Investing Thoughts and Wisdom (mostly from others) – Part 16
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.]
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.
Circle of Competence
“What I cannot create, I do not understand.” —Richard Feynman
Do I understand the entire process of how they make money?
Do I understand the true economics of the business?
How are all the stakeholders/employees compensated?
How do the economics compare to the reported earnings?
(Test yourself and describe it to a ten year old.)
What is the selling model: razor/blades? services? one-off contracts?
Can you describe the sales process from order to fulfillment?
What are the economics of the base business unit?
How does it stack up against competitors?
Can I get complete information to understand the business?
Do I have an edge either in information gathering or in interpreting the information?
Do I understand the competitive landscape?
And remember to think about the potential competitive landscape. For example, a company with a good niche may look to have a great competitive position or maybe even a lock on a local market. But if margins and returns on capital are high, it may entice a larger competitor to finally enter the market, spend money, and drive down returns and margins for everyone. (“Your margin is my opportunity.” –Jeff Bezos)
“In order to best understand a company, you first have to understand the industry. Only focus on companies and industries you understand. Don’t go outside your circle of competence. You need to know what the strengths of the company are in relation to the competition, if they have a good management team, and most importantly, what the moat is. If you don’t know how many competitors the company has, do not invest in the company. Coke’s moat is that it has no taste accumulation, and the moat of railroad companies are that no one can build anymore because of saturation. That is why I am currently invested in both industries.” —Warren Buffett (2015 meeting with Ivey School students)
Can I define why the stock is undervalued?
Do I understand the country and culture I am investing in?
Can I talk to the company’s trade association, customers, or competitors to gain a better understanding of the business and competitive landscape?
Peter Bevelin quote: “Meeting and learning from certain people and my own practical experiences has been more important in my development. As an example – When I was in my 30s a good friend told me something that has been very useful in looking at products and businesses. He said I should always ask who the real customer is: ‘Who ultimately decides what to buy and what are their decision criteria and how are they measured and rewarded and who pays?’”
What insight do I have on this business that others don’t have?
Industry Specific Quotes:
Warren Buffett on retail: “Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail…. Buying a retailer without good management is like buying the Eiffel Tower without an elevator.”
Roger Lowenstein’s oil example in Security Analysis, Sixth Edition: “The competition for such values is fiercer in the United States, but they can be found, especially, again, when some broader trend punishes an entire sector of the market. In 2001, for instance, energy stocks were cheap (as was the price of oil). Graham and Dodd would not have advised speculating on the price of oil—which is dependent on myriad uncertain factors from OPEC to the growth rate of China’s economy to the weather. But because the industry was depressed, drilling companies were selling for less than the value of their equipment. Ensco International was trading at less than $15 per share, while the replacement value of its rigs was estimated at $35. Patterson-UTI Energy owned some 350 rigs worth about $2.8 billion. Yet its stock was trading for only $1 billion. Investors were getting the assets at a huge discount. Though the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price. Graham and Dodd investors bought into these stocks with a substantial margin of safety.”
Chris Begg Q4 2015 letter sections -- Quality of the Business, Culture [Note: More letters are available HERE.]:
Quality of the Business – Distinction
The first lens of our investment process begins with an assessment of the Quality of the Business. We have articulated our hexagonal approach to Distinction in previous quarterly letters and have referred to this element of our process as the “Six Sides of Great.” Toward this end we are qualifying and quantifying a business’s economics, competitive advantage, market opportunity, pricing power, capital (structure and allocation history), and management’s operational capability. We are looking to determine what owner earnings will look like over the next five to ten years with some confidence. Businesses are categorized as Compounders, Transformations and Workouts depending on their lifecycle and economics.
The beacon that lights the way for any business that passes our due diligence of Distinction lens is a PIPER mindset. Persistent Incremental Progress Eternally Repeated is at the heart of anything that grows and grows better over time. We are ideally looking for businesses where the terminal value will be materially better in five years or more.
PIPER Mindset – Twin Lights South – Distinction
Great businesses have a focused and far-reaching signal that is driven by a winning system and strategy. Every great business has a flywheel at work that is providing a steady state – non-intermittent power source producing abundant and amplified power. We attempt to identify a business’s key drivers based on what flywheel effects are at work. We borrowed this idea from the actual back of the napkin flywheel that Jeff Bezos created when he launched Amazon. We have found this template a creative way to identify six critical areas of the business that will create enduring growth or help identify when there is a fatal flaw in the system. We have looked at East Coast’s investment management principles under the same framework.
1. Win-Win: Our flywheel begins with the objective of a win-win mandate. We want our operations and the businesses we invest in to pass the “Win-Win Test” with all six counterparties: customers, employees, suppliers, stewards, shareholders, and the community. Win-Win is the only system that is sustainable over the long-term – any fatal flaw with any counterparty will inevitably self-correct. We believe by striving to eliminate Win-Lose, Lose-Win, and Lose-Lose situations we can go far in removing many of the blind spots that those unsustainable relationships nurture.
2. Mastery: We are seeking a level of Mastery in understanding the fundamental truths that enable a business to earn superior returns, with a healthy margin of safety over the longest duration possible. We prefer “one decision” (buy) to “three decision” (buy, sell, reallocate) investments, therefore the duration and sustainability of a business’s advantages are important to us. We want to cultivate a level of creativity and imagination of how we curate and source the opportunities that meet our criteria.
3. 20%: We believe Pareto’s principle is one of nature’s most prominent signatures. 20% of anything that is allowed to thrive owes its gratitude to the 80% that gives birth to its contrasting advantageous divergence. We believe it is likely that less than 20% of all businesses, worldwide, are actually going to be better five years from now. We are qualifying better as a widening moat and quantifying better as its return on tangible assets employed. This insight has taken greater essence for us as our process has evolved and is particularly important for focused investment strategies. This quality insight came out of the rhetorical question Warren Buffett has often asked – what percent of businesses will be better five years from now?
4. IRR: If we are successful in seeking Win-Win relationships, arriving at investment Mastery in our niche, and investing in a curated universe of businesses that are improving (20%), we increase our odds of earning superior compounded returns, without risking permanent loss of capital over a long duration.
5. Partners: Our desire is to work with clients and partners who share our appreciation of the logarithmic path – compounding of learning and capital. We believe our success will be directly correlated with whom we partner with to maintain a structure that can enable mutual success. Partners will lead to leaping emergent effects in both the joy of compounding and compounding of joy. We are interested in both so our business development efforts are limited to introductions by interested parties that we trust. We endeavor to deserve a call from potential clients and partners that share these ideals.
6. Network: A carefully cultivated network of investors and operators drives exponential benefits to the proceeding five ideals. This is one of the great sources of intellectual property we honor. This is also one of the areas in which we receive our greatest sources of joy in solving the puzzles with curious, intelligent, hardworking individuals.
“In chess you might find a good move. Then you might find a better move. But take your time. Find the best move.... It is rarely a mysterious technique that drives us to the top, but rather a profound mastery of what may well be a basic skill set.” - Josh Waitzkin – The Art of Learning
Quality of the Investment – Safety
The second lens of our investment process takes a quality business of distinction through an assessment of the Quality of the Investment. We have written about our hexagonal approach to Safety and referred to this stage of our process as “M-Theory.” Toward this end we are qualifying and quantifying the investment’s merit by the following attributes: nature of its mispricing (M), critical data points that will drive the investment (H4), margin of safety (MoS), price and valuation (IRR), the duration and durability of competitive advantage (Nth) and economics (e). The foundational understanding where we are looking to arrive at is to determine the compounding merit of the investment – superior returns, asymmetric risk, and ideally a long-duration. We value the important truth that almost any advantage can be copied away eventually and that the only truly sustainable long-term competitive advantage lies in the culture of a business.
The beacon that lights the way for any investment that passes the due diligence of our Safety lens is Culture.
“Quality tends to fan out like waves. The Quality job he didn't think anyone was going to see is seen, and the person who sees it feels a little better because of it, and is likely to pass that feeling on to others, and in that way the Quality tends to keep on going.” - Robert M. Pirsig – Zen and the Art of Motorcycle Maintenance
Culture – Twin Lights North – Safety
We are keenly aware that the only, truly durable competitive advantage is Culture.
1. Win-Win: Win-win is as much safety as it is compassion. The sustainability of any organization ultimately rests on delivering a win-win partnership with counterparties. Any other relationship will eventually lead to a fatal flaw that will eventually be corrected. Be constant – Be Kind.
2. LATitude: The best, most thriving business cultures typically have a combination of three things: 1) a centralized leader who sets the tone of the organization, 2) a leader who gives responsibility and autonomy to their teams, individuals and often business units to carry out their vision, and 3) a leaping emergent effect driven by team dynamics. We see the effectiveness of this at Berkshire Hathaway, Transdigm, Constellation Software, and Glenair. The alternative is an approach of centralized control and micromanaging that, while it can optimize cost and control, rarely aligns with human nature’s innate desire for freedom.
“A leader is best when people barely know he exists, when his work is done, his aim fulfilled, they will say: we did it ourselves.” - Lao Tzu – Dao de Jing
3. Winning System & Strategy: Winning is just as important for employees as it is for the owners and operators of the business. Winning is essential to the culture of the organization. Not every human being is given the same opportunities at birth. For many employees working for a winning business may be one of their first opportunities to be part of something greater than themselves. Shared success and purpose amplify human achievement and the whole can accomplish things that were never thought possible.
“The achievement in my life of which I am the most proud was turning that crew into a tight-knit, smoothly functioning team that boasted—accurately—that Benfold was the best damn ship in the Navy.” - D. Michael Abrashoff – It’s Your Ship: Management Techniques from the Best Damn Ship in the Navy
4. Getting the Air Right: A safe, secure environment where there is plenty of work is one of the most important elements of a great culture. Any species on this planet, when there is a feeling that resources are scarce, will hoard. Employees, when they feel the work is scarce or their job is at risk of being rationalized, will hoard work and hoard information so no one will know how to do their job. This culture of hoarding exists in many businesses that fail to understand the important psychology of scarcity and abundance. The goal is to create a homeostasis environment where workers can feel safe and thrive. This insight was recently imprinted again after a recent visit to see Peter Kaufman at Glenair – one of the best cultures and most exceptional CEOs in the world.
5. Positively Spring-Loaded: Every organization is subject to chaos. Uncertainties of economic cycles, disruptive technologies, and competition affect every company. The goal is to have a culture where the chaos can be confronted with a positive, united force. If all of the first four attributes of a great culture are in place, the business will have prepaid the system for positive outcomes. Cultures that are inferior when they face challenges will often spiral out of control because the system is negatively spring-loaded.
6. Self-Policing: Another virtuous effect of a great culture is that the work force and system participants will take great care to protect that which they value. They value their career, livelihood, and the joy and purpose of their job that they will monitor to make sure nothing stands in the way of hindering their happiness and autonomy.