What the hell is a Leveraged Buyout (LBO)?

LBO business nature, on a legitimate basis, is a fraud. Not that it is fraud in the conventional sense upheld in the court of law.

In LBO, you need money to be in this business, but not a lot. Let's be honest about it, in fact, you may need more money to open a small grocery shop than you do to buy a $2 billion company. To buy or open a grocery shop, if it costs $20,000, you need $20,000. If you don't have it in cash today, you need to bring it by Tuesday.

But in an LBO, not only do you not have to bring it, you don't have to see it, you don't know where you're going to get it, nobody knows where they got it from. The whole situation comes from absolutely nothing.

But the more you need, of course, the less money you need. In other words, if there's money involved, you don't get involved in this business. This is a business for people who don't have the money, but who know somebody who has the money, but who doesn't put it up either. All they do is buy out somebody else business by injecting much debts into the balance sheet and within a short span of time, resell it to the public with all sorts of decorations.

The rules in LBO business is simple. 1) Never pay cash. 2) Never tell the truth. 3) Never play by the rules.

An example to estimating the intrinsic value of a business

Before reading on, it is important to recognize that no two people estimating the intrinsic value of the same business at the same time will produce the same value, even Warren Buffett acknowledged that he and Charlie never will have the same intrinsic value estimation. So this is just a general guideline with certain assumptions built in which some of you may find unrealistic or realistic - so it is important to cater to your own needs.

Intrinsic value is defined as the discounted value of all future cash flows or earnings that a business is estimated to generated during the remaining life of the business. So we can be talking about infinity or at least a period of more than 10 years. In order for intrinsic value to be accurate, it is important to compare between two different types of investments. I shall clearly illustrate the importance of having a really long term investing time frame if the decision of investment is based on intrinsic value. The basic concept to intrinsic value is that an investor is buying all the future earnings discounted back to present value of a business at a comfortable discount today. In other words, it needs a certain number of years of accumulated future earnings to make the intrinsic value to be worthwhile.

For the example in this exercise, we shall take the business of Home Depot. There are 3 main variables to consider in the calculation of the intrinsic value, namely, the book value, the historical return on shareholder's equity of the business, and the rate of return of the alternative choice of investment (in this case, it shall be the risk-free interest rate of government bonds).

In fiscal ended Jan 06, the book value for Home Depot was US$12.53. It was traded at about US$34 back then. The historical ROE is about 20%. And finally, the risk-free interest rate is 5.25%.

For an intrinsic value calculated for 10 years of earnings flow, the book value of Home Depot would have grown from $12.53 to approximately $77.6. Alternatively, if you have chosen to invest in risk-free bonds, the $34 which would otherwise be originally invested in Home Depot, would have grown to $56.72. Therefore, for the 10 years, the earnings from Home Depot generates about $65.07 ($77.6 - $12.53) while the earnings from the bond generates about $22.72. On the surface, the accumulated earnings from the business appears to be $65.07 for ten years before discounting it to present value. However, in order for the intrinsic value to be accurate, the accumulated earnings flow from bonds must be deducted from the earnings flow of the business, which gives a value of $42.35. Then this $42.35 must be discounted with an appropriate interest rate to get the present value of the intrinsic value today. In this case, the discount rate is 5.25%. So, after discounting for 10 years back to today, the intrinsic value of the earnings flow gives an intrinsic value of $25.39.

Then if you calculate the earnings flow for 20 years, the book value of the business would grow from $12.53 to $480.50 in 20 years. While the bond value would grow from $34 to $94.61 in 20 years. Thus, the earnings from the business is $467.97 while the earnings from the bond is $60.61. Again, the intrinsic value at the end of 20 years is $407.36, and then you need to discount it again at an appropriate rate to the present value, which gives $146.40.

Now to summarize the example for Home Depot. The intrinsic value based on 10 years earnings is $25.39, and 20 years is $146.40. The trading price is about $34 somewhere at the start of 2006. So if your time frame is 10 years, obviously, you are paying more than what the accumulated earnings in 10 years will be. But if you calculate based on 20 years, you get more than what you pay for. In fact, in you are paying $34 dollars for every $146.40 (in present value terms) of the next 20 years earnings flow.

And what is also clearly illustrated here in terms of book value is book value is meaningless as an indicator of intrinsic value if you should invest in a business. In fact here, you are paying $34 per $12.53 of book value which is a P/B ratio of 2.71. But it is capital well deployed since you will be getting $146.40 of future earnings in present intrinsic value today.

By the way, if you are wondering why is there a need to deduct the earnings which would otherwise be earned from bonds from the earnings of the business, here is the reason. In intrinsic value, it is in fact a comparison between two options. For example, between spending money in an education or to skip education and work straight away. So to compare which option is better in terms of future earnings, it is the difference in earnings between the earnings of having an education and the earnings of not having an education. To understand further on the basic concept of intrinsic value, do refer to one of my past subject on this.

Some ideas from Warren and Charlie on stock pickings

Firstly, it is important to pick out businesses which you can understand and naturally, when you can understand something, you tend to like them more. So, that narrows it down the pool of available businesses by a whole chunk of 90%. There will always be all types of things one do not understand, but fortunately, there is always enough for anyone to understand - therefore, you would not have to force yourself to understand something you do not understand. You have this big wide world out there and almost every company is publicly owned. So you have all kinds of businesses practically available to you and thus, it makes sense to go with the things you can understand.

Take for example, Coca Cola. Most people will be able to understand this. Since 1886, it is a simple business but it is not an easy business. Always distinguish between simple and easy. No one should go after an easy business as it will be easy for competitors. A simple business with a moat around it is the best form of business that an investor should look out for. Warren wants a very valuable castle in the middle and then he wants the Duke who is in charge of that castle to be honest and hard working and able. Then he wants a moat around that castle. The moat can be in various forms - for example, the moat around his auto insurance business, Geico, is low cost.

Anyone who is driving a car have to buy an auto insurance. You can't sell them 20 but they have to buy one. So what are these people going to base their criteria on when they buy? They will buy based on service and cost. Most people will assume the service is identical among companies or close enough. So they will do it on cost. So when Geico have a low-cost producer - they have the moat. All the time while you are having a castle whether with a moat or not, there are people out there who are going to attack it and try to take it away from you. So he wants both a castle which he can understand and also a castle with a moat around it with all kinds of sharks, crocs and gators thrown in to protect the castle. 30 years back, Eastman Kodak's moat was just as wide as Coca Cola's moat. If you were going to take a picture of you six-month old baby and you want to look at that picture 20 years from now or 50 years from now, so you want to evaluate what is going to look good 20 or 50 years ago. And if you are not a professional photographer, what will then be in your mind about photography? You need a peace of mind and that is what counts. Because Kodak is promising you that the picture you take today is going to be terrific 20 to 50 years from now is something that is very important to you. Well, Kodak had that in spades 30 years ago. They had what is called a share or peace of mind. Forget about share of market, it is share of mind. They had something - that little yellow box - that said Kodak is the best. That is priceless. But they have since lost it. They allow the moat to narrow. They let Fuji in and the moat starts narrowing in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people's minds, Fuji becomes more into parity with Kodak.

As for Coke, you haven't seen their moat diminishing, in fact, its moat now is wider than it was 30 years ago. You can't see the moat day by day but every time the infrastructure that gets built in some countries that isn't yet profitable for Coke, that will be 20 years from now. The moat is widening a little bit each time. Things are, all the time, changing a little in one direction or the other. Ten years from now, you will see the difference. Warren wants the managers of his businesses to widen the moat to keep away competitors. That can comes through service, through quality of product, through cost, some times through patents and/or real estate location. So that is the kind of business he looks for.

Now what kind of businesses is he going to find like that? He is going to find them in simple products because he is not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Then it is almost certain to figure how their competitors will look like then. But it is easy to figure out how the chewing gum business will look like ten years from now. The internet is not going to change how we chew gum and nothing much is going to change how we chew gum. There will be lots of other products but is Spearmint or Juicy Fruit going to evaporate? It's highly not likely to happen. You can give anyone a billion and tell him or her to go into the chewing business and try to make a real dent in Wrigney's. He or she can't do it. That is how Warren thinks about businesses. He says to himself, "Give me a billion dollars and how much can I hurt the guy?" He can't do it and those are great businesses.

So Warren wants a simple business, easy to understand, great economics, honest and able management and then he can see about in a general way where they will be ten years from now. If he can't see where they will be ten years from now, he do not want to buy it. In other words, he do not want to buy any stock where if NYSE is close tomorrow for 5 years, he won't be happy owning it. If he buys a farm and he don't get a quote on it for 5 years, he will be happy if the farm does ok. If he buys an apartment house and don't get a quote on it for 5 years, he will be happy if the apartment produces the returns that he expects. People buy a stock and they look at the price the next morning and they decide to see if they're doing well or not doing well. It is bonkers. They're buying a piece of the business. That is what Graham - the most fundamental part - taught him. You're not buying a stock, you're buying part ownership in a business. You'll do well if the business does well if you do not pay a silly price. That's what it is all about. You ought to buy businesses you understand. Just like buying any other things, you ought to buy things you understand. It isn't complicated.

By the way, this is pure Graham method for which Warren admitted he was extremely fortunately or the luckiest event in his whole lifetime. That is to pick up Graham book (The Intelligent Investor) when he was nineteen, He got interested in stocks when he was 6 or 7 and he bought his first stock when he was eleven. But he was then playing around with all this stuff - charts, volume and all types of technical analysis. Then he picked up a little book that said you're not just buying some little ticker symbol that bounces around every day, but instead, you're buying part of a business. Soon as he started thinking about it that way, everything else like they say is history. It is very simple but not easy as what is layed out earlier. So he buys businesses he thinks he can understand and avoid all that he can't. There is no one who can't understand Coke.

In Buffett words, if he was teaching a class at business school, and on the final exam he would pass out the information on an internet company and ask each student to value it. If anyone that gave him an answer, he'd flunk him or her.

Investing is really all about putting money to be sure of getting more back later at an appropriate rate at an appropriate time frame. And to do that, you have to understand what you are doing at any time. You have to understand the business, your actions and your basics.

Business and investing wisdom from Warren Buffett

Warren remarked in Berkshire Hathawat 1993 annual report, "It's only when the tide goes out that you learn who has been swimming naked."

The sage of Omaha's much quoted, and misquoted, comment was about inadequate preparedness in the U.S insurance industry with catastrophe. Those words are also of immense value of the exuberance in every other things from Chinese to Indian to Vietnamnese euquities to Indonesian Corporate Bonds to recently the bullishness of Singapore properties. In all bull markets, it is typical for all kinds of investments - great or lousy - to all rise when the tide rises.

Developers recently paid HKD42,196 (USD5,444) psf in Hong Kong, smashing the 1997 record of HKD18,357. Six real-estate companies have tapped the Alternative Investment Market in London this year to raise money to invest in India. Their pickings? More than £1.2 billion, or $2.4 billion. And according to The Today newspaper in Singapore, an investor who paid about 14 million Singapore dollars, or $9.1 million, last week for a 4,400- square-foot, or about a 400-square-meter, apartment near the main Singapore business district turned down an offer to sell it at a 19 percent profit, or an annualized 1,000 percent profit. He wants more, the paper said. Worst of all investment in my view is property because property by itself is not a value adding product in the value chain.

Investors recently offered more than 450 billion yuan, or $58 billion, for the shares of a Chinese rail operator in Guangdong Province. Guangshen Railway needed only 10 billion yuan. Qantas is offered by a buyout firm to bring it private, and usually buyout will not even look at the aviation industry to buy. Some teachers pension fund has been buying container shipper terminals in the West Coast of U.S.A. I wonder what these fund managers operating the teachers' pension fund know about the shipping industry.

It is apparent in some sectors structural weaknesses are being brushed aside. Global investors who snapped up $2.7 billion in international corporate- bond issuances by Indonesian companies this year are not at all perturbed about the dubious legality, under Indonesian jurisprudence, of offshore special-purpose vehicles that are routinely used in structuring such deals.

Graft and nepotism remain big headaches 10 years after the Asian crisis exposed weaknesses in governance. In Taiwan, President Chen Shui-bian's wife is being tried on a charge of embezzling state funds. She rejects the allegations.

In Thailand, businesses linked to the deposed prime minister, Thaksin Shinawatra, are being investigated by the junta that overthrew him in September, alleging corruption and cronyism. And look at the "flip-flop" blunder made by the hastily assembled setup by the Junta. It seems that to chop down a single tree, they destroyed the whole forest just to get the tree down. It is so easy to undo 10 years of reform that is put in by the previous business savvy regime.

The legal system in Indonesia is at best a work in progress: The building that will house the all-powerful Constitutional Court, set up in 2003, is still under construction.

Malaysia looks both unable and unwilling to stop clinging to an anachronistic racial policy that does nothing to add much needed dynamism to its economy.

As long as the tide of liquidity runs high and is left undisturbed, investors do not care about anything else, much less about the basic weakness in the structure of what they invest in.

A nationalistic whiplash against foreign buyout firms in South Korea is being shrugged off as par for the course.

Meanwhile, the Bank of Thailand this week tried to tax the deluge of funds entering the economy and it got punished. Stocks collapsed. The move had to be hastily scaled down. An incompetent ruling party is bad enough, the worst scenario is to couple and compound an incompetent decision maker who flip-flops.

Will sobriety return in 2007? Will there be a decline in the amount of cash chasing Asian assets? Perhaps not.

And that is because the investment slump seen in Asian nations since the crisis may actually be part of a more widespread phenomenon. And also importantly, there is so much excess cash with the money managers chasing after a limited number of assets, and to make it worst, a much limited number of assets which are great business. So naturally many scraps are treated as "gold."

Behind the surfeit of worldwide liquidity, there is a global shortage of new fixed assets, Raghuram Rajan, the outgoing chief economist at the International Monetary Fund, noted in a speech earlier this month.
"The glut has spilt over into markets for existing real and financial assets — real estate, high-risk credit, private equity, art, commodities — pushing prices higher," he said.

Except for Asian central banks suddenly draining excessive liquidity, skinny-dipping will continue to be all thrills and no embarrassment until the midnight strucks but then, too many people does not know the time when they are high on dancing.

Method of evaluating and selecting stocks (Part 3)

Again, this is in response to Jojo. Yes, I totally agree that a summation of all FCF or otherwise could be known as the total earnings that a business will generate, till infinity is the best way to figure out the intrinsic value of a business.

And of course, the most difficult part is to determine a fair growth rate. And to determine this, it encompasses many factors from the quality of the management, the goal of the management, the plan for expansion or where the company is heading to few years down the road, the historical performance of the business and many more. To determine a growth rate is a large part for me personally can be attributed to both having an explicit plan for the future and to determine how the past performance matches the explicit plan at that time in point.

For example, a very recent acquisition of mine - Walgreens, I determined its growth rate and estimated value as described as follows, guided by the general guidelines as aforesaid.

In Walgreens latest annual report ended fiscal 2006, they plan to operate 7000 drugstores by 2010 as stated explicitly. This represents a 400 stores per year increase from today. So you can be pretty sure they are still growing at some decent pace.

So how sure can one be that they can achieve their goal? Then, we shall back-track to year 1994. In 1994 annual report, they had a plan to grow to 3000 drugstores in 2000. And they exceeded it. So if we compare the period b/w 94 to 00, & 06 to 2010, you will see that they grew from 1966 stores in 1994 to 3181 stores in 2000 which represents an increase of 61% from 94. If they can grow to 7000 stores in 2010 from the existing 5481 stores at end Aug 2006, it is about a 27% increase. Though if you compare it period to period, obviously the one from 94 to 00 is growing much more but then, it gotta be so when it is easier to grow it when on a smaller scale. But if you look at its per store sales, in 94, a store generated about USD4.7M, in 2000 it was US$6.67M, in 06, it was US$8.68 millions, in 2010, I estimate at about US$9.68 millions. I think my estimation is pretty conservative. I maintain a file to play around with the valuations, in 2010 if you use a PE of say 25, it can hit a price of USD74. In 2008, if you use PE of 22, it can goes to US$48.

Then it is important to be conservative in valuation in order to have a margin of safety too. And the calculation I did for the above are pretty conservative in my view if it was to compare it to how the market valued Walgreen a decade prior from now. If I were to use the same set of constants to calculate "Walgreen estimated value" from 94 to 00, the actual result, i.e. the actual average trading price then, was way a lot more than what I estimated. If I had bought in 94 at USD4.84, my valuation done in 1994 for the stock price was estimated to be about US$13 in 00, but it hit US$29.63 in reality....not only in that year was my calculation way off from the actual, any year before that is also way off but it is better to calculate conservatively.

Method of evaluating and selecting stocks (Part 2)

Again this is in response to Jojo, a fellow value investor, it's great to share ideas with someone who has a similar mindset towards investing, though may not be exactly the same in totality but the basic foundations are the same.

I too subscribe in total to Benjamin Graham basic notion of investing which is to find a dollar worth of business for 50 cents. This may be sniffed out in many ways, for instance, through the pure Grahamites method, or the improved method like how Warren and Charlie did.

Ok, I shall go part by part to elaborate how I select my business thus far. As to what I said earlier, I got to add that the ratios are just a trigger to consider investing in it. Well, PER and PBR are important triggers to telling you if a business is undervalued in a large part but it don't give you an idea of what the intrinsic value is.

The level of margin of safety is dependent on how confident an investor is to his valuation. Let's say if you are driving a 10-tons truck across a bridge over the Grand Canyon, you would feel you need a lot more in the way of margin of safety. But if you are driving over the Sin/Johor causeway, you need a lot less.

As for intrinsic value, I do not necessary base on that for my decision in investment. This is because if I can find a stock that is a great business and that it will survive, and have certain organic growth in the years ahead, and coupled with a valuation which is almost at its low for a long time, say, 10 years or more, I am sure the intrinsic value of its future flow of earnings at the present value today will be worth much more than the price that I pay today. Further, I got to add that I like to consider businesses which has a long history of getting good average return on shareholder equity.

Though I do not calculate the intrinsic value as always in all my purchases, I do have a method to calculate it. But the method is not simple and it is just an estimation though it is an all-important concept that offers a logical approach to evaluating the relative attractiveness of investments and businesses. To start, intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. So what is meant here is really a long run for all the great businesses who has a great moat that has the durability to survive and grow its moat and more importantly, the durability of the moat. It is quite pointless to do an estimation of intrinsic value if the duration is 3 years, 5 years or such because you will not be able to see the effects of cash flowing in to make up for the price you pay at with such a short time frame.

And the inputs to the calculation of the intrinsic value is all important as well. And it has to be changed yearly when interest rates changes or future cash flows are revised.

And what importance intrinsic value brings to the table is it also helps to determine the fair amount of what you should pay irregardless of what is carried on the book or its book value at the point of valuation. In other words, book value by itself is meaningless as an indicator of intrinsic value.

Here's an example on how I calculate the intrinsic value for a business, I shall take this business called, USG, as an example.

In calculating intrinsic value, it is basically to compare between two options. In this case, we are to compare between investing in USG or to invest in risk-free equities like government bonds.

The process of estimating intrinsic value is firstly, to estimate the earnings that the business (USG) will receive over its lifetime or for the duration of the time frame you are willing to invest for (10, 15, 20 years or so on). Then once you manage to estimate the earnings for the duration, you must substract from that figure an estimate of what the investor would have otherwise earned if he had deployed it in some other securities like risk-free bonds. This will give you an excess earnings figure which must then be discounted at an appropriate interest rate back to the day you invested in. The dollar result equals the intrinsic economic value of the investment. This figure will then give you an idea of how much you should pay for at maximum and it brings you back to the old Aesop's axiom of "if a bird in hand is worth two in the bush."

Here's the exact intrinsic value that I calculated for USG and see if it makes much sense to you. But be cautioned that the outcome of it at the end is really dependent on two important variables, the current interest rate that I used at 5% for risk-free interest and the return of equity of the business at roughly about 26% historically.

A few months back, USG was traded at US$46.50. I used a time frame of 11 years. Then the book value of USG was about US$20, and by the year 2016, it is calcuated to be worth about $210. On the other hand, if I had opted to invest in bonds which pays 5% till 2016, the initial value of $46.50 would grow to US$75 by 2016. Obviously, at first glance, USG is a better investment but that is not the intrinsic value and it does not show you what the present value is for USG future value. So now, you got to take the difference between $210 and $75 and discount it back to today at an appropriate rate of say, 5% again. So the present value of the difference which is $135 is worth $82.90 today. So effectively, you are paying $46.50 for $82.90 of future cash flows.

I shall give another example that may make it much clearer in distinguishing the intrinsic value to the price that you should pay. I think some people like to value things too much by having the book value of the business or something as the yardstick but it isn't exactly a good way to do so.

You can gain a lot of insight from a college education. Think of education cost as its book value. And if this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college over a job. Here is how it works. Firstly, you must estimate again the earnings the student will receive over his lifetime and then subtract from that figure an estimate of what he would otherwise have earned had he lacked his education. Again, the difference will give you an excess earnings figure, which must be discounted at an appropriate interest rate back to graduation day. This will then give you the intrinsic value. So the next question is if the parents of the student got his money (the cost of the education which is the book value) worth? Some students will find that the book value of their education far exceeds the intrinsic value, which means the parents or who ever paying for his education did not get his money worth. In other cases, the intrinsic value of an education will far exceed its book value, a result which proves capital is wisely deployed.

What we can glean from these 2 cases is clearly that book value is meaningless as an indicator of intrinsic value.

I am not sure if I describe clearly or I may have missed out any important point, which you may point out to me. I am extremely interested to learn more and improve on my method.

Aside from the intrinsic value, just as important, I can afford to hold businesses like these for many years or even throughout my lifetime because they have great business models which gives investor great returns if gotten at a fair price, or even better at a great price.

As for the value of USD, yes, it will definitely fall in the future because they are buying more than they are selling. So slowly, they got to sell away their assets and things like that and it will cause their currency to be worth lesser. Well, in any thing, there will be rock bottom or hit its bottom and then goes up again. So if my time frame for USG is 11 years, I really cannot tell if the exchange rate today of 1.55 will be worth more or less in 11 years but somewhere between now and then, it will probably be worth less. If I recall, in my poly days in mid 90s, SGD hit 1.42 to the Dollar, in 2002 it was at 1.82. I am no currency expert but if my time frame is long enough, I do not worry about the exchange rate of USD to SGD. Moreover, Singapore imports more from US than US imports more from SG, the only thing is SGD is pegged to a basket of currency which it is not easy to predict which direction it goes. I am pretty comfortable with the exchange rate for now which is probably at the middle between the bottom of 1.42 and high of 1.85 in recent 10 years.

Method of evaluating and selecting stocks

This is in response to a question by Jojo on how I evaluate and select businesses. Since last November where I picked up Value Investing and made my first stock purchase, my method of evaluation and selection has evolved from the classic Benjamin Graham concept to an approach which is an improved and extended concept that originated from Benjamin Graham’s tree of thoughts which is to buy a dollar for 40 cents.

The classic Graham method advocates purchasing businesses 1) for 60% of current net asset value or working capital, 2) uninterrupted dividend payout record for 10 years or more, 3) Price to book value ratio of not more than 1.5 and so on. As the years went by, the bargain which met Graham standard got lesser and lesser. By and large, at the time, he was living in the 1930s, the situation was totally different. You could get a business that is worth less than the sellout value or working capital, close shop, fire all the workers and take home the capital. In today's world, it is simply not possible or at least they didn't.

However, having said that, his basic notion is very much applicable today or timeless. He had this concept of value to a private owner - what an enterprise would sell for if it is available and in many cases, it is calculable. As the years moved on, the disciples of Graham got wiser as those obvious bargains disappeared and they changed the calibration of measuring a bargain. Graham would be horrified at certain calibration of value investing especially those that involve paying 2, 3 or 4 times book value which he would never even consider touching. But there are still many who stick to the classic Benjamin Graham route - not that it is no longer safe or good to practice, but it will not give an above average return - it is like the man with the hammer, in Charlie Munger’s words, everything looks like a nail.

So, people started to look for bargain in a different way. People kept changing their definition so that they could keep doing what they'd always done. And it worked pretty well. So in effect, the basic Graham intellectual system is a very good and timeless one.

The best notion he crafted was "Mr. Market." To Graham, it was a blessing to do business with a manic depressive who gave him a series of options all the time. On some day, he wants to buy from Graham his stake at a very high price. On some other day, he will offer to sell to Graham at a price which is very low. To buy or to sell is all up to Graham where he has a choice or to totally ignore Mr. Market. And this is one of the most useful construct one can have for his entire investment lifetime.

However, to stick with the pure Graham method today, it is very tough to get an outsize return because Graham would not consider many things which are essential to getting an outsize return. To be fair to Graham, he is more of an academic where he wanted to construct an investment framework for people from all walks including the layman. So his ideas have to be easily understood and practiced by the ordinary people. Thus, he would not consider bringing in any idea that the layman would otherwise not understand or will be accessible to and that is exactly how he preached and practiced it.

So what are the things he did not bring to the table to enhance the chances of getting a better return? For example, he would not talk to management which he believes most ordinary shareholders do not have access to and secondly, he would not consider buying any business which is priced a couple times or more of book value even if the business has a superb underlying business economic model. And the most important extension to the classic Graham intellectual system is to first and foremost consider buying better business at a fair price even if it is a few times book value. In all cases, the notion of value investing is to find mispriced bet and gain more than what you pay for, and this may not be just limited to discount to book value, free cash flow and the old-school way of value investing.

And one of the best insights to selecting businesses is mentioned by Charlie Munger, "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." So the trick is to buy into better businesses.

Starting as Grahamites is totally fine and will work out fine or at least average for the rest of your investment lifetime. But then, to get better returns, it is important to recognize that buying companies which are 2 or 3 times book value can be a hell of a bargain because of the momentum implicit in its position and sometimes combined with an unusual management present in an individual or some other system.

Plainly speaking, it is better to consider investing in better business, evaluate the moat of a business, you may want a simple business but not an easy one where anyone can take over its place easily, look for a great and honest management, buy into businesses you can understand (for me I avoid tech stocks as much as possible and any business that always require change to maintain its existence), stick to your circle of competency. It is also importance not to buy a business which has a great management but lousy business economics as most times, it is highly unlikely a business would turn over due to the brilliance of an individual if a moat is missing. Conversely, if you come across a situation where you have to bet between a brilliant manager or a brilliant business, bet on the business. Also, if you have to bet between a fair business available at a great price or a great business available at a fair price, bet on the latter.

Here, I shall illustrate of how far I have evolved to from a pure Grahamite to buying businesses at an improved method from the classic Graham way.

Grahamite stock - Kingboard and United Food.

1) Kingboard - Late last year, the stock was available at slightly below 26 cents per share. At that price, it was selling at slightly less than 6 of 2005 earnings. Discount to NAV of 44%. Current ratio of more than 2. Sadly then, all I looked at was through the back screen rather than the front windscreen. I could not tell where the business will be 5 years down the road. And even if they survive, I could not tell explicitly what their plan is and how they are going to grow their business.

2) United Food - This is a total Ben Graham stock. Early this year, the stock was selling at 24 cents or so. Some slight discount to Net working capital. A huge discount to NAV. No debts and so on. Sadly, the reason of looking into the future is not calculable. Today, the discount to NWC is much more, traded at 18.5 cents, luckily, I sold it at about 30 cents somewhere in Apr this year. But if you are to bet on this today, it is a totally mispriced stock and the returns could be pretty significant.

Such stocks are safe stocks because of sound financial standing but the problem is the business economics are not great. They are perhaps only fair or good at most. But such stocks you can be sure that you are very well protected because essentially you are paying 50 cents for a dollar. You need lots of patience in pure classic Grahamite method and a control over your temperament for being on the other side of the fence when the majority is against you. Well, value investing is just as exciting as watching grass grows.

Therefore, after reading more on both Warren Buffett and Charlie Munger, I changed the calibration by buying into better businesses. I like businesses like Walgreens, Wal-Mart, Lowes, Home Depot, Radian, USG, Coca Cola, Harley Davidson, McDonalds, Johnson & Johnson and many more. I bought USG, Walgreens and Radian. I want to buy Lowes and J&J if I have spare cash now. All the rest it is just a matter of waiting for the right time. In investing, always study a great business, keep it in mind, keep studying and wait for it.

Walgreen - I bought it at slightly above US$40 per share. At this price, it is the lowest for the past 52 weeks but that is beside the point and unimportant unless you are a total momentum or technical buyer. At US$40, it is priced at about 4 times book value, 23 times earnings. However, considering the business historically earns 19% to 20% on shareholder's equity, at this price, I am buying at a future valuation of 2.25 times book value, 13.55 times earnings into year 2010. And most important, I can both understand the business model which is very simple and how they plan to grow their business into the future by year 2010. The business they operate is retail of drugs. They operate round-the-clock drugstores in the States. In retail, the overall business model is to stock items that the consumers are seeking for in a timely fashion and conversely to sell these items while generating the most sale per square feet of retail space. At the end of fiscal 2006, Walgreens operate 5461 drugstores, they intend to grow up to 7000 stores by 2010. That is to say you can be pretty sure sales and profit will grow and thus, shareholders will ultimately by getting more profit and value per share. The next question is how confident Walgreens will be able to achieve 7000 stores? In 1994, there were 1966 stores, they had a plan then to grow to 3000 stores by year 2000. In year 2000, they operated 3181 stores. And the best thing here while growing is they do not need to dilute shareholders stake by selling any new shares to fund their expansion which is very common in many companies. So for each original shareholder in 1994, they had a share of profit of US$0.29 per share, in year 2000, they had a profit of $0.75 per share. In fiscal 06, it was $1.72. And the business is coupled with a great management where they focused on the business rather than on the share price. The CEO mentioned something to the effect that "if a business is well taken care of, the share price will take care of itself and the share price is one matrix where he has no control over." I think that is honest management and bam, you have both a great management and a great business which has more than 100 years of operations and counting.

As for the rest of the great businesses, it is too long to even put the reasons down here.

To summarize, to get better returns and also importantly so as not to worry about the daily quotes on the tickers, it is important to buy into better businesses because if you get a great business at a fair price today, you can essentially put it aside, can it up, sit on it and maybe some many years down the road and you look at the price and value, you will have a pleasant surprise. And also just as important, you will have missed a lot of unhappy and tensed experiences.

Basic to being a good stock picker (Part7)

Another very simple effect that is very seldom seen discussed either by the investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that will work out is that after taxes, you get to keep 13.3% per annum.

In contrast, if you bought the same investment buy had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% - or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you have chose to sit back for long, long stretches in great companies, you can get a huge advantage from nothing except from the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

However, in terms of business mistakes, trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. Terrible mistakes are made from people being overly motivated by tax considerations. Anytime someone offers you a tax shelter from here on in life, shun it.

In fact, anytime anybody offers you anything with a big commission and a 200-page prospectus, don’t buy it. Occasionally, you’ll be wrong if you adopt this rule. But, over a lifetime, you’ll find yourself a long way ahead – and you’ll miss a lot of unhappy experiences that might otherwise reduce you love for your fellow man.

There’re huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait. Firstly, you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf? Lots of luck.

Are there any dangers in this philosophy? Yes, everything in life has dangers. Since it’s so obvious by investing in great companies work, it gets horribly overdone from time to time. In the “Nifty-Fifty” years, everybody could tell which companies were the great ones. So they got bided up to 50, 60 and 70 times earnings – thus the name “Nifty-Fifty.” And just as IBM fell off the wave, other companies did too. Thus, a large investment disaster resulted from too high prices. And you got to be aware of the danger.

So there are risks. Nothing is automatic and easy in life. But if you can find some fairly priced great companies and buy it and sit, that tends to work out very, very well indeed – especially for the individual.

Within the growth stock model, there’s a sub-position: There’re actually business that you will find a few times in a lifetime where any manager could raise the return enormously just by raising the product prices – and yet some of they haven’t done it. So they have huge untapped pricing power that they’re not yet using. That is the ultimate no-brainer.

That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance still stay right up there.

So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.

And at Berkshire Hathaway, they are the largest shareholder in Coca Cola – which had some untapped pricing power. And it had brilliant management. It was perfect.

Basic to being a good stock picker (Part 6)

This is to continue on the earlier 5 parts of the same subject.

Most investment managers are in a game where clients expect them to know a lot about a lot of things. At Berkshire Hathaway, fortunately, they are not governed by such notion. And instead Berkshire came to this notion of finding a mispriced bet and loading up when they are very confident that they are right. So they are less diversified and system is miles ahead.

However, in all fairness, a lot of money managers could not successfully sell their services if they used Berkshire system. But if you’re investing for 40 years in some pension fund, what difference does it make if the path from start to the finish is a little more bumpy or a little different than everybody else so long as it’s all going to work out well in the end? So what if there’s a little extra volatility.

In investment management today, everyone wants not only to win, but to have a yearly outcome path that never diverges very much from the standard path except on the upside. Oh man, that is a very artificial and crazy construct. That’s the equivalent in investment management to the custom of binding the feet of Chinese woman. It’s the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it.

It is really hobbling oneself. Now, the investment managers would say, “We have to be that way. That’s how we’re measured.” And they have the right in terms of the way the business is now constructed. But from the viewpoint of a rational customer, the whole system is bonkers and draws a lot of talented people into socially useless activity.

However, the Berkshire system is not bonkers. It’s so damned elementary, simple that even bright people are going to have limited, really valuable insights in a very competitive world when they’re fighting against other very bright people.

And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times. You’re much more likely to do well if you start out to do something feasible instead of something that isn’t feasible. Is that perfectly obvious?

How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands please. How many of you have two or three insights that you have some confidence in? I rest my case. Berkshire system is exactly the same where it adapts to the nature of the investment problem as it really is.

Berkshire made the money out of high quality businesses. In some case, they bought the whole business. In other, they bought just a big block of stock. But when you analyze what happened, the big money has been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns a 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.

How do you get into these great businesses? One method is what Charlie Munger call the method of finding them small get them when they’re little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it’s a very beguiling idea. Finding them small is a perfectly intelligent way. But at Berkshire, it doesn’t work anymore because they’ve too much money. They can’t find anything that fits their size parameter that way.

Then finding them big obviously is very hard because of the competition. It gets even harder each year for Berkshire.

Ideally, you should get into a great business which also has a great manager because manager matters. For example, it’s made a great difference to General Electric that Jack Welch came in instead of the guy who took over Westinghouse.

And some of it is predictable. It does not take a genius to understand that Jack Welch was a more insightful person and a better manager than his peers in other companies. Nor it does not take a genius to understand that Disney had basic momentums in place which are very powerful and that Eisner and Wells were very unusual managers.

So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. If you don’t load up when you get those opportunities, it is a big mistake.

These people do come along and in many cases, they are not all that hard to identify. If they have got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party - then management can matter much.

However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to chose one, bet on the business, not the brilliance of the manager.

But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.

Proposed changes on securities market

In ST today, there is an article on some proposed changes to the rule of the securities market to both protect the investors and also to ease the regulation of offers of investments.

On the first front of protect the investors, I think it is high time that changes ought to be made to ensure that all financial advisors are to make all their charges and its impact known to the unwitting investors. In fact here, the financial advisors and the investors stand on two different extreme corners though many times, the picture is otherwise painted out to be. On one end, the goal of financial advisors are to fatten their sales and thus their cut. How can this be achieved if investors do not turn their holdings constantly? On the other end, investors want to maximize their returns, however, by constantly turning in and out, the ultimate returns will be lessened by the accumulated cut by the advisors.

On the other front of easing the rule of offers to investors, there is particularly one requirement that even the best investing firm in the world, Berkshire Hathaway, can never or has ever before achieve even at its gigantic size today. The requirement states, "Has carried out at least 40 transactions with a minimum total value of $200,000 in the last 12 months." In all years, Warren will be happy to even find one single great idea or investment to buy. Hardly can he even find more than 5 at any given year. As explained earlier, the more you turn over what you hold, the more you lessen your maximum returns. So this requirement goes against the basic of value investing. Though this rule is meant to protect all unwitting investors away from damage, the nature of it contravenes with what a well-heeled and knowledgeable value investor will practice.

On the whole, policies are made to cater to protect the majority which i totally agree with, so for the minority who know what they are doing, they do not get to enjoy certain type of cake. Well, it is always better to protect the majority than the minority though the well-heeled minority does not qualify. But they will surely have other type of cakes that can produce just as good if not better. So to say that the world is not fair or policies are always slanted towards the well-heeled, i beg to differ because it is not always so. I think it is pretty fair in this world that certain things are more protected towards the unwitting crowd from damage and some that prevents the well-heeled and knowledgeable people from making use of certain schemes.

Business and investing wisdom from Warren Buffett

1) Never lose money.
2) Never forget rule 1.
3) Do what you enjoy doing and do it well time after time.
4) Stay simple.
5) Look for business that are hard to replicate, that has a moat around it and expanding. The moat can comes in various forms - location, service, distribution, cost structure, logistics, patents, monopoly, branding and so on.
6) Always stick to your circle of competency. In simple english, it says do what you understand.
7) In value investing, if it doesn't works the way you run things, you should get out of there till it is time to come back into play. You should never join the other side of how others play the game.
8) Have a vision and make shape out of the unknowns as much as you can through logical means. This last one is not from Buffett but Li Ka Shing.

Basic to being a good stock picker (Part 5)

To continue on the earlier 4 parts on how to be a good stock picker, in general, many investors are sort of too influenced by their investment managers or their friends who are indirectly also too influenced by all the reports issued by the investment managers. It is thus important to understand what makes sense for the investor is different from what makes sense for the manager. For instance, at Berkshire Hathaway, it would be hard to get paid as an investment manager as well as what they’re currently paid because you’d be holding a block of Wal-Mart, a block of Coca Cola, a block of Nike, a block of American Express, a block of P&G, Johnson & Johnson and so on. You’d just sit there. And the client would be getting rich. And after a while, the client would think, “Why am I paying this guy half a percent a year on my wonderful passive holdings?” So what determines the behavior in human affairs? As usual, incentives are the determinant for the decision maker.

A classic case on incentives is Federal Express. The heart and soul of their system which creates the integrity of the product is having their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product of full integrity to FedEx customers.

And it was always screwed up at one time. They could never get it done on time. They tried everything you named it and nothing worked.

Finally, someone came along with the idea to pay all these people not so much an hour, but so much a shift and “bam”, it’s all solved. And when it’s done, they can all go home. Well, problems cleared up overnight.

So, getting the incentives right is a very, very important lesson. It was not obvious to FedEx what the solution was. But maybe now, it will hereafter more often be obvious to you.

As we’ve recognized that the market is efficient as a pari-mutuel system is efficient for the favorite to be more likely than the long shot to do well in racing, but not necessarily giving any betting advantage to those who bet on the favorite.

In the stock market, some railroad that’s beset by better competitors may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So, it’s just like a pari-mutuel system. Any fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn’t so clear anymore what was going to work best for a buyer choosing between the two stocks. So it’s a lot like the pari-mutuel system and, thus, it gets very hard to beat.

So, what style should the investor use as a picker of common stocks in order to beat the market, in other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called “sector rotation.” You simply figure out when oils are going to outperform retailers, when car manufacturer are going to outperform oils and so on. You just kind of dart around being in the hot sector of the market by making better choices than other people. And presumably, over a long period of time, you get ahead. However, there’s no truly known investor who got successful or really rich in this fashion. Maybe some people can do it and no one is saying they can’t. All that is known is so far no one can give an example of someone who got really rich and successful by practicing it consistently in the long run. And conversely, there’re many successful investors who did not do it this way.

The second basic approach is the one that Benjamin Graham used – much admired by Warren Buffet and Charlie Munger and many other successful value investors. He had this concept of value to a private investor – whereby what the whole enterprise would sell for if it were available. And that was calculable in many cases.

Then, if you could take the stock price and multiply by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business. This significant excess of real value per share that is working for you means that all kinds of good things can happen to you. You had a margin of safety as he puts it by having this big excess value going for you.

But he was, by and large, operating when the world was in shell shock from the 1930s which was the worst contraction in the world in about 600 years. Wheat in Liverpool got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Benjamin could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owner’s pockets. That was the way capitalism worked then.

In modern times, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of civilization, so much is owed to the employees that the minute the enterprise goes into reverse, some of the assets on the balance sheet are not there anymore.

However, that may not be true all the time. If you run a little auto dealership yourself and run it without any health plan, unions and so on, you can still take your working capital home and close your business. But in businesses like IBM, General Motors, they can’t or at least they didn’t. Just look at what disappeared from its balance sheet when it decided to change size both because the world had changed technologically and because its market position had deteriorated.

And in terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after “surfing” successfully for 60 years.

At any rate, the trouble with what is called the classic Ben Graham’s concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and nothing clicked. But such is the nature of people who have a hammer – everything seems like a nail. So, Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.

Of course, the best part of it all was his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. In some days, Mr. Market comes by and says, “I’ll buy your interest at a price that’s way higher than you think it’s worth.” And you get the option of deciding whether you want to sell your interest to him, buy his interest or do nothing at all.

To Benjamin, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it’s been very useful to many value investors over their lifetime.

However, his concept was not totally unflawed. If Warren Buffett had stayed totally with the classic Benjamin way, Berkshire would surely not be where they are now – not even close to it. And that’s because Graham was not trying to do what Berkshire did. For example, Benjamin didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man on the street could run around and talk to management and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Thus, it was very difficult.

And with the way Warren Buffett started out as a pure Grahamites which was actually a fine way, he gradually got what is better insights to value investment. He realized that some company that was selling at 2 or 3 times book value could still be hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

And once he gotten over the hurdle of recognizing that a business could be a bargain based on quantitative measures that would have otherwise horrified Benjamin, he started looking out for better businesses. For example, he got American Express and Disney when they got pounded down.

Basic to being a good stock picker (Part 4)

In the earlier three parts of this subject, it’s a mix of microeconomics, a little bit of psychology, a little bit of mathematics which help to create a general structure of worldly wisdom. Now, we shall move on from the carrot part of the subject to the dessert part of the subject, which shall bring us closer to the subject of stock picking. While we move on, we shall also draw on this general worldly wisdom which was earlier touched on.

Common stock picking shall be touched on, we’ll not be going into emerging markets, bond arbitrage, or any other “sophisticated” financial instruments.

The first question to ask is, “What’s the nature of the stock market?” And that gets you directly to this efficient market theory that got to be the rage taught at all business schools. It states that at any point, at any time, the market is always efficient, that is to say the price always adjust very quickly to reflect all the news of a business. Simply, it means that no one can beat or perform better than the average of the market. Those who do are plain lucky.

So the next question is to ask, “Is the stock market so efficient that people can’t beat it?” Well, the efficient market theory is only roughly right – meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.

Surely, the average result has to be the average result. By definition, everybody can’t beat the market as it is an average. But the iron rule in life is that only 20% of the people can be in the top fifth. That’s just the way it is. So the answer is that it’s partly efficient and partly inefficient.

Then there are people who went to the extreme efficient market theory by doing extreme research. It was just an intellectually consistent theory that enabled them to do pretty mathematics. So obviously when things get complicated, it gets a little more seductive to people with large mathematical gifts. The problem is they have a difficulty in that the fundamental assumption does not tie properly to reality. Again, to the man with a hammer, everything seems like a nail. If you’re good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?

If you think about the pari-mutuel system of the racetrack, pari-mutuel system is essentially a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in a stock market.

Any fool can see that a horse carrying a light weight with a wonderful win rate and a good post position and etc. is way more likely to win than a horse with a terrible record and extra weight and so on. But if you look at the odds, the bad horse pays 100 to 1 while the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using mathematic. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit the rest of the betters, but you have to outwit them by such a huge margin that on average you can afford to pay the 17% of your gross bets off the top to the house before the rest of the money can be put to work.

Given those constraints, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge because a lot of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical incline could have a very considerable edge, in the absence of the frictional cost caused by the house take.

Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce is average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the 17% house take. Then perhaps these people would bet only occasionally when he saw some mispriced bet available. And by doing so, after paying the full take by the house, he made a substantial living.

You have to say that’s rare. But the market was not perfectly efficient. And if it weren’t for that big 17% take, lots of people would regularly be beating lots of other people at the horse races. It’s efficient but not perfectly. And with enough shrewdness and dedication, some people will get better results than the others.

The stock market works about the same way except that the house take is a lot much lesser though I would say it is still very substantial. If take transaction costs – the spread between the bid and the ask plus the commissions – and if you do not trade too actively, you are talking about fairly low transaction costs. So that together with enough dedication and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things. Of course, like the nature of things, 50% will end up in the bottom half and 70% will end up in the bottom 70%, you can’t change the nature. But some people will have an advantage and they ends up in the upper tier of the class. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner – in a relative sense – instead of a loser?

Again, look at the pari-mutuel system. In the whole history of people who’ve beaten the pari-mutuel system is quite simple – they bet very seldom.

It’s not given to mankind to have such talents that they can know just everything about everything all the time. But it is given to humans who work hard at it – who took and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them the opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

It’s such a simple concept but yet, in investment management, practically no one operates that way. A large majority of the investment community have some crazy ideas in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time. That’s insane. The way to win is to work, work, work, work and hope to have a few insights.

So how many insights do you need? Well, you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated millions, the top ten insights account for most of it. That doesn’t means the man operating Berkshire has got only ten insights. It is just that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced bet or something. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.

Warren Buffett preaches that “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches – each representing all the investments that you got to make in a lifetime. And once you’ve punched through the card, you couldn’t make any more investments at all.”

He says, “Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

This is a concept which is pretty straightforward and obvious but yet, this one of the few idea which very few business schools will teach – simply because it isn’t a conventional wisdom. It is obvious because the winner has to bet very selectively.

Why then it isn’t obvious to the rest? The reason could be like in this story about what someone told a guy who sold fishing tackle. Someone ask the seller, “My god, they’re in purple and green. Do fish really take these lures?” and the sell said, “Mister, I don’t sell fish.” Investment managers are in the position of that fishing tackle salesman. They’re like the guy who was selling salt to the guy who already has too much salt. And as long as the guy will buy salt, they’ll sell salt. But that isn’t what ordinarily works for the buyer of investment advice. On Wall Street, they will sell anything that you will buy – quality control is never prized.

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.

Basic to being a good stock picker (Part 2)

In the history of thoughts, there’s one very accurate observation that comes from Pascal, “The mind of man at one and the same time is both the glory and the shame of the universe.”

It pays to take heed to this statement because it describes exactly what had taken place and will takes place. This statement has enormous power. However, it also has some standard malfunctions that often cause it to reach the wrong conclusions. It also makes man extraordinarily susceptible to manipulation by others. For instance, roughly half of the army of Adolf Hitler comprised of Catholics (this has nothing to do with religion). Given enough clever psychological manipulation, what human beings will do is quite interesting.

There are two questions to ask. First, what are the factors that really govern the interest involved taken with rational consideration? Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things – which by and large are useful but often malfunction.

One approach is rationality – the way you work out any problem – by evaluating the real interest, the real probabilities and so on. And the other is to evaluate the psychological factors that cause subconscious conclusions which are often wrong.

Then we come to another somewhat less reliable form of human wisdom – microeconomics. Here, it is useful to think of a free market economy as kind of equivalent to an ecosystem. Though it is an outdated way of thinking because in the early days after Darwin came along, people like the robbers barons assumed that the doctrine of the survivor of the fittest authenticated them as deserving power – “I’m the richest. Thus, I’m the best.” And that thinking of the robber barons surely does not goes well to the others and it makes it unfashionable to think of an economy as an ecosystem. But in truth, a free market economy is a lot like an ecosystem.

Just like an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. It is the same as how animals flourish in niches. Similarly, people who specialize in the business world frequently find good economics that they wouldn’t get in any other way.

Here, we get into the concept of advantages of scale which brings us much closer to actual investment analysis because in terms of which businesses succeed and which fail, much is dependent on advantages of scale.

An example of advantages of scale taught in all business schools is cost reductions along the so-called experience curve. Well, as human do something more and more in volume, it enables them to do it more efficiently as they try to improve while being motivated by the incentives of capitalism.

If you think of it in simple geometric in building a spherical tank, obviously as you build it bigger, the amount of steel you use for the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. Like that, simple geometric exercise like this shows simple reality of life which gives one an advantage of scale.

A much more relevant example that shows how advantage of scale is towards business is from TV advertising. When TV advertising first arrived, it was an unbelievably powerful tool. If you were P&G, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn’t. And there was no way you can buy it in part. Thus, the small guy can’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising which was the most effective technique. So when TV came along, the big companies were given a huge tail wind pushing them forward. Indeed, they prospered and prospered until some of them got really fat and sluggish – which happens with prosperity inevitably most times.

And this sort of advantage of scale through TV advertising gives an informational advantage too. For instance, if I’m to buy chewing gum, between Wrigley Gum and China Gum, Wrigley costs 40 cents and China costs 30 cents, which do I choose? I know Wrigley and how it taste. Am I going to take something else I don’t know and put it in my mouth which is a pretty personal place after all just for a difference of a lousy dime? Surely not! So what can you gain from here? When you have advantage of scale, it goes in many ways that is advantageous to the business. Most important, as in the Wrigley case, they have an advantage in dictating price even if it is 33% more than their competitors.

Another advantage of scale comes from psychology or rather what psychologists term as “social proof.” We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everyone’s buying something, we think and assume it must be better. We don’t like to be the odd one out.

Then again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, “Hey, I don’t know much about this. They know more than I do. So, why shouldn’t I follow them?”

So why does social proof give huge advantages of scale? So for any business that holds an advantage of scale of such kind, for example, coca cola, they have a very wide distribution where it’s available almost everywhere on earth. So when you have an advantage of such kind, it can become very hard for anybody to dislodge you.

Then, there is another form of advantages of scale. In some businesses, the nature of things is kind of cascade toward the overwhelming dominance of one firm – monopoly. One great example is newspapers business. And, that is a scale thing. Once one secures most of the business, one gets most of the advertising. And once one gets most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-takes-all situation. Similarly, all these huge advantages of scale allow greater specialization within the firm. So, each person can be better at what he does.

And really, these advantages of scale are a great thing although it kills out the smaller players. But well, that is how the way the world works – the Darwin way. When Jack Welch first came into control at General Electric, he said, “To hell with it. We’re either going to be number 1 or 3 in every field we’re in or we’re going out of it. I don’t care how many people I have to fire and what I have to sell. We’re going to be number 1 or 2 or out.” Wow, that was a very tough worded statement and thing to make and do. But there was nothing wrong in the idea. In fact, it was a great guiding principle and a correct decision if you’re thinking about maximizing shareholder’s wealth. And it is not a bad thing to do either, even if competition was killed because better products were delivered and GE was stronger with Jack there.

Thus far, only advantages of scale are mentioned. But in truth, there are also disadvantages of scale. An example is in some newspaper of publication business. As you know, when we talk about a business which does newspaper or publishing or both, it is really a specialization of doing something. At Capital Cities/ABC (a USA media company), they had trade publications that got killed and also a few who got ahead of them. And the way those who got ahead of them was by going to a narrower specialization. They have a travel magazine. Then someone would create one which addressed corporate travel. Like an ecosystem, you are getting a narrower and narrower specialization. Well, the one who got narrower got more efficient in what they do. They could tell the guy who ran corporate travel department more. Plus, they didn’t have to waste ink and paper mailing out stuff that corporate travel staff wouldn’t be interested in reading. It was a more efficient system. There are some papers that did not further specialize who got killed, and some who survive were those who further specialize. For example, there’s Motorcross – a magazine which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. These people they don’t care much about the price of the magazine, it is their purpose of life. A magazine of such kind is really a total necessity to these people. And its profit margin would make anyone salivate.

So if you think about it, occasionally scaling down gives you the big advantage. Bigger is not always better.

Then one of the greatest defects of scale is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality which is again sort grounded in the nature of human. This defect really makes the game much more interesting because when you get bigger, it creates some problems and it shows that the big people don’t always win.
For example, let’s say that you work in a very big company with a great deal of bureaucracy, who the hell will really think about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-tray into someone else’s in-tray. But of course, it isn’t. The work is not done until the business delivers what it’s supposed to deliver. So you get the big, fat, dumb and unmotivated bureaucracies. They also tend to be somewhat “corrupt.” In other words, if I’ve got a department and you’ve got a department, and we kind of share power running this thing, there’s a sort of unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs which no one needs. Then, while people are justifying these layers, it takes forever to get any real jobs that count done. They’re too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it tends to lead to big and dumb bureaucracy which gets to the highest and worst form in governments where the incentives are really perverse. That doesn’t mean we don’t need government which of course is needed. But it is a terrible problem to solve by getting big bureaucracy to behave. So, people use ploys. They create little decentralized units and fancy motivation and training programs. One of the big companies that fought off bureaucracy with amazing skill was GE. But that’s because they have a genius and a fanatic running it and that’s was Jack. And they put him in young enough to have a long run in it to get things work out.

Then, there is another interesting aspect of psychology which CBS provides an interesting example – namely Pavlovian association. If people tell you what you really don’t want to hear and unpleasant, there’s an almost automatic reaction of antipathy. You’ve to train yourself out of it. It isn’t destined that you have to be in this way. But you will tend to be this way if you don’t think about it.

In the early days, CBS was the dominance TV network. And their founder, Paley was a god. But he didn’t like to hear what he didn’t like to hear. And people soon learned that. So they only told him what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt although it was a great business.

So the stupidity that crept into the system was followed by a huge tide. You can get severe malfunction in the high ranks of business. And if you are investing, it can make a lot of difference. If you take all the acquisitions made under him, his advisors – the investment bankers, management consultants and so forth – were all paid handsomely which was absolutely terrible. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss. It’s really hard to tell the emperor that he is naked.

So in a business and life is an everlasting battle between those two forces – to get these advantages of scale on one side and a tendency to get very bureaucratic where they just sit around doing nothing much useful.