up capital, which, together with labor, constitutes the two measured inputs to production that power the economy, the sinews and joints that make the economy work. Gross domestic product is defined as the sum of the value of consumption, investment, government spending, and net exports; of these four, investment is often the driver of booms and recessions, as it tends to rise and fall in response to monetary policy and business confidence.
The problem is that national statistical offices have, until very recently, measured only tangible investments.
The Dark Matter of Investment
In 2002 in Washington, at a meeting of the Conference on Research in Income and Wealth, economists considered investments people made in the “new economy.” Carol Corrado and Dan Sichel of the US Federal Reserve Board and Charles Hulten of the University of Maryland developed a framework for thinking about different types of investments.
Haskel and Westlake mention Microsoft as an example. In 2006, Microsoft’s market value was about $250 billion. There was $70 billion in assets, $60 billion of which was cash and cash equivalents. Plant and equipment totaled only $3 billion, 4 percent of Microsoft’s assets and 1 percent of its market value. In a sense, Microsoft is a miracle: capitalism without capital.
(Photo by tashatuvango)
Charles Hulten sought to explain Microsoft’s value by using intangible assets:
Examples include the ideas generated by Microsoft’s investments in R&D and product design, the value of its brands, its supply chains and internal structures, and the human capital built up by training.
Such intangible assets are similar to tangible assets in that the company had to spend time and money on them up-front, while the value to the company was delivered over time.
Why Intangible Investment is Different
Businesses change what they invest in all the time, so how is intangible investment different? Haskel and Westlake:
Our central argument in this book is that there is something fundamentally different about intangible investment, and that understanding the steady move to intangible investment helps us understand some of the key issues facing us today: innovation and growth, inequality, the role of management, and financial and policy reform.
We shall argue there are two big differences with intangible assets. First, most measurement conventions ignore them. There are some good reasons for this, but as intangibles have become more important, it means we are now trying to measure capitalism without counting all the capital. Second, the basic economic properties of intangibles make an intangible-rich economy behave differently from a tangible-rich one.
Outline for this blog post:
Part I The Rise of the Intangible Economy
Capital’s Vanishing Act: The Rise of Intangible Investment
How to Measure Intangible Investment
What’s Different About Intangible Investment? The Four S’s of Intangibles
Part II The Consequences of the Rise of the Intangible Economy
Intangibles, Investment, Productivity, and Secular Stagnation
Intangibles and the Rise of Inequality
Infrastructure for Intangibles, and Intangible Infrastructure
The Challenge of Financing an Intangible Economy
Competing, Managing, and Investing in the Intangible Economy
Public Policy in an Intangible Economy: Five Hard Questions
Part I The Rise of the Intangible Economy
CAPITAL’S VANISHING ACT
Investment has changed:
The type of investment that has risen inexorably is intangible: investment in ideas, in knowledge, in aesthetic content, in software, in brands, in networks and relationships.
Investment, assets, and capital all have multiple meanings.
For investment, Haskel and Westlake stick with the internationally agreed upon definition as given by the UN’s System of National Accounts:
Investment is what happens when a producer either acquires a fixed asset or spends resources (money, effort, raw materials) to improve it.
An asset is an economic resource that is expected to provide a benefit over a period of time. A fixed asset is an asset that results from using up resources in the process of its production.
Spending resources: To be an investment, the business doing the investing has to acquire the asset or pay some cost to produce it themselves.
Haskel and Westlake offer some examples of intangible investments:
Suppose a solar panel manufacturer researches and discovers a cheaper process for making photovoltaic cells: it is incurring expense in the present to generate knowledge it expects to benefit from in the future. Or consider a streaming music start-up that spends months designing and negotiating deals with record labels to allow it to use songs the record labels own–again, short-term expenditure to create longer-term gain. Or imagine a training company pays for the long-term rights to run a popular psychometric test: it too is investing.
(Photo by magele-picture)
Intangible investing results in intangible assets. More examples of intangible investments:
Software
Databases
R&D
Mineral exploration
Creating entertainment, literary or artistic originals
Design
Training
Market research and branding
Business process re-engineering
Intangible Investment Has Steadily Grown
Supermarkets have developed complex pricing systems, more ambitious branding and marketing campaigns, and more detailed processes and systems (including better use of bar codes). Moreover, as you might expect, tech firms make heavy use of intangible investments, as Haskel and Westlake explain:
Fast-growing tech companies are some of the most intangible-intensive of firms. This is in part because software and data are intangibles, and the growing power of computers and telecommunications is increasing the scope of things that software can achieve. But the process of “software eating the world,” in venture capitalist Marc Andreesen’s words, is not just about software: it involves other intangibles in abundance. Consider Apple’s designs and its unrivaled supply chain, which has helped it to bring elegant products to market quickly and in sufficient numbers to meet customer demand, or the networks of drivers and hosts that sharing-economy giants like Uber and AirBnB have developed, or Tesla’s manufacturing know-how. Computers and the Internet are important drivers of this change in investment, but the change is long running and predates not only the World Wide Web but even the Internet and the PC.
By the mid-1990s, intangible investment in the United States exceeded tangible investment. There is a similar pattern for the UK, Sweden, and Finland. But tangible investment is still greater than intangible investment in Spain, Italy, Germany, Austria, Denmark, and the Netherlands.
Reasons for the Growth of Intangible Investment
Because the productivity of the manufacturing sector typically increases faster than that of the services sector, labor-intensive services gradually become more expensive compared to manufactured goods. (This is called Baumol’s Cost Disease.) This implies that intangible investing will grow faster than tangible investing over time.
Furthermore, new technology seems to create greater opportunities for businesses to invest productively in intangibles. Haskel and Westlake give Uber as an example. It would have been possible before computers and smartphones for Uber to develop its large network of drivers. But smartphones–which connect people quickly, allow the rating of drivers, and make payment quick and easy–significantly boosted the return on investment for Uber.
It’s natural to wonder if computers are the cause of increased intangible investment. Haskel and Westlake suggest that while computers may be a primary cause, they do not seem to be the only cause:
First of all, as we saw earlier, the rise of intangible investment began before the semiconductor revolution, in the 1940s and 1950s and perhaps before. Second, while some intangibles like software and data strongly rely on computers, others do not: brands, organizational development, and training, for example. Finally, a number of writers in the innovation studies literature argue that it may be that it was the rise of intangibles that led to the development of modern IT as much as the other way around.
HOW TO MEASURE INTANGIBLE INVESTMENT
Productivity growth in the United States starting in the mid-1970s and throughout the 1980s seemed quite low. Economists found this puzzling because computers seemed to be making a difference in a variety of areas. Statistical agencies, led by the US Bureau of Economic Analysis (BEA), made two adjustments:
First, in the 1980s, in conjunction with IBM, the BEA started to produce indexes of computer prices that were quality adjusted. This turned out to make a very big difference to measuring how much investment businesses were making in computer hardware.
In most cases–for products, for example–prices for the same good tend to rise gently in line with overall inflation. But even if sticker prices for computers were rising, they were decidedly not the same good, since every dimension of their quality (speed, memory, and space) was improving incredibly. So their “quality-adjusted” prices were, in fact, falling and falling very fast, meaning that the quality you could buy per dollar spent on computers was in fact rising very fast.
In the 1990s, statisticians looked at business spending that creates computer software. Haskel and Westlake comment that banks are huge spenders on the creation of software (at one point, Citibank employed more programmers than Microsoft). Software is an intangible good–knowledge written down in lines of code.
(Photo by Krisana Antharith)
By the early 2000s, many business economists realized that knowledge more generally is an intangible investment that should be included in GDP and productivity measures. Gradually statistical offices began to incorporate various intangible investments into GDP statistics. Haskel and Westlake:
And these changes added up. In the United States, for example, the capitalization of software added about 1.1 percent to 1999 US GDP and R&D added 2.5 percent to 2012 GDP, with these numbers growing all the time…
What Sorts of Intangibles Are There?
Corrado, Hulten, and Sichel divided intangible investment into three broad types:
Innovative Property: R&D; Mineral exploration; Creating entertainment and artistic originals; Design and other product development costs.
Economic Competencies: Training; Market research and branding; Business process re-engineering.
Right now, design and other product development costs are not included in official GDP measures. Also not included: training, market research and branding, and business process re-engineering.
Measuring Investment in Intangibles
Haskel and Westlake:
Measuring investment requires a number of steps. First, we need to find out how much firms are spending on the intangible. Second, in some cases, not all of that spending will be creating a long-lived asset… So we may have to adjust that spending to measure investment–that is, that part of spending creating a long-lived asset. Third, we need to adjust that investment for inflation and quality change so we can compare investment in different periods when prices and quality are changing.
For most investment goods, national accountants simply send out a survey to companies asking them how much there are spending on each good. It’s trickier, however, if it’s an intangible good that the company makes for itself, like writing its own software or doing its own R&D. In this case, statisticians can figure out how much it costs a company–over and above wages–to produce the intangible good. Statisticians also must estimate how much of that additional spending is an investment that will last for more than a year. The third step is to adjust for inflation and quality changes.
To measure the intangible asset created by intangible investment, economists have to estimate depreciation. Once you know the flow of intangible investment and you adjust for depreciation, you can then estimate the stock–the value of intangible assets in a given year. For software, design, marketing, and training, depreciation is about 33 percent a year. For R&D, depreciation is roughly 15 percent a year. For entertainment and artistic originals and mineral exploration, depreciation is lower.
WHAT’S DIFFERENT ABOUT INTANGIBLE INVESTMENT?
An intangible-rich economy has four characteristics–the four S’s–that distinguish it from a tangible-rich economy. Intangible assets:
Are more likely to be scalable;
Their costs are more likely to be sunk;
They are inclined to have spillovers;
They tend to exhibit synergies with each other.
Scalability
Why Are Intangibles Scalable?
Scalability derives from what economists call “non-rivalry” goods. A rival good is like a loaf of bread. Once one person eats the loaf of bread, no one else can eat that loaf. In contrast, a non-rival good is not used up when one person uses it. For instance, once a software program has been created, it can be reproduced an infinite number of times at almost no cost. There’s virtually no limit to how many people can make use of that one software program. Another example, given by Paul Romer–a pioneer of how economists think about economic growth–is oral rehydration therapy (ORT). ORT is a simple treatment that has saved many lives in the developing world by stopping children’s deaths from diarrhea. The idea of ORT can be used again and again–it’s never used up.
Note: Scalability can really take off if there are “network effects.” Haskel and Westlake mention networks like Uber drivers or Instagram users as examples.
(Illustration by Aquir)
Why Does Scalability Matter?
Haskel and Westlake say that we will see three unusual things happening in an economy where more investments are clearly scalable:
There will be some highly intangible-intensive businesses that have gotten very large. Google, Microsoft, and Facebook are good examples. Their software can be reproduced countless times at almost no cost.
Given the prospects of such large markets, ever more firms feel incentivized to go for it.
Businesses who compete with owners of scalable assets are in a tough position. In markets with hugely scalable assets, the rewards for runners-up are often meager.
Sunkenness
Why Are Intangibles Sunk Costs?
Intangible assets are much harder to sell than tangible assets. If an intangible investment works, creating value for the company that made the investment, then there’s no issue. However, if an intangible investment doesn’t work or the company wants to back out, it’s often hard to sell. Specifically, if knowledge isn’t protected by intellectual property rights, it’s often impossible to sell.
(Image by OpturaDesign)
Why Does Sunkenness Matter?
Because intangible investments frequently involve unrecoverable costs, they can be difficult to finance, especially with debt. There’s a reason why many small business loans require a lien on directors’ houses: a house is a tangible asset with ascertainable value.
Moreover, people tend to fall for the sunk-cost fallacy, whereby they overvalue an intangible asset that hasn’t worked out because of the time, energy, and resources they’ve poured into it. People are inclined to continue putting in more time and resources. This may contribute to bubbles.
Spillovers
Why Do Intangibles Generate Spillovers?
Intangible investments can be used relatively easily by companies that didn’t make the investments. Consider R&D. Unless it is protected by patents, knowledge gained through R&D can be re-used again and again. Haskel and Westlake remark:
Patents and copyrights are, on the whole, less secure and more subject to challenge than the title deeds to farmland or the ownership of a shipping container or a computer.
One reason is that property rights related to tangible assets have been around for thousands of years.
Why Do Spillovers Matter?
(Photo by Vs1489)
Haskel and Westlake remark that spillovers matter for three reasons:
First, in a world where companies can’t be sure they will obtain the benefits of their investments, we would expect them to invest less.
Second, there is a premium on the ability to manage spillovers: companies that can make the most of their own investments in intangibles, or that are especially good at exploiting the spillovers from others’ investments, will do particularly well.
Third, spillovers affect the geography of modern economies.
The U.S. government funds 30 percent of the R&D that happens in the country. It’s the classic answer to the issue of companies being unsure about the benefits of intangible investments they’re considering. Public R&D is particularly important for basic research.
Haskel and Westlake:
Patent trolls and copyright lawsuits catch our attention because they are newsworthy, but other ways of capturing the spillovers of intangible investment are common–in fact, they’re part of the invisible fabric of everyday business life. They often involve reciprocity rather than compulsion or legal threats. Software developers use online repositories like GitHub to share code; being an active contributor and an effective user of GitHub is a badge of honor for some developers. Firms sometimes pool their patents; they realize that the spillovers from each company’s technologies are valuable, and that enforcing everyone’s individual legal rights is not worth it. (Indeed, the US government helped end the patent war between the Wright Brothers and Curtiss Aeroplane and Motor Company that was holding back the US aircraft industry in the 1910s by getting everyone to set up a patent pool, the Manufacturers Aircraft Association.)
Synergies
Why Do Intangibles Exhibit Synergies?
Haskel and Westlake give the example of the microwave. Near the end of World War II, Raytheon was mass-producing cavity magnetrons (similar to a vacuum tube), a crucial part of the radar defenses the British had invented. A Raytheon engineer, Percy Spenser, realized the microwaves from magnetrons could heat food by creating electromagnetic fields in a box.
Haskel and Westlake write:
A few companies tried to sell domestic microwave ovens, but none were very successful. Then, in the 1960s, Raytheon bought Amana, a white goods manufacturer, and combined their microwave expertise with Amana’s kitchen appliance knowledge to build a more successful product. At the same time, Litton, another defense contractor, invented the modern microwave oven shape and tweaked the magnetron to make it safer.
In 1970 forty thousand microwaves were sold. By 1975 it was a million. What made this possible was the gradual accumulation of ideas and innovations. The magnetron on its own wasn’t very useful to a customer, but combined with other incremental bits of R&D and the design and marketing ideas of Litton and Amana, it became a defining innovation of the late twentieth century.
The point of the microwave story is that intangible assets have synergies with one another. Also, it’s hard to predict where innovations will come from or how they will combine. In this example, military technology led to a kitchen appliance.
(Synergies in digital business, science, and technology: Illustration by Agsandrew)
Intangible assets have synergies with tangible assets as well. In the 1990s, productivity increased and at first people didn’t know why. Haskel and Westlake explain:
In 2000 the McKinsey Global Institute analyzed the sources of this productivity increase. Counterintuitively, they found that the bulk of it came from the way big chains retailers, in particular Walmart, were using computers and software to reorganize their supply chains, improve efficiency, and lower prices. In a sense, it was a technological revolution. But the gains were realized through organizational and business practice changes in a low-tech sector. Or, to put it another way, there were big synergies between Walmart’s investment in computers and its investment in processes and supply chain development to make the most of the computers.
Why Do the Synergies of Intangible Assets Matter?
While spillovers cause firms to be protective of their intangible investments, synergies have the opposite effect and lead to open innovation.
In its simplest form, open innovation happens when a firm deliberately connects with and benefits from new ideas that arise outside the firm itself. Cooking up ideas in a big corporate R&D lab is not open innovation; getting ideas by buying start-ups, partnering with academic researchers, or undertaking joint ventures with other companies is.
(Illustration by mindscanner)
Besides open innovation, there’s a second reason why synergies matter:
They also matter because they create an alternative way for firms to protect their intangible investments against competition: by building synergistic clusters of intangible investments, rather than by protecting individual assets.
Part II The Consequences of the Rise of the Intangible Economy
INTANGIBLES, INVESTMENT, PRODUCTIVITY, AND SECULAR STAGNATION
Two characteristics of secular stagnation are low investment and low interest rates. Investment fell in the 1970s, recovered some in the mid-1980s, but fell sharply in the financial crisis (2008) and hasn’t recovered.
What’s puzzling is that investment hasn’t recovered despite low interest rates. In the past, central banks relied on lowering rates to spur investment activity. But that seems not to have worked this time.
(Illustration by ibreakstock)
One possible explanation is that technological progress has slowed. Robert Gordon makes this argument in The Rise and Fall of American Growth (2016). But technological progress is quite difficult to measure.
There are three more aspects to secular stagnation.
Corporate profits in the United States are higher than they’ve been for decades, and they seem to keep increasing. Return on invested capital (ROIC) has grown significantly since the 1990s.
When it comes to both profitability and productivity, there is a growing gap between leaders and laggards.
Productivity growth has slowed due mostly to a decline in total factor productivity–workers are working less effectively with the capital they have.
Haskel and Westlake note that a good explanation for secular stagnation should explain four facts:
A fall in measured investment at the same time as a fall in interest rates
Strong profits
Increasingly unequal productivity and profits
Weak total factor productivity growth
Intangibles can help explain these facts.
Mismeasurement: Intangibles and Apparently Low Investment
Intangible investment exceeds tangible investment in countries including the United States and the UK. Are economies growing faster than reported because the value of intangibles is not being properly measured? Haskel and Westlake show that including intangibles does not noticeably change investment/GDP.
Profits and Productivity Differences: Scale, Spillovers, and the Incentives to Invest
Haskel and Westlake state:
…leading firms, which are confident of their ability to create scalable assets and to appropriate most of their benefits, will continue to invest (and enjoy a high rate of return on those investments); but laggard firms, expecting low private returns from their investments, will not. In a world where there are a few leaders and many laggards, the net effect of this could be lower aggregate rates of investment, combined with high returns on those investments that do get made.
Spillovers: Intangibles and Slowing TFP Growth A Lower Pace of Intangible Growth?
The slowdown in intangible investment since the financial crisis does seem to account for slowing TFP (Total Factor Productivity) growth, although the data are noisy and more exploration is needed.
Are Intangibles Generating Fewer Spillovers?
Lagging firms may be less able to absorb spillovers from leaders, possibly because leading firms can gain from synergies between different intangibles to a much greater extent than laggards.
INTANGIBLES AND THE RISE OF INEQUALITY
In addition to inequality of income and inequality of wealth, there is also what Haskel and Westlake call “inequality of esteem.” Some communities feel left-behind and overlooked by America’s prosperous coastal cities.
Standard explanations for inequality
One standard explanation for inequality is that new technologies replace workers, which causes wages to fall and profits to rise.
A second explanation relates to trade. In the 1980s, before the collapse of the Soviet Union and before market reforms in China and India, the global economy had 1.46 billion workers. Then in the 1990s, the number of workers doubled to 2.93 billion workers. This puts pressure on lower-skilled workers in developed economies. The flip side is that lower-skilled workers in China and India end up far better off than they were before.
A third explanation for inequality is that capital tends to accumulate. Capital tends to grow faster than the economy–this is Thomas Piketty’s famous r > g inequality–which causes capital to build up over time.
(Illustration by manakil)
How Intangibles Affect Income, Wealth, and Esteem Inequality
Intangibles, Firms, and Income Inequality
The best firms–owning scalable intangibles and able to extract spillovers from other businesses–will be highly productive and profitable while their competitors will lose out. But that doesn’t necessarily mean the best firms pays all their workers more. To explain rising wage inequality, more is needed.
Who is Benefiting from Intangible-Based Firm Inequality?
“Superstars” benefit by being associated with exceptionally valuable intangibles that can scale massively. Whereas in most markets a top worker could probably be replaced by two not-as-fast workers, this isn’t true for superstar markets: you can’t replace the best opera singer or the best basketball player with two not-quite-as-good ones. Tech billionaires also tend to be superstars with large equity stakes in companies they founded–companies that probably scaled massively.
However, senior managers have also done very well. Haskel and Westlake explain why:
Intangible investment increases. Because of its scalability and the benefits to companies that can appropriate intangible spillovers, leading companies pull ahead of laggards in terms of productivity, especially in the more intangible-intensive industries. The employees of these highly productive companies benefit from higher wages. Because intangibles are contestable, companies are especially eager to hire people who are good at contesting them–appropriating spillovers from other firms or identifying and maximizing synergies.
Why are CEOs at many companies being paid so much more than other workers? One reason relates to a “fundamental attribution error” whereby people explain a good business outcome by referring to what is simple and salient–like the skill of the CEO–rather than by acknowledging complexity and the fact that luck typically plays a major role. It’s also possible, say Haskel and Westlake, that shareholders–especially those who are most diversified–are not paying much attention to CEO pay.
Housing Prices, Cities, Intangibles, and Wealth Inequality
Intangibles can help explain wealth inequality. First, intangibles tend to drive up property prices. Second, the mobility of intangible capital means it’s harder to tax.
In a world where intangibles are becoming more abundant and a more important part of the way businesses create value, the benefits to exploiting spillovers and synergies increase. And as these benefits increase, we would expect businesses and their employees to want to locate in diverse, growing cities where synergies and spillovers abound.
Haskel and Westlake summarize how intangibles impact long-run inequality:
First, inequality of income. The synergies and spillovers that intangibles create increase inequality between competing companies, and this inequality leads to increasing differences in employee pay… In addition, managing intangibles requires particular skills and education, and people with these skills are clustering in high-paid jobs in intangible-intensive firms. Finally, the growing economic importance of the kind of people who manage intangibles helps foster myths that can be used to justify excessive pay, especially for top managers.
Second, inequality of wealth. Thriving cities are places where spillovers and synergies abound. The rise of intangibles makes cities increasingly attractive places to be, driving up the prices of prime property. This type of inflation has been shown to be one of the major causes of the increase in the wealth of the richest. In addition, intangibles are often mobile; they can be shifted across firms and borders. This makes capital more mobile, which makes it harder to tax. Since capital is disproportionately owned by the rich, this makes redistributive taxation to reduce wealth inequality harder.
Finally, inequality of esteem. There is some evidence that supporters of populist movements… are more likely to hold traditional views and to score low on tests for the psychological trait of openness to experience.
INFRASTRUCTURE FOR INTANGIBLES, AND INTANGIBLE INFRASTRUCTURE
On the one hand, in order to thrive, the intangible economy needs new buildings in and around cities. On the other hand, artistic and creative institutions are important for combinatorial innovation. In the longer term, face-to-face interaction may eventually be phased out, but often these kinds of changes can take much longer than initially supposed.
(Illustration by Panimoni)
Haskel and Westlake comment:
The death of distance has failed to take place. Indeed, the importance of spillovers and synergies has increased the importance of places where people come together to share ideas and the importance of the transport and social spaces that make cities work.
But the death of distance may have been postponed rather than cancelled. Information technologies are slowly, gradually, replacing some aspects of face-to-face interaction. This may be a slow-motion change, like the electrification of factories–if so, the importance of physical infrastructure will radically change.
Soft infrastructure will also matter increasingly. The synergies between intangibles increase the importance of standards and norms, which together make up a kind of social infrastructure for intangible investment. And standards and norms are underpinned by trust and social capital, which are particularly important in an intangible economy.
THE CHALLENGE OF FINANCING AN INTANGIBLE ECONOMY
Banks are often criticized for not providing enough capital for businesses to succeed. Equity markets are criticized for being too short-term and also too influential. Managers seem to fixate more and more on shorter term stock prices. Managers may cut R&D to try to please short-term investors. Haskel and Westlake remark:
These concerns drive public policy across the developed world: most governments to some extent subsidize or coerce banks to lend to businesses, and they give tax advantages to companies that finance using debt. Many countries are considering measures to make equity investors take a longer-term perspective, such as imposing taxes on short-term shareholdings or changing financial reporting requirements. And most governments have spent money trying to encourage alternative forms of financing, particularly venture capital (VC), which is regarded as providing a big potential source of business growth and national wealth.
Banking: The Problem of Lending in a World of Intangibles
When a bank lends money to a business, the bank usually has some recourse to the assets of the business if the debt isn’t repaid. However, intangible assets are typically much harder to value than tangible assets, and frequently intangible assets don’t have much value at all when a business fails. Thus it is difficult for a bank to lend to a business whose assets are mostly intangible.
This is why industries with mostly tangible assets–like oil and gas producers–have high leverage (are funded more with debt than equity), while industries with mostly intangible assets–like software–have less debt and more equity.
One way to increase bank lending to businesses with more intangible assets is for the government to cofund or guarantee bank loans. A second way is financial innovation, such as finding ways to value intangible assets–like patents–more accurately. A third way to deal with the issue of lending against intangibles is to get businesses to rely more on equity than debt.
Haskel and Westlake on how equity markets impact intangible investing:
There is some evidence that markets are short-termist, to the extent that management can sometimes boost their company’s share price by cutting intangible investment to preserve or increase profits, or cut investment to buy back stock. But it also seems that some of what is happening is a sharpening of managerial incentives: publicly held companies whose managers own stock focus on types of intangible investment that are more likely to be successful. And the extent of market myopia varies: companies with more concentrated, sophisticated investors are less likely to feel pressure to cut intangible investment than those with dispersed, unsophisticated ones.
Why VC Works for Intangibles
(Photo by designer491)
Haskel and Westlake observe:
VC has several characteristics that make it especially well-suited to intangible-intensive businesses: VC firms take equity stakes, not debt, because intangible-rich businesses are unlikely to be worth much if they fail–all those sunk investments. Similarly, to satisfy their own investors, VC funds rely on home-run successes, made possible by the scalability of assets like Google’s algorithms, Uber’s driver network, or Genentech’s patents. Third, VC is often sequential, with rounds of funding proceeding in stages. This is a response to the inherent uncertainty of intangible investment.
Leading VC firms and their partners are well-connected and credible, which helps in building networks to exploit synergies.
COMPETING, MANAGING, AND INVESTING IN THE INTANGIBLE ECONOMY
Businesses look to improve their performance in a way that is sustainable. How can this be done? The advice has always been to build and maintain distinctive assets. Tangible assets are usually not distinctive, or at least not for long. Haskel and Westlake:
It’s much more likely that the types of intangible assets we have talked about in this book are going to be distinctive: reputation, product design, trained employees providing customer service. Indeed, perhaps the most distinctive asset will be the ability to weave all these assets together; so a particularly valuable intangible asset will be the organization itself.
When it comes to management, Haskel and Westlake suggest replacing the question, “What are managers for?” with a deeper question, “What’s the role of authority in an economy?”
Markets work with minimal government interference. However, firms can do a better job than dispersed individuals at organizing certain activities. Managers are people at firms who have authority. This is usually more efficient: managers tell employees what to do rather than discussing or arguing about every step.
But if management is largely just monitoring, and software can do the job of monitoring, then what is the role of managers in an intangible-intensive economy? For one, note Haskel and Westlake, the stakes tend to be much higher in the intangible economy. Moreover, in synergistic firms, only managers may understand the big picture.
How can managers build a good organization in an intangible-intensive firm? Haskel and Westlake explain:
…if you are primarily a producer of intangible assets (writing software, doing design, producing research) you probably want to build an organization that allows information to flow, helps serendipitous interactions, and keeps the key talent. That probably means allowing more autonomy, fewer targets, and more access to the boss, even if that is at the cost of influence activities.
Leadership is important in an intangible economy.
(Photo by Raywoo)
Having voluntary followers is really useful in an intangible economy. A follower will stay loyal to the firm, which keeps the tacit intangible capital at the firm. Better, if they are inspired by and empathize with the leader, they will cooperate with each other and feed information up to the leader. This is why leadership is going to be so valued in an intangible economy. It can at best replace, and likely mitigate, the costly and possibly distortive aspects of managing by authority.
Investing
How can an investor discern if a business is building intangible assets? Can investors learn about intangibles from accounting data?
Accountants try to match revenues with costs. If the company has a long-lived asset that produces revenues, then the company measures the annual cost by depreciation or amortization of that asset.
The other way to measure the cost of a long-lived asset is to expense the entire cost of creating the asset in the year in which the expenditures are made. However, this can lead to distortions. First, the costs in creating the asset can make profits in that year appear unusually low. By the same logic, if the asset in question continues producing revenues, then in future years profits will appear unusually high.
In the case of intangible assets, if the asset is bought from outside the company, then it is capitalized (and annual expenses are calculated based on depreciation or amortization). If the asset is created within the company, then the costs are recognized when they are spent (even if the asset is long-lived).
The result is that much intangible investment is hidden because it is expensed. This is a challenge for investors because economies are coming to rely increasingly on intangible assets. Book value–which is frequently based largely on tangible assets–is less relevant for a company that relies on intangible assets–especially if the company develops those assets internally.
What Should Investors Do?
The simplest solution for investors is to invest in low-cost broad market index funds. In this way, the investor will benefit from companies that rely on intangible assets.
Because index funds outpace 90-95% of all active investors if you measure performance over several decades, it already makes excellent sense for many investors to invest in index funds.
Haskel and Westlake sum up the chapter:
The growth of intangible investment has significant implications for managers, but it will affect different firms in different ways. Firms that produce intangible assets will want to maximize synergies, create opportunities to learn from the ideas of others (and appropriate the spillovers from others’ intangibles), and retain talent. These workplaces may end up looking rather like the popular image of hip knowledge-based companies. But companies that rely on exploiting existing intangible assets may look very different, especially where the intangible assets are organizational structure and processes. These may be much more controlled environments–Amazon’s warehouses rather than its headquarters. Leadership will be increasingly prized, to the extent that it allows firms to coordinate intangible investments in different areas and exploit their synergies.
Financial investors who can understand the complexity of intangible-rich firms will also do well. The greater uncertainty of intangible assets and the decreasing usefulness of company accounts put a premium on good equity research and on insight into firm management.
PUBLIC POLICY IN AN INTANGIBLE ECONOMY: FIVE HARD QUESTIONS
Haskel and Westlake highlight five of the most important challenges in an intangible-rich economy:
First, intangibles tend to be contested: it is hard to prove who owns them, and even then their benefits have a tendency to spill over to others. Good intellectual property frameworks are important for an economy increasingly dependent on intangibles.
Second, in an intangible economy, synergies are very important. Combining different ideas and intangible assets is central to successful business innovation. An important objective for policy makers is to create conditions for ideas to come together.
The third challenge relates to finance and investment. Businesses and financial markets seem to underinvest in scalable, sunk intangible investments with a tendency to generate spillovers and synergies. The current system of business finance exacerbates the problem. A thriving intangible economy will significantly improve its financial system to make it easier for companies to invest in intangibles.
Fourth, it will probably be harder for most businesses to appropriate the benefits of capital investment in the economies of the future than in the tangible-rich economies we are familiar with. Successful intangible-rich economies will have higher levels of public investment in intangibles.
Fifth, governments must work out how to deal with the dilemma of the particular type of inequality that intangibles seem to encourage.
(Illustration by Robert Wilson)
Clearer Rules and Norms about the Ownership of Intangibles
Stronger IP rights are not necessarily best because while they can increase incentive to invest, productivity gains are lowered. Also, strengthening IP rights might accidentally favor incumbent rights-holders and patent trolls.
Clearer IP rights can be helpful, though. They can reduce lawsuits that often end up in the notoriously troll-friendly Eastern District of Texas court.
Moreover, since intangible assets are often much more difficult to value than tangible assets, there are ways to help with this. For instance, Ian Hargreaves in 2011 suggested that the UK have a Digital Copyright Exchange. Another example is patent pools where firms coinvest in research and agree to share the resulting rights.
Helping Ideas Combine: Maximizing the Benefits of Synergies
Good public policy should be just as assiduous about creating the conditions for knowledge to spread, mingle, and fructify as it is about creating property rights for those who invest in intangibles.
It should be easy to build new workplaces and homes in cities. But simultaneously, cities have to be connected and livable.
A Financial Architecture for Intangible Investment
Governments should encourage new forms of debt that facilitate the ability to borrow against intangible assets. Longer term, governments should help a shift from debt to equity financing. Currently, debt is cheaper than equity due to the tax benefits of debt. This must change, but it will be very difficult because vested interests still rely on debt. Furthermore, new institutions will be required that provide equity financing to small and medium-size businesses. Although these shifts will be challenging, the rewards will be ever greater, note Haskel and Westlake.
Solving the Intangible Investment Gap
Some large firms seem able to gain from both their own intangible investments and from intangible investments made by others. These companies–like Google or Facebook–can be expected to continue making intangible investments.
Outside of these companies, the government and other public interest bodies (like large non-profit foundations) must make intangible investments.
The government is the investor of last resort. Here are three practical tips given by Haskel and Westlake for government investment in intangibles:
Public R&D Funding. This means the government spending more on university research, public research institutes, or research undertaken by businesses. This type of government spending is not at all ideologically controversial and it can help a great deal over time.
Public Procurement. When the US military funded the development of the semiconductor industry in the 1950s, they also acted as a lead customer. This helped Texas Instruments and other firms not just to invest in R&D, but also to build the capacity to produce and sell chips.
Training and Education. Because it’s hard to predict what skills will be needed in 20 to 30 years, adult education may be a good area in which to invest. This could also help with inequality to some extent.
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: https://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 approachesintrinsic 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.
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.
Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, is an excellent book by Jeremy C. Miller. Miller did the book with no input at all from Buffett. But Buffett has commented quite favorably on the result:
Mr. Miller has done a superb job of researching and dissecting the operation of Buffett Partnership Ltd., and of explaining how Berkshire’s culture has evolved from its BPL origin. If you are fascinated by investment theory and practice, you will enjoy this book.
Miller has arranged each chapter around a single theme. Here is a brief summary of these chapters:
Orientation–The Principles of Ben Graham
Compounding
Measuring Up
The Partnership–An Elegant Structure
The Generals
Workouts
Controls
Dempster Diving–The Asset Conversion Play
Conservative versus Conventional
Size versus Performance
Go-Go or No-Go
Toward a Higher Form
(Buffett teaching at the University of Nebraska, via Wikimedia Commons)
ORIENTATION–The Principles of Ben Graham
At the beginning of the Buffett Partnership Ltd. (BPL), the small amount of capital Buffett was investing–$100,100–meant that, in a sense, his opportunities were similar to that of any small individual investor. No companies were too small or obscure to be potential investment opportunities.
Ben Graham, the father of value investing, was Buffett’s teacher and mentor. Buffett learned several key principles from Graham that are still true today and that still inform Buffett’s investing:
Margin of Safety
Market Prices
Owning Stock is Owning Part of a Business
Forecasting
Margin of Safety
Margin of safety means that if you think a stock is worth $20 a share, then you try to buy it at $10 (or lower). You try to buy well below your estimate of the intrinsic value of the business.
No investor is always right. Good value investors tend to be right about 60% of the time and wrong 40% of the time. Sometimes an investor makes a mistake. Other times an investor gets unlucky. Luck does play a role, and the future is always unpredictable to an extent.
A margin of safety is meant to help limit losses in those cases where you make a mistake or are unlucky.
Market Prices
Market prices in the shorter term often deviate from intrinsic value. The intrinsic value of any business is the total cash that can be taken out of the business over time, discounted back to the present. (For some businesses,liquidation value is the best estimate of intrinsic value.) Figuring out the intrinsic value of a given business requires careful analysis, which should be done without any input from stock price fluctuations. Graham notes that many investors make the mistake of thinking that random stock price movements actually represent something fundamental, but they rarely do.
(Illustration by Prairat Fhunta)
It is only over a long period of time that a stock price will approximate the intrinsic value of a business based on the actual business results. Over shorter periods of time, stock prices can be completely irrational, deviating significantly from the intrinsic value of a given business.
According to Graham, the wise, long-term value investor will buy if the price get irrationally low and will sell if the price gets irrationally high. Most of the time, however, he will simply ignore the random daily gyrations of stock prices. Summarizing Graham’s lesson, Buffett wrote:
[A] market quote’s availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.
It is only over a period of roughly 3 to 5 years–at a minimum–that the stock price of an individual business can be expected to track intrinsic value.
Owning Stock is Owning Part of a Business
A share of stock is a fractional ownership claim on the entire business. Thus, if you can value the business–whether based on liquidation value, net asset value, or discounted cash flows–then you can value the stock.
(Illustration byTeguh Jati Prasetyo)
As Miller explains, a company’s shares over the lifetime of a business will necessarily produce a return equal to the returns produced by that business. Any investor can enjoy the returns of a given business as long as they do not pay too high a price for the stock.
Value investors focus on valuing businesses, and they do not worry about unpredictable shorter term stock prices. Buffett again:
We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.
Buffett stresses these lessons repeatedly. As Miller writes, stocks are not pieces of paper to trade back and forth. Stocks are claims on a business, and some of those businesses can be valued. We cannot predict when a stock price will approximate intrinsic value, but we know that it will in the long run. The market eventually gets it right. The proper focus for an investor is finding the right businesses at the right prices, without worrying about when an investment will work.
Forecasting
Buffett learned from Graham that macro variables simply cannot be predicted. It’s just too hard to forecast the stock market, interest rates, commodity prices, GDP, etc. Regarding the annual values of macro variables, Buffett was (and still is) extremely consistent in his opinion:
I don’t have the first clue.
All of Buffett’s experience over the past 65+ years has convinced him even more that such variables simply can’t be predicted from year to year with any sort of reliability. As Buffett wrote in 2014:
Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.
Seth Klarman:
In reality, no one knows what the market will do; trying to predict it is a waste of time and investing based upon that prediction is a speculative undertaking.
Finally, Buffett again:
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.
The unpredictability of the stock market from year to year (along with other macro variables) is an extremely important lesson for investors. History is full of examples of highly intelligent people making these types of predictions, and being wrong. Miller notes:
Through Buffett’s insights, we learn not to fall victim to the siren songs of these ‘expert’ opinions and churn our portfolios, jumping from guesstimate to guesstimate and allowing what could otherwise be a decent result to be consumed by taxes, commissions, and random chance.
Buffett himself is a good example of how unpredictable the stock market is. For most of the years when Buffett ran BPL–from the mid-1950’s until 1969–he often commented that he thought stocks were overvalued. But as a value investor, Buffett focused nearly all his time on finding individual stocks that were undervalued. He kept writing that the stock market would decline, even though he didn’t know when. It turned out to take almost a decade from Buffett’s initial warning before the stock market actually did decline. Because he stayed focused on individual stocks, his track record was stellar. Had Buffett ever stopped focusing on individual stocks because he was worried about a stock market decline, he would have missed many years of excellent results.
Miller remarks:
A good deal of Buffett’s astonishing success during the Partnership years and beyond has come from never pretending to know things that were either unknowable or unknown.
Miller concludes:
The good news is that the occasional market drop is of little consequence to long-term investors. Preparing yourself to shrug off the next downturn is an important element of the method Buffett lays out. While no one knows what the market is going to do from year to year, odds are we will have at least a few 20-30% drops over the next decade or two. Exactly when these occur is of no great significance. What matters is where you start and where you end up–shuffle around the order of the plus and minus years and you still come to the same ultimate result in the end. Since the general trend is up, as long as a severe 25-40% drop isn’t going to somehow cause you to sell out at the low prices, you’re apt to do pretty well in stocks over the long run. You can allow the market pops and drops to come and go, as they inevitably will.
For the vast majority of investors, it is literally true that they would get the best long-term results if, after buying some decent investments (value investments or index funds), they completely forgot about these holdings. One study by Fidelity showed that the best performing of all their account holders literally forgot they had portfolios at all.
Graham explained this long ago (as quoted by Miller):
The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.
COMPOUNDING
If Buffett skipped a haircut for $10 in 1956 and invested it instead, that $10 would be worth more than $1 million today ($10 compounded at 22% for 60 years). Being keenly aware of the power of compounding, Buffett has always been exceptionally frugal.
(Photo byBj¸rn Hovdal)
Another example of the power of compounding is Ronald Read, a gas station attendant. As Miller observes, Read ended up with $8 million by consistently investing a small portion of his salary into high-quality dividend-paying stocks.
In Buffett’s case, after becoming the world’s richest man during a few different years, he was able to make the largest private charitable donation in history–to the Gates Foundation, run by his friends Bill and Melinda Gates. It’s also noteworthy, says Miller, that Buffett is (and has long been) one of the happiest people on earth because he gets to spend the majority of his time doing things he loves doing.
Stocks versus Bonds Today
Miller writes (in 2016):
Today, with bond yields not too far from zero, a 5-6% per annum result over the next 20 to 30 years seems like a reasonable assumption [for stocks]. If we get those kinds of results, the power of compound interest will be just as important, but it will take longer for the effects to gain momentum.
One of Buffett’s “Ground Rules” for BPL was Ground Rule #5:
While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
Buffett also set very ambitious goals at the outset of BPL, including beating the Dow by an average margin of 10 percentage points per year. Buffett explains how his value investing approach could achieve this target:
I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.
THE PARTNERSHIP: AN ELEGANT STRUCTURE
Incentives drive human conduct. The vast majority of people underestimate just how important incentives are when trying to predict or explain human behavior. As Charlie Munger has said:
I think I’ve been in the top 5% of my age cohort almost my entire adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of the incentive superpower.
(Image by Ctitze)
Buffett figured that stocks would increase 5-7% per year on average. He designed the fee structure of BPL with this in mind. The chief fee structure was as follows: there would be no flat fee based on assets under management, and there would be no fee on the first 6% increase in any given year. There would be a fee of 25% of profits above the first 6% increase in any given year.
The 6% would compound from year to year. Because Buffett’s explicitly stated goal was to beat the Dow by an average of 10% per year, his fee structure was designed accordingly. Unlike most professional investors, Buffett didn’t charge any flat fee just for having assets under management. Rather, his entire fee essentially came from beating the market–or beating a 6% increase compounded each year. If Buffett did much better than the market, then he would be rewarded accordingly. Yet if Buffett fell behind the market, then it could take some time before he earned any fees, since the 6% level compounded each and every year.
In a nutshell, the incentives were well-designed for Buffett to minimize the downside and maximize the upside. Because Buffett understood Graham’s value investing approach to be set up in just this way–where minimizing the downside was a part of maximizing the upside–Buffett was incentivized to do value investing as well as he possibly could.
Compare Buffett’s fee structure in BPL to the fee structure of many of today’s hedge funds. These days, many hedge funds charge “2 and 20,” or a 2% flat fee for assets under management and 20% of all profits. There are, of course, some hedge funds that have outstanding track records. Yet there are quite a few hedge funds where the performance, net of all fees, is not very different (and frequently worse) than the S&P 500 Index. Whereas Buffett’s entire fee was based upon performance above a 6% compounded annual return, there are many hedge funds bringing in huge fees even though their net results are not much different from 6% per year.
In pursuing his investment goals, Buffett used three categories of investments:
The Generals
Workouts
Controls
Miller discusses each category in turn.
THE GENERALS
Miller begins by highlighting that there are many different approaches to value investing. You can focus on very cheap stocks, regardless of business quality or fundamentals. You can instead look for great, well-protected franchise businesses that can compound value over time. You can focus on tiny, obscure microcap companies that are much too small for most professional investors even to consider. Or you could find value in mid- or large-cap companies. And within these categories, you could take a passive approach–like an index fund or a quantitative fund–or you could adopt an active approach of carefully picking each individual stock.
Miller says Buffett essentially used all of these different approaches at one time or another. Miller:
For Buffett, the Generals were a highly secretive, highly concentrated portfolio of undervalued common stocks that produced the majority of the Partnership’s overall gains.
With one exception, Buffett never revealed the names of the companies in which he was investing. These were trade secrets.
Using the Moody’s Manuals and other primary sources of statistical data, Buffett scoured the field to find stocks trading at rock-bottom valuations. Often these were tiny, obscure, and off-the-radar companies trading below their liquidation value. In the early years especially, the Partnership was small enough to be largely unconstrained, allowing for a go-anywhere, do-anything approach, similar to that of most individual investors today.
Even today, it’s remarkable how many tiny microcap companies are virtually unknown. They’re simply too small for most professional investors even to consider. Quite a few have no analyst coverage.
(Photo by Sean824)
Buffett was never concerned about when specific cheap stocks would finally rise toward their intrinsic values. Buffett:
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid.
Among the Generals, Buffett had two subdivisions, as Miller explains.
“Generals – Private Owner” were undervalued based on what a private owner would pay–which itself is still based on discounted future cash flows or liquidation value. But in some cases, these Generals became controlled investments in BPL, meaning Buffett bought enough stock to be able to influence management.
“Generals – Relatively Undervalued” were undervalued stocks that lacked any prospect for BPL or any other private owner to acquire control. Without the possibility of an activist, these cheap stocks were riskier than “Generals – Private Owner.”
Earlier I mentioned discounted cash flows and liquidation value as two primary ways to value companies. These two valuation methods can also be referred to as earnings power value and net asset value. They are linked in that net asset value for a going concern is based on the earnings power of the assets.
Often, however, net asset value is better approximated by liquidation value rather than earnings power. Buffett referred to these deep value opportunities 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.”
One potential problem with Graham’s cigar-butt approach–buying well below liquidation value–is that if a company continues to lose money, then the liquidation value gradually gets eroded.
(Illustration by Preecha Israphiwat)
In these cases, if possible, Buffett would try to buy enough stock in order to influence management. Thus, a General would become a Control. Buffett also looked for situations where another investor would take control. Buffett called this “coattail riding.”
Buffett wrote that deep value cigar butts were central to the great performance of the Buffett Partnership:
… over the years this has been our best category, measured by average return, and has also maintained by far the best percentage of profitable transactions. This approach was the way I was taught the business, and it formerly accounted for a large proportion of all our investment ideas. Our total individual profits in this category during the twelve-year BPL history are probably fifty times or more our total losses.
Yet over time, Buffett evolved from primarily a deep value, cigar-butt strategy to an approach focused on higher quality businesses. Buffett explained the difference in his 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 the qualitative decisions, but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.
Much later, in his 2014 Berkshire Hathaway Letter to Shareholders, Buffett would explain his evolution from deep value investing to investing in higher quality companies that could be held for a long time. See page 25: http://berkshirehathaway.com/letters/2014ltr.pdf
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…
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.
In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise.
Miller quotes Charlie Munger:
… having started out as Grahamites–which, by the way, worked fine–we gradually got what I would call better insights. And we realized that some company that was selling at two or three times book value could still be a hell of a bargain because of the momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.
And once we’d gotten over the hurdle of recognizing that a thing could be based on quantitative measures that would have horrified Graham, we started thinking about better businesses… Buffett Partnership, for example, owned American Express and Disney when they got pounded down.
(Illustration by Patrick Marcel Pelz)
Buffett actually amended the Ground Rules so that he could put 40% of BPL into American Express, which had gotten cheap after a huge, but solvable problem–exposure to the Salad Oil Scandal. This was the largest position the partnership ever held, both on a percentage and absolute dollar basis. BPL’s $13 million investment into American Express produced $20 million in profits over the course of a few years, thus creating a large portion of the partnership’s performance during this time. (In today’s dollars, BPL’s Amex investment was about $90 million, while the profit was about $140 million.)
A high quality company has a high and sustainable return on invested capital (ROIC). That’s only possible if the business has asustainable competitive advantage. Buffett:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Any investor who could find a company like See’s Candies–the quintessential high quality business–and buy it at a reasonable price, would do extremely well over time. But it is exceedingly difficult, even for the smartest investors, to find companies like See’s Candies.
(Photo by Cihcvlss, via Wikimedia Commons)
Buffett and his business partner, Charlie Munger, acquired See’s Candies in 1972. The company has typically experienced a return on invested capital (ROIC) of over 100 percent, which is extraordinary. Buffett and Munger purchased See’s Candies for $25 million. Since then, the business has generated over $2 billion in pre-tax earnings.
Tom Gayner of the Markel Corporation is another investor who has done quite well by buying high quality businesses. Miller notes:
Tom emphasizes that you have to get only a very small number of these right for this type of strategy to really pay off. The companies you get right will harness the power of compounding and grow to dwarf the mistakes. He argues that investors who make twenty or so sound purchases over a lifetime will come to see one or two grow to become a significant percentage of their net worth.
Tom has a great example of this phenomenon that also reminds us not to pigeonhole Ben Graham as purely a deep value investor. Graham paid up for quality when he bought the insurance company GEICO–he ended up making more profits from that single investment than he did from all his other activities combined.
What Should You Do?
Assume that you are an investor operating with modest sums. Is it best to follow the deep value, cigar butt approach, or is it best to look for high-quality companies that can compound business value over time? Miller writes:
One can make a strong case for either method, just as many well-respected investors have done. Both can work, but what’s right for you will depend on the size of funds you are working with, your personality, your own ability to do good valuation work, and your ability to define objectively the outer edges of your own competence.
Tobias Carlisle, with his 2014 book, Deep Value, comes out as a good example of a Graham purist. His research shows that the worse a cheap company’s fundamentals, the better the stock is likely to do. With his deeply quantitative orientation, Tobias has developed something he calls the ‘Acquirer’s Multiple’ to identify and systematically make good investment decisions. He seems to have found something that he understands and that works well for him. Note that he literally shuns quality in his approach to finding value.
… While he’s smart to have found something that works for him, he’s even smarter to avoid what doesn’t. Of course he’d prefer to buy a great business over a poor business if he could be sure that it could maintain its high returns well into the future. However, he hasn’t yet found a way to identify the companies with the factors needed to protect those high returns from competition, at least systematically, so he avoids them.
As Buffett himself has often written, a quantitative, deep value approach is a much surer source of investment profits than an approach based on finding high quality companies. Many investors are better off following a cigar-butt approach. (This is what the Boole Microcap Fund does.)
Buffett has often observed that only a small handful of investments have been responsible for the vast majority of wealth he’s created over time. Buffett:
I will only swing at pitches that I really like. If you do it 10 times in your life, you’ll be rich. You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life.
I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime. You know what would happen? They would make sure that each buy was a good one. They would do lots and lots of research before they made the buy. You don’t have to have many 4X growth opportunities to get rich. You don’t need to do too much, but the environment makes you feel like you need to do something all the time.
Whether you use a deep value approach or a strategy based on higher quality, it is possible to concentrate.
That said, if you use a quantitative approach–which works well for deep value–then having at least 15-20 positions generally works better over time. Part of the reason is that, when buying a basket of deep value stocks–stocks which are typically very ugly–it is rarely possible to say which ones will be the best performers. The legendary value investor Joel Greenblatt, who has excelled at both deep value and high-quality value, has readily admitted that the deep value stocks he picks as best often are not the best. Greenblatt also has said:
In our experience, eliminating the stocks you would obviously not want to own eliminates many big winners.
As Tobias Carlisle so clearly illustrates in Deep Value, the ugliest of the ugly often end up being among the best performers. Without a fully quantitative strategy–which forces you to buy the cheapest, ugliest stocks–it is easy to miss many big winners.
Tom Gayner’s strategy is almost the opposite of Tobias Carlisle’s but he understands it and it works for him. Neither one is ‘right’ or ‘wrong’; each has developed a value system that works for him. What’s right in investing is what works for the individual.
WORKOUTS
What Buffett called Workouts is now known as merger arbitrage (or risk arbitrage). When one company announces that it will buy another, the acquisition target stock will move up towards the announced price, but not all the way.
With a sufficient spread and with a high probability of the deal closing, Buffett would take a position in the target company’s stock. Buffett learned the technique from Graham. If one were to combine the record of Graham-Newman, BPL, and Berkshire Hathaway through 1988–a total period of 65 years–Buffett calculated that merger arbitrage produced unlevered returns of about 20% per year. So this was a very profitable category for the Buffett Partnership.
Because Buffett would often use up to 10% margin–and never more than 25%–the actual net returns for BPL were likely higher than 20% per year. Thus, not only could Workouts do just as well as the Generals–because of the modest leverage used in merger arbitrage–but even more importantly, Workouts were largely uncorrelated (and often negatively correlated) with the overall stock market. So even when the overall market was flat or down–which often meant that the Generals were flat or down–Workouts could and sometimes did produce a positive return. As Buffett wrote:
Obviously the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final result would have been much poorer, although still quite respectable considering market conditions during the year. We could just as well have had a much smaller percentage of our portfolio in workouts that year; availability decided it, not any notion on my part as to what the market was going to do. Therefore, it is important to realize that in 1962 we were just plain lucky regarding mix of categories.
In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow….
Buffett goes on to note that in 1964, Workouts were a big drag on performance. So Workouts didn’t work in every year, but they did tend to produce excellent returns over time. And these returns were uncorrelated or negatively correlated with the returns of the Generals. Buffett wrote: “In years of market decline, it piles up a big edge for us; during bull markets, it is a drag on performance.”
Note: Merger arbitrage has gotten much more difficult and competitive these days based on a much larger number of investors and based on huge computing power. Thus, merger arbitrage is best not to do for most investors today. Yet there are other types of investments with low correlation with the overall market that nonetheless can provide good long-term returns. For instance, privately owned businesses might serve in this role. Energy-related stocks–if held for at least 5 years–have low correlation with the overall market and also tend to outperform it. Similarly, many microcap stocks have relatively low correlation with the broad market and outperform it over time.
CONTROLS
Controls are situations when Buffett bought enough stock so as to influence management to unlock value. Miller gives the example of the Sanborn Map Company. Buffett had more than one-third of the Partnership invested in this stock. The company published and constantly revised highly detailed maps of all cities in the United States. Fire insurance companies were the primary users of these maps. Buffett wrote:
In the early 1950’s a competitive method of underwriting known as ‘carding’ made inroads on Sanborn’s business and after-tax profits of the map business fell from an average level of over $500,000 in the late 1930’s to under $100,000 in 1958 and 1959. Considering the upward bias in the economy during this period, this amounted to an almost complete elimination of what had been sizable, stable earning power.
However, during the early 1930’s Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.
Let me give you some idea of the extreme divergence of these two factors. In 1938 when the Dow-Jones Industrial Average was in the 100-120 range, Sanborn sold at $110 per share. In 1958 with the Average in the 550 area, Sanborn sold at $45 per share. Yet during that same period the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share. This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.
Buffett:
… The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business. Sanborn had a sales volume of about $2 million per year and owned about $7 million worth of marketable securities. The income from the investment portfolio was substantial, the business had no possible financial worries, the insurance companies were satisfied with the price paid for maps, and the stockholders still received dividends. However, these dividends were cut five times in eight years although I could never find any record of suggestions pertaining to cutting salaries or director’s and committee fees.
[Most board members owned virtually no stock…] The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors. The final member of our cast was a son of a deceased president of Sanborn. The widow owned about 15,000 shares of stock.
In late 1958, the son, unhappy with the trend of the business, demanded the top position in the company, was turned down, and submitted his resignation, which was accepted. Shortly thereafter we made a bid to his mother for her block of stock, which was accepted. At the time there were two other large holdings, one of about 10,000 shares (dispersed among customers of a brokerage firm) and one of about 8,000. These people were quite unhappy with the situation and desired a separation of the investment portfolio from the map business as did we.
Buffett continues:
There was considerable opposition on the Board to change of any type, particularly when initiated by an outsider, although management was in complete accord with our plan… To avoid a proxy fight… and to avoid time delay with a large portion of Sanborn’s money tied up in blue-chip stocks which I didn’t care for at current prices, a plan was evolved taking out all stockholders at fair value who wanted out. The SEC ruled favorably on the fairness of the plan. About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value. The map business was left with over $1.25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated. The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.
Lessons from Controls
Miller reminds us that investing in a stock is becoming a part owner of the business:
In 1960, one-third of the Partnership was in Sanborn’s stock, meaning one-third of the Partnership was in the business of selling insurance maps and managing a securities portfolio. In his discussion of Controls, Buffett is teaching us to not think about ‘investing in a stock’ but instead to think about ‘being in a business.’
Miller again:
Whether you are running a business or evaluating one, a singular question remains paramount: what is its value, both in terms of the assets involved and the earnings produced, then, how can it be maximized? The skill in answering these questions determines the success of investors and business managers like.
Buffett often quotes Ben Graham on this point:
Investment is most intelligent when it is most businesslike and business is most intelligent when it’s most investment-like.
In some cases, a General would languish in price for years, allowing BPL to continue acquiring the stock at cheap prices. In this way, a General would sometimes become a Control. A General is attractive as a cheap stock. When a General becomes a Control, it becomes more attractive to the extent that BPL can actively work to unlock value.
In the case of Controls, Buffett was willing to work actively to unlock value, but it did often require taking actions that would be criticized, as Miller writes:
… he had to threaten Sanborn Map’s board with a proxy fight (legal battle) to get them to act… At Dempster Mill, we’ll see that he had to fire the CEO and bring in his own man, Harry Bottle. Together they liquidated large parts of the business to restore the economics of the company. Buffett was vilified in the local newspaper for doing so. While he saw himself as saving the business by excising the rotten parts, critics only saw the lost jobs. Early at Berkshire, he had to fire the CEO and hit the brakes on capital expenditures in textiles before redirecting the company’s focus to insurance and banking. It was never easy and often stressful, but when action was needed, action was taken. As he said, ‘Everything else being equal, I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.’
The ability to actively unlock value led Buffett naturally to concentrate heavily. A situation like Sanborn had high upside and a tiny risk of loss, so it made sense to bet big.
With Dempster Mill, Berkshire, and Diversified Retailing Company (DRC), the values had to be estimated by Buffett and confirmed by auditors. In the case of Dempster and Berkshire, BPL owned so much stock that trying to trade it could dramatically impact the market price. That is why the year-end values had to be estimated, which Buffett did conservatively based on current value rather than future value. DRC also had to be valued this way because it was a privately owned business that never had a publicly traded stock.
Correctly valuing the Controls was important. Not only would it impact the year-end overall performance of BPL–too high of an estimate would inflate the performance, while too low of an estimate would depress the performance. But also, correctly valuing Controls would impact limited partners who were entering or leaving the Partnership. Exiting limited partners would benefit at the expense of remaining limited partners if the estimated value of the Controls was too high. Conversely, new limited partners would benefit at the expense of existing limited partners if the estimated value of the Controls was too low. Buffett was very careful, and his estimates were audited by the firm that would later become KPMG.
Buffett’s November 1966 letter to partners gives some detail on the appraisal process:
The dominant factors affecting control valuations are earnings power (past and prospective) and asset values. The nature of our controlled businesses, the quality of the assets involved, and the fact that the Federal Income Tax basis applicable to the net assets substantially exceeds our valuations, cause us to place considerably more weight on the asset factor than is typical in most business valuations…. The Partnership Agreement charges me with the responsibility for establishing fair value for controlling interests, and this means fair to both adding and withdrawing partners at a specific point in time. 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…
It’s worth noting that Sanborn, Dempster, and Berkshire were all cigar butts where net asset value was much higher than the current market price. They were very cheap businesses, but they were notgood businesses, which is part of why valuing them was mostly based on asset value rather than earnings power.
Because Ben Graham relied mostly on the cigar-butt approach, basing his investments on discounts to liquidation value, Buffett had already learned how to value companies based on their assets. Miller quotes Chapter 43 of Graham and Dodd’s Security Analysis:
The rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value to be ascribed to the assets, however, will vary according to their character.
Graham advised the following rule of thumb for liquidation analysis: 100 cents on the dollar for cash, 80 cents on the dollar for receivables, 67 cents on the dollar for inventory (with a wide range depending on the business), and 15 cents on the dollar for fixed assets.
In the case of Sanborn, the company had a hidden asset in the form of a large investment portfolio that was not reflected on its balance sheet. Dempster Mill’s net assets were much higher on the balance sheet than was indicated by the market price. Buffett had to determine what the assets were really worth. With Berkshire, part of the value would be determined by redeploying capital into higher return opportunities. (Buffett’s successful redeployment of Berkshire’s cash formed the foundation for Berkshire Hathaway, now one of the largest and most successful U.S. companies.)
Circle of Competence
A central concept for Buffett and Munger is circle of competence. For any given company, are you capable of reasonably estimating what the assets are worth? If not, you can either spend the time required to understand the company and the industry, or you can put it into the TOO HARD pile.
Buffett and Munger have three piles: IN, OUT, and TOO HARD. A great many public companies simply go into the TOO HARD pile. This limitation–sticking with companies you can understand well–has been a key to the excellent long-term performance of Buffett and Munger.
For a value investor managing a smaller sum, who can focus on tiny, obscure microcap companies, there are thousands and thousands of businesses. When there are so many that you probablycan understand well, it makes no sense to spend long periods of time on businesses that are decidedly difficult to understand.
For example, you could spend months gaining an understanding of General Electric, or you could spend that same amount of time gaining a complete understanding of at least a dozen tiny microcap companies. Many microcap businesses are quite simple.
Here’s the thing: As Buffett has pointed out, frequently you don’t get paid for degree of difficulty in investing. If you’re willing to turn over enough rocks, eventually you can find a microcap business that you can easily understand and that is extraordinarily cheap. You’ll almost certainly do far better with that type of investment than with a mid-cap or large-cap company that’s much harder to understand and probably not nearly as cheap.
DEMPSTER DIVING: THE ASSET CONVERSION PLAY
Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.
(Photo by Digikhmer)
Miller:
Much of the fun in investing comes from the hunting process itself… Picture the pulse-quickening moment in 1956 when Buffett, thumbing through the Moody’s Manual, came across a tiny, obscure manufacturing company whose stock had fallen 75% in the previous year. Realizing that it was now available for a fraction of its net working capital and an even smaller fraction of its book value, he started buying the stock as low as $17 a share. He got out at $80.
Miller writes that Dempster can serve as a template for valuing businesses using the net asset value approach. Dempster’s profits were very low, but the stock traded far below its asset value.
Buffett joined the board of directors soon after his first purchase. He kept buying the stock for the next five years. A large block of stock from the Dempster family became available for sale in 1961. By August of that year, BPL owned 70% of Dempster and a few “associates” owned another 10%. BPL’s average price was $1.2 million ($28/share), roughly a 50% discount to working capital and 66% discount to book value. Dempster accounted for roughly 20% of BPL’s total assets by year-end.
The situation was challenging at first because the inventories were high and rising. Buffett tried to work with existing management, but had to throw them out because inventories kept rising. The company’s bank was threatening to seize the collateral backing the loan. With 20% of BPL in Dempster, if the company went under it would have a large negative impact on the Partnership. At Munger’s recommendation, Buffett met and hired an “operating man” name Harry Bottle.
Bottle was a turnaround specialist. Buffett was so happy with Bottle’s work that in the next year’s letter, Buffett named him “man of the year.” He cut inventories from $4 million to $1 million, quickly repaid the bank loan, cut administrative and selling expenses in half, and closed five unprofitable branches. With help from Buffett and Munger, Bottle also raised prices up to 500% on their used equipment. There was little impact on sales volume. All of these steps worked together to put Dempster on a healthy economic footing.
Buffett then took an unusual step. Whereas most managers feel automatically that they must reinvest profits into the business, even if the business is creating low returns, Buffett was more rational. Miller explains:
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 in windmills. He immediately stopped the company from putting more capital in and started taking the capital out.
Instead, Buffett invested the capital into the cheapest stocks he could find, those offering the highest potential returns. In effect, he was converting capital from a low-return business to a high-return business–buying cheap stocks until they rose towards intrinsic value. Over time, Dempster looked less like a manufacturing company and more like the investment partnership. Miller observes:
The willingness and ability to see investment capital as completely fungible, whether it is capital tied up in the assets of a business or capital that’s invested in securities, is an exceedingly rare trait.
Dempster initially was worth $35/share in 1961. By year-end 1962, Dempster was worth $51/share, with market securities worth $35/share and the manufacturing operations worth $16/share.
Buffett also learned from this experience the importance of a high-quality and trustworthy CEO. Buffett heaped praise on Harry Bottle. Miller points out that Buffett developed a style like that of Dale Carnegie: Praise by name, criticize by category.
It should also be noted that Dempster’s market value in 1961 was $1.6 million, a tiny microcap company. This kind of opportunity–including being able to buy control–is open to those investing relatively small sums. Very often the cheapest stocks can be found among microcap companies. This high degree of inefficiency results from the fact that most professionals investors never look at micro caps.
Miller sums it up:
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. Buffett commented, ‘Harry has continued this year to turn under-utilized assets into cash, but in addition, he has made the remaining needed assets productive.’
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. Raising prices on replacement parts and reducing operating costs pulled levers #1 and #2. Lever #3 was pulled as inventories (assets) were reduced. Lever #4 was pulled when Buffett borrowed money to buy more stocks. Lever #5 was pulled when he avoided a big tax bill by selling all the operating assets of the company.
When profitability goes up and the capital required to produce it goes down, the returns and the value of the business go straight up. Buffett understood this intrinsically and Dempster is now a powerful example for today’s investors who obsess over (1) and (2) at the expense of (3). Pulling underutilized assets out of a company not only produces cash to be used elsewhere, it makes the business better and more valuable. It is a wonderful reminder to individual and professional investors alike to focus their attention first on the balance sheet (there is a reason it comes first in the set of financial statements). Never lose sight of the fact that without tangible assets, there would be no earnings in the first place.
CONSERVATIVE VERSUS CONVENTIONAL
Although following the crowd made sense in our evolutionary history, and still makes sense in many circumstances, following the crowd kills your ability to outperform the stock market. Miller explains:
Successful investing requires you to do your own thinking and train yourself to be comfortable going against the crowd. You could say that good results come primarily from a properly calibrated balance of hubris and humility–hubris enough to think you can have insights that are superior to the collective wisdom of the market, humility enough to know the limits of your abilities and to be willing to change course when errors are recognized.
You’ll have to evaluate facts and circumstances, apply logic and reason to form a hypothesis, and then act when the facts line up, irrespective of whether the crowd agrees or disagrees with your conclusions. Investing well goes against the grain of social proof; it goes against the instincts that have been genetically programmed into our human nature. That’s part of what makes it so hard.
Howard Marks, a Buffett contemporary who also has a literary bent, challenges his readers to “dare to be great” in order to dare to be better investors. As he tells his readers, “the real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both.”
There are two key ideas in Buffett’s highly independent approach:
The best purchases are made when your thinking puts you in opposition to conventional wisdom or popular trends.
A concentrated portfolio can actually be more conservative than a diversified one when the right conditions are met.
Conventional, academic thinking equates the riskiness of a stock with its beta, which is a measure of its volatility. Buffett, later in his career, gave the following example to illustrate the silliness of beta:
The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more…
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, it’s beta would have been greater. And to people who think beta [or, more importantly, downside volatility] measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million….
In the 1970’s, the Washington Post Company was an outstanding, high-return business and remained so for decades. Of course, like most businesses, its high profitability did not last, in this case because of the internet.
But the point is that if you, as a value investor, buy something at 20% of probable intrinsic value, and the stock then drops 50% and you buy a bunch more, your investment now has 10x upside instead of 5x, and simultaneously, your investment is now probably safer.
Having the expected return from your investment double, while at the same time having the downside risk get cut in half, is completely contrary to what is taught in modern finance theory. Finance theory says that a higher potential return always requires higher risk. Yet the experience of many value investors is that quite often an increase in potential return also means a decreasein risk. Thus, a value investor cheers (and backs up the truck) when his or her best idea keeps going down in price, and this happens routinely.
Thinking for Yourself
The best time to buy is when the crowd is most fearful. But this requires thinking for yourself. A good example is when Buffett put 40% of BPL into American Express after the Salad Oil Scandal. Miller:
The Partnership lessons teach investors that there is only one set of circumstances where you or anyone else should make an investment–when the important facts in a situation are fully understood and when the course of action is as plain as day. Otherwise, pass. For instance, in Sanborn, when Buffett realized he was virtually assured to make money in the stock given he was buying the securities portfolio at 70 cents on the dollar with the map company coming for free, he invested heavily. When he saw Dempster was selling below the value of its excess inventory alone, he loaded up.
Miller quotes Buffett:
When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action is obvious. In that case–whether conventional or unconventional–whether others agree or disagree–we feel–we are progressing in a conservative manner.
Ben Graham:
You’re neither right nor wrong because the crowd disagrees with you. You’re right because your data and reasoning are right.
Buffett again:
You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you… You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct.
Buffett, once more:
A public opinion poll is no substitute for thought.
Loading Up
Buffett thought it was conservative and rational to put 40% of the Partnership assets into American Express. Buffett had amended the Ground Rules of the Partnership to include a provision that allowed up to 40% of BPL’s assets to be in a single security under conditions “coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”
Miller notes that Buffett gave the following advice to a group of students in the late 1990s:
If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is going to be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best.
Your Best Ideas Define Your Next Choice
If you’re using concentrated value investing, then the simple test for whether to add a new idea to your portfolio is to compare any new idea to your best current ideas.
Successful concentrated value investing requires a great deal of passion, curiosity, patience, and prior experience (i.e., lots of mistakes). It also often requires a focus on tiny, obscure micro caps, since this is the most inefficient part of the market and it contains many simple businesses.
Buffett explains:
Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year–one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.
Buffett in the January 25, 1967, BPL Letter:
Our relative performance in this category [Generals–Relatively Undervalued] was the best we have ever had–due to one holding which was our largest investment at yearend 1965 and also yearend 1966. This investment has substantially outperformed the general market for us during each year (1964, 1965, 1966) that we have held it. While any single year’s performance can be quite erratic, we think the probabilities are highly favorable for superior future performance over a three or four year period. The attractiveness and relative certainty of this particular security are what caused me to introduce Ground Rule 7 in November, 1965 to allow individual holdings of up to 40% of our net assets. We spend considerable effort continuously evaluating every facet of the company and constantly testing our hypothesis that this security is superior to alternative investment choices. Such constant evaluation and comparison at shifting prices is absolutely essential to our investment operation.
It would be much more pleasant (and indicate a more favorable future) to report that our results in the Generals–Relatively Undervalued category represented fifteen securities in ten industries, practically all of which outperformed the market. We simply don’t have that many good ideas…
SIZE VERSUS PERFORMANCE
Miller comments that Buffett, if he were managing a relatively small amount of money, probably would have stayed fully invested even during the speculative peak of the late 1990’s. This is largely because there are almost always cheap microcap companies that are too small and obscure to be noticed by most investors. As Buffett said during the late 1990’s:
If I was running $1 million, or $10 million for that matter, I’d be fully invested.
There were times when he was managing BPL when Buffett recognized that more assets under management would increase the Partnership’s ability to do Control investments. But according to Buffett, it was also sometimes true that lessassets under management made it easier to invest in tiny, cheap microcap companies. So Buffett wrote:
What is more important–the decreasing prospects of profitability in passive investments or the increasing prospects in control investments? I can’t give a definite answer to this since to a great extent it depends on the type of market in which we are operating. My present opinion is that there is no reason to think these should not be offsetting factors; if my opinion should change, you will be told. I can say, most assuredly, that our results in 1960 and 1961 would not have been better if we had been operating with the much smaller sums of 1956 and 1957.
By 1966, however, when assets under management reached $43 million, Buffett changed his mind. He wrote his partners:
As circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results.
Buffett saw a drag on performance that would probably develop as a result of two factors: larger assets under management, and a stock market that was high overall, with far fewer opportunities. It’s important to note again that Buffett did not think a high market would be a factor if he were managing smaller sums. As Buffett said in 2005, when asked if he could still make 50% per year with smaller sums:
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 could 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.
Ideas versus Capital
The bottom line is simple: If you have more capital than ideas, then assets are too large and will be a drag on performance. If you have more ideas than capital, then assets are not a drag and may even be too small.
GO-GO OR NO-GO
In 1956, Buffett had told his partners that he thought the stock market was high relative to intrinsic value. Since he never tried to predict the market, he remained focused on finding tiny microcap companies that were cheap. Staying focused on finding what was cheapest was central to the 29.8% per year the BPL achieved over the ensuing decade. Had Buffett ever invested less because he was worried about a stock market decline, his record would have been nowhere near as good.
An expensive stock market says nothing about when a correction will happen. And an expensive stock market rarely means that there are no obscure, cheap microcap companies.
By 1966, however, because BPL had more assets under management and because Buffett thought the stock market was even more overvalued, Buffett finally decided not to accept any new capital.
Somewhat ironically, BPL had its best year ever in 1968, with a return of 58.8%. But this also led Buffett to consider closing the Partnership altogether. Buffett had simply run out of ideas, due to the combination of his assets under management and a stock market that was quite overvalued in his view.
In May 1969, Buffett announced his decision to liquidate the Partnership. Performance in 1969 was mediocre, and Buffett wrote:
… I would continue to operate the Partnership in 1970, or even 1971, if I had some really first class ideas. Not because I want to, but simply because I would so much rather end with a good year than a poor one. However, I just don’t see anything available that gives any reasonable hope of delivering such a good year and I have no desire to grope around, hoping to ‘get lucky’ with other people’s money. I am not attuned to this market environment and I don’t want to spoil a decent result by trying to play a game I don’t understand just so I can go out a hero.
Go-Go Years – Jerry Tsai
The big bull market run of the 1960s became known as the Go-Go years. Jerry Tsai’s highly speculative investment style, which produced high returns for some time, was representative of the Go-Go years. In 1968, Tsai shrewdly sold his Manhattan Fund, which had $500 million under management. The fund went on to lose 90% of its value over the next several years.
TOWARD A HIGHER FORM
Buffett constantly evolved as an investor. As Miller writes:
A good deal of this evolution occurred throughout the Partnership years, where we have seen a willingness to concentrate his investments to greater and greater degrees, a steady migration toward quality compounders from statistically cheap cigar butts, and the forging of his highly unique ability to break down the distinction between assets and capital in a way that allows for their fungibility in the pursuit of higher returns.
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: https://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 approachesintrinsic 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.
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.
You’re deluding yourself. I’m deluding myself. Our brains just do this automatically, all the time. We invent simple stories based on cause and effect. Often this is harmless. But sometimes it’s important to recognize that reality is far more unpredictable than we’d like.
We’re not wired to understand probabilities. As Daniel Kahneman and Amos Tversky have demonstrated, even many professional statisticians are not good “intuitive statisticians.” They’re usually only good if they slow down and work through the problem at hand step-by-step. Otherwise, they too tend to create overly simplistic, overly deterministic stories.
(Photo by Wittayayut Seethong)
To develop better mental habits, a good place to start is by recognizingdelusions andbiases, which are widespread in business, politics, and economics. To that end, here are fourof the best books:
Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011), by Daniel Kahneman
Poor Charlie’s Almanack (Walsworth, 3rd edition, 2005), by Charles T. Munger
The Halo Effect…and Eight Other Business Delusions That Deceive Managers (Free Press, 2007), by Phil Rosenzweig
Expert Political Judgment: How Good Is It? How Can We Know? (Princeton University Press, 2006), by Philip Tetlock
Tetlock’s work is particularly important. He tracked over 27,000 predictions made in real time by 284 experts from 1984 to 2003. Tetlock found that the expert predictions–on the whole–were no better than chance. Many of these experts have deep historical knowledge of politics or economics, which can give us important insights and is often a precursor to scientific knowledge. But it’s not yet science–the ability to make predictions.
Kahneman and Munger both show how our intuition uses mental shortcuts (heuristics) to jump to conclusions. Often these conclusions are fine. But not if probabilistic reasoning is needed to reach a good decision.
This blog post focuses on Rosenzweig’s book, which examinesdelusions in business, with particular emphasis onthe Halo Effect.
Outline for this blog post:
The Halo Effect
Illusions and Delusions
How Little We Know
The Story of Cisco
Up and Down with ABB
Halos All Around Us
Research to the Rescue?
Searching for Stars, Finding Halos
The Mother of All Business Questions,Take Two
Managing Without Coconut Headsets
THE HALO EFFECT
Rosenzweig quotes John Kay of theFinancial Times:
The power of the halo effect means that when things are going well praise spills over to every aspect of performance, but also that when the wheel of fortune spins, the reappraisal is equally extensive. Our search for excessively simple explanations, our desire to find great men and excellent companies, gets in the way of the complex truth.
(Image by Ileezhun)
Rosenzweig explains the essence of the Halo Effect:
If you select companies on the basis of outcomes–whether success or failure–and then gather data that are biased by those outcomes, you’ll never know what drives performance. You’ll only know how high performers or low performers are described.
Rosenzweig describes his book as “a guide for the reflective manager,” a way to avoid delusions and to think critically. It’s quite natural for us to construct simple stories about why things happen. But many events–including business success and failure–don’t happen in a straightforward way. There’s a large measure of uncertainty (chance) involved.
Rosenzweig adds:
Of course, for those who want a book that promises to reveal the secret of success, or the formula to dominate their market, or the six steps to greatness, there are plenty to choose from. Every year, dozens of new books claim to reveal the secrets of leading companies… Others tell you how to become an innovation powerhouse, or craft a failsafe strategy, or devise a boundaryless organization, or make the competition irrelevant.
But if anything, the world is getting more unpredictable:
In fact, for all the secrets and formulas, for all the self-proclaimed thought leadership, success in business is as elusive as ever. It’s probably more elusive than ever, with increasingly global competition and technological change moving at faster and faster rates–which might explain why we’re tempted by promises of breakthroughs and secrets and quick fixes in the first place. Desperate circumstances push us to look for miracle cures.
Rosenzweig explains that business managers are under great pressure to increase profits. So they naturally look for clear solutions that they can implement right away. Business writers and experts are happy to supply what is demanded. However, reality is usually far more unpredictable than is commonly assumed.
ILLUSIONS AND DELUSIONS
Science is the ability to predict things: if x, then y (with probability z). (If we’re talking about physics–other than quantum mechanics–then z = 100% in the vast majority of cases.) But the sciences that deal with human behavior still haven’t discovered enough to make many predictions. There are specific experiments or circumstances where good predictions can be made–such as where to place specific items in a retailer to maximize sales. And good research has uncovered numerous statistical correlations.
But on the whole, there’s still much unpredictability in business and in human behavior generally. There’s still not much scientific knowledge.
Rosenzweig says some of the biggest recent business blockbusters contain several delusions:
For all their claims of scientific rigor, for all their lengthy descriptions of apparently solid and careful research, they operate mainly at the level of storytelling. They offer tales of inspiration that we find comforting and satisfying, but they’re based on shaky thinking. They’re deluded.
Rosenzweig explains that most management books seek to understand what leads to high performance. By contrast, Rosenzweig asks why it is so difficult to understand high performance. We suffer from many delusions. Our intuition leads us to construct simple stories to explain things, even when those stories are false.
(Image by Edward H. Adelson, via Wikimedia commons)
Look at squares A and B just above: Are they the same color? Or is one square lighter than the other?
A and B are exactly the same color. However, our visual system automatically uses contrast. If it didn’t, then as Steven Pinker has pointed out, we would think a lump of coal in bright sunlight was white. We would think a lump of snow inside a dark house was black. We don’t make these mistakes because our visual system works in part by contrast. Kathryn Schulz mentions this in her excellent book,Being Wrong (HarperCollins, 2010).
This use of contrast is a heuristic–a shortcut–used by our visual system. This happens automatically. And usually this heuristic helps us, as in Pinker’s examples.
The important point is that our intuition (part of our mental system) islike our visual system. Ourintuitionalso uses heuristics.
If we are asked a difficult question, our intuition substitutes an easier question and then answers that question. This happens automatically and without our conscious awareness.
Similarly, our intuition constructs simple stories in terms of cause and effect, even if reality is far more complex and random. This happens automatically and without our conscious awareness.
(Image by Edward H. Adelson, via Wikimedia Commons)
This second image is the same as the previous one–except this one has two vertical grey bars. This helps (to some extent) our eyes to see that squares A and B are exactly the same color.
Rosenzweig mentions that some rigorous research of business has been conducted. But this research often reaches far more modest conclusions than what we seek. As a result, it’s not popular or well-known. For instance, there may be a 0.2 correlation between certain approaches of a CEO and business performance. That’s a huge finding–20% of business performance is based on specific CEO behavior.
But that means 80% of business performance is due to other factors, including chance. That’s not the type of information people in business want to hear when they’re busy and under pressure.
HOW LITTLE WE KNOW
In January 2004, after a disastrous holiday season, Lego–the Danish toymaker–fired its chief operating officer, Poul Ploughman. Rosenzweig points out that when a company does well, we tend to automatically think its leaders did the right things and should be praised or promoted. When a company does poorly, we tend to jump to the conclusion that its leaders did the wrong things and should be replaced.
But reality is far more complex. Good leadership may represent 20-30% of the reason a company is doing well now, but luck may be an even bigger factor. Similarly, bad leadership may be responsible for 20-30% of a company’s poor performance, whereas bad luck–unforeseeable events–may be a bigger factor.
(Photo by Marco Clarizia)
As humans, we’re driven to construct stories in which success and failure are completely explainable–without reference to luck–based on the actions of people and systems. This satisfies our psychological need to see the world as a predictable place.
However, reality is unpredictable to an extent. We understand far less than we think. Luck usually plays a large role in business success and failure.
When Lego hired Ploughman, it was seen as a coup. Ploughman helped Lego expand into electronic toys. When the initial results of this expansion were not positive, Lego’s CEO Kjeld Kirk Kristiansen lost patience and fired Ploughman.
The business press reported that Lego had “strayed from its core.” However, the company tried to expand because its traditional operations were not as profitable as before. If the company’s attempted expansion had been more profitable, the business press would have reported that Lego “wisely expanded.”
(Photo of lego bricks by Benjamin D. Esham)
When it comes to business performance, there are many factors–including luck. A company may move forward on an absolute basis, but fall behind relative to competitors. Also, consumer tastes are unpredictable.
A company may attempt expansion and fail, but the decision may have been wise based on available information. Regardless, observers are likely to say the company “unwisely strayed from its core.”
Or a company may try to expand and succeed, but it may have been a stupid decision based on available information. Regardless, observers are likely to claim that the company “brilliantly expanded.”
To understand better how businesses succeed, we should try to understand what factors are involved in good decisions, even though good decisions often don’t work and bad decisions sometimes do. We want to avoidoutcome bias, where our evaluation of the quality of a decision is colored by whether the result was favorable or not.
Science is: if x, then y (with probability z).This is a slightly modified definition (I added “with probability z”) Rosenzweig borrowed from physicist Richard Feynman.
In some areas of business, scientists have discovered reliable statistical correlations. For instance, this set of behaviors–a, b, and c–has a 0.10 correlation with revenues. If you do a, b, and c–holding all else constant–then revenues will increase approximately 10%.
The difficult thing about studying business is that often you cannot run controlled experiments. Of course, sometimes you can. For instance, you can experiment with where to place various items in a store (or chain of stores). You can compare results and gain good statistical information. Also, there are promotions and advertising campaigns that you can test. And you can track consumer behavior online.
But frequently you cannot run controlled experiments. As Rosenzweig observes, you can’t do 100 acquisitions, and manage half of them one way, the other half another way, and then compare the results.
There’s nothing wrong withstories, which are satisfying explanations we construct about various events. But stories are not science, and it’s important to keep the distinction straight, especially when we’re trying to understand why things happen.
An even better term thanpseudo-science is Feynman’s term,Cargo Cult Science. Rosenzweig quotes Feynman:
In the South Seas, there is a cult of people. During the war, they saw airplanes land with lots of materials, and they want the same thing to happen now. So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas–he’s the controller–and they wait for the airplanes to land. They’re doing everything right. The form is perfect. But it doesn’t work. No airplanes land. So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.
(Photo of Richard Feynman in 1984, by Tamiko Thiel)
Rosenzweig concludes:
The business world is full of Cargo Cult Science, books and articles that claim to be rigorous scientific research but operate mainly at the level of storytelling. In later chapters, we’ll look at some of this research–some that meet the standard of science but aren’t satisfying as stories, and some that offer wonderful stories but are doubtful as science. As we’ll see, some of the most successful business books of recent years, perched atop the bestseller list for months on end, cloak themselves in the mantle of science, but have little more predictive power than a pair of coconut headsets on a tropical island.
It’s not that stories have nothing to teach us. For instance, experts may develop deep historical knowledge that offers us useful insights into human behavior. And such knowledge is often an antecedent to scientific knowledge.
But we have to be careful not to confuse stories with science. Otherwise, it’s very easy and natural to delude ourselves that we understand something scientifically, when in fact we don’t. Our intuition creates simple stories of cause and effect just as automatically as our visual system is unable to avoid optical illusions.
(Holy grail or two girls, by Micka)
THE STORY OF CISCO
Rosenzweig tells the story of Cisco. Sandra K. Lerner and Leonard Bosack met in graduate school, fell in love, and got married. After graduating, they each took jobs managing computer networks at different corners of the Stanford campus. They wanted to communicate, and they invented a multiprotocol router. Rosenzweig:
Like many start-ups, Cisco began by operating out of a basement and at first sold its wares to friends and professional acquaintances. Once revenues approached $1 million, Lerner and Bosack went in search of venture capital. The man who finally said yes was Donald Valentine at Sequoia Capital, the seventy-seventh moneyman they approached, who invested $2.5 million for a third of the stock and management control. Valentine began to professionalize Cisco’s management, bringing in as CEO an industry veteran, John Morgridge. Sales grew rapidly, from $1.5 million in 1987 to $28 million in 1989, and in February 1990, Cisco went public.
Valentine and Morgridge brought on John Chambers as a sales executive in 1991. Chambers had worked at IBM and Wang Labs, and was ready to work at a smaller company where he might have more of an impact. Chambers came up with a plan for Cisco to dominate the market for computer infrastructure. Over the next three years, Cisco acquired two dozen companies.
(Cisco Logo, via Wikimedia Commons)
Chambers became CEO in 1995 and Cisco continued acquiring companies. Cisco’s revenues reached $4 billion in 1997. Rosenzweig:
Cisco rode the crest of the internet wave in 1998… Cisco had a 40 percent share of the $20 billion data-networking equipment industry–routers, hubs, and devices that made up the so-called plumbing of the Internet–and a massive 80 percent share of the high-end router market. But Cisco wasn’t just growing revenues. It was profitable, too. At a time when even the most admired Internet start-ups, like Amazon.com, were losing money, Cisco posted operating margins of 60 percent. This wasn’t some dot-com with a business plan, way out there in the blue, riding on a smile and a shoeshine. It wasn’t panning for Internet gold, it was selling picks and shovels to miners who were lining up around the corner to buy them…
Cisco reached $100 billion market capitalization in just twelve years. It had taken Microsoft twenty years (the previous record).
Accounts explaining Cisco’s success nearly always gave credit to John Chambers. He’d overcome dyslexia to go to law school. And Chambers said he learned from working at IBM and Wang that if you don’t react to shifts in technology, your work will be lost and the lives of employees disrupted. Cisco wouldn’t make that mistake, Chambers declared.
Cisco had a disciplined, detailed process for making acquisitions, and an even more disciplined process for integrating acquisitions into Cisco’s operations. Cisco had made “a science” of acquisitions. And it cared a lot about the human side–turnover rate for acquired employees was only 2.1% versus an industry average of 20%.
After the Internet stock bubble burst, business reporters completely reversed their opinion of Cisco on every major point:
Customer service–from excellent to poor
Forecasting ability–from outstanding to terrible
Innovation–from nearly perfect to visibly flawed
Acquisitions–from scientific process to binge buying
Senior leadership–from amazing to arrogant
Business reporters recalled that Chambers had claimed that Cisco “was faster, smarter, and just plain better than competitors.” Rosenzweig says this is fascinating because only business reporters had said this when Cisco was doing well. Chambers himself never said it, but now business writers seemed to recall that he had.
Rosenzweig points out that it was possible that Cisco had changed. But that’s not what business reporters were saying. They viewed Cisco through an entirely different lens, now that the company was struggling.
The essence of the Halo Effect: If a company is performing well, then it’s easy to view virtually everything it does through a positive lens. If a company is doing poorly, then it’s natural to view virtually everything it does through a negative lens. The story of Cisco certainly fits this pattern.
As Rosenzweig remarks, the fundamental problem is twofold:
We have little scientific knowledge of what leads to business success or failure.
But we do know about revenues, profits, and the stock price. If these observable measures are positive, we intuitively jump to the conclusion that the company must be doing many things well. If these observable measures are declining, we conclude that the company must be doing many things poorly.
UP AND DOWN WITH ABB
ABB is a Swedish-Swiss industrial company that was created in 1988 by the merger of two leading engineering companies, Sweden’s ASEA and Switzerland’s Brown Boveri.
(ABB Logo, via Wikimedia Commons)
Rosenzweig thought it would be interesting to look at a non-American, non-Internet company. The Halo Effect is still clearly visible in the accounts of ABB’s rise and fall.
When it came to ABB’s rise, from the late 1980’s to the late 1990’s, we see that business experts drew similar conclusions. First, the CEO, Percy Barnevik, was widely and highly praised. Rosenzweig describes Barnevik as a “Scandinavian who combined old world manners and language skills with American pragmatism and an orientation for action.” Barnevik was described in the press as very driven, but also unpretentious and accessible. He met frequently with all levels of ABB management. He was a speed reader and highly analytical. Away from work, he climbed mountains and went for long jogs (lasting up to 10 hours). On top of all this, Barnevik was viewed as humble, not arrogant.By 1993, Barnevik had become a legend.
Another explanation for ABB’s success was its culture. Despite its conservative Swedish and Swiss roots, ABB had a strong bias for action. Barnevik said so on several occasions, asserting that the only unacceptable thing was to do nothing. He claimed that if you do 50 things, and 35 are in the right direction, that is enough.
A third explanation was that the company was designed to be globally efficient, but still able to compete in local markets. Barnevik wanted people in different locations to be able to launch new products, make design changes, or alter production methods. ABB had a matrix structure, with fifty-one business areas and forty-one country managers. This resulted in 5,000 profit centers, with each one empowered to achieve high performance and accountable to do so.
In 1996, ABB was named Europe’sMost Respected Company for the third year in a row by theFinancial Times. Kevin Barham and Claudia Heimer, of Ashridge Management Centre in England, published a 382-page book about ABB. They identified five reasons for ABB’s success: customer focus, connectivity, communication, collegiality, and convergence. They placed ABB in the same category as Microsoft and General Electric.
In 1997, Barnevik stepped down as CEO, replaced by Goran Lindahl. Then the company transitioned towards businesses based on intellectual capital. ABB entered new areas, like financial services. It exited the trains and trams business, as well as the nuclear fuels business. Rosensweig asks if ABB was “straying from its core.” Not at all because ABB was still seen as a success. Lindahl was CEO of the year in 1999 according to the American publication,Industry Week. Lindahl was the first European to get this award.
In November 2000, Lindahl abruptly stepped down, saying he wanted to be replaced by someone with more expertise in IT. J¼rgen Centerman became the new CEO.
ABB’s performance entered a steep decline. Centerman was replaced by J¼rgen Dormann in September 2002. Dormann sold the company’s petrochemicals business and its structured finance business. ABB focused on automation technologies and power technologies. But the company’s market cap dipped below $4 billion, down from a peak of $40 billion.
When ABB was on the rise in terms of performance, it was described as bold and daring because of its bias for action and experimentation. Now, with performance being poor, ABB was described as impulsive and foolish. Moreover, whereas ABB’s decentralized strategy had been praised when ABB was rising, now the same strategy was criticized. As for Barnevik, while he had previously been described as bold and visionary, now he was called arrogant and imperial.
Most interesting of all, notes Rosenzweig, is that neither the company nor Barnevik was thought to have changed. It was only how they were characterized that had changed–clear examples of the Halo Effect.
Rosenzweig writes:
…one of the main reasons we love stories is that they don’t simply report disconnected facts but make connections about cause and effect, often ascribing credit or blame to individuals. Our most compelling stories often place people at the center of events… Once widely revered, Percy Barnevik was now an exemplar of arrogance, of greed, of bad leadership.
HALOS ALL AROUND US
During World War I, the American psychologist Edward Thorndike studied how superiors rated their subordinates. Thorndike noticed that good soldiers were good on nearly every attribute, whereas underperforming soldiers were bad on nearly every attribute. Rosenzweig comments:
It was as if officers figured that a soldier who was handsome and had good posture should also be able to shoot straight, polish his shoes well, and play the harmonica, too.
Thorndike called this the Halo Effect. Rosenzweig:
There are a few kinds of Halo Effect. One refers to what Thorndike observed, a tendency to make inferences about specific traits on the basis of a general impression. It’s difficult for most people to independently measure separate features; there’s a common tendency to blend them together. The Halo Effect is a way for the mind to create and maintain a coherent and consistent picture, to reduce cognitive dissonance.
(Image by Aliaksandra Molash)
Rosenzweig gives the example of George W. Bush. After the September 11 attacks in 2001, Bush’s approval ratings rose sharply, not surprisingly as the public rallied behind him. But Bush’s ratings on other factors, such as his management of the economy, also rose significantly. There was no logical reason to think Bush’s handling of the economy was suddenly much better after the attacks. This is an instance of the Halo Effect.
By October 2005, the situation had reversed. Support for the Iraq War waned, and people were upset about the government response to Hurricane Katrina. Bush’s overall ratings were at 37 percent. His rating was also lower in every individual category.
Rosenzweig then explains another kind of Halo Effect:
…the Halo Effect is not just a way to reduce cognitive dissonance. It’s also a heuristic, a sort of rule of thumb that people use to make guesses about things that are hard to assess directly. We tend to grasp information that is relevant, tangible, and appears to be objective, and then make attributions about other features that are more vague or ambiguous.
Rosenzweig later adds:
All of which helps explain what we saw at Cisco and ABB. As long as Cisco was growing and profitable and setting records for its share price, managers and journalists and professors inferred that it had a wonderful ability to listen to its customers, a cohesive corporate culture, and a brilliant strategy. And when the bubble burst, observers were quick to make the opposite attribution. It all made sense. It told a coherent story. Same for ABB, where rising sales and profits led to favorable evaluations of its organization structure, its risk-taking culture, and most clearly the man at the top–and then to unfavorable evaluations when performance fell.
Rosenzweig recounts an experiment by professor Barry Staw. Various groups of people were asked to forecast future sales and earnings based on a set of financial data. Then some groups were told they’d done a good job, while other groups were told the opposite. But this was doneat random, completely independent of actual performance.
Later, each group was asked about how it had functioned as a group. Groups that had been told that they did well on their forecasts reported that their group had been cohesive, with good communication, openness to change, and good motivation. Groups that had been told that they didn’t do well on their forecasts reported that they lacked cohesion, had poor communication, and were unmotivated.
Staw’s experiment is a clear demonstration of the Halo Effect.
If people believe that a group is effective–irrespective of whether the group can be measured as such–then they attribute one set of characteristics to it.
If people believe that a group is ineffective–irrespective of whether the group can be measured as such–then they attribute the opposite set of characteristics to it.
This doesn’t mean that cohesiveness, motivation, etc., is unimportant for group communication. Rather, it means that people typically cannot assess these types of qualities with much (or any) objectivity, especially if they already have a belief about how a given group has performed in some task.
When it’s hard to measure something objectively, people tend to look for something that is objective and use that as a heuristic, inferring that harder-to-measure attributes must be similar to whatever is objective (like financial peformance).
As yet another example, Rosenzweig mentions that IBM’s employees were viewed as smart, creative, and hardworking in 1984 when IBM was doing well. In 1992, after IBM had faltered, the same people were described as complacent and bureauratic.
As we’ve seen, the Halo Effect is particularly frequent when people try to judge how good a leader is. Just as we don’t have much scientific knowledge for how a company can succeed, we also don’t have much scientific knowledge about what makes a good leader. Experts, when they look at a company that is doing well, tend to think that the leader has many good qualities such as courage, clear vision, and integrity. When the same experts examine a company that is doing poorly, they tend to conclude that the leader lacks courage, vision, and integrity.This happens even when experts are looking at the same company and that company is doing the same things.
(Image by Kirsty Pargeter)
When Microsoft was doing well, Bill Gates was described as ambitious, brilliant, and visionary. When Microsoft appeared to falter in 2001, after Judge Thomas Penfield Jackson ordered Microsoft to be broken up, Bill Gates was described as arrogant and stubborn.
Rosenzweig gives two more examples: Fortune’sWorld’s Most Admired Companies, and the Great Places to Work Institute’sBest Companies to Work For index. Both lists appear to be significantly impacted by the Halo Effect. Companies that have been doing well financially tend to be viewed and described much more favorably on a range of metrics.
Rosenzweig closes the chapter by noting that the Halo Effect is the most basic delusion, but that there are several more delusions he will examine in the coming chapters.
RESEARCH TO THE RESCUE?
Rosenzweig:
The Halo Effect shapes how we commonly talk about so many topics in business, from decision processes to people to leadership and more. It shows up in our everyday conversations and in newspaper and magazine articles. It affects case studies and large-sample surveys. It’s not so much the result of conscious distortion as it is a natural human tendency to make judgments about things that are abstract and ambiguous on the basis of other things that are salient and seemingly objective. The Halo Effect is just too strong, the desire to tell a coherent story too great, the tendency to jump on bandwagons too appealing.
The most fundamental business question is:
What leads to high business performance?
The Halo Effect is far from inevitable, despite being very common. There are researchers who use careful statistical tests to isolate the effects of independent variables on dependent variables.
The dependent variables relate to company performance. And we have good data on that, from revenues to profits to return on capital.
As for the independent variables, some of these, such as R&D spending, are not tainted. Much trickier is what happens inside a company, such as quality of management, customer orientation, company culture, etc.
Rosenzweig explores the question of whether customer focus leads to better company performance. It probably does. However, in order to measure the effect of customer focus on performance objectively, we should not look at magazine and newspaper articles–since these are impacted by the Halo Effect. Nor should we ask company employees about their customer focus. How a company is performing–well or poorly–will impact the opinions of managers and employees regarding customer focus.
Similar logic applies to the question of how corporate culture impacts business performance. Surveys of managers and employees will be tainted by the Halo Effect. Yes, corporate culture impacts business performance. But to figure out the statistical correlation, we have to be sure to avoid data likely to be skewed by the Halo Effect.
Delusion Two: The Delusion of Correlation and Causality
Rosenzweig gives the example of employee turnover and company performance. If there is a statistical correlation between the two, then what does that mean? Does lower employee turnover lead to higher company performance? That sounds reasonable. On the other hand, does higher company performance lead to lower employee turnover? That could very well be the case.
Potential confusion about correlation versus causality is widespread when it comes to the study of business.
One way to get some insight into potential causality is to conduct alongitudinal study, looking at independent variables in one period and hypothetically dependent variables in some later period. Rosenzweig:
One recent study, by Benjamin Schneider and colleagues at the University of Maryland, used a longitudinal design to examine the question of employee satisfaction and company performance to try to find out which one causes which. They gathered data over several years so they could watch both changes in satisfaction and changes in company performance. Their conclusion? Financial performance, measured by return on assets and earnings per share, has a more powerful effect on employee satisfaction than the reverse. It seems that being on a winning team is a stronger cause of employee satisfaction; satisfied employees don’t have as much of an effect on company performance. How were Schneider and his colleagues able to break the logjam and answer the question of which leads to which? By gathering data over time.
Delusion Three: The Delusion of Single Explanations
Rosenzweig describes two studies that were carefully conducted, one on the effect of market orientation on company performance, and the other on the effect of CSR–corporate social responsibility–on company performance. The studies were careful in that they didn’t just ask for opinions. They asked about different activities in which the company did or did not engage.
The conclusion of the first study was that market orientation is responsible for 25 percent of company performance. The second study concluded that CSR is responsible for 40 percent of company performance. Rosenzweig asks: Does that mean that market orientation and CSR together explain 65 percent of company performance? Or do the variables overlap to an extent? The problem with studying a single cause of company performance is that you don’t know if part of the effect may be due to some other variable you’re not measuring. If a company is well-managed, then wouldn’t that be seen in market orientation and also in CSR?
(Photo byJ¶rg St¶ber)
We could throw human resource management–HRM–into the mix, too. Same goes for leadership. One study found that good leadership is responsible for 15 percent of company performance. But is that in addition to market orientation, CSR, and HRM? Or do these things overlap to an extent? It’s likely that there is significant overlap among these four variables.
One problem is that many researchers would like to tell a clear story about cause and effect. Admitting that many key variables likely overlap means that the story is much less clear. People–especially if busy or pressured–prefer simple stories where cause and effect seem obvious.
Furthermore, many important questions are at the intersection of different fields. Rosenzweig gives the example of decision making, which involves psychology, sociology, and economics. The trouble is that an expert in marketing will tend to exaggerate the importance of marketing. An expert in CSR will tend to exaggerate the importance of CSR. And so forth for other specialties.
SEARCHING FOR STARS, FINDING HALOS
Rosenzweig lists the eight practices of America’s best companies according toIn Search of Excellence: Lessons from America’s Best-Run Companies, published by Tom Peters and Bob Waterman in 1982:
A bias for action–a preference for doing something–anything–rather than sending a question through cycles and cycles of analyses and committee reports.
Staying close to the customer–learning his preferences and catering to them.
Autonomy and entrepreneurship–breaking the corporation into small companies and encouraging them to think independently and competitively.
Productivity through people–creating in all employees the awareness that their best efforts are essential and that they will share in the rewards of the company’s success.
Hands-on, value-driven–insisting that executives keep in touch with the firm’s essential business.
Stick to the knitting–remaining with the business the company knows best.
Simple form, lean staff–few administrative layers, few people at the upper levels.
Simultaneous loose-tight properties–fostering a climate where there is dedication to the central values of the company combined with a tolerance for all employees who accept those values.
Rosenzweig points out that this list looks familiar: Care about your customers. Have strong values. Create a culture where people can thrive. Empower your employees. Stay focused.
If these look correlated, says Rosenzweig, that’s because they are. The best companies do all of them. Of course, again there’s the Halo Effect. If you isolate the top-performing companies (43 of them in this case), and then ask managers and employees about customer focus, values, culture, leadership, focus, etc., then you won’t know what caused what. Did clear strategy, good organization, strong corporate culture, and customer focus lead to the high performance? Or do people view high-performing companies as doing well in these areas?
(Image by Eriksvoboda)
When the book was published in 1982, there was a widespread concern among American businesses that Japanese companies were better overall. Peters and Waterman made the point that the leading American businesses were doing well in a variety of key areas. This message was viewed not only as inspirational, but even as patriotic. It was the right story for the times.
Many thought thatIn Search of Excellence contained scientific knowledge: if x, then y (with probability z).People thought that if they implemented the principles highlighted by Peters and Waterman, then they would be successful in business.
However, just two years later, some of the excellent companies did not seem as excellent as before. Some were blamed for changing–not sticking to their knitting. Others were blamed for NOT changing–not being adaptable enough, not taking action. More generally, some were blamed for overemphasizing certain principles, while underemphasizing other principles.
Rosenzweig examined the profitability of 35 of the 43 excellent companies–the 35 companies for which data were available because these companies were public. He found that, in the five years after 1982, 30 out of 35 had a decline in profitability. If these were truly excellent companies, then such a decline for 30 of 35 doesn’t make sense.
(Image by Dejan Lazarevic)
Rosenzweig observes that it’s possible that the previous success of these companies was due to more than the eight principles identified by Peters and Waterman. And so changes in other variables may explain the subsequent declines in profitability. It’s also possible–because Peters and Waterman identified 43 highly successful companies and then interviewed managers at those companies–that the Halo Effect came into play. The eight principles may reflect attributions that people tend to make about currently successful companies.
Delusion Four: The Delusion of Connecting the Winning Dots
You can’t choose a sample based only on the dependent variable you’re trying to test. The dependent variable in this case is successful companies. If all you look at is successful companies, then you won’t be able to compare successful companies directly to unsuccessful companies in order to learn about their respective causes–the independent variables. Rosenzweig refers to this error as theDelusion of Connecting the Winning Dots. You can connect the dots any way you wish, but following this approach, you can’t learn about the independent variables that lead to success.
Like many areas of social science, it’s not easy. You can’t run an experiment where you take 100 companies, and manage half of them one way, and half of them another way, and then compare results.
(Image by Macrovector)
Jim Collins and Jerry Porras isolated 18 companies based on excellent performance over a long period of time. Also, for each of these companies, Collins and Porras identified a similar company that had been less successful. This at least could avoid the error that Peters and Waterman made. As Collins and Porras said, if all you looked at were successful companies, you might find that they all reside in buildings.
Collins, Porras, and their team read more than 100 books and looked at more than 3,000 documents. All told, they had a huge amount of data. They certainly worked very hard. But that in itself does not increase the scientific validity of their study.
Collins and Porras claimed to have found “timeless principles,” which they listed:
Having a strong core ideology that guides the company’s decisions and behavior
Building a strong corporate culture
Setting audacious goals that can inspire and stretch people–so-called big hairy audacious goals, or BHAGs
Developing people and promoting them from within
Creating a spirit of experimentation and risk taking
Driving for excellence
Unfortunately, much of the data came from books, the business press, and company documents, all likely to contain Halos. They also conducted interviews with managers, who were asked to look back on their success and explain the reasons. These interviews were probably tinged by Halos in many cases. Some of the principles identified may have led to success. However, successful companies were also likely to be described in these terms. The Halo Effect hadn’t been dealt with by Collins and Porras.
Rosenzweig looked at profitability over the subsequent five years. Eleven companies saw profits decline. One was unchanged. Only five of the best companies had profits increase. It seems the “master blueprint for long-term prosperity” is largely a delusion, writes Rosenzweig.
(Graph by Experimental)
It’s not just some of the companies, but most of the companies that saw profits decline. Characterizations of the “best” companies were probably impacted significantly by the Halo Effect. The very fact that these companies had been doing well for some time led many to see them as having positive attributes across the board.
Delusion Five: The Delusion of Rigorous Research
As noted, psychologist Philip Tetlock tracked the predictions of 284 leading experts over two decades. Tetlock looked at over 27,000 predictions in real time of the form: more of x, no change in x, or less of x. He found that these predictions were no better than random chance.
Many experts have deep knowledge–historical or otherwise–that can give us valuable insights into human affairs. Some of this expertise is probably accurate. But until we have testable predictions, it’s difficult to say which hypotheses are true and to what degree.
We should never forget the difference between scientific knowledge and other types of knowledge, including stories. It’s very easy for us humans to be overconfident and deluded, especially if certain stories are the result of “many years of hard work.”
Delusion Six: The Delusion of Lasting Success
Richard Foster and Sarah Kaplan looked at companies in the S&P 500 from 1957 to 1997. By 1997, only 74 out of the original largest 500 companies were still in the S&P 500. Of those 74 survivors, how many outperformed the S&P 500 over those 40 years? Only 12.
Foster and Kaplan conclude:
KcKinsey’s long-term studies of corporate birth, survival, and death in America clearly show that the corporate equivalent of El Dorado, the golden company that continually performs better than the markets,has never existed. It is a myth. Managing for survival, even among the best and most revered corporations, does not guarantee strong long-term performance for shareholders. In fact, just the opposite is true. In the long run, the markets always win.
It’s not that busines success is completely random. Of course not. But there is usually a large degree of luck involved. More fundamentally, capitalism is about competition through innovation, orcreative destruction, as the great Austrian economist Joseph Schumpeter called it. There is some inherent unpredictability–or luck–in this endless process.
Delusion Seven: The Delusion of Absolute Performance
Kmart improved noticeably from 1994 to 2002, but Wal-Mart and Target were ahead at the beginning of that period, and they improved even faster than Kmart. Thus, although it would seem Kmart was doing the right things in terms of absolute performance, Kmart was falling even further behind in terms of relative performance.
In 2005, GM was making much better cars than in the 1980s. But its market share kept slipping, from 35 percent in 1990 to 25 percent in 2005. GM’s competitors were improving faster.
Rosenzweig sums it up:
The greater the number of rivals, and the easier for competitors to enter the market, and the more rapidly technology changes, the more difficult it is to sustain success. That’s an uncomfortable truth, because it admits that some elements of business performance are outside of our control. It’s far more appealing to downplay the relative nature of performance or ignore it completely. Telling a company it can achieve high performance, regardless of what competitors do, makes for a more attractive story.
Delusion Eight: The Delusion of the Wrong End of the Stick
InGood to Great, Collins argues that a company can decide to become great and follow the blueprint in the book. Part of the recipe is to be like a Hedgehog–to have a narrow focus and pursue it with great discipline. The problem, again, is that the role of chance–or factors outside one’s control–is not considered. (The terms “Hedgehog” and “Fox” come from an essay by Isaiah Berlin. The Hedgehog knows one big thing, whereas the Fox knows many things.)
(Image by Marek Uliasz)
Statistically, it’s possible that, on the whole, more Hedgehogs than Foxes failed. You could still argue that the potential upside for becoming a great company is so large that it’s worth taking the risk of being like a Hedgehog. But Collins doesn’t mention risk, or chance, at all.
Of course, we’d all prefer a story where greatness is purely a matter of choice. But it’s rarely that simple and luck nearly always plays a pivotal role.
Delusion Nine: The Delusion of Organizational Physics
For many questions in business, we can’t run experiments. That said, with enough care, important statistical correlations can be discovered. Other things can be measured even more precisely.
But to think that the study of business is like the science of physics is a delusion, at least for now.
It’s reasonable to suppose that, with enough scientific knowledge in neuroscience, genetics, psychology, economics, artificial intelligence, and related areas, eventually human behavior may become largely predictable. But there’s a long way to go.
THE MOTHER OF ALL BUSINESS QUESTIONS,TAKE TWO
By nature, we prefer stories where business success is entirely a result of choosing to do the right things, while not reaching success must be due to a failure to do the right things. But stories like this neglect the role of chance. Rosenzweig writes:
…all the emphasis on steps and formulas may obscure a more simple truth. It may further the fiction that a specific set of steps will lead, predictably, to success. And if you never achieve greatness, well, the problem isn’t with our formula–which was, after all, the product of rigorous research, of extensive data exhaustively analyzed–but with you and your failure to follow the formula. But in fact, the truth may be considerably simpler than these formula suggest. They may divert our attention from a more powerful insight–that while we can do many things to improve our chances of success, at its core business performance contains a large measure of uncertainty. Business performance may actually be simpler than it is often made out to be, but may also be less certain and less amenable to engineering with predictable outcomes.
There is a simpler way to think about business performance–suggested by Michael Porter–without neglecting the role of chance. Strategy is doing certain things different from rivals.Execution is people working together to create products by implementing the strategy. This is a reasonable way to think about business performance as long as you also note the role of chance.
It’s usually hard to know how potential customers will behave. There are, of course, many examples where, contrary to expectations, a product was embraced or rejected. Moreover, even if you correctly understand customers, competitors may come up with a better product.
There’s also the issue of technological change, which can be a significant source of unpredictability in some industries.
(Illustration by T. L. Furrer)
Clayton Christensen has demonstrated–inThe Innovator’s Dilemma–that frequently companies fail because they keep doing theright things, giving customers what they want. Meanwhile, competitors develop a new technology that, at first, is not profitable–which is part of why the company “doing the right things” ignores it. But then, unpredictably, some of these new technologies end up being popular and also profitable.
One good question is: What should a company do when its core comes under pressure? Should it redouble its focus on the core, like a Hedgehog? Or should it be adaptable, like a Fox? There are no good answers at the moment, says Rosenzweig. There are too many variables. Chance–or uncertainty–plays a key role.
Rosenzweig continues:
In the meantime, we’re left with the brutal fact that strategic choice is hugely consequential for a company’s performance yet also inherently risky. We may look at successful companies and applaud them for what seem, in retrospect, to have been brilliant decisions, but we forget that at the time those decisions were made, they were controversial and risky. McDonald’s bet on franchising looks smart today, but in the 1950s it was a leap in the dark. Dell’s strategy of selling direct now seems brilliant but was attempted only after multiple failures with conventional channels. Or, recalling companies we discussed in earlier chapters, remember Cisco’s decision to assemble a full range of product offerings through acquisitions or ABB’s bet on leading rationalization of the European power industry through consolidation and cost cutting. The managers who took those choices appraised a wide variety of factors and decided to be different from their rivals. We remember all of these decisions because they turned out well, but success was not inevitable. As James March of Stanford and Zur Shapira of New York University explained, “Post hoc reconstruction permits history to be told in such a way that ‘chance,’ either in the sense of genuinely probabilistic phenomena or in the sense of unexplained variation, is minimized as an explanation.” But chance DOES play a role, and the difference between a brilliant visionary and a foolish gambler is usually inferred after the fact, an attribution based on outcomes. The fact is, strategic choices always involve risk. The task of strategic leadership is to gather appropriate information and evaluate it thoughtfully, then make choice that, while risky, provide the best chances for success in a competitive industry setting.
(Image by Donfiore)
As for execution, certain practices do correlate with modestly higher performance. If leaders can identify the few areas where better execution is needed, then some progress can be made.
But inherent unpredictability is hidden by the Halo Effect. If a company succeeds, it’s easy to say it executed well. If a company fails, it’s natural to conclude that execution was poor. Often to a large extent, these conclusions are driven by the Halo Effect, even if there is some truth to them.
In brief, smart strategic choices and good execution–plus good luck–may lead to success, at least temporarily. But success brings challengers, some of whom will take greater risks that may work. There’s no formula to guarantee success. And if success is achieved, there’s no way to guarantee continued success over time.
MANAGING WITHOUT COCONUT HEADSETS
Given that there’s no simple formula that brings business success, what should we do? Rosenzweig answers:
A first step is to set aside the delusions that color so much of our thinking about business performance. To recognize that stories of inspiration may give us comfort but have little more predictive power than a pair of coconut headsets on a tropical island. Instead, managers would do better to understand that business success is relative, not absolute, and that competitive advantage demands calculated risks. To accept that few companies achieve lasting success, and that those that do are perhaps best understood as having strung together several short-term successes rather than having consciously pursued enduring greatness. To admit that, as Tom Lester of theFinancial Times so neatly put it, “the margin between success and failure is often very narrow, and never quite as distinct or as enduring as it appears at a distance.” By extension, to recognize that good decisions don’t always lead to favorable outcomes, that unfavorable outcomes are not always the result of mistakes, and therefore to resist the natural tendency to make attributions based solely on outcomes. And finally, to acknowledge that luck often plays a role in company success. Successful companies aren’t “just lucky”–high performance isnot purely random–but good fortune does play a role, and sometimes a pivotal one.
Rosenzweig mentions Robert Rubin as a good example of someone who learned to make decisions in terms of scenarios and their probabilities.
(Image by Elnur)
Rubin worked for eight years in the Clinton administration, first as director of the White House National Economic Council and later as secretary of the Treasury. Prior to working in the Clinton administration, Rubin toiled for twenty-six years at Goldman Sachs.
Rubin first learned about the fundamental uncertainties of the world when he studied philosophy as an undergraduate. He learned to view every proposition with skepticism. Later at Goldman Sachs, Rubin saw first-hand that one had to consider possible outcomes and their associated probabilities.
Rubin spent years in risk arbitrage. Many times Goldman made money, but roughly one out of every seven times, Goldman lost money. Sometimes the loss would greatly exceed Goldman’s worst-case scenario. But occasionally large and painful losses didn’t mean that Goldman’s decision-making process was flawed. In fact, if Goldman wasn’t taking some losses, then they almost certainly weren’t taking enough risk.
(Photo by Alain Lacroix)
Rosenzweig asks: If a large and painful loss doesn’t mean a mistake, then what does?
We have to take a close look at the decision process itself, setting aside the eventual outcome. Had the right information been gathered, or had some important data been overlooked? Were the assumptions reasonable, or had they been flawed? Were calculations accurate, or had there been errors? Had the full set of eventualities been identified and their impact estimated? Had Goldman Sachs’s overall risk portfolio been properly considered?
Once again, a profitable outcome doesn’t necessarily mean the decision was good. An unprofitable outcome doesn’t necessarily mean the decision was bad. If you’re making decisions under uncertainty–probabilistic decisions–the only way to improve is to evaluate the process of decision-making independently of specific outcomes.
Of course, often important decisions for an individual business are quite infrequent. Rosenzweig highlights important lessons for managers:
If independent variables aren’t measured independently, we may find ourselves standing hip-deep in Halos.
If the data are full of Halos, it doesn’t matter how much we’ve gathered or how sophisticated our analysis appears to be.
Success rarely lasts as long as we’d like–for the most part, long-term success is a delusion based on selection after the fact.
Company performance is relative, not absolute. A company can get better and fall further behind at the same time.
It may be true that many successful companies bet on long shots, but betting on long shots does not often lead to success.
Anyone who claims to have foundlaws of business physics either understands little about business, or little about physics, or both.
Searching for the secrets of business success reveals little about the world of business but speaks volumes about the searchers–their aspirations and their desires for certainty.
Getting rid of delusions is a crucial step. Furthermore, writes Rosenzweig, a wise manager knows:
Any good strategy involves risk. If you think your strategy is foolproof, the fool may well be you.
Execution, too, is uncertain–what works in one company with one workforce may have different results elsewhere.
Chance often plays a greater role than we think, or than successful managers usually like to admit.
The link between inputs and outcomes is tenuous. Bad outcomes don’t always mean that managers made mistakes; and good outcomes don’t always mean they acted brilliantly.
But when the die is cast, the best managers act as if chance is irrelevant–persistence and tenacity are everything.
Of course, none of this guarantees success. But the sensible goal is to improve your chances of success.
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: https://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 approachesintrinsic 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.
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.
Value investing can be a relatively low risk way for some investors to beat the market over time. Yet it often takes a decade to get the hang of it. Even then, you have to keep improving indefinitely. But the great thing is that you can keep improving indefinitely as long as your health stays good. In addition to learning from experience, an excellent way to progress is by studying the best value investors.
Howard Marks is not only a great value investor. But he also has written an outstanding book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia University Press, 2011). Like most classics, Marks’s book is worth re-reading periodically.
This blog post is intended for two groups:
People who already have some experience with value investing. It’s worth regularly reviewing the teachings of the masters.
People who are interested in learning about value investing.
Here’s an outline. Each section can be read independently:
The title of the book is based on the fact that Marks wrote a series of memos to clients identifying “the most important thing.” Looking back, Marks realized that there were many “most important things.”
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. – Howard Marks
A VALUE INVESTING PHILOSOPHY
A value investing philosophy takes time to develop, as Marks notes:
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.
…
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.
(Photo by Yuryz)
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.
(Photo by Andreykuzmin)
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 you have 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.
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?
UNDERSTANDING MARKET EFFICIENCY
Marks holds a view of market efficiency similar to that of Warren Buffett: The market is usually efficient, but it is far from always efficient.
(Illustration by Lancelotlachartre)
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.
(Photo byMarijus Auruskevicius)
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.
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.
And yet many deep value approaches are fully quantitative, relying on statistical rules for stock selection. The quantitative deep value investor does not typically make a detailed judgment on each individual stock–a judgment which would imply that the buyer is correct and the seller is incorrect in the individual case. Rather, the quantitative deep value investor forms a portfolio of the statistically cheapest 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).
A concentrated deep value approach, by contrast, involves the effort to select the most promising and the cheapest individual stocks available. Warren Buffett and Charlie Munger–both inspired in part by Philip Fisher–followed this approach when they were managing smaller amounts of capital. They would usually have between 3 and 8 positions making up nearly the entire portfolio.
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 you 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 net asset value or normalized earnings. 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.
(Photo by Farang)
Marks notes that a successful value investment requires a non-consensus view on net asset value or normalized earnings. Successful growth investing, by contrast, requires a non-consensus view on future earnings (based on growth). Sometimes the rewards for growth investing are higher, but a value investing approach is much more repeatable and achievable.
Buying assets below fair value, however, does not mean those assets will outperform right away. 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 you 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 through 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 Buffett and 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 cognitive biases, which often operate subconsciously.
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.
(Photo by Alain Lacroix)
On the other hand, in general, assets that promise higher returns 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 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 you 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 guaranteesnegative long-term returns. Repeatedly overbetting guarantees long-term failure.
This is part of why Howard Marks, Warren Buffett, Charlie Munger, Seth Klarman and other great value investors often point out that minimizing big mistakes is more important for long-term success in investing than hitting home runs.
Again, 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 negative for riskier investments.
(Photo by Wittayayut Seethong)
Marks agrees with Buffett and Munger that the best definition of risk is the potential to experience loss.
Of course, even the best investors are generally right only two-thirds of the time, while they are wrong one-third of the time. Thus, following a successful long-term value investing framework where you consistently and carefully pays cheap prices for assets still entails being wrong once every three tries, whether due to a mistake, bad luck, or unforeseen events.
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 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 far from 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 question 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 you attempt 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. You must also make sure that your portfolio can withstand a run of bad luck; and you must recognize when you have 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.
(via Wikimedia Commons)
Marks defines investment performance in the context of risk:
… 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.
It’s tough to quantify risk without a large number of repeated trials under similar circumstances. Marks:
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 suggests, 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
(Photo by Shawn Hempel)
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.
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.
(Photo by Michele Lombardo)
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.
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?
(Photo by Donfiore)
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.
Marks sums it up:
… 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.
(Image by Anhluong.tdnb, via Wikimedia Commons)
Because people inevitably overreact or underreact, both business activity and stock prices overshoot on the upside and on the downside:
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
the risk of missing opportunity
Most investors consistently do the wrong thing 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
(Photo by Nikki Zalewski)
Like Buffett and Munger, Marks believes that temperament, or the ability to master your emotions, is more important than intellect for success in investing:
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.’
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 made sense. When a movement in the grass frequently meant the presence of a dangerous predator, immediate fear–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 danger and injury. (Chemical reactions would cause an injured hunter not to feel much pain.) If everyone in your tribe 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 it. This would often lead to 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 difficulties, injuries, and even deaths.
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.
Thus, like other psychological tendencies, self-deception often plays a constructive role. However, when it comes to investing, self-deception is generally harmful, especially as the time horizon is extended so that luck virtually disappears.
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 brains 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. See: https://en.wikipedia.org/wiki/Tulip_mania
At the peak of tulip mania, in March 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman.
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.
Envymay have been useful for hunter-gatherers. But today 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 other sins, is no 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 caused the downfall of human beings for millenia. This certainly holds true in investing.
Ego and overconfidence are powerful psychological tendencies that humans have. Overconfidence will kill any investor eventually. The antidote is humility and objectivity. Many of the best investors–from Warren Buffett to Ray Dalio–are fundamentally humble and objective. And women tend to be better investors than men on the whole because women are not as overconfident. Marks writes:
[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 of psychological excess 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 it’s 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
(Illustration by Sasinparaksa)
Sir John Templeton:
To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
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, as Buffett points out:
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.
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, whether due to bad luck, unforeseen events, or a mistake. But getting the facts and reasoning right leads to ‘being right’ roughly two-third of the time.
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 ultimately 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.
(Illustration by Sangoiri)
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 ask, ‘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.
(Illustration by Chris Dorney)
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 puts it briefly:
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 remarks:
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
(Illustration by Marek)
Marks makes the same point that Buffett and 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. Marks offers:
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 you are able to ignore short-term volatility and focus on the next five to ten years, then you can probably find some undervalued stocks, especially if you look at microcaps. At some point–the precise timing of which is unpredictable–there will be a bear market. But that would create many bargains for the long-term value investor.
KNOWING WHAT YOU DON’T KNOW
John Kenneth Galbraith:
We have two classes of forecasters: Those who don’t know–and those who don’t know they don’t know.
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 of 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.
(Illustration by Maxim Popov)
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):
Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few forecasters 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 today (mid-2018)? 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 lows) roughly 300% as the U.S. economy expanded from 2009 to today (mid-2018).
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. If you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going. Marks:
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.
(Photo by Elnur)
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.
In a word:
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.
Or as Warren Buffett has written:
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
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.
(Image by Walta, via Wikimedia Commons)
It may be more difficult today to take the market’s temperature because of the policy of low 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 very low 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 50 or more.
If you are able to buy enough cheap stocks, while maintaining a focus on the next five or ten years, and if you are psychologically prepared for the occasional bear market–the precise timing of which is always unpredictable–then you will be in good position.
It can also help if you find cheap stocks that have low or even negative correlation with the broad stock market:
Gold mining stocks have often been negatively correlated with the broad market. The great economist and value investor J. M. Keynes recommended having a gold mining stock–as long as you know the company well–in your portfolio .
Oil stocks have low correlation with the broad stock market. Many oil-related stocks are very cheap today as long as you can hold for at least five years.
Cheap turnarounds also have low correlation with the broad stock market. If the company is turned around, the stock is likely to do well even in a bear market.
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.
(Albrecht Durer’sWheel of Fortunefrom Sebastien Brant’sShip of Fools(1494) via Wikimedia Commons)
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), you must usually assume that many “alternative histories” were possible.
As an investor, given a future that is currently unknowable in many respects, you need to develop a reasonable set of scenarios along with estimated probabilities for each scenario. And, when judging the quality of past decisions, you should think carefully about various possible histories. What actually happened is a small subset of what could have happened.
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. Nevertheless, 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), you 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.
Marks continues:
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 your 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 the broad market appears to be high. But you must be fully prepared–psychologically and in your portfolio–for stocks that are already very cheap 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. Know thyself. You must really think through all the possible scenarios, because things can get much worse than you can imagine during bear markets. And bear markets are inevitable, though unpredictable.
There is usually 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.
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–either betting too often (investing in too many different stocks) or betting too much (having position sizes that are too large)–is thus a common cause of failure for long-term investors. We know from the Kelly criterion that overbetting guaranteesnegative 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 more likely to achieve long-term success by minimizing losses and mistakes, than by hitting a lot of home runs.
As Marks concludes:
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: https://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 approachesintrinsic 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.
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.
Would you like to improve as an investor? One of the best things you can do is to study great investors like Warren Buffett.
Robert Hagstrom has written an excellent book–The Warren Buffett Way(Wiley, 2014)–explaining Buffett’s approach to investing. Hagstrom’s goal is to help investors improve.
Here is the outline for this blog post:
A Five-Sigma Event: The World’s Greatest Investor
The Education of Warren Buffett
Buying a Business: The Twelve Immutable Tenets
Common Stock Purchases: Nine Case Studies
Portfolio Management: The Mathematics of Investing
The Psychology of Investing
The Value of Patience
The World’s Greatest Investor
(Photo by USA International Trade Administration)
A FIVE-SIGMA EVENT: THE WORLD’S GREATEST INVESTOR
Buffett has always maintained that he won the ovarian lottery.
My wealth has come from a combination of living in America, some lucky genes, and compound interest. My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well.
Buffett keeps things in perspective by saying that he happens to work “in an economy that rewards someone who saves lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricing of securities with sums reaching into the billions.”
Buffett was entrepreneurial from a young age. He would buy a six-pack of coke for 25 cents, then sell each one for 6 cents. He had two paper routes during the time he lived in Washington, D.C., when his father was a congressman from Nebraska. He and a buddy bought used pinball machines, and made a profit from them.
(Photo by Shahroozporia, via Wikimedia Commons)
But Buffett didn’t figure out the right way to invest for some time. He tried charting. He read books on technical analysis. He got hot tips from brokers. Finally, he came across a copy of The Intelligent Investor, by Benjamin Graham. Buffett then realized that the strategy of value investing explained by Graham was a reliable way to succeed at investing over time.
Buffett attendedgraduate school at Columbia University in order to study under Graham. Once in Graham’s class, everyone saw that Buffett was the brightest and most knowledgeable student. The class was like a conversation between Graham and Buffett. Buffett got an A+ in the course, the first A+ Graham had given in 22 years of teaching.
Upon graduating from Columbia, Buffett was not able to work for Graham at Graham-Newman right away. At the time, Graham was only hiring Jewish analysts because they were being discriminated against elsewhere. Buffett periodically sent Graham stock ideas until Graham finally hired him.
Two years later in 1956, after Graham retired, Buffett returned to Omaha. Buffett launched a limited investment partnership, which included some family and friends as investors. At the outset, the partnership had $105,000 under management.
Buffett’s goal was to beat the Dow Jones Industrial Average by 10 percentage points a year. Approximately thirteen years later, Buffett had beaten the Dow Jones Average by over 22 percentage points a year.
In the early 1960s there was a corporate scandal. The Allied Crude Vegetable Oil Company, led by Tino De Angelis, found that it could get loans based on its inventory of salad oil. De Angelis built a refinery in New Jersey with 139 five-story storage tanks. Because oil floats on top of water, De Angelis filled the tanks with water with just a few feet of oil on the top. The inspectors didn’t notice for some time.
American Express lost $58 million in the salad oil scandal, and its stock dropped over 50 percent. Buffett went to restaurants in Omaha, and discovered that there was no decrease in usage of the American Express Green Card. Buffett also visited banks and learned that the scandal was having no impact on the use of American Express Travelers Cheques.
(Amex Logo, by American Express via Wikimedia Commons)
The strong brand of American Express was still intact. The stock had plummeted based on a huge, but temporary problem. So Buffett invested 40 percent of the partnership in American Express. The shares nearly tripled over the next two years.
By 1965, Buffett had acquired–via the partnership–a controlling interest in Berkshire Hathaway, a struggling New England textile company. When Buffett closed his investment partnership in 1969, he himself kept his stock in Berkshire Hathaway and limited partners received some stock in Berkshire Hathaway. Buffett advised limited partners on how to invest in municipal bonds. (Buffett thought that stocks were not a very good value in 1969.) Or limited partners could invest with Bill Ruane, Buffett’s friend from Columbia University and Graham-Newman. Meanwhile, Berkshire Hathaway, despite excellent management from Ken Chace, had disappointing results for many years. Buffett only kept Berkshire Hathaway open out of concern for the workers.
The textile mills were the largest employer in the area; the workforce was an older age group that possessed relatively nontransferable skills; management had shown a high degree of enthusiasm; the unions were being reasonable; and, very importantly, Buffett believed that some profits could be realized from the textile business.
But Berkshire Hathaway continued to struggle. Buffett siphoned off cash from the business in order to invest in better businesses. (Had the cash been reinvested in Berkshire, the returns would have been below the cost of capital, thus destroying value.) Later, Buffett reluctantly closed Berkshire Hathaway because unending losses would otherwise have been the result.
(Hathaway Mills, Photo byMarcbela via Wikimedia Commons)
In 1967, with the excess cash from the textile operations, Berkshire Hathaway purchased two insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine Insurance Company. As Hagstrom writes, this was the beginning of Berkshire Hathaway’s legendary success story.
Instead of having the float from the insurance operations invested mostly in bonds, Buffett invested much of the float in stocks. Over time, due to Buffett’s great skill in investing, investment assets grew significantly in value. Importantly, the underlying insurance operations themselves were profitable because they were disciplined in pricing their policies. The profitability of the insurance operations meant that the float had a very low cost.
Going forward, Buffett was open to investing in more insurance companies. By 1991, Berkshire owned nearly half of GEICO. GEICO was a very profitable auto insurer. GEICO had structurally lower costs than its competitors because GEICO sold direct to customers, without needing agents or branch offices.
Buffett bought other insurance companies over time, including large reinsurers. Hagstrom notes that Buffett’s best acquisition was a person–Ajit Jain. Jain has brilliantly managed the Berkshire Hathaway Reinsurance Group over the years. Buffett said of Ajit:
His operation combines capacity, speed, decisiveness, and most importantly, brains in a manager that is unique in the insurance business.
Over several decades, Buffett invested in a focused portfolio of common stocks. He also acquired a number of private businesses. He views both types of investment the same way: he looks to pay a good price for a simple business, run by able and honest management, with good economics.
Hagstrom notes Buffett’s track record:
Over the past 48 years, starting in 1965, the year Buffett took control of Berkshire Hathaway, the book value of the company has grown from $19 to $114,214 per share, a compounded gain of 19.7 percent; during that period, the Standard & Poor’s (S&P) 500 index gained 9.4 percent, dividends included.
The margin of outperformance combined with the length of the track record is simply unparalleled in the investment world. But Hagstrom argues that other investors can improve by studying Buffett’s career. Hagstrom quotes Buffett:
What we do is not beyond anyone else’s competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results.
THE EDUCATION OF WARREN BUFFETT
Hagstrom writes that Buffett was influenced primarily by three investors: Benjamin Graham, Philip Fisher, and Charlie Munger.
At age 20, Graham graduated from Columbia University and was offered several positions at the university (in literature, mathematics, and philosophy). Graham was clearly a genius. Perhaps based partly on his experience of poverty–his father had died while Graham was young, leaving the family in a difficult financial situation–Graham decided to work on Wall Street rather than work in academia.
Graham’s first job was as a messenger–for $12 a week–for the brokerage firm of Newburger, Henderson & Loeb. Five years later, in 1919, Graham was earning $600,000 a year (almost $8 million in 2012 dollars) as a partner in the firm.
Graham launched Graham-Newman in 1926. In 1929-1932, Graham-Newman lost most of its value. Graham personally was financially ruined.
From 1929 to 1934, Graham, while teaching at Columbia University and in cooperation with another professor, David Dodd, produced Security Analysis, which continues to be the bible for value investors to this day. Graham was slowly rebuilding his fortune, and the philosophy of value investing–as expressed in Security Analysis–was the key.
(Ben Graham, by Equim43 via Wikimedia Commons)
Graham realized that many investors try to get good results over short periods of time. He saw that short-term movements in stock prices are largely random and unpredictable, but that over time, a stock price follows the earnings of a company. Graham thus distinguished between speculation and investing. Speculation meant trying to predict stock prices over the short term, whereas investing means buying below probable intrinsic value–based on net asset value or earnings power.
Intrinsic value is based on net asset value or earnings power. As long as the investor pays a price below intrinsic value, the investor has a margin of safety. The margin of safety offers protection against errors by the investor and against bad luck (or unforeseen negative events). Simultaneously, the margin of safety represents the profit the investor can earn in those cases where he or she is right and the stock price approaches intrinsic value.
Graham preferred to focus on net asset value. If you take the current assets of the company and subtract all liabilities, and if the stock price can be bought below that level, there is a strong margin of safety present. This is Graham’s net-net approach. It is meant to be applied to a basket of stocks.
The net-net approach is inherently safer than buying stocks at a discount to their earnings power. It is generally more difficult to estimate the earnings power of a company than to estimate the net-net value. (The net-net value is simply an extremely conservative measure of liquidation value.)
Thus Graham placed much more emphasis on quantitative cheapness than he did on qualitative factors like competitive position and management capability. If you keep buying stocks at a huge discount to net asset value, you are nearly certain to get good results over time. On the other hand, if you keep buying stocks at a discount to earnings power, you cannot be as certain because in many cases future earnings may turn out to be different than expected.
In brief, Graham offered two methods for investors to succeed: buying below net current asset value and buying at a low price-to-earnings ratios (P/E). In either case, the stock in question is deeply out of favor.
Every business, at any given time, is either in one of two states: it is experiencing problems or it will be experiencing problems. When a business runs into problems, the stock price typically will decline and the company will fall out of favor. The key is that most business problems are temporary and not permanent, at least when viewed over the subsequent 3 to 5 years.
When a company runs into problems, investors usually overreact and sell the stock to much lower levels than is justified by net asset value or earnings power. By systematically buying a basket of these oversold stocks, you can do well over time.
Philip Fisher
Fisher believed in a concentrated portfolio of five to eight stocks. Fisher would conduct ‘scuttlebutt’ research, which involved speaking with customers, suppliers, competitors, and industry experts. Fisher wanted to understand the quality of management and the strength of the company’s competitive position.
(Philip A. Fisher)
If you can buy stock in a company that has a strong competitive position based on continued innovation, and that is run by able and honest managers, then you’ll do well over time. Fisher also insisted that the sales force of the company in question be strong. This should be ensured by strong management. As well, Fisher made sure the company had good profits.
Good managers focus on building shareholder value. And they are honest about their mistakes and about the real difficulties being encountered by the business.
Charlie Munger
Charlie Munger was from Omaha, like Buffett. As a kid, Munger had worked for the grocery store run by Warren Buffett’s grandfather.
Munger’s grandfather was a federal judge and his father was a lawyer. Munger became a successful lawyer in Los Angeles after graduating from Harvard Law School.
One of Buffett’s early investors, Dr. Edwin Davis, had decided to invest in the Buffett Partnership because Buffett reminded him of Charlie Munger. A few years later, in 1959, Dr. David arranged a meeting between Buffett and Munger. This was the beginning of an extraordinary partnership.
(Charlie Munger at the 2010 Berkshire Hathaway shareholders meeting. Photo by Nick Webb)
Munger realized that it is better to pay a fair price for a wonderful company than a wonderful price for a fair company. Buffett had recently invested in several statistically cheap companies:
My punishment was an education in the economies of short-line farm implementation manufacturers (Dempster Mill Manufacturing), third-place department stores (Hochschild-Kohn), and New England textile manufacturers (Berkshire Hathaway).
These were three situations of paying a wonderful price for a fair company. Only the investment in Dempster worked, thanks to a turnaround specialist, Harry Bottle, whom Munger had introduced to Buffett. The Dempster investment easily could have failed. Hochschild-Kohn didn’t work. Berkshire Hathaway–the textile manufacturer–eventually went out of business.
Note: Buffett took cash out of the textile business and made a long series of highly successful investments. This was the beginning of Buffett and Munger creating today’s Berkshire Hathaway. The old textile business was closed.
In 1972, Berkshire Hathaway acquired See’s Candies at a large premium to book value. This stock was not at all statistically cheap. But it was a wonderful company at a fair price, which Munger argued made excellent sense.
Over the ensuing decades, See’s Candies produced an extraordinarily high return on invested capital (ROIC) and return on equity (ROE). Thus even though Buffett and Munger paid nearly three times book value, the investment turned out to be a grand slam. Charlie said it was ‘the first time we paid for quality.’
The success of the See’s Candies investment is what made Buffett open to making a large investment in Coca-Cola in the late 1980s. Buffett invested about one billion dollars in Coca-Cola–about a third of Berkshire’s portfolio–even though the P/E and the P/CF were high. The key was that Coca-Cola could develop and maintain a very high ROE (and ROIC).
A Blending of Influences
From Graham, Buffett learned the importance of a margin of safety. Buffett learned that it is important to estimate the intrinsic value of the business, and then pay a price well below that value. Buffett also learned from Graham that stock price fluctuations are largely random and should be ignored except when they create bargains. Thirdly, Buffett learned from Graham the importance of being an independent thinker. As Graham said:
You’re neither right nor wrong because the crowd disagrees with you. You’re right because your data and reasoning are right.
From Fisher, Buffett learned to concentrate his portfolio in his best ideas: it is safer to own a few ideas with which you are thoroughly familiar than to own many ideas without knowing much about them. Buffett also learned from Fisher the value of ‘scuttlebutt’ research, which meant interviewing customers, suppliers, competitors, and industry experts. Finally, Buffett learned that a high-quality company can increase its intrinsic value over a long period of time.
Charlie Munger figured out on his own that it made sense to pay a fair price for a wonderful company. Even paying a large premium to book value, you could still have a significant margin of safety relative to a long future of compounding intrinsic value.
Thus it was primarily Munger’s influence that got Buffett to agree to purchase See’s Candies at a large premium to book value. Munger also became an expert in psychology, which impacted Buffett.
Hagstrom sums up the three influences:
Graham gave Buffett the intellectual basis for investing–the margin of safety–and helped him learn to master his emotions in order to take advantage of market fluctuations. Fisher gave Buffett an updated, workable methodology that enabled him to identify good long-term investments and manage a focused portfolio over time. Charlie helped Buffett appreciate the economic returns that come from buying and owning great businesses. [And] Charlie helped educate Buffett on the psychological missteps that often occur when individuals make financial decisions.
BUYING A BUSINESS: THE TWELVE IMMUTABLE TENETS
Buffett uses the same basic approach whether he is acquiring the business outright or buying a piece of the business via shares of stock. Owning the entire company allows Buffett to control the capital allocation of the business. On the other hand, because the stock market is so large, there are many more opportunities to find bargains among public equities than among private businesses. Hagstrom quotes Buffett:
When investing, we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts, and not even as security analysts.
Thus Buffett acts primarily as a businessperson, whether he is acquiring a company or buying stock.
Hagstrom has distilled Buffett’s investment approach into twelve key tenets:
Business Tenets
Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favorable long-term prospects?
Management Tenets
Is management rational?
Is management candid with its shareholders?
Does management resist the institutional imperative?
Financial Tenets
Focus on return on equity (ROE), not earnings per share (EPS).
Calculate ‘owner earnings.’
Look for companies with high profit margins.
For every dollar retained, make sure the company has created at least one dollar of market value.
Market Tenets
What is the value of the business?
Can the business be purchased at a significant discount to its value?
Business Tenets
Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favorable long-term prospects?
Buffett holds that most business success stories involve companies doing the same things they have been doing for decades. This often does involve ongoing innovation, but in the context of a business that already has a sustainable competitive advantage.
Investment success is not how much you know, but how well you understand the limits of what you know (and what you can know). Buffett:
Invest in your circle of competence. It’s not how big the circle is that counts; it’s how well you define the parameters.
Buffett is looking for a company with a sustainable competitive advantage demonstrated in a consistent operating history and expected to last well into the future. This doesn’t guarantee success in every case, but it does maximize the probability of success over time.
Buffett looks for great businesses or franchises:
He defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.
(Image by Marek Uliasz)
Buffett:
The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Buffett again:
[The] definition of a great company is one that will be great for 25 to 30 years.
Management Tenets
Is management rational?
Is management candid with its shareholders?
Does management resist the institutional imperative?
Buffett looks for honest and able managers whobehave like owners. Such managers understand that their mission is to build business value over time.
Allocating capital in a rational way is central to maximizing the value of the business over time. Particularly for mature companies, which Buffett often prefers based on their predictability, the allocation of excess cash can have a large impact on the value of the business.
The key is to get a return on invested capital (ROIC)–or return on equity (ROE)–that exceeds the cost of capital. (ROE is close to ROIC for companies with low or no debt, which Buffett has always preferred.) If there is no project that promises a sufficiently high return on capital, then the managers should consider buying back stock or paying dividends. Buying back stock only creates value when the stock price is below intrinsic value.
When considering projects that may have a high ROIC (or high ROE), it’s vital that managers are thinking independently.
(Photo by Marijus Auruskevicius)
Similarly, managers should never simply copy what other managers in the same industry are doing. This is a recipe for disaster. But it happens often enough. Buffett and Munger call it the institutional imperative–the lemming-like tendency of managers to imitate the behavior of others, no matter how silly or irrational. Buffett and Munger think the institutional imperative is responsible for several problems:
(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
Jack Ringwalt was the head of National Indemnity when Berkshire acquired it in 1967. There were times when Ringwalt would simply stop selling insurance altogether if the rates on policies didn’t make sense. Buffett learned this lesson well, both for Berkshire’s many insurance operations and in general.
Management candor is essential. Good managers admit their mistakes and confront their problems rather than hiding behind GAAP (generally accepted accounting principles).
Financial Tenets
Focus on return on equity (ROE), not earnings per share (EPS).
Calculate ‘owner earnings.’
Look for companies with high profit margins.
For every dollar retained, make sure the company has created at least one dollar of market value.
Buffett does not take yearly results too seriously. He focuses on five-year averages. There is too much randomness in periods shorter than five years.
ROE (or ROIC) is more important than EPS. As noted earlier, a company only creates value over time to the extent that its ROIC exceeds its cost of capital. Often the cost of capital can be understood as the opportunity cost of capital, or the next best investment opportunity with a similar level of risk.
In calculating ROE–or ROIC–Buffett excludes extraordinary items. He seeks to isolate the underlying performance of the business.
The intrinsic value of any business is all future free cash flow (FCF) discounted back to the present. Buffett uses the term owner earnings in place of FCF. It equals net income plus depreciation, depletion, and amortization, and minus capital expenditures. (There may also be adjustments for changes in working capital.)
Buffett’s favorite managers minimize costs just like they breathe. They do it automatically at all times.
Market Tenets
What is the value of the business?
Can the business be purchased at a significant discount to its value?
The value of any business is all future FCF discounted back to the present. This definition was first explained by John Burr Williams in The Theory of Investment Value.
Buffett compares valuing a business to valuing a bond. You know the coupon and maturity date for the bond, so you know the future cash flows. Then you discount those future cash flows back to the present using an appropriate discount rate.
Buffett nearly always insists on a ‘coupon-like’ certainty for the future cash flows of a business in which he invests. Therefore, Buffett uses the rate of the long-term U.S. government bond as his discount rate. (If rates are very low, as today, Buffett often uses 6% as the discount rate.)
Hagstrom quotes Buffett:
[Irrespective] of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.
Buffett wrote in the 1981 Berkshire Hathaway Letter to Shareholders:
[We have made mistakes as to:] (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.We have made plenty of such mistakes–both in the purchase of non-controlling and controlling interests in businesses. Category (2) miscalculations are the most common.
Ben Graham taught that you only buy when there is a margin of safety between the price you pay and the intrinsic value of the business. A margin of safety simultaneously lowers the risk of the investment AND increases the potential return. The notion that lowering your risk can increase your return is directly contrary to what is taught in modern finance, where higher returns always require higher risks.
Buffett has adopted Graham’s view that investing means becoming a part owner of a business. Investing is not trading pieces of paper. Graham:
Investing is most intelligent when it is most businesslike.
Buffett says these are “the nine most important words ever written about investing.” For Buffett, becoming a part owner of a public business by buying stock is no different than becoming a part owner–or full owner–of a private business. Buffett notes:
I am a better investor because I am a businessman, and a better businessman because I am an investor.
COMMON STOCK PURCHASES: NINE CASE STUDIES
The Washington Post Company
Millionaire financier Eugene Meyer bought the Washington Post for $825,000 at an auction held to pay off creditors. Much later, Philip Graham, a brilliant Harvard-educated lawyer, took over management of the paper. Graham had married Meyer’s daughter Katharine. Graham transformed the Washington Post from a single newspaper into a media and communications company.
(Photo by Michael Fleischhacker, via Wikimedia Commons)
After Graham’s tragic suicide, control of the paper passed to Katharine Graham. She learned quickly that she had to make decisions. She made two great decisions: hiring Ben Bradlee as managing editor and then inviting Warren Buffett to become a director. Bradlee persuaded Katharine Graham to publish the Pentagon Papers and to pursue the Watergate investigation. This earned the paper a reputation for award-winning journalism. Meanwhile, Buffett taught Katharine Graham how to run a successful business. (Buffett later tutored Katharine’s son, Don Graham.)
Simple and Understandable
For Buffett, the newspaper business was simple and understandable. Buffett has said that if he were not an investor, he probably would be a journalist.
The Washington Post had a consistent operating history and favorable long-term prospects. Newspapers had outstanding economics at the time. (This was in the early 1970s, well before the advent of the internet.) Even mediocre newspapers were generally quite profitable. People and businesses wanting to get a message out to the community would typically use the newspaper to do so. Moreover, newspapers had low capital needs, which meant a high ROIC and high profit margins.
Buy at Attractive Prices
In 1973, the total market value of the Washington Post Company was $80 million. Buffett held that most security analysts, media brokers, and media executives at the time would have estimated WPC’s value at $400 or $500 million. Assuming a $400 million intrinsic value, Buffett was buying at 20 percent of intrinsic value.
Return on Equity and Profit Margins
When Buffett purchased a stake in the WPC, its return on equity (ROE) was 15.7 percent. Within five years, ROE had doubled. WPC maintained a high ROE over the next ten years. At the same time, WPC had paid down most of its debt.
By 1988, pretax margin reached a high of 31.8 percent, compared to 16.9 percent for its newspaper peer group and 8.6% for S&P Industrials.
Management Rationality
Using the gobs of excess cash, between 1975 and 1991, the Washington Post Company repurchased an incredible 43 percent of its shares at relatively low prices.
GEICO Corporation
Leo Goodwin, an insurance accountant, founded the Government Employees Insurance Company (GEICO) in 1936. His idea was to insure only preferred-risk drivers and to sell this insurance directly by mail, bypassing the need for agents or branch offices. Direct selling eliminated overhead expenses equal to 10 to 25 percent of every premium dollar. Goodwin also realized that government employees had fewer accidents than the general public.
(GEICO logo by Dream out loud, via Wikimedia Commons)
Goodwin partnered with a Fort Worth, Texas, banker Cleaves Rhea. Goodwin invested $25,000 for a 25% stake in the business, while Rhea invested $75,000 for a 75% stake in the business. In 1948, the Rhea family decided to sell its interest. Ben Graham decided to buy half Rhea’s stock for $720,000. David Kreeger, a Washington, D.C., lawyer and Lorimer Davidson, a Baltimore bond salesperson, bought the other half.
Lorimer Davidson joined GEICO’s management team and became chairman in 1958. By 1970, GEICO not only had written policies that would lead to underwriting losses; but it also had inadequate reserves. Norman Gidden was tapped to run the company when Davidson retired.
GEICO attempted to grow out of its problems. By 1974, GEICO was facing a potential underwriting loss of $140 million (it turned out to be $126 million). The stock fell from $61 to $5, and was heading lower. GEICO had lost underwriting and cost control discipline.
In 1976, John J. Byrne, a 43-year-old marketing executive from Travelers Corporation, took over as president of GEICO. Meanwhile, the stock drifted down to $2.
Warren Buffett invested $4.1 million at an average price of $3.18.
Simple and Understandable
Back in 1950, Ben Graham–Buffett’s teacher at Columbia University–was a director of GEICO. One Saturday, Buffett went to visit the company in Washington, D.C., to try to learn. A janitor let him in the building, and Buffett ended up getting a 5-hour tutorial from Lorimer Davidson, who was the only executive in the office that day.
Later, when Buffett returned to Omaha and his father’s brokerage firm, he recommended GEICO to the firm’s clients. Buffett himself invested $10,000, two-thirds of his net worth. He sold a year later at a 50 percent profit. Buffett would not invest again in GEICO until 1976.
Buffett owned Kansas City Life and Massachusetts Indemnity & Life Insurance. In 1967, Buffett purchased a controlling interest in National Indemnity. Over the next decade, Buffett learned the insurance business from Jack Ringwalt, the CEO of National Indemnity.
Buffett’s expertise in insurance is what gave him the confidence to invest heavily in GEICO. Between 1976 and 1980, Berkshire invested $47 million in GEICO, 7.2 million shares at an average price of $6.67. The stake was worth $105 million by 1980, representing Buffett’s largest holding.
Buffett’s large investment in GEICO seemed to violate the consistent operating history tenet, since GEICO was a turnaround. But Buffett had determined that the essential competitive advantage of the business–providing low-cost agentless insurance–was still intact. Thus, Buffett judged that the problems in 1976, though huge, would ultimately be temporary.
Management Candor and Rationality
Byrne drastically reduced costs. The number of policyholders went from 2.7 million to 1.5 million. GEICO went from being the 18th largest insurer to 31st a year later. But GEICO went from losing $126 million in 1976 to earning an impressive $58.6 million (on $463 million in revenues) in 1977.
Byrne continued to reduce costs. The company stumbled in 1985. But Byrne was very candid about it, and the company quickly recovered. By this point, Byrne had developed a reputation not only for great leadership, but also for candor with shareholders.
From 1983 to 1992, GEICO used excess cash to repurchase 30 million shares, reducing total shares outstanding by 30 percent. GEICO also increased the dividend.
Return on Equity and Profit Margins
In 1980, the ROE at GEICO was 30.8 percent, almost twice as high as the peer group average. Buying back stock and paying dividends helped maintain a high ROE by reducing capital.
GEICO’s combined ratio of corporate expenses and underwriting losses was significantly better than the industry average.
Capital Cities/ABC
(Wikimedia Commons)
In 1954, Lowell Thomas, the famous journalist; his business manager, Frank Smith; and a group of associates bought Hudson Valley Broadcasting Company, which included an Albany television and AM radio station. At the time, Tom Murphy was a product manager at Lever Brothers.
Frank Smith was a golfing partner of Murphy’s father. Smith hired Murphy to manage the company’s television station. In 1957, the company purchased a Raleigh-Durham television station. The company was renamed Capital Cities Broadcasting, since Albany and Raleigh were capital cities.
In 1960, Murphy hired Dan Burke to manage the Albany station. During the next several decades, Murphy and Burke ran Capital Cities. They made more than 30 acquisitions in broadcasting and publishing.
In the late 1960s, Murphy met Buffett. Murphy invited Buffett to join the board of Cap Cities. Buffett declined, but he and Murphy became good friends.
In early 1985, Murphy obtained an initial agreement for a merger between Cap Cities and ABC. Although Murphy had always done his own deals up until then, this time he brought his friend Warren Buffett. They worked out the largest media merger in history (up to that point). Berkshire Hathaway agreed to purchase three million newly issued shares of Cap Cities at $172.50 per share. Murphy asked Buffett again to join the board, and this time Buffett agreed.
Simple and Understandable
Having served on the Washington Post Company board for more than a decade, Buffett had a very good understanding of television broadcasting, and newspaper and magazine publishing.
Both Cap Cities and ABC had more than 30 years of profitable histories. ABC averaged 17 percent ROE from 1975 through 1984. Cap Cities, in the decade before its purchase of ABC, averaged 19 percent ROE. (Both companies also had low debt.)
Hagstrom explains the economics:
Once a broadcasting tower is built, capital reinvestment and working capital needs are minor and inventory investment is nonexistent. Movies and programs can be bought on credit and settled later when advertising dollars roll in. Thus, as a general rule, broadcasting companies produce above-average returns on capital and generate substantial cash in excess of their operating needs.
In 1985, the basic economics were above average.
Determine the Value
Berkshire’s $517 million investment in Cap Cities was the single largest investment Buffett ever made up until then. This was not a cheap price. Buffett joked, ‘I doubt if Ben’s up there applauding me on this one.’
Much of Buffett’s investment depended on Murphy. Operating margins at Cap Cities were 28 percent, but were only 11 percent at ABC. Murphy could improve the margins at ABC.
In essence, Murphy was Buffett’s margin of safety. Murphy and Burke used a decentralized management style, hiring the best people and then leaving them alone to do their job. Managers were expected to operate their businesses as if they owned them. Moreover, Murphy excelled at minimizing costs, while Burke excelled at ongoing operations.
The Institutional Imperative and Rationality
Despite enormous free cash flow, Murphy remained very disciplined about not overpaying for acquisitions. He would sometimes wait for years until the right property at the right price became available.
Because the stock of Cap Cities/ABC was cheap for several years, Murphy repurchased a large number of shares. Murphy also reduced the company’s debt that had resulted from the ABC acquisition.
Buffett viewed Cap Cities/ABC as the best-managed public company in the United States. He assigned all voting rights for the ensuing 11 years to Murphy and Burke as long as at least one of them managed the company.
The Coca-Cola Company
(Wikimedia Commons)
Hagstrom writes:
By the spring of 1989, Berkshire Hathaway shareholders learned that Buffett had spent $1.02 billion buying Coca-Cola shares. He had bet a third of the Berkshire portfolio, and now owned 7 percent of the company. It was the single-largest Berkshire investment to date, and already Wall Street was scratching its head. Buffett had paid five times book value and over 15 times earnings, then a premium to the stock market, for a hundred-year-old company that sold soda pop. What did the Wizard of Omaha see that everyone else missed?
As a kid, Buffett would buy six Cokes for 25 cents, then resell them at 5 cents each. And in 1986, Buffett announced that Cherry Coke would be the official soft drink at Berkshire Hathaway’s annual meetings. But it wasn’t until 1988 that Buffett began buying shares.
Simple and Understandable
The company sells a concentrate to bottlers, who combine it with other ingredients and then sell the finished product to retail outlets. The company also sells soft drink syrups to restaurants and fast-food retailers.
Buffett explained in an interview with Melissa Turner of the Atlanta Constitution his reasoning: If he could make one investment and then go away for ten years without access to any information about the investment, what would he buy? As far as remaining a worldwide leader and experiencing big ongoing unit growth, there was nothing (in 1989) like Coke.
Furthermore, the chairman and CEO of Coke, Roberto Goizueta, and the president Donald Keough, were doing an outstanding job erasing mistakes that had been made in the 1970s. Robert Woodruff, the company’s 91-year-old patriarch, hired Roberto Goizueta in 1980. Goizueta cut costs and demanded that any business owned by Coca-Cola maximize return on assets.
High Profit Margins and ROE
Under Goizueta and Keough, pretax margins rose from 12.9 percent to a record 19 percent by 1988. Goizueta sold any business that did not generate good ROE. By 1988, the company’s ROE reached 31 percent, up from 20 percent during the 1970s.
Management Candor and Rationality
Under Goizueta’s leadership, Coke’s mission became crystal clear: maximize shareholder value over time. This would be achieved by optimizing profit margins and ROE.
Meanwhile, Goizueta announced that the company would repurchase shares, which were trading at a discount to the company’s now-higher intrinsic value.
The Institutional Imperative
Hagstrom describes Goizueta’s leadership:
When Goizueta took over Coca-Cola, one of his first moves was to jettison the unrelated businesses that Paul Austin had developed, and return the company to its core business: selling syrup. It was a clear demonstration of Coca-Cola’s ability to resist the institutional imperative.
Reducing the company to a single-product business was undeniably a bold move…
… Because the economic returns of selling syrup far outweighed the economic returns of the other businesses, the company was now reinvesting its profits in its highest-return business.
Determine the Value
Buffett paid 5 times book value, 15 times earnings, and 12 times cash flow. This was at a time when long-term bonds were yielding 9 percent. Hagstrom:
…The company was earning 31 percent on equity while employing relatively little in capital investment. Buffett has explained that price tells you nothing about value. The value of Coca-Cola, he said, like that of any other company, is determined by the total owner earnings expected to occur over the life of the business, discounted by the appropriate interest rate.
Owner earnings is the term Buffett uses for free cash flow (FCF). We can use a two-stage discount model to calculate the present value in 1988. Assuming 15 percent growth in owner earnings for the next 10 years, and then 5 percent growth thereafter, and assuming a 9 percent discount rate, intrinsic value for Coca-Cola would be $48.377 billion. That’s compared to the 1988 market value of $14.8 billion.
At year-end 1999, the market value of Coke was $143 billion, and Berkshire’s original $1.02 billion investment was worth $11.6 billion.
General Dynamics
In 1990, General Dynamics was the country’s second-largest defense contractor behind McDonnell Douglas Corporation. General Dynamics produced missile systems in addition to air defense systems, space-launched vehicles, and fighter planes for the U.S. armed forces.
(Wikimedia Commons)
In January 1991, General Dynamics appointed William Anders as CEO. Within six months, the company had raised $1.25 billion by selling noncore businesses. With the cash, the company first paid down its debt. Then as excess cash flow continued, General Dynamics purchased 13.2 million shares at prices between $65.37 and $72.25, reducing its shares outstanding by 30 percent.
Although Buffett initially had purchased General Dynamics as an arbitrage–in anticipation of stocks buybacks–Buffett later noticed that Anders was very focused on maximizing shareholder value. So Buffett held the stake:
From July 1992 through the end of 1993, for its investment of $72 per share, Berkshire received $2.60 in common dividends, $50 in special dividends, and a share price that rose to $103. It amounted to a 116 percent return over 18 months.
Wells Fargo & Company
In October 1990, Buffett announced that Berkshire had purchased five million shares in Wells Fargo, investing $289 million at an average price of $57.88 per share. This turned into a battle between bulls like Buffett and bears like the Feshbach brothers.
(Wikimedia Commons)
Buffett knew a lot about the business of banking. In 1969, Berkshire Hathaway purchased 98 percent of the holdings of Illinois National Bank and Trust Company. Gene Abegg, the chairman of Illinois National Bank, taught Buffett about the banking business. Buffett learned that banks were profitable if they issued loans intelligently and curtailed costs.
Favorable Long-Term Prospects
When assets are 20 times equity, which is normal in banking, even a small mistake can cause the bank to go bankrupt. But if management does a good job, a bank can earn 20 percent on equity, which is above the average of most businesses. Also, Buffett believed he had the best management team in Carl Reichardt and Paul Hazen. Buffett: “In many ways, the combination of Carl and Paul reminds me of another–Tom Murphy and Dan Burke at Capital Cities/ABC.”
Munger explained: ‘It’s all a bet on management. We think they will fix the problems faster and better than other people.”
Rationality
Reichardt was legendary for relentlessly lowering costs. He never let up, always searching for ways to improve profitability.
American Express Company
(Wikimedia Commons)
Buffett: “I find that a long-term familiarity with a company and its products is often helpful in evaluating it.” Hagstrom explains:
With the exception of selling bottles of Coca-Cola for a nickel, delivering copies of the Washington Post, and recommending that his father’s clients buy shares of GEICO, Buffett has had a longer history with American Express than any other company Berkshire owns. You may recall that in the mid-1960s, the Buffett Limited Partnership invested 40 percent of its assets in American Express shortly after the company’s losses in the salad oil scandal. Thirty years later, Berkshire accumulated 10 percent of American Express shares for $1.4 billion.
Consistent Operating History
American Express was essentially the same business when Berkshire invested as it had been when the Buffett partnership invested. Travel Related Services (TRS) made up 72 percent of American Express’s sales. American Express Financial Advisors represented 22 percent of sales. American Express Bank was about 5%.
Under James Robinson, the company used excess cash to acquire related business. Although IDS (renamed American Express Financial Advisors) had proved to be a profitable purchase, Robinson’s $4 billion investment in Shearson-Lehman was a financial drain and prompted Robinson to contact Buffett. Buffett was willing to buy $300 million in preferred shares. But Buffett was not ready to invest in the common shares until he saw more management rationality.
Rationality
In 1992, Harvey Golub took over as CEO. Golub clearly recognized the brand value of the American Express Card. Over the next two years, Golub sold off American Express’s underperforming assets, and restored profitability and high ROE. By 1994, American Express management was focused on making the American Express Card the “world’s most respected service brand.”
Golub also set financial targets: to increase EPS by 12 to 15 percent annually and to achieve an 18 to 20 percent ROE. Management was also planning to repurchase 20 million shares of its common stock.
In the summer of 1994, Buffett converted Berkshire’s preferred issue into American Express common stock. And he began to acquire even more shares of common stock. Berkshire owned 27 million shares at an average price of $25 by the end of the year. When American Express finished repurchasing 20 million shares, it announced that it would repurchase an additional 40 million shares, or 8 percent of the stock outstanding. By March 1995, Buffett had added another 20 million shares, which increased Berkshire’s ownership to a bit less than 10 percent of American Express.
Determine the Value
Assuming 12 percent growth in owner earnings for 10 years, then 5 percent growth thereafter, and assuming a discount rate of 10 percent–which is conservative–the intrinsic value of American Express at the end of 1994 was about $50 billion, or $100 per share. Thus Buffett’s purchase of 27 million shares at $25 had a significant margin of safety, and therefore significant potential upside.
International Business Machines
Buffett had always avoided investing in technology companies because constant disruption and innovation make for very short company life spans. But by the end of 2011, Berkshire Hathaway had purchased 63.9 million shares of IBM, or 5.4 percent of the company. At $10.8 billion, it was the largest purchase of individual stock Buffett has ever made.
(Photo by Paul Rand, via Wikimedia Commons)
Favorable Long-Term Prospects
After 50 years of reading the financial statements of IBM, Buffett suddenly realized the competitive advantages IBM has in finding and keeping clients. IBM dominates information technology (IT) services, which includes consulting, systems integration, IT outsourcing, and business process outsourcing. IBM is number-one globally in the consulting and systems integration space, and number-one globally in IT outsourcing.
Revenues from IT services are relatively stable. Consulting, systems integration, and IT outsourcing are even thought to possess ‘moat-like’ qualities, writes Hagstrom. In consulting and systems integration, intangible assets like reputation, track record, and client relationships are sources of a moat. In IT outsourcing, switching costs and scale advantages create a moat.
J. Heinz Company
On February 14, 2013, Berkshire Hathaway and 3G Capital purchased H. J. Heinz Company for $23 billion. The purchase price was $72.50 a share, a 20 percent premium to the stock price the day before.
(Wikimedia Commons)
Favorable Long-Term Prospects; Rationality
Heinz is number one in ketchup globally and second in sauces. The company is poised to do well in rapidly growing emerging markets.
Buffett has partnered with 3G Capital in the purchase of Heinz. 3G has a track record of relentlessly lowering costs.
Holding Period: Forever
Buffett is “quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.”
PORTFOLIO MANAGEMENT: THE MATHEMATICS OF INVESTING
If you do not have the time or inclination to study companies in depth, then a low-cost index fund is best. But if you can understand some businesses, then a concentrated portfolio makes sense.
There is a mathematical formula, the Kelly criterion, that you can use to get an idea of how large a position to take on your best ideas. The formula was invented by the physicist John L. Kelly.
(John L. Kelly, Wikimedia Commons)
Buffett talked about index funds vs. focused portfolios in the 1993 Berkshire Hathaway Letter to Shareholders:
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices–the businesses he understands best and that present the least risk, along with the greatest profit potential.
Here is Buffett in a 1998 lecture at the University of Florida:
If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake. Very few people have gotten rich on their seventh best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best.
Even in a highly focused portfolio of 5 to 10 stocks, often your best idea should be by far the largest position in your portfolio.
Recall that Buffett invested two-thirds of his net worth in GEICO before he launched the Buffett partnership. He had over a 50 percent profit after a year. Later, Buffett invested 40 percent of the Buffett partnership in American Express. The shares nearly tripled over the next two years. A couple of decades later, Buffett invested $1.02 billion–about a third of Berkshire Hathaway’s portfolio–in Coca-Cola. This turned out to be a 10-bagger for Berkshire, netting $10 billion in profit over the ensuing decade.
It can be tempting for an investor to listen to forecasters predict the stock market, the economy, or elections. But owning a few good businesses over time is a far more reliable and safer way to compound your capital–at higher rates–than speculating on the stock market or the economy.
Here are a few good quotes from Buffett on forecasting:
I don’t invest a dime based on macro forecasts.
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.
Hagstrom puts it as follows:
In shorter periods, we realize that changes in interest rates, inflation, or near-term expectations for a company’s earnings can affect share prices. But as the time horizon lengthens, the trendline economics of the underlying business will increasingly dominate its share price.
… Focus investors tolerate the [short-term] bumpiness because they know that, in the long run, the underlying economics of the companies will more than compensate for any short-term price fluctuations.
Investing is Probabilistic
(Photo by Michele Lombardo)
Nearly all investments are probabilistic decisions, or decisions under uncertainty. Hagstrom quotes Buffett:
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect but that’s what it is all about.
Hagstrom also quotes 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 and think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds are changed 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 good position et cetera 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. The prices have changed in such a way that it’s very hard to beat the system.
When you find a high-probability bet with substantial upside–which will only happen rarely–then you should take a big position. How big? You have to know yourself in terms of how much portfolio volatility you can tolerate. As long as you can hold for the longer term–for at least 5 or 10 years–without reacting to shorter term volatility, then it makes sense to take large positions on the best ideas you find.
If you apply the Kelly criterion to a focused portfolio of value stocks, then you typically need to normalize positions sizes. Mohnish Pabrai has explained this: https://boolefund.com/the-dhandho-investor/
It is a mistake to think one limits one’s risk by spreading too much between enterprises which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.
Keynes was against market timing, and in favor of a very concentrated portfolio.
Hagstrom also mentions Ruane, Cuniff & Company, started by Bill Ruane and Rick Cuniff. They would have 90 percent of the fund in 6 to 10 positions.
Lou Simpson used a very concentrated approach when he managed GEICO’s equity portfolio. Between 1980 and 2004, GEICO’s portfolio returned 20.3 percent per year compared to 13.5 percent for the market.
Active share is the percentage of a portfolio that differs from the benchmark index holdings. The only way to do better than the index is to invest differently. Yet most professional investors have portfolios not much different than the index. They are more worried about not underperforming the index than they are focused on doing better than the index. Hagstrom reports that just 25 percent of mutual funds today are considered truly active.
Moreover, many professional investors are focused on short-term results. The problem is that the performance of a portfolio of stocks is largely random for time horizons less than 5 years. That is why Buffett focuses on 5-year periods to measure Berkshire Hathaway’s performance. After 5 years–and even more after 10 years–a stock will track the performance of the underlying business.
(Illustration by Marek)
Many professional investors fixate on quarterly or annual results because many of their clients (or potential clients) decide to invest in the fund based on these short-term results.
Many of the best long-term investors have had periods of significant underperformance over shorter periods of time. When Keynes managed the Chest Fund, it underperformed the market one-third of the time. This includes underperforming the market by 18 percentage points in the first three years Keynes managed the fund. But Keynes’ record over a couple of decades was outstanding.
The Sequoia Fund, managed by Bill Ruane, underperformed the market 37 percent of the time. In fact, Sequoia underperformed for the first 4 years of its existence. By the end of 1974, the fund was 36 percentage points behind the market. Yet three years later–seven years since inception–Sequoia was up 220 percent, versus 60 percent for the S&P 500 Index.
Over 14 years, Charlie Munger underperformed 36 percent of the time. But Munger’s overall record was far better than the market. (Lou Simpson underperformed the market 24 percent of the time, but also had a remarkable long-term record of beating the market.)
If you’re a long-term investor in businesses–whether public or private–what matters over time is the economic performance of those businesses, not the prices at which the businesses can be bought or sold. Hagstrom:
If you owned a business and there were no daily quotes to measure its performance, how would you determine your progress? Likely you would measure the growth in earnings, the increase in return on capital, or the improvement in operating margins. You simply would let the economics of the business dictate whether you were increasing or decreasing the value of your investment.
Hagstrom quotes Buffett:
While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously.
Buffett again:
The speed at which a business’s success is recognized… is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give you a chance to buy more of a good thing at a bargain price.
When you consider a new investment idea, you should always compare it to the best ideas already in your portfolio. Since good ideas are rare, this should set a high threshold and screen out 99 percent of what you consider. Hagstrom observes:
You already have at your disposal, with what you now own, an economic benchmark–a measuring stick. You can define your own personal benchmark in several different ways: look-through earnings, return on equity, or margin of safety, for example. When you buy or sell stock of a company in your portfolio, you have either raised or lowered your economic benchmark. The job of a portfolio manager who is a long-term owner of securities, and who believes future stock prices eventually will match with underlying economics, is to find ways to raise your benchmark.
If you step back and think for a moment, the Standard & Poor’s 500 index is a measuring stick. It is made up of 500 companies and each has its own economic return. To outperform the S&P 500 index over time–to raise that benchmark–we have to assemble and manage a portfolio of companies with economics that are superior to the average weighted economics of the index.
Buffett:
If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business. Second, assess the quality of the people in charge of running it; and third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? Our motto is: If at first you succeed, quit trying.
Buffett again:
Inactivity strikes us as an intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit has reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?
Buying and holding wonderful businesses has two important benefits in addition to growing capital at an above-average rate. Transaction costs are kept to an absolute minimum, and after-tax returns are maximized.
Buffett gives an example of $1 doubling every year for 20 years. First assume that you sell and pay tax at the end of each year. So after the first year, you would have a total of $1.66. By the end of 20 years, you would have a net gain of $25,200, after paying taxes of $13,000. By contrast, if you held the $1 dollar as it repeatedly doubled, and didn’t sell until the end of the 20-year period, you would have $692,000 after paying taxes of about $356,000.
To achieve high after-tax returns, turnover should be between 0 and 20 percent. 20 percent turnover implies a 5-year holding period. As long as you are very patient and can stay focused on the long term without reacting emotionally to shorter term volatility, you should be able to construct and stick with a focused portfolio of businesses that you understand. Always being rational and not reacting out of emotion is more important than IQ. Buffett:
You don’t need to be a rocket scientist. Investing is not a game where the 160 IQ guy beats the guy with the 130 IQ. The size of an investor’s brain is less important than his ability to detach the brain from the emotions.
THE PSYCHOLOGY OF INVESTING
Although it’s not widely recognized, Ben Graham was keenly aware of the importance of psychology for investors. Graham held that your worst enemy as an investor is usually yourself.
Warren Buffett, Graham’s most famous student, says there are three important principles in Graham’s approach to investing:
Stock is a fractional ownership in a business. What matters for the investor is how the business performs over time.
Margin of safety: Given a reasonable estimate of intrinsic value–based on net asset value or earnings power–you should only buy when the price is well below that estimate. The lower the price is compared to intrinsic value, the safer the investment and simultaneously the higher the potential reward.
Short-term price fluctuations have no meaning for the true investor because on the whole they do not reflect changes in business value. Fluctuations do occasionally create opportunities, however, for the investor to buy if the price becomes cheap enough.
When the stock price drops, a rational investor’s reaction should be the same as a businessperson who gets a lowball offer on his or her privately owned business: Ignore it. Graham:
The true investor scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.
Behavioral Finance
(Daniel Kahneman, via Wikimedia Commons)
Behavioral finance is based on discoveries (in the past few decades) in psychology by Daniel Kahneman, Amos Tversky, and many others. Kahneman was awarded the Nobel Prize in economics in 2002 for discoveries that he and Tversky made from decades of experiments of people making decisions under uncertainty.
Before Kahneman and Tversky, economists always assumed–based on utility theory as described by John von Neumann and Oskar Morgenstern–that people make rational decisions under uncertainty. (Investment decisions are decisions under uncertainty.)
We now know that nearly all investors make systematic errors. Behavioral finance allows us to understand these errors.
People by nature are overconfident. Typically if you ask people in a random group how good a driver they are, at least 80-90 percent will say ‘above average.’ But of course no more than 50% can be above average.
In many areas of life, overconfidence is not bad and often even is helpful. When we were hunter-gatherers, it was a net benefit for the tribe if hunters were individually overconfident. Similarly today, although many entrepreneurs fail, it is a net benefit for the economy that nearly all entrepreneurs believe they will succeed.
When you are investing, however, overconfidence will penalize your results over time. Hagstrom points out:
Investors, as a rule, are highly confident they are smarter than everyone else. They have a tendency to overestimate their skills and their knowledge. They typically rely on information that confirms what they believe, and disregard contrary information. In addition, the mind works to assess whatever information is readily available rather than to seek out information that is little known….
Overconfidence explains why so many money managers make wrong calls. They take too much confidence from the information they gather, and think they are more right than they actually are.
Confirmation bias means only seeing information that confirms what you already believe, rather than seeking and being aware of potentially disconfirming information. Availability bias means only noticing information that is readily available.
Overreaction Bias
Overreaction Bias means investors overreact to bad news and react slowly to good news. If there is bad news and the stock price drops, an investor is likely to overreact and to sell, even though the long-term, underlying economics of the business are often unchanged.
Richard Thaler researched overreaction. He constructed a portfolio of ‘Loser’ stocks–stocks that had been the worst performers over the preceding 5 years. He compared the ‘Loser’ portfolio to a portfolio of ‘Winner’ stocks–stocks that had performed best over the preceding 5 years. Thaler found that over the subsequent 5 years, the ‘Loser’ portfolio far outperformed both the market and the ‘Winner’ portfolio.
Loss Aversion
People are risk averse when considering potential gains, but risk seeking when facing the possibility of a certain loss. This is the essence ofprospect theory–invented by Kahneman and Tversky–which is captured in the following graph:
(Value function in Prospect Theory, drawing by Marc Rieger, via Wikimedia Commons)
Loss aversion means that, in general, people feel a loss 2 to 2.5 times more than an equivalent gain. (That’s why the value function in the graph is steeper for losses.) Therefore, when people are presented with a 50/50 bet, on average they will only bet if the potential gain is at least twice as large as the potential loss.
Loss aversion causes people to hold on to their losing investments for too long. By not selling an investment that hasn’t worked, the investor can postpone the feeling of a loss. Yet the sooner the investor can recognize a mistake and close the position, the sooner the investor can reinvest that capital in a potentially more profitable way.
Mistakes in investing are inevitable. Even for the best value investors, on average they tend to be right about two-thirds of the time and wrong one-third of the time. The best investors can recognize quickly when either they have made a mistake or when unforeseeable events have invalidated the investment thesis.
Long-Term Investment Time Horizon
Warren Buffett focuses on the performance of the business over a 5-year or 10-year period. He invests in a stock when it is a bargain relative to the probable long-term earnings power of the business.
Many investors are way too focused on the short term. The problem is that if you check a stock price each day, there is 50 percent chance it will be lower. And due to loss aversion, you will feel the pain of a lower price at least twice as much as the pleasure of an equivalent gain. Therefore, after carefully constructing your portfolio, it’s essential to stay focused on the performance of the businesses over rolling 5-year periods. It’s also essential to check stock prices as infrequently as you can.
Very often the individual investors who have gotten the best results over the course of 20-30 years are those investors who effectively forgot about their investments. These investors often didn’t check stock prices for years at a time. As Ben Graham said, for many investors it would be better if they couldn’t get any stock quote at all.
Warren Buffett has often said you should only invest in a business where you wouldn’t worry at all if the stock market closed for 5 or 10 years. All that matters for the long-term value investor is how the underlying business performs over time. If it’s a good business that increases earnings and maintains a high return on capital over time, then your fractional ownership of the business will track the increase in intrinsic value.
THE VALUE OF PATIENCE
Too many investors have the mistaken belief that the stock market can be predicted. But it can’t. 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.
Hagstrom did some research about long-term investing, and here is what he found:
We calculated the one-year return, trailing three-year return, and trailing five-year return (price only) between 1970 and 2012. During this 43-year period, the average number of stocks in the S&P 500 index that doubled in any one year averaged 1.8 percent, or about nine stocks out of 500. Over three-year rolling periods, 15.3 percent of stocks doubled, about 77 stocks out of 500. In rolling five-year blocks, 29.9 percent doubled, about 150 out of 500.
So, back to the original question: Over the long term, do large returns from buying and holding stocks actually exist? The answer is indisputably yes. And unless you think a double over five years is trivial, this equates to a 14.9 percent average annual compounded return.
Then Hagstrom notes that the greatest number of opportunities to get high excess returns is after three years. So, as an investor, you should patiently find cheap and good stocks that you can hold for at least 3 to 5 years. There continue to be many opportunities over this time frame because many investors only look at the very short term. The average holding period is only a few months, which is hardly different from a coin flip.
Rationality
Keith Stanovich holds that rationality is not the same thing as intelligence. He says IQ tests or SAT/ACT exams do a poor job of measuring rational thought:
It is a mild predictor at best, and some rational thinking skills are totally dissociated from intelligence.
There appear to be two main reasons why even many high IQ people are not able to think rationally: a processing problem and a content problem.
To understand the processing problem, we must first note that we have essentially two different brains: System 1 and System 2.
System 1 operates automatically and quickly. It makes instinctual decisions based on heuristics.
System 2 allocates attention (which has a limited budget) to the effortful mental activities that demand it, including complex computations involving logic, math, or statistics.
Usually System 1 and System 2 work well together, but not always. Daniel Kahneman explains in his great book, Thinking, Fast and Slow:
The division of labor between System 1 and System 2 is highly efficient: it minimizes effort and optimizes performance. The arrangement works well most of the time because System 1 is generally very good at what it does: its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate. System 1 has biases, however, systematic errors that it is prone to make in specified circumstances… it sometimes answers easier questions than the one it was asked, and it has little understanding of logic and statistics. One further limitation of System 1 is that it cannot be turned off.
If the situation requires a complex computation in order to arrive at a good decision, then System 1 makes predictable errors. In order to avoid these mistakes, a person must train his or her System 2 to activate and to think carefully.
So the processing problem requires training System 2. But there is a second problem the investor also must solve: the content problem. The ability to think rationally using System 2 can only lead to good decisions if System 2 has access to enough mindware. Mindware–as defined by Harvard cognitive scientist David Perkins–is all the rules, strategies, procedures, and knowledge people have at their disposal to help solve a problem.
In investing, the most important thing is reading a great deal, especially the financial statements of various companies. Over time, an investor can slowly develop useful mindware.
THE WORLD’S GREATEST INVESTOR
To determine how good Warren Buffett is, there are two basic variables: relative outperformance and duration. Hagstrom argues that both are needed. Over shorter periods of time, luck plays a large role. But as you extend out in time–several decades and then some–luck plays less and less of a role.
Buffett has crushed the market over a period of almost 60 years. Buffett is unmatched over this time frame.
Buffett also remains very bullish on the United States. He says the luckiest new babies in history are those being born today:
…Warren Buffett is unabashedly bullish on the United States of America. He has never been shy to express his belief that the United States offers tremendous opportunity to anyone who is willing to work hard. He is upbeat, cheerful, and optimistic about life in general. Conventional wisdom holds that it is the young who are the eternal optimists and as you get older pessimism begins to tilt the scale. But Buffett appears to be the exception. And I think part of the reason is that for almost six decades he has managed money through a long list of dramatic and traumatic events, only to see the market, the economy, and the country recover and thrive.
It is a worthwhile exercise to Google the noteworthy events of the 1950s, 1960s, 1970s, 1980s, 1990s, and the first decade of the twenty-first century. Although too numerous to list here, the front-page headlines would include nuclear war brinksmanship; presidential assassination and resignation; civil unrest and riots; regional wars; oil crisis, hyperinflation, and double-digit interest rates; and terrorist attacks–not to mention the occasional recession and periodic stock market crash.
Hagstrom proceeds to argue that Buffett has three advantages: behavioral, analytical, and organizational.
Behavioral Advantage
Those who know Buffett agree that it is rationality that sets him apart. Buffett is extremely rational. As Roger Lowenstein writes in Buffett: The Making of an American Capitalist, “Buffett’s genius [is] largely a genius of character–of patience, discipline, and rationality.” The maximization of shareholder value depends largely on the rational allocation of capital. This is a key trait Buffett looks for in good managers, and it’s a trait he himself has to a remarkable degree.
Analytical Advantage
For Buffett, both the investor and the businessperson should look at a company in terms of how much cash it can produce over time. By recognizing, furthermore, that short-term stock prices are largely random, you can learn to value a business–based on discounted FCF or net asset value–and wait patiently until its stock price is well below intrinsic value.
Don’t waste time trying to predict the stock market, the economy, or elections. No one has been able to predict these things. Instead, stay focused on understanding individual businesses. Over a long period of time–at least 5-10 years–what really matters, as long as you paid reasonable prices, is the performance of the businesses you own.
Organizational Advantage
Buffett has set up Berkshire Hathaway so that he can focus on long-term capital allocation, while the managers of the businesses Berkshire owns can focus on maximizing long-term business value.
If you’re an individual investor, you don’t have to worry about short-term performance or consensus opinions. You can find a simple business that you understand, and then wait patiently for it to go on sale. Find a few such businesses. Then buy and hold, paying attention only to how the businesses perform over the years.
I would add that, for the individual investor, most often you can find the best investment opportunities among microcap companies–companies with market caps up to $300 million. Because very few professional investors ever look at micro caps, the greatest pricing inefficiencies usually occur here.
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: https://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 approachesintrinsic 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.
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.
Daniel Pecaut and Corey Wrenn recently published a wonderful book, University of Berkshire Hathaway. The book is a summary of 30 years’ worth of teachings delivered by Warren Buffett and Charlie Munger at the annual meetings of Berkshire Hathaway (1986 through 2015).
Pecaut and Wrenn had the same idea that many value investors have had: To figure out how to succeed as a value investor, it makes sense to study the best. Warren Buffett and Charlie Munger are at the top of the list.
(Photo by USA International Trade Administration, via Wikimedia Commons)
Through 2017, after 52 years under Buffett and Munger’s management, the value of Berkshire Hathaway has grown 2,404,748% versus 15,508% for the S&P 500 Index. Compounded annually, that’s 20.9% per year for Berkshire stock versus 9.9% per year for the S&P 500.
(Photo by Nick Webb)
Pecaut and Wrenn point out a key fact about how Buffett and Munger have achieved this stunning success:
More than two-thirds of Berkshire’s performance over the S&P was earned during down years. This is the fruit of Buffett and Munger’s “Don’t lose” philosophy. It’s the losing ideas avoided, as much as the money made in bull markets that has built Berkshire’s superior wealth over the long run.
Buffett himself has made the same point, including at the 2007 meeting. His best ideas have not outperformed the best ideas of other great value investors. However, his worst ideas have not been as bad, and have lost less over time, as compared with the worst ideas of other top value investors.
Pecaut then states:
Though Corey and I have been aware of the results for a number of years, we still marvel at Buffett and Munger’s marvelous achievement. They have presided over one of the greatest records of wealth-building in history. For five decades, money under Buffett’s control has grown at a phenomenal rate.
In the 1970s, the annual meeting of Berkshire Hathaway was attended by a half-dozen people or so. In recent years, there have been roughly 40,000 attendees. The event has been dubbed “Woodstock for Capitalists.”
(2011 Berkshire Hathaway Annual Meeting, Photo by timbu, licensed under CC BY 2.0)
Pecaut and Wrenn write that studying the teachings of Professors Buffett and Munger can be as good as an MBA if you’re a value investor. They declare:
It is, without a shadow of a doubt, the best investment either of us has ever made.
That’s not to say there are any easy answers if you want to become a good value investor. It takes many years to master the art. And even after you’ve found an investment strategy that fits you personally, you must keep learning and improving forever.
There are two important points to make immediately. First, it’s a statistical fact that most of us will do better over time by adopting a fully automated investment strategy “” whether indexed or quantitative.
Second, whether you use an automated strategy or not, if you’re investing relatively small sums, you are likely to do best by focusing on micro caps (companies with market caps under $300 million). Most great value investors, including Buffett and Munger, started their careers investing in micro caps. In general, you can get the best returns by investing in micro caps because they are largely neglected by investors. Also, most microcap businesses are tiny and thus easier to understand.
Although Pecaut and Wrenn’s book is organized by year, I’ve re-arranged the teachings of Buffett and Munger based on topic. Here’s the outline:
Value Investing
Value Investing
What vs. When
Temperament and Discipline
Modern Portfolio Theory
Growth, Book Value
Business Risk
Good Managers
Sustainable Competitive Advantage
Know the Big Cost
Basic “Macro Thesis”
Macro Forecasting
Capital-Intensive Businesses
Cyclical Industries
Thinking for Yourself
Logic, Not Emotion
Intellectual Independence
In/Out/Too Hard
Information: Good, Not Quick
LifetimeLearning
Lifetime Learning and Constructive Criticism
Invest in Yourself
Making It In Business
Multidisciplinary Models, Opportunity Cost
Biographies: Improve Your Friends
What is Berkshire Hathaway?
Berkshire Hathaway
Berkshire: Good Home for Good Businesses
No Master Plan
Culture
Munger’s Optimism
Legacy
Insurance
Buying National Indemnity
Insurance and Hurricanes
Building the Insurance Business
The Unexpected
Comments on Specific Investments
BYD
GEICO
3G Capital Partners
ISCAR
Other Topics
The Game of Bridge
The Ovarian Lottery
Predicting Changes in Technology
Inflation: Gold vs. Wonderful Business
Luck and an Open Mind
The Luckiest Crop in History
Value Investing
VALUE INVESTING
Here’s a summary of the basic concepts of value investing. The intrinsic value of any business is the total cash that will be generated by the business in the future, discounted back to the present. Another way to think of intrinsic value is “what a company would bring if sold to a knowledgeable buyer.”
Typically, if a value investor thinks a business is worth X, they will try to buy it at 1/2 X. This creates a margin of safety in case the investor has made a mistake or experiences bad luck. If the investor is roughly correct, they can double their money or better.
(Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, Equim43 via Wikimedia Commons)
Many good value investors are right 60% of the time and wrong 40% of the time. Mistakes and surprises (both good and bad) are inevitable for every investor. That’s why a margin of safety is essential.
Another wrinkle is business quality. When Buffett and Munger started their careers, they followed the teachings of Ben Graham. In Graham’s approach, business quality doesn’t matter as long as you buy a basket of cheap stocks. However, Buffett and Munger slowly learned from experience the following lesson:
It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
If you buy a mediocre or bad business at half price, the problem is that the intrinsic value of the business can decline. On the other hand, if you buy a great business, it’s often hard to overpay because the value compounds over time.
A great business is one that has a high return on invested capital (ROIC) “” and high return on equity (ROE) “” that can be sustained, ideally for decades. If you pay a fair or even high price, but hold the business for decades, then your annual return eventually will approximate the ROE of the business.
Say a business has an ROE of 40% and can sustain it over time. Then your annual return as investor, if you hold the stock over decades, eventually will approximate 40%. That’s the power of investing in a high-quality business.
But such a great business is exceedingly rare and hard to find. Tread very carefully. The vast majority of investors are unable to invest successfully using this method.
Also bear in mind that Buffett and Munger have never paid any attention to forecasts, whether of the economy, interest rates, the stock market, or elections. When they’ve been able to find a good or great business at a reasonable price, they’ve always bought, regardless of forecasts and regardless of the current economic or political situation.
Most investors who’ve paid attention to forecasts have done worse than they would have done had they simply ignored forecasts.
Buffett and Munger focus exclusively on the future cash flow of the individual business as compared to its current price. Typically they assume the future cash flow will occur over decades. Thus, shorter term forecasts of the stock market or the economy are irrelevant, in addition to being fundamentally unreliable (see Macro Forecasting below).
Central to this approach is circle of competence, or a clear awareness of which businesses you can understand. It doesn’t matter if most businesses are beyond your ability to analyze as long as you stick with those businesses than you can analyze.
Even if you were only able to understand 100-200 simple businesses, eventually a few of them will become cheap for temporary reasons. That’s all you need. Getting to that point may take a few years, though, so it’s essential that you enjoy the process. Otherwise, just stick with index funds or quantitative value funds.
For a value investor, there are no called strikes. As Buffett has explained, you can stand at the plate all day and watch hundreds of “pitches” “” businesses at specific prices “” without taking a swing. You wait for the “fat pitch” “” a business you can really understand that’s available at a good price.
What’s the ideal business? One that has a high and sustainable ROIC (and ROE). Or, as Buffett put it at the 1987 Berkshire meeting:
Something that costs a penny, sells for a dollar and is habit forming.
Moreover, a company with a sustainably high ROIC is the best hedge against inflation over time, according to Buffett and Munger. But it’s very difficult to find businesses like this. There just aren’t that many. And since Buffett and Munger have to invest tens of billions of dollars a year “” unlike earlier in their careers “” they’re forced to focus mostly on larger businesses.
At the 1996 meeting, Buffett observed that they invested in high-quality businesses that were easy to understand and not likely to change much. Specifically, they had investments in soft drinks, candy, shaving, and chewing gum. Buffett:
There’s not a whole lot of technology going into the art of the chew.
TEMPERAMENT AND DISCIPLINE
Buffett and Munger have observed that having the right temperament and extraordinary discipline is far more important than IQ for long-term success in investing. (Of course, if you’ve got the right temperament plus a great deal of discipline, high IQ certainly helps.)
High IQ alone won’t bring success in investing. Buffett said at the 2004 meeting that Sir Isaac Newton, one of the smartest people in history, wasted much time trying to turn lead into gold and also lost a bundle in the South Sea Bubble.
MODERN PORTFOLIO THEORY
Buffett and Munger have been critical of modern portfolio theory for a long time. Munger often notes that to a man with a hammer, every problem looks pretty much like a nail. Buffett has observed that academics have been able to gather huge amounts of data on past stock prices. When there’s so much data, it’s often easy to find patterns. Also, those who have been trained in higher mathematics sometimes feel the need to apply that skill even to areas that are better understood in very simple terms. Buffett:
The business schools reward difficult, complex behavior more than simple behavior, but simple behavior is more effective.
A key part of modern portfolio theory is EMH “” the Efficient Market Hypothesis. EMH takes different forms. But essentially it says that all available information is already reflected in stock prices. Therefore, it’s not possible for any investor to beat the market except by luck.
Buffett and Munger have maintained that markets are usually efficient, but not always. If an investor has enough patience and diligence, occasionally she will discover certain stock prices that are far away from intrinsic value.
Moreover, a stock is not just a price that wiggles around. A stock represents fractional ownership in the underlying business. Some businesses are simple enough to be understandable. The dedicated investor can gain enough understanding of certain businesses so that she can know if the stock price is obviously too high or too low. Modern portfolio theorists have overlooked the fact that a stock represents fractional ownership of a business.
Buffett advises thinking about buying part ownership of a business like you would think about buying a farm. You’d want to look at how much it produces on average and how much you’d be willing to pay for that. Only then would you look at the current price.
(Farmland at Moss Landing, California, Photo by Fastily via Wikimedia Commons)
Furthermore, if you owned a farm, you wouldn’t consider selling just because a farm nearby was sold for a lower-than-expected price. In Chapter 12 of The General Theory of Employment, Interest, and Money, John Maynard Keynes uses a similar example:
But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) 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.
GROWTH, BOOK VALUE
Growth only creates value if the company has a return on invested capital (ROIC) that is higher than the cost of capital.
Also, if a company has a sustainably high ROIC and ROE, then book value is not an important factor in the investment decision. Book value, Buffett said, is what was put into the business in the past. What matters is how much cash you can take out of the business in the future. If the company is high quality “” with a sustainably high ROIC and ROE “” then it’s hard to pay too high a price if you’re going to hold it for decades. (In the 1990’s, Buffett and Munger noted that the average ROE for American businesses was about 12-13%.)
However, it’s exceptionally difficult to identify a business that will maintain a high ROIC and ROE for a couple of decades or more. Buffett and Munger have been able to do it because they are seriously smart and they are learning machines who’ve constantly evolved. Most investors simply cannot beat the market, regardless of their method. Most investors would be better off investing in a low-cost index fund or in a quantitative value fund.
BUSINESS RISK
(Photo by Alain Lacroix)
At the 1997 meeting, Buffett identified three key business risks. First, in general, a company with high debt is at risk of bankruptcy. A good recent example of this is Seadrill Ltd. (NYSE: SDRL). This company was an industry leader that was started by billionaire John Fredriksen (who started out in shipping, which he continues to do). Seadrill is an excellent company, but it’s now in serious trouble because of its high debt levels. Fredriksen has been forced to launch a new offshore drilling company.
The second business risk Buffett mentioned is capital intensity. The ideal business has a sustainably high ROE and low capital requirements. That doesn’t necessarily mean that a capital-intensive business can’t be a good investment. For instance, Berkshire recently acquired the railroad BNSF. The ROE obviously isn’t nearly as high as that of a company like See’s Candies. But it’s a solid investment for Berkshire.
As Buffett and Munger have explained, if the ROE on a regulated business is 11-12%, but part of Berkshire’s capital is insurance float that costs 3% or less, that’s obviously a good situation because the return on capital exceeds the cost by at least 8-9% per year. In some years, Berkshire’s insurance float has even had a negative cost, meaning that Berkshire has been paid to hold it.
A third business risk is being in a commodity business. Because a true commodity business “” like an oil producer “” has no control over price, it must be a low-cost producer to be a good investment.
GOOD MANAGERS
Buffett and Munger have explained that they look for .400 hitters in the business world. Buffett says when he finds one, and can buy the business at a reasonable price while keeping the manager in place, he is thrilled. He doesn’t then try to tell the .400 hitter how to swing. Instead, he lets the star continue to run the business as before.
Buffett has also commented that it’s quite difficult to pay a .400 hitter too much. A great manager can make a world of difference for a business. For instance, when Robert Goizueta took over Coca-Cola in 1981, its market value was $4 billion. As of 1997, Buffett remarked, the market value exceeded $150 billion.
Using another analogy, Buffett has said that he loves painting his own canvas and getting applause for it. So he looks for managers who are wired the same way. He gives them the freedom to continue to paint their own paintings. Also, they don’t have to talk with shareholders, lawyers, reporters, etc.
SUSTAINABLE COMPETITIVE ADVANTAGE
Buffett and Munger look for companies that have a sustainably high ROIC (and ROE). To maintain a high ROIC (and ROE) requires a sustainable competitive advantage. Buffett:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.
Buffett and Munger have also used the term moat. In 1995, Munger said the ideal business is a terrific castle with an honest lord. The moat is a barrier to competition and can take many forms including low costs, patents, trademarks, technology, or advantages of scale.
(Bodiam Castle in England, Photo by Allen Watkin, via Wikimedia Commons)
A sustainable competitive advantage “” a moat “” is very rare. The essence of capitalism is that high returns get competed away. Generally if a company is experiencing a high ROIC, competitors will enter the market and drive the ROIC down toward the cost of capital.
ROIC (return on invested capital) is a more accurate measure of how the business is doing than ROE (return on equity). Buffett uses return on net tangible assets, which is ROIC.
But ROE is close to ROIC for companies with low or no debt, which are the types of companies Berkshire usually prefers.
Also, ROE is a bit more intuitive when you’re thinking about the advantages of holding a high-quality business for decades. In this situation, your returns as an investor will approximate the ROE over time.
When you buy a great business with a sustainably high ROIC, you typically only have to be smart once, says Buffett. But if it’s a mediocre business, you have to stay smart.
Buffett has also observed that paying a high price for a great business is rarely a mistake.
KNOW THE BIG COST
A superior cost structure is often central to a company’s competitive advantage. Buffett said in 2001 that he doesn’t care whether the business is raw-material-intensive, people-intensive, or capital-intensive. What matters is that the business must have a sustainable competitive advantage whereby a relatively high ROIC and ROE can be maintained.
ROIC must stay above the cost of capital. A superior cost structure is a common way to help achieve this.
BASIC “MACRO THESIS”
The only long-term macro thesis Buffett has is that America will continue to do well and grow over time. Buffett often points out that in the 20th century, there were wars, a depression, epidemics, recessions, etc., but the Dow went from 66 to 11,000 and GDP per capita increased sixfold.
As long as you believe GDP per capita will continue to increase, even if a bit more slowly, then you want to buy (and hold) good businesses. For most investors, you should simply buy (and hold) either a quantitative value fund or a low-cost broad market index fund.
Another way Buffett has put it: In 1790, there were four million people in America, 290 million in China, and 100 million in Europe. But 215 years later “” as of 2005 “” America has 30% of the world’s GDP. It’s an unbelievable success story.
MACRO FORECASTING
Looking historically, there are virtually no top investors or business people who have done well from macro forecasting “” which includes trying to predict the stock market, the economy, interest rates, or elections. As for those investors who have done well from macro forecasting, luck played a key role in most cases.
Warren Buffett puts it best:
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.
We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
Market forecasters will fill your ear but never fill your wallet.
Forecastsmay tell you a great deal about the forecaster; they tell you nothing about the future.
Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
[On economic forecasts:] Why spend time talking about something you don’t know anything about? People do it all the time, but why do it?
I don’t invest a dime based on macro forecasts.
Consider efforts to forecast what the stock market will do in any given year. There have always been pundits making such predictions, but no one has been able to do it correctly with any sort of consistency.
(Illustration by Maxim Popov)
Furthermore, if you simply focus on individual businesses, as Buffett and Munger advise and have always done, then what happens to the overall stock market doesn’t matter. Bear markets occur periodically, but their timing is unpredictable. Also, even in a bear market, some stocks decline less than the market and some stocks even go up. If you’re focused on individual businesses, then the only “macro” thesis you need is that the U.S. and global economy will continue to grow over time.
Virtually every top investor and business person has done well by being heavily invested in businesses (often only a few). As Buffett and Munger have repeatedly observed, understanding a business is achievable, while forecasting the stock market is not.
Indeed, when Buffett started his career as an investor, both Graham and his father told him the Dow was too high. Buffett had about $10,000. Buffett has commented since then that if he had listened to Graham and his father, he would still probably have about $10,000.
Now, every year there are “pundits” who make predictions about the stock market. Therefore, as a matter of pure chance, there will always be people in any given year who are “right.” But there’s zero evidence that any of those who were “right” at some point in the past have been correct with any sort of reliability. In other words, the fact that certain pundits turned out to be right during one period tells you virtually nothing about which pundits will turn out to be right in some future period.
There are always naysayers making bearish predictions. But anyone who owned an S&P 500 index fund from 2007 to present (early 2018) would have done dramatically better than most of those who listened to naysayers. Buffett:
Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.
Consider Buffett’s recent 10-year bet on index funds versus hedge funds.
Many forecasters (including many investors) have predicted, starting in 2012 or 2013 and continuing up until today (April 2018), that the S&P 500 Index was going to be far lower. One reason the hedge funds involved in Buffett’s bet didn’t do well at all, as a group, is because many of them were hedged against a possible market decline.
The timing of bear markets is unpredictable. Also, the stock market has recovered from every decline and has eventually gone on to new highs. (As long as humans keep making progress in technology and in other areas, the stock market will keep increasing over the long term.) For these reasons, it virtually never pays to hedge against market declines.
Most of those who successfully hedged against the bear market in 2008 missed the recovery starting in 2009. Said differently, most of those who “successfully” (mostly by luck) hedged against the bear market in 2008 would have been at least as well off if they’d stayed fully invested without hedging.
Virtually no one predicted 2800+ on the S&P 500, which again shows that forecasting the stock market is just not doable on a repeated basis.
The largest companies include Apple, Alphabet (Google), Microsoft, Amazon, and Facebook, most of which have far higher normalized profit margins and ROE than the vast majority of large companies in history. Software and related technologies are becoming much more important in the world economy.
Moreover, progress in computer science or in other technologies could accelerate. For instance, a big breakthrough in artificial intelligence could conceivably boost GDP by 5-10% or more. Historically, it’s never paid to bet against progress, especially technological progress.
WHAT vs. WHEN
In 1994, Munger commented that figuring out the future of an individual business is much more doable “” and repeatable “” than trying to make a macro forecast “” which can’t be done repeatedly. Munger:
To think about what will happen versus when is a far more efficient way to behave.
CAPITAL-INTENSIVE BUSINESSES
In 2010, Buffett discussed Berkshire’s recent investment in capital-intensive businesses. He noted that for most of its history under current management, Berkshire tried to invest in high ROIC (and ROE) businesses that don’t require much capital, with See’s Candies being the best example. However, due to its many successful investments, Buffett has had torrents of cash coming to headquarters for many years now.
There simply are not many businesses like See’s, and besides, as Berkshire gets larger, Buffett would need to find hundreds of companies like See’s in order to move the needle.
Buffett started investing in MidAmerican Energy in 1999. Buffett learned that a regulated, capital-intensive business like this could earn decent returns of 11-12%. Not brilliant and nothing like See’s. But still decent, with ROIC above the cost of capital.
Based on his experience with MidAmerican Energy, Buffett reached the decision to acquire Burlington Northern Santa Fe (BNSF) for Berkshire. Again, a capital-intensive, regulated business, but with a strong competitive position and with decent returns on capital.
(BNSF, Photo by Winnie Chao)
Also remember that Berkshire’s insurance float continues to have low cost “” often 3% or less, and sometimes even negative. Investing such low-cost float at 11-12% returns is quite good.
CYCLICAL INDUSTRIES
Most investors don’t invest in cyclical companies because they don’t like earnings that are highly variable and unpredictable. As a result, many cyclical companies can get very cheap indeed.
Buffett and Munger focus on normalized earnings instead of current earnings. The volatility and unpredictability of current earnings creates some wonderful opportunities for long-term value investors.
The Boole Microcap Fund had an investment in Atwood Oceanics, which was acquired by Ensco plc. (NYSE: ESV) last year. The Boole Fund continues to hold Ensco because it’s very cheap. The current price is $5.43, while book value per share is $26.86.
Just how cheap is Ensco?
Low case: If oil prices languish below $60 for the next 3 to 5 years, then Ensco will be a survivor, due to its large fleet, globally diverse customer base, industry leading customer satisfaction ratings, and well-capitalized position. Ensco is likely worth at least half of book value ($26.86 a share), which would be $13.43 a share, nearly 150% higher than today’s $5.43.
Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years ““ which is likely based on long-term supply and demand ““ then Ensco is probably worth at least book value ($26.86 a share), nearly 400% higher than today’s $5.43.
High case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years ““ and if global rig utilization normalizes ““ then Ensco could easily be worth at least 150% of book value, which is $40+ a share, over 640% higher than today’s $5.43.
Note that oil-related companies in general are often excellent long-term investments. They outperform the broader market over time, especially when they are cheap, as they are today. And oil-related companies offer notable diversification, inflation protection, and exposure to global growth.
Buffett has pointed out that See’s Candies loses money eight months out of the year. But the company has been phenomenally profitable over the decades.
(Photo by Cihcvlss, via Wikimedia Commons)
Thinking for Yourself
LOGIC, NOT EMOTION
(Photo by Djama86)
Buffett first learned this lesson from Ben Graham:
You’re neither right nor wrong because the crowd disagrees with you. You’re right because your data and reasoning are right.
Focus on what is knowable and important. Ignore the crowd. The market is there to serve you, not to instruct you. Graham:
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.
Buffett has often suggested, including in 2010, that most investors would be better off if there were no stock market quotations. Buy a good business and then totally ignore prices. Just follow the progress of the business over time. If you don’t want to follow individual businesses, then simply buy a low-cost index fund or a quantitative value fund.
INTELLECTUAL INDEPENDENCE
Buffett and Munger have pointed out that you’re better off as an investor not knowing popular opinion. You’re better off learning as much as you can about businesses that you can understand. You’re better off insulating yourself from the crowd.
Along these lines, Buffett has also commented that he’s never read an analyst report. All the information you need can be found in the company’s financial statements. If you need more information, you can conduct scuttlebutt research by talking with employees, customers, suppliers, competitors, etc.
Munger has said that you should focus only on the intrinsic value of the business. If it’s a business you can understand, then only after you have a rough estimate of intrinsic value do you look at the current price. In other words, you figure out the value of the business based on what it does and its financials. You don’t look to the current price for information (other than as a market consensus).
IN/OUT/TOO HARD
Buffett and Munger have remarked that they have three boxes for potential investment ideas: in, out, and too hard.
It’s a big advantage if you classify most ideas as “too hard” because that means you can focus only on those businesses that you can understand. As Buffett said at the 2006 meeting, if you’re fast, you can run the 100 meters for the gold medal. You don’t have to throw the shot put.
Buffett has also often observed that generally you don’t get paid for degree of difficulty in investing. Many of the best investment ideas have been rather simple.
At the 2008 meeting, Buffett mentioned that if it’s a worthwhile investment idea, he can usually make a good decision in five minutes. Buffett said spending five months wouldn’t improve the quality of the decision past the five minute point. Similarly, if it’s a “no go,” Buffett typically cuts off the proposal mid-sentence.
INFORMATION: GOOD, NOT QUICK
In 1994, Buffett said good information is far more important than quick information. His primary source for information is annual reports. Buffett said if the mail and quotes were delayed three weeks, he would still do just fine.
LifetimeLearning
LIFETIME LEARNING AND CONSTRUCTIVE CRITICISM
Buffett and Munger are learning machines. Buffett always says to read everything you can get your hands on.
Munger observed in 2003 that “Berkshire has been built on criticism.” The ability to take constructive criticism is a central part of being a rational learning machine.
(Illustration by Hafakot)
Buffett and Munger also indicated in 2003 that their biggest errors have been errors of omission rather than commission. Buffett said that Berkshire would have made roughly $10 billion if he had finished buying Wal-Mart. The stock went up a bit when Buffett started buying. Buffett waited for it to come back down, but it never did.
INVEST IN YOURSELF
Buffett and Munger contend that the very best investment you can make is in yourself. Become a learning machine, and never stop learning about your passions and areas of interest. You’ve got one brain and one life, so maximize them and have fun along the way.
(Photo by Marek Uliasz)
Do what you love. Work for people you admire. You can become, to a large extent, the person you want to be, notes Buffett. And if you hang around people better than you, you’ll become better.
MAKING IT IN BUSINESS
In 2010, Buffett said the common factor for all of Berkshire’s excellent managers is that they love what they do. Buffett noted that there’s nothing like following your passion.
Munger again recommended being a learning machine. If you resolve to go to bed each night wiser than when you got up, you may rise slowly, but you’re sure to rise.
Buffett and Munger also reminded investors: stay in your circle of competence. The size of the circle isn’t important, but knowing its boundaries is crucial.
For most investors, a quantitative value fund or an index fund is the best option. (Buffett advises his own friends of modest means to stick with index funds.)
The Boole Microcap Fund is a quantitative value fund.
MULTIDISCIPLINARY MODELS, OPPORTUNITY COST
Munger has long argued that in order to be as rational a thinker and decision-maker as you can be, you need to master the primary models in the major disciplines. Munger noted at the meeting in 2000 that these models include probability in math and break-points and back-up systems in engineering.
If you’ve only mastered one area, that can create many problems.
To a man with a hammer, every problem looks pretty much like a nail.
Moreover, Munger has pointed out that when you’re making a decision “” investment or otherwise “” your best decision is automatically a function of your next-best decision, which is your “opportunity cost.”
BIOGRAPHIES: IMPROVE YOUR FRIENDS
In 1988, Munger recommended reading biographies and “making friends with the eminent dead.” This is a good way to improve your experience while also improving the quality of your friends.
Biographies are often a good way to learn about a specific subject when the person written about is an expert in that subject.
What is Berkshire Hathaway?
People often think Berkshire Hathaway is like a mutual fund that owns many positions in equities. But that’s not correct. See Buffett’s 2016 letter to shareholders: http://berkshirehathaway.com/letters/2016ltr.pdf
(I focus here on the 2016 letter because it’s the most recent letter that still contains some discussion of the major business areas. Going forward “”including 2017 “” you have to go to the annual report to see the discussion. Here’s the 2017 annual report: http://berkshirehathaway.com/2017ar/2017ar.pdf)
(Berkshire Hathaway logo via Wikimedia Commons)
First, Berkshire Hathaway is one of the largest and most successful insurance companies in the world. Berkshire owns excellent property/casualty (P/C) insurance companies, including reinsurance and also GEICO. Berkshire has operated at an underwriting profit for 14 consecutive years “” up to but not including 2017 “” generating a total pre-tax gain of $28 billion.
Second, Berkshire owns outright many great (and many good) individual businesses. This includes 44 businesses in manufacturing, services, and retailing. Buffett refers to this group as a “motley crew,” with a couple earning an unlevered return on net tangible assets in excess of 100%. Most earn returns in the 12% to 20% range. As well, some of these businesses have many individual business lines. For instance, notes Buffett, Marmon has 175 separate business units.
Many of these businesses can operate far better being owned by Berkshire than they would if they were independent. These companies can focus entirely on building long-term intrinsic value, without worrying about shorter term results or capital. They can make the capital investments that make sense. If they generate excess capital, it is sent to the parent company level, where Warren Buffett can invest it in the best available opportunities.
Viewed as a single business, says Buffett, in 2016 this entity employed $24 billion in net tangible assets and earned 24% after-tax on that capital.
Recent additions include Duracell and Precision Castparts.
Third, Berkshire owns regulated businesses such as Berkshire Hathaway Energy “” a multi-state, multi-country utility business, including renewable energy projects and gas pipelines. Buffett:
When it comes to wind energy, Iowa is the Saudi Arabia of America.
The other major regulated business is Burlington Northern Santa Fe. For BNSF, it takes a single gallon of diesel fuel to move a ton of freight almost 500 miles. This makes railroads four times as fuel-efficient as trucks, writes Buffett.
Fourth, Berkshire owns businesses Buffett classifies as finance and financial products. This includes CORT (furniture), XTRA (semi-trailers), and Marmon (primarily tank cars but also freight cars, intermodal tank containers and cranes). And there’s Clayton Homes. Most of its revenue comes from the sale of manufactured homes, but most of its earnings result from a large mortgage portfolio.
Clayton’s customers are usually lower-income families who would not otherwise be able to own a home. Monthly payments average only $587, including the cost of insurance and property taxes. Clayton has programs “” such as loan extensions and payment forgiveness “” to help borrowers through difficulties. Clayton foreclosed on only 2.5% of its mortgage portfolio in 2016.
Finally, Berkshire has well over $100 billion in public equities, such as American Express, Apple, Coca-Cola, IBM, Phillips 66, U.S. Bancorp, and Wells Fargo. Note that Todd Combs and Ted Weschler each manage more than $12 billion of Berkshire’s public equity portfolio.
Buffett and Munger have always been highly ethical leaders, seeking to follow all laws and rules, and also working to treat their partners and employees as they would wish to be treated were their positions reversed.
BERKSHIRE: GOOD HOME FOR GOOD BUSINESSES
In 2013, Munger remarked that Buffett was highly successful early in his career, when he managed an investment partnership, because he had very little competition. This occurred primarily because Buffett focused on microcap companies, where few other investors ever look.
Even today, micro caps are overlooked and neglected by the vast majority of investors. There’s far less competition in microcap investing, especially as compared with mid caps and large caps. You can usually find a far greater number of undervalued stocks among micro caps. That’s why I launched the Boole Microcap Fund, to help folks profit in a systematic way from inexpensive micro caps: https://boolefund.com/best-performers-microcap-stocks/
Because Buffett is one of the best investors ever, his returns today, were he starting again, would still be phenomenal. In fact, Buffett has said on many occasions that if he were starting again today, he could get 50% annual returns by investing in micro caps.
So the key to Buffett’s early success was no real competition.
Similarly, one reason Berkshire Hathaway has become remarkably successful today is lack of competition. Berkshire is one of the only companies that buys great or good businesses on the condition that those businesses continue to be run as before (ideally by the same manager). Moreover, Buffett can usually decide in five minutes whether to buy the business in question. And no seller ever worries about Berkshire’s check clearing.
Berkshire gets many calls no one else gets. Berkshire has the money, the willingness to act immediately, and the policy that the business be run as before. Perhaps even more importantly, Munger has noted, Berkshire uses the golden rule in its treatment of subsidiaries: Berkshire seeks to treat subsidiaries as it would itself like to be treated were the positions reversed.
To illustrate the point, Buffett told the story of a business owner thinking about selling. He worried that if he sold to competitors, they would fire the people who built the business. The new owners would behave like Attila the Hun.
If the owner sold the business to a private equity firm, they would load it up with debt with the goal of reselling it. And when they resold it, the Attila the Hun scenario would occur again.
The owner concluded that selling to Berkshire was not necessarily wonderful, but it was the only real choice. Buffett then commented that this particular business turned out to be an outstanding acquisition for Berkshire. The people stayed, and the previous owner is still doing what he loves. Buffett:
Our competitive advantage is that we have no competitors.
A similar situation happened with Nebraska Furniture Mart (NFM). Rose Blumkin, known as “Mrs. B”, borrowed $500 from her brother and launched NFM in 1937. Mrs. B sold products at cheaper prices than her competitors in the furniture business.
(Nebraska Furniture Mart logo, via Wikimedia Commons)
In 1983, at the age of 89, Mrs. B was interested in selling. Many were interested in buying, but Mrs. B only wanted to sell to “Mr. Buffett”. She sold him 80% of Nebraska Furniture Mart based on a one-page deal and a handshake. (Buffett later commented that Mrs. B was the best entrepreneur he’d ever met and could run rings around chief executives of the Fortune 500.)
Finally, Buffett mentioned that Berkshire has a different shareholder base. Virtually everyone “” including owner/managers “” thinks like a long-term owner.
NO MASTER PLAN
In 2001, say Pecaut and Wrenn, Buffett observed that he and Charlie did not have any master plan. They just were continuing to focus on allocating capital as rationally as they could.
Henry Singleton, CEO of Teledyne, who has been described by Buffett and Munger as the greatest CEO/capital allocator in American business history, also never had a plan.
Furthermore, Buffett and Munger have often remarked that, as a value investor, you only need one good idea a year to do well over time.
CULTURE
In 2015, Buffett talked about developing the right culture. It takes a long time. Culture comes from the top. The leader must consistently set a good example and communicate well. Good behavior must be rewarded and bad behavior punished.
The Golden Rule
Buffett asserted that always striving to treat people the way you would like to be treated has always been a core value at Berkshire.
MUNGER’S OPTIMISM
People love Munger for his brilliance, wit, and honesty. He tells it like it is in as few words as possible. Munger sometimes comes across as a curmudgeon next to Buffett, who’s typically very upbeat and optimistic.
But the truth is that Munger loves science and technology, and is extremely optimistic about the future. He has said that most problems are technical problems that will be solved. The future is very bright.
At the same time, Munger recommends low expectations and gratitude “” in addition to hard work and honesty “” as a recipe for personal happiness. Be grateful for all the good things and good people in life. Keep your expectations low, and you’ll often be pleasantly surprised. Be stoic through the inevitable challenges.
Munger also commented at a Daily Journal meeting in 2016 that what you want to be is stressed and challenged. Your full potential can only come out if you challenge yourself and if you embrace all the challenges that life throws at you.
LEGACY
In 2011, Munger joked that Warren wanted people to say at his funeral, “That’s the oldest looking corpse I ever saw.”
More seriously, write Pecaut and Wrenn, Munger wanted his own tombstone to read, “Fairly won, wisely used.”
Buffett, for his part, wanted to be remembered as “Teacher.” Buffett loves teaching. At every annual meeting, Buffett and Munger spend virtually six hours teaching. In addition to that, Buffett writes the annual letter as a form of teaching. Buffett appears in the media frequently. And Buffett generously hosts many hundreds of business students, who come in groups every year to Omaha for hours of great teaching.
As a young man, Buffett taught at the University of Nebraska:
(via Wikimedia Commons)
Munger:
The best thing a human being can do is to help another human being know more.
Insurance
BUYING NATIONAL INDEMNITY
In 2003, Buffett told the story of how he bought National Indemnity from Jack Ringwalt in 1967. Buffett had noticed that Ringwalt would get worked up once a year for 15 minutes, threatening to sell the company. Buffett asked a mutual friend, Charlie Heider, to let Buffett know the next time Ringwalt had an episode.
Heider called Buffett one day to let him know Jack was ready. Buffett immediately called Ringwalt and was able to buy the company from him. National Indemnity was the foundation for Berkshire Hathaway, which today is one of the largest and most successful insurance companies in the world.
INSURANCE AND HURRICANES
In 2006, Buffett remarked that Hurricane Katrina was a $60 billion event and Berkshire paid out $3.4 billion. This brought up the question of whether the preceding two years, or the previous 100 years, was the best way to think about the future. Buffett announced:
We’re in. If the last two years hold, we’re not getting enough. If the last 100 years hold, we’re getting paid plenty.
Buffett imagined that there could be a $250 billion event, and that Berkshire’s exposure would be 4%, or $10 billion. Pecaut and Wrenn pose the following question. Berkshire has had about 8-10% of the property/casualty (P/C) insurance market based on their float. But their exposure is around 4-5%. How? Shrewd, it seems.
Berkshire doesn’t care at all about smoothness of earnings, especially in P/C insurance. Berkshire always has at least $20 billion in cash. And it’s approaching the point where more cash than that will come in every year from its wide variety of businesses. Thus, Berkshire is easily able to cover occasional large payments in P/C.
In brief, Berkshire gets larger, though lumpier earnings because it’s designed that way, whereas Berkshire’s competitors need some smoothness in their earnings. Buffett says this is close to a permanent advantage for Berkshire that increases every year.
BUILDING THE INSURANCE BUSINESS
In 2011, Buffett said that Ajit Jain built Berkshire’s reinsurance business from scratch. Buffett pointed out that Ajit is as rational as anyone he’s met and loves what he does. There’s not a single decision Ajit has made that Buffett thinks he could have done better.
Furthermore, before Ajit came along, Berkshire spent 15 years in reinsurance not making any money. Ajit turned Berkshire’s reinsurance business into a real profit center.
Buffett also remarked that it’s difficult to differentiate between a long-term trend and a series of random events. This makes it very challenging to price reinsurance of catastrophes. Buffett’s tactic is to assume the worst and price from there.
(Photo by Wittayayut Seethong)
Munger observed that P/C is not such a good business in itself. You must be in the top 10% to do well. Of course, to the extent that Berkshire maintains its huge float at a very low cost, it gains additional long-term benefits by investing a portion of the float in undervalued or high-quality businesses.
In 2013, Buffett commented that it’s much better to build the reinsurance business “” rather than buy “” once you’ve got the right people and plenty of capital.
As Pecaut and Wrenn record, Buffett has often emphasized that Berkshire is “an unusually rational place.” Buffett has said that it’s been good that he and Charlie have not had outside influences pushing them in unwanted directions.
Specifically in insurance, Berkshire has chosen to write no policies at all (for long stretches of time) if the prices are not right. This has added to their long-term profitability, even though their earnings are lumpier than most. (One time National Indemnity shrunk its business by 80% until prices recovered.)
Most insurers are pressured by Wall Street to increase premiums every year. But some years insurance prices don’t make sense and virtually guarantee losses. As well, many managers do not have much vested interest in the insurer they manage. This makes them even more likely to give in because they don’t want criticism or pressure.
To make matters worse, if other insurers are writing policies and collecting premiums when prices don’t make sense, then there is “social proof” or a “bandwagon effect”: it appears that many others are doing well at the moment, even if it’s long-term unprofitable.
It’s not greed, but envy that drives much human behavior, says Buffett. Envy is particularly stupid because there’s no upside, adds Munger. Buffett agrees, joking: “Gluttony is a lot of fun. Lust has its place, too, but we won’t get into that.”
Recently some hedge funds have gotten into reinsurance. Buffett commented that anything Wall Street can sell, it will. Munger chimed in, saying Wall Street would “throw in a lot of big words, too.”
Buffett concluded that if you own a gas station, and the guy across the street sells below cost, you’ve got a problem. But insurance works differently. It pays over time not to write policies when prices don’t make sense.
Munger: “With our cranky methods, we probably have the best insurance operation in the world. So why change?”
THE UNEXPECTED
Having spent decades in insurance, Buffett and Munger know how to think about risks and probabilities. In 2004, Buffett said people tend to underestimate risks that haven’t happened for awhile, while overestimating risks when they’ve happened recently.
Buffett also has repeatedly stated that the person who runs Berkshire after Buffett must be able to consider scenarios that have never occurred before.
Here’s something else to keep in mind. Assume there’s only a 2% chance of some event happening in any given year. Assume the probability stays unchanged from year to year. Then after 50 years, there’s a 63.6% chance the event will have occurred. After 100 years, there’s an 86.7% chance the event will have ocurred.
(Photo by Michele Lombardo)
Berkshire is extremely rigorous in its consideration of various risks. Buffett quipped at the 2005 meeting:
It’s Armageddon around here every day.
Buffett and Munger say they’ll never lose sleep because they are very careful and conservative in how they’ve structured Berkshire. As Buffett asks, why have even a tiny risk of failure just to get an extra percentage point of return? Ironically, write Pecaut and Wrenn, Buffett and Munger’s conservative approach has led to one of the highest multi-decade records of compounding anywhere.
Comments on Specific Investments
BYD
In 2010, Munger recounted how he had lost money in a venture capital investment when he was young. Finally, decades later, Munger came across BYD, a Chinese maker of rechargeable batteries and electric cars, employing over 17,000 top engineers. Berkshire made an investment in BYD that has worked well.
(BYD logo via Wikimedia Commons)
Munger suggested that BYD is an illustration of Berkshire’s commitment to keep learning.
GEICO
When Berkshire acquired control of GEICO in 1995, the auto insurer had 2.5% market share. At the end of 2016, GEICO had reached 12% of industry volume. GEICO’s low costs “” they sell direct without agents “” gives it a very sustainable competitive advantage.
(GEICO logo by Dream out loud, via Wikimedia Commons)
Buffett recognized GEICO’s advantage long ago when writing his Columbia grad school thesis on the company. Since 1995, Berkshire, under Buffett’s direction, has spent annually more on advertising for GEICO than the rest of the auto insurance industry combined. The net result is that GEICO continues to gobble up market share every year.
Pecaut and Wrenn record that in 2013, two-thirds of all new auto policies went to GEICO.
Additionally, GEICO has enjoyed excellent management. Buffett on Tony Nicely:
Tony became CEO of GEICO in 1993, and since then the company has been flying. There is no better manager than Tony, who brings his combination of brilliance, dedication and soundness to the job. (The latter quality is essential to sustained success. As Charlie says, it’s great to have a manager with a 160 IQ ““ unless he thinks it’s 180.) Like Ajit, Tony has created tens of billions of value for Berkshire.
Berkshire recently joined with 3G Capital Partners on some deals, including the $23 billion acquisition of Heinz in 2013. 3G’s Jorge Paulo Lemann and Warren Buffett have known each other since they were both on the board of Gillette.
At the 2015 meeting, a question was asked about 3G’s method of significantly reducing the workforce of recently acquired companies. Buffett replied that Burger King was now outperforming its competitors by a wide margin, thanks to the cost-cutting methods of 3G.
Buffett then noted that the railroad business had 1.6 million people employed after World War II. Now the railroad industry has under 200,000 employees, but it is much larger, more efficient, and safer. In short, Buffett applauds 3G’s achievements. Ongoing progress and improvement is the nature of capitalism.
ISCAR
In 2013, Buffett announced that Berkshire was buying the final 20% of ISCAR that it didn’t own from the Wertheimer family for roughly $2 billion.
Buffett compared ISCAR to Sandvik, a Swedish company that owns Sandvik Tooling and Seco Tools “” competitors of ISCAR. Buffett stated that Sandvik is very good, but ISCAR “” an Israeli company “” is much better.
How did ISCAR become so good? Buffett said the combination of brains and a huge amount of passion is what created ISCAR’s success. ISCAR has long had talented and extremely hard-working people who constantly improve the product and work to delight customers. Buffett praised ISCAR as one of the best companies in the world.
Other Topics
THE GAME OF BRIDGE
In the 1990’s, Buffett and Munger commented that their main job is capital allocation. Buffett: “Aside from that, we play bridge.” Bridge is a great game for value investors because you constantly have to make decisions based on probabilities.
www.bridgebase.com is a great site for learning and playing bridge. Like most games, bridge gets increasingly fun the more you learn how to play. (I enjoy bridge and chess, though I’m still a novice at both.)
(Image by Otm, via Wikimedia Commons)
THE OVARIAN LOTTERY
In order to create a fair economic and political system, Buffett suggests using a thought experiment called The Ovarian Lottery. The idea is that you get to write the rules for society. The catch is that it’s 24 hours before you will be born and you don’t know if you’ll be bright or retarded, female or male, able or disabled, etc.
No one chooses the advantages or disadvantages of one’s birth. If you go through this thought experiment carefully, you’re likely to set up a fair society. American political philosopher John Rawls used a similar thought experiment: https://en.wikipedia.org/wiki/John_Rawls
Warren Buffett’s hero is his father, Howard Buffett. Warren has called him the best human being he ever knew. But Howard Buffett was a Republican. Warren Buffett became a Democrat over time, partly through the influence of his wife, Susie, and partly due to thinking along the lines of The Ovarian Lottery.
PREDICTING CHANGES IN TECHNOLOGY
Buffett and Munger have generally avoided investing in technology companies because it’s extremely difficult to predict how technology will change. As Munger commented at the 1999 meeting:
The development of the streetcar led to the rise of the department store. Since streetcar lines are immovable, it was thought that the department store had an unbeatable position. Offering revolving credit and a remarkable breadth of merchandise, the department store was king. Yet in time, while the rails remained, the streetcars disappeared. People moved to the suburbs, which led to the rise of the shopping center and ended the dominance of department stores.
Now the Internet poses a threat to both.
INFLATION: GOLD vs. WONDERFUL BUSINESS
What’s a better inflation hedge, gold or owning a wonderful business?
When Buffett took over Berkshire, the stock was trading at three-quarters of an ounce of gold. Now gold is just north of $1,280, while Berkshire is around $250,000. Berkshire has returned 20x more than gold. It’s no contest.
LUCK AND AN OPEN MIND
In 2015, Buffett remarked that he’d experienced many pieces of good luck, three in particular: meeting Lorimer Davidson, buying National Indemnity, and hiring Ajit Jain.
When Buffett was a young man, he stopped by a GEICO office on a Saturday. Buffett told the guard he was a student of Ben Graham. The guard let him in. Buffett met Lorimer Davidson, a GEICO executive. Davidson thought he would spend 5 minutes helping a student of Graham. But when Davidson started talking with Buffett, he recognized how unusually smart and knowledgeable Buffett was. So Davidson answered Buffett’s questions and educated him on the insurance business for four hours. Buffett claims that he learned more in those four hours than he could have at any university course.
As described earlier, Buffett bought National Indemnity from Jack Ringwalt. Buffett had noticed that Ringwalt would want to sell for about 15 minutes each year. Buffett was very patient, and then persuasive and decisive.
In the mid 1980’s, Ajit Jain walked in on a Saturday offering to work for Berkshire even though he didn’t have any experience in insurance.
Buffett has marveled at his good luck. He also observes that maintaining an open mind has been essential.
THE LUCKIEST CROP IN HISTORY
Buffett has frequently repeated that babies born in America today are the luckiest crop in history. GDP per capita is higher than ever. The standard of living is higher than ever. The average person today lives far better than John D. Rockefeller, for instance. Innovation and economic growth continue to move forward.
Buffett still says that, if he were given the choice of being born anywhere today, he would choose the U.S. over any other place.
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: https://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.
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.
Pine Cliff Energy (PIFYF) is a Canadian natural gas producer. Pine Cliff Energy has a low-risk, low decline, natural gas asset consolidation strategy in Western Canada with 11 acquisitions since 2012. PIFYF has one of the lowest decline rates in the oil and gas sector with a base decline rate of about 6% on base production.
Demand for natural gas is likely to continue to surprise to the upside. Power burn demand is likely to remain high. At the same time, there is a shortage of global LNG. New LNG export capacity is being added in the U.S. and Canada. High power burn plus high LNG gas exports is causing total natural gas demand to be very high.
Furthermore, natural gas storage in the U.S. is 16% below its 5-year average. And natural gas storage in Canada is at an unprecedented low level.
Natural gas production in the U.S. remains flat.
With high demand, low storage, and flat supply, natural gas prices are likely to remain high and will probably go higher. The AECO near-month price is $7.53 (CAD/GJ) while the NYMEX near-month price is $8.67 ($/mmbtu).
For 2022, revenue will be about $175 million, EBITDA $146 million, cash flow $135 million, and earnings $95 million. The current market cap is $503.6 million, while enterprise value (EV) is $526.5 million.
Using these figures, we get the following multiples:
EV/EBITDA = 3.61
P/E = 5.30
P/B = 3.49
P/CF = 3.73
P/S = 2.88
Insider ownership is 12.9%, which is good. TL/TA (total liabilities/total assets) is 21.6%, which is very good. ROE is 828.24%, which is outstanding.
The Piotroski F_score is 9, which is excellent.
Intrinsic value scenarios:
Low case: Natural gas prices could fall during a global recession. The stock of PIFYF could decline 50% or more.
Mid case: Current EV/CF (where CF is cash flow) is 3.9. The average EV/CF for Pine Cliff Energy historically is 8.0. With EV/CF at 8.0, the stock would be worth $3.12, which is 105% higher than today’s $1.52.
High case: Natural gas prices could increase significantly, which means Pine Cliff Energy’s cash flow would increase significantly. The stock could be worth at least $4.50, which is close to 200% higher than today’s $1.52.
Risks
There will probably be a bear market and/or global recession during which natural gas prices fall temporarily but then quickly rebound. In this case, PIFYF stock would fall temporarily but then quickly rebound.
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 approachesintrinsic 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.
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.
For 2022, revenue will be about $673 million, EBITDA $365 million, cash flow $337 million, and earnings $240 million. The current market cap is $804.7 million, while enterprise value (EV) is $924.8 million.
Book value at the end of 2022 will be about $742.7 million.
Using these figures, we get the following multiples:
EV/EBITDA = 2.53
P/E = 3.35
P/B = 1.08
P/CF = 2.39
P/S = 1.20
Insider ownership is 18%, which is very good. TL/TA (total liabilities/total assets) is 33.1%, which is good. ROE is 52.1%, which is excellent.
The Piotroski F_score is 8, which is very good.
Due to years of underinvestment from oil producers, oil supply is constrained. (Government policy has also discouraged oil investment.) Moreover, due to money printing by central banks plus strong fiscal stimulus, oil demand is strong and increasing.
The net result of constrained supply and strong demand is a structural bull market for oil that is likely to last years. The oil price is likely to remain high at $90-110 per barrel (WTI) and later perhaps even higher.
Intrinsic value scenarios:
Low case: Book value per share at the end of 2022 will be about $4.94. This is 7% lower than today’s stock price of $5.29.
Mid case: Free cash flow in 2022 will be about $233 million. Because this is probably the beginning of a structural bull market for oil, $233 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8. That works out to $12.39, which is 135% higher than today’s $5.29.
High case: Free cash flow is likely to reach $470 million in the next few years. With a free cash flow multiple of 6, the stock would be worth $18.75, over 250% higher than today’s $5.29.
Risks
There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound. In this case, CRLFF stock would fall temporarily but then quickly rebound.
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 approachesintrinsic 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.
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.
For 2022, revenue will be about $300 million, EBITDA $160 million, cash flow $150 million, and earnings $90 million. The current market cap is $261.7 million, while enterprise value (EV) is $307.5 million.
Using these figures, we get the following multiples:
EV/EBITDA = 1.92
P/E = 2.91
P/B = 0.93
P/CF = 1.74
P/S = 0.87
Insider ownership is 29.7%, which is excellent. TL/TA (total liabilities/total assets) is 53.4%, which is decent. ROE is 97.9%, which is outstanding.
The Piotroski F_score is 8, which is very good.
Intrinsic value scenarios:
Low case: Book value per share at the end of 2022 will be about $3.24. This is 7% higher than today’s stock price of $3.03.
Mid case: Free cash flow in 2022 will be about $90 million. Because this is probably the beginning of a structural bull market for oil””based on strong demand and constrained supply over the next 3 to 10 years””$90 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8. That works out to $8.35, which is 175% higher than today’s $3.03.
High case: Because it’s probably a structural bull market for oil, free cash flow is likely to reach $180 million in the next few years. With a free cash flow multiple of 6, the stock would be worth $12.53, over 310% higher than today’s $3.03.
Risks
There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound. In this case, IPOOF stock would fall temporarily but then quickly rebound.
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.
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.
