Saturday, November 18, 2006

Basic to being a good stock picker (Part 3)

In continuation of the subject of advantages of scale in part two of the same subject, the concept of chain stores is extremely interesting. It was a fascinating and refreshing invention. You get this huge purchasing power which translates to lower merchandising cost.

If one little guy is trying to buy across 30 different merchandise categories influenced by traveling salesmen in a decentralized way, he’s going to make a lot of poor decisions. But if the buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about televisions and so on to do the buying. So there are huge purchasing advantages. And then you get the slick systems of forcing everyone else to do what works

A classic example is Wal-Mart. It is interesting to think about how Wal-Mart starting from a single store in Bentonville, Arkansas rolled over the Sears, Roebuck with its name, reputation and all of its billions. How did a guy in Bentonville with no money blow right by Sears? And he does it during his lifetime. He played the chain store game harder and better than anyone. Sam invented practically nothing. But he copied everything anybody else ever did that was smart – and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so that he could be in the finals and make a big TV hit. But what did he do? He went out and fought 42 fighters. And the result was knockout, knockout and knockout for 42 times.

Being shrewd as he was, he broke other small town merchants in the early days. With his more efficient system, he might not be able to tackle some titan head-on as yet. But with his better system, he could destroy those smaller players. And he went around doing it time and again and then, as he got better, he got stronger and he started destroying the bigger boys.

Well, that is a simple and very shrewd strategy. But you may think if it is a nice way to behave. And, capitalism is a pretty brutal place where the idea of Darwin is in place. But personally, the world is a better place with Wal-Mart around than to have lots of small merchants around to service the customers. Wal-Mart created lots of jobs, brought down prices with a more efficient system. In any case, there is no qualm for a superior culture to replace an inferior culture.

Then when you think of the other side where the big boys were destroyed where with all the great advantages they seem to have, it is very interesting to see what causes it. The disadvantages of bureaucracy did such terrible damage to Sears. Sears had layers and layers of people it didn’t need. It was slowed to react and by the time they decide on something, they were behind the line. And in such a system, if you poked your head up with a new thought, the system kind of turned against you.

The great lesson in microeconomics is to discriminate between when technology is going to help you and when it is going to destroy you. And many people do not get this straight. For example, in the early days when Buffett acquired Berkshire when it was still in the textile business, one day, the people came to Warren and said, “A new loom was invented that we think will do twice as much work as our old ones.” And Warren said, “I hope this doesn’t work because if it does, I’m going to close the mill.”

What was he thinking? He was thinking, “It’s a lousy business. We’re earning substandard returns and keeping it open just to be nice to the elderly workers. But he’s not going to put huge amounts of new capital into a lousy business.”
Although huge productivity increases would come from a better machine introduced into the production of a product, but all the benefits will go to the buyers of the product. Nothing was going to stick to the ribs of the owners. This is a simple and obvious concept – that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow to the customers.

By and large in all cases, the people who sell the invention show you projections with the amount you will save at current prices with the new technology. However, they don’t do the second step of the analysis which is to determine how much is going to stay home and how much is going to flow to the customers. Rather, they always read, “This capital outlay will save “you” so much money that it will pay for itself in 3 years.”

So if you keep buying things that will pay for itself in 3 years. And after 20 years of doing it, somehow you’ve still earned a return of only about 4% per annum. And that’s the way how some businesses are.

It just isn’t that the machine is not better. It is just that the savings don’t go to you. The cost reductions came through all right as projected. But the benefit of the cost reductions didn’t go to the guy who bought the equipment. It’s such a simple idea and basic but yet, so forgotten as in many other things.

There’s another model from microeconomics which is very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which is termed competitive destruction. You may have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead. It just happens again and again.

And when these new businesses come in, the early birds have the most advantages. And when you’re an early bird, there’s a model called “surfing.” In surfing, a surfer gets up and catches the wave and just stays there, he can go a long time. But if he gets off the wave, he becomes mired in shallows. Think of Intel, Dell, or in the early days, National Cash Register.

The cash register was a wonderful story. Patterson, founder of NCR, didn’t make much money when he was a small retail merchant. Then, someone sold him a crude cash register which he used for his retail operation. And instantly, it instantly changed from losing money to making because it was harder for an employee to steal. Then he thought “Oh, good for my retail business, if I can sell it to the others retailer, why not go into the cash register business?” And then NCR was created and he surfed. He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic as well. And a well educated orangutan can see that buying into the business in those early days of surfing is a 100% sure bet. And that’s exactly what an investor should look out for. In a lifetime, you can expect to profit heavily from at least a few of these opportunities if you develop the wisdom and will to seize them. In any case, “surfing” is a very powerful tool.

However, this method of investment should be not popularized or practiced because it is not easy for one to develop the correct wisdom to pick out the right surfer from the millions. Unless you’ve the right competence in selecting the winner in the technology field, then it is easy. And again, this is yet another powerful tool to recognize at what you are good at.

Every person should have a circle of competency and know its boundaries. So you have to figure out what your own aptitudes are. If you are going to play games where other people have the aptitudes but you don’t, you are going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got the advantage and you’ve to play within your own circle of competence.

If you want to be the best tennis player in the world, you may start out trying and soon realize that it’s hopeless because other people blow right by you. However, if you want to become the best plumbing contractor in your hometown, that is probably achievable by most of us. It takes a will and the intelligence. And after a while, you’d gradually know all about the plumbing business and master the art. That is an attainable objective, given enough discipline. And for people who could never win a chess tournament or stand in center court in a respectable tennis tournament, they can still rise quite high in life by slowly developing a circle of competence which results partly from what they were born with and partly from what they slowly develop through work and experience.

So, some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor. Very few of us are chosen to win the world’s tennis tournaments.


Anonymous said...

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One fine post