I was recently reading through some old investor interviews from the excellent Graham and Doddsville newsletter from Columbia Business School, and I came across an interview from Glenn Greenberg of Brave Warrior (formerly Chieftain Capital). A couple years ago I commented on a talk that Glenn Greenberg did at Columbia, where he discussed his investment approach. My own investment approach tends to fall in line with Greenberg’s investment philosophy as well as his portfolio management approach. Despite a few misses here and there (notably Greenberg’s investment in Valeant, a company I discussed last year in this post), his overall performance has been outstanding over the past 3 decades.

But putting Greenberg’s individual investment ideas aside, I’ve always like his general approach, specifically the following two points:

  • Focus on the quality businesses (he lived through the stock market crash of 1987, where the market tumbled over 20% in one day, and he wanted to ensure that if that ever happened again, he would feel comfortable with the businesses he owned)
  • Position Sizing: If it’s not worth putting 5% of your portfolio in the stock, then it’s probably either too risky, outside your circle of competence, or doesn’t have enough upside

Focus on the Quality Businesses

Greenberg lived through the stock market crash of 1987, where the market tumbled over 20% in one day. He wanted to make sure that if/when that type of crash ever happened again, he’d be perfectly comfortable owning the businesses in his portfolio. In other words, he thought of his stocks as businesses that he owned for the long-term, and looked for durable companies that could withstand a variety of economic downturns, macro shocks, and stock market crashes.

I’ve talked about how I’ve moved away from long, specific checklists (not that I’m against them, but I prefer simple, more general checklists. This frees me up to think about each individual business and all of its own unique nuances and set of risk factors, competitive dynamics, etc…). But despite not having a 100 point checklist for each stock I look at, I do have a few general tenets that I think about with all of my investments. One of these tenets is very simple: I ask myself if I’d feel comfortable with this company if the stock dropped 50% due to either a market crash or an economic downturn.

In other words, a recession can cause many businesses permanent damage that they often cannot recover from (some go out of business, others are forced to restructure in bankruptcy). I consider these types of events (bear markets, macroeconomic crises, recessions) to be a completely normal and a regular occurring part of the business cycle, yet I also consider them to be completely unpredictable. I know with certainty that they are going to happen; I just don’t have any idea when they are going to happen. So I want to own stock in durable companies that can withstand these inevitable economic headwinds.

Position Sizing

Another key “general checklist item” is another question to reflect on: Would you be willing to put 5% of your portfolio (minimum) into this investment? If not, then there usually is a higher than ideal amount of risk associated with the investment, or you just don’t know the investment as well as you should.

Some investors will say that there is always a place for small investments (1-3% “bets” that will return multiples of the initial investment if they work out well, but will suffer large losses if they don’t work out, possibly even going to $0).

The math of these long-shot bets can be configured to be very compelling. A “bet” that pays 10 to 1 with 25% odds of success should be taken every time. The problem with these types of bets is that assigning probabilities (and payoffs) with any sort of precision is extremely hard—much more difficult and error-prone than most investors realize in my opinion. I see a lot of write-ups that seem to slap arbitrary probabilities to justify the long-shot investment, but when I do the math on some of these, the investment looks like a bad bet if the probability of success goes from say 25% to 10%. While I think I’m good at judging which “bets” are high probability vs. low probability, I don’t seem to be very good at being able to accurately pinpoint whether a low probability event has a 25% chance of success or a 10% chance of success, and sometimes that is the difference between a great bet and a terrible bet. I think many people overestimate the odds of success and/or the payoff potential on these types of ideas in order to improve their estimate of the expectancy of the investment and to justify buying the stock.

There are some investors who succeed at placing these long-shot, low-probability but high-payoff bets. But I think the vast majority of investors who attempt these types of investments are overestimating the potential of these ideas. And for me, I’m just more comfortable focusing on higher probability ideas, thinking of my investments as long-term stakes in real operating businesses rather than chips at the poker table.

I’ve found that most of my mistakes tend to be with smaller positions—stocks of companies that I knew weren’t good businesses but I was more attracted to the security, the special situation, or the opportunity to make sizable gains relative to the amount I was risking. These long-shot investments by definition fail more often than they succeed, but I think even when they work, they work out in both lower frequency (the probability is lower than expected) and lower severity (they don’t have as much upside as people initially expected).

The 5% rule forces you to think about the business the way an owner would think. I try to think about each individual stock investment as if it were a private business that I was buying a minority stake in and couldn’t sell for a period of time. Of course, the stock market allows us to sell our position whenever we’d like, but I’d rather take advantage of this liquidity than have it take advantage of me. By imagining that you are buying into the business and partnering with management, you are forced to think more about things that impact the competitive position of the business and the long-term value of the enterprise, and less about things that will impact the short-term nature of the stock price.

I think both of these “rules” are worth considering:

  • Ask yourself if you’d be okay holding (owning) this stock during an economic or stock market collapse.
  • Ask yourself if you’d be okay investing a minimum of 5% of your capital in the stock.

I think staying focused on the durable businesses that you are willing to put 5% of your capital into is an initial hurdle that will certainly limit some of the investments you can make (and thereby possibly limit certain profitable opportunities), but I think more importantly, this general rule of thumb will help reduce many mistakes and focus your attention on the high-probability (and usually higher quality) investment opportunities.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I wrote a note to my clients last week regarding my general thoughts on the presidential election, some broader historical reference points, as well as how I tend to think about these major political and macro-oriented events from my perch as an investor in stocks at Saber Capital Management.

I spend most of my free time doing the same thing I do when I’m working: reading and thinking about businesses and possible investments. But I keep tabs on sports and politics quite closely; sports I sometimes reference here, but politics I never do. BHI is (and will remain) completely free from such opinions. The futility of political discourse seems to increase with each passing election cycle. I can’t think of many greater drags on human productivity than the time spent and ink spilled opining on why one politician is better than the other (note: there isn’t much difference).

But like many Americans, I am interested in both sports and politics—but much more for the strategic aspects than the actual theater/entertainment value. This is especially true with politics, where I am greatly interested (in part because I love history as well as news/current events), but my interest is nearly 100% related to either the individual policies or the game theory and strategic aspects of the political process itself; whereas in sports my interest is mostly strategic (statistics, front office moves, trades, gameplans, in-game decisions, etc…), but also partly because of the theater/entertainment aspects of sports; plus sports are more fun (and contain less vitriol)!

I have always felt that the majority of the participants in the market (and certainly the average American citizen) places too much weight on who sits in the White House. In this investor note I discuss some historical reference points to illustrate why I believe this is the case, and what the proper mindset should be from the viewpoint of an equity investor, and a long-term owner of American businesses.

I don’t usually publish my investor notes here, but I thought some BHI readers might enjoy reading it.

For those interested, here is my recent note to investors: Saber Capital Investor Note – November 11th, 2016 – Presidential Edition

Have a great weekend!

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I gave a talk at an investing conference in Philadelphia last week where I discussed my overall approach to investment along with three broad categories where I think investors could focus to gain an edge (I’ll share the slides in a later post). I don’t attend many of these industry events, but it is fun to attend them occasionally, as I got to meet with a few Saber Capital clients who live in the NYC/NJ/Philly area as well as other friends I have in the business. One friend was telling me about a research project he is working on where he is testing out a few key fundamental variables that have had a meaningful impact on stock prices over a period of time. This got me thinking later that evening about one variable (unrelated to his research) that I think has an enormously valuable impact over time.

Learning From Successful Businesses

These are just some rough scratch notes on the subject. Before I get the inevitable questions on bias—no, I haven’t tested this, and no, I haven’t tried to eliminate survivorship or hindsight bias in any way. I’ve always felt that studying successful businesses is a valuable exercise. I understand the flaws of survivorship bias (basically this is drawing conclusions from successful companies that have “made it” and then ascribing reasons for those successes). This idea was probably the biggest criticism of the excellent books Good to Great and also The Outsiders. But I thought both were outstanding books because I think it is always helpful to study successful businesses.

In other words, the risk of succumbing to survivorship bias is a risk worth taking. I’d rather risk that bias in exchange for the reward of potentially learning something useful from these success stories.

I’ve used this example in previous comments on posts: there are reasons other professional sports teams study the New England Patriots or the San Antonio Spurs (who just clobbered the pre-anointed Super Team, the Golden State Warriors in the first game of the regular season last week). The Spurs, like the Patriots, always seem to be near or at the top of the list, but even when there are teams with flashier players, those organizations found ways to win more titles than those teams who had more”buzz” surrounding a star player.

I think it’s worthwhile studying organizations (businesses, teams, schools, or any other entity) that experienced a lot of success. They key is trying to reverse engineer their success while simultaneously being aware of the inherent bias can occur when analyzing these situations. I think it’s possible to do the former without succumbing to the latter. I also think the rewards of doing these case studies greatly exceed the risk of coming to some conclusion that isn’t relevant or happens to be rooted in bias. There are all kinds of tangential benefits to reading about great businesses, and those benefits accrue over time and build on each other like compound interest.

So it’s good to be aware of bias (hindsight, survivorship, etc…), but it’s not worth letting those biases restrict you from trying to learn why something or someone became so successful.

Profiles of Successful Founders

How I Built This is a new podcast from NPR, and it is excellent. One of the first episodes featured an interview with Sara Blakely, and it is an excellent glimpse into why sometimes great businesses come from industries/businesses that many would describe as lacking “competitive advantages” or “moats”. Spanx really had no business succeeding in the product category it tried to enter. And most rational minded, probability-focused business experts would have said it really had very little chance of success—except, of course, for the fact that Spanx was started by Sara Blakely, who is a passionate, driven entrepreneur who was 100% determined to make the company a success. I highly recommend listening to that podcast as well as the other interviews also.

I’ve spent a lot of time thinking about factors that influence the long-term success of a business, and I think firms (public or private) that are run by the founders often have a huge intangible quality to them—one that is crucial to the firm’s ultimate success. This intangible quality is that the founder is often motivated by much more than money. And that is a driving force that can be incredibly powerful, and incredibly valuable for the owners of those firms.

“What’s an exit strategy?

According to the podcast, Blakely was approached numerous times by investment groups wanting a piece of Spanx. They asked her what her exit strategy was, something she hadn’t even ever thought about. She said it never occurred to her to consider selling her business, and as all of these money guys kept calling, she realized that other people started businesses with the intent to sell them.

Even today, she owns 100% of her company, which is remarkable for a business that has become so massively successful.

Blakely’s vision for her firm, her relentless focus on executing her business model, her passion for the day-to-day process of building her company—none of those things show up in her company’s financial statements. But all of those things have had an incredibly meaningful impact on those financial statements and are a critical component of the company’s value.

Firms like Under Armour, Starbucks, Alibaba, Facebook, Workday, Amazon, Google, Atlassian, and many others have founders who are maniacally focused on pleasing their customers and thinking about strategies that will impact their companies’ values ten or twenty years down the road.

Incentives Matter

Charlie Munger talked a lot about incentives. He once said he feels like he understands incentives better than just about everyone and yet he even underestimates the power of incentives.

We usually associate incentives with money. People are obviously motivated by money, and will adjust their work habits in such a way that will maximize their own earning power. Incentives are often designed to try and encourage certain behaviors that will maximize the long-term value of the company; other times, incentives encourage certain short-term behaviors (which may or may not be at odds with long-term value) such as market share, revenue gains, EBITDA, etc… But one thing you can generally count on is that corporate executives will behave (despite what they say) in such a way that will maximize their own pocket books.

The Intensity of the Founders

But there is one form of incentive that transcends money. Some might look at this as cliché, but I believe there is absolutely something to be said for the passion and drive that certain people possess. Some athletes have this quality, certain musicians have it, some business people have it, and it can be found in all walks of life when evaluating the most successful people—the people that have reached the pinnacle of their chosen endeavor. I’ve studied a lot of these people, and while many of them are certainly motivated by money, I think money is rarely if ever the primary motivating factor. These people all have huge amounts of competitive spirit, and they are generally motivated by the day-to-day process of building something. They are motivated by the process itself more than the end game.

I think that while it’s hard to identify this quality early, it’s worth considering because I think it’s very valuable and it’s often underrated.

All of the companies mentioned above compete in significantly competitive businesses (what business can honestly say it isn’t competitive?). All of these firms in theory shouldn’t have been able to develop the staying power that they did; but the common denominator is that they were all led by passionate, long-term, relentlessly focused and driven people who founded them. They had the hugely important intangible benefit of being led by a manager who had real skin in the game; and more than just money on the line. Sears Roebuck didn’t have a chance at matching the intensity of Sam Walton, despite having just about every other advantage over the small Wal-Mart in the early years. But it was Walton’s drive and intense focus on execution that mattered over everything else in the end.

Many of these businesses engulfed their founders’ lives. Their egos and identities were/are tied to these firms. Money is a byproduct of their success, but it wasn’t the driving factor. In many cases, it wasn’t even close to a driving factor in their motivation. The common denominators that I get from studying these individuals through various biographies and interviews is that they love what they do, they are more interested in the process, and they absolutely live for their businesses.

It is tough to compete against these types of individuals, and it’s hard (if not impossible) for an unaffiliated corporate manager (even if he or she has skin (i.e. stock) in the game) to match the same level of intensity that these founders bring to the table.

Bet on the Founders Who Have Already “Won”

This is a good time to point out the obvious: there are many more firms that fail that were led by founders, many of whom had the same level of passion and intensity. The latter doesn’t guarantee success by any stretch. But once success has been clinched—at least initially—these founders tend to be very difficult people to “dethrone”. I think it’s a valuable competitive advantage in many cases.

Again, this isn’t a scientific or data driven analysis. This is just my own observation from studying some of these firms—and my thoughts and research have accelerated lately on a few of these companies.

Regardless of the risk of hindsight or survivorship bias, I think it’s still worth studying the successful organizations (teams should continue to try and glean clues from how the Patriots and the Spurs run their organizations). It doesn’t guarantee that such study will lead to similar results, but to me, there is no downside to studying the best to try and add a few more strings to the web of cumulative knowledge that we are all trying to continue building as we go about our day to day investment process.

Have a great week.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”

–Warren Buffett, 2007 Shareholder Letter

A reader recently sent me the following clips from the 2007 Shareholder Letter that pertains to a topic that we’ve discussed quite a bit here: the concept of return on capital, why it’s important, and how to think about it.

For those interested, you could review all the previous posts on the concept of ROIC here.

Basically, I just thought I’d make a few brief comments on Buffett’s ideas here, but largely just clip a few portions of the letter, since I think this is a really useful topic to think about.

In this 2007 letter, Buffett groups businesses into three general categories based on their ROIC profile, and explains the differences between those three categories.

Category #1—High ROIC Businesses with Low Capital Requirements

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings. 

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire. 

Buffett then talks about the return on incremental capital and how he thinks about ROIC:

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. 

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.) 

I used this general back of the envelope math when thinking about return on capital (see this post for details on how I think about calculating incremental ROIC). It’s helpful to know roughly how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.

So See’s invested an incremental $32 million over the life of the business which produced an additional $1.35 billion of aggregate profits over that time, an astronomically high return on capital. Obviously, See’s is a “capital light business” and the ROIC is high because the denominator is low. See’s couldn’t reinvest that cash flow at high rates of return, so it had to ship the cash to Omaha for Buffett to reinvest elsewhere.

Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital

Companies like See’s produce huge returns on the small amount of capital that it previously invested. These are rare businesses that can grow their earning power without capital investment. In See’s case, this was largely done through pricing power. But See’s is a rare business, and as Buffett points out, companies that can reinvest capital at high rates of return are still attractive businesses to own:

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. 

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google. 

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure. 

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million. 

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it. 

Category #3—Businesses that Require Capital but Generates Low Returns

Here he uses the often-cited airline business as one that requires a lot of capital but can’t generate a decent return on that capital:

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice. 

He sums it up by using a savings account analogy:

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. 

What’s interesting is that Buffett talks about See’s as the most attractive type of business in this example, and certainly a business that produces steadily rising cash flow on a very low capital base is a great business. But a business that has the ability to retain and reinvest a large portion of its cash flow at high rates of return is also a great business in my view.

See’s is great because it produces cash flow without the need for capital investments, and it can still grow its earnings through pricing power. So this is truly an exceptional business. Moody’s might be a similar business—the ability to grow without new capital, which in essence means an infinitely high return on capital.

But those companies are incredibly rare birds. The next best business (and depending on the rate of return maybe even a better business) is one that can reinvest lots of capital at very high rates. This is where the compounding machine kicks into gear.

I used the example of CMG in the previous post mentioned above. The company had incredible attractive restaurant-level economics: it could set up a new location for around $800,000 and in the first year that restaurant would generate over $2 million in sales and $600,000 in cash flow, or a 75% return on capital.

Combine these high returns, with a long runway to put lots of capital to work (it was able to maintain these returns while growing from 500 stores to over 2000), and you have a formula for a compounding machine of great proportions.

CMG invested $1.25 billion during the decade between 2006-2015, an investment that led to $435 million of incremental earnings, an outstanding 35% return on incremental capital:

cmg-roic

These high returns on capital led to steadily rising intrinsic value for the business over that time. In these types of businesses, requiring a lot of capital is a good thing (or at least certainly not a bad thing if it can be reinvested at 75% cash on cash returns).

Another example is Markel, an insurance business that is obviously much more capital intensive than See’s Candy, but yet has been an incredible compounding machine over the years thanks to its ability to retain its earnings and reinvest them back into the business at high rates of returns. The result of these high returns on incremental capital has been a steadily rising intrinsic value per share (and stock price):

mkl-20-year-snapshot

Buffett himself described this type of business in an earlier letter (1992) when he said:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

So we might think two categories of great businesses:

  • Those that can retain and reinvest most/all of its earnings at high rates of returns
  • Those that don’t have any reinvestment ability within the business but can still grow earning power with little to no incremental capital

In a durable business with predictable cash flows, the latter category leads to a compounding effect that sees earning power per share impacted by the absolute growth of earnings as well as the steadily shrinking share count.

Both types of businesses are rare birds, but I would say the second category (the See’s or Moody’s type businesses that can produce sizable free cash flow using very little capital and can grow its earnings through pricing power) is exceedingly rare, but probably the most valuable.

A Few Other Posts on the topic of ROIC:

I also wrote a piece (Good Businesses Tend to Stay Good) on our new research site where Matt Brice and I discuss our investment ideas, share our research notes on the companies we follow, and discuss various investing topics with readers. That post discusses some research that (somewhat surprisingly) points to how high returns on capital are more sustainable than one might think, given the nature of capitalism.

Thanks for reading!

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

My good friend and fellow investment manager Matt Brice and I have decided to start a subscription-based sister site that we are calling the BHI Members Site. I’ve known Matt for a number of years now, and he and I think similarly when it comes to our approach to investing, which is focused on making a few select investments in high-quality companies that produce attractive returns on capital and, by our estimation, can continue to compound value going forward. Matt is one of the best investors I know, and he has produced net returns of over 25% annually since 2011 when he founded his investment firm The Sova Group.

So What is the Members Site?

Basically, it’s going to be a database of our investment ideas. The site will include:

  • All of our watchlists on the stocks we follow in various categories
  • Our database of great businesses we follow (around 50 of our favorite companies)
  • Our research notes on actionable ideas
  • Our scratch notes from our investment journals (notes on companies we are reading about)
  • An education section that will include investment theory posts and case studies

We will also begin (and have already begun) populating posts on our own summaries and comments on the Buffett partnerships and the Berkshire Hathaway letters. In addition to the Buffett letter summaries and commentary, we’ll include some general investment philosophy and strategy talk.

But for the most part, the site will be a database for our own research notes that Matt and I can use as a way of organizing information, research, links to articles on companies we follow, brief thoughts on company developments, and lots of other things.

No Change at BaseHitInvesting.com 

The main site—Base Hit Investing—will continue providing content on investment thoughts. The Members Site will be more of an inside look at our research files, our real-time thinking, and scratch notes (i.e. notes that we write in our own personal investment journals as we are in the midst of conducting research on stocks). The Members Site will also discuss our positions and investment decisions, etc… basically our investment journals made public. We decided to put it behind a paywall for a few reasons:

  1. Writing helps improve the investment process—and having a subscriber base (even a small one) gives us not just a platform but an obligation to write high-quality, thought-clarifying work—which is a precursor to an improved investment process.
  2. We like the idea of sharing research and scratch notes. I think it helps clarify my thought process, as I’ve mentioned before.
  3. We like the idea of having a database of research that we can use to look back on.
  4. Certainly, like any good capitalist, we don’t mind reaping some rewards on the content we produce if anyone finds value in it.

One ground rule: My investment management firm (Saber Capital Management, LLC) and Matt’s investment firm (The Sova Group, LLC) will always be our first priority when it comes to investment ideas. Most of the stocks that we buy have plenty of liquidity, but in the rare cases where they don’t, we will either buy first before commenting anything, or reserve the right not to mention the stock at all. But in almost all cases, sharing ideas—especially with a relatively small group of potential subscribers—will not hurt our own buying ability nor those of our readers.

That said, we have both found that writing in public has helped our investment process, and has improved our skills as investors. So for us, it’s a win/win. Writing helps us become better investors, which benefits our clients who we manage capital for. Hopefully, by offering more insight into our investment process, serious-minded investors who choose to participate will also benefit.

A Quick Word on Matt Brice

I am lucky to know a number of really outstanding investors (many of them off-the-radar small investors with very bright futures ahead). Matt is at the top of this list in my view. He is one of the most independent thinkers I am aware of. He runs a strategy that is straightforward and logical, but he is one of the rare investors who truly does concentrate on his best ideas, a “punch card” approach that has worked out tremendously well for him thus far.

I am familiar with each major investment Matt has made, and in my opinion his returns have been achieved without taking on excess risk, at least not by my definition (risk being the chance of losing permanent capital). Matt has achieved his record by owning quality investments, as well as investing in a few opportunistic special situations, but one of the best qualities of his portfolio management is his ability to truly focus on his best ideas, owning just a handful of stocks at a time.

Matt is a close friend. We talk frequently about investing ideas that we are looking at and companies that we are reading about. We use each other as sounding boards for our research, which helps us gain honest, unbiased feedback. As Buffett has said, it helps to have a sounding board, and I’ve found it to be very valuable, especially when the sounding board isn’t afraid to tell you where you’re wrong.

Feel free to contact Matt at matt@thesovagroup.com. Also follow him on twitter: @thesovagroup.

Our Research

So what we thought we’d do is basically begin to share some of our research with our readers who are interested.

If this is something you’re interested in, click here to subscribe or to see more details on what we’re offering. Also: we are making it real simple so that I don’t have to spend any back office time worrying about this (again, we have a business to run which is first priority and time is valuable).

So in light of this, the subscription will be a yearly subscription with no prorations or refunds. You can simply buy the access to the site for $500 per year, or $50 per month. There will be no trials or refunds, as that alleviates a lot of back office headaches on our end.

The objective here is not really to maximize subscribers, although we’d love to get some subscribers! The idea here is to put together a database of information, share it with those who want to read or participate, and hopefully improve our collective investment skills.

Check it out if you’d like. If not, keep reading the main blog! And as always, thanks for reading!

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

 

John Hempton, who runs a hedge fund and writes the blog called Bronte Capital, wrote a really interesting post over the weekend on investment philosophy. He basically calls out the majority of the professional money management community for cloning Buffett in word, but not in deed. His main point: many Buffett followers talk about the “punch card” approach to investing, but very few people actually implement this approach.

Here is Buffett explaining the Punch Card philosophy:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

It’s hard to describe how important and valuable this simple concept is. It’s one that I try to focus on, and try to get better at implementing each year.

But Hempton brings up a good point: lots of people talk about it, but very few people actually act this way. His reasoning for why people don’t follow such a sound approach is that it is hard to sell to clients. If you bought one stock every year or two, and you have a portfolio of say 7 or 8 stocks at a time, it may appear to clients (who see hardly any activity in their portfolios for months, sometimes years at a time) that you might not be working all that hard.

Trading activity has a way of making clients think that work is actually getting done. However, trading activity is almost always inversely correlated with investment performance. The client would be better off with the manager who charged his or her fee for selecting the punch card investments and then just sitting and waiting.

Bias Toward Activity

But human nature is difficult to overcome, and this type of an approach is difficult to implement. There are a few: Norbert Lou (who fittingly runs a fund named Punch Card) has built an outstanding track record of beating the market handily while making very few investments (his current portfolio consists of just three stocks and he makes very few new investments).

Hempton mentions that even Buffett’s two portfolio managers (Todd Combs and Ted Weschler) don’t follow a true punch card approach. I don’t know about Combs, but Hempton is wrong on Weschler I think, who is known for owning very concentrated positions in very few stocks and holding them for years (he compounded money at around 25% annually for 12 years in his fund before closing it to go work for Buffett, and the majority of his returns came from just a few positions that he held the entire life of the fund).

In fact, the majority of Weschler’s performance can be traced to two large investments that he owned throughout the life of his fund: DaVita and WR Grace. You could argue that those two investments were in large part responsible for his landing of a position at Berkshire. According to this article, he still holds a large personal stake in WR Grace (and what must be a massive personal deferred tax liability of something close to $100 million—he bought the stock for $2 in the early 2000’s).

So there are a few out there who walk the walk. But largely, I think Hempton is exactly right that most managers are biased toward activity. I also think many managers might not even consciously realize this bias. They intuitively want to convey to their clients that they are working hard, and one of the only ways to measure work progress (from the perspective of the client) is by looking at activity within the portfolio.

Some investment managers fear their clients think like this:

  • Lots of activity: the manager must be busy looking at lots of ideas
  • No change in the portfolio since last quarter: what has this guy been doing for three months? And why am I paying him?

Also, during a period of underwhelming performance, it can be difficult to stick with this approach. As Hempton says, these times can be extremely productive from a learning point of view:

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and 

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada 

This is such a great point. That type of workload will produce measurable results at some point in the future, but it won’t show up in this quarter’s statement that clients receive.

Just because there isn’t a lot (or any) activity in the portfolio doesn’t mean there isn’t a lot of activity going on in the research/learning department. I try and focus on getting better each day, regardless of whether I’m buying or selling anything. And in fact, the days I feel I’ve improved the most as an investor are usually the days where I am away from my computer screen deep in thought, reading something useful, or having productive conversations with someone that knows more about a particular business than I do.

Fortunately, I happen to have great clients who don’t expect activity from me, so I don’t feel any pressure to “come up with new ideas”. Instead, I can conduct my research efforts each and every day, and wait for opportunities. That said, I can improve on focusing more on my best ideas, and I try each year to get better at this.

The Concept Matters

Let me say that the concept is what is important here, not the actual number of punches. Buffett selected 20 as an example. Obviously, Buffett has made hundreds of investments over the years. He once said at an annual meeting that his partnership (from 1956-1969) made somewhere around 400 investments in various stocks. But he also said that the vast majority of those investments were small investments that didn’t have a significant net benefit to his returns. The vast majority of the money he made in his partnership was made from a handful of well-selected investments that he made a large portion of his portfolio (the famous example of course being American Express in the early 60’s, when he put 40% of his assets into that stock).

The key for Buffett was not his batting average, but his slugging percentage. He hit a lot of home runs in the stocks that he took big positions in. And even in the 70’s and 80’s when he was running a much larger portfolio, his best ideas made up a sizable portion of his portfolio. A quick glance at the equity portfolio from 1977 shows 24% of the assets in GEICO and another 18% in Washington Post. 2/3rds of his portfolio was concentrated in five stocks. By that point in his career, he was fully implementing the punch card approach, probably in large part because of his review of his partnership where he realized only a few big ideas were responsible for the entire performance record.

But again, there is no magic number that should be focused on. I think the concept is what is the key: there aren’t that many great investment ideas, and it’s crazy to think that you can find great ideas every day, week, month, or even year. Great ideas are rare, should be patiently waited on, and should be capitalized on when they come.

Easy to say, hard to do—especially when there is a built-in bias toward activity.

To Sum It Up

I really liked Hempton’s introspective review of his own investment philosophy, along with his honest observations. The strange thing is that he seems to imply that the punch card approach is the most sound, but yet he himself doesn’t practice it. This confounds me a bit. Either he hasn’t been able to shake the same bias he talks about (in his view it’s a very tough sell to clients), or maybe he thinks he can build a bigger business (more AUM) if he implements a more conventional long/short hedge fund strategy. I’m just completely guessing at his reasoning. Maybe I’m wrong and he doesn’t think the punch card approach is best.

But I think recognizing the “over-activity” bias is most of the battle—if you understand that you, as an investment manager, are going to be prone to activity and over-trading in an effort to justify your existence, then you at least have a chance to guard against it. It’s those who “don’t know that they don’t know” are the ones who don’t have a chance. Hempton clearly isn’t in the latter camp. He knows that he (like most humans) might be prone to this bias, so you’d think he would choose to guard against it and implement the better approach.

Either way, it was an interesting commentary, and one that I really agree with. Practicing a portfolio management strategy that involves very few (and very large) investments in high-quality companies at very infrequent junctures is a great approach, but one that can be viewed as unconventional, and thus difficult to practice in real life. I hope and plan to keep improving on this, one day at a time.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I thought I’d put up a quick post with a couple articles I’m reading this weekend. But first, I wanted to mention to readers that I’ll be speaking at the MicroCap Conference in Philadelphia on October 24th. It should be a fun event with both investing strategy discussions as well as opportunities to talk with management teams of small companies about their businesses. Check out their site for more details or to register for the event. If anyone is attending and would like to meet up, feel free to contact me.

Weekend Reading

I often get asked what I read on a regular basis. At some point, I’ll put together a list, but for now, this list covers lots of ground, and overlaps with a good amount of what I read as well. This list was put together by my friend Connor Leonard, who manages the equity portfolio for IMC, a holding company that owns stocks and wholly-owned businesses. Connor also has written a couple excellent guest posts here on BHI. This is an AP-style ranking of Connor’s top reading material:

connor-reading-list

The Economist ranks number 18 on his list, just behind Women’s Wear Daily (which to date remains unranked on my Top 25). I tend to read the Economist on the weekend, as it usually contains a number of articles and news I find interesting, but these articles often get pushed to the back burner during the week.

Here are a few that I thought were worth reading this weekend from the Economist:

Still Ringing Bells–Slowing Growth and Less Innovation Do Not Spell the End of an Era

According to one research shop’s estimates, the global smartphone market will be about a $350 billion market this year. It is maturing, especially in developed countries, which was a primary reason for Apple’s stagnating stock price earlier this year. However, I agree with the author’s main point in this piece. The smartphone generally, and Apple in particular, have a very bright future (despite the saturation level).

My thought that I’ll add is that while innovation and technological shifts will keep occurring, Apple will continue to be a primary conduit from which that technology finds its way to the consumer. Apple sells hardware and software, but it is first and foremost a brand. Regardless of what widget it produces going forward, the brand remains one of the most valuable in the world. (And while other widgets will become popular, the iPhone isn’t going anywhere).

The REIT Stuff–Explaining the Boom in Property-based Investment Trusts

I think the residential housing market in the US is very strong, and with low inventories, low interest rates, still below average new builds, and the largest generation in history (the millenials) still largely preferring to rent (this will change as they get married, get dogs, get kids, get minivans, etc…), there are some tailwinds to that asset class.

I don’t feel as good about some of the commercial property sectors, as capital has been flowing into that asset class at a very high rate over the past few years:

“This year their market capitalisation passed $1 trillion, or 4% of the American total, close to the size of the utilities sector. They have been performing well, beating the market in 2014, 2015 and so far this year, when they have generated a return of 18.1%, and are trading at an average multiple of 23 times earnings, compared with 17 times for the S&P 500 index as a whole. In a mark of their new prominence, this month S&P and MSCI, another index provider, classified real estate as a distinct sector.”

Retail investors love these stocks for their dividends, and the sponsors love to issue those retail investors new shares, as their incentives often are aligned with “assets under management” (the more debt and equity capital they issue, the more they get paid). All REITs shouldn’t be painted with this brush, but the demand for dividend income from mom and pop investors who can’t find comparable interest rates for their savings have driven a large amount of demand for these securities. Those capital flows mean more demand for the underlying real estate, which has driven cap rates (a property’s cash flow divided by its purchase price) toward all-time lows. This, along with the high management fees, should be heavily considered when considering investing in these stocks, which own cyclical assets.

Prison Breakthrough

An interesting piece about the Nash Equilibrium, a theory which is best illustrated by the famous “prisoner’s dilemma” (which is described in the piece). Nash was a mathematical genius whose life was the subject of the movie A Beautiful Mind, and his contributions to mathematics and the subject of game theory won him a Nobel Prize. The Nash Equilibrium has practical implications for the business world:

“From auctions to labour markets, the Nash equilibrium gave the dismal science a way to make real-world predictions based on information about each person’s incentives…

“…Nash’s idea had antecedents. In 1838 August Cournot, a French economist, theorised that in a market with only two competing companies, each would see the disadvantages of pursuing market share by boosting output, in the form of lower prices and thinner profit margins. Unwittingly, Cournot had stumbled across an example of a Nash equilibrium. It made sense for each firm to set production levels based on the strategy of its competitor; consumers, however, would end up with less stuff and higher prices than if full-blooded competition had prevailed.”

Charlie Munger once mentioned how perplexed he was at how one industry (such as cereal makers) would all coexist with sizable profit margins while another industry (such as airlines) relentlessly pursue market share, eroding profitability in the process. It seems that airlines pursue their own interests to the detriment of the entire industry, whereas cereal makers (at least at one time) for some reason found a Nash equilibrium.

A Few Other Articles from Other Publications:

Have a great weekend!

Disclosure: John Huber owns shares of Apple and Saber Capital Management, LLC manages accounts that own shares of Apple. 

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I am not a big fan of going through specific “checklist” items one by one when evaluating an investment idea. I know this idea has gained enormous popularity in recent years, partly due to the good book The Checklist Manifesto, and partly popularized in value investing circles by Mohnish Pabrai.

I respect Mohnish a lot, and I think his idea of evaluating previous investment mistakes (both his own mistakes and especially the mistakes of other great investors) is an excellent exercise.

One investment mistake to study would be Pabrai’s own investment in Horsehead Holdings (ZINC). This investment would be a case study that maybe I’ll put together for a separate post sometime, as it’s one that I followed during the time he owned it. There are a few reasons why I always scratched my head at why he bought ZINC, and there are a few reasons why I think it ultimately didn’t work, but one thing I’ll point out is what Buffett said in his 2004 shareholder letter (thanks to my friend Saurabh Madaan who runs the Investor Talks at Google for pointing me to this passage):

“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

“Our failure here illustrates the importance of a guideline—stay with simple propositions—that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.”

This sounds very similar to the problem that Horsehead Holdings (ZINC) had with its zinc facility in North Carolina. Without going into details, I think there were too many variables that needed to go right for ZINC to work out as an investment.

But let me just say that mistakes are part of investing. So many people are so quick to cast judgment on investors like Pabrai, David Einhorn, or Bill Ackman when they make big mistakes. I’m not apologizing for these investors, but I think that those who are criticizing these investors should look at their entire body of work to draw conclusions, not just one bad investment. These three are very good investors with outstanding long-term records that have vastly exceeded the S&P 500, and they should be judged on that record, not the underperformance of the past couple years.

But regardless of what you think of these investors, it helps to try and learn from their mistakes. I wrote a post on Valeant a while back, which is Ackman’s biggest error. I also looked at SunEdison, which was an Einhorn investment. It is infinitely easier in hindsight (the rearview mirror is always clear) to attribute reasons for why these investments didn’t work out, but nevertheless, I think it’s helpful to study these mistakes.

I don’t think a 100-point checklist would have been necessary to pass on any of these three investments (ZINC, VRX, or SunEdison). Two of the three companies were ultra-focused on growing revenue regardless of the return on capital associated with that growth, using the so-called “roll-up” approach. All three of these investments saw their losses dramatically accentuated by debt.

I think each of these investments hinged on a few key variables (in addition to debt), and I think rather than running through a generic “pre-flight” checklist, a better method is to have a few very broad checklist items, and then determine the key variables that really matter regarding the business in question.

What do I mean by “broad checklist items”? One general checklist that Buffett and Munger use:

  1. Do I understand the business?
  2. Is this a good business? (Competitive advantages, high returns on capital, etc…)
  3. Is management competent and ethical?
  4. Is the price attractive?

It doesn’t get much simpler than that, and I think this 4-point filter is a common denominator that could be used on just about every investment.

Obviously, there is a lot of thought and analysis that goes into answering those simple questions, and so there are sub-categories that might pop up.

Key Checklist/Concept #1

This isn’t really a checklist item. But it’s a takeaway I’ve had through my own experiences:

  • Whenever I find myself getting more attracted to the security than I am to the business, it’s often a good reason to pass

My mistakes have almost always come from investing in “cheap” stocks of subpar businesses. I’ve learned that I’m better off focusing on good businesses. This means missing certain opportunities, but for me, it also means reducing errors. Also, when it comes to managing other people’s money at Saber Capital Management, I don’t feel comfortable owning low-quality businesses, regardless of how attractive the valuation appears to be. I mentioned this on Twitter recently and it sparked some interesting discussions.

There are a number of investors who disagree with me on this point. Some investors make a lot of money buying crappy businesses that are beaten down to really cheap valuation levels. It’s possible to make excellent returns buying garbage that no one else wants and selling them when the extreme pessimism abates some. This is the approach that guys like Walter Schloss used to great success in the 1950’s-1970’s—the so-called “cigar butt” style of investing.

But I think one big difference between the cigar butts of yesteryear and the stocks that investors get attracted to today is the debt levels on the balance sheet. The cigar butts that I read being pitched today are often questionable businesses that are loaded with debt. If things turn around and the company survives, the equity can appreciate multiples from its current level. If not, the company goes bankrupt and the equity gets wiped out.

It’s possible to become very good at handicapping these types of situations, but it’s not my style of investing. I choose to pass on these overleveraged companies with minimal chances of success.

Low Probability, High Payoff Investment Ideas

This brings me to another point I want to make regarding estimating probabilities. I read investment pitches all the time that discuss the probability of various outcomes. This makes sense—Buffett himself has talked about assigning probabilities to various outcomes of an investment. And certain odds might tell you that even a low probability event can be a very good bet to take. For example, a bet that has a 25% chance of winning and pays out 10 to 1 is a very good bet. It is a low probability bet that has positive expectancy, and it’s a bet you should take every time.

But I generally pass on low-probability ideas for the following two reasons:

  1. Unlike cards or dice (or other games of chance where probability can be more or less accurately determined), business and investing are dynamic with ever-changing odds. Cards and dice are closed-systems with a finite set of possible outcomes. Business is fluid, and there are an infinite set of unpredictable events that can greatly impact the outcome. It’s unreasonable to assign rigid probabilities to these types of situations.
  2. Investors tend to overestimate the likelihood of success of low-probability events (to use the above example, an investor might assume a 25% odds of success and a 10 to 1 payoff; but in reality it’s just 10% odds with a 5 to 1 payoff. The investor might accurately describe all of the moving parts of the investment, and rightly understand that it is a low-probability event, but still be way off with his or her estimate of risk/reward and thus make a bad bet). It is too easy to arbitrarily assign overly optimistic probabilities to this type of investment in an effort to justify buying the stock.

A year or two ago I read numerous Dex Media write-ups (the company that published phone books), including one by Kyle Bass. DXM was an equity stub—a sliver of equity with a huge amount of debt on a dying business that was trying to make a transition to digital from print. All of the write-ups recognized the obvious struggles of the business, and all recognized that odds of success were too low. But I think those who bought the stock overestimated the odds of success and/or the amount of the potential payoff. One investor said the DXM payoff could be as high as 100-1. This reward could justify an investment even at a very low likelihood of success.

The Fannie Mae and Freddie Mac investment cases might be current examples of this type of low-probability, high-payoff type investment. Maybe these will work out, but I think many are overestimating the likelihood of success.

In my experience, it’s better to forego the low-probability investment ideas. They are too difficult to accurately judge, and they usually involve bad (or highly leveraged) businesses.

Key Checklist/Concept #2

Schloss invested in poor-quality businesses in many instances. How was he so successful? Schloss used a checklist of sorts, and the very last (but not least) item on his checklist was:

  • Be careful of leverage. It can go against you.

This seemingly oversimplified statement is really great advice. I think that while Schloss invested in businesses with subpar (or no) competitive advantages, he was able to do well because of his patience and his willingness to wait for the cycle to turn. Many of his investments were in capital intensive, cyclical businesses—but most of the companies he bought had clean balance sheets.

Today, our society is much more accepting of higher debt levels—both at the personal level and at the corporate level. Because of the availability of debt made possible in part through securitization, it is much easier for companies to gain access to credit than it was in the 1950’s. Most companies that Schloss would have looked at in his day are now saddled with debt in an attempt to improve their inherent low returns on equity through leverage. Schloss was satisfied with the low ROE’s, as he figured he wasn’t paying much for it, and eventually, the earning power would inevitably turn higher as the business cycle turned from bust back to boom.

The business cycle still has the same fluctuations of course, but leverage now magnifies the equity values. I see scores of oil and gas producers whose stocks have risen 500% or more since the February lows. Leverage has magnified the comeback in their equity values. It also would have been their death knell had oil prices not bounced in the nick of time.

Schloss said in a Forbes article in 1973—aptly titled “Making Money Out of Junk” that there are three things that can go in your favor when you buy cheap, out of favor companies:

  • Earnings turn around and the stock appreciates significantly
  • Someone buys control of the company (buyout)
  • The company begins buying its own stock

However, you need a clean balance sheet to put yourself in position to capitalize on a cyclical upturn and the corresponding rebound in earning power that could come with it.

Where the Puck is Going

Stanley Druckenmiller gave an excellent talk early last year where he mentioned one of the two key things his mentor taught him:

“Never, ever invest in the present. It doesn’t matter what a company is earning, (or) what they have earned. He taught me that you have to visualize the situation 18 months from now… Too many people tend to look at the present…”

Buffett has mentioned closing his eyes and visualizing where a company is 10 years from now, or being happy owning the stock if the exchange shut down for five years.

I don’t think it matters what the exact length of time is, but the point is that when you make an investment in a stock, you’re buying a piece of a business. When I look out to a certain point into the future, whether its 18 months or 5 years, I’d rather try to focus on a company that I think will be doing more business, have greater earning power, and be more valuable than it is today.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

Someone I’m connected with on Linkedin sent me this old article from 1977 in the Wall Street Journal on Warren Buffett. I thought I’d share it here, along with a few highlights. It’s an article I haven’t seen previously. There isn’t much new here, but I thought it was quick read with a couple passages worth commenting on.

One thing I don’t recall Buffett ever describing were the pressures of money management that he felt while running his partnership. This is Buffett describing the relief he felt after closing his fund:

“I’m having a lot of fun because I’m only going into businesses that I find interesting and where I like the people running them, and their products,” Mr. Buffett says. “It’s a tremendous relief being out of money management. I’m not constantly thinking about business anymore. During the partnership my ego was on the line, and I was trying to lead the league in hitting every year.”

I think there are a couple things to note here. First, Buffett knew that his overall record was due to his skill as an investor. But I think he also knew that his individual yearly results, where he beat the market each and every year for 13 years, was very unlikely and almost certain not to be repeated (or continued if he kept his partnership open). He knew that over 5 year periods, he would beat the market handily. But he also knew that any given year was much more up for grabs.

If we compare the results of Charlie Munger and Walter Schloss (who also ran partnerships during the same time), all three produced fantastic records, but Munger and Schloss underperformed the market about 1 in every 3 years, despite beating the market overall by huge margins (see this post for details on their performance records).

So I think the unrealistic expectations that Buffett thought his investors were placing on him began to wear on him. It’s unlikely these investors would have been so demanding (after all, Buffett made them all rich), but I can understand—being in the money management business and actively managing money for clients—that there is pressure when it comes to other peoples’ money. You treat it with much more importance than you do your own capital. That said, I was surprised to hear Buffett say he was glad to be out. I personally couldn’t imagine wanting to do anything else.

But Buffett felt a relief after shutting his partnership, and in the early years, it almost sounded like a semi-retirement. This is ironic of course, because he now is a fiduciary on a much larger scale than he was in the 1960’s.

But ultra-competitive people have a hard time staying away from the game, and Buffett is certainly no exception.

Retail is a Tough Business

“Mr. Buffett has taken some lumps. Several years ago, for example, Berkshire Hathaway lost half of a $6 million investment in Vornado Inc., a discount retailing concern based in New Jersey. ‘The stock looked undervalued when I bought it, but I proved to be incredibly wrong about the discount department-store business,’ Mr. Buffett says. ‘It turned out that the industry was over-stored, and Vornado and the rest of the discounters were getting killed by competition from K mart stores.’”

What’s interesting is that this quote is as relevant now as it was in 1977. It’s the same game with different players. Macy’s, JC Penney’s, Kohl’s and other struggling department stores have replaced Vornado, and the competitor wreaking havoc is no longer K-mart, but Amazon.

But it’s also interesting that Buffett says, “The stock looked undervalued when I bought it.” It’s strangely reassuring to know that Buffett himself was tempted by mediocre businesses that looked cheap. And most retailers are mediocre businesses that look cheap.

Whenever I review my own investment mistakes, they almost always come from situations where I was attracted much more to the valuation than to the business. These are the so-called value-traps—catnip to most value investors, but very often poor choices as investment candidates. I’ve learned to steer clear.

The problem for many investors is that sometimes these so-called value traps work out. You’re able to buy them and sell them for a 50% gain. But a year or two later they are often trading at or below (often well below) your original purchase price. The investment looked smart based on the realized gain, but was it really being smart, or just fortunate timing?

Each investment situation is unique, but the general lesson from this particular passage is that retail, specifically discount department stores, is a very tough business. Your competitors are offering the same merchandise you are (for the most part), and Amazon can match or surpass you in terms of price, selection and convenience. This puts you between a rock and a hard place—either cede market share to Amazon or other competitors (which isn’t really an option because that means lower revenue to spread across a largely fixed cost base), or cut prices to compete for customers (which, unless your lower prices lead to faster inventory turns, will still lead to lower revenue on already thin margins).

For some store concepts, this operating leverage can be a positive driver of margin expansion, returns on capital and earnings growth, but when your store that was once a favorite with customers begins losing its luster, this leverage works in reverse. All along the way, competition is brutal.

As Buffett has said regarding the retail store he ran in Baltimore (paraphrasing), “If the guy across the street started offering a 15% weekend discount, we had no choice but to match that promotion.”

It’s a very difficult game. There will be some winners for sure, but there will be a lot of losers. And it’s hard to predict (other than maybe Amazon) who will win. Some will “win” for a period of time before losing (K-mart and Sears once dominated before getting disrupted by Wal-mart, which itself is now getting disrupted by Amazon, etc…)

Inflation

“Wall Street sources close to Mr. Buffett say that his stock investments in the past few years have been largely dictated by his concern over inflation. David Gottesman, senior partner of the New York investment concern First Manhattan Corp says:

“Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. For example, Warren likens owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.”

I don’t think Gottesman’s reasoning is completely accurate here. I doubt Buffett necessarily was buying companies as an inflation hedge—although that was a byproduct of the types of investments he made. I think his preference for durable businesses with strong competitive positions and excess free cash flow would have been his preference regardless of whether the economy was experiencing high inflation, low inflation, or even deflation.

I am not suggesting Buffett didn’t consider inflation as a major factor (he did discuss inflation often in his letters as well as this famous piece in Fortune), but I don’t think he changed his investment preferences much, if at all, based on what inflation was doing.

Regardless, it was an interesting piece from the Wall Street Journal archives.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

This is just a quick post on some interesting articles I read over the weekend as I caught up on some newspaper reading.

There were a couple recent pieces (one in the Economist and one in the NY Times) on WeChat, the Chinese messaging app that now boasts over 700 million users. WeChat is also generating a significant amount of revenue (unlike Facebook’s WhatsApp and Messenger apps that haven’t monetized their networks yet). WeChat is also estimated to be very profitable for its owner, Tencent Holdings, an online gaming and social media giant in China.

Here are a few notes as I read the two articles:

What is WeChat?

From the Economist piece:

Like most professionals on the mainland, her mother uses WeChat rather than e-mail to conduct much of her business. The app offers everything from free video calls and instant group chats to news updates and easy sharing of large multimedia files…

Yu Hui’s mother also uses her smartphone camera to scan the WeChat QR (quick response) codes of people she meets far more often these days than she exchanges business cards. Yu Hui’s father uses the app to shop online, to pay for goods at physical stores, settle utility bills and split dinner tabs with friends, just with a few taps. He can easily book and pay for taxis, dumpling deliveries, theatre tickets, hospital appointments and foreign holidays, all without ever leaving the WeChat universe.”

Here is a snapshot of the app compared to the two other huge messaging apps (both owned by Facebook):

WeChat Profile

Why/How was WeChat able to grow so quickly:

  • SMS messaging is costly in China. This is unlike the US where large telecoms bundled text messaging services with other basic phone services to make texting affordable.
  • In the US, this affordability of texting via your phone provider also meant that there wasn’t as much of a need for a separate dedicated messaging app. This is partly why messaging apps like Facebook’s Messenger or WhatsApp, while very popular in the US, aren’t completely ubiquitous like WeChat is in China. There are 700 million users despite there being “only” 600 million smartphone users in the country. Just about everyone uses WeChat in China.
  • The higher cost of text messages in China led to a gap that WeChat was able to fill. Users eager to text one another quickly led to mass adoption and a foundation for WeChat to provide other offerings to its suddenly vast network of users.
  • China consumers largely skipped right to smartphones—many never purchased a PC. The lack of experience using a desktop made it more natural for Chinese consumers to complete tasks on a mobile device that Americans and Europeans might still be using their PC’s for. Half of all online sales in China take place on a mobile device, versus roughly a third in the US.
  • The app ecosystem didn’t grab hold as much as it did in the US and Europe. Instead of smartphone users utilizing hundreds of apps that each perform unique functions, firms in China like Baidu, Alibaba, and Tencent have developed apps that can perform many different tasks (messaging, social media, games, mobile payments, ecommerce, videos) all within the same app.

Network effect

WeChat’s exponential growth in users has created a platform that has allowed the app to branch out into mobile payments and ecommerce, among other offerings. Consumers can make purchases directly from merchants (who are increasingly attracted to the vast potential customer base), with WeChat taking a cut on every transaction. As the number of users grows, so does the value proposition for potential merchants, advertisers, and developers (who can create their own apps inside of the WeChat universe).

The Economist summarizes the network effect:

“E-commerce is another driver of the business model. The firm earns fees when customers shop at one of the more than 10m merchants (including some celebrities) that have official accounts on the app. Once users attach their bank cards to WeChat’s wallet, they typically go on shopping sprees involving far more transactions per month than, for instance, Americans make on plastic. Three years ago, very few people bought things using WeChat but now roughly a third of its users are making regular e-commerce purchases directly through the app. A virtuous circle is operating: as more merchants and brands set up official accounts, it becomes a buzzier and more appealing bazaar.”

WeChat’s First-Mover Advantage

The more fragmented app ecosystem in the West will make it harder for any one messaging app (including WeChat) to build as powerful a network effect as WeChat has done in China. Western users already use many different apps for a variety of services, and so it will be difficult for any single app to achieve the winner-take-all status that WeChat was able to grab in China. But as the article summarizes, this also creates a moat for WeChat on its home turf:

“Nor is there much chance that Facebook could make a significant dent in WeChat’s dominance in China. The Silicon Valley darling enjoys incumbency and the network effect in many of its markets. That has sabotaged WeChat’s own efforts to expand abroad… But the same rule applies if Facebook enters China, which could happen this year or next. ‘We have the huge advantage of incumbency and local knowledge,’ says an executive at Tencent. ‘Weixin (the Chinese name for WeChat) is quite simply more of a super-app than Facebook.’”

Tencent’s Potential Crown Jewel?

The app that is there “at every point of your daily contact with the world, from morning until night” is a very valuable asset for its owner Tencent Holdings.

I haven’t spent any time looking at Tencent, but I did pick up the annual report this weekend and skim through it. Here are the numbers of for the past five years that I converted into USD at the current exchange rate as of today:

Tencent Income Statement

The company makes most of its revenues and earnings from online gaming, with advertising generating most of the rest of the revenue. WeChat’s revenue was an estimated $1.8 billion last year, which is a small piece of the pie at this point. Time will tell if the company is effective at monetizing the platform that it has built (which is needed to justify the stock’s current valuation), but it appears to be building a lot of momentum.

I had never looked at Tencent before, but I put it on a watch list to study more in depth. I’ve been wary of investing outside the US (which is my own geographical circle of competence)—especially in a company that isn’t listed on an American exchange. But investing is a game of connecting the dots, as Ted Weschler said recently, and reading articles about growing businesses like this adds a few new dots to the mix.

Here are some other pieces to help connect the dots:

Some other articles that discuss WeChat or the business of apps in general (some are old, but I thought still provided helpful context):

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.