Investing Thoughts and Wisdom (mostly from others) – Part 1

I have a file full of notes and excerpts from investors that I’ve collected over the years. I’ve been meaning to organize it for a while, and now that this newsletter is started, I’ll use it as a reason to gradually do so (in several parts).

I used to read through this file a lot, but it got to be pretty long, which led me to summarize the key parts of my own philosophy (as of the present time) in a blog post titled Final Decision Checklist last year.

Please note: Nothing here should be considered investment advice or the best way to invest. These are things I’ve saved as reminders and notes to myself that I’ve found helpful in the past, and think they are worth sharing in case any of you happen to get an insight from any of it.

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Preparation. Discipline. Patience. Decisiveness.

“What the pupil must learn, if he learns anything at all, is that the world will do most of the work for you, provided you cooperate with it by identifying how it really works and aligning with those realities. If we do not let the world teach us, it teaches us a lesson.” — Joseph Tussman

3-legged stool – QUALITY (Business and People -- high return on capital with the ability to reinvest at high rates; and management that understands capital allocation), GROWTH (long runway of reinvestment at high rates of return), and VALUE (not necessarily just a low multiple….because a true compounder may look expensive but in reality be undervalued).

Focus on downside first. Then expected returns without any change to multiple (dividend and repurchase yield + earnings-per-share growth). And thirdly, possible overall IRR’s with potential multiple expansion or contraction.

“Far more money has been lost preparing for corrections than has been lost in corrections themselves.” –Peter Lynch

"The best way to become poor quickly is to try to get rich quickly." –Mark Spitznagel

“You only have to be right on a very, very few things in your lifetime as long as you never make any big mistakes…An investor needs to do very few things right as long as he or she avoids big mistakes.” –Warren Buffett

From Mark Yusko’s Q2 2016 Letter: “Klarman's response to this phenomenon is, ‘while no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.’ That speculative urge is a psychological characteristic in all of us that we must fight in order to reach our full potential as great investors. B.F. Skinner did a great deal of work on trying to discern why human beings seemed hard-wired to want to speculate (gamble), and found that the behavior was linked to a concept called ‘sporadic reinforcement.’ In essence, by winning only occasionally, the desire to participate in that activity actually increases.”

Other quotes on simplicity and avoiding mistakes:

“There’s no magic to it…We haven’t succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself.” —Warren Buffett

“Our ideas are so simple that people keep asking us for mysteries when all we have are the most elementary ideas…There’s nothing remarkable about it. I don’t have any wonderful insights that other people don’t have. Just slightly more consistently than others, I’ve avoided idiocy…It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” —Charlie Munger

“It really is simple – just avoid doing the dumb things. Avoiding the dumb things is the most important.” —Warren Buffett

Key Things to Think About Throughout the Process of Considering a New Investment…

What’s the downside?

What’s the case for having a reasonable expectation of making a 26% IRR (i.e. a double/100% return in 3 years, or a 2.5x/150% return in 4 years)? While the actual expected return can be less if there is adequate downside, you want there to be a reasonable chance it can produce this IRR.

If I need to get out of this because I am wrong, what will be the likely reason I was wrong on it (i.e. do a pre-mortem)?

Are you sure this is within your circle of competence? What work have you done? Do you understand how the company stands in its industry and versus its key competitors? And remember to never underestimate competition, and that high returns tend to attract competition ‘like a moth to a flame’, and this includes businesses and entrepreneurs that aren’t even competitors yet.

Is my upside 3 times greater than my downside? (And since most investments can be down at least 50% due to the unknown unknowables, you need to really look hard for growing businesses that you think will be worth about 2.5x where you are buying them over a 4-7 year period. And remember that growth can both create and destroy value, so it needs to be economically profitable growth).

“Your goal as an investor should simply be to purchase, at a rational  price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.” –Warren Buffett (1996 Letter to Shareholders) [emphasis mine]

Is the business a good business?

• Does it earn high returns on capital?

• Does it have a long runway of reinvestment prospects? (Look for businesses that can at least double revenue per share in 10 years, and preferably businesses that can increase revenue per share 3-4x, with profit per share increasing even more.)

• Does it have a moat that protects those returns from competition and allows reinvestment to also occur at a high rate?

• Prefer a business that does not require a lot of capital to grow (i.e. not too capital intensive) where much of the growth will be due to the company’s own actions (instead of relying on things like commodity prices, interest rates, etc.).

• The business needs to be in a Win-Win relationship with all six of its constituents to be sustainable over the long term (customers, suppliers, employees, owners, regulators, and communities).

• “A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.” –Jeff Bezos

Does it have a good balance sheet?

• Is there a conservative level of debt (and preferably, no debt)?

• Are there any off-balance sheet liabilities that I need to account for (leases, pensions, options, etc.)?

• Is the balance sheet structured to allow the company to take advantage of unforeseen opportunities or market crises should they present themselves?

• You want a company that can control its own destiny and not depend on the kindness of strangers (for access to capital, debt rollovers, etc.).

Does it have good management?

• Look for “intelligent fanatics” who are owner-operators, and where the ownership was preferably gained through buying in the open market or from founding the company, as opposed to option grants where they got the upside without the corresponding downside risk.

• You want management teams with intelligence, integrity, and energy that pursue excellence in everything they do (products, people, etc.).

• Does management understand capital allocation? Management skill in allocating capital is extremely important.

Is it trading at a good price?

• Is there a significant margin of safety? You need margin for error, because you are bound to make plenty of errors over time. So always consider the question, what if I’m wrong?

Is this a good addition to a portfolio goal of having 6-12 mostly non-correlated positions (where a position may hold more than one stock if there is high correlation among certain ideas and they look about equally attractive to purchase together)?

When looking at a potential business, you need to take the mentality of buying the entire business, and retaining management. If you are buying the business as your only family asset and have to keep these people running it, how comfortable are you buying the business at this price? Make sure you are taking a fundamental, entrepreneurial view of the business and NOT an MBA/outside-investor-know-it-all type of view.

What are the 1-3 main things that will drive this business, and what data can I use to track them over time?

If you talk to management, see if you can get answers to the following:

• If you went away for 5 years and could only get updates on 1-3 business metrics to tell you how the business was doing, what would those key metrics be?

• (After assuring them their answer would be kept private…) If you had to buy the stock of any company in your industry, excluding your own, what company would it be, and why?

"Our strategy remains to own the best companies in worthwhile fields. Our companies retain an abundant potential for growth, an ability to withstand adversity, a lowish valuation, a low likelihood of the business becoming obsolete, and managements that have a record of creating franchises out of thin air. We don't focus excessively on stock prices, because we know that if our companies are gaining on competitors, building up cash and paying off debt, lowering their cost structures, and otherwise better positioning themselves for the next upcycle, we will eventually be pleased with the outcome." —Greg Alexander