Lessons of Value Investor

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Klarman's Perseverance

perseverance 

–noun

1.

steady persistence in a course of action, a purpose, a state,etc., esp. in spite of difficulties, obstacles, or discouragement.

Normally people know Seth Klarman as the genius who averaged over 20% per annum since 1983 while S&P 500 over the same period averaged only 7%. The difference between those two returns is that if you invested 1000$ with Seth Klarman in 1983 it would have become $137000 today while the same amount would be $6200 today if invested in S&P 500.

But one quality of Seth Klarman that gets under emphasized is his perseverance. Lets look at the following table

During the tech bubble of late 90's tech stocks valuations were sky high. Due to the lack of finding good values Klarman kept around 25% in cash, 30% in special situations, 10% in bond and only 35% in stocks. He also hedge the stock market exposure by buying PUT options. Every year from 1995 to 2000 he underperformed the index and also lost money on the PUT options that would expire worthless at end of the year. But consistently he held onto the cash as well as kept buying PUT options every year. 

As we all know well S&P 500 index fell 43% after 2000 and 10 years later is still 30% lower than its peak set in 2000.

He wrote this to his investors in 1999 

"We underperformed in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum,and very ironically, we got hurt not speculating in the U.S. stock market."

 Thus for long term success in investing you need not just the right technique but the right temperament.

In Buffett's words

"Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." 

Takeaways from the book "Warren Buffet Way"

Recently heard a concise audiobook version of "Warren Buffet Way" - Robert Hangstrom

The author suggests that all of Buffett`s company purchases over time seem to have all or some of the following tenents:

1) Business Tenents:

1. Is the business simple and understandable ? Investment should be based on business fundamentals and not economic forecast or any exterior factors.
2. Does the business have consistent operating history ? Businesses that are turning around or have a new operating strategy increases likelihood of failure.
3. Does the business have favorable long term prospects ? A franchise is much better than a commodity business. A franchise who is not regulated can increase prices without loosing market share or volume.Even if demand is flat the prices can be raised.Conversely a commodity products is indistinguishable from each other. Now banks,insurance etc have become commodity products.Franchises can tolerate mismanagement or mistakes.

2) Management Tenents:

1. Is the management rational i.e. is it a good capital allocator ?
2. Does the management communicate with shareholder candidly without hiding behind GAAP ? Does the management discuss failure openly ?
3. Does management withstand the institutional imperative ? This is the act of imitating other corporate managers no matter how silly the behavior is.You can find that institutional imperative exists when 1) institution resists changes in its current direction 2) just as work expands to fill available time, corporate acquisitions and projects will be started to soak up available funds 3) Any ambitious craving of its leader will be quickly supported by a detailed rate of return and benefit analysis by its troops 4) behavior of peer companies will be mindlessly immitated

3) Financial Tenents:

1. Do not take one year result seriously.......use 4-5 year averages
2. Focus on Return on Equity and not EPS. Since most companies retain earnings from previous year so there is no big deal about increasing EPS. For calculating ROE all marketable securities should be valued at cost. You should exclude all capital gains and extraordinary items. Debt levels should not be too high.
3. Use owner earnings instead of reported earnings. Owner Earnings = Net Income + Depreciation + Depletion + Amortization - Capex - Working Capital. Calculating future capex might just be estimates but guess is better than no guess.
4. Look for companies with high profit margin. High profit margin shows that management is cost sensitive and keeps costs low.
5. For every dollar retained make sure the management has created more than dollar of market value. The stock market tracks the business value over long periods. Hence we can compare the increase in market value with increase in retained earnings to estimate the effective allocation of capital by the management.
6. A value of business is determined by the net cash flow to occur over the life of the business discounted by an appropriate discount rate" . If you are not able to project the future cash flow don't buy the company. Buffet uses discount rate of existing long term government bond.
7. Difference between growth and value is pointless. Value is the discounted value of cash a business would generate over time. Growth is simply the rate at which the free cash flow will increase over time.Using the growth estimate you arrive at the intrinsic value of the company. The decision to buy one company vs other should be purely based on intrinsic value and not the growth rate since intrinsic value already should reflect the growth rate.

4) Market Tenents:

1. Is the intrinsic value greater than the market value ? Always keep a margin of safety between your estimated value and the market value. Because if you made an error in your valuation the discount to intrinsic value might protect you from making a loss on investment.

If we make mistake in investment it can be because of price we paid,management we joined or the future economics of the business. Mistakes in estimating the future economics of businesses is the most common.

Identifying Business Moat

Here is a one line principle that summarizes investment thesis of Warren Buffett according to me:

"Buy a company that has a sustainable competitive advantage(moat) and still has lot of ground to conquer(growth) at a reasonable price and then just enjoy the ride :) "

So todays post is going to be about what are the characteristics that give a company a competitive advantage. Also how do you make an investment decision given a choice between two companies with high barries to entry business.Well...lets learn from the grand master himself
Buffett:

Generic brands have been with us a long time. But lately they’ve attracted a great deal of attention—partly because they’re doing better and in particular because of Philip Morris’s (MO) actions a few weeks ago—when, in reaction to the threat and the inroads of generics, they cut the price dramatically on Marlboro.

I wouldn’t say Marlboro is the most valuable brand name in the world. Coca-Cola (KO) is more valuable—and I think that’s been proven by subsequent events. But Marlboro earned more money than any brand name in the world.

And all of a sudden, Philip Morris took some actions which dramatically reduced the earnings of that brand and changed the pricing dynamic that had existed in the cigarette business for many decades. And since then, Philip Morris has had $16 billion lopped off its market value and RJR’s suffered accordingly.

It’s a terribly interesting case study and it illustrates one of the dangers of generic competition. Philip Morris cigarettes got to where they were selling for $2.00 a pack. The average cigarette consumer uses something close to ten packs a week. Meanwhile, the generic was at about $1 or thereabouts.So you really have a $500 a year differential in cost per year to a ten-pack-a-week smoker. And that is a big annual cost differential. You better have something that people think is dramatically better than the generic for the average consumer to shell out an extra $500 a year. It’s happening in other areas, too—whether it’s corn flakes or diapers or a lot of things...

In our case, I think the Proctor & Gamble's Gillette brand name, for example, is far better protected against generic competition than the main product of Philip Morris—although there always has been generic competition in blades and there always will be.

The average male purchases something like 30 blades a year. He pays 70 cents each if he buys the best—which is the Sensor.

That’s $21 a year. The best he can do if he wants something that leaves him Band-Aids on his face and an uncomfortable experience costs him $10 a year. So you’re talking $11 for a 365-day experience...

I think there’s a generic threat of some sort in any industry where the leaders are earning high returns on equity. It just stands to reason that that’s going to encourage competition.

And the threat may be accelerating in many industries. But I think that brand names with the right ingredients are enormously valuable. Sometimes infrastructure is a problem for the generics. The worldwide infrastructure for Coca-Cola, for example, is very impressive and very hard for a generic provider to duplicate.

But if somebody wants to sell a generic box of chocolates in California against See’s Chocolates, that’s obviously somewhat of a threat.

And I just hope that they take them home on Valentine’s Day and say, ‘Here, Honey, I took the low bid.’

Wal-Mart’s (WMT) selling Sam’s Cola. And Wal-Mart is a very, very potent force. One thing that’s helpful is that they were selling it as cheap as $4 a case here. And I don’t believe that’s sustainable. That’s 16 2/3 cents a can.

It’s been a while since I looked at aluminum—and it’s down. But I think the can is close to a six-cent item by itself. The can is far more expensive than the ingredients... Distribution costs, trucking, stocking and all that sort of thing have to be fairly similar. In a 12-ounce can, there’s 1.3 ounces of sugar—which at the domestic price, would be around 1 3/4 cents per can. And that’s got to be the same whether it’s Sam’s Cola or Coca-Cola.

The Coca-Cola Company sells about 700 million 8-ounce servings—largely of Coca-Cola, but also of other soft drinks—worldwide every day. If you take 700 million and multiply it by 365 days, you come up with 250 billion or so 8-ounce servings of Coke or its products in the world each year.

The Coca-Cola Company made about $2 1/2 billion pretax last year. That’s one penny per serving.

One penny per serving does not leave a huge umbrella. The generic is not going to buy the can any cheaper. And they’re not going to buy the sugar any cheaper and so on. Their trucks aren’t going to be any cheaper.

To summarize a company selling low cost product due to advantage of scale is better than a company selling high cost product due to customer goodwill(brand recognition).Hence with ROE or Price/Cash Flow being the same companies like P&G,Colgate,Unilever,Coca Cola,Gilette,Nestle,Cadbury,Wrigley etc will be a better buy vs Coach,Apple,Sony,Porche,BMW,etc.

Types of comptetive advantage a business can possess

One source would be economies of scale and scope. Wal-Mart is an example of this, as is Cintas in the uniform rental business or Procter & Gamble or Home Depot and Lowe's.

Another source is the network affect, ala eBay or Mastercard or Visa or American Express.

A third would be intellectual property rights, such as patents, trademarks, regulatory approvals, or customer goodwill. Disney, Nike, or Genentech would be good examples here.

A fourth and final type of moat would be high customer switching costs. Paychex and Microsoft are great examples of companies that benefit from high customer switching costs.

These are the only four types of competitive advantages that are durable,
because they are very difficult for competitors to duplicate. And just like a company needs to develop a moat or suffer from mediocrity, an investor needs some sort of edge over the competition or he'll suffer from mediocrity.

Munger Quotes

"You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger

"Never wrestle with a pig, for if you do, you will both get dirty, but the pig will enjoy it." - Charlie Munger

"Many of you probably don’t remember what happened after the South Sea Bubble, which caused an enormous financial contraction, and a lot of pain. They banned publicly traded stock in England for decades. Parliament passed a law that said you can have a partnership with a few partners, but you can’t have publicly traded stock. And, by the way, England continued to grow without publicly traded stock. The people who are in the business of prospering because there’s a lot of stock being traded in casino-like frenzy wouldn’t like this example if they studied it enough. It didn’t ruin England to have a long period when they didn’t have publicly traded shares.

Notes from Snowball

-> Warren Buffett made mistakes in buying bad businesses but his success lies in quickly learning and adapting from the environment.
->His purchase of Berkshire and department stores taught him this
" Time is a friend of wonderful business, the enemy of mediocre. You might think this principle is obvious,but I had to learn it the hard way.Its far better to buy a wonderful company at a fair price than a fair company at a wonderful price.Now we look for first class businesses accompanied by first class managements. Good jockeys will do well on good horses but not on broken-down nags"