Investing Thoughts and Wisdom (mostly from others) – Part 18
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.]
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.
John Maynard Keynes was not a great investor until he switched to focusing on high quality, concentrated bets where he did a lot of work in getting to know the businesses he was invested in. In a memo, he laid out what some of his core principles. From Chris Mayer’s book 100 Baggers (with slight formatting edits to fit this newsletter):
Keynes’s investment performance improved markedly after adopting these ideas. Whereas in the 1920s he generally trailed the market, he was a great performer after the crash. Walsh dates Keynes’s adoption of what we might think of as a Warren Buffett sort of approach as beginning in 1931. From that time to 1945, the Chest Fund rose tenfold in value in 15 years, versus no return for the overall market. That is a truly awesome performance in an awfully tough environment.
A more recent paper is “Keynes the Stock Market Investor,” by David Chambers and Elroy Dimson. They add more interesting details about how his investing style changed. As Chambers and Dimson note, “As a young man, Keynes was supremely self-assured about his capabilities, and he traded most actively to the detriment of performance in the first period of his stewardship of the College endowment up to the early 1930s.”
In the early 1930s, he changed his approach. With the exception of 1938, he would never trail the market again. This change showed up in a number of ways. First, he traded less frequently. He became more patient and more focused on the long-term.
Here is his portfolio turnover by decade:
1921–1929: 55%
1930–1939: 30%
1940–1946: 14%
Turnover was just one aspect of Keynes’s change. Another was how he reacted during market declines. From 1929 to 1930, Keynes sold one-fifth of his holdings and switched to bonds. But when the market fell in the 1937–1938, he added to his positions. He stayed 90 percent invested throughout.
This is a remarkable change. It again reflects less concern about short-term stock prices. He was clearly more focused on the value of what he owned, as his letters show. The authors of the paper note of Keynes’s change, “Essentially, he switched from a macro market-timing approach to bottom-up stock-picking.”
In a memorandum in May of 1938, Keynes offered the best summing up of his own philosophy:
“careful selection of a few investments (or a few types of investment) based on their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments;
a steadfast holding of these investments in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it has become evident that their purchase was a mistake; and
a balanced investment position, that is, a portfolio exposed to a variety of risks in spite of individual holdings being large, and if possible, opposed risks.”
Here is one last bit of advice from the same memo:
“In the main, therefore, slumps are experiences to be lived through and survived with as much equanimity and patience as possible. Advantage can be taken of them more because individual securities fall out of their reasonable parity with other securities on such occasions, than by attempts at wholesale shifts into and out of equities as a whole. One must not allow one’s attitude to securities which have a daily market quotation to be disturbed by this fact.”
Sanjay Bakshi on when management is especially important:
[Warren Buffett’s] words “leverage magnifies the effects of managerial strengths and weaknesses” imply that whenever leverage is high, management factor is important.
Take HDFC Bank. Would you like to remain invested in HDFC Bank if it was run by a fool who doesn’t know anything about risk management and would love to learn on the job?
Which other highly leveraged industry has attracted Mr. Buffett’s interest? Well, the answer of course is the insurance industry.
Insurance uses float (other peoples’ money) which is another form of leverage. The role of management becomes terribly important in this business. That’s because it’s easy for a fool to under-price insurance contracts, the consequences of which will not show up in the P&L for many years.
This even more true in the Super Cat insurance business. That’s because there is little baseline information to be relied on to adequately price insurance contracts.
The same logic applies to derivatives, where leverage magnifies the effects of smart, as well as, dumb behavior.
Imagine if one day someone like Kenneth Lay replaced Ajit Jain to run Berkshire Hathaway’s Reinsurance business and its derivatives book!
Which other business models require you to focus a lot on managerial skills? Well, one that comes to mind would be a good business which operates on wafer-thin margins but still delivers an acceptable return on equity because of high capital turns and/or presence of float. [e.g. “McLane, a Berkshire Hathaway subsidiary which is a distributor of groceries, confections and non-food items to thousands of retail outlets, the largest of them being Wal-Mart.”]
Sanjay Bakshi on Intelligent Fanatics:
“If you get an opportunity to get into a wonderful business that’s being run by an intelligent fanatic and if you don’t load up, it’s a big mistake.” –Charlie Munger
Who are intelligent fanatics? What are their traits? How do we find them?
These were important questions which fascinated me.
The idea of an intelligent fanatic is a simple one but it must not be taken lightly. Charlie likes to say: “Take a simple idea and take it seriously.”
So I took up this simple idea and I took it seriously. I went about looking for people who
Charlie would call intelligent fanatics. I read up everything he and Warren had written about the kinds of business owners they had partnered with. People like Rose Blumkin — founder of Nebraska Furniture Mart, for example.
Let’s take Rose Blumkin. Buffett adored her. Why? What qualities did she possess that made him adore her? There were three — integrity, energy and intelligence.
I found the very same attributes in the other entrepreneurs who had sold their businesses to Berkshire. As I read through all the material and reflected upon it, a pattern starting to emerge. I started to see similarities with some entrepreneurs in India. They had the same combination of integrity, energy and intelligence. And they ran really high quality operations.
…. Now, let’s shift focus to the second ingredient of an intelligent fanatic: Energy.
All entrepreneurs, by definition have a lot of energy and these seven guys have plenty of it too. But there’s something about energy that these seven guys (and other intelligent fanatics) have, which other entrepreneurs usually don’t. And that something is FOCUS.
An INTENSE FOCUS.
…These guys understand the power of focus, and the power of extreme specialization. They agree with Charlie and they agree with Warren.
“Our job is to find a few intelligent things to do, and not to keep up with every damn thing in the world.” –Charlie Munger
“The difference between successful people and really successful people is that really successful people say NO to almost everything.” –Warren Buffett
…. So, there we have it. Two of the three ingredients of Intelligent Fanatics — integrity, and right type of energy. But there’s a third ingredient: Intelligence. As investors, the last thing we need is to partner with dumb fanatics. So, what are the things we are looking for when we look for intelligence? Well, one trick Munger uses is that of inversion. So, let’s try that. What are the common elements of dumb behavior? Four are key. (1) Over-aggression, usually expressed in the form of excessive leverage; (2) Growth without any regard to profitability; (3) A tendency to gamble; and (4) An inability or unwillingness to delegate, constraining growth potential.
Well, you won’t find any of those elements in the seven guys I talked about. They are low profile, frugal and conservative. Five of them have no debt and the remaining three have extremely strong balance sheets. They run their businesses for profitable growth as the numbers I showed you proved. They understand the idea of per-share intrinsic business value. They don’t over bid for assets in acquisition deals. Nor do they dilute equity on unfavourable terms. In fact, most of them have delivered growth with zero dilution.
Moreover, they understand the concept of moat and spend all their time trying to expand theirs. Charlie’s observation that “almost all good businesses engage in ‘pain today, gain tomorrow’ activities” applies very well to the businesses managed by these seven guys. They invest in their businesses while thinking in terms of decades and not the next quarter.
They are also what Charlie calls “learning machines.” Recall, the case of Achal Bakeri — the cooler guy [who had taken the company bankrupt before changing his business model]. He made many mistakes, but he learnt and he never repeated them. In fact, he was candid about his mistakes. He listed them in his letters. And he said ‘I am never going to borrow money again, I am going to focus on becoming the best cooler company in the world and I am going to outsource manufacturing so I can focus on product design and branding and marketing.’
These guys understand risk management. They don’t gamble. No matter how lucrative the numbers look, they never bet the company on one product or one deal. And they know they can’t do it on their own, so they know the importance of getting help.
…. These seven guys taught me a lot of things. They taught me the importance of extreme specialization. That’s why when I started a fund, my partner and I decided to become extreme specialists in moat investing. We don’t waste our time on other businesses. They taught me about the benefits of partnering with entrepreneurs like them. It is obvious to me that the formula of owning a group of great businesses run by intelligent fanatics is a very good business plan. It took me 15 years to figure this out. Finally, Sid taught me the benefits of holding on to a great business run by someone like him. I don’t ever want to sell a business at 600 and see its value soar to 20,000 over the next 6 years.
My study of Intelligent Fanatics taught me that they are geniuses who have the ability to compound capital at handsome rates of return for decades and that ending your partnership with them by selling out is almost always a bad idea.