Commodity Businesses, Holding Margins, and Incentives

Over the past few months I’ve been carefully reading Warren Buffett’s past annual letters to Berkshire Hathaway shareholders. Buffett has great insights on successfully managing a commodity business (1) by holding margins and avoiding unprofitable business and (2) by creating the right incentives. Below are some of the most enlightening passages broken down by year, with my comments in italics.

2004 Annual Letter

“Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (‘owned’ by policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don’t care from whom they buy. Customers by the millions say ‘I need some Gillette blades’ or ‘I’ll have a Coke’ but we wait in vain for ‘I’d like National Indemnity policy, please.’ Consequently, price competition in insurance is usually fierce. Think airline seats.”

This is one of the best definitions I’ve read of a commodity business: a standard/uniform product across the industry, lots of suppliers of this standard product, and customers who “don’t care from whom they buy.” The less these conditions apply, the more pricing power a company has.

“So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s (National Indemnity’s) strategy.

When we purchased the company — a specialist in commercial auto and general liability insurance — it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. . . .

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. . . . Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers — but they left us. . . .

Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organization intact and the distribution system happy. If this course isn’t followed, these employees argue, the company will not participate in the recovery that they invariably feel is just around the corner.

To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired for declining volume, however severe the contraction. . . . NICO is not labor-intensive, and, as the table suggests, can live with excess overhead. It can’t live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organization that doesn’t care deeply about underwriting at a profit this year is unlikely to care next year either.

Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good.”

So here you see how Berkshire has used incentives — a no-layoff policy — to avoid unprofitable business and maintain underwriting margins even if it means declining sales. Through these incentives, and through its willingness to suffer long periods of declining sales, Berkshire and NICO have created a unique business model and business strategy that competitors are unwilling or unable to copy. This is consistent with Michael Porter’s belief (1) that companies should compete to be unique and (2) that they shouldn’t try to grow sales at the expense of a unique, profitable strategy.

“Another way to prosper in a commodity-type business is to be the low-cost operator. Among auto insurers operating on a broad scale, GEICO holds that cherished title. For NICO, as we have seen, an ebb-and-flow business model makes sense. But a company holding a low-cost advantage must pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO. . . .”

So if you’re in a commodity business and are not the low cost operator (NICO’s situation), you can stay profitable (1) through incentives that maintain healthy profit margins and (2) through tight cost control (especially with new hires). If you’re in a commodity business and are the low cost operator (like GEICO), it’s essential to always look for new ways to drive costs even lower.

“Reinsurance — insurance sold to other insurers who wish to lay off part of the risks they have assumed — should not be a commodity product. At bottom, any insurance policy is simply a promise, and as everyone knows, promises very enormously in their quality.”

This is another great snippet about how Buffett distinguishes a commodity business with no pricing power from a non-commodity business with lots of pricing power. When the quality of the product or service matters to the customer, and this quality varies across the industry, then the product or service isn’t a commodity and the seller has pricing power.

Property-casualty insurance sold to the individual insured is a commodity because policies are standard and customers aren’t concerned about the insurer’s ability to pay a claim. Reinsurance isn’t a commodity because property-casualty insurers can only lay off claims exposure — through reinsurance — if the reinsurer is financially sound and the reinsurance promise is “high quality.”

2003 Annual Letter

“Our [insurance] results have been exceptional for one reason: We have truly exceptional managers. Insurers sell a non-proprietary piece of paper containing a non-proprietary promise. Anyone can copy anyone else’s product. No installed base, key patents, critical real estate or natural resource position protects an insurer’s competitive position. Typically, brands do not mean much either. The critical variables, therefore, are managerial brains, discipline and integrity.”

Another excellent, succinct definition of a commodity business: a product that’s easy to copy, with no installed base and no patent protection.

2002 Annual Letter

“On another front, Gen Re’s underwriting attitude has been dramatically altered: The entire organization now understands that we wish to write only properly-priced business, whatever the effect on volume. Joe and Tad judge themselves only by Gen Re’s underwriting profitability. Size simply doesn’t count. . . .

At GEICO, everything went so well in 2002 that we should pinch ourselves. Growth was substantial, profits were outstanding, policyholder retention was up and sales productivity jumped significantly. . . .

Randy Watson at Justin [Shoes] also contributed to this improvement, increasing margins significantly while trimming invested capital. Shoes are a tough business, but we have terrific managers and believe that in the future we will earn reasonable returns on the capital we employ in this operation. . . .

Bob Shaw and Julian Saul are terrific operators. Carpet prices increased only 1% last year, but Shaw’s productivity gains and excellent expense control delivered significantly improved margins. We cherish cost-consciousness at Berkshire. . . .”

These quotes all emphasize the importance of avoiding unprofitable business, retaining and keeping customers happy, and increasing productivity while tightly controlling costs.

2000 Annual Letter

“Despite State Farm’s strengths, however, GEICO has much the better business model, one that embodies significantly lower operating costs. And, when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important. This enduring competitive advantage of GEICO . . . is the reason that over time it will inevitably increase its market share significantly while simultaneously achieving excellent profits. Our growth will be slow, however, if State Farm elects to continue bearing the underwriting losses that it is now suffering.”

This quote is interesting because it notes how sales growth can suffer due to unprofitable competitors. Buffett seems quite alright with this — he prioritizes profits and a reasonable return on invested capital over sales growth.

Many companies seem to reverse this, prioritizing sales growth over reasonable profits. Some of these companies — Uber, Tesla, etc. — are losing popularity as investors realize they’re subsidizing unprofitable, unproven business models through multiple rounds of equity fundraising. Investor tolerance for these losses runs contrary to Clay Christensen’s advice: in deciding whether to pursue a new business model, Christensen recommends companies be impatient for profits and patient for sales growth.

Using High ROIC’s to Raise Per Share Intrinsic Value

Below are some personal notes on how high ROIC’s can raise a stock’s per share intrinsic value, using Apple as an example:

  • Apple has authorized $100B plus in share repurchases going forward, a result of robust returns on capital — the company is generating more cash than it needs for the business. Repurchases cause share count to go down, causing EPS to grow and market cap to decline, despite flattening/declining operating earnings.
  • High returns on capital — and capital returns via prudent buybacks — should allow Apple to continue growing EPS and reducing market cap at a rate that arguably makes the company undervalued despite slower growth in operating earnings.
  • Apple shouldn’t be making share repurchases if the shares are overvalued — repurchases in this situation are a waste of balance sheet cash. In this situation excess capital should instead be paid out as dividends, leaving shareholders free to invest these monies in other investment opportunities.
  • It’s interesting how a company can grow EPS through share buybacks without growing bottom line earnings. These buybacks should be at fair value or less to avoid wasting balance sheet cash. Buybacks reduce share count, which reduces market cap (the total market price of the company) and increases per share cash flows, both of which make a company more attractive/undervalued from a present value, DCF perspective. This is one of the big benefits of high returns on capital: if a portion of earnings isn’t operationally needed and can’t be invested in incremental capital at attractive return rates, then these earnings can still be used to reduce share count, which reduces total market price and grows per share cash flows, which then leads to a more attractive price to present value ratio (applying DCF analysis).
  • When a company pays more than fair value to repurchase shares, it’s like the company is indirectly making shareholders pay too much for shares relative to earnings — i.e., it’s like forcing shareholders to buy a stock with a low earnings yield, a long payback period, and an unattractive price to present value ratio.
  • An interesting question is whether buybacks at slightly more than fair value could still benefit existing shareholders, and ultimately lead to an attractive earnings yield on the repurchased shares (after repurchases are complete), by increasing the value of each share since each share is now entitled to a greater percentage of earnings.
  • It’s easy to imagine a cash cow type company with high returns on capital liberally repurchasing shares and hypothetically offsetting any unfavorable purchase price (with a low earnings yield on repurchases) with the higher earnings now attributable to each share. The bottom line is that as EPS goes up each share becomes more valuable on a pure DCF basis (ignoring any resulting new debt and/or irresponsible depletion of balance sheet cash by management).

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. The author owns stock shares of Apple.

Earning Power and Intrinsic Value

One of my investing challenges has been managing a portfolio without getting whipsawed by fluctuations in 12 month trailing earnings or free cash flow. If you’re a quantitative value investor and you pay close attention to trailing 12 month results, either in deciding what to purchase or when to sell, then portfolio management, emotional/behavioral management, and portfolio turnover can become serious problems. That’s because your investing decisions rest heavily on short term results rather than a meaningful assessment of intrinsic value and long term earning power. Ironically, Benjamin Graham encouraged some of this short term focus in the 1973 edition of The Intelligent Investor and in subsequent interviews and writings, where he espoused a simplified, formulaic approach to value investing that gives special weight to a company’s trailing, 12 month PE ratio. Joel Greenblatt and Tobias Carlisle have promulgated a similar approach that rests largely on trailing, 12 month enterprise value to operating earnings (or EBIT).

For me personally these simplified approaches — particularly the low PE, low debt approach — have worked well, although the past three to four years have been challenging. As Charlie Munger notes, value investors keep recalibrating the “Geiger counter” to identify statistical bargains. It seems like investors have become better at detecting statistical bargains through a simple formula, possibly explaining why these approaches don’t work quite as well as they used to.

It’s strange that many value investors use short term earnings and simple purchase/sales criteria — as I’ve done myself — when this approach seems to depart from core Graham teachings, namely that: (1) an investor should treat a stock as an ownership interest in a business, not as a piece of paper; (2) investment is most successful when it’s most businesslike; (3) investors should invest intelligently and avoid speculation; and (4) investors should buy at a substantial discount to intrinsic value. Buy/sell decisions based largely on the most recent financial results, or based on short-term focused, mechanical formulas, seem to violate these four principles. In my case, while simple formulas have sometimes produced exceptional returns, they’ve also led to myopic thinking and unnecessary portfolio turnover. Simple, mechanical approaches — which I’ve espoused in this blog and which I’m still fond of — have moved me away from the core Graham concept of intrinsic value, arguably making my investing more speculative.

Warren Buffett has said the investing book that changed his life was the 1949 edition of The Intelligent Investor, so I went back and reread some past highlights. In chapters 10 and 12 of this book Graham notes that earning power should be assessed based on multi-year averages, not based on individual/separate years, since all companies have good and bad years. The Intelligent Investor, by Benjamin Graham, pp. 160-161, 175 (HarperBusiness, 1949). He says a company’s intrinsic value only changes when new developments arise that weren’t captured in the initial appraisal, and that this value does not change when earnings rise or fall due to an economic boom or bust. Id. at 175. Finally, he notes that stock price behavior “departs radically from this concept of intrinsic worth,” that “prices respond vigorously to any significant change in either current earnings or short-term earning prospects,” and that “both favorable and unfavorable situations are part of any normal long-term picture — and as a consequence should be accepted without undue excitement . . . .” Id. at 175-176.

The larger point is that investors may want to consider using averages and more meaningful statistical measures when estimating intrinsic value and deciding whether to buy or sell a company. From a big picture perspective, it makes little sense to estimate long term earning power, and conclude that a company is selling at a discount or premium to intrinsic value, based on 12 months of earnings or free cash flow. Making decisions on this basis promotes knee-jerk, irrational behavior and excessive portfolio turnover.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Past Universe vs. Current Universe

In his 2008 annual letter for Berkshire Hathaway, Warren Buffett writes about the dangers of back-tested, historical results and formula-based investing:

“The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. ‘Back-tested’ models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe ‘past’ and universe ‘current’ had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact. 

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” 

The larger point is that the past universe for a particular investment, whether it’s a bond, stock, or some other type of financial instrument, may not be the current universe. The present situation may be fundamentally different than what’s generally prevailed in the past. If you invest in a way that doesn’t recognize or factor in this type of fundamental change, then your results may suffer.

If, for example, you don’t feel comfortable about a particular retail company’s ability to survive in today’s competitive landscape, then it probably shouldn’t be in your portfolio regardless of whether it looks quantitatively cheap. Prospects like these should probably go in what Buffett calls the “too hard” pile.

It seems like many value investors are buying groups of stocks that appear quantitatively undervalued but really should be avoided because the past universe is much different than the current universe. This may explain — at least in part — why these same investors have often underperformed the FAANG companies disrupting so many traditional businesses and industries. If the competitive landscape of a traditional business/industry has fundamentally changed, then past financial results may not matter much, making an apparent quantitative bargain illusory. In this situation value metrics drawn from past data may be misleading and unreliable, leaving the investor unable to intelligently predict or estimate whether: (1) an investment prospect will survive, and (2) what the prospect’s normalized earning power will be going forward. Funds invested in the face of these problems probably amount to speculation and guesswork rather than businesslike, Graham-style investment.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Buffett’s Favorite Themes

Low Cost and Size Advantages 

In Buffett’s annual letters certain themes keep popping up. One is that Buffett likes a low cost competitive advantage and another is that he likes it when sheer size confers a competitive advantage. A low cost example is GEICO. A large size example is reinsurance and Berkshire’s ability to insure and reinsure large risks that no one else can — this leads to huge amounts of investable float and often extraordinary underwriting profits.

Capital Intensity 

Buffett also likes capital intensive businesses when large amounts of incremental invested capital can be deployed at attractive rates of return. Berkshire invests huge amounts of incremental capital in utilities and railroads. Businesses like these often face little competition or inferior competition because of regulatory entry barriers and because most companies are reluctant to make these kinds of large investments. Berkshire’s access to abundant capital, and its willingness to freely deploy this capital when return rates are attractive, give it a competitive advantage in capital intensive businesses.

Great, Hard to Copy Products 

Finally, Buffett likes companies with unique, hard to copy, great products. These qualities lead to strong brands, high customer satisfaction rates, and high customer loyalty. This theme seems to drive Buffett’s investments in Coca-Cola, See’s Candies, Apple, and American Express. In his letters Buffett regularly refers to customer satisfaction metrics because these numbers measure loyalty and brand value.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. 

The “Too Hard” Pile

Investors using DCF analysis to make concentrated investments in companies selling below estimated present value must be careful to avoid (1) companies they don’t fully understand and (2) companies with uncertain prospects over the next 10 to 20 years. When Charlie Munger and Warren Buffett look for investments to concentrate in, they put companies in the “too hard” pile unless they meet both these criteria. Very few companies make the cut, and Buffett is willing to wait a long time for the right prospect at a fair price. Citing Ted Williams, Buffett says he gets his results by only swinging at fat pitches in his “happy zone” — otherwise he keeps the bat on his shoulder.

I think the too hard concept — and the importance of patience — is often forgotten or ignored by investors trying to imitate Buffett’s concentrated approach. Impatient for returns, these investors apply DCF analysis, and estimate future earnings, even though they don’t understand the business and therefore can’t assess earnings resilience and competitive threats. An investor may also understand the current business but still be uncertain of future prospects because the company lacks a unique, defensible strategy — a competitive moat — or because the product or industry changes too fast due to competition or new technologies. Despite these issues, many investors project long term earnings, incorporate these figures into present value estimates, and make concentrated investments in companies that should be placed in the too hard pile. Lacking patience, they swing at bad pitches. Mistakes like these can devastate the value of a concentrated portfolio. 

You could argue that Buffett’s best investments have generally been in companies with the simplest businesses and the clearest long term prospects. Coca-Cola, See’s Candies, and GEICO come to mind — all simple businesses with wide competitive moats and very long runways of profitable, predictable demand (especially when Buffett made his original purchases). Buffett has encountered trouble when the business is more complicated, the competitive moat isn’t obvious, and long term demand is less clear: IBM, Oracle, U.S. Air, Solomon Brothers, and even Wells Fargo (with its more recent troubles) quickly come to mind.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Capital Allocation

In his annual letters Warren Buffett talks about the importance of capital allocation. Paraphrasing Buffett, when a company can invest its earnings in incremental assets at high rates of return it should do so, or it should use this money to acquire — in whole or in part — fairly priced “wonderful” companies generating attractive returns. When these options are unavailable, the company should return earnings to shareholders through share buybacks if the company is meaningfully undervalued, or though cash dividends if the company is fairly valued or overvalued.

Buffett says one of Berkshire Hathaway’s key advantages is its ability, as a conglomerate, to dispassionately invest capital in closely held and publicly traded companies across a range of industries. This kind of choice makes it easier for Berkshire to find fairly priced companies — to purchase in whole or in part — that are growing sales and earnings at high capital return rates. Additionally, Buffett doesn’t insist on operating control when looking for investing prospects — he’d rather own part of a great company than all of an average company. This gives Berkshire a flexibility advantage over companies that want control. Buffett also notes how easy it is for Berkshire to internally shift capital from a “cash cow” subsidiary that can’t invest retained earnings at attractive returns to a growing subsidiary that can.

Berkshire’s flexibility in deploying capital allows it to continue growing despite large sales and a large market capitalization. Most companies can’t invest capital in such a varied way: they operate in one business and one industry, resulting in fewer acquisition choices and fewer ways to shift money around internally. Limited choice often causes a company’s management to invest capital poorly, either by (1) expanding an existing, low capital return business or (2) making a controlling acquisition at a premium price.

Berkshire benefits not just from the varied ways it deploys capital, but from the large capital amounts it has to deploy. The company invests equity capital in the form of earnings generated by its subsidiaries, in addition to debt capital in the form of insurance float generated by subsidiaries like GEICO. Insurance float is the up-front premium money insurers hold/invest until these monies are paid out in claims. Berkshire invests float in attractively priced equities generating high capital returns. Float is a debt liability on the balance sheet, but Buffett believes this is a mischaracterization: he views Berkshire’s float as a costless, revolving fund — which Berkshire can invest in attractive equities — whereby claim payouts are continually replenished by insurance premiums. Through the years Berkshire’s insurance float has steadily grown, giving the company more and more money to invest. Buffett notes that returns from invested float are then augmented or reduced by underwriting profits or losses. When insurance premiums exceed expenses and eventual losses there’s an underwriting profit. When expenses and eventual losses exceed premiums there’s an underwriting loss. In most years Berkshire’s insurance subsidiaries have generated an underwriting profit. 

Companies shifting from growth to maturity often have trouble adjusting their capital allocation: they retain earnings for low return projects or acquisitions instead of distributing this money to shareholders through dividends or share repurchases. It takes managerial discipline for a company to forgo low return investments, even when these investments generate additional sales, earnings, and earnings per share. Low return investments waste retained earnings because shareholders could invest this money elsewhere at higher returns.

Poor capital allocation, industry competition, technological disruption, and business model disruption all cause declining returns and regression to industry mean returns. A company can delay and sometimes prevent declining capital returns through (1) shareholder-friendly capital allocation and (2) unique activities/strategy a la Michael Porter (e.g., Apple and Southwest Airlines). 

Buffett notes that shareholders of companies that allocate capital poorly actually pay twice: once via the earnings retained and invested by management at low returns, and once via the lower market value assigned to companies that behave this way. Smart capital allocation, whether it’s repurchasing shares at appropriate times or retaining earnings at appropriate times, may be the best quantitative indication of good management.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Market Whims

The biggest benefit of Buffett-style concentration may be that it tends to untie your portfolio’s performance from the broader market. For this reason a concentrated investor arguably has more control over his investment results. Conversely, a well-diversified investor ties much of his investment performance to the broader market. The more diversified you are, the more likely your portfolio matches market swings and market returns.

Concentration increases the importance and impact of the individual companies you’ve selected and decreases the importance and impact of the broader market. With concentration the mental focus shifts from relative performance, and the goal of beating the market, to absolute performance, and the goal of maximizing your returns regardless of how the broader market performs.

If the broader market appears overvalued, then a well-diversified portfolio that roughly matches broad market swings may be more risky than a concentrated portfolio that’s more likely to move independently.

For these reasons, your long term investment prospects are arguably more predictable when you invest in a small group of undervalued companies you know well versus a big diversified group you know less well. The small group is more likely to move independently of the unpredictable broader market, while the big group is more likely to mirror market volatility.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Teamwork, Leadership, and Cumulative Impacts

I make my living as an investor and attorney, so over my career I've worked mainly as a lone specialist rather than working on teams. Nonetheless, my brain is an analytical meat grinder and I've had a few team experiences, so I wanted to briefly share my thoughts on the subject:

  • A team leader's impact normally isn’t felt after one or two decisions -- it's felt after hundreds or thousands of small decisions/interactions with team members and people throughout the organization. If the majority of these small decisions/interactions are good, then the cumulative impact will be good and the organization will go in the right direction, like a slow moving barge passing through the center of a river channel. Conversely, if the majority of these small decisions/interactions are bad, then the cumulative impact will be bad and the organization will decline, like a slow moving barge gradually steered out of the channel and run aground.
  • The team leader must keep a close eye on the barge's course and make sure his decisions/interactions keep the barge in the center of the channel. He must listen to feedback, be an open-minded, ego-free learner, and make lots of good decisions.
  • It can be hard to tell whether the barge is being run aground, because it often happens incrementally. If the shipping owner gets a new captain only after he's sure the barge is being run aground, then the vessel will already have sustained major damage. The owner must act when it's more likely than not that a new captain is needed, before a lot of incremental, irreparable damage occurs.
  • The team leader must actively solicit ideas from all team members and from people throughout the organization, and then the leader and team must winnow down to the best ideas through candid, constructive debate and conversation. All team members must candidly speak their minds, even when it's uncomfortable, to improve the team’s chances of making a good decision. Candid, constructive criticism is important so bad ideas can be weeded out and good ideas can move forward.
  • The biggest benefit of a team is that you have more than one person offering ideas. This leads to more varied, more creative ideas/solutions than one person can come up with.
  • Unless it's a crisis requiring quick top-down solutions, leaders must allot adequate time to attracting followers and getting buy-in from people throughout the organization. The buy-in process should start well before any change initiative is finalized and implemented, and this process should allow people to offer input on the new idea. These suggestions can then be adopted or rejected by the leader and his team. Buy-in is critical so people will embrace and execute the new idea. If the leader's style is too top-down, or the leader procrastinates and does not spend enough time getting buy-in, then the idea will fail due to poor execution.
  • Pilot programs are a good way to test, iterate, and improve new ideas/solutions -- these programs can make the original idea better/stronger. Additionally, buy-in goes up when people in the organization see the pilot working and can suggest changes/improvements, which then leads to better execution if the idea is fully implemented.

Price to Tangible Book, Competitive Moats, and ROIC

I recently made some notes on price to tangible book, competitive moats, and return on invested capital. The first note below is from a series of Twitter posts on the subject of price to tangible book; the other comments are just personal notes on investing:

  1. On the irrelevance of price to tangible book versus the relevance of debt to total assets (from a 2018 Twitter exchange with Tobias Carlisle): (a) reposted by Tobias Carlisle: "For stocks in the S&P 500, the correlation between price and tangible book value is just 14% [as of 2018]. This is a very big change from 25 years ago, when that correlation was 71%—or 5x stronger than it is now. Today the book value of a stock gives little clue as to its price.” -Bill Nygren https://twitter.com/acquirersx/status/1016994746185613312”; (b) my combined Twitter reply posts on the subject of price to tangible book: "@Greenbackd [Warren] Buffett has probably played a part in this change- based on annual letters he prefers unleveraged, asset light companies (less to maintain and low CapEx) that are generating lots of predictable cash flow; that’s probably what you’d want when buying a private business . . . Sine qua non of investing is 'what would you want if you were buying the whole business?’ You’d want few fixed assets to maintain/improve, low annual CapEx, little debt to pay off, and a strong, consistent history of FCF relative to price paid. This may be area where [Ben] Graham was a bit off, in terms of advocating for low price to tang book, because a low price to tang book screen tends to pull fixed asset heavy companies with high annual CapEx —> not what you’d want if you were a private business buyer. I think the best way to look at tangible book is by comparing debt to total assets—> a private business buyer may not care much about book value relative to price, but he does care about whether most of the company’s assets are encumbered/financed by debt (that he has to pay off)."
  2. The upside of a low price to tangible book is that it can help with downside risk in the event the company is liquidated (an unlikely event if you follow Graham's debt and current ratio criteria). Another upside to an asset heavy company with a low price to tangible book relates to barriers to entry — asset heavy businesses/industries are less attractive to new competitors and harder for them to break into.
  3. The downside of an asset heavy company with a low price to tangible book is that this kind of business is less attractive to potential acquirers because the acquirer gets stuck with the large annual CapEx needed to maintain, improve, and grow the business. Big CapEx makes growth more expensive and makes it more difficult for the company to quickly/flexibly change its business model — as needed — in response to changing competition and business conditions. Capital intensive businesses may also require more debt financing for the fixed assets needed to run the business. Finally, large CapEx eats up operating cash flow and returns on invested capital.
  4. The upsides and downsides of companies with capital intensive businesses seem to make price to tangible book a bit of a “wash” when analyzing a company — it doesn’t add much or detract much.
  5. When it comes to competitive “moats,” the best quantitative evidence of a moat is probably a consistent, stable history of positive free cash flow. Companies with consistent FCF are probably not competitively threatened in a serious way — otherwise their cash flows wouldn’t be so consistent. It’s interesting to think how a company can have consistent FCF, suggesting a competitive moat, and still be considered unattractive because it’s not growing fast enough or it's too capital intensive or it’s not earning high enough returns on invested capital. This probably explains why ugly companies with consistent FCF and apparent competitive moats can be cheap relative to market price. 
  6. If returns on invested capital are too low (in the single digits), then reinvested profits are effectively wasted profits, meaning the investor doesn’t get the full benefit of his apparent investing bargain. An investment's earnings yield (earnings divided by market price) can look attractive, but this yield is reduced by management reinvesting earnings in low returning assets (rather than paying out earnings to shareholders through dividends or buybacks). 

Regarding point six above, I wasn’t going to include any examples for fear my math or methodology might be off. I’ve since decided to include examples from my notes, with the warning that anyone reading these examples should follow their own methodology and do their own calculations — they should not blindly rely on my methodology. So the examples from my notes (with minor edits) are as follows:

  1. Even if the company maintains foolish reinvestment policies for a period of time, the company’s tangible book value (total tangible assets less total debt) should go up at a nice clip relative to the price I paid as an investor. If the company has a 20% earnings yield, a market cap of $1,000,000, and a tangible book value of $800,000, then every year the company fully reinvests earnings its tangible book goes up by roughly $200,000. If the company has invested capital of $600,000 and a low return on invested capital (ROIC) of 2%, then first year invested capital contributes another $12,000 of return. So even with a really low ROIC tangible book is going up significantly on an annual basis ($200,000 a year) — relative to the price I paid — and I’m getting 2% on $600,000 in invested capital tacked onto this. In this example tangible book would go to $1,000,000 the first year. The investor would have ownership rights on that book value if the company liquidated. If the company’s tangible book value can be liquidated for 40 cents on the dollar, then shareholders “earn” 40% of the $200,000 in reinvested earnings used to increase tangible book, or $80,000. Shareholders also earn $12,000 in ROIC (2% of $600,000 in invested capital). So in the first year shareholders get an investment return of roughly $92,000 ($80,000 in increased liquidation value plus $12,000 in ROIC), or a 9.2% return on the original $1,000,000 market cap. If you change the earnings yield to 10%, then tangible book increases by $100,000, from $800,000 to $900,000. If the investor “earns” 40% of increased tangible book, or $40,000, from reinvested earnings of $100,000, plus $12,000 in ROIC, then in the first year the investor ends up with $52,000 in investment return (reduced as appropriate by his ownership share of the company), or a 5.2% return on the original $1,000,000 market cap. These are conservative/pessimistic scenarios for an investor who buys a company with a high earnings yield and a low ROIC.
  2. Taking the 10% earnings yield example a bit further, if during the year the same company unexpectedly announces its intent to pay 50% of its earnings to shareholders through a one time dividend, then as an investor I get 50% of $100,000 in earnings, or $50,000 (reduced as appropriate by my ownership share of the company). I also “earn” 40% of the increase in tangible book, or $20,000, from the remaining $50,000 of earnings reinvested in the company, plus $12,000 in ROIC. So my first year return is roughly $50,000 in cash dividend, $20,000 in increased liquidation value from the increase in tangible book, and $12,000 in ROIC, for a total first year investment return of $82,000, or an 8.2% investment yield on the original $1,000,000 market cap. The point here is that small improvements in the payout policies of a low ROIC company can have a big, positive impact on my investment returns. In this example the company’s decision to increase its payout to 50% of earnings got me an investment return of roughly 8.2%, very close to the 10% earnings yield that I’d receive if the company increased its payout rate to around 100%.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

The Group Approach, Part II

A concentrated, Buffett-style investor will sometimes look at a Graham-style, cigar butt investor and say: "You're making valuation decisions based on over-simplified metrics like PE or price to cash flow or price to book when the true value of a company is the sum of discounted future cash flows. Your selection criteria are too superficial."

Pure quant, Graham-style value investing might be too superficial to justify heavy concentration in an individual stock, but it can work well when funds are equally divided among a large group of stocks. The prudence of a particular investment strategy often depends on diversification. Healthy diversification helps minimize the impact of Black Swan events.

Buffett-style investors think it's okay to concentrate, and prudent to do so, because they know a lot about their individual holdings -- they've done DCF analysis, have studied the company and its competitors, and feel certain in their assessment of the company's long term competitive advantage. Yet future events can still surprise. Every so often a famous value investor suffers a large, unanticipated, Black Swan loss from a concentrated, "sure thing" investment. Bill Ackman's loss in Valeant Pharmaceuticals comes to mind. No matter one’s confidence, heavy concentration entails outsized exposure to large Black Swan losses. Unless you're a business conglomerate with an indefinite lifespan -- Berkshire Hathaway for example -- big losses are hard to recoup.

Charlie Munger has talked about the remedy for concentrated investments and unexpected Black Swans. He advises value investors to buy a small basket of stocks and then "watch that basket closely." Vigilance helps, except when a concentrated investor makes more bad decisions that magnify the original loss. With Valeant Pharmaceuticals, Ackman and other well-known value investors bought more Valeant stock as the company declined, increasing their losses. Averaging down makes sense when a stock declines for no reason, but in Valeant's case the decline was justified. 

I don't know if value investors like Ackman failed to cut Valeant losses because they fell in love with the company or because they were unable to see or acknowledge their mistake, but the moral of the story is that concentrated investors watching the basket closely can still make costly mistakes. Concentrated investing makes it more difficult to stay rational and unemotional, increasing the odds of misjudgments.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Emotion and Quant Style Investing

The more quantitative your buy/sell investing criteria, and the more diversified you are, the easier it is to make rational, unemotional, and contrarian investment decisions. Conversely, the more you rely on subjective assessments of competitive advantage or future prospects, and the more concentrated you are, the harder it is to make rational, unemotional, and contrarian investment decisions.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Cigar Butts, Debt, and Black Swans

I've been reading a couple books by Nassim Taleb, specifically The Black Swan and Antifragile. I've also been reading The Success Equation by Michael Mauboussin. These books have made me think about how an improbable, extreme outcome that no one can predict -- a Black Swan -- impacts investing strategies.

Citing Taleb’s theory, in The Success Equation Mauboussin says that when you’re working in a field that sometimes has improbable and extreme outcomes, it's better to regularly buy low cost options that allow you to reap a large, one time Black Swan profit than it is to sell options that generate small, recurring profits but leave you exposed to a large, one time Black Swan loss.

If you're a Graham-style value investor buying a low multiple, cigar butt stock, your two improbable, extreme outcomes are: (1) bankruptcy or (2) the company's unexpected return to high growth. The interesting point is that if you buy a low multiple stock with little or no debt and plenty of working capital, then you can dramatically reduce the odds of a Black Swan bankruptcy while still preserving the buyer’s option you purchased on unexpected growth. Consistent with Mauboussin's advice, a diversified portfolio of low multiple, low debt stocks are like buyer options with limited bankruptcy risk and the possibility of large, one time profits from unexpected growth or other good news (like a buyout offer).

If you’re a growth stock investor buying high multiple stocks, then your two improbable, extreme outcomes are: (1) much higher growth than what's occurred in the past or (2) negative, declining growth. The problem is that the Black Swan risk of negative, declining growth can't be eliminated.

Black Swans, and the need to factor them into your investing strategy, remind me of a J.R.R. Tolkien quote my father, who was in the construction business, had on his office wall:

"It does not do to leave a live dragon out of your calculations, if you live near him."

Black Swans and big negative outcomes also remind me of the importance of avoiding investing losses. It's easy to forget that investing performance is impacted by both gains and losses.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

The Group Approach

Ben Graham gave a couple interviews in 1976, after the final, 1973 edition of The Intelligent Investor, where he talks about the "group approach" or the idea of "buy[ing] groups of stocks that meet some simple criterion for being undervalued -- regardless of the industry and with very little attention to the individual company." The Rediscovered Benjamin Graham, by Janet Lowe (John Wiley & Sons, Inc., 1999), p. 270. Graham details a simple, mechanical way of generating strong investment returns by purchasing a group of unleveraged stocks with low PE's and selling them based on a mechanical sales rule. Id. at 259-275. 

When Graham gave these interviews he had his fullest, most complete investing perspective, with over 50 years of investing experience. Over this time he authored multiple versions of Security Analysis and The Intelligent Investor. With this perspective and experience in mind, Graham ultimately concluded as follows:

"Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles."

Id. at 270.

To me these quotes mean an investor should follow an investing process that tries to be right on a group basis rather than a process that tries to be right about each individual stock pick. I think too many investors get hung up on being right about each stock pick, which is inherently difficult, when they only need to be right on a group, average basis.

The beauty of a diversified group approach is that you can follow simple buy/sell rules, be wrong about individual decisions or stock picks, and still get good results. The more concentrated you are the more right you have to be about each individual stock, versus just being right about the larger group.

Investors who focus on being right about each stock pick often forgo investments that could be prudently and profitably included in a mechanically chosen, well-diversified group of low PE, low debt stocks. It's hard to be contrarian when you're concentrated in just a few positions and you feel the need to be right about each pick.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Volatility

One of my favorite Ben Graham quotes is from the introduction to the 1949 version of The Intelligent Investor:

"In nine companies out of ten the factor of fluctuation has been a more dominant and important consideration in the matter of investment than has the factor of long-term growth or decline. Yet the market tends to greet each upsurge as if it were the beginning of an endless growth and each decline in earnings as if it presaged ultimate extinction."

The Intelligent Investor, by Benjamin Graham (HarperCollins Publishers, 1949). As this quote suggests, you don't ignore stock price volatility -- you take advantage of it.

With all due respect to Phil Fisher, Warren Buffett, and Charlie Munger, the problem with buy and hold forever investment strategies is that you're not taking advantage of volatility and Mr. Market's irrationalities. The buy and hold forever investor forgoes a time-tested driver of long term returns, temporary mispricings due to volatility, and relies on a far less certain driver of long term returns, future earnings growth and future high returns on capital.

As discussed by Tobias Carlisle in Deep Value and The Acquirer's Multiple, competition and mean reversion make reliance on future growth and future returns on capital a very uncertain bet. High margin, high growth companies usually mean revert due to: (1) new entrants and future competition; (2) new, disruptive business models; and/or (3) new technologies that make a company's product obsolete.

With buy and hold strategies the general thought is that it's okay to hold onto positions that are temporarily overvalued -- a la Phil Fisher -- because even if the stock price retreats a little you still do well over the long term. To me this doesn't make sense. Why give up the incremental annual return that irrational volatility can provide, particularly when even small increases in annual returns can have a big impact on compounding and long term returns? Why not reduce your opportunity costs by taking advantage of volatility, buying or holding onto positions when they're undervalued and selling them when they're overvalued?

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.