Tuesday, February 27, 2007
This following article could be a little too lengthy but I figure out that one of the best ways to learn besides learning from the best past and present practitioners is to teach or by documenting it down in writing. The latter is a better way for me to learn because as you write, you get into intellectually stimulating questions which you only encounter as the idea comes to you. Thus, writing is a tremendously helpful tool to systematically build the original framework that you had in mind and add on with ideas along the way when you write. What's more, if the writing can help a few others in their investment results, I'd consider that as a sense of accomplishment. For it not only help that individual, it also aids the offspring of that individual’s family tree. Just like during the Holocaust period in Germany and Poland during World War II, the Nazis who were anti-semitism were out to exterminate the whole Jewish community. What happened then? Millions perished and those who were lucky enough fled to Shanghai, China. Shanghai who were magnanimous, took the Jewish in. When the war ended, the Jewish community at Shanghai either moved back to their home country or relocate to North America. For every Jewish Shanghai took in then, they saved the entire family of offspring for whom each Jewish produced later on. So do bear with it.
It is funny how throughout the daily noise of our lives and the market that we forget the most simple things. The media has conditioned us to want an instant fix - instant results. Yet that's completely contrary to how the most successful practitioners in all kinds of fields operates ranging from business to investing to study to sports to practically almost everything you can do on holy earth.
In the case of most successful investors with sustainable results, they all shared a similar characteristic which is they sit around doing practically nothing for most of the time. As how Christopher Browne, the framed value investor who operates the Tweedy Browne Fund, pointed out: "We as value investors are like farmers. Farmers plant the seeds and wait for the crops to grow. Due to changes in environment conditions like a dry spell, the crops may sprout out later than expected from time to time. When this happens, the farmers just sit back and wait for the crops to sprout out after the weather changes for the better. They do not pluck out the seeds and re-harvest it because of the adverse weather."
Essentially, what are needed are patience, discipline and the character to sit on your bum and do nothing alone. You just need to let the game come to you. Although, as and when, there will be lots of people giving you lots of opinions and advices to keep on moving, to keep on trading, it is best to ignore it by and large. The world is moving so fast sometimes that there are days when the person who says it cannot be done is often interrupted by the person who is doing it. The stock market is best likened to how Benjamin Graham described. Ben created the fictional character called "Mr. Market." Every day Mr. Market will comes by and gives you an offer to either buy from him a product or sell your product to him at his price. On some days, when Mr. Market is euphoric, he'll offer you a very high price to sell your stake to him. On some other days, when he is depressed, he'll offer you a very low price to sell his stake to you. What Mr. Market offers to the market is only very superficial which does not gives you an idea of what value the price gives. I came across an email titled "Eyes effect" and in it, there're numerous pictures where the eyes can play trick on the individual by causing one to see things that isn't there and not able to see things that are there. And may I borrow a quote from the email, "So never make decision based only on what you see but try to see beyond what you see."
Some of the answers to a successful career can be drawn from having a look into the thoughts and habits of an excellent investor. Warren Buffett is known as being the best investors of all time. However, though he may be the best, his basic method of investing actually originated from the tree of thoughts of Benjamin Graham. So in effect, all value investor is a cloner who copied the method brought about by Ben. The degree of success on the outcome varies according to how well you can clone the fundamentals. Making reasonable changes to strengthen the fundamentals will also improve the resulting outcome.
Buffett gives credence to the theory that activity should not be confused with productivity. On stock investing, sometimes you hear from others that it is essential to monitor the stock price and to make money, you need to constantly buy and sell on news. In truth, if you study the actions of truly successful investors, usually only two or three variables control most of the outcome. The rest is noise. If you can make out how those key variables are approximately likely to play out, then you have a basis to do something. This process ought to be awfully simple to understand. It is thus very clear that one do not get more rewards just because one does more things.
It might come as a surprise to many people that Buffett's investing strategy often encompasses long periods of what he calls "sitting on my butt." There have been periods of years when Berkshire Hathaway has purchased not a single share of stock, which is often crowded with an enormous amount of activities on Wall Street. Sometimes doing nothing is the best way you can do.
Blaise Pascal, the 17th century French scientist, is perhaps best remembered for his contribution to the field of pure geometry. In the 39 years that he lived, he found time to invent such modern day fundamentals as the syringe, the hydraulic press, and the first digital calculator. And, if that weren't enough, he was also a profound thinker. One of his famous quotes is: "All man's miseries derive from not being able to sit quietly in a room alone."
Now if you bring that quote to the boardroom of Wall Street, it might well apply to a relatively new subset of humanity, "All portfolio managers’ miseries derive from not being able to sit quietly in a room alone."
Why should portfolio and investment managers sit and do nothing? And why would that be good for them? Well, let's start with the story of D.E. Shaw and Co. Founded in 1988, Shaw was staffed with some of the brightest mathematicians, computer scientists and bond trading experts on the planet. Jeff Bezos worked at Shaw before embarking on his Amazon.com journey. These folks found that there was a lot of money to be made with risk-free arbitrage in the bond markets with some highly sophisticated bond arbitrage trading algorithms. Shaw was able to capitalize on minuscule short-term inefficiencies in the bond markets with highly leveraged capital. The annualized returns were nothing short of spectacular - and all of it risk-free! The bright folks at Shaw put their trading on auto-pilot, with minimal human tweaking required. They came to work and mostly played pool or video games or just simply goofed off. Shaw's profit per employee was astronomical, and everyone was, of course, pleased with this utopian arrangement. Eventually, the nerds got fidgety and they wanted to do something. They felt that they had only scratched the surface and, if they could dig deeper, there would be more gold to be mined. And so they fiddled with the system to try to juice more returns.
What followed was a similar path taken by Long-Term Capital Management (LTCM), a fund once considered so big and smart on Wall Street where all big investment banks including some first-world country investment vehicles invested in them. They were viewed as a fund that could not fail. And yet, when economic events that did not conform to its historical model which these funds undertaken in a rapid succession, it nearly just did them in. At Shaw, they moved gradually from pure risk-free arbitrage to playing the risky arbitrage game in the equity markets. A lot more capital is deployed, and the returns looked appealing. With no guaranteed short-term convergence of prices and a highly leveraged position, the eventual result was a blow-up that nearly wiped out the firm. In Shaw case, it is a clear example in the words of Warren: “What the wise man does in the beginning, fools do in the end.” Shaw was clearly smart at first by making lots of money risk-free, but they ended as fools as they outsmarted themselves.
Compared to nearly any other discipline, fund management is, in many respects, a bizarre field where hard work and intellect don't necessarily lead to satisfactory results. As Warren Buffett succinctly put it during the 1998 Berkshire Hathaway annual meeting: "We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely." Compared to what your stock broker will tell you, they keep telling you to sell this share and buy another share which potentially can gives you a better return. And what they are actually telling you is to trade as many times as possible. Because by doing so with increased activities, you pay them commission.
Warren Buffett together with his alter-ego, Charlie Munger are easily among the smartest and wisest folks I've come across. As we've seen with Shaw and LTCM, a high I.Q individual may not lead to stellar investing results. After all, LTCM's founders had among them two Nobel Prize winning economists. In the long run, it did not do them much good. In fact, they outsmarted themselves. In a 1999 interview with BusinessWeek, Buffett stated: "Success in investing doesn't correlate with I.Q - once you've above the level of 25. Once you've ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."
Looking back at the events at Shaw and LTCM, it shows that high-I.Q folks have a hard time sitting around doing nothing. The problem is that once you engage in these intellectually stimulating problems, you're almost guaranteed to find what you think are the correct answers and act upon them which usually lead to a disastrous result for investors.
Having observed Buffett and Munger closely in the past year through their speeches and writings, it is clear to me that, like the folks at Shaw and LTCM, both men need enormous doses of intellectual stimulation as part of their diet. But how did they satisfy their intellectual hunger without the accompanying actions that get investors into trouble? Here is the trick.
You may consider this and take a step back to think. While Warren plays Bridge, Munger spends his time mostly on expanding his worldly wisdom and constantly improving his latticework of mental models. Charlie is an insatiable reader of intellectually engaging books on a variety of disciplines, ranging from the Ice Ages to The Wealth and Poverty of Nations. He spends considerable time in applying perspectives gained from one field of study into other disciplines - especially Capital Allocation.
At one of Wesco (Munger is the Chairman) annual meeting, Munger acknowledged that the first few hundred million dollars at Berkshire came from "running a Geiger counter over everything", in other words, they make the first few '00 millions from trading activities. But the subsequent tens of billions of dollars came from simply "waiting for the no-brainers" or as Buffett puts it "waiting for the phone to ring." It means the large part of their fortune came from waiting for the game to come to them. For example, Warren is best known to be a Coke drinker since he was young. Although he is an ardent Coke fan, he did not purchase his first Coke share until he was 58 years old. In 1988, Coke was a screaming stock which screamed "buy" to all intelligent values back then. So what did he do? He gobbled up 8% of all outstanding Coke shares and with an initial investment of slightly over a billion, it is worth more than $8 billion today, not counting all the yearly dividends.
Sometimes running the Geiger counter over lots of stuff may bring some rewards which I believe Buffett still does, as and when the opportunity presents itself. Fairly recently, Berkshire bought a whole lot of Target's shares in early 2006, and they sold the whole batch somewhere late 2006. But the question here is how can he avoid getting into trouble by running the Geiger counter? The following may be some of the reasons.
1) Running the Geiger counter can work very well if one knows when to run it. The two quotes give a lot of insights into the mind of Warren which he quoted.
In 1970, he showed his dismay at the elevated stock prices when he said, "I feel like a sex-starved man on a deserted island."
In 1974, he expressed his glee at the low levels to which the market has fallen, he said, "I feel like a sex-starved man in a harem filled with beautiful women!"
By 1970, he had terminated his investment partnership fund and made virtually no public market investment until 1974. The price-to-earnings ratio for the S&P500 dropped from 20 to 7 in those four short years. By 1974, he acknowledged selling "stocks he'd bought recently at 3 times earnings to buy stocks selling at 2 times earnings."
Then, from 1984 to 1987, Buffett did not add a single new equity position for the Berkshire portfolio. Berkshire Hathaway was sitting on a mountain of cash, and still he did nothing. In the latter half of 1987, Berkshire used that pile of cash to buy a billion dollars worth of Coca Cola shares. He invested 25% of Berkshire's book value in a single company that they did not control.
What were Buffett and Munger doing from 1970-1973 and 1984-1987? Both men realized that successful investing requires the patience and discipline to make big bets during the relatively infrequent intervals when the market is undervalued and thus, the odds is stacked in their favor hugely. And during these periods, they were perhaps doing something else besides investing when the marker is fully-priced or over-priced, and I'm willing to bet Warren was playing more Bridge in 1972 than in 1974.
2) The Geiger counter approach works far better in smaller, under-followed companies and a host of special reasons.
Given the smaller size of these companies which are under-followed by the investing community at large, these smaller companies would do nothing much to better the result of Berkshire given their enormous size today. In Warren's words, it takes a "whale to move the needle." But Buffett uses these opportunities presented by the Geiger counter approach for his personal portfolio. A good example is his recent investment in mortgage REIT Laser Mortgage Management (LMM), where there was a decent spread between the liquidation value and quoted stock price. These LMM-type of investments are significant for Buffett's personal portfolio because of the relative size.
Being versatile, he moves his Geiger counter away from the equity markets to other fields of inefficiency whenever the public markets get overheated. These include high-yield bonds (Berkshire bought over a $1 billon worth of Finova bonds at a steep discount in 2001), REITs (he bought First Industrial Realty in 2000 for his own personal portfolio), his recent investing adventure in Silver, or his bet beginning in 2002 on the depreciation on the US Dollars. And in recent time, in Sep 2006, it had slashed its bet on foreign exchange contracts to $1.1 billion from $13.8 billion in December 2005.
3) The Buffett/Munger partnership and relationship is a hugely unusual one which probably only occurs once in a million years.
Both men are fiercely independent thinkers, and both prefer to work alone. When Buffett has an investment idea, and after it makes it through his filter, he usually runs it to Munger. Munger would then apply his broad latticework of mental models to find faults with Buffett's ideas, and shoots it down if Munger sees any fault. Thus, if the idea goes through Munger's filter as well, it is a rare idea that can makes it both past Buffett, and then Munger. So for any such idea, it is a no-brainer to make it past both of them.
The Buffett/Munger approach of multi-year periods of inactivity clearly contrasts starkly with the frenzied activity that takes place daily at all major stock exchanges. So this brings me back to the fundamental question: Why have we set up portfolio managers as full-time professionals to manage other people's money with the expectation that they "do something smart" every day? Warren once gave part of the reason to that when he said: "The stock market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’'", and on the other hand, in life, there're tens of thousands of balls thrown your way, and keeping in mind, some balls are filled with gold and some are hollow, and what a smart pitcher should really do is to select his pitch and swing at the fat ball that is thrown at his way. That is what distinguished an All-Star pitcher from an ordinary-average pitcher.
Thus, the fund-management industry needs to reflect on Pascal's potent words of advice and how Buffett and Munger have taken that piece of advice and figured out how to sit quietly alone in a room, indefinitely.
Tuesday, February 20, 2007
A common mistake among many investors is misdirecting their focus. Many think that to find a winner like Wal-Mart, Coke, or businesses like that is to buy them when they were small or when they were trading at a "cheap" price. By any means, this is a much misconstrued notion for which this article attempts to bring your attention, and hopefully shed some light for you.
To optimize our returns, it is important to sell our mistakes quickly, hold sound companies for a number of years, and then if you can get a great business at a great price, you should maintain your stake in the very best of the lot for a quarter of a century or even forever. The best time to sell shares of a truly superior business is almost never, barring when its valuation is totally driven out of logic. Selling Wal-Mart in the early days after tripling your capital in 1982 would have cost you dearly since it continued to crush the market as the years rolled on. Selling Coke in the early 1986 after more than doubling your original investment in 1983 would also cost you dearly as the years rolled by. For example in Coke, it costs $2 in 1983 and in 1986, it was worth $5. But if you held till 1997 and sold, you will have multiplied your principle by 30 times.
How to find a "penny" stock? Think Wal-Mart.
One way to find a future great is to carefully study the major winners from the past. Relatively few of the multi-decade superstars are technology companies. While I hardly invest in any industry that requires constant changes, I do not avoid them totally. However, it consists of a minority of my holdings. And one of the most classic examples of how a superstar is similar to a penny stock is Wal-Mart. In truth, its stock price was never a penny stock at any time in point.
The story of Wal-Mart’s rise is the stuff of legend. Fortunately with the ease of locating past information facilitated by the internet, I managed to dig out Wal-Mart’s 1972 annual report in the archives. The annual report offers a blueprint of a small company (although not that small after all they operated 51 stores located in 5 states) on the verge of world domination, and along the way bulldozed its larger competitors with inferior business models out of the way. The cover of its 1972 report featured the location of its 51 stores in 5 states, all in the Midwest. Today, there are more than 3800 stores, in 11 countries. Sam Walton then had 2,300 employees. Today, with Sam long gone, there’re 1.8 million associates. Since the early 70’s, the business has grown by almost 1000 times in value from $200 million to $200 billion. By any record, it is the stuff of dreams.
So then, what did they do? How could investors back then tell it could be such a record breaking growth story? There’re certain clues which can ease the process. While flipping the annual report then, there’re 3 traits which kind of jump right at you.
1) Based on top-line growth, the company was going no where but up. From 1969 to 1970, the sales grew 44%. From 1970 to 71, it grew by another 44%. From 70 to 71, it grew by another 44%. From 1971 to 1972, sales grew by an astonishing 76%. Sales were persistently accelerating.
2) Management at the young company was competent and hard working, especially with a fanatic owner like Sam Walton in charge. Return on equity was 35% in 1971. The very next year ROE was an absurd 63%. It shows Sam Walton’s idea of his retail business model is being maximized.
3) Sam had a very clear and compelling vision for Wal-Mart future. That vision included dominant store growth in communities within 300 miles of the distribution center and an efficient business model that could maintain the lowest possible price.
So with the 3 traits, namely, accelerated sales, great management, and a sustainable advantage (otherwise known as moat), Wal-Mart is where they are today.
In 1980, Wal-Mart was trading after accounting for stock-split at an adjusted value of 12 cents. Yes, 12 cents. However, at that point in time, the stock price is $50. So it was never a penny stock. So you may be wondering how it could be 12 cents. That is because a single share of $50 in 1980 is worth 416 shares today. That means a stock in 1980 is split 9 times. So if the stock was never split in 1980, each original stock in 1980 is worth about $20,800 today. It’s thus nearly impossible to become a penny stock millionaire if your idea of a penny stock is literally by purchasing a stock that is indicated by the ticker as a few cents to a few dollars. Because of the stock splits, some investors think they can find the next Wal-Mart while searching among the 20-cent stocks. You won’t. So the title of this article is kind of a mischievous title.
So what has Wal-Mart achieved since 1980, a full decade after it went public?
With the stock traded at above $48 as of the writing of this article, it has returned 400 times in value over the past 26 years. A $10,000 investment would be worth $4 million today. That would have cleaned up many investment mistakes.
But what if we go all the way back to Wal-Mart’s IPO when it became a public company in October 1970? The business was valued at a tiny $21.5 million then. That means the stock went up by an astronomical 10,000 times since. That’s about a compounded growth of 30% a year, and if you had tucked $10,000 then you will be worth $100 million now.
When the company went public then, it raised $4.5 million in cash to pay down debts. Wal-Mart was nothing back then. No one knew about it. Hardly anyone followed it, while dozens flocked to Eastman Kodak - a safe bet then that hasn’t quite matched the rate of inflation since then. None of the big boys on Wall Street really care about it. And that plays right into the intelligent investors’ hands. In 1982, Forbes magazine ranked Wal-Mart first among all American retailers - including chain stores, department stores, jewellers, and variety stores - in financial strength. This is in terms of the past 5 year return on equity, return on capital invested and sales growth. Being big as they are big then in 1982, how apt can its slogan be when they stated "You ain't see nothing yet."
Let's examine what did Sam do right. One of the advantages that can be brought to the business is economies of scale - a central idea to the concept of chain store. Sam concept was "we sell for less." They were there before everyone else joins the wagon in the concept of "Every day low prices." Just as clearly stated above all the concepts that he had was "Wal-Mart has been willing to pay for future benefits and has a strong commitment to avoid any short-term strategy which does not enhance its long term goals."
So with these concepts that he had for the business, Wal-Mart operated with this huge purchasing power which meant that they have lower merchandising cost. This in turn translated to supporting the strategy of "we sell for less" and "Every day low prices." That is one area of specialization which none of his competitions can beat him.
From a single store in Bentonville, Arkansas, against all the giants - Sears, Roebuck - back then, all the name and billions which these giants had mattered for little. Warren like to use the concept of "give any one a billion, but how do you destroy Coke?" How does a single guy from Bentonville with no money blow right by the giants? And amazing all during his lifetime - in fact, he started pretty late during his lifetime because he started out with one little store pretty old.
He played the chain store game harder and better than anyone else. Sam invented practically nothing. All he did was he copied everything anybody else ever did that was smart. And he did it with more fanaticism and better employee manipulation. So he blew right through them. He was like a prizefighter who wanted a great record so that he could be in the finals and make a big hit. So what did he do? He went out and fought 40 gorillas, right? And the result was each time he went out, he knock each out one by one, for 40 times.
Being as shrewd as he was, he basically broke other small town merchants in the early days. With his more efficient system, he might not been able to have tackled some titan head-on then. But with his better system, he could destroy the smaller players before he moves on. And he went out doing it time after time while at the same time, fighting a better opponent after each time. And as time went by, he started destroying the big boys.
That was a shrewd strategy although you may wonder if it was a nice way to behave for he took away the others' livelihood. But what he did was great for civilization as a whole, although in the short term it doesn't seems nice for many others because others probably lost their jobs. But he offered lower cost of living to the general public and at the end of his journey, he offered a million people jobs compared to 2,300 employees in the early 1970's. So what’s so unnice about his behavior?
But well, capitalism seems to be a very brutal game. But personally I think the world is a much better place for having people like Sam around where a superior culture destroyed an inferior system. But sometimes people get defocus for being too nostalgic and getting disillusions. But anyway, the model which Sam has is really a powerful tool when both fanaticism and his central concept of chain store merged.
By reversing the process of construction of this superstar, you can pick out a few other traits which Wal-Mart has in her early days.
1) A few years after going public, it began paying a dividend and never stops. Amazing for a small company.
2) Even more amazing is it started giving dividend in the teeth of a bear market in the early 1970's. A telling sign of her financial strength, even in adverse economic conditions.
3) Wall Street treated the company as if it was a hillbilly, some small time Midwest cowboy. For years, no analyst followed the stock.
4) Institutional ownership was less than 50% for years and years. As stated, no one cared about it.
5) Same owned the majority of the stock. This is an important advantage whereby owner and investors moved in locksteps.
6) Its concept was proven and yet not a completely new concept. Wal-Mart was in business for 8 years before going public with more than 30 stores and $32 million in sales on the day of its listing.
7) He did not sell his shares more than he would take when it went public.
Anyway, this article is not trying to commute to you on reinventing the wheel, because it isn't necessary. There's something on the order of 100 years of researchable history of the stock markets and tons of data available over the past 30 years which can bring you many advantages as an investor. Moreover, many are free and with a little effort, you get a lot more in return.
Interestingly enough, Wal-Mart per share of today is only traded at 6 cents in 1973, 4.5 cents in 1974 and 3 cents in 1975. That is as penny a share you can get but in reality in those years, those shares were never traded at those prices, if not for the action of stock splits.