Investing Thoughts and Wisdom (mostly from others) – Part 23
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). [Previous posts: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12, Part 13, Part 14, Part 15, Part 16, Part 17, Part 18, Part 19, Part 20, Part 21, Part 22.]
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.
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.
The Balance of Skepticism and an Open-Mind
This is from the book Capital Account and was written in 2001 during the tech bust, but it is probably timely for many technology companies (or those that claim to be technology companies) that have become popular in 2020-2021 as well [emphasis mine]:
The challenge for investors is to distinguish the genuine innovations which create sustainable competitive advantage for companies and value for shareholders from the MacGuffins of this world. This requires a balance between an openness to new ideas and a healthy scepticism. In the last few years, we have seen many new investment concepts turn out to be nothing more than flagrant promotions. Even in the more questioning times that lie ahead, an aptitude for spotting absurdities in the stock market -- the financial equivalent of devices for trapping lions in Scotland -- remains an invaluable component in the fund manager's tool-kit.
Howard Marks on skepticism (via The Most Important Thing):
The global credit crisis of 2007– 2008 represents the greatest crash I have ever seen. The lessons to be learned from this experience are many, which is one reason I discuss aspects of it in more than one chapter. For me, one such lesson consisted of reaching a new understanding of the skepticism required for contrarian thinking. I’m not usually given to epiphanies, but I had one on the subject of skepticism.
Every time a bubble bursts, a bull market collapses or a silver bullet fails to work, we hear people bemoan their error. The skeptic, highly aware of that, tries to identify delusions ahead of time and avoid falling into line with the crowd in accepting them. So, usually, investment skepticism is associated with rejecting investment fads, bull market manias and Ponzi schemes.
…
It was readily apparent immediately after the bankruptcy of Lehman Brothers that . . . a spiral was under way, and no one could see how or when it might end. That was really the problem: no scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish.
There was an element of truth in this, of course: nothing was impossible. But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.
During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. . . .
For forty years I’ve seen the manic- depressive pendulum of investor psychology swing crazily: between fear and greed— we all know the refrain— but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd— and swinging with the pendulum— will give you average performance in the long run and can get you killed at the extremes. . . .
If you believe the story everyone else believes, you’ll do what they do. Usually you’ll buy at high prices and sell at lows. You’ll fall for tales of the “silver bullet” capable of delivering high returns without risk. You’ll buy what’s been doing well and sell what’s been doing poorly. And you’ll suffer losses in crashes and miss out when things recover from bottoms. In other words, you’ll be a conformist, not a maverick; a follower, not a contrarian.
Skepticism is what it takes to look behind a balance sheet, the latest miracle of financial engineering or the can’t-miss story. . . . Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity.
Lots of bad things happened to kick off the credit crisis that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical— or pessimistic— enough.
But that triggered an epiphany: skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
Some Warren Buffett Comments on inflation, and the types of businesses/investments that do well in an inflationary environment:
From Warren Buffett’s 1981 Letter to Shareholders:
In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.
The second category involves the managerial superstars - men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2). From both direct and vicarious experience, we recognize the difficulty and rarity of these executives’ achievements. (So do they; these champs have made very few deals in recent years, and often have found repurchase of their own shares to be the most sensible employment of corporate capital.)
From the Appendix of Warren Buffett’s 1983 Letter to Shareholders:
But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.
Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.
That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.
Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.
After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)
See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.
Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.
And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.
But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled "No-Will". Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an "asset" just as if the acquisition had been a sensible one.
From Warren Buffett’s 1984 Letter to Shareholders:
While there is not much to choose between bonds and stocks (as a class) when annual inflation is in the 5%-10% range, runaway inflation is a different story. In that circumstance, a diversified stock portfolio would almost surely suffer an enormous loss in real value. But bonds already outstanding would suffer far more. Thus, we think an all-bond portfolio carries a small but unacceptable “wipe out” risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.