I was glancing through the Berkshire letters from the late 1990’s because I recall Buffett briefly mentioning his large silver position he acquired and I was trying to see if Buffett referenced the specific cash cost of production. He didn’t in the letter—only mentioning that Berkshire acquired 111 million ounces. He has mentioned in other interviews that silver was in fact below the cost of production—a supply/demand imbalance that can persist for a while, but not forever.

Buffett felt comfortable loading up on silver (he took down roughly 25% of the world’s available inventory), and then just storing it in the vault until this supply/demand dynamic normalized. He didn’t have to wait long, as silver appreciated modestly back above the cost of production later that year, and Berkshire booked a nearly $100 million gain on Buffett’s unconventional investment.

Today, the cost of production of silver has fallen to around $8 per oz, and the price is around $14, so for anyone hoping that silver might be a bargain after a 3 year bear market, it is still nearly 100% above the relative level where it was when Buffett backed up the truck to load up… (note: this is the so-called “cash cost” of production, which excludes company overhead expenses, exploration costs, and capex–it’s just the actual cost to pull the metal out of the ground, which is the metric I believe Buffett used in his decision to buy it in the late 90’s).

Speaking of unconventional investments—these are ideas that I think Buffett really loves, although he talks far more in the recent letters about the great businesses (and for good reason, those are the businesses that provide the “sure” money).

Of course, in his partnership years, Buffett talks a lot about both “generals” (stocks that are purchased simply because they are undervalued) and “workouts” (stocks with some corporate catalyst or event that will help realize the valuation gap). The workouts tend to be more “unconventional”, but can provide profits that are often uncorrelated to what the general stock market is doing. In Buffett’s early days, this involved things like oil company mergers, cocoa bean arbitrage, closed end fund liquidations, special dividends, spinoffs, activist positions, and many others. These situations provided significant profits to Buffett personally in the early years, and then later for his partners.

Buffett even bought silver in the late 1960’s—although he wasn’t a gold (silver) bug, like so many today.

Anyhow, here is Buffett in the 1997 letter discussing a few unconventional investments that Berkshire participated in. These are quite small relative to Berkshire’s equity, but it still describes his affinity for making profits out of unconventional special situations:

Unconventional Investments 1 Unconventional Investments 2 Unconventional Investments 3

The other interesting takeaway from this clip is that Buffett said he followed the fundamentals of silver for 3 decades without investing in it. Reminds me of how he talked about reading Bank of America annual reports and IBM annual reports for 50 years before ever buying a single share.

Patience—all knowledge is cumulative…

Buy when everyone else is selling and hold until everyone else is buying.” -J. Paul Getty

I recently came across a transcript of a talk that James Tisch gave to a group of students at Columbia. Tisch runs Loews (the conglomerate, not the home improvement store). Loews (L) has struggled in the past few years, but the long term investment record is outstanding. The stock price has compounded at 17% over the past 50 years.

I’ve never invested in Loews—the operating results of the equity investments they control and the returns on capital of the businesses they own have never been attractive to me, but I have high respect for the Tisch family and I read their annual reports each year. They have proven to be disciplined, prudent investors over the years, and have done a superb job compounding shareholder capital over the long term. They are also a company that Charlie Munger would refer to as a cannibal—constantly “eating” away at their own share count by steadily buying back stock. Over the years, Loews has reduced their share count from around 1.3 billion (adjusted for splits) in 1971 to around 370 million today.

Maybe at some point we’ll take a look at the operating businesses under the Loews “hood”, but it’s interesting to note that while Loews has been a compounder through successful investments and steady share buybacks over the years, the businesses and equity investments themselves often have been more opportunistic in nature—in other words, Loews is led by contrarian bargain hunters.

My own style of investing consists of an interplay between high quality businesses that are compounding intrinsic value and the plain bargains that are blatantly mispriced relative to normal earning power.

Stocks in the former category are my favorite types of investments. They are the longer term investments in companies that do the work for you. They generally are businesses that are able to produce consistently high returns on shareholder capital and often have reinvestment opportunities within the business—a dynamic that leads to growing earning power and a compounding effect over time. When these companies become available at cheap prices, it’s time to load up.

However, the latter category also provides really interesting investment opportunities. These are the bargains—the special situations that involve some sort of a corporate event, a misunderstood business division, or maybe a misunderstood event that is driving a gap between price and value. Sometimes these situations arise out of neglect, other times they arise out of disgust. Cyclical companies might fall into this category as well—stocks that fall in and out of favor depending on the economy or industry specific trends.

Loews often gets lumped in with the Berkshires, the Markels, the Leucadias, the Fairfaxes of the world simply because it’s another conglomerate led by value oriented management. But unlike some of these other investment vehicles whose management have tended to focus more on using the business model of insurance and float to acquire growing businesses at fair prices, I would describe the Tisch family as investors who have done more work in the second category—the category of bargains and special situations—specifically the cyclical businesses. Insurance, shipping, drillers, pipelines, hotels, and a variety of other cyclical industries have been represented in Loews’ portfolio of businesses and equity investments over the years.

Buying Bargains

In this talk to the Columbia students, Tisch talks about a few of his common sense simplistic approaches to investing. Basically, as Paul J Getty said, Tisch spent a lot of his time buying when everyone else was selling. He talks about the supertanker supply glut of the 1970’s when these ships were trading for less than scrap values:

“Let’s go back to 1975, when there was a building boom in supertankers, brought about by relatively low oil prices that had caused large increases in oil demand. A few years later, in the late ‘70s, there was an oil embargo and resulting oil price hike, which drastically reduced the amount of oil coming out of the Persian Gulf – much less oil, but still lots of tankers, now just bobbing in the water.

It was soon afterward, in the early ‘80s, that we started thinking about buying tankers. We had seen from reading newspapers that the worldwide supply of tankers was vastly overbuilt; according to quoted estimates, the market required only 30% of the ships that were afloat. As a result, ships were trading at scrap value. That’s right. Perfectly good seven-year-old ships were selling like hamburger meat – dollars per pound of steel on the ship. Or, to put it another way, one was able to buy fabricated steel for the price of scrap steel. We had confidence that with continued scrapping of ships and increased oil demand, one day the remaining ships would be worth far more than their value as scrap.

We were sure of three other things: First, by buying at scrap value, there was very little downside. Second, we knew that the ships would not rust away while we waited for the cyclical market to turn. And third, we knew that no one would build more ships with existing ships selling at a 90% discount to the new build cost. We were confident that the demand for oil, particularly from the Persian Gulf, would ultimately increase with worldwide economic growth and so the remaining tankers would ultimately be worth much more than their scrap value.”

He references a similar dynamic in the late 80’s after OPEC tough-talked the oil market causing prices to plummet and US production to slow (sound familiar?)—creating an oversupply of offshore drilling rigs. Tisch stepped in to buy his first rig at a price well below replacement cost, knowing that at some point the business would come back. This was the beginning of what is now Diamond Offshore.

Tisch also goes into how Loews got into the pipeline business, and discusses his overall contrarian investment philosophy.

Being a contrarian in and of itself doesn’t guarantee success, but when investing in cyclical industries, or in stocks in general, bargains often come about when “everyone” is selling and pessimism reigns supreme.

I personally don’t get excited about some of the investments that Loews has made over the years, as the businesses they own tend to produce mediocre returns on capital and that becomes a drag on the compounding ability of the conglomerate if these businesses are owned for a long time. Time is the friend of the wonderful business. Markel continues to grow intrinsic value because of its ability to reinvest sizable amounts of retained earnings at above average returns on capital. An offshore drilling business, a hotel chain, or a pipeline tend to throw off cash, but produce low returns on capital and have limited reinvestment opportunities. That’s not necessarily a bad thing for a company like Loews that might have alternative investments elsewhere, but those businesses themselves tend not to compound value of time.

An example would be to look at Diamond Offshore. Just glancing at the stock price will show periods where the stock was presumably trading at bargain levels, and there were certainly opportunities for astute contrarian investors to capitalize at various points in the cycle, but over the past 20 years, the internal returns on capital of the offshore drilling business are average, and lead to an average long term result from owning this business:

Diamond Offshore

Again, there are times when bargains abound in cyclical businesses, and Loews has been able to find a number of them. But as Joel Greenblatt once said, when it comes to stock picking, I’d prefer to “trade the bad ones, invest in the good ones”. Cyclical stocks often become incredible bargains, but these bargains should be sold at fair value because over time the stock price tracks the underlying business results, and cyclical businesses tend to produce average returns on capital over the full business cycle.

So while I love the bargain approach to buying ships below scrap value, drilling rigs when it was unprofitable to drill offshore, and pipelines when no one else wanted them, I wouldn’t be excited about owning them permanently. But then again, neither would most investors and that’s probably why the Tisches have been able to make money–. Reminds me a lot of one of my favorite investors—Walter Schloss—who made a lot of money out of junk over the years.

As an aside, Loews stock happens to currently be trading at a level that implies it’s out of favor itself. The stock currently trades at less than 70% of book value—a valuation level that has rarely been seen throughout the history of the company, possibly in part due to its recent operating results or maybe because of its exposure to energy. The operating results of the subsidiary businesses have been relatively mediocre over the past few years, leading to a subpar stock price performance in the last decade relative to their historical numbers. Nevertheless, I enjoy reading the annual reports and like the simplistic philosophy that has been the foundation of the firm for 50 years.

But regardless of whether you prefer quality compounders, bargains, or maybe a combination of both depending on the situation, I think it’s always interesting to listen to what someone like Tisch has to say.

Here is a transcript of the talk referenced above.

Stock prices have finally entered the much anticipated correction, and so I’ve spent more time lately looking at my watchlist of great businesses that I’d like to own at some point. My portfolio has been largely made up of special situation investments for some time, and although I don’t really have a preference when it comes to value (I’m just looking for the most mispriced investments relative to risk), I’ve always liked the compounders. These types of businesses do a lot of the work for you, and at the right price they can be sized very large as often their quality provides a margin of safety.

That said, I only think great businesses make great investments at great prices, and at least by the looks of my watchlist, it doesn’t appear that we are generally to a market level where great prices can be had yet. Although prices have come down, they could certainly fall much further (and will have to before there are numerous quality businesses at prices that I would really get excited about). So for now, I continue to look under the rocks and in the nooks and crannies for the special situation investments and bargains that are usually present in any market environment. But I have dusted off the “great business” watchlist and may become more interested if (hopefully) stock prices continue their descent.


“A diamond is a piece of coal that stuck to the job” – Thomas Edison

One business I have spent some time on recently is the coal industry (I’ve been reading about coal for a few different reasons, but not because I’m interested in owning coal stocks—if anything the opposite would be the case).

Despite Thomas Edison’s enthusiastic view of the potential of a diligent, hard-working piece of coal, I’m not sure he would have felt the same way about coal stocks. After spending some time researching the industry and a few specific companies, I’ve come to the conclusion that the aggregate equity across the entire US coal industry could be close to being worthless (so no coal stock is on my great business watchlist). Maybe that’s a bit harsh—a few low cost producers in the lower cost basins will probably see their equity survive, but most will have to restructure. There have been numerous bankruptcy filings already, and I think that trend will continue. Like many commodity businesses, these companies borrowed heavily to expand their plants right as the price of their product was reaching all time highs:

Metallurgical Coal

The coal companies leveraged up hugely in 2011 when demand from China—the world’s largest coal consumer—was at an all-time high and metallurgical coal prices were soaring (met coal is a key ingredient in the production of steel). Companies were making huge capital investments to expand capacity in order to meet this growing demand from Chinese steel mills, and since pulling coal out of the ground is a business that often consumes more cash than it throws off, these capital expenditures and expansion projects were financed with massive amounts of new debt.

I’ve found that a simple axiom has helped keep me out of trouble when evaluating companies or investment opportunities:

  • Rising Debt + Shrinking Revenues = Bad News for Stockholders

Debt-fueled Acquisitions at the Top of the Market

Not only did companies take on debt to finance “growth” capex, but some began acquiring other businesses based on overly optimistic outlooks for met coal prices and Chinese demand.

In 2011, Walter Energy paid $3.3 billion to buy a large Canadian met coal producer, Alpha Natural Resources spent $6.7 billion for Massey Energy group, and Arch Coal spent $3.4 billion for International Coal Group. Just 4 years later, Walter and Alpha have gone bankrupt, and Arch has found itself in the midst of an interesting bit of game theory between management and the senior and junior bondholders that may result in a “kicking of the can” down the road a year or two, but will almost certainly at some point see the equity wiped out.

So this cycle rhymes with most of the other boom/bust commodity cycles we’ve seen in the past. But with coal, it could be particularly more painful since coal is a commodity—unlike oil, gas or base metals—that likely has already seen its peak demand and could be in a long (but very slow) secular decline. According to the US Energy Information Administration, in April, natural gas topped coal for the first time as the number one source of electrical power generation in the US. This trend might accelerate or slow down based on the price of nat gas, but it does appear to be a trend. 5 years ago, coal-fired power generation was twice the level of nat gas-fired power generation, and now both coal and nat gas have roughly equal share of US power generation.

Adding to the cyclical woes are the regulatory hurdles that the industry currently faces, and will likely continue to face going forward. The US Supreme Court remanded the EPA’s Mercury and Air Toxic Standards on June 29th, which would have cost power plants upwards of $10 billion annually. This was perceived as a victory for the coal industry, but many power plants have already been converting from thermal coal to natural gas in anticipation of regulatory requirements. Who knows what lower courts will decide regarding mercury emissions, but once a plant switches to gas, it’s not going back to coal regardless of price.

But the bankruptcies we’ve seen so far (and likely will continue to see in the next couple years) have more to do with mismanaged balance sheets than regulatory policies or even pricing issues.

Is Trouble Opportunity Here? 

Is the pessimism surrounding the coal industry overblown? My own feeling is the pessimism surrounding coal as an energy source might be overblown, as coal is still used to produce nearly a third of the country’s electricity. This might be in terminal decline, but it will decline slowly over decades, not anytime soon. It takes a lot of time and money to convert a power plant from coal to natural gas or some other energy source. That said, many debt-laden coal stocks will go to $0, so while the industry will survive for a long time to come, current stockholders might not.

So has the carnage in coal brought down other businesses with it?


One place to look is railroads. The rail stocks have been clobbered over the past couple months (partly due to the recent stock market decline, but mostly due to the market suddenly worrying about lower coal volumes). Coal could be a legitimate concern for the railroads. In 2014 coal accounted for 39% of tonnage shipped and 19% of rail revenues, the single largest driver of revenue for the rails:

Rail Tonnage and Revenue Breakdown

I have just started thinking about this and reading about railroads. I don’t have any opinion on the value of rail stocks yet, and maybe this price decline is justified, or maybe it’s simply that rail stocks have been in a huge bull market over the past four years and this pullback is warranted simply from a valuation standpoint.

I’m not sure, but it’s a business that has some qualities that are attractive such as high operating margins, pricing power, and significant barriers to entry. It would be virtually impossible to replicate the rail network that Union Pacific or BNSF have cobbled together over the past century.

It also has certain things that are generally not viewed as positives such as unionized work force and significant capital requirements. The US rail industry will spend an estimated $29 billion in 2015 on maintaining and improving their network, and since deregulation in 1980, the railroads have spent over half a trillion in capex:

Rail Capex

Not exactly the “capital light” business than many investors look for… Of course, businesses that soak up sizable chunks of capital can still create significant value if there is an attractive return associated with that capital investment.

Another data point that could be considered positive or negative is the dramatic increase in crude by rail that coincided with the US energy production boom of the past 7 years—specifically the rise of hydraulic fracturing in the Bakken field of North Dakota. In large part thanks to the frackers, crude by rail has nearly tripled since 2008:

Crude by Rail

This is obviously good for the railroads if it can continue, but this could also be a point of concern if US production begins slowing down due to much lower energy prices. Crude is much less a factor than coal however, at only around 4% of revenue, but when combined with sand and gravel tonnage that is also used in fracking, it becomes a more meaningful revenue contributor.

Of course Buffett famously surprised many people when he bought BNSF back in 2009, a purchase that–despite what he said on Charlie Rose’s show–has provided Berkshire with spectacular returns. One of BNSF’s competitors is Union Pacific, which Buffett said took market share from Berkshire in 2014.

UNP has been clobbered along with the other rail stocks.

Here is a good article on the rail business—UNP specifically—that is worth a read.

It’s been a great decade to be a Union Pacific shareholder as pricing power and operating leverage have combined to triple operating margins from 13% to 37%:

UNP Margins

Operating income has increased to $8.7 billion from $1.8 billion in 2004, and the stock price is up 5x, even when factoring in the recent 30% decline.

I think it’s a good business. But I’m not yet sure what to think about some of the fundamental drivers (namely how will declining coal volumes affect the business, and where will margins be in the coming years).

This post is more of just jotting down some notes/thoughts on these businesses. I may begin writing more shorter-form posts on companies I’m researching as a way to share my notes and also get feedback from readers who may have also done some work on things I’m interested in.

So I have no real conclusion other than to say that UNP is one business on my “companies to read about list” that maybe will set up for an opportunity via a double whammy of a pessimistic coal outlook and an increasingly bearish stock market sentiment. We’ll see… Until then, I may begin parlaying some reading on coal into some work on the railroads.

Have a great weekend.

I just thought I’d put up a quick post as it’s Sunday night and I’m getting ready for the week and listing some things I’m going to be focusing on and researching this week, as is my routine on Sunday evenings.

I don’t often discuss the overall markets, but as I was doing some homework this weekend on individual stocks, I also spent some time reading the papers and various macroeconomic blogs to get a feel for what people are thinking about the dramatic stock market decline last week. I say dramatic, because although it was a swift a fierce selloff on Thursday and especially Friday, I think we should step back and remember that stocks and markets go up and down, not just up. The markets are only down 10% or so from the highs, the S&P down just 7%, which hasn’t even reached correction mode.

As I am typing this however around midnight EST, the Chinese markets are plummeting (again), and markets in Hong Kong and Japan are down 4% in early Asian market trading, bringing the US futures down with them in overnight trading so it appears we will finally get our much anticipated 10% “correction” in the S&P.

One thing that is interesting to me is how swiftly markets decline in recent years, only to bounce back nearly as swiftly. It seems everyone for the past 3 years has been expecting a 10-20% correction, and so at the first sign of trouble, everyone begins rushing for the exits. Those who aren’t pushing the sell button are frantically buying puts for protection or maybe to outright short the market, which has the effect of sending the VIX skyrocketing. In recent years, despite being in a bull market, the VIX has at times seen shocking intraday rallies. Friday’s spike of 46% was I believe the second largest daily spike ever. To put this in perspective, the VIX spiked 23% the day Lehman filed for bankruptcy on September 15th, 2008. The market participants are very quick to anticipate the worst, and are willing to pay up for this protection at just about any cost.

These violent moves can be also due to forced selling from large institutional investment managers as well—hedge funds and mutual funds that either face redemptions or maybe participate in the panic themselves, rushing to sell stocks at any price to preserve returns or prevent further losses in the event the market does enter bear territory.

All of this said, we will at some point see another 20% decline. At some point, those that “panicked” on Friday might end up being right in that stock prices could certainly go a lot lower.

But of course, this type of behavior often creates significant opportunity. I’ve received a few questions lately regarding what I’m invested in, what my views on the markets are, etc… My investment approach is mostly based on two main strategies:

  1. Special situation investments: locating significantly mispriced investments with catalysts, and
  2. Investing in great businesses when they are priced at pessimistic levels.

My approach is very flexible. I often think of it as an opportunistic approach to value investing. I sometimes spend a significant amount of time in cash or with significant cash holdings while I wait for ideas to present themselves. It’s the most comfortable way I know how to manage capital.

As to the questions on what I’ve been up to: I plan to discuss more investment ideas on this blog. I won’t discuss certain situations as some need to remain quiet to preserve the mispricing. But many of the stocks I look at are very liquid and I find it helpful to write down my ideas, and get alternative perspectives from readers as well. I might even discuss stocks that I don’t own as well, simply because I do a lot of research that often doesn’t turn into actionable investment decisions. As for my portfolio now, I have a few positions but a large portion of the capital is in cash. The few positions I am in currently are special situation investments. I prefer those types of investments in these markets, simply because most of the businesses I love are all priced at levels that indicate they are loved by many others. So my favorite compounders rarely make it into my portfolio. This could change based on the action that we’ve seen over the past few days.

Typically, when it comes to category #2 (the “generals”, or compounders, or stocks without a specific catalyst), I have a hurdle when I think about investing in them. I am basically looking for a large enough valuation gap that provides me with a chance to make 50-100% returns in a year or two. It obviously varies from situation to situation, and larger cap stocks typically provide lower, but more predictable returns. But I’ve found it a useful—if not somewhat unorthodox—checklist item to ask myself if I think the stock can double at some point in the not too distant future. Sort of a forward looking 50-70 cent dollar approach to looking at the valuation. Again, with larger cap compounders this might not be realistic, but even 50% returns over the course of 12-18 months are possible at certain times on the larger high quality compounders. But outside of a few company specific opportunities, we certainly haven’t seen a market environment recently that has brought general valuations down to a level that this hurdle could be achieved.

So the opportunity to invest in one of these high quality companies come from one of two main setups:

  • Pessimism surrounding the company—maybe a short term problem, a poor quarter, or some other temporary negative that allows you to take advantage of time arbitrage (looking out 2-3 years when the market is focused on the next 2-3 quarters)
  • General market fear and lower overall stock prices

I actually welcome either or both of these things, and I hope that stock prices continue lower. However, the market has proved resilient and I don’t necessarily expect a large decline, given the strong economic numbers that have been consistently getting better.

For those that have asked my opinion on the markets—I don’t have one, and I don’t really ever think about where the market will go. Well, sometimes I do—a friend and I have been discussing this over the past week—but I don’t ever make decisions based on where I think the S&P is going to go in the near term. This is simply because I don’t know.

CNBC tonight had a special called “Markets in Turmoil”, which I found to be slightly dramatic, but nonetheless interesting to watch. CNBC of course thrives on market panic. The ratings of financial news media always skyrocket during these times of fear. I can’t blame CNBC—the ratings go through the roof when fear enters the markets. Also, it would have been a thrilling time to be a financial journalist during 2008 when Lehman failed and when markets were crashing. One of my favorite topics to read about is the financial crisis. It’s absolutely incredible to read about the various aspects of the crash including the market turmoil, the investor reaction, the policy decisions, and the general panic.

However, I think it’s a bit premature to begin anticipating disaster. While I said I don’t have a view on where the markets will go—certainly not in the next week, month, or year—I don’t anticipate the worst. Maybe I’m wrong here, but rarely do markets crash when the domestic economy is improving. And rarely do bear markets occur without the economy entering a recession (this has happened twice, but it’s quite rare).

One interesting token of macroeconomics that I read this weekend: The US economy has never entered a recession without the jobless claims spiking 20% year over year first. Again, maybe this spike is going to happen in the coming months, but it hasn’t yet. Like many other economic indicators that are improving, jobless claims continue to decline:

Jobless Claims

Another positive for the US economy is the state of housing. The housing depression was the deepest we’ve seen since the 30’s. The price declines, plummeting sales, and the ensuing near halting of new construction has created a situation that has left a shortage of inventory across the US and pent-up demand in many markets. Housing starts have been climbing for a few years now, but still have a long way to go before reaching levels that would be considered equilibrium:

Housing Starts

I have a spreadsheet of data points that I’ve started to track. I don’t make investment decisions based on economic information, but I find it useful to have a grasp of certain datapoints that impact the overall economy or better yet—specific industries (retail sales, new home starts, railcar loadings, etc…). One other piece of information that I find interesting to look at is investor sentiment. Again, I don’t make investment decisions based on sentiment–I’m looking for specific investment situations that really have nothing to do with the overall stock market. But nevertheless, sentiment–when at extremes one way or another–can provide useful information.

Sentiment isn’t at extreme levels yet, but it is quite bearish. In fact, last week’s AAII investor bullish sentiment was just 26%, which is a level that is fairly close to the bearishness that existed at the March 2009 bottom. Sentiment is volatile, but typically, extreme bearish sentiment exists near market bottoms, not market tops:

AAII Sentiment

Does Any of This Matter?

Things look scary right now, especially if you’re paying attention to the general market perceptions. However, domestic economic data does not seem to indicate impending doom for the US economy and sentiment seems to indicate that it’s probably unlikely that stocks are in for a significant crash.

But that doesn’t mean stocks can’t fall further. They certainly can.

Emerging markets look like they are in real trouble and that could certainly spill over into the US economy at some point, but it doesn’t appear likely as of yet. But we know that stock markets go up and down, and while there is always some reason to point to, the fact that the market is currently going down is nothing to be surprised about.

That said, I agree with some of those who say valuations are stretched, and we are “due” for a correction. I do think in general, that valuations are modestly (but not extremely) overvalued. But this in and of itself doesn’t usually mean that the market will crash. Markets rarely if ever crash because of overvaluation unless it’s the result of a mania (like 1929 or the Nasdaq in 2000, and even in those cases the overall economy was about to enter a recession).

But not having a crash doesn’t mean the markets can’t go down 10-20% (or even more). This is a very normal part of the way markets work, and it’s nothing to be surprised about or panicked about. The memory of 2008 is recent enough to still be in our review mirror, and it probably exacerbates the fear that comes back so quickly, even when the market is less than 10% from all-time highs.

Anyhow, these are just some thoughts I had as we get ready for what could be an eventful week. Not much changes in what I do during weeks like this–lots of reading about companies as usual–but these types of situations do make it more fun when you’re an investor who prefers buying undervalued merchandise.

All in all, it should be an exciting week that hopefully will begin presenting some investment opportunities.

Have a great week.

“One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.” – Warren Buffett, 1965 BPL Partnership Letter

I’ve read a few things lately discussing the benefits of designing a “tax-efficient” investment strategy. I’ve said this before, but I think there is a significant misunderstanding on the tax benefits of a low-turnover portfolio, and there is an even larger misunderstanding on the concept of turnover itself.

I’ve commented on portfolio turnover previously—turnover is neither good nor bad. It gets a bad connotation—especially among value investors—because many people think higher turnover (and more investment decisions) leads to hyperactivity and trading—and eventually results in investment mistakes. While this may be true in many cases, investment mistakes are not due to turnover—they’re due to making investment mistakes, plain and simple. I do believe that too many decisions may lead to this result—and I’m a fan of concentration and a relatively small number of stocks in my portfolio. But it is really important to understand—turnover in and of itself is neither good nor bad.

In fact, as I’ve said in a previous post, turnover is one of the key factors of overall portfolio performance. Just like a business (assuming a given level of tax rates, interest rates, and leverage) achieves its return on equity by two main factors—asset turnover and profit margins—so too does the return on equity (or CAGR) of an investment portfolio get determined by these two factors.

But this post is not about turnover, it’s about taxes. I bring this up because often I find investors lamenting the issue of taxes—especially when it comes to capital gains on their investment portfolio.

I have some thoughts on this topic of taxes and turnover, which I’ll share in the next post. I was going to reference a short passage of the 1965 Buffett partnership letter where he addresses this very same issue. But I thought I’d just post a slightly condensed version of the whole passage here, because I think it’s a good concept to think about.

Here are a few passages that I pieced together from the 1965 Buffett commentary on taxes (emphasis mine):

“We have had a chorus of groans this year regarding partners’ tax liabilities. Of course, we also might have had a few if the tax sheet had gone out blank.

“More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. “One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.”…

“Let’s get back to the West Coast. What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if the two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t, the latter course is superior. However, we find this is rarely the case.

It is extremely improbable that 20 stocks selected from say, 3000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives prevailing at a later date. If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change).

“It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to “get even” in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.

“If gains are involved, changing portfolios involves paying taxes…

“I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick. There are only three ways to avoid ultimately paying the tax: 1) die with the asset—and that’s a little too ultimate for me—even the zealots would have to view this “cure” with mixed emotions; 2) give the asset away—you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc.. either; and 3) lose back the gain—if your mouth waters at this tax-saver, I have to admire you—you certainly have the courage of your convictions.

“So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury—at the lowest rates the rules will allow.”

Buffett ends the section with a tongue-in-cheek reference to the “tax-efficient” funds of his day:

Buffett Tax Table

I thought these were interesting comments—especially regarding Buffett discussing “changing portfolios”, i.e. portfolio turnover. A portfolio of stocks one year will almost certainly not be the same optimum portfolio with the same risk/reward the next year. This implies that the portfolio should be more dynamic—always hunting for value.

Buffett doesn’t operate this way now, but it’s by necessity not by choice. There is only so much you can do when your stock portfolio is over $100 billion. But in the partnership days, there was higher turnover, higher taxes, and higher returns.

Related Posts:

Since oil prices were in the headlines yesterday after an 8% fall, I thought it might be a good time to comment on something I’ve been working my way through while putting in the miles after a day of looking for bargains.

I’m about halfway through the excellent series of podcast called “A History of Oil”. It’s an outstanding series that starts by introducing George Henry Bissell—the father of the oil industry—who in 1853 began experimenting with “rock oil” that was discovered in northwestern Pennsylvania. Bissell commissioned a $526 study of this strange substance and determined that it could be refined into kerosene—a highly demanded fuel used to light homes at night. Since whale blubber was becoming more costly (you could say the world was witnessing “peak whale”—i.e. whale population was plummeting), this newfound oil could prove to become quite lucrative as a whale blubber substitute.

The History of Oil series then moves to the fascinating beginning of the oil industry at “Oil Creek”, the stretch of the Allegheny River where drilling for oil first started in the small town of Titusville. This tiny hillside town in northwestern Pennsylvania quickly became the 1860’s version of the California gold rush. The population went from a sleepy 250 to a bustling 10,000, real estate prices skyrocketed, and fortunes were made. A lucky man named Jonathan Watson became the first millionaire from oil—Watson owned the land where the first successful well was drilled by Colonel Edwin L. Drake—an employee of Bissell’s Pennsylvania Rock Oil Company.

The guys at Oil Creek didn't care if a rig was in their back yard.

The guys at Oil Creek didn’t care if a rig was in their back yard.

The podcast series recounts the early tales of riches and the many booms and busts. I’ve made my way through the portion of oil history that witnessed a 23-year old grocery store owner named John D. Rockefeller, who began selling kerosene in his store—and eventually transitioned into the refining business that later was built into Standard Oil—one of the world’s most valuable, and most intimidating companies of all time.

Indeed, it was the very first Big Oil—later to be broken up when an ambitious populist from Ohio named John Sherman—whose resume included three terms in the House of Representatives, the US Senate, Secretary of the Treasury, and Secretary of State—introduced a bill called the Sherman Antitrust Act. The bill passed 52-1 in the Senate and unanimously in the House. The law sparked the first of many battles between Big Oil and government regulation.

Standard Oil was broken into pieces, but not before John D. Rockefeller became the richest man in the world—creating a net worth that would approach half a trillion bucks in today’s dollars—far more than Gates, Buffett, or any of today’s titans. Not bad for a guy who, as an ambitious young grocer, set a goal of making $100,000 during his lifetime.

This was no ordinary grocer

This was no ordinary grocer

The Oil Business

I began slowly investigating the oil industry last fall as energy prices plummeted. There is one company I have taken small positions in on a couple occasions, but by and large I have stayed on the sidelines as I continue to watch debt-laden businesses continue to struggle and cash flow dry up. Many of these companies are dead companies walking—almost certain to go bankrupt as their revenues fall, margins evaporate, and fixed costs (i.e. interest payments) persistently eat up a larger share of each barrel produced.

I think the oil business is very interesting, and it is one of the industries (especially the “upstream” exploration/production side) that really lends itself to the classic boom/bust cycle.

Soros once said regarding oil prices in his “real time experiment” in 1985:

“The supply curve is inverted. Most producers need to generate a certain amount of dollars; as the price falls, they will try to increase the amount sold until the price falls below the point at which high cost producers can break even. Many of them will be unable to service their debt.”

The more things change, the more they stay the same. In 1985 Saudi Arabia became frustrated that their production cuts weren’t having the impact they desired (which was oil price increases). This led them to decide to shift its focus from prices to market share. In December of 1985, OPEC shocked everyone by formally announcing its intention to maintain market share (i.e. maintain or increase production levels). The price of oil collapsed 50% over the next 6 months from $30 to $15 per barrel.

1986 Oil price collapse

Does this look familiar?

This 1986 price collapse was quite similar to the chain of events that unfolded starting last November 2014 when OPEC again announced its intention to maintain production in an effort to squash US high cost producers and maintain market share.

In both 1985 and 2014, these decisions by producers (both OPEC and US domestic producers) defied the logic of the “rational economic man”.

Where is the “Rational Economic Man”?

The “rational economic man” theory in economics basically says that this hypothetical figure will always act with perfect knowledge and complete rationality in pursuit of his own economic interests—meaning he will act in such a way that the supply/demand balance will always stay close to equilibrium. For example, as the price of a commodity falls, demand should theoretically increase and/or production should decrease—this balance should always trend toward equilibrium.

This makes a lot of sense. For example, chemical companies add capacity and/or increase utilization when prices are rising in order to satiate demand. Like most commodity businesses, this eventually leads to excess capacity and bloated cost structures. As the cycle surpasses its peak, companies are forced to lay off workers, cut back production, and sometimes take capacity out of the system as prices are falling, which then sets the cycle up for another repeat.

So eventually the economic man shows up and the cycle ends. But in the meantime—before this self-correcting process occurs—a self-reinforcing behavior (as Soros calls it) is prevalent—a behavior that takes prices (and supply/demand) far from “equilibrium”—or where they should be based on economic theory.

So sometimes there is a disconnect between reality and economic theory and the “economic man” is nowhere to be found.

For example, banks influence the value of the collateral as they lend more. In the recent case of the mid-2000’s housing bubble, securitization and newfangled financial products such as synthetic CDO’s reinforced home prices—these new products created an entire new market for CDO’s and the demand from investors for these securities fueled more lending. The more loans that were packaged up and sold in the form of securities, the more lenders were willing to give loans, which meant easier credit and more demand for the actual product—the house. This circular cycle was self-reinforcing for a period of years. Banks were willing to lend up to 100% (or more in some cases) on the ever-rising value of a house, but this value was rising in large part because of the fact the bank was willing to lend on it. It’s the chicken and the egg.

This is the same concept that has occurred in virtually every boom/bust cycle in the past.

The oil industry behaves in a similar way. Interestingly, what has happened over the past 9 months has surprised many economists and industry analysts. When prices started falling, many predicted drastic cuts in production by the high cost shale producers. Eventually, this would have to be true as producers run out of money. But what is interesting is that they continue to produce more as long as they have the cash in the bank to do so—even if they destroy value with every barrel that they pull out of the ground. By April 2015, six months after the price declines began, US production was at multi-decade highs:

US Crude Production Chart

So despite what economic theory says, what has actually happened on numerous occasions is that as energy prices decline, sometimes production increases (or at least remains stable) by producers who desperately try to maintain market share or by countries (such as the OPEC nations) who increase volumes to offset price declines in order to meet budgetary needs.

This was true in the late 1960’s when Soros was formulating his reflexivity theory, it was true in 1986 when Saudi Arabia dropped the hammer on the oil market, and it is true today as OPEC—at least for now—continues to maintain its production level.

Interestingly, this very same behavior was prevalent in the 1880’s at Oil Creek.

Even back then, or maybe especially back then, oil prices swung violently as supply/demand fluctuated and the boom/bust cycles repeated themselves over and over again. This nonsense was much to the dismay of Rockefeller, who specialized in the “downstream” business of refining oil—which means he had to buy his raw material from these irrational producers and was thus at mercy to the wild swings of the market.

One of the episodes of A History of Oil describes the fascinating turn of events as Rockefeller defies the advice of his own board of directors and—in an effort to fight this irrational behavior of the producers who frantically began drilling more and more in a “race to the bottom” as prices plummeted—began buying up “every barrel” of oil that was produced. Rockefeller eventually forced his company into the upstream (production) business in order to try and get more control over the raw material needed for his kerosene, and thus add an element of “economic man” behavior to the industry.

But whether its human nature or the nature of the oil business (or probably both), this defiance of economic logic repeats itself over and over.

Just this past weekend, Iran pledged to double its own production when/if sanctions get lifted—despite oil prices at half of where they were trading at a year ago.

Meanwhile, US oil production has begun to slow down in the past couple months, but as recently as April, crude output was rising and reached a high not seen since 1972—leaving analysts, economists, and Middle East oil producing nations scratching their heads.

It’s very interesting theater.

I’d recommend A History of Oil to anyone who is interested in locating bargains (or short opportunities) among the carnage in oil that is certain to continue if prices stay where they are. The business is a difficult one—like most commodity businesses. But it’s one that probably provides significant opportunity for the skilled bargain hunter who can be greedy when everyone else is fearful.

Caveat Emptor…

Have a great week.

Someone on the Corner of Berkshire and Fairfax board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977.

In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns:

  1. Increase turnover
  2. Cheaper leverage (reduce interest charges)
  3. More leverage (increase the amount of assets relative to a given level of equity)
  4. Lower income taxes
  5. Wider margins

Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins.

Some executives at the DuPont Corporation also noticed these drivers in the 1920’s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins.

Portfolio Turnover

I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors.

I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of (not the only) factor to consider.

We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business. We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time.

Notice that taxes is one of the (but not the only) factors.

Turnover is also one of the (but not the only) factors.

Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager.

Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year.

Of course, he was paying a lot of taxes. His investors—the ones in the highest tax bracket—might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account?

Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return.

I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time.

This is one of the reasons I love bargains and deep value special situations in addition to the compounders.

As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them.

How Did Buffett and Munger Achieve Their Results?

It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50’s, Greenblatt doing 40% annual returns in the 80’s and 90’s, etc…).

It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling.

Charlie Munger has promoted the idea of low turnover—and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example–and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30 year time horizon.

Another example I’ve discussed before is Disney. Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60’s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one.

Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas.

Buffett/Munger of Old vs. New

I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered.

They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him.

Their bargain hunting days provided them and their investors with 20-30% annual returns.

They made a lot of money.

They paid a lot of taxes.

As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs).

By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains.

I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses—and everyone knows they are great).

But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it.

I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece (which is a great piece to read if you haven’t) prompted some of these thoughts which I decided to write down and share.

I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business.

Feel free to add to the discussion if you’d like.

Have a great week, and for the golf fans, enjoy the US Open.

Earlier this year I watched Lang Lang play Grieg’s Piano Concerto in A Minor—one of my all-time favorite pieces of music. The concerto is a monster—full of big octaves, virtuosity, excitement and power. It has around 30,000 notes, but the music is tied together with a simple 10 note melody that is repeated throughout the piece.

I am currently working on a few different investment ideas that have numerous moving parts, but as I conduct my research, I continue coming back to just a few key variables that will largely determine the outcome of the business operations and the investment situation. I think that when analyzing a business or a special situation, this is one of the most important things to remember: there are many complicated aspects to analyzing a business—hundreds of data points, thousands of potential outcomes, pages and pages of SEC filings—all which often create a fuzzy view of the future. Sometimes there is no view of the future at all (or at least one that I can’t see), in which case I simply move on to the next idea. But sometimes through the complication and the inevitable unknowns that come with investing, one or two key variables emerge as the only things that really matter in the end.

I came across this quote last week in one of the posts over at Value Investing World, so thanks to Joe Koster for the link.

This is an interesting quote from Buffett from his 2004 shareholder letter, describing how important it is to know the one or two variables that really matter to an investment. There are a lot of things going on with a business, but if you can pinpoint the one or two variables that really matter, you’ll vastly simplify the investment process, you’ll focus your mind on researching and understanding those variables, and you’ll also improve the probability of a successful outcome.

Here is Buffett discussing the importance of simple propositions (emphasis mine):

“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.”

Hopefully Joe doesn’t mind me borrowing the other (very relevant) quote he chose to highlight from Buffett’s 2008 letter. For those who are familiar, Buffett bought an oil stock at the height of the commodity boom just prior to the financial crisis and subsequent crash in oil prices. He liked a lot of things about this company (Conoco), but when it was all said and done, just one variable determined the outcome of this investment: oil prices.

Here is Buffett from the 2008 letter:

“I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

Here is a look at the chart of Conoco—a solid company in the energy sector, but not immune to the downturn in the price of the one key variable that really made all the difference:

Conoco Chart

While reading through the transcripts of some of Greenblatt’s classes at Columbia, I noticed he mentioned a similar point about being average at valuation work (not really better than anyone else in the business), but being above average at putting the information in context, remembering the big picture, and being able to pinpoint what factors really matter to an investment.

“Explain the big picture. Your predecessors (MBAs) failed over a long period of time.  It has nothing to do about their ability to do a spreadsheet.  It has more to do with the big picture.   I focus on the big picture. Think of the logic, not just the formula.”

So the footnotes are crucial, and occasionally you’ll be able to sleuth out some detail that might give you a big advantage, but I think more often than not, the big picture (in other words, the key variables that matter) is more important than the footnotes. Markel’s advantage is the prudent underwriting, a value investing mindset, combined with a management team that thinks like owners. It’s really that simple—sometimes too simple. Wells Fargo takes deposits in cheaper than just about everyone else. Some of the special situation investments I look at have just one thing that will determine the outcome of the investment—a pending lawsuit, a regulatory resolution, a new order, a sale of an asset, etc… This is a topic for another post, but sometimes I think the best investment theses are also the simplest.

Just like the Grieg concerto—a complex piece of music that is centered on 10 simple notes that make all the difference.

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.