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on investment discipline

3 Nov

For investors, it’s imperative to establish a disciplined approach and stick with it.   Developing that approach is one of the most difficult parts, however, as what has worked over time in investing does not work at all times.  Yet regardless of what the market is doing someone has done well recently.  Some hedge fund manager made a billion dollars on natural gas spreads, wheat futures, or in Latvian mud art, rare stamps, or old soda pop bottles.  The media will always find examples of who has done well lately.  If it were easy to flit around from strategy to strategy I’d be all over it, but it’s nearly impossible to execute reliably over long time periods.  The trick is not to lose focus on your own approach and to understand that if the core investment framework is sound and well-reasoned, there’s no cause to abandon it just because it’s not working at the moment.  To do so would be like piloting a rudderless ship, at the mercy of winds on the open seas.  It’d be tough to get anywhere.

There is also an undue focus on ‘the market’.  The goal is to beat the market, yes, because active management is, in theory, a fool’s errand without this outcome.  However, the majority of active managers don’t beat the market, and even index funds fall behind (due to fees and expenses).  The overriding goal should be to limit risk while generating returns that meet long-term goals.

Let’s face reality here, the smorgasbord of available investments today – stocks, bonds, real estate, commodities – have rather low forward return prospects.  The low interest rate environment has caused asset prices to be bid up to the point where forward return prospects are in the 4-7% range on average.  The capital markets are not just a place to blindly place capital today.  As Peter Bernstein observed, “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”  Yes, it’d be nice to see double-digit returns, but given the macro environment it doesn’t look possible on a sustainable basis.  (That is, it could run up 20% annually for five years, but the gains would likely be borrowing from well into the future.)  Investors should view an index fund investment today as a decent place to put money, but not a spectacular one.  Individual investments, on the other hand, may offer opportunities for better-than-average returns.

This leads me back to the main point: finding a consistent, disciplined investment approach.  How?  Identify what’s worked over time, regardless of market environment.  A few of these are listed below.  These provide good perspective for investors today, with a stock market that has declined for the past several weeks (but nonetheless remains up for the year).  It’s useful to remind oneself frequently of what has actually worked, especially when the pickings are slim.  As mentioned, they may work over time, but notall the time.

A list of some basics:

  •           A Low Price in relation to earnings, cash flow and asset value,
  •           Insider purchases of significant size,
  •           Recent large declines in a stock’s price,
  •           Smaller companies, and
  •           The above, especially with companies that generate high returns on invested capital.

Consistent execution of a strategy is tough.  For a portfolio manager, it requires institutional support to follow a discipline, especially because there aren’t loads of qualifying investments at all times.  When stocks are cheap, it’s psychologically tough to buy (“they could go lower”) and when they’re high it’s hard to sell (“they could go higher.”)  Individuals might have an easier go at implementing the strategy – the only thing they have to fight is “the urge to do something,” which is a powerful tendency.  (Professional investors aren’t immune, either.)

A final note: following a consistent investment strategy over time requires being very discipline on price paid in relation to value.  So when one can’t find qualifying investments, what ought they do with it?  Hold cash.  Just because it’s not ‘making anything’ doesn’t mean a whole lot. Think about it this way: an investor has $1,000 and a target stock is priced at $50 (worth $50).  If the investor buys today he’ll have 20 shares.  If the stock subsequently declines to $25 (worth $50), he’ll have only $500 (20 shares at $25) and won’t be able to buy more at the now-lower price. If he waited and holds cash, he’ll have $1,000, still, and be able to buy 40 shares for $1,000 that are now worth $2,000 total.  (Yes, the stock could also go up from $50, but wasn’t under-valued in the first place.)   I call the potential returns earned from having excess cash at the right time the ‘opportunity yield’.  The ability to hold cash is an important tool in an investors’ toolkit, and one an investor shouldn’t hesitate to wield.  Warren Buffett says it eloquently, “Lethargy bordering on sloth remains the cornerstone of our investment style.”

In investing there are no strikes called for not swinging, so there’s often no point in swinging unless they’re coming down the middle of the plate.


Ability to Pass Up Investments is Key

26 Nov

As Warren Buffett has said, the ability to say “No” is one of the most important powers an investor has. Knowing when to turn down an investment can be more important as when to say yes. Another way I’ve heard Buffett look at it is to imagine as an investor that you’ve got a 20-slot punch card that represents your lifetime of investment decisions to be made. Looking at it from this perspective, it’s likely each investment decision will be made more carefully.

Another crucial part of making good investment decisions is being aware of your own biases. These biases are well-documented in behavioral finance: overconfidence, hindsight bias, overreaction, belief perseverance, and regret avoidance, for example. Knowing where you decisions are coming from helps to determine whether your choices are truly objective and rational, not overly influenced by your own biases.

Companies Should be Viewed As Investment Conduits

30 Oct

We think that the best way to view a company is as an investment vehicle. This is what corporate management is paid to do – invest shareholder capital in areas where attractive investment returns are (hopefully) available.

At its base, a business invests capital in a collection of projects, products, or services and hopes to earn a return commensurate with the risk taken. It wants to earn a return on its invested capital – that is, equity and debt invested. And over time, the business will create wealth if it can earn above its cost of capital.

For a simple example, we’ll ignore taxes and consider a piece of real estate worth $1 million. Perhaps the buyer puts down 20% ($200k) of the purchase price, leaving $800k to be financed with debt at an 8% interest rate. So, the debt portion must earn enough in rent to pay costs plus an 8% (net of tax) payment to at least break even. That is, costs (maintenance, management, insurance, taxes, etc.) plus $64,000 to pay the principal and interest (P&I) on the loan. This is break-even on the debt portion.

The equity (20%) portion is a little trickier since it doesn’t actually have an explicit cost. Yet according to economic theory, this portion should be assigned an opportunity cost. For example, the opportunity forgone to invest in a similarly risky stock or bond that would earn 10%. Thus, this portion should earn costs plus 10% to earn an economically break-even return – $20,000 after costs.

In order to earn an excess economic return, returns must be greater than the weighted-average of these capital costs – [(.20×10%)+(.80×8%] = 8.4% after costs to break even in economic terms. So if the investment earns 10%, there is a 1.6% excess return (10%-8.4%). This is how economic wealth is created.

Many companies do not earn long run returns above their cost of capital, so how do they go on living? Certainly if it can’t pay its debts it should be bankrupt! Well, as I mentioned, the equity portion of capital does not really have an explicit cost, so a company can still cover its explicit debt costs while eroding the returns to equity.

Same thing in the real estate example. If it only earns 7% on the entire building after costs, it still has $70,000 to cover the $64,000 P&I. Ignoring principal payoff and appreciation, this leaves only $6,000 for the equity portion – a 3% return on the equity. If such a situation is expected to continue, this capital would be better employed in a money market account earning 5%. The exact same concept applies to publicly traded companies, albeit on a more complicated scale.

The bottom line is that we want a company to, say, borrow at 7% what it can invest at 15%, earning the “spread” of the investment return minus its cost of capital. This is, at its base, what every company is trying to do whether it sells steel, toilet paper, tax preparation, or owns real estate. Earning a return on its investments above the cost of the funds in the long run generates economic value for shareholders.

A Few Words on Our Investment Philosophy

16 Oct

A few words about the investment philosophy that is behind the postings on this site:

In most cases, we’re trying to determine what the value of a company is to a private market buyer in a negotiated transaction. But we’re not going to pay that price. We want to buy the company at a (hopefully large) discount from this value. After all, as a minority shareholder, we can’t have any influence on what the company does with its excess cash flows. That is, the cash beyond what is needed to sustain and grow the business given available reinvestment or new investment opportunities. A private market buyer would be able to go in and, say, invest in public securities or pay out the excess cash to himself. And thus he should have to pay more for this control. Sometimes, we can profit from this difference between our position and his. We look at adjusted book values, normal earning power, free cash flow generation, and other metrics to determine what a company is worth.

As Charlie Munger has said, “It’s not a competency unless you know the edge of it.” We can’t know everything, but we try to be aware of what we don’t know. We look for businesses we understand that are being run by honest, able managers whose personal stakes in the success of the company are high. If we can buy these companies below what they are worth, we should do reasonably well over the long-term.

We’re not worried about near-term market prices, just investment risk – something going wrong with the business. If we find value, we feel comfortable making a purchase and waiting for the market price to take care of itself. If the company’s management continues to create value by generating satisfactory incremental investment returns, the market price should rise accordingly, albeit non-linearly with intrinsic value. This is not to say that we aren’t concerned with market prices, we are just not focused solely on them.

Also, some ideas posted here are not meant to be long-term. These could be called “trades.” But such trades are taken with a long-term perspective.

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