Monthly Archives: May 2012

15% Return Today and Let it Grow

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

I was recently reading some forum posts by Warren Buffett’s biographer, Alice Schroeder. Alice wrote that much of what Buffett does is screening. Not with a computer model of course, but just scanning page after page with his eyes. In fact this is the way he began too. When Buffett began his investing partnership he took a copies of the moody’s manuals, which were many thousands of pages long, and flipped through them page by page. He did this with each one more than once too. In the beginning he was able to compound money at rates north of 30% per year with the moody’s manuals as his guide.

That gets one to thinking… what was in those manuals? Not much. They had the company name, a description of the business, its properties and subsidiaries, a list of officers and directors, a basic income statement and balance sheet for the last 2 years, and a description of the capital structure. If you would like to see samples here are two:


He wasn’t projecting earnings, he wasn’t doing a discounted cash flow analysis and complex financial modeling. He still doesn’t do those things today. Don’t believe me? Here is Alice explaining:

If the greatest investor in the history of the world doesn’t do discounted cash flow and projections, why should I? I’m not saying that a DCF is completely useless, just almost useless. I am at odds with Bruce Greenwald on this one. I saw him speak in Omaha two weeks ago where he announced that DCF was a “complete waste of time.” I think it is an almost complete waste of time. I think it is useful if you reverse engineer it. It is much easier to make a binary judgement on market expectations than to try and project earnings. This is all for another post though. Back to the topic.

Alice said that Buffett would look for a 15% return day one and let it grow from there. So Buffett needed to make sure that he was going to get a 15% earnings yield and that the return would likely grow. Of course this isn’t the only way he invests, but it is one of the ways he invests. Buffett often likes to say that he would rather be vaguely right than precisely wrong.

So how do we know if a business will give us a 15% return day one. When you buy a business you are paying for a stream of earnings. If a business earns $10 and you pay $100 then you are getting a 10% earnings yield. In this way a stock is just like a bond except without a call or maturity date. Additionally that earnings yield can grow as the business earns more and more. The trick now is finding businesses that give you a 15% earnings yield and maybe more.

Our advantage over Buffett

When Buffett worked at Benjamin Graham’s hedge fund, he sat in an office next to Walter Schloss and calculated net current asset values (looking for stocks trading below their liquidation value) hour after hour, day after day. Today that would take less than one one-thousandth of a second. At my fingertips I can scan 10,000 publicly traded companies faster than an eye-blink. I just did it and found 64 companies trading for a conservative estimate of net current assets. I just did Buffett’s entire calculation job at the Graham-Newman partnership faster than it takes to say booya! Earnings yields can be found the same way. In fact even complicated formulas can now be applied and even backtested in nano seconds.

This means that we could narrow the universe down to only companies that are likely to give us our desired 15%.

I’m sure that Buffett gained a lot more from flipping through the Moody’s manuals than just which stocks to buy that day. The mental database and work ethic that was built is part of what has made him a legend. However, unless you are Warren Buffett, you have a great deal to gain by using modern screening technology.


Forecasting is Futile

On a similar subject to my last post here are James Montier’s thoughts on forecasting and discounted cash flow. Well stated.

How You Can Beat the Pros

Before I get to typing I have to warn you that the title of this post is a little misleading. You see, I’ve been reading “How to Invest” books for many years now and I would like to let you in on a little secret. Most of these books are deceiving. It’s not that they don’t have value investing theory correct, they do. It’s that they make it sound much easier than it is. Even Joel Greenblatt’s “The Little Book that Beats the Market” (which I highly recommend) makes the strategy sound much easier than it is, and it doesn’t get much easier than buying stocks off of a list once a year.

The average “how to” investment book teaches you the basics (a stock is a piece of a business, Mr. Market is crazy, buy companies on the cheap) but they don’t tell you that you are up against some serious competition. Think of the stock market like a sport, say boxing. With a little training the average person may have a chance against the local tough guy, but get in with the big boys and you may be drinking your food through a straw for a while.

I believe the average investor has a few significant advantages over the institutional investors but one of those advantages is not in the “analysis” department. So why do all these books try and teach the layman valuation analysis, especially of large and well-known companies? Do you really think you will know more than 20 full time analysts? Remember that every time you buy a stock, someone is selling it. What makes you think that you know more than the other guy? How has the universe made this value apparent to only you? (hint: it hasn’t) On average the individual investor’s main strengths over the top analysts are two: small amounts of capital, and the ability to weather periods of underperformance. The former doesn’t sound like much of an advantage but just trust me on this one. The latter can be quite the challenge without a systematic, replicable, and disciplined approach.

Implied in the “small amounts of capital” advantage is the ability to search in areas of the market that the big guys can’t play. Of course if the big guys aren’t playing there then there are more likely to be gamblers in that area, not intelligent analysts. (Warren Buffett tells a story about when he was on his honeymoon in Vegas and at a casino. He says he remembers looking around the room at hundreds of well off fools participating in various mathematically unfavorable activities with their hard earned money and thinking to himself “if this is who I’m up against in life, I’m going to be rich.”)

In order to pay for a good analyst a mutual fund or hedge fund must be managing a relatively large amount of money, since this is where they pull their fees from. A relatively large amount of money is usually more than a few hundred million dollars and often a few billion dollars. So pretend you are a mutual fund and you have $1B. One day you are combing through financial statements and you stumble upon a ship builder in Louisiana that is selling for $40m. It has about $28m in cash, another $28m in receivables, $10m in inventory, another $15m in other current assets, and has normalized earnings of about $20m. Not only that the company has existed for more than 60 years, generates average returns on capital of 20%, has 50% insider ownership and only $5m in debt. You begin to get excited because this company is silly cheap. You could buy it at $7 and it must be worth at least $15, maybe more. There are a few problems though.

$40m is 4% of $1B. If you buy the company and the price doubles you will have made 4%. That’s good. The problem here is that you have no chance of buying that entire company for $40m. As Dr. Michael Burry has written:

“…I buy common stocks for the portfolio as if I were buying pieces of businesses.

In fact, at all times I strive to buy stock at prices per share that no acquirer could ever pay for the whole company – not because the prices are too high, but because the prices are so low that a potential acquirer proposing them would be laughed out of the boardroom. Such is the opportunity afforded by the very human market for common stocks.”

With 50% insider ownership and low liquidity you would have to pay much more than $40 m for that business. Also, you are a mutual fund. Mutual funds are restricted by law from owning more than 10% of a company’s outstanding shares. So at most you could buy $4m dollars of this company. That is .4% of your fund. So a doubling of the stock price gets you .4%. There may be issues with buying 10% of the company also. Because of the infrequent trades in a small company like this where owners hold 50% of shares, your buying is likely to move the share price quite a bit. Depending on your fund, you may also be restricted from buying illiquid companies like this. So even though it is a no-brainer investment, you have to pass.

There aren’t many disadvantages to having a fat wallet but here we have found one. This means that all of the people with fat wallets (read as “talented analysts”) are forced to play in the big companies. If thousands of very talented analysts who manage trillions of dollars are constantly combing for bargains in the big companies the survival chances of a weekend stock picker are slim… if they compete head to head.

To beat the big guys you must be more patient and also try and be in the areas that they can’t (or wait for another 2008 when panicked investors force a manager’s hand). I’m not saying that buying large companies is always out of the question, I’m just saying that you will be competing with some very skilled people and to think that you might be buying shares from Jeremy Grantham or David Einhorn is a terrifying thought.

Berkshire: the Pilgramige

Last night I returned from the Berkshire Hathaway annual meeting. Hearing the most successful investor in the world speak about hundreds of topics was an amazing experience; I recommend it to anyone who has the opportunity.  Buffett is, of course, one of a kind and there will probably never be another investor quite like him, but that doesn’t mean the rest of us should give up and accept the poor returns of many large mutual funds. Buffett himself has said that emotional stability, a favorable temperament, is the most important key to investing success, not a high IQ. This is good news.

Buffett spoke to this topic in particular at the annual meeting and he said one thing I’ve heard him say a few times before:  if he were going to teach people how to invest there would be two courses, how to think about the market and how to value a business. The introductory concepts to each of these imaginary courses are presented in chapter 8 and chapter 20 of Benjamin Graham’s The Intelligent Investor.

In chapter 8 the reader is introduced to the ignominious Mr. Market. Buffett says this chapter is the most important thing he has ever read about in his life. Mr. Market is to be thought of as an occasional drunk or mentally ill business partner. Sometimes he is feeling euphoric and will only sell you his shares of the businesses at a high price, and sometimes he has fallen off the wagon (again) and is willing to unload businesses at a substantial discount. The trick is to take advantage of him, not to mimic his moods. Taking advantage of a mentally ill Mr. Market sounds a little bit exploitative, but be honest with yourself–it sounds fun, too.

While this seems easy, it is very challenging in practice because we are all hardwired to follow the herd. Even as my father-in-law and I were rushing through the Centurylink Convention Center (where the Berkshire meeting is held) on our way to find our seats, we found ourselves saying “let’s go this way, that’s where everyone else is going.” A lot of that behavior came from not knowing what we were doing and the irony at following the crowd was pretty thick given that we were there to glean wisdom from one of the world’s foremost contrarians. I couldn’t help but think that the market often functions exactly like a crowd rushing to find their seats. There is a major difference between seat selection and investing though; if you make a wrong seat selection you can still see the entire event, if you make a bad enough investment decision your retirement is gone (maybe not gone, but I had to add a little drama). In most cases there is safety in numbers and comfort in consensus. In the stock market, however, the consensus is often wrong, therefore, if you’ve followed along, so are you.

Joel Greenblatt, in his book “The Big Secret for the Small Investor” explains that the best performing mutual fund of the last decade compounded at an incredible 18% per year. However, the average investor in that fund lost 11%. How can that be? Remember the saying “buy low, sell high?” It turns out the average investor does just the opposite. (See the Wall Street Journal article here.) This behavior is not unique to this mutual fund either; almost every stock fund sees inflows of money after a period of outperformance and outflows after a period of underperformance. Deduct the fees that the average mutual fund charges and you have the unmistakable disappointment of very low returns.

So don’t do it! Benjamin Graham once said something to the effect of, “an investor’s biggest enemy is likely to be himself.” It follows that if you remain disciplined through Mr. Market’s highs and tantrums you will have eliminated the largest obstacle standing between you and good returns.

How can it be done? There are two ways. You can either be born with a favorable disposition, disinclined to follow the crowd, or develop an understanding of investment principles sufficient that your rationality can overcome your tendency to get your lemming on. I can’t do anything for you on the former; this blog is hopefully a resource to those interested in the latter.