Investing Thoughts and Wisdom (mostly from others) – Part 22
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.]
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.
Questions and thoughts on assessing investment purchase price:
Remember that the price you pay determines the return you get and that the market is there to serve you, not guide you.
Downside first – is the downside limited?
Am I properly considering the downside under extreme conditions?
The first question should be: “Where can I not lose money (in real terms)?” instead of “Where can I make money?”
Do I expect at least a 20% annual rate of return, with little chance of losing money? This number may be higher or lower for different people, but the more important thing is targeting risk, not return. An expectation of the return you want to earn when investing does not mean that you should do it without considering risk first (see Klarman quote below).
If the expected return is less, then the risk must also be significantly less (i.e. near certain to achieve lower return).
Seth Klarman (“Margin of Safety”):
Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15% a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.
Targeting investment returns leads investors to focus on upside potential rather than on downside risk. Depending on the level of security prices, investors may have to incur considerable downside risk to have a chance of meeting predetermined return objectives. If Treasury bills yield 6%, more cannot be achieved from owning them. If thirty-year government bonds yield 8%, it is possible, for a while, to achieve a 15% annual return through capital appreciation resulting from a decline in interest rates. If the bonds are held to maturity, however, the return will be 8%.
Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond. Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one’s estimate of future share prices.
In the long run, however, stock prices are also tethered, albeit more loosely than bonds, to the performance of the underlying businesses. If the prevailing stock price is not warranted by underlying value, it will eventually fall. Those who bought in at a price that itself reflected overly optimistic assumptions will incur losses.
Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a risk-less investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.
Tom Russo uses about a 10% discount rate (in 2012: “the discount rate is sort of 10%”) when thinking about investments when rates are well below 10%. Historically it has been the long-term treasury rate plus a risk premium, but it’s also the hurdle that he believes equity returns ought to generate for investors, and he thinks equity investors ought to expect—over time and over market cycles—to have double-digit returns to warrant the risk that they take. So he uses 10% when rates are very low.
Does my position size properly reflect the opportunity and an uncertain world? [See Part 3 for more detailed thoughts than below on position-sizing.]
Typically, should have 3-6% positions. Very occasional 10% positions. And maybe a few times in one’s life, a very large, all-in type of bet.
There is definitely a case to be made for more concentration for a know-something investor that does proper due diligence. [Again, see Part 3 for more.]
Would I be willing to buy the entire business at this price? And have I really done enough work to make that kind of commitment if I had to (which is what you want to do if you’re making something a large position)?
Remember, it takes 20 years to build a reputation and 5 minutes to ruin it. Going all in and being wrong can take you out of the game.
“Nobody ever got into big trouble by saying ‘I don’t know.’ The way you get into big trouble is by saying ‘I know,’ and betting heavily on your opinion, and being wrong.” —Howard Marks
Why is this investment undervalued and/or misunderstood, and what do I know that the market doesn’t?
What is the value of the business on DCF, sum-of-the-parts, and private market value?
Don’t just buy something because it is just cheap on an EBITDA basis (such as Cable TV or Blockbuster) or cheap based on FCF (i.e. Tyco).
Earnings can disappear quickly. Need to consider sustainability and CapEx .
And most value traps first look like cheap stocks.
With technology companies, especially those where the software underlying the business is important, the market leader may be worth more than all the other players combined. The long-run is often a winner-take-all or winner-take-most market, or at least a winner-take-most-of-the-profits market. So be especially careful when using comparable multiples with market leaders, because those that are not the market leader may not deserve a multiple comparable with the market leader. And those that are market leaders might be worth paying up for.
Am I using the right comparable?
e.g. “Is motor oil used in car parts of the same industry as motor oil used in trucks and stationary engines? The oil itself is similar. But automotive oil is marketed through consumer advertising, sold to fragmented customers through powerful channels, and produced locally to offset the high logistics costs of small packaging. Truck and power generation lubricants face a different industry structure—different customers and selling channels, different supply chains, and so on. From a strategy perspective, these are distinct industries.” —Understanding Michael Porter: The Essential Guide to Competition and Strategy
Earnings Surprises:
Are there any potential upsides to earnings (i.e. R&D costs that could potentially either lead to increased profits or eventually be saved and added to earnings; or venture capital type of investments yet to come to fruition, but not being priced in to the current valuation; or wildcatting for oil; or prospecting for mineral deposits.)?
Has the company been a good citizen (i.e. environmental clean-up, etc.)? If not, there is downside risk that may not be showing up by looking at the financials.
Does the company pay competitive wages to workers? Fair pay helps foster a good culture (e.g. Costco), while unfair pay can do the opposite. Good cultures are more likely to see positive surprises, and bad cultures or those with high employee turnover are more likely to see negative surprises.
Is there a chance that they’ll be forced to significantly increase wages over time (especially true with manufacturing operations in less developed countries)?
Is there a chance that key people could leave?
What is the valuation of the overall market?
Howard Marks: “If you buy a cheap stock when the market is high, it is a challenge because, if the market being high is followed by a general decline in prices, then for you to make money in your cheap stock, you have to swim against the tide. If you buy when the market is low, and that lowness is going to be corrected by a general inflation, and you buy your cheap stock, then you have the tailwind in your favor….I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.”
Seth Klarman quote:
We clear a high bar before making an investment, and we resist the many pressures that other investors surely feel to lower that bar. The prospective return must always be generous relative to the risk incurred. For riskier investments, the upside potential must be many multiples of any potential loss. We believe there is room for a few of these potential five and ten baggers in a diversified, low-risk portfolio. A bargain price is necessary but not sufficient for making an investment, because sometimes securities that seem superficially inexpensive really aren’t. “Value traps” are cheap for a reason--perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline. A catalyst for the realization of underlying value is something we seek, but we will also make investments without a catalyst when the price is sufficiently compelling. It is easy to find middling opportunities but rare to find exceptional ones. We conduct an expansive search for opportunity across industries, asset classes, and geographies, and when we find compelling bargains we drill deep to verify the validity of our assumptions. Only then do we buy. As for what we own, we continually assess and reassess to incorporate new fundamental information about an investment in the context of market price fluctuations. When bargains are lacking, we are comfortable holding cash. This approach has been rewarding--as one would hope with a philosophy that is painstaking, extremely disciplined, and highly opportunistic.
Remember that intrinsic value is not a precise figure; it's a guess.
Though you need to sell something when it is clearly at or above intrinsic value, be careful about cutting the flowers to water the weeds.
When do you average down? – by John Hempton [SOURCE]
The last post explained why I think a full valuation is not a necessary part of the investment process. A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.
Valuation might normally be a set of questions along the lines of "what do I need to believe" to get/not get my money back.
But I would prefer a simple modification to this process. This is a modification we have not done well at Bronte (at least formally) and we should do better. And that is the question of averaging down.
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Warren Buffett is famously fond of "averaging down". If you liked it at $10 you should love it at $6. If it goes down "just buy more". And in the value investing canon you will not find that much objection to that view.
But averaging down has been the destroyer of many a value investor. Indeed averaging down is the iconic way in which value investors destroy themselves (and their clients).
After all if you loved something at $40 and you were wrong, you might love it more at $25 and you almost as likely to be wrong, and like it more still at $12 and could equally be wrong.
And before you know it you have doubled down three times, turning a 7 percent position into a 18 percent loss.
Do that on a few stocks and you can be down 50 percent. And in a bad market that 50 percent can be 80 percent.
And if you do not believe me this has a name: Bill Miller. Bill Miller assembled a startling record beating the S&P ever year for fifteen straight years and then blew it up.
Miller had a (false) reputation as one of the greatest value investors of all time: In reality he is one of the biggest stock market losers of all time and a model of how not to behave in markets.
How not to behave is be a false value investor, buying stocks on which you are wrong, and recklessly and repeatedly average down.
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At the other end traders who (correctly) think that people who average down die. The most famous exposition of this is a photo of Paul Tudor Jones - with a piece of paper glued to his wall stating that "losers average losers".
And yet Warren Buffett and a few of his acolytes have averaged down many times and successfully. And frankly sometimes I have averaged down to great success.
At least sometimes - the Bill Miller slogan is correct: "lowest average cost wins". Paul Tudor Jones may be a great trader - but he is not a patch on Warren Buffett.
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I would love it if I had an encyclopedic knowledge of every mid-cap in Europe and could buy the odd startlingly good business when tiny and cheap. But the task is too large. The world is complicated and I can't cover everything.
But when I look at tasks that can be achieved by a four-analyst shop I have one very high on my list of things we can do and should do: We should get the average down decision right more often.
So I have thought about this a lot. (The implementation leaves a little to be desired.)
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At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.
At the first pick the question then is "when are you wrong?", but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.
So the question becomes is not "are you wrong". That is not going to add anything analytically.
Instead the question is "under what circumstances are you wrong" and "how would you tell"?
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When you put it that way it becomes obvious that you must not average down (much) on highly levered business models. And looking at Buffett he is very good at that. He bought half a billion dollars worth of Irish Banks as they collapsed. They went approximately to zero. But he did not double down. He liked them down 90 percent, he did not like them more down 95 percent.
By contrast these are the stocks that Bill Miller blew up on: American International Group, Wachovia, Washington Mutual, Freddie Mac, Countrywide Financial and Citigroup. They were all levered business models.
By contrast you can probably safely average down on Coca Cola: indeed Buffett did. It is really hard to work out a realistic circumstance in which Coca Cola is a zero. And if it is still growing there is going to be a price at which you are right - so averaging down is going to go some way to obtaining an average cost near or below that price.
Of course even Coca Cola is not entirely safe. You could imagine a world where the underlying problem was litigation - where some secret ingredient is found to be a carcinogen and where the company faces an uncertain future of lawsuits. It is not likely - and if it happens you are going to get at least some warning that this is a circumstance on which you could be wrong. Whatever, outside that circumstance on which you might be warned, Coca Cola is not a leveraged business model subject to bankruptcy and is almost entirely unlikely to halve four times in a row. You can average that one down.
Operationally levered business models
Not every business model is as as safe as Coca Cola. Indeed almost every business model is more dangerous than Coca Cola. A not financially levered mining stock can halve five or six times. If you have a mining company that mines coal at $40 per tonne, has no debt and the price is $60 a tonne it is going to be really profitable. But prices below $40 (highly possible) will take profits negative. Add in some environmental clean up and some closing costs and it is entirely possible that a stock loses 95 percent of its value. Averaging down when down 40%, some more when it halves, and then halves again and it will still lose two thirds of its value. The difference between averaging stuff like that down and doing what Bill Miller did is only one of degree.
It is still a disaster. And you will have proven Paul Tudor Jones adage: losers average losers.
Obsolescence
There is another iconic way that value investors lose money - and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999.
You might thing it was worth owning Kodak as a "cigar butt stock" - plenty of cash flow and deal with the future later. There was a reasonable buy case for Kodak the whole way down. But technical obsolescence is always a way you should be wrong. When the threat is obsolescence you are not allowed to average down.
Bill Miller averaged Kodak down. Ugh.
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If I could improve our formal stock notes in any way I would like an ex-ante description of what circumstances we are allowed to average down a particular stock, and how much.
We have a default at Bronte - and the default at Bronte is that we have a maximum percentage for a stock (typically say 9 percent but often as low as 3 percent depending on how we assess the risk of the stock) and as the fund manager I am allowed to spend that whenever I want but I am not allowed to overspend it. If we have a 6 percent position with a 9 percent loss limit and it halves I am allowed to add three percentage points more to the exposure. But that is it. Simon, being the risk manager, isn't particularly fussed if add the extra when the stock is down 30 percent of 50 percent, but I can't add it twice. If it is a position on which we agree we are allowed to risk 9 percent then I am allowed to risk 9 percent.
We will not fall for the value investor trap of losing 18 percent on a 7 percent position.
We have made a modification of this over time. And that is every six to nine months I get another percentage point to add. That is at Simon's discretion - but the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more.
But we can and should do better with ex-ante descriptions under the circumstances in which we are prepared to add and circumstances where we are not. The problem is that you can wind up in a mindset where you always where you want to add, where you think the world is against you and you are right and you will just be proven to be right.
Clear ex-ante descriptions of the issue (which require competent business analysis) might help with that problem.
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The bad case of averaging down
The iconic bad situation to average down is a levered business model involving fraud. It is surprisingly common because people who run highly levered business models have very strong incentives to lie or to cover it up when things turn to custard. I can think of two recent examples: Valeant and Sun Edison.
Much to my shame I added to my (small) position in Sun Edison as it fell. Ugh. But also this was a highly levered business model and thus by definition the sort of place where losers average losers. I should not have done it - and I won't in future.
But the highly levered business models apply fairly generally. When Bill Ackman rang Michael Pearson and asked if there was any fraud at Valeant he already had the wrong mindset. Then he added to a large holding in a company with over 30 billion dollars in junk-rated debt. Losers average losers.
Incidentally our six month rule (before you were allowed to add) would have saved Mr Ackman a lot of extra losses. Time has revealed plenty about Valeant. And it would have saved me at Sun Edison too.
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Whilst I think that someone asking me (as per the last blog post) for a valuation on every stock is absurd, I think it is entirely reasonable for them to ask "under what circumstances would you average down". If you can't answer that you probably should not own the stock. I should insist on it with every long investment.
Charlie Munger’s Two-Track Analysis:
1. First, what are the factors that really govern the interests involved, rationally considered?
2. And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things – which by and large are useful, but which often misfunction.
One approach is rationality – the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions – many of which are wrong.
And
Charlie Munger’s “ultra-simple general notions”:
1. Solve the big no-brainer questions first.
2. Use math to support your reasoning.
3. Think through a problem backward, not just forward.
4. Use a multidisciplinary approach.
5. Properly consider results from a combination of factors, or lollapalooza effects.