Michael Burry’s story is captivating. And in fact so good of a story that excellent financial storytellers like Michael Lewis and Greg Zuckerman turned it into main portions of best-selling books on the financial crisis.

The story goes something like this: Burry was just a guy writing a blog (before people knew what a blog was). He was discussing his ideas in early internet chat rooms. He picked stocks. He was a value stock picker at a time when value investing couldn’t have been less popular—the late 1990’s. But Burry did well investing his own account, and he got a small following on these early message boards. One day, he posted that he had decided to leave medicine, and he was starting his own fund. Joel Greenblatt—who had been reading, and profiting, from Burry’s posts—promptly contacted Burry, offered him a million bucks for an equity stake in his new business, and help seed Burry’s tiny fund.

Burry gained success as a stock picker who preferred bargains over market darlings, but he became famous when Michael Lewis wrote a book about the famous subprime trade. Burry went from a complete unknown (but very successful) stock picker to a fund manager who brilliantly predicted and profited from the biggest bubble in decades. His trade became the focal point of the financial crisis books, and his name became known by the heaviest of hitters such as Warren Buffett and Alan Greenspan.

Burry’s story is often told as a Cinderella type story about “just a guy” who was a good stock picker, got discovered, and then made it big in a Soros-esque trade of a lifetime.

Not exactly… That is how the sequence of events unfolded, but I think the story of Burry’s success in the subprime trade actually downplays how talented a stock picker the guy really is. He deservedly gets attention for his investment in the credit default swaps that soared when housing crashed. But as he himself states in his investor letters, he’s a stock picker at the core. He is classic value investor, hunting for bargains in the nooks and crannies of the market. As he said of his own philosophy in an early post:

“My strategy isn’t very complex. I try to buy shares of unpopular companies when they look like road kill, and sell them when they’ve been polished up a bit.”

The thing I admire most about Burry is his ability to think independently. He studied Buffett, but realized Buffett couldn’t be cloned. His style was originally much closer to Ben Graham’s—he was a bargain hunter. But he didn’t clone Graham either. From what I can tell, he simply looked for bargain-priced stocks by turning over a lot of rocks. Many of his early investments were sort of special situation type bargains—some with catalysts that played out fairly quickly, others just unloved and neglected bargains selling for less than a private buyer would be willing to pay for the business.

This weekend, I happened across a link to a very nice write-up and summary of Burry’s original posts on the message board I referenced above. It prompted me to re-read the compilation of Burry’s original articles he wrote for MSN Money, as well as review a couple old letters that I printed off. Unfortunately, I don’t know if Burry’s original Scion Capital letters are still in the public domain, but if anyone would be willing to share them with me, I’d love to read them. I only have a few of them. As for the MSN articles, they were written for the lay-person investor, but they provide a glimpse into how Burry thought about his investments.

I thought I’d highlight just a few clips from the investor letters and the MSN letters. The first thing I thought was remarkable was the fact that Burry was very bearish on the stock market in 2001, yet he remained fully invested and produced incredible results from buying bargains: +36% annually for the first 2+ years of his fund, even as stocks were in an extreme bear market, with the S&P dropping 50% and the Nasdaq falling 80% from their 2000 highs.

He describes his pessimism on the overall stock market in an early investor letter:

Burry Scion Letter Bearish View

He describes a situation that could easily describe 2015. Established companies with durable products, competitive advantages, and stable long term prospects (but with no real hope of growing much faster than 7 or 8% annually) are priced at 20 to 30 times earnings in many cases (I’m referring to large, high quality stalwarts at these valuations. This isn’t to mention the ridiculous valuations of some of the more recent IPO’s). The popular argument for this seemingly pricy valuation among high quality companies rests on the fact that interest rates are so low—a dubious justification in my view.

But back to 2001… Despite Burry’s lack of enthusiasm for the overall stock market and general valuations, and despite his bearishness on the economy, he remained fully invested in stocks he thought were undervalued. This is a good lesson—his bearish assumptions were correct, but he still preserved capital and made remarkable returns by staying focused on identifying undervalued securities and not worrying about where the market will go next:

“So, I will go on record right now as saying that this is a time of tremendous uncertainty about market direction—but no more so than at any time in the past. I continue to believe the prudent view is no market view. Rather, I will remain content in the certainty that popular predictions are less likely to come to pass than is believed and the absurd individual stock values will come along every once in a while regardless of what the market does.”

Burry turned out to be correct in his assessment that the market was overvalued, even after a significant drop. But what’s interesting to me is that he still maintained a fully invested portfolio filled with bargain securities.

In his early letters he describes how he maintained his portfolio filled with cheap stocks, and despite his bearishness, was long bargain stocks that did extraordinarily well as the overall market dropped 50% from 2000-2002. Here are his early results (Burry started his fund in November 2000):

  • 2000: +8.2% (vs -7.5% S&P 500)
  • 2001: +55.4% (vs. -11.9% S&P 500)
  • 2002: +16.1% (vs. -22.0% S&P 500)

So for the first 2 years and 2 months of his fund, he had compounded at a rate of 36.1% per year vs. a CAGR of -18.8% for the S&P 500.

And it’s remarkable that this was done primarily being long stocks with basically no shorting. Burry said in his 2006 investor letter that:

“A Scion portfolio will be a concentrated portfolio, though, and I have generally thought that in any market environment I should be able to spot the handful of investments that will make all the difference.”

So I think it’s notable that although Burry was extremely bearish (as described in his letters and the MSN articles), but he still stuck to his knitting—looking for low risk bargains.

Buffett and Munger said something similar at the recent meeting about just looking for undervalued companies and let the macroeconomic tide take care of itself.

Burry eventually got much more interested in the macro tides, and profited from it, but I think his early results as a stock picker are a good reminder that regardless of how overvalued we think the market is, there are always opportunities to invest in low risk, high probability bargain situations.

As for the MSN articles, Burry’s value stock picks there also did very well, even as the broad stock market indexes got crushed. His picks returned +23% while the S&P 500 dropped 22% and the Nasdaq plummeted 58%—a testament that in most markets, good old fashioned value can in fact protect capital from permanent capital loss.

One other comment from Burry on why it’s more important to focus on bottom-up stock picking than to try and predict stock market movements:

“Regardless of what the future holds, intelligent investment in common stocks offer a solid route for a reasonable return on investment going forward. When I say this, I do not mean that the S&P 500, the Nasdaq Composite or the market broadly defined will necessarily do well. In fact, I leave the dogma on market direction to others. What I rather expect is that the out-of-favor and sometimes obscure common stock situations in which I choose to invest ought to do well. They will not generally track the market, but I view this as a favorable characteristic.”

Here are Scion’s returns over the life of his fund until he liquidated the partnership:

Michael Burry Scion Capital Returns

Here are a few other links of interest regarding Burry and the financial crisis:

Charlie Munger is not only insightful, but he’s an entertaining guy to listen to. These Munger comments below were compiled by Aznaur Midov from the annual meeting for Daily Journal Corporation, a company that Munger chairs.

I just thought I’d highlight a few comments that I thought were interesting.

Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:

“The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very Darwinian—it’s tough out there. Technological change is one of the toughest things.”

Munger had this story when asked to identify a moat:

Question: What is the least talked about or most misunderstood moat?

Munger: You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it”.

This was an interesting response. Moats are all the rage these days among value investors—especially Munger and Buffett disciples (a group of which I consider myself a part of as well). This is for good reason—all things equal, we’d ideally prefer to own a company with a competitive advantage (a “moat”). The problem is that it’s relatively easy to identify a company that is doing well. It’s much harder to look into the future and determine if said company will continue to do well. The durability of moats is much harder to identify than the moat itself. And the durability is really what is most important, since most of the time the company that is doing well currently is often priced to reflect that.

Thus, the other problem is valuation. Munger again:

“Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case. They keep raising the prices to the point when the odds change. I always knew that, but they were teaching my colleagues that the market is so efficient that no one can beat it. I knew people in Omaha who beat the pari-mutuel system. I never went near a business school, so my mind wasn’t polluted by this craziness. People are trying to be smart—all I am trying to do is not to be idiotic, but it’s harder than most people think.”

Munger’s comment above reminded me of the comment that he made years ago in a speech in California. In this lecture, Munger points out how important it is to think in decision trees and simple probability. He references the concepts of two 17th century mathematicians: Pierre de Fermat and Blaise Pascal.

In the summer of 1654, one of Pascal’s friends—a gambler who was smart, but consistently lost money—came to Pascal asking for help with why he consistently lost money. This problem was interesting for Pascal, and a series of letters ensued that summer between Pascal and another mathematician, Fermat. By the end of the summer, these casual letters ended up proving to be a linchpin in the fundamentals of modern day probability.

Munger didn’t get into detail of this in his talk, but he did state how important the concept of thinking probabilistically is. And he even attributed this skill as one of the reasons for Buffett’s success:

“One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations…”

But the main point of bringing up a couple of 400 year old mathematicians was to describe how the pari-mutuel system works:

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position, etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.”

So the pari-mutuel system that is the stock market is fairly good at leveling the playing field between the high quality stallions and the broken down nags. Munger says a railroad company at 1/3rd of book value might not necessarily be as attractive a value as IBM at 6 times book value. Of course, it’s not perfectly efficient, and sometimes the nags provide more value relative to the price you can buy them for, other times the stallions do.

Reducing the Probability for Error

I think the stallions (the good businesses) often prove to be the lowest risk, highest probability outcomes, but this is not always the case. I’ve always thought generally speaking—most investment mistakes are made because an error was made evaluating the business as opposed to an error based on the valuation given the current state of the business. Of course, you could argue that a bad business (or one that gets progressively bad) turned out to be overvalued. But I’m just referring to the idea that very few serious investment mistakes come from buying great businesses at too high prices. Sometimes this happens—like buying Coke in 1998 or Microsoft in 2000. Business results at both of those companies continued to be good, but the stocks performed poorly. But usually, this type of mistake (while still a mistake) means mediocre results going forward, and not necessarily significant loss of capital. The big losses tend to come from being wrong about the business.

So I find I spend a lot of time trying to reduce errors, and this leads me to preferring high quality businesses. And Munger and Buffett have obviously proved the merit of this idea over time. As Munger said in that same lecture:

“And so having started out as Grahamites—which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual…”

So moats are important, valuation is crucial, but thinking in terms of probability is also very important. Evaluating what Walmart will look like in 10 years will probably lead to a more predictable outcome than evaluating Facebook (note: more predictable, not necessarily better). There are no sure things, but there are probabilities, and the probabilities—unlike card games or dice—are dynamic and ever changing. It’s not an exact science.

What you’re trying to do is locate what Munger calls the “easy decisions”. The low risk, high probability bets. Sometimes those come from the best companies in the world with significant advantages, other times they come from off the beaten path—companies that are involved with some sort of special situation that might not have these sought after moats, but nonetheless offer significant value and low risk of permanent capital impairment.

I think what Munger is really saying—if I can be so bold to put words in his mouth—is that identifying moats is not a science, and it’s not easy to describe to someone who is asking about them. (After all, the quote above is from a speech called “The Art of Stock Picking”). Each situation is different and each company has its own set of circumstances. Despite how much we’d like to boil this down into a checklist and a simple box checking exercise, investing just doesn’t work that way. It takes a lot of preparation to put yourself in the position to identify these low risk, high probability investments, and it also takes a lot of patience and discipline to wait for them in the meantime when they aren’t available.

Munger succinctly summarizes this point when he was asked at the meeting “what system do you use to identify great investments?”

“We tend to look for the easy decisions, but we find it very hard to find “easy decisions”. We found just barely enough and they had their own problems. So, I don’t have a system.”

It is certainly a lot harder for Munger than the rest of us. He is 91, he’s a billionaire, and he unfortunately has far fewer investment opportunities than most of us.

But his experience is relevant, and we can take away certain aspects of his investment philosophy as we hunt for our own bargains.

I have been busy over the past couple of weeks. My wife gave birth to twins about two weeks ago, and now that I am back in the office, I am catching up on some reading. While we were in the hospital for about a week, I did have some time to do some reading, and I have some comments on two annual reports of current holdings of mine—JP Morgan and Markel—which I may turn into brief posts.

But briefly, I thought I’d share two videos I recently watched of two great investors—one I talk a lot about, and one who I’ve rarely mentioned.

Joel Greenblatt and Stanley Druckenmiller have put together two of the all-time great track records.

Stanley Druckenmiller

Druckenmiller has arguably one of the four or five most impressive track records of all time when you combine CAGR, assets managed, and longevity. If there was an NCAA-style bracket for all-time great investors, he’d probably be a 2 seed, or possibly even snag the final 1 seed spot—he’s that good. He compounded at around 30% annually from 1981 until he retired from active money management in 2010. He started with a few million and was managing tens of billions by the time he retired. He also famously co-managed the Quantum fund with George Soros for a period of time (Druckenmiller actually managed the fund and came up with most of the investment ideas—including the famous British Pound short. Soros was busy traveling around Europe and mostly just provided Druckenmiller with general advice on position sizing and portfolio management).

Druckenmiller generally stays out of the limelight, and rarely gives interviews. There is a chapter on him in New Market Wizards when he was a young manager in 1992, but there isn’t much in the public domain relative to the size of his success. But recently he gave a talk that was very interesting (transcript is here).

He runs a strategy that is very different from my investment approach, but I still find him to be an interesting investor and his talk had a few conceptual things that I think are important for any investor who hopes to achieve significant outperformance over time. In fact, I think there are a few simple, if not overgeneralized reasons for his success.

These are mentioned in the lecture, but I’ll highlight my takeaways here:

  • He waits for the fat pitch. I’ll paraphrase something he once said: “the best thing to do is sit around and do nothing, and then when you see something, go a little bit crazy”.
  • He is very willing to admit he is wrong (when the facts change, he changes his mind).
  • He takes big positions when he finds high probability ideas.

I think these points were a big part of his investment philosophy, and despite his strategy being one that I find difficult to replicate or emulate, I think these concepts had more to do with his success than his ability to analyze macro events, currency movements, or secular trends.

And in fact, those three points are usually exemplified in all the great value investors. Druckenmiller says in the lecture that he really sees no point in watering down your best ideas with marginal ideas just for the sake of diversification. It only will lead to mediocre long term results. He also says something I strongly agree with: there just aren’t that many great ideas. In order to get great results, you have to capitalize on great ideas. And you might only find 1 or 2 or 3 really great ideas in any given year.

It takes patience and discipline to be willing to reject most everything that comes across your plate, and then really capitalize when you locate a high probability idea.

So it’s not much different in terms of philosophy, just the way the philosophy gets implemented: I tend to prefer undervalued high quality businesses that I can easily understand, but Druckenmiller and Soros found an edge by analyzing macroeconomics.

Joel Greenblatt-Different Strategy, Similar Concept, Similar Success

Joel Greenblatt—on the other hand—ran a much simpler (in my opinion) strategy that is much more akin to my own investment approach (thus the reason I mentioned him often and rarely have talked about Druckenmiller).

Greenblatt made 50% annually for a 10 year stretch from 1985-1994 (something not even Druckenmiller and his mentor Soros could match in their famous Quantum fund). Greenblatt and his partner Rob Goldstein then returned outside money, but continued running their own money using the same strategy for another ten years, achieving great results.

Greenblatt’s strategy is nothing like Druckenmiller’s, but there are a few philosophical similarities, namely that Greenblatt tended to put most of his capital into the 5 to 8 best ideas he had at any one time. He felt strongly that beyond this level, diversification didn’t really reduce any additional risk, but did water down results.

There is a case study in Greenblatt’s first book that outlines an average company that was trading for less than liquidation value (or more likely, the value that the business could be sold to a private buyer for). The twist was that the company had a very small retail subsidiary that was growing and had enormous potential. The main business was mundane, lowly profitable, and generally unattractive. The small retail operation was just a small fraction of the overall value, but if the concept worked, it could grow into a much larger piece of the pie—perhaps equaling or exceeding the market value of the entire company.

Greenblatt recognized the growth potential of the growing retail subsidiary, and in fact underestimated the possibilities. But he knew that since he could buy the whole company for less than what the main business could be sold to a private buyer for, he got what amounted to a free call option on the retail business.

Things worked out as planned, and the retail business reported strong growth and Greenblatt subsequently sold when the value and prospects of the retail subsidiary became more recognized.

The case is interesting, but the thing I took away is that Greenblatt said that his favorite ideas consist of finding an investment opportunity where there are very few ways to lose money and multiple ways to win. In the case above: the main business could have been sold, assets could have been liquidated, or maybe the operations could have turned around. And of course, the growing retail business was just gravy. There were multiple “good things” that could happen and very few “bad things”. In fact, I don’t recall exactly how the situation resolved itself, but I think the bad business didn’t really get better. I think assets ended up getting sold and the company more or less closed down the unprofitable line in order to focus on the good business.

The point is that Greenblatt’s favorite ideas were the ones where he felt there was very little chance of losing money—not necessarily the highest potential returns.

In the video below, he emphasizes this point. (By the way, thanks to Joe Koster who posted this video—I found it on his site—and Joe also emphasized this quote, which is a good one):

“My largest positions are not the ones I think I’m going to make the most money from. My largest positions are the ones I don’t think I’m going to lose money in.”

I think that’s a very important thing to consider. Bill Ackman made about 50% last year. His largest position—because of a catalyst that he himself was very much a part of—was a position that had a very, very low probability of causing a permanent capital loss. As it turns out, the investment worked out great—maybe better than Ackman expected, even though they were unsuccessful in achieving the outcome they originally set out to achieve (which was getting Allergan sold to Valeant). Instead Allergan sold itself to a higher bidder and Ackman probably smiled the whole way.

Some people don’t care for Ackman—I’m not particularly fond of big egos myself, but this was a brilliant investment by a very smart manager. Very low chance of losing money. Upside uncertain, but very low downside. Thus the reason Ackman had around a third of his capital in it.

I think both Greenblatt and Druckenmiller, despite running completely different strategies, both were successful in part because they understood the importance of that concept.

Here is the Druckenmiller lecture: great read even for us much more simple minded value investors.

Here is a video of Druckenmiller in a recent Bloomberg interview.

And here is the Greenblatt interview with Howard Marks that I referenced above:

Last weekend I spent a couple hours reading through Buffett’s old partnership letters (again). I was looking for something specific that I remembered him talking about, but then as I was flipping through them trying to find this comment, I just decided to read them again. I’ve always found it extremely valuable to read Buffett’s letters. Although I’ve read both the partnership letters and the Berkshire letters multiple times, I feel like I pick up something new each time I read them, or maybe I notice something helpful or relevant to a particular investment situation I’m currently working on.

I think the best way to learn and improve as an investor is by doing it—just invest. You learn a lot by reading about companies and researching situations. The second best thing you can do outside of investing itself is by reading and reverse engineering case studies. There aren’t many in the Buffett letters, but there are a few. (I found it interesting that he lists an oil stock arbitrage in an appendix to the 1963 letter, and discusses how it was very profitable to invest in merger arbitrage deals during that time—Buffett would buy stocks of smaller oil producers that were selling out to the larger integrated oil majors, with the objective of making 20% annualized returns on the investment operations).

Anyhow, maybe I’ll review a case study or two some other time. For now, I wanted to write a post with a few comments that Buffett made in those early letters that were thought provoking. Another thing for me personally, I think the partnership letters are interesting because Buffett was operating with a much smaller sum of capital, and was engaging in investment operations that were much different than he engaged in even a decade or two later at Berkshire.

For instance, he was managing $4 million in 1961, which was a small sum even then (however, it was large enough for Buffett to engage in activist investment operations even back then).

A good friend and I have considered writing a series of posts, or some sort of compilation at some point discussing these letters, but for now, here are just a few clips that made me think while flipping through them over the weekend.

1962 Letter

Buffett talks about his strategy here. I’ve always liked his approach to categorizing investment ideas. Although I’ve said before that I don’t seek out investments in any specific category, I do think it helps to know which investment idea belongs in which category—but the horse has to come before the cart (seek out value first, not categories of investments). As far as Buffett is concerned, he described his approach in the 1961 letter. I might summarize his portfolio strategy in a separate post, because I think it is generally misunderstood by the casual investing public, especially in the early years.

In the 1962 letter (and most letters thereafter), he briefly summarizes his portfolio strategy:

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon available factors.”

I’ll go into more detail in another post, but he lists his three categories of investments as:

  • Generals—plain vanilla investments in stocks that are undervalued without any specific catalyst
  • Workouts—special situations such as merger arbitrage, spinoffs, etc…
  • Controls—investments where Buffett became the largest or majority shareholder and pushed for change (a category that would now be referred to as activism).

Buffett and the Activist Put

Since the title of this post is “Things You Didn’t Know About Buffett”, here is the first comment I jotted down that I hadn’t noticed before (the title is presumptuous… maybe you did know!). Buffett, when discussing the general investment category said this:

“Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”

This sounds like what has recently been referred to as the “activist put”. Basically, a large shareholder takes a stake in a company and announces the “changes” they’d like to see (usually, it’s something really creative like loading the company with debt to buy back stock in the name of “unlocking shareholder value”). Investors who believe in the merit of this “activist put” will then invest in this company under the assumption that if things get better and operations improve or the stock price rises, great… if the stock price falls, then the activist will buy more and continue rattling the cage until things do improve. The theory is that this creates a floor (or “put”) under the price.

I’ve never been a big fan of such a strategy, and I wouldn’t make an investment decision that is founded on this type of theory. But I do understand that in reality this type of situation exists. Heck, there was even talk of a “Buffett put” a year or two ago when Buffett announced he would buy back stock at 1.1 (later increased to 1.2) times book value.

So the activist put can be real—I just wouldn’t make it a primary reason for being interested in an investment. And as Buffett says, value has to be present, and probably most importantly when evaluating the activist put is to “be careful whose coat we are holding”.

Using Borrowed Money

The second thing that some people might not have known is that Buffett used borrowed money in his partnerships. He didn’t borrow a lot, and he didn’t borrow against the “general” investments, but he did use leverage when investing in special situations, or “workouts” as he called them.

Buffett describes workouts as “securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities… Corporate situations such as mergers, liquidations, reorganizations, spin-offs, etc… lead to workouts.”

He describes the benefits of investing in these special situations:

“This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout the year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.”

So the workouts provide, as the portfolio academics would say, uncorrelated and attractive risk-adjusted returns. While any one deal could go sour, a basket of these investments over a period of time would provide quite predictable results.

This is why Buffett decided to add leverage:

“Over the years, workouts have provided our second largest category. At any given time, we may be in five to ten of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our workout portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.”

Buffett goes on to say that these situations typically provide 10-20% annualized returns (before the benefits of leverage), and that he limits the leverage to 25% of the partnership’s assets.

Quick Comment on Buffett’s Evolution as an Investor

Obviously, Buffett uses leverage at Berkshire, but it’s interesting to read about how opportunistic he was during his partnership days as well. His plan was certainly not to buy and hold Coke for decades in the 1950’s and 60’s.

His thoughts on investing evolved, but I think the reason for the evolution was much more due to the rising asset base than for the more commonly attributed reason—Charlie Munger’s influence (and this is not a slight to Munger at all-he’ll tell you the same thing). The latter was certainly a big factor, but the former was (and still is) the driving reason behind Buffett’s continual evolution as an investor. We may be entering a new phase of Buffett’s career in present years as he gets more involved with 3G and their hands-on approach to the operational side of businesses.

Buffett has always taken what the defense has given him. I think deep down, he probably longs for the days of the cigar butts, the oil stock arbitrage deals, and the quantitative bargains. But that’s a moot point—Buffett has always been opportunistic, and has maximized his returns with a minimum of risk by investing in the opportunity set that was in front of him at any given time.

There are a number of other things I’d like to discuss, but we’ll save them for another post. The letters are good reads, and I think there are beneficial discussions on investment philosophy, portfolio strategy, and also some interesting case studies.

Have a great weekend!

I wrote a post recently on intrinsic value, and I received some comments and questions that made me think a lot of readers are still looking for a formula to calculate a stock’s value precisely. I really don’t think this is the case. I think the best result that an investor can hope to achieve when it comes to appraising business values is to come up with a fairly sizable range of values, and then wait for the market to offer you a price that is significantly below the lower end of the range—which gives you both a margin of safety in the event your analysis is wrong and high returns on your investment if you’re right.

Investing should be simple. The concept of intrinsic value is simple. The value of a business is simply the present value of the cash that you can pull out of it over time. Graham and Buffett both agreed that this is the intrinsic value of a security—either a bond or a stock. But it’s hard to determine the precise level of future cash flows of a business. I think both Graham and Buffett would agree that instead of trying to crunch numbers into a spreadsheet and using DCF’s to value businesses, they thought of intrinsic value in terms of private owner value. Essentially, what is the normal future earning power of this business and what is that earning power worth to a rational private buyer? This is just a more practical way to think about what something is worth. What will a rational buyer pay for this business?

This, to me, is the simplest way to think about value and it’s how I think about intrinsic value.

I like to think of each investment as a separate business that I am about to buy. And with each business, I want to consider the sum of cash flows that I’ll be able to take from the business each year on average in the future. Then, given all of the other qualitative/quantitative factors that go with each individual business, I will decide how much I’m willing to pay to acquire that stream of earnings.

Each business is different. $10 of earnings from Costco is obviously worth more to me than $10 of earnings from Sears. So you have to look at each business’ earning power along with the future prospects of the business to decide how much you’re willing to pay to acquire that business’s future cash flows.

So keep in mind the two questions I referenced in a previous post:

  • How much does the business earn?
  • What is that worth to me?

Remember, you want “normal” earning power of a business. You’re not looking at the P/E ratio or the EPS from the last twelve months. You’re trying to understand the business to make a judgment on what their earning power will look like over the long term (over the next 3-5 years, or even longer perhaps). This is an art. You’re not trying to predict down to the penny what EPS will be in 2017. You’re just trying to understand the business to make an informed estimate on what the cash earnings will look like in a normal year going forward.

I sometimes use a simple real estate investment as an example, and I referenced this example in the last post. Imagine you own a duplex that rents for $900 on each side ($1800 per month of gross rent). This duplex has a gross potential rent of $21,600 per year. Of course, in any given year, a smart duplex owner understands that he might sustain a vacancy in one of the units, so maybe you’d take 8% off of that potential rent to arrive at a gross effective rent of just under $20,000. Then you have taxes, insurance, utilities, property management fees, and routine maintenance. Let’s say after paying all of these expenses, you’re left with $12,000 of annual net operating income from your duplex (NOI is a real estate term, but this is technically a pretax number, as we aren’t factoring in personal income taxes that you’ll owe on your duplex earnings, and we’ll assume for simplicity that there is no mortgage).

In this example, the duplex earns about $12,000 per year of pretax cash flow before depreciation, but since you’re a smart duplex owner, you’ll set aside around $2,000 per year for maintenance capital expenditures (larger outlays of capital for non-recurring items such as a new roof or a new air conditioner, etc…). These are maintenance capital expenditures—real expenses that are required of an owner of a duplex to maintain the current competitive position of this duplex (i.e. without a functioning roof, it will be hard to attract tenants).

So let’s say the pretax owner earnings are around $10,000 per year.

Once you know this, you can then decide how much that is worth to you. If this duplex is in a slow growth, average neighborhood that hasn’t changed much over time and won’t likely experience any abnormal appreciation, maybe you’d be willing to pay $80,000 to $90,000 for the property. If the duplex is newer and is located in a great part of town that is growing rapidly, you might be willing to pay $110,000 to $120,000. If the duplex sits in town on a half-acre lot across the street from a piece of land that is getting developed into luxury condominiums and land is trading at $300,000 per acre, maybe you’d be willing to pay more still to get this same $10,000 of earning power.

And to make a different point, it’s pretty safe to assume that the duplex has earning power of $10,000. This is a “business” that is pretty easy to understand—it’s easy to estimate the future earning power of this asset. Even if in one year you had to make some renovations and sustained an abnormally high level of vacancy and your duplex only earned $5,000 in the last 12 months, you’d still consider the “normal earning power” of the duplex to be around $10,000.

But in each case, you’d decide on the earning power of the duplex (how much does the business earn?), and then you’d weight the other factors such as age, location, neighborhood, population growth, job market, etc… and you would decide how much you’d be willing to pay to acquire that duplex’s earning power.

So just like the duplex, when you’re looking at the earnings from Costco, you’re going to capitalize that earning power differently than you would for the earnings from Sears.

Like the Concert Pianist, Practice Makes Perfect

Start with the businesses you know how to value. For practice, read a book called Analyzing and Investing in Community Banks and then go out and read a few annual reports of tiny community banks–which are fairly transparent and relatively easy to value. Or pick an industry that you have some expertise in and begin reading some annual reports of businesses in those industries. Pick simple things–I recently read a 10-K on a business that sells hot dogs and has a nice competitive position in that niche. It’s easier to understand–and value–a business that has been selling hot dogs for the past 100 years than it is to value a business that sells pharmaceuticals (at least for me–others might have an advantage with drug companies, or software, or oil and gas, etc…).

So if you’re going to value individual businesses, you have to understand that business. As Joel Greenblatt says, if you don’t understand it, move on to the next one. There are 10,000 stocks in the US, and probably over 50,000 worldwide in developed markets. You only need to find a minuscule percentage of them to fully allocate a portfolio.

Also, value investing comes in many different shapes and sizes, and if you choose not to value individual businesses, there are alternative measures such as quantitative investing in the Graham or Schloss tradition, or even Greenblatt’s “formula”. This quantitative approach values the basket as whole, removing the need to value each individual business. It relies on the law of large numbers, similar to the insurance underwriting business. I personally enjoy reading about those types of strategies, and the results from Schloss are absolutely phenomenal, but I prefer to think of the stocks in my portfolio as fractions of businesses, and thus I endeavor to understand them and value them individually.

Anyhow, valuation is an art form, and it takes practice. Just like practicing the piano, you’ll get better the more you practice. And the best way to practice is to just start reading reports. Over time, you’ll begin to understand the different metrics that are important for each business, and you’ll be less inclined to use hard and fast rules (ROIC above X, P/E below X, etc…) and more inclined to think inquisitively about the business and its operations.

The last thing I’ll mention: over time, as business owners our results are tied to the internal results of the businesses we own. A business that is growing intrinsic value over time will reward us as owners. Over the longer term, quality is the most important determinant of our results as equity owners. A business that can compound value over time at 12-15% annually will create fabulous amounts of wealth for the owners of that business.

So quality is crucial for long term owners. BUT, valuation is the most important determinant (or at least as important) over the shorter term (say 1-3 years). If you overpay–even for great businesses–you’ll have to wait a long time for your investment returns to “catch up” to the internal compounding returns of the business. Conversely, if you buy a great business that compounds value at 12% per year–if you can buy it at a discount to its fair value, then your returns will generally exceed the business’s results in the early years of the investment.

The market is a weighing machine, and over 3-5 years, it tends to weigh things properly. So valuation is an absolutely crucial factor over the near term.

Have a great week!

A while back I wrote a post about how the gap between 52 week high and low prices presents an opportunity for investors in public markets.

I mentioned that this simple observation (the huge gap between yearly highs and lows) is all the evidence you need to debunk the theory that markets are efficiently priced all the time. I think the market generally does a good job at valuing companies within a range of reasonableness, but there is absolutely no way that the intrinsic values of these multibillion dollar organizations fluctuate by 50%, 80%, 120%, 150% or more during the span of just 52 weeks.

The market is constantly serving up opportunities. I just checked a screener and there are 375 stocks in the US that are 50% higher than they were 1 year ago today.

This leads me to a thought that I think, for some reason, is not really discussed in investing circles—at least not in value investing circles: and that is the concept of portfolio “turnover”.

To think about portfolio turnover, let’s first take a look at a concept that security analysts and value investors think about more often: asset turnover.

Asset turnover basically measures how efficient a company is at using the resources it has to generate revenue. It’s simply a company’s revenue in a given period divided by its assets. Generally speaking, asset turnover is a good thing—the higher the better. If two companies have the same asset base, the company with the higher level of sales is doing a better job at employing those assets.

Coke and Pepsi

Coke and Pepsi are somewhat similar businesses, but it isn’t necessary to compare their business models when it comes to understanding the math of turnover. Just look at how Coke’s profit margins are almost double the margins at Pepsi, but Pepsi is about equally profitable (produces similar returns on assets) because Pepsi is more efficient than Coke is at using the assets it has.

Let’s glance at two homebuilders:

NVR and Lennar

NVR has a different business model than Lennar as it uses less capital (it employs a smaller asset base). This allows NVR to be almost three times more efficient with its resources than Lennar, and although Lennar has a higher profit margin, NVR produced a much better return on assets.

We can compare two businesses in different industries to see how their business models and operating results affect their profitability:

Coke and Whole Foods

Coke and Whole Foods produce roughly the same ROA, but got there in very different ways… Coke has very high profit margins but takes nearly 2 years to produce $1 of revenue for every $1 of assets. Meanwhile, Whole Foods’ profit margin is less than 1/4th the size of Coke’s, but it turns over its asset base nearly 5 times faster, yielding roughly the same return on the resources it has to deploy.

These examples aren’t to say one business or one measurement is better than the other–it’s really just to point out the importance of turnover.

Inventory turnover is a similar ratio. A grocery store is a very low margin business, but in some cases grocers can produce adequate (or sometimes better than adequate) returns on capital if they are able to turn their inventory (merchandise on the shelves) faster than competitors. Two competitors with identically low profit margins might have vastly different profitability because one grocer might be producing much higher ROA due to its ability to turn its inventory over faster.

So in business, it is clear that asset turnover (and inventory turnover) is a good thing. The higher the turnover, the higher the returns.

Portfolio Turnover

I once mentioned I have put together notes on investors who have achieved exceptional (20-30% annual returns or better) over a long period of time (say 10-15 years minimum). There are a variety of strategies and tactics employed, but there are a few common denominators. In addition to the expected commonalities (most are value investors), there is one common denominator that isn’t talked about much: portfolio turnover.

Portfolio turnover is a phrase that I’m using—I don’t like using phrases and words that you might find in a CFA textbook, but this is the easiest way to refer to the concept. Basically, think of portfolio turnover as asset turnover.

The capital you have in your account might consists of stocks, bonds, cash, etc… these are your assets. The faster you turn these assets over (at any given level of profit), the better.

It’s simple math. I think a lot of value investors get hung up on the Buffett 3.0 version. Let Seth Klarman explain this… Klarman once said that Buffett’s career has evolved a few different times and can be categorized generally as follows:

  • Stage 1: Classic Graham and Dodd deep value and arbitrage (special situations)
  • Stage 2: Great businesses at really cheap prices (think American Express after Salad Oil Scandal, Washington Post, Disney—the first time at 10 times earnings in the 60’s)
  • Stage 3: Great businesses at so-so prices

Now, if we look at Buffett’s results, even lately, some might take issue with Klarman calling them “so-so” prices. But nevertheless, I think Klarman is basically correct in his assessment of Buffett’s career, and I actually think Buffett himself would agree with this. As Buffett’s capital base expanded, he had to begin to begrudgingly adjust the investment hurdle rate that he required. He mentions this in his 1992 letter to shareholders, replacing his demand for “a very attractive price” with simply “an attractive price”.

This description by Klarman took place during an interview with Charlie Rose, and Klarman jokes that he (Klarman) is still in Stage 1, scavenging for bargains. What’s interesting about this comment, is Klarman has been able to produce really solid returns on a very large amount of capital, and I think it’s in large part because of the simple math of asset turnover—Klarman buys bargains, waits for them to be valued at a more reasonable level, sells them, and repeats.

Walter Schloss was another master at turning over his portfolio that was filled with bargains. Schloss actually ran his portfolio like a grocery store. I’d say on balance, his stocks produced relative small profits (I’d venture Schloss had many 20-50% gainers, but very few 5-10 baggers), but collectively, he produced 20% annual returns for nearly 50 years because he was able to adequately turn over his “inventory” (i.e. his stocks) fast enough. This isn’t to say that you have to look for activity, or actively trade—Schloss said he kept his stocks an average of  3-4 years. But it just means that he would not have produced anywhere near the results he did if he held his stocks “forever”, or for 10 years instead of 4, etc…

Walter Schloss was akin to the low margin grocery store that didn’t produce exciting margins on any one product, but collectively across the store it was able to effectively turn over the merchandise fast enough to make exceptional returns on the assets it employed.

Some other investors might be more akin to the higher margin, lower turnover businesses that might produce much lower asset and inventory turns, but still generates very attractive returns on capital because of its very high return on sales (profit margin). These investors hold stocks for longer periods of time, but find big winners that rise 3, 5, 10 times in value over many years. A business can produce incredible profitability on lower asset turnover if it can wring out a large amount of bottom line earning power from its top line revenue.

The Two Drivers of Profitability

Some people might be familiar with the simple math of this situation, but it might help to briefly illustrate this to show what ROA (Return on Assets) consists of:

The Return on Assets (ROA) is one measure of profitability and it is calculated simply by dividing net income into total assets. A lemonade stand that produces $20 of earnings and has $100 worth of assets (the stand, the small square of front lawn, the inventory of lemonade, etc…) is producing a 20% return on assets.

The two functions that determine ROA are:

  • Profit Margin (some accountants refer to this as “Return on Sales”). Profit margin is calculated as follows:
    • Profit Margin = Net Income/Sales
  • Asset Turnover (the measure of how efficiently a business uses its assets—i.e. how much revenue can be generated from each $1 of assets). Asset turnover is calculated as follows:
    • Asset Turnover = Sales/Assets

So I hear a lot of people talking about the profit margins (big winners) but few investors talk much about asset turnover (how quickly you go from one investment to the next). And worse yet, when they do discuss turnover, it’s usually negative (most investors say lower turnover is better, which is not true—more on this shortly).

Higher Turnover Isn’t Necessary—But It Does Influence Returns

Now, it’s important to keep in mind the above equation—there are two drivers of profitability of a business:

  • Efficiency—how much revenue you can produce from your available resources (assets)
  • Profitability—how much profit you earn for each $1 of sales

So, turnover (whether we’re talking about asset turnover in the context of a business, or portfolio turnover in the context of an investment account) is just one driver of the returns that the business (or portfolio) generates.

The other driver is how much money you make on each $1 of sale (or each $1 invested).

If your business begins to turn over its assets more slowly (i.e. it begins to generate less revenue per $1 of assets), then you’ll need to make up for that by earning a higher profit margin on each $1 of revenue if you are to maintain the same ROA.

Similarly, as an investor, if your portfolio turnover decreases (which is often the result of a longer time horizon), your profit margin (in the context of investing, the amount of money you make on each $1 invested) must increase if you are to maintain the same level of annual returns on your overall portfolio.

I think this is where there is somewhat of a disconnect in the value investing community—which often considers portfolio turnover to be a negative thing. In and of itself, turnover is not bad. In fact, generally speaking, the math tells us that it is one of two main drivers of investment performance. So it’s actually necessary!

Why Do Investors Think Portfolio Turnover is Bad?

I think the reason for this negative connotation is that portfolio turnover is often associated with excess, or inappropriately high levels of trading, which is often done for emotional reasons without regard for the fundamentals of the business.

But let’s assume you are a rational, disciplined value investor. If that’s you, then you should try to turn your portfolio (your assets) over as fast (as efficiently) as possible. The faster you can buy and sell 50 cent dollars, the higher your returns.

Again, simple math (this might be painfully obvious, but I’m still going to demonstrate):

Let’s say you buy a stock at $10 and you sell it at $20:

  • If it takes 5 years to get from $10 to $20, you’ll earn a 15% CAGR on that invested capital
  • If it takes 2 years to get from $10 to $20, you’ll earn a 41% CAGR on that invested capital
  • If it takes 1 year to get from $10 to $20, you’ll earn 100% CAGR on that invested capital

In this case, your “profit margin” is the same in each case: it’s 100% in all three examples (the stock doubled in all three cases). However, your CAGR increases as your asset turnover increases—in other words, the more opportunities like this you can find and the faster they play out, the higher your portfolio returns will be.

So that demonstrates the various CAGR’s on the same level of profit margin. This is the same basic math that you’d see if you compare two companies with a 10% net margin, but Company A turns over its assets twice as fast as company B, then Company A’s ROA will be twice as high.

Now let’s quickly look at the same level of asset turnover on different levels of profitability:

Let’s say each year on January 1st, you buy one stock, and each year on December 31st, you sell it to buy something else:

  • If the stock you bought goes up 15% over the course of the 1 year, obviously your CAGR is 15% on this 1 year investment
  • If your stock goes up 25%, your CAGR is 25%, etc…

In this example, your asset turnover is exactly the same (you turn over your assets once per year in this case), but your profit margins are different.

Obvious stuff, right?

I think so, but I consistently read a lot of people referring to portfolio turnover as a bad thing, which runs counter to the math behind these examples.

Buffett’s Returns and Peter Lynch’s Famous 10-Baggers

It’s clear to see with these simple examples that portfolio returns (ROA) is dependent on two drivers:

  • How much you make on each investment (profit margin)
  • How quickly you can turn over your assets (asset turnover)

Buffett’s transition that Klarman referred to above is one where he transitioned over the course of his career from a lower profit margin, higher turnover investor to a higher margin, lower turnover investor. In the 50’s and 60’s, Buffett made many more investments, and made much smaller profits on average (in other words, he bought stocks, sold them when they appreciated to buy still more undervalued stocks). In the 80’s and 90’s, he began making fewer investments (due to increasing capital levels), but his profit margins grew (he went from making 20%-50% gains in shorter time periods to making 1000%+ gains over many years).

Interestingly, Buffett’s results (on a percentage return basis) were much better when he had higher turnover (and lower average profit per investment) in the early years than they are now. In fact, Buffett said his best decade of returns was the 1950’s, when he was making 50% annual returns, and investing in a variety of bargains and special situation events.

This wasn’t necessarily intended or by design, it was simply that Buffett was “taking what the defense gave him”. As his capital grew, he had to look for larger investments and had to extend his time horizon.

If he were investing again with $1 million or so, he’d be making many more investments and his asset turnover would be much, much higher—there is absolutely no doubt about this.

He may have a few investments that become big winners, but there would be very few 10 baggers, and many, many smaller, faster gains.

One other point that runs counterintuitive to what most people think: Peter Lynch is famous for the term “10-baggers”—investment that rise 10 times in value. But in fact, when Lynch started running the Magellan fund and was producing incredible 50%+ returns in the early years, his turnover exceeded 300% every year for the first 4 years (in other words, the average length of time he held a stock was only 4 months). I think in reality, his fantastic track record is much more because of higher portfolio turnover and much less because of the famous “10-baggers” that he cites in One Up on Wall Street.

Certainly profit margins are just as important a driver to profitability (portfolio returns), but I think turnover is vastly misunderstood.

I think it’s important when listening to the great investors–even Buffett–to keep in mind this math when you hear ubiquitous investment advice and generally accepted wisdom regarding turnover, investment time frames and holding periods.

I was catching up on some links and articles this weekend. Sometimes, things that are interesting but not time sensitive get pushed to the back burner. In these cases, I sometimes create a file filled with things that I’d like to read and the early morning Saturday hours are sometimes a good time to catch up on these things.

Anyhow, here are some things I’ve read recently that I read that I thought readers might be interested in taking a look at.

The Advantage of Cheapness

This is a piece from 1997 on the then-CEO of Fastenal (now Chairman) Bob Kierlin. The article discusses his incredible appetite for low costs at all costs, and how his cheapness helped foster the culture at Fastenal, and helped it become lean, profitable, and sustainably competitive.

Some Ivy League MBA professors will say cost cutting is not a “sustainable competitive advantage”. In other words, these skeptics will say: yeah, a frugal management team is great, but if keeping a lid on costs is the only advantage one company has over competitors, soon those competitors will cut their costs also and erase this edge.

Once again, I think this calls for the great Yogi Berra quote: “In theory, there is no difference between practice and theory. In practice, there is.”

There aren’t many CEO’s worth a quarter of a billion who are renting vans to drive themselves on business trips, eating fast food, staying in motels, and eschewing the stationary store’s scratch pads in favor of homemade notepads made from used paper and glue. Maybe this passage takes the cake:

“And then there are his suits. At a discount store, they’d probably go for $200 apiece. But Kierlin didn’t buy them there. He got them from the manager of a men’s clothing store. Not from the manager’s store. From the manager. The suits are used. “Luckily, we’re the same size,” says Kierlin, a triumphant smile crossing his face. “I picked up six of those suits for 60 bucks each.”

Cheapness might be a personality trait, but there are some who can use this to foster a culture that leads to increased profitability. And the reason this is sustainable is simply because being cheap often means not taking the easy route (i.e. the company paying for your private jet is much more comfortable than driving yourself for 5 and a half hours in a rented van). In practice, most CEO’s aren’t willing to do what in theory they would.

Read the full article here.

Munger Complilation

For you Charlie Munger fans, here is a document I came across a few weeks ago that is a nice compilation of the Wesco annual meeting notes as well as a number of other transcripts and articles written by or about Munger.

The title of the compilation is “Best of Charlie Munger” or something to that effect. But any compilation of Munger isn’t complete without this one: The Art of Stock Picking. I might highlight a passage or two from this piece some other time: it’s a great discussion on behavior, mindset and investment philosophy.

Jeff Bezos Interview

This was a great discussion with Jeff Bezos. The Amazon.com CEO rarely gives these types of at-length interviews, and it’s worth watching if you have some time. I’ve never invested in Amazon, but I really admire Bezos’ ability to stay focused on the long term mission of building value at his company with complete disinterest for what short term traders, analysts, and observers think about him or his strategy. Time will tell if Bezos’ strategy of investing “profits” back into the business is successful, but it is refreshing to listen to a CEO who really doesn’t care about short term results and pays more than just lip service to “thinking for the long term”.

Other Odds and Ends

Here are a few other interesting articles that I came across recently…

I hope a few of these are interesting. Have a great week!

A few weeks back I came across an article that someone had posted on Sears. It is a fascinating read for a few different reasons. One, I think Sears is an excellent case study of the retail industry and the difficulties of investing and allocating capital in that type of business, and two, the article was written in the summer of 1988.

This post is not a prediction of the demise of Sears, or an indictment against those who find value in the stock, it’s just my own commentary on the case study and some observations I had while reading the interesting piece.

Some Clips From 1988

First the title of the piece itself is telling:

Sears: Why the last big store must transform itself, or die“.

Sounds like a headline for a piece from 2014, doesn’t it?

Here are some other “deja vu all over again” type quotes from this 1988 article on Sears (emphasis mine):

First, the article depicts the scene at an analyst conference where Sears’ executives pleaded their case that progress at the firm–while elusive so far–was imminent:

“(The CEO of Sears pledged that the retailer) stood poised for a long-awaited turnaround… Despite past, unsuccessful counterattacks against specialty and discount merchants, there would be no more false starts. Success lay just around the corner. But (the CEO and his top executive) soon found themselves in familiar waters: Sears was selling a bill of goods that nobody wanted to buy.”

I found the following interesting solely because of the reference to market value:

“With a market capitalization of $14 billion, Sears is too big, and too powerful, to fall to a raider.” 

Sears current market cap: $3.5 billion. (Note: Of course, this isn’t completely apples to apples because of the many different asset sales, spinoffs, restructurings, and other corporate events that split off some value for shareholders. However, the 1988 Sears Roebuck value didn’t include Kmart either, which paid $11 billion or so to buy Sears in 2004. Anyway you slice it, the last 27 years hasn’t been kind to shareholders…)

How about this comment on the value of Sears’ real estate assets:

“Certainly, the profit potential of a Sears bust-up is tempting. Despite hidden assets, especially a coveted real estate portfolio valued as high as $11 billion, Sears’ shares are selling at about $36.50 each–slightly above book value and a whopping 160% less than Sears’ estimated break-up value.”

Wow… this is from 1988! Insert whatever the current estimates for those numbers are, and you have an investment thesis that has been repeated–including by some really high quality investors–for the past decade or so.

This brings me to a quick aside: One thing that I think often gets left out of liquidation valuations, break-up analyses, asset sales, etc… is the general concept of the time value of money. Key factors such as absorption rates or inventory levels often get left out of the argument–i.e. how long is it going to take to sell these properties? Even if the current values of the assets are accurate–which is a big “if” if you’ve visited a vacant Sears-anchored mall lately–if it takes 10 years to sell off a massive portfolio of illiquid real estate assets, then the net present value of those assets is much lower. You can’t dump all of the assets into a real estate sector like retail all at once. Well I guess you could, but not without enormous price consequences.

There are some really high quality write-ups I’ve read regarding the value of Sears’ assets, but many others that I’ve read forget the all-important concept of time value of money. Are those two birds in the bush really worth the one in the hand? The answer depends on many things, but specifically two come to mind: your level of conviction that there are in fact two birds in the bush, and your estimate of the time it will take to get those birds out of the bush.

Back to the article… this clip generally summarizes how difficult and competitive the business is:

“Montgomery Ward & Co. has transformed itself into a tight network of value-driven specialty stores; J.C. Penney Co. has exited most hard-goods lines to concentrate on fashion-oriented soft goods. And other general merchants, such as Kmart Corp and Wal-mart Stores Inc. have made razor-sharp discount pricing a specialty unto itself.

“Sears drifts between the role of no-frills discounter and full-service department store. It sells everything from dishwashers to dresses, but not as well as specialty stores, nor as cheaply as discounters and outlet stores.” 

It’s a tough business… The fate of Sears is perhaps summed up by this last clip from the article:

“‘Sears, in its present form, is not where America wants to shop‘, declares Louis Stern, a professor at (Northwestern University) and a retailing expert.”

7-Foot Hurdles

Retail is a difficult business to be in. Reading Buffett’s letters and studying his previous investments have left me with a couple broad (and possibly contradictory) conclusions. One, you don’t have to be a Buffett clone to do well in investing—I think it’s wise to think independently, do your own analysis, and come to your own conclusions. Two, it’s almost always a wise thing to follow Buffett’s general advice on investing and business.

Lampert once referenced Buffett’s quote “I don’t try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over“. Lampert said that he loves 1 foot hurdles also, but he can’t find any… I was surprised to hear him say this because he was basically admitting that Sears was a 7 foot hurdle—in other words, a less than ideal investment, but he justified the investment simply because there were no other 1 foot hurdles that he could find.

This always struck me as strange because Lampert was regarded by many as “the next Warren Buffett”. I’m not a fan of referring to anyone as “the next” anyone, but Lampert certainly had a skillset and a temperament that was conducive to producing long-term results in the stock market. A young Lampert once reverse engineered Buffett’s past investments and in one particular case while still in his 20’s, flew out to Omaha and somehow got Warren to meet with him for an hour and a half so the younger investor could pepper the master with questions.

The results for Lampert were absolutely outstanding, and the Buffett comparisons, which started early, continued to grow as his fund and his track record grew. Even today, many liken the asset-heavy Sears Holdings to the original Berkshire Hathaway—the dying textile business that consumed more cash than it spit out for Buffett. Many Sears investors are hoping Lampert turns it into “the next Berkshire Hathaway”—another “the next” comparison that may end up being relevant but probably gets thrown around too frivolously.

Anyhow, there are a lot of lessons with Sears, and I suppose that the story isn’t finished yet for Lampert nor SHLD, but I think the story probably is finished for Sears as a retailer. It was probably finished a long time ago—probably well before Eddie even began producing 30% annual returns in his investment partnership. There still might be value there somewhere in the holding company, and I would not be betting against Lampert. Again, this is not a knock on the guy—I think he’s incredible, and I think his investment record (outside of Sears) is probably one of the best records of the last few decades. If there is any way to squeeze value out of Sears, I believe Lampert will do it. But again, there certainly were far lower hurdles for him to step over than tackling this monster.

Anyway you slice it, it’s a fascinating case study, and one that is worth reading about. Here is the link to the full article referenced above from 1988.

Have a great week!

“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.

Ben Graham, Security Analysis (1951 Edition)

Graham went on to say this about the definition of intrinsic value:

“A general definition of intrinsic value would be that value which is justified by the facts—e.g. assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.

Graham was a very eloquent speaker and writer, but Joel Greenblatt I think does a great job at summarizing the crux of the issue when he says:

“Value investing is figuring out what something is worth and paying a lot less for it.”

When I’ve referenced intrinsic value in the past, I’ve received questions like: yes, but how do you figure out what something is worth? In other words, how do you determine intrinsic value?

This post will just have some of my comments that I’ve compiled on the topic of intrinsic value. For those hoping for a spreadsheet or a formula, you will be disappointed. But hopefully this post will provide some general ideas you might find helpful with understanding and grasping the concept of intrinsic value, which at the core is very simple.

Determining Intrinsic Value is an Art Form

The process of determining the intrinsic value of a business is an art form. There are no rigid rules that you can use to plug data into a spreadsheet and hope that it spits out the value for you. I’ve looked at a lot of different models over the years, including many DCF’s, and I’m usually skeptical of most of these types of models. On page 4 of his owner’s manual, Buffett simply defines intrinsic value:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  

This implies that a DCF model is the proper method of determining value. However, he goes on to say on page 5 that:

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.”

Buffett implies that valuation is an art form. Determining the present value of all the future cash flows of a business involves looking at all different aspects of a business’s DNA including its historical financials, its profitability, the stability of its operating history, its balance sheet, evaluating its competitive position, critically thinking about its future prospects, and evaluating its management team, among other factors–all weighted and compared to the current price.

So it’s an art form, and it takes practice.

Buffett was asked about intrinsic value at the annual meeting, and he basically said that it’s really the concept of private owner value. What is the price that a private buyer would pay for the entire business and its future stream of cash?

This is a simple concept, and it makes sense… the question I’ve been getting is how can we determine that?

What is the Earning Power, and What is that Worth?

To me, the concept of a business’ intrinsic value is very simple. It’s based on earning power. Take a look at that Graham quote above one more time… it’s interesting to note that Graham is saying that future earning power is the “most important single factor determining value”.

I can boil down Graham’s words into my own simple definition of intrinsic value by asking two questions:

  1. How much does the business earn in a normal year?
  2. What is that earnings stream worth to me?

So the real question you’re trying to answer is what is the business’s normal earning power? In other words, if I am a private buyer, how much cash will this business put in my pocket each year after paying for capital expenditures required to maintain my competitive position? (What are the normal owner earnings that I can expect from this business)?

In Security Analysis, Graham—contrary to popular belief—actually spends a lot of time discussing future earnings, as that is really what we’re after…. Not what the business earned in the past, but what we can expect the business to earn each year on average in the future.

So think of earning power when you’re thinking about a business’s intrinsic value. Try to determine the stream of cash that you could expect to get from the business over time in the future. If you think a business can earn $3 per share, how much is that $3 worth to you? If you think the business, by retaining and reinvesting a portion of its earnings, can grow its earning power at 10% per year, maybe that $3 is worth more to you than a business that earns a consistent $3 that pays it all out in dividends but can’t retain and reinvest anything (i.e. it’s not growing).

Focus on Predictable Businesses

It’s important to note that not all securities can be valued by everyone. Each investor has a circle of competence. You can’t possibly know everything about everything all the time. You just need to know a little bit about something some of the time.

It helps to also know that some businesses are just easier to value than other businesses. Predictability of cash flows is a very important thing to consider. Graham talked about this as well when he said that the security analyst must:

use good judgment in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis.”

In other words, it’s easier to value a business with stable operations and cash flows than one with a wide variation in cash flows from year to year.

Don’t Overcomplicate Things

Investing is simple. Weigh things against each other, and think in simple terms. Simple decision trees… How much is the cash flow, what will the cash flow look like in normal times going forward, and what is that worth to me?

If you can’t figure out what the normal earnings will look like 5 years down the road, don’t buy the stock and move onto something where the earning power is more predictable. Most business won’t be able to be valued with any sort of accuracy. If you can’t figure out normal earning power, it will be difficult to figure out what the business is worth.

People tend to make things far too complicated. Intrinsic value is simply what the future stream of cash flow is worth. I think a lot of new investors are searching for a formula or some specific number, and it doesn’t really work that way. As Buffett says, he and Charlie would come up with two different intrinsic values for Berkshire Hathaway if they were forced to write down what they thought it was worth (it would be close, but it wouldn’t be exactly the same).

You don’t have to be precise either. Remember, you don’t need a scale to know that a 350 pound man is fat. Don’t try to sweat over whether the business will earn $3 or $3.25. Just try to focus on finding the big gaps between the current price and the value you’ve placed on future earning power. Remember, Buffett thought PetroChina was worth $100 billion and he could buy it at $35 billion. You could do all sorts of elaborate analysis, but Buffett basically boils down everything to what will the business look like in 5 to 10 years (i.e. what will the business, and all of its assets, be able to produce in owner earnings over time, and how much are those owner earnings worth to a rational buyer).

Simple Logic of Intrinsic Value

If I’m looking at a duplex that I think can earn $10,000 per year, how much am I willing to pay for that duplex? Each situation is different. If the duplex sits in a stable neighborhood with very modest growth and development, I might be willing to pay $80,000 or $90,000. If the duplex sits in a growing part of town with a rapidly developing landscape, maybe those earnings will grow and are worth more to me. If the duplex has a plot of land in the back that can be developed into two more units that will double the cash flow, the overall investment has significantly more future earning power and I might be willing to pay more still.

The level of capitalization I put on those earnings depends on my overall analysis of the situation including what I expect the future earnings to be, but the basic two questions I’m always asking myself when it comes to the concept of intrinsic value are:

  • What can the business earn? And,
  • How much is that worth to me?

Keep things simple. I’ve never bought a stock because of numbers that a spreadsheet gave me based on specific future projections for growth, cost of capital, etc… I spend most of my time reading and thinking, and I try to keep the math very simple. And I try to give myself a large margin of safety in case my assessment of the situation is wrong. But I don’t want to invest in a situation where heroics are needed to reach a certain earnings level or a complicated model is needed to justify a purchase price.

I don’t think Graham ever used a model, and I don’t think Buffett ever did either. I’m not saying models are completely useless, I just prefer not to use them. I think more often than not they provide a false sense of precision, and the real world just isn’t that precise. The world is a dynamic, ever changing landscape, and investing and valuation are—in large part—art forms.

I hope this discussion is somewhat useful, and Happy New Year to all!

This weekend I came across a link to an excellent Manual of Ideas interview with Allan Mecham that I’ve read before, but I decided to read through it again. There are a few key points that Mecham brings up that I think are really worth repeating, so I thought I’d highlight them here. Investing is not easy, but it should be simplistic. Here are some points worth keeping in mind:

Understand What You Are Buying

The first is the concept of understanding a business like an owner.

Mecham said something interesting when asked how he generates ideas:

“Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically… Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years—we like to stick to what we know.”

A friend and I have jokingly talked about the concept of a “Grandma Watchlist”, or a list of businesses that your grandma would feel comfortable owning. These are the great businesses. Unfortunately, they are also stocks that aren’t often cheap. However, I think building a list of great businesses is extremely valuable for two reasons:

  1. Studying a great business is never a bad idea. It helps you develop pattern recognition skills, and might help you identify successful characteristics of other businesses over time.
  2. More directly, studying a high quality business that you understand will allow you to act aggressively if that business ever is offered up by Mr. Market at a price that represents significant value

So this exercise of reading, researching, and building a database can be beneficial over time, and this process compounds over time. You might start with 1 business you understand well, which won’t leave you with much opportunity. But as the list grows to 3, then 5, then 10, etc… it begins to increase your opportunity set as well as your knowledge base.

My own investment strategy involves a two-fold approach of looking for the undervalued compounders that are building value (good businesses at bargain prices) as well as special situations (workout investments that possess significant value that might get realized through some corporate event or other catalyst). But I don’t think categorizing investments is that important—the key is finding bargains that you understand. While I’m focused first and foremost on locating bargains (gaps between price and value), I do spend a considerable amount of time reading and contemplating aspects of businesses.

So what I’m really after is quite simple: Good businesses that I can understand—at bargain prices. I think an underrated principle of investing is focusing on what you know. I think this will reduce unforced errors, which—like the amateur tennis player—is the best way to win.

In my hunt for bargains, I always keep an eye on a list of businesses that I know well, so that I’m prepared to act if and when they fall to a price that I know represents a sizable gap between price and value.

Be like the plumber in Bemidji, who keeps carving out his niche and stays focused on his small, but effective circle of competence.

Focus On Downside

Speaking of unforced errors, Mecham references the importance of reducing them when answering a question on mistakes investors tend to make:

“Patience, discipline, and intellectual honest are the main factors in my opinion. Most investors are their own worst enemies—buying and selling too often, ignorning the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity.”

Everyone talks about the importance of focusing on downside (just like everyone talks about understanding what you own). But I still think these concepts get implemented much less frequently than the “air time” they receive would have you believe.

Beware the Lottery Ticket Investments

The concept of focusing on the downside brings me to a tangential topic that I’d like to briefly talk about, and that is the allure of the “lottery ticket” investment. This is the type of investment that has long odds of paying off but could result in a huge payday if it works. For example, let’s say investment has a 40% chance of making 5 times your money, and a 60% chance of going to 0. In theory, this investment has a high expected value, and should be taken (if you could make this investment 10 times, 4 times out of 10 you’ll make 5 times your money, which far more than compensates for the 6 times your investment went to 0). In other words, if you bet $1 on a situation like this 10 times, you’d end up with $20 on a $10 total investment.

I’ve read many investment write-ups that are very similar to the example I just described. The investor acknowledges the risk, but then points out that in the event that the situation works out favorably, it will be a big winner. Again, in theory, this makes sense. But as Yogi Berra wisely said once: “In theory there is no difference between theory and practice. In practice there is.”

One thing I’ve observed over time is that market participants tend to overestimate the probability of the favorable outcome. It’s very easy to do this for a number of reasons: one, we are generally optimistic beings. Two, we naturally want to find a situation with high expected value like the one described above.

But since weighting the various outcomes is a very subjective exercise without a precisely calculable set of probabilities, it makes it very easy to skew these probabilities in our favor. Our desire to locate such an investment only makes this skewed analysis more likely. This makes it possible to justify an investment that in theory looks like a great bet, but in reality is just a risky bet.

Some investors have done very well making a living off of these types of situations, but if you are going to invest in these types of binary type events with two widely different potential outcomes, I think you need to be well aware of the biases described above, and be very careful when estimating the probabilities of the various outcomes.

I think in general, it’s much better to simply focus on simple situations that you understand very well—good businesses at bargain prices—and patiently keep building out your circle of competence while waiting for the proverbial fat pitch. Home runs will help increase long term returns, but they don’t need to come from swinging at really difficult pitches that are outside the strike zone.

The interview touches on these points, as well as a few other aspects of investing that are interesting. You can also read the 400% Man article from a few years back to get a better idea of how Mecham thinks about investing, which I think is a very prudent way to allocate capital.

Merry Christmas and Happy Holidays to everyone. I hope you get to spend time with family, and enjoy the week.