Investing Thoughts and Wisdom (mostly from others) – Part 2

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). Part 1 can be found HERE.

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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Charlie Munger: “This is the way you win big in the world...” (via Peter Bevelin’s All I Want To Know Is Where I'm Going To Die So I'll Never Go There):

Munger   "Really big effects, lollapalooza effects, will often come only from large combinations of factors. For instance, tuberculosis was tamed, at least for a long time, only by routine combined use in each case of three different drugs."

"This is the way you win big in the world -- by getting two or three forces working together in the same direction."

Seeker   "Since I have lost big, tell me more about how I can win big."

Munger   "Extreme success is likely to be caused by some combination of the following factors:

a)      Extreme maximization or minimization of one or two variables.

b)      Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

c)      An extreme of good performance over many factors.

d)     Catching and riding some sort of big wave.

Seeker   "What do you mean with 'big wave'?"

Munger   "When...new businesses come in, there are huge advantages for the early birds. And when you're an early bird, there's a model that I call 'surfing' -- when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows...But people get long runs when they're right on the edge of the wave -- whether it's Microsoft or Intel or all kinds of people, including National Cash Register in the early days."

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Stephen Hawking’s Productive Laziness – By Cal Newport (Source):

In the 1980s, at the height of his intellectual productivity, Stephen Hawking used to head home from his office between five and six. He rarely worked later.

Here’s how he explained his behavior to his PhD student Bruce Allen (now a professor at the Max Planck Institute for Gravitational Physics):

“Bruce, here’s some advice: The problem with physics is that most of the days we don’t make any major headway (on our projects). That’s why you should do other stuff: listen to music, meet good friends. There’s one exception to this rule: If you find a solution for a given problem, you work 24 hours a day and forget everything else. Until the problem is solved in its entirety.”

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Danny Kahneman on Persistence, as quoted by Morgan Housel:

On persistence: “When I work I have no sunk costs. I like changing my mind. Some people really don’t like it but for me changing my mind is a thrill. It’s an indication that I’m learning something. So I have no sunk costs in the sense that I can walk away from an idea that I’ve worked on for a year if I can see a better idea. It’s a good attitude for a researcher. The main track that young researchers fall into is sunk costs. They get to work on a project that doesn’t work and that is not promising but they keep at it. I think too much persistence can be bad for you in the intellectual world.”

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Marathon Asset Management on corporate culture (from February 2015, via the book Capital Returns):

Marathon Asset Management’s focus on management forces us to think about corporate culture

Corporate culture is constituted by a set of shared assumptions and values that guide the actions of employees, and encourage workers to act collectively towards a specific goal. Cultures both reflect the values, and are a prime responsibility, of management. Yet strong cultures can persist long after the careers of those who put them in place. Still, sceptics might ask, why should investors bother with something so ineffable, so intangible? Well, the evidence suggests that culture pays.

Marathon Asset Management: Corporate Culture and Performance

Perhaps the best known study of the subject is Corporate Culture and Performance by John Kotter and James Heskett. This work examines the relationship between corporate culture and company performance in over 200 firms during the 1980s. The authors asked employees their opinions of attitudes to customers and shareholders at competitor firms. Shares in companies exhibiting strong and positive cultures outperformed rivals by more than 800 per cent during the study period. Other studies which measure corporate culture according to how employees regard their own workplace have found a similar link between culture with market returns.

Kotter and Heskett’s work established that strong cultures are liable to produce extreme outcomes, both exceptionally good and dreadfully bad. Positive cultures can take different forms. Perhaps the most commonly successful corporate trait is an emphasis is on cost control. Almost every firm periodically engages in bouts of cost-cutting. Exceptional firms, however, are involved in a permanent revolution against unnecessary expenses. In the early days of Admiral, the British insurance company, employees wishing to use the printer were required to do a push-up in sight of the CEO. Another example of the corporate Scrooge is Fastenal, a US distributor of low value industrial products, which boasted the “cheapest CEO in America.” There are legends of Fastenal executives being required to share hotel rooms at conferences. Company offices are said to be decorated with second-hand furniture. Frugal cultures may not sound attractive to employees, but when married to decentralised profit-sharing schemes they can work wonders. Between 1987 and 2012, Fastenal provided a return of over 38,000 per cent (excluding dividends,) better than any other company in the index. Take that, Bill Gates.

Cost-cutting is not the only successful cultural model. In fact, some firms have strengthened their cultures by spending more not less. The classic example is Costco, the discount retailer. Bucking the conventional retail model, Costco pays its staff more than the legal minimum wage – and far more than rivals. The average Costco employee makes in excess of $20 an hour, compared to average US national retail pay of less than $12 an hour. The company also sponsors healthcare for nearly 90 per cent of workers. Wall Street is constantly pressuring Costco to cut its wage bill, with the cacophony reaching a peak during the crisis of 2009. Instead, the company raised wages over the following three years. The return for this munificence is that Costco employees stay on longer, thus saving on training costs. Turnover for employees who have been with the company for more than one year is a paltry 5 per cent. Loyal employees are more likely to excel. Costco is regularly rated as excellent for customer service.

The point is that a strong corporate culture constitutes an intangible asset, potentially as valuable as a high profile brand or network of customer relationships. As Warren Buffett says of Berkshire Hathaway’s family of businesses: “If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength… On a daily basis, the effects are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat.’ ”

Marathon Asset Management – Story of a rotten culture: AIG

On the other hand, a rotten culture can be a firm’s undoing. Look no further than AIG, one of the major disasters in the recent financial meltdown. Dominated for so long by an imperial CEO, Hank Greenberg, the global insurance developed in the words of one commentator “a culture of complicity.” Unthinking obedience, the lack of an “outside view,” and an obsession with growth at any cost led to riskier and riskier positioning. Even as the end grew nearer, AIG executives proved incapable of recognizing the danger the company faced. In August 2007, the head of AIG Financial Products commented on his division’s positions in the credit derivatives market: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these transactions.” Little more than a year later AIG announced a quarterly loss of $11bn, which largely derived from its Financial Products division.

Just as positive cultures take a number of different forms, so too can negative ones. An obsession with growing earnings occasionally results in outright fraud. In the 1990s, during the tenure of Al ‘Chainsaw’ Dunlap, the accounts of consumer appliance maker Sunbeam were concocted to meet aggressive earnings targets. In extreme cases, a poor corporate culture can have tragic consequences. In 2010, 29 miners were killed in an explosion at one of Massey Energy’s coal mines. The US Labor Department investigation blamed a corporate culture that “valued production over safety” and fostered “fear and intimidation.”

If a beneficial culture is a valuable intangible asset, and a corrosive one an existential threat, it becomes important to ask: how can an outside investor tell the difference? As with so much of investment, the process is one of piecing together incomplete and obscure pieces of evidence, gathered over time through meetings and research.

Some quantitative measures can be helpful: staff loyalty and inside share ownership are liable to be higher at firms in which employees believe in what they are doing. Corporate incentive schemes say a lot about the firm’s culture. Is management being greedy? What performance metrics are valued – growth for its own sake or customer satisfaction? What do employees think? Opinions can be unearthed through websites such as glassdoor.com (a sort of TripAdvisor for companies). We are constantly looking out for signs of management extravagance and vanity. Danger signs include expensive executive travel (a corporate jet is liable to elicit groans), too numerous pictures of the CEO in the annual report, and dandyish attire.

There are numerous examples of successful cultures among our portfolio companies. The empowerment of branch managers that promotes responsible banking at Sweden’s Svenska Handelsbanken, for instance. Reckitt Benckiser, another holding, fosters an entrepreneurial spirit among its senior managers. Yet even if a strong culture is instilled in a company, it can take many years for its full effects to play out. That may be beyond Wall Street’s limited investment horizon. Long-term investors, however, would be wise to take heed.

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Phil Fisher’s 15 Points, via Morningstar (Source):

All good principles are timeless, and Fisher's famous "Fifteen Points to Look for in a Common Stock" from Common Stocks and Uncommon Profits remain as relevant today as when they were first published. The 15 points are a qualitative guide to finding superbly managed companies with excellent growth prospects. According to Fisher, a company must qualify on most of these 15 points to be considered a worthwhile investment:

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? A company seeking a sustained period of spectacular growth must have products that address large and expanding markets.

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? All markets eventually mature, and to maintain above-average growth over a period of decades, a company must continually develop new products to either expand existing markets or enter new ones.

3. How effective are the company's research-and-development efforts in relation to its size? To develop new products, a company's research-and-development (R&D) effort must be both efficient and effective.

4. Does the company have an above-average sales organization? Fisher wrote that in a competitive environment, few products or services are so compelling that they will sell to their maximum potential without expert merchandising.

5. Does the company have a worthwhile profit margin? Berkshire Hathaway's BRK.B vice-chairman Charlie Munger is fond of saying that if something is not worth doing, it is not worth doing well. Similarly, a company can show tremendous growth, but the growth must bring worthwhile profits to reward investors.

6. What is the company doing to maintain or improve profit margins? Fisher stated, "It is not the profit margin of the past but those of the future that are basically important to the investor." Because inflation increases a company's expenses and competitors will pressure profit margins, you should pay attention to a company's strategy for reducing costs and improving profit margins over the long haul. This is where the moat framework we've spoken about throughout the Investing Classroom series can be a big help.

7. Does the company have outstanding labor and personnel relations? According to Fisher, a company with good labor relations tends to be more profitable than one with mediocre relations because happy employees are likely to be more productive. There is no single yardstick to measure the state of a company's labor relations, but there are a few items investors should investigate. First, companies with good labor relations usually make every effort to settle employee grievances quickly. In addition, a company that makes above-average profits, even while paying above-average wages to its employees is likely to have good labor relations. Finally, investors should pay attention to the attitude of top management toward employees.

8. Does the company have outstanding executive relations? Just as having good employee relations is important, a company must also cultivate the right atmosphere in its executive suite. Fisher noted that in companies where the founding family retains control, family members should not be promoted ahead of more able executives. In addition, executive salaries should be at least in line with industry norms. Salaries should also be reviewed regularly so that merited pay increases are given without having to be demanded.

9. Does the company have depth to its management? As a company continues to grow over a span of decades, it is vital that a deep pool of management talent be properly developed. Fisher warned investors to avoid companies where top management is reluctant to delegate significant authority to lower-level managers.

10. How good are the company's cost analysis and accounting controls? A company cannot deliver outstanding results over the long term if it is unable to closely track costs in each step of its operations. Fisher stated that getting a precise handle on a company's cost analysis is difficult, but an investor can discern which companies are exceptionally deficient--these are the companies to avoid.

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? Fisher described this point as a catch-all because the "important clues" will vary widely among industries. The skill with which a retailer, like Wal-Mart WMT or Costco COST, handles its merchandising and inventory is of paramount importance. However, in an industry such as insurance, a completely different set of business factors is important. It is critical for an investor to understand which industry factors determine the success of a company and how that company stacks up in relation to its rivals.

12. Does the company have a short-range or long-range outlook in regard to profits? Fisher argued that investors should take a long-range view, and thus should favor companies that take a long-range view on profits. In addition, companies focused on meeting Wall Street's quarterly earnings estimates may forgo beneficial long-term actions if they cause a short-term hit to earnings. Even worse, management may be tempted to make aggressive accounting assumptions in order to report an acceptable quarterly profit number.

13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth? As an investor, you should seek companies with sufficient cash or borrowing capacity to fund growth without diluting the interests of its current owners with follow-on equity offerings.

14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur? Every business, no matter how wonderful, will occasionally face disappointments. Investors should seek out management that reports candidly to shareholders all aspects of the business, good or bad.

15. Does the company have a management of unquestionable integrity? The accounting scandals that led to the bankruptcies of Enron and WorldCom should highlight the importance of investing only with management teams of unquestionable integrity. Investors will be well-served by following Fisher's warning that regardless of how highly a company rates on the other 14 points, "If there is a serious question of the lack of a strong management sense of trusteeship for shareholders, the investor should never seriously consider participating in such an enterprise."