Investing Thoughts and Wisdom (mostly from others) – Part 9
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.]
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.
Alice Schroeder on Warren Buffett’s filtering process:
“Typically, and this is not well understood, his way of thinking is that there are disqualifying features to an investment. So he rifles through and as soon as you hit one of those it’s done. Doesn’t like the CEO, forget it. Too much tail risk, forget it. Low-margin business, forget it. Many people would try to see whether a balance of other factors made up for these things. He doesn’t analyze from A to Z; it’s a time-waster.”
More on Buffett’s filtering process, from Peter Bevelin’s Seeking Wisdom:
At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.
Can I understand it? If it passes this filter,
Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
Is the management composed of able and honest people? If it passes this filter,
Is the price right? If it passes this filter, then we write a check.
Warren Buffett on his criteria, from his 1993 letter to shareholders:
In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.
These factors will probably strike many analysts as unbearably fuzzy, since they cannot be extracted from a data base of any kind. But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless asserted, "I know it when I see it," so also can investors - in an inexact but useful way - "see" the risks inherent in certain investments without reference to complex equations or price histories.
Alice Schroeder (from a talk on Mid-Continent Tab) discussing Buffett’s first filter (What can go wrong?):
So when Wayne Ace and Warren Cleary who were two friends of Warren’s saw that IBM was going to have to divest in this business, and they thought, “We are going to buy a Carroll Press which was a press that makes these cards. And we are going to compete with IBM because we are based in the Mid West, we can ship faster. We can provide better service. And they went to Warren and they said, “Should we invest in this company and would you come in with us? And Warren said, “No.”
Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went through the first step in his investing process. This is where I think what he does is very automatic but it isn’t well understood. He acted like a horse handicapper. The first stop in Warren’s investing process is always to say, “What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail? And if there is any chance that any significant part of his capital would be subject to catastrophe risk, he just stops thinking. NO. He just won’t go there.
It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a projection and then at the end, they ask, “What could go wrong?”
Warren starts with what could go wrong and here he thought that a start-up business competing with IBM can fail. Nope, pass, sorry. And he didn’t think anymore about it. But Wayne and Cleary went ahead anyway and within a year they were printing 35 million tab cards a month. At that point, they knew they had to buy more Carroll Presses so they came back to Warren and said, we need money—would you like to come in?
So now, Warren is interested because the catastrophe risk is gone. They are competing successfully against IBM. So he asks them the numbers, and they explain to him that they are turning their capital over 7 times a year. A Carroll Press costs $78,000 dollars and every time they run a set of cards through and turn their capital over, they are making over $11,000. So basically their gross profit on a press (7 x $11,000 = $77,000) is enough to buy another printing press. At this point Warren is very interested because their net profit margins are 40%. It is one of the most profitable businesses he has ever had the opportunity to invest in.
Notably people are now bringing Warren special deals to invest in—it is 1959. He has been in business for 2.5 years running the partnership. Why are they doing that? It is not because he is a great stock picker. They don’t know that. He hasn’t yet made that record. It is because he knows so much about business, and he started so early he has a lot of money. So this is something interesting about Warren Buffett—people were bringing him special deals like they are today with Goldman Sachs and GE.
He decided to come in and invest in the Mid-Continent Tab Company but, interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were very enticing. But, again, he went through, and he acted like a horse handicapper.
Now here is another point of departure. Everyone that I know or knew as an analyst would have created a model for this company and projected out its earnings or looked at its return on investment in the future.
Warren didn’t do that. In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out theone or two factorsthat determined the success of the investment. In this case, it was the cost advantage that had to continue for the investment to work. And then he took all the historical data, quarter by quarter for every single plant and he obtained similar information as best he could from every competitor they had, and he filled several pages with little hen scratches with all this information and then he studied that information.
Then he made a yes/no decision. He looked at—they were getting 36% margins, they were growing over 70% a year on a $1 million of sales—so those were the historical numbers. He looked at them in great detail like a horse handicapper would studying the races and then he said to himself, “I want a 15% return on $2 million of sales and said, Yes, I can get that.” Then he came in as an investor.
OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence. He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that. …You are not laughing, what’s wrong? (Laughs)
It is a very simple thing, nothing fancy about it. And that is another important lesson because he is a very simple guy. He doesn’t do any DCF models or any thing like that. He has said for decades, “I want a 15% day one return on my capital and I want it to grow from there-ta da! The $2 million of sales was pretty simple too. It had a million in sales already and it was growing at 70% so there was a big margin of safety built into those
numbers.
It had a 36% profit margin—he said I would take half that or 18%. And he ended up putting in $60,000 of his personal, non-partnership money which was 20% of his net worth at that time. He got 16% of the company’s stock plus some subordinated notes. And the way he thought about it was really simple. It was a one step decision. He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.
I think that is a really interesting way to look at it because I saw him do it over and over again in different investments.
Kinetic Energy
In physics, the kinetic energy of an object is the energy which it possesses due to its motion. It is defined as the work needed to accelerate a body of a given mass from rest to its stated velocity. Having gained this energy during its acceleration, the body maintains this kinetic energy unless its speed changes. The same amount of work is done by the body in decelerating from its current speed to a state of rest.
In classical mechanics, the kinetic energy of a non-rotating object of mass m traveling at a speed v is ½ mv². In relativistic mechanics, this is only a good approximation when v is much less than the speed of light.
Velocity is more important than mass because it gets squared….changing it by the same amount has that exponential effect.
The difference between velocity and speed is that velocity includes direction.
This mental model helps explain why some small companies seem to come from nowhere and eventually overtake larger competitors (e.g. Wal-Mart, Google, Amazon, etc.)….they travel fast and in the right direction, and the larger companies have trouble keeping up. Some larger companies have been good in the past at disrupting their core businesses in order to not become victims to smaller, faster-moving companies that could have disrupted what they were doing (e.g. Apple [iPod/iPhone], Amazon [books/Kindle], etc.). And in return, they became the leaders in the new market, as well as the old.
Excerpt from East Coast Asset Management’s Q3 2014 Letter:
I recently invited Peter D. Kaufman, CEO of Glenair, Board Member of the Daily Journal, and Editor of Poor Charlie’s Almanac, to come speak to the Security Analysis class I teach at Columbia Business School. Peter Kaufman is an exceptional business operator and is also one of the great multidisciplinary thinkers of our time. On the topic of multidisciplinary learning and rational decision-making, Peter shared the approach he uses, which he refers to as his “three-bucket” framework, to arrive at universal principles that have high utility. Peter shared:
“Every statistician knows that a large, relevant sample size is their best friend. What are the three largest, most relevant sample sizes for identifying universal principals? Bucket number one is inorganic systems, which are 13.7 billion years in size. It's all the laws of math and physics, the entire physical universe. Bucket number two is organic systems, 3.5 billion years of biology on Earth. And bucket number three is human history, you can pick your own number, I picked 20,000 years of recorded human behavior. Those are the three largest sample sizes we can access and the most relevant.”
Peter then walked the class through how compounding and the law of reciprocity can be applied to these data sets and therefore applied to reason. A light immediately went on. Applying questions to these three large data sets simplified and strengthened how I was organizing and applying mental models. Kaufman’s approach provides a framework of general laws that have stood the test of time – invariant, unchanging lenses that we can use to focus and arrive at workable answers. A multidisciplinary framework helps shift the human paradigm to one of an empathetic perspective, as if we were looking from the outside in. Just as I began this letter with the three foundational insights of Dialectical Materialism, we want to be constantly searching for these types of invariant strategies that can serve us in rational decision-making….
Seeing the Forest and the Trees:
One of the most limiting biases for individuals attempting to make sense of complex systems is that they are a part of the systems. When you are part of the system it becomes increasingly difficult to see the forest for the trees. Each individual tree’s uniqueness and complexity can lead to confusion and ambiguity. The key is to attempt to step outside of the system and see the forest and trees for the essence of what they are. How can we find these groves or islands of simplicity in an infinitely complex world?
Jason Zweig of the Wall Street Journal asked Charlie Munger to describe a key attribute of Berkshire Hathaway’s evolution over the years. His response: “There isn’t one novel thought in all of how Berkshire is run. It’s all about what [Mr. Munger’s friend] Peter [Kaufman] calls ‘exploiting unrecognized simplicities.” Peter Kaufman was sitting with Charlie during this interview after the recent Daily Journal annual meeting. The entire quote that Charlie was referencing was one that Peter attributes to a 28 year old writer for Sports Illustrated named Andy Benoit, who wrote these words to describe the essence of a particular quarterback’s genius: “Most geniuses—especially those who lead others—prosper not by deconstructing intricate complexities but by exploiting unrecognized simplicities.” This quote captures the essence of genius and can serve as a roadmap to the Grove of Titans.
Finding unrecognized simplicities requires one to step outside the forest, outside of the human system to see and measure holistically without biases….
IV. Evolution – Persistent Incremental Progress Eternally Repeated:
Compounding, evolution, and human and business success are only made possible by persistent, incremental progress, repeated without end. The Coastal Redwood, with the help of an evolved cultural hexaploidal DNA, doggedly progresses incrementally every day, every year, some over the last two millennia. Always getting better, flood and fire prepared, quenched by drinking in the fog of uncertainty in the niche they dominate, leaning toward a shifting angle of the sun, growing deeper roots through evolving geology. The Coastal Redwood also importantly controls growth. Most trees grow too fast reaching for the sun. Overreaching is one of most common causes of death in trees as it creates an air pocket in the trees’ pipes, xylem, which is why trees will often rot from the inside out.
Enduring businesses avoid this fate by employing resolute incremental growth. The stewards of these enduring businesses know that most business failures are the direct result of overreaching. Instead of incremental progress, they overreach in an effort to ‘get theirs now.’ Quite often, that unnecessary “extra” decays the organization from the inside out. If you study business failure, you can point to overreaching as the single biggest cause of dialectical materialism in business. We see it every day in the marketplace, in how management rewards themselves with options, and in how management teams follow inferior mergers and acquisitions strategies. How often do we see mergers and acquisitions work well in biology? It is a biologically flawed objective, so why should it work seamlessly in business? It is a short-cut strategy to produce growth that often creates that same embolism that will eventually rot the decent business as they try to merge contrasting DNAs. There are evolved business systems that can integrate mergers and acquisitions well, but they are outliers.
From Peter Bevelin (on Buffett and Munger):
As Munger says: “All I want to know is where I’m going to die so I’ll never go there.” When I hear them at the annual meeting, I am thinking about Einstein’s reply to a student. The student had challenged Einstein’s statement that the laws of physics should be simple by asking: “What if they aren’t simple?” Einstein replied, “Then I would not be interested in them.”
They have a unique ability to distinguish masses of trivia from what is really important – to filter out situations, and find what’s at their core.
More from Peter Bevelin (Farnam Street 2016 interview):
And as the years have passed, I’ve found that filters are a great way to save time and misery. As Buffett says, “I process information very quickly since I have filters in my mind.” And they have to be simple – as the proverb says, “Beware of the door that has too many keys.” The more complicated a process is, the less effective it is.