Notes – The Snowball, By Alice Schroeder: Part III, Chap. 20-33

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This post covers Part III: The Racetrack, Chap. 20-33

Racing On

The third part of The Snowball opens with Warren Buffett on the verge of starting his infamous partnerships, the precursor to his Berkshire Hathaway holding company conglomerate. On the way, he took a few short detours and learned lessons all over the place, some of them completely unrelated to the art of investing. For example, witnessing the implosion of his father’s political career and campaign, Warren realized:

• allies are essential
• commitments are so sacred that by nature they should be rare
• grandstanding rarely gets anything done

And from his father-in-law, Doc Thompson, the young Buffett learned

always surround yourself with women. They’re more loyal and they work harder

Meanwhile, Buffett’s young wife and mother-to-be, Susie Thompson, was learning just how deep the rabbit hole went when it came to Warren’s insecurities:

Leila [Buffett’s emotionally unbalanced mother] convinced both Warren and Doris that deep down they were worthless… [Buffett] was riddled with self-doubt. He had never felt loved, and she saw that he did not feel lovable

The depth of Buffett’s personal insecurities not only explain a lot about his later behavior and public persona, but they also provide a couple of startling questions to ponder, namely:

• how did a person with such fundamental self-confidence issues nevertheless summon the self-confidence necessary to trust his own investment thinking?
• being as insecure as he appeared to be, how much better of an investor might Warren Buffett have been had he not been carrying around such a handicap?

Who is Charlie Munger?

In Part III, we begin to get a more detailed picture of Buffett’s soon-to-be-infamous partner, Charlie Munger, as well as the subtle but fundamental ways in which his own thinking about investing and business analysis came to influence and then dominate Buffett’s own style. A mathematics major at the University of Michigan at age 17, following the incident at Pearl Harbor, the young Munger enlisted in the military and found himself as an Army meteorologist in Nome, Alaska. He took up poker where he learned to bet big when he had the odds and fold fast when he did not. He later attended Harvard Law School where he claims he graduated “without learning anything.”

After law school, he was obsessed with the idea of achieving social prominence, choosing Los Angeles as a place that was growing and full of opportunity but not so big and developed that he’d never be noticed. Munger’s life, like Buffett’s, was not without personal tragedy. His first marriage fell apart right around the time his 8-year-old son came down with a terminal illness. Munger had to watch these two pillars of his life dissolve simultaneously.

He later became obsessed with children and raised eight of them with his second wife. Munger was a compulsive reader and thinker, known to his family as a “book with legs” and was constantly found reading books on science and the achievements of great figures. Munger was interested in making money early on. When he was a young lawyer and earning about $20/hr he realized his most valuable client was himself so, in the style of [amazon text=The Richest Man In Babylon&asin=0451205367], Munger decided to “sell himself an hour each day”, which he used to pursue real estate and construction projects as well as other investment opportunities. Munger had

a considerable passion to get rich, not because I wanted Ferraris– I wanted the independence

Buffett was patient with Munger. Even though Munger was his senior by several years, Munger pleadingly inquired about whether he could do what Buffett was doing in Los Angeles. Not only did Buffett tell him he could and should, he proceeded to build a relationship with him that involved hours of phone conversations everyday as the two came up with different business ideas together. As Munger described Buffett, and his fascination with him,

That is no ordinary human being

In other words, they seemed to be soulmates, a truly odd couple.

The Munger Effect

Charlie Munger entered Buffett’s life and investment world at a critical juncture in Buffett’s development as a capital allocator.

Until 1958, his straightforward route was to buy a stock and wait for the cigar butt to light. Then he usually sold the stock, sometimes with regret, to buy another he wanted more, his ambitions limited by his partnerships’ capital

But as his total AUM approached $1M with his partnerships and personal money, Buffett had a new scale that let him branch out into new styles of investing. His investments began to become concentrated, elaborate and time-consuming, such as the Sanborn Maps episode. Munger himself started his own partnership in 1962 with his poker buddy Jack Wheeler  who was a trader on the floor of the Pacific Stock Exchange and $300,000 in capital he had accumulated through real estate investments. He eventually gave up his law practice at age 41 and decided to pursue investing full-time. He also used Wheeler’s membership on the exchange to lever up (at a ratio of 95/100) when he felt sure about his investments, something Buffett was not willing to do early on.

Munger’s early investment style involved net-nets, arbitrage and even the acquisition of small businesses. But his real interest lay in buying “great businesses”, which he identified by:

• strength of management
• durability of brand
• cost to compete/replicate the firm
• did not require continual investment
• created more cash than it consumed

To find these businesses, Munger asked everyone he met, “What is the greatest business you’ve ever heard of?”

As the market for net-nets dried up in the mid-60s and Buffett’s capital swelled, he found more and more he had to look at the kinds of great businesses that Charlie Munger favored, changing his focus from statistical cheapness (quantitative investing) to competitive advantage (qualitative investing).

With his capital ballooning, Buffett began looking at the acquisition of entire businesses as a more attractive option. In 1966, this twinkle in Buffett’s eye became Diversified Retailing Company, Inc., an 80/10/10-ownership holding company owned by Buffett, Munger and Sandy Gottesman, whose first acquistion was a $12M Baltimore department store called Hochschild-Kohn, financed 50% with bank borrowings, a “second-class department store” at a “third-class price”. However, the store had no competitive advantage, as the partners soon learned, and was continually caught up in a game of “standing tiptoe at a parade” as every innovation by a competitor had to be quickly imitated (at additional capital expense) lest customers shop elsewhere. It was here that Buffett and Munger learned that the essential skill of retailing was merchandising, not finance, and that retailing, like restaurants, is

a wearing marathon in which, every mile, fresh, aggressive competition could leap in and race ahead of you

Having learned their lesson, their next foray into Associated Cotton Shops, “a set of third-class stores for a fourth-class price” 80 in number led by Benjamin Rosner, a “true merchandiser” found them with a retail operation generating $44M in sales and approximately $2M/yr in earnings. Buffett made a deal to buy the stores for $6M, a sale which was ultimately made by Rosner in part to screw over his female business partner who drove him nuts, causing him to purposefully sell the business for less than it was worth just to get back at her. Buffett and Munger also insisted that Rosner stay on the manage the company for them.

In 1967, Buffett increased his control of the Buffett Partnerships while simultaneously weeding out 32,000 shares worth of investors who preferred a 7.5% debenture to Berkshire stock, ensuring that those who remained were in for growth and the risks that came with it.

Miscellany of the markets

As Buffett’s investment strategy changed over the 1950s and 1960s and his level of sophistication rose, he picked up a number of useful techniques for gaining informational edges in the market and making successful investments:

• coat-tail riding – Buffett became a notorious borrower of good ideas and was not too proud to keep an eye on people who demonstrated deal-making intelligence in the past, such as Ben Graham and Jay Pritzker, assuming they’d continue to make good judgments in the future
• detective-work/sleuthing – Buffett was the only person digging through the Moody’s Manuals at their company headquarters, or going to the shareholder meetings of small companies, or even meeting with executives of small companies to get an idea of who was running these companies
• no self-imposed market cap restrictions – Buffett looked at EVERY company he came across, no matter how small, looking for opportunities others weren’t focused on; he was particularly fond of the “Pink Sheets” publications
• consulting lists of registered shareholders – Buffett would buy blocks of companies he was interested in by hunting down individual shareholders and convincing them to unload the shares to him
• collecting scarce things – Buffett’s National American Fire Insurance investment taught him “the value of gathering as much as possible of something scarce”, both undervalued stocks and information related to said stocks
• proxy-investing – Buffett would often have his friends buy stocks he was interested in to hide his identity as the main buyer accumulating a position
• benefit from sentiment – when the market hit a fever pitch in the 1960s, Buffett went into fundraising overdrive and raised as much capital as he could while people were eager to invest
• use psychology to your advantage – as Buffett’s success unfolded, he forced would-be partners to ask him to allow them to invest with him, which put him psychologically in control
• preservation of capital – Buffett would willingly forgo the chance of profit to avoid too much risk, viewing it as a “holy imperative”; his partner Munger believed unless you were already wealthy you could afford to take risk if the odds were right
• haystack of gold – a concept imparted to him by friend Herb Wolf, the idea was if you’re looking for a gold needle in a haystack of gold it is not better to find the gold needle; obscurity was not virtue
• expense control – Buffett only took on overhead as needed, and in ways that could be easily turned back off or were free to begin with; he made extensive use of “soft-dollars” in his brokerage commissions to buy research from his favorite sleuth brokers
• profile visibility – when he was buying small companies early in his career, Buffett valued secrecy and anonymity, but as he began to target bigger companies he saw the value of a public profile and cultivated a relationship with Carol Loomis, a financial markets journalist

Buffett’s partnerships

Buffett had a total of 9 official partnerships that later became the infamous Berkshire Hathaway. However, he also set up an early partnership with his father, Howard, called Buffett & Buffett, which

formalized the way they had occasionally bought stocks together. Howard contributed some capital, and Warren’s contribution was a token amount of money, but mostly ideas and labor

Why was Buffett interested in managing money? Two reasons. One, Buffett had a strong aversion to working for others and he understood that

The overseer of capital was not an employee

Two, Buffett was obsessed with becoming a millionaire. Managing money for others and collecting a fee on profits generated would allow him to grow his own capital faster than if he were earning a return on just the money that was actually his. In other words, agreeing to manage money for others was a way to leverage his own investment returns.

Buffett started with 7 official partnerships, which were essentially all mini-hedge funds under his exclusive control, and which he viewed as “compounding machines”, meaning once the money went in it should not come out, which is why he managed most of his own wealth separately (as he would be living off his trading gains). And Buffett was so obsessed with compounding he decided to rent rather than own his own home, to free more capital for compounding.

The seven initial partnerships and several follow-on partnerships were as follows:

1. May 1, 1956, Buffett Associates Ltd., starting capital of $105,100, seven partners: Doc Thompson, Doris Buffett, Truman Wood, Chuck Peterson, Elizabeth Peterson, Dan Monen and Warren Buffett; Buffett charged 50% performance fee on returns over 4% (4% returns being guaranteed as a minimum by Buffett); added $8,000 in capital in 1960 from Buffett’s aunt and uncle
2. September 1, 1956, Buffett Fund, Ltd., starting capital of $120,000, partnered with Homer Dodge, a former Graham-Newman investor
3. Late 1956, B-C, Ltd., starting capital of $55,000, partnered with John Cleary, Howard Buffett’s secretary in Congress
4. June 1957, Underwood, starting capital of $85,000, partnered with Elizabeth Peterson; 1960, another $51,000 from connections of Chuck Peterson’s
5. August 5, 1957, Dacee, starting capital of $100,000, partnered with the Davis Family
6. May 5, 1958, Mo-Buff, starting capital of $70,000, partnered with Dan Monen (who had withdrawn his capital from partnership #1 to do a special investment with Buffett on National American), later joined by the Sarnats and Estey Graham with another $25,000 in capital
7. February 1959, Glenoff, starting capital of $50,000, partnered with Casper Offutt, Jr., John Offutt and William Glenn
8. August 15, 1960, Emdee, starting capital of $110,000, partnered with  11 local doctors
9. 1960, Ann Investments, starting capital of ??, partnered with a prominent member of a local Omaha family
10. 1960, Buffett-TD, starting capital of $250,000, partnered with Mattie Topp and two daughters plus son-in-law (MT owned the fanciest dress shop in town)
11. May 16, 1961, Buffett-Holland, starting capital of ??, partnered with Dick and Mary Holland, friends he had met through his lawyer Dan Monen
12. May 1, 1962, Buffett dissolves all partnerships into Buffett Partnership, Ltd. (BPL), beginning the year with $7.2M in net assets

His total starting capital across all of his partnerships was $580,000 and he

never deviated from the principles of Ben Graham. Everything he bought was extraordinarily cheap, cigar butts all, soggy stogies containing one free puff

Truly, one man’s junk is another man’s treasure.

Buffett’s investments

The “racetrack” period of Buffett’s life marked Buffett’s gradual transformation from a Grahamian “cigar butt” (Net-Net) investor to the well-known “growing franchise” investor of today. As Buffett’s assets under management (AUM) grew and the general market conditions of the era changed, so, too, did Buffett’s idea of a good investment. Below is a list of some of Buffett’s investments for his partnerships, as well as his personal and peripheral portfolios:

• Greif Bros. Cooperage; originally purchased for the B&B partnership in the early 1950s
• Western Insurance; purchased for Buffett’s personal portfolio in the early 1950s, Buffett actually sold his GEICO position to raise money to invest in this company earning $29/share and selling for $3/share, “He bought as much as he could”
• Philadelphia and Reading Coal & Iron Company; controlled by Graham-Newman, Buffett has discovered it on his own and had invested $35,000 by the end of 1954; it was not worth much as a business but was throwing off a lot of excess cash; Buffett learned about the value of capital allocation with this company
• Rockwood & Co.; controlled by Jay Pritzker, the company was offering to exchange $36 of chocolate beans for shares trading at $34, a classic arbitrage opportunity; unlike Graham, Buffett didn’t arbitrage but instead bought 222 shares and held them, figuring Pritzker had a reason he was buying the stock, “inverting” the scenario; the stock ended up being worth $85/share, earning Buffett $13,000 vs. the $444 he would’ve received from the arbitrage
• Union Street Railway; a net-net he discovered through Ben Graham, had about $60/share in net current assets against a selling price of $30-35/share, Buffett ultimately made $20,000 on this investment through sleuthing and speaking to the CEO in person
• Jeddo-Highland Coal Company (mentioned as an idea Buffett investigated on a road trip)
• Kalamazoo Stove and Furnace Company (mentioned as an idea Buffett investigated on a road trip)
• National American Fire Insurance, earning $29/share, selling for around $30/share, Buffett first bought five shares for $35/share, and later realized that paying $100/share would bring out the sellers because it would make them whole (financially and psychologically) after being sold the stock years earlier
• Blue Eagle Stamps, a failed investment scheme between Buffett and Tom Knapp, they eventually spent $25,000 accumulating these “rare” stamps that weren’t worth more than their face value ultimately
• Hidden Splendor, Stanrock, Northspan, uranium plays that Buffett described as “shooting fish in a barrel”
• United States & International Securities and Selected Industries, two “cigar butt” mutual funds recommended to him by Arthur Wisenberger, a well known money manager of the era; in 1950, represented 2/3 of Buffett’s assets
• Davenport Hosiery, Meadow River Coal & Land, Westpan Hydrocarbon, Maracaibo Oil Exploration, all stocks Buffett found through the Moody’s Manuals
• Sanborn Maps, in 1958 represented 1/3 of his partnerships’ capital; the stock was trading at $45/share but had an investment portfolio worth $65/share; Buffett acquired control of the board in part through proxy leverage; ultimately he prevailed over management and had part of the investment portfolio exchanged for the 24,000 shares he controlled
• Dempster Mill Manufacturing, sold for $18/share with growing BV of $72/share, Buffett’s strategy as with many net-nets was to buy the stock as long as it was below BV and sell anytime it rose above it and if it remained cheap, keep buying it until you owned enough to control it and then liquidate at a profit; he and his proxies gained control of 11% of the stock and got Warren on the board, then bought out the controlling Dempster family, creating a position worth 21% of the partnership’s assets; the business was sliding and at one point he was months away from losing $1M on the investment, but was ultimately rescued by Harry Bottle, a new manager brought in on Charlie Munger’s recommendation; the business eventually recovered through strict working capital controls and began producing cash, which Buffett augmented by borrowing about $20/share worth of additional money and used it to purchase an investment portfolio for the company; he later sold the company for a $2M profit
• Merchants National Property, Vermont Marble, Genesee & Wyoming Railroad, all net-nets he later sold to Walter Schloss to free up capital
• British Columbia Power, selling for $19/share and being taken over by the Canadian government at $22/share, this merger arb was recommended by Munger and Munger borrowed $3M to lever up his returns on this “sure thing”
• American Express, one of Buffett’s first “great company at a good price” investments, the firm’s reputation was temporarily tarnished in the aftermath of the soybean oil scandal; Buffett did scuttlebutt research and realized the public still believed in American Express, and as trust was the value of its brand, the company still had value; Buffett eventually invested $3M in the company and it represented the largest investment in the partnership in 1964, 1/3 of the partnership by 1965 and a $13M position in 1966
• Texas Gulf Producing, a net-net Buffett put $4.6M into in 1964
• Pure Oil, a net-net Buffett put $3.5M into in 1964
• Berkshire Hathaway, the company was selling at a discount to the value of its assets ($22M BV or $19.46/share) and Buffett’s original intent was to buy it and liquidate it, which he started accumulating 2000 shares for $7.50/share; the owner, Seabury Stanton had been tendering shares with the company’s cash flow, so Buffett tried to time his transactions, buying when it was cheap and tendering when it was dear; he continued purchasing stock assuming Seabury would buy him out via tender offers, the two eventually agreed to a $11.50 tender but Seabury reneged at the last moment, changing the bid to $11 and 3/8, sending Buffett into a rage and causing him to abandon his original strategy in favor of acquiring the entire company; he eventually bought out Otis Stanton’s two thousand shares and had acquired enough to gain control with 49% of Berkshire
• Employers Reinsurance, F.W. Woolworth, First Lincoln Financial, undervalued stocks he found in Standard & Poor’s weekly reports
• Disney, which he bought after meeting Walt Disney and being impressed by his singular focus, love of work and the priceless entertainment catalog
• A portfolio of shorts to hedge against a potential market collapse in the mid 60s, totally $7M and consisting of Alcoa, Montgomery Ward, Travelers Insurance and Caterpillar Tractor
• Near the end of 1968, as the market became more and more overvalued, Buffett relented and bought some of the “blandest, most popular stocks that remained reasonably priced” such as AT&T ($18M), BF Goodrich ($9.6M), United Brands ($8.4M) and Jones & Laughlin Steel ($8.7M)
• Blue Chip Stamps, a “classic monopoly” Buffett and Munger discovered in 1968, the company was involved in a lawsuit that the pair thought would be resolved in the company’s favor, and it also possessed “float” which could be invested in more securities, Munger and his friend Guerin each purchased 20,000 shares while Buffett acquired 70,000 for the partnership, in part through share swaps with other companies that owned Blue Chip stock for their own stock; the lawsuit was eventually resolved and the $2M investment produced a $7M profit
• Illinois National Bank & Trust, a highly profitable bank that still issued its own bank notes, it was managed by Eugene Abegg, an able steward of the company whose retainer was one condition for Buffett’s investment in the company
• The Omaha Sun and other local newspapers, which Buffett figured he’d make an 8% yield on, his motivation for buying seemed to be primarily connected to his desire to be a newspaper publisher
• The Washington Monthly, a startup newsmagazine that Buffett lost at least $50,000 on, again, as a vanity project

Buffett’s AUM

Below is a record of the growth of Buffett’s personal wealth, partnership AUM and performance fees accrued:

• 1954, Buffett’s total personal capital stood at approximately $100,000
• 1956, Buffett was 26 years old and had $174,000 of personal capital, growing his money by more than 61% per year for six years since he entered Columbia with $9,800 in capital
• 1959, partnership returns beat the market by 6%
• 1960, partnership assets stood at $1.9M and returns beat the market by 29%, and Buffett’s reinvested partnership fees had earned him $243,494 (13% of partnership assets belonged to him)
• 1962, Buffett was a millionaire and his outside investments totalled over $500,000, which he added with the rest of his money into the BPL partnership; he had acquired more than a million dollars in six years and owned 14% of the partnership
• 1964, $5M in new capital for the partnerships, and $3M in investment earnings, Buffett’s personal net worth was $1.8M and BPL had $17.5M in capital
• 1965, ended the year with assets of $37M, including $3.5M in profit on American Express, Buffett had earned more than $2.5M in fees, bringing his total stake to $6.8M
• 1966, $6.8M in additional capital investments in the partnerships, with total capital amounting to $44M, some of which was set aside as cash for the first time in Buffett’s career
• 1967, Buffett’s personal net worth was $9M and he had generated $1.5M in fees in 1966
• 1968, the partnership was worth $105M thanks to additional capital infusions and investment returns
• 1969, Buffett’s net worth was $26M

The Desert Island Challenge

Buffett and his investor friends came up with the following challenge that is a helpful mental tool for thinking about the investment problem:

If you were stranded on a desert island for ten years, he asked, in what stock would you invest? The trick was to find a company with the strongest franchise, one least subject to the corroding forces of competition and time: Munger’s idea of a great business.

Notes – The Snowball, By Alice Schroeder: Part II, Chap. 5-19

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This post covers Part II: The Inner Scorecard, Chap. 5-19

The beginning of Buffett

In a letter to a family member from one of Warren Buffett’s ancestors, Zebulon, the elder Buffett counsels his grandson to

be content with moderate gains

almost as if some strain of value investing ethic permeated his lineage from before Buffett himself had even heard of The Intelligent Investor. Buffett’s family represents a long line of business minded people. Yet, despite this heritage,

Buffett always credited most of his success to luck

It’s an odd, likely guilt-laden existential belief to carry around with oneself! But it is maybe no surprise. Love doesn’t sound like it was given much attention in Buffett’s childhood home, and self-love is probably included, as we learn that:

Politics, money and philosophy were acceptable topics for dinner-table discussion at the Buffett house, but feelings were not. Nobody in the Buffett household said “I love you,” and nobody tucked the children into bed with a kiss.

Any guess as to where some of Buffett’s later self-hating charitable giving ideas might have come from?

[Buffett’s mother, Leila’s] favorite stories told of her and Howard’s sacrifices… anything for Howard. “She crucified herself”… But Leila’s attitude of duty and sacrifice had another, darker side: blame and shame.

If you guessed his psychotic, clinically depressed mother, you answered correctly!

It is Buffett’s relationship to his mother and his vulnerability to her rage as a child that we actually see Buffett in the most sympathetic light. We see as Warren recounts his relationship with his mother this grown, aged man “weeping helplessly”, and we also learn that despite the savage treatment from his mother, which his idolized father was aware of, Howard “didn’t intervene.”

The most vulnerable people in any society are children– they’re physically, intellectually AND emotionally unequipped to make sense of and thoughtfully respond to the irrationalities and volatilities of unstable and violent adults. It is actually quite touching imagining this young, budding genius, Warren Buffett, suffering at the hands of his psychologically diseased mother and developing a precarious existential belief system that leaves him feeling so guilty for the remainder of his life that after all he has (legitimately) achieved, he is still convinced it was mostly due to luck! What an absolute tragedy of human imagination! It would be nice to imagine the poor, hurting and timid child inside of Warren Buffett eventually being freed to go on his way and let Warren wrestle with these childhood demons no more.

What a different world it would be if Warren was a hero entrepreneur rather than a man so tormented by his past that he carries his fears and anxieties into his public persona and recommendations for society at large!

We also see in this information the source of Warren’s fascination with other people’s mothers (who he often developed crushes on), with motherly women in general and with his tendency to have a cadre of close female friends in both his personal and professional life, all while simultaneously having a troubled and distant relationship with his own wife and children later on. What a sad development for an otherwise triumphant individual.

The search for a system – Buffett the handicapper

One of the central themes of Part II is the young Warren Buffett’s search for a “system”: a predictable, confined process for predicting and handicapping the odds of various events in his life. Starting with his bathtub marble race, extending to the racing track (horses) and eventually culminating in his quest for an investment system (part of his initial attraction to Graham, who was especially formulaic, scientific and systematic in his approach to the investment question in general).

And a system, once found, is only valuable if it has a lot of information to process:

There were opportunities to calculate odds everywhere. The key was to collect information, as much information as you could find.

We also begin to see hints of the later, “original” Buffett, with his love of monopoly as a competitive advantage. The anecdotes of Buffett and his friend Russ collecting license plate information in the hopes of eventually providing it to the police to catch a bank robber are examples of Buffett’s early obsession with  the value of a monopoly. Similarly, while the young Warren was holed up in a hospital with an illness, he took to collecting the fingerprints of the nurses so that if one of them committed a crime,

he, Warren Buffett, would own the clues to the culprit’s identity

This is a pretty astounding conclusion for a young child to reach, even if it is innocently done. It appears Warren had something of an intuitive understanding of the value of a restricted supply granted by a monopoly on a particular resource.

He also was perplexed by the way so much valuable information (valuable to someone with a system in place for interpreting and analyzing it) went uncollected and unused. An early example is Buffett’s collecting of bottle caps nearby soda dispensers:

The numbers told him which soft drinks were most popular

Do you see the future investor in Coca-Cola beginning to formulate his understanding of the value of consumer habits and patterns?

In the 1940s, Buffett started visiting horse racing tracks where he learned

The art of handicapping is based on information. The key was having more information than the other guy

Buffett ended up reading HUNDREDS of books on horse handicapping before he eventually learned the Rules of the Racetrack:

• Nobody ever goes home after the first race
• You don’t have to make it back the way you lost it

Buffett later connected these experiences to his investing and understood

The market is a racetrack too. The less sophisticated the track, the better… the trick, of course, is to be in a group where practically no one is analytical and you have a lot of data

In this way, a handicapper or investor can develop informational asymmetries which grant him the all-important edge. Interestingly, Buffett earned a college scholarship in just this way, as he was the only person to show up to a scholarship committee session and thus earned the scholarship by default because he had no competition.

This is where the quote about Buffett sifting through the Moody’s Manuals company by company, page by page (all ten thousand) comes from, and the famous quote,

I actually looked at every business– although I didn’t look very hard at some

In a similar vein, Warren’s classmates at the Columbia Business School completely ignored the opportunity they had, right in front of them, to learn investing from the premier guru of their era, Benjamin Graham. Instead,

They were a remarkably homogeneous group of men, mostly headed to General Motors, IBM or U.S. Steel after they got their degrees

These young men were being trained to become managers. Meanwhile, Buffett was training to become an owner (and he would later own IBM, while the other two American stalwarts died slow, painful deaths). Or, as Buffett later put it,

U.S. Steel was a good business… it was a big business, but they weren’t thinking about what kind of train they were getting on

Buffett also learned the importance of “swinging at the right pitches”:

You’re not supposed to bet every race. I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day

Simultaneously, Buffett was realizing the importance of thinking for oneself and not being a mindless trend follower. Granted an opportunity to play “the echo” to another trumpeter in the school band, Buffett found himself in a confusing and embarrassing situation in which the lead player played the wrong note and Warren didn’t know what to do as his “echo”. The lesson?

It might seem easier to go through life as the echo– but only until the other guy plays a wrong note

He also became enamored with Dale Carnegie and his social system, one of the most important lessons of which he felt was “Don’t criticize, condemn or complain.”

In addition, Buffett studied the biographies of great businessmen such as:

• Jay Cooke
• Daniel Drew
• Jim Fisk
• Cornelius Vanderbilt
• Jay Gould
• John D. Rockefeller
• Andrew Carnegie

looking for the keys to their “system”.

History repeats itself, or at least rhymes

In Part II we also get a glimpse into the way that early themes and experiences in Buffett’s life replayed themselves as important investments in his later life as the world’s best known and must successful investor. For example:

• as a child, Buffett sold chewing gum door-to-door; he later successfully invested in Wrigley’s chewing gum
• as a child, Buffett collected soda bottle caps; he later successfully invested in Coca-Cola
• as a child, Buffett was obsessed with model trains and always dreamed of owning a train set; he later successfully invested in Burlington Northern railroads
• as a child, Buffett met Sidney Weinberg, an important figure at Goldman Sachs, during a field trip to Wall St with his father; he later successfully invested in Goldman Sachs
• as a child, Buffett had a paper route in which he distributed, amongst many other papers, the Washington Post; he later successfully invested in the Washington Post and other dailies

Warren catches the wealth-bug

It was on his trip to the Stock Exchange in New York City in 1940 with his father that Warren first understood the money-making potential of stock investing. Witnessing exchange members who had servants roll custom cigars, Warren realized

the Stock Exchange must pour forth streams of money… he worked with a passion for the future he saw ahead of him, right there in sight. He wanted money

Later, Warren came across a book entitled “One Thousand Ways to Make $1,000” or, in Warren’s mind, how to make a million dollars. This was it. He was going to be a millionaire. The book had hopeful, helpful and optimistic advice that we would all well consider and pay attention to in the event that we become similarly motivated:

the opportunities of yesterday are as nothing compared with the opportunities that await the courageous, resourceful man of today! You cannot possibly succeed until you start. The way to begin making money is to begin… Hundreds of thousands of people in this country who would like to make a lot of money are not making it because they are waiting for this, that or the other to happen

Buffett also learned around this time the power of compounding and decided

If a dollar today was going to be worth ten some years from now, then in his mind the two were the same

Early Buffett investments, and why he made them

Before he had even graduated from college, the young Warren Buffett had made a number of stock and private investments:

• Cities Service Preferred; bought three shares at $114.75 for himself and his sister, the shares fell and then recovered; Buffett sold at $40/share for a $5 profit, only to watch the shares rise to $202, lessons learned:
  • Do not overly fixate on the price paid for a stock
  • Don’t rush unthinkingly to grab a small profit; it can take years to earn back the profit “lost” through opportunity cost
  • Buffett didn’t want to have responsibility for other people’s money unless he was sure he could succeed
• Around age 15, Warren had invested in “Builders Supply Co.”, a hardware store owned and operated by his father and his father’s business partner, Carl Falk, in Omaha
• Around age 15, Warren bought a 40-acre farm for $1,200 that he split the profits of with a tenant farmer; he sold it when he was in college (5 years later) for $2,400
• Buffett invested “sweat equity” in a paper route which earned him $175/mo in an era when a grown man felt well-paid on $3,000/yr
• Buffett started a used golf-ball retailing business with a friend, selling golf balls for $6/dozen, through a wholesaler in Chicago named Witek
• Buffett bought a pinball machine for $25, placed it in a barbershop and recouped $4 in the first day; he went on to purchase 7-8 pinball machines for “Mr. Wilson’s pinball machine company”, learning the principle of capital,  money that works for its owner, as if it had a job of its own
• 1949, Buffett shorts automaker Kaiser-Frazer, which went from producing 1/20 cars to 1/100 in the market; Buffett saw a trend in the statistics
• Preparing to enter Columbia, Buffett invested in Parkersburg Rig & Reel, purchasing 200 shares after discovering the company “according to Graham’s rules” in The Intelligent Investor
• At Columbia, Buffett was invested in Tyer Rubber Company, Sargent & Co. and Marshell-Wells (a hardware company) of which he had jointly purchased 25 shares with his father; Marshell-Wells was the largest hardware wholesaler in the US and traded for $200 but earned $62/share, making it similar to a bond with a 31% yield
• After visiting with Lou Simpson at GEICO, Buffett dumped 3/4ths of his stock portfolio to buy 350 shares of GEICO, which was trading at 8x current earnings at $42/share and was rapidly growing; Buffett felt his margin of safety was a growing, small company in a large field meaning it had a lot of opportunity ahead of it, especially because it was the lowest cost provider
• Grief Bros. Cooperage, a barrel maker and Ben Graham stock
• Philadelphia Reading Coal & Iron Company, selling for $19/share with $8/share worth of culm banks
• Cleveland Worsted Mills, textile manufacturer selling for less than its current assets of $146/share; the company cut the dividend which was part of Buffett’s investment thesis and he sold the stock in disgust
• A gas service station, which he bought with a friend for $2,000; the property never made money as they couldn’t entice customers from the nearby Texaco station; Buffett lost his investment and learned the value of customer habit

Related to the theme of early Buffett investments is the course of the young Buffett’s savings and the accumulation of his capital stock:

• Age 14, his savings totaled around $1,000, “he was ahead of the game… getting ahead of the game, he knew, was the way to the goal”
• Age 15, his savings totaled around $2,000, much of which was from his newspaper route
• Age 16, his savings totaled around $5,000 ($53,000 in 2007 dollars), much of it from his pinball and golfball businesses
• Age 20 (1950), his savings totaled $9,803.70 which was partly invested in stocks, as well as a $500 scholarship and $2,000 from his father for not smoking
• Age 21, his savings totaled $19,738, he had boosted his capital 75% in a single year and he felt “supremely confident in his own investing abilities”, he also was willing to take on debt equal to a quarter of his net worth, or about $5,000, for total capital of around $25,000

Miscellaneous Buffett lessons

On betting and deal-making in general:

Know what the deal is in advance

What Buffett learned from Graham:

• A stock is the right to own a little piece of a business
• Use a margin of safety so the effects of good decisions are not wiped out by errors; the way to advance is to not retreat
• Mr. Market is your servant, not your master

On influence:

it pays to hang around people better than you are, because you will float upward a little bit. And if you hang around with people that behave worse than you, pretty soon you’ll start sliding down the pole

Buffett’s authorship of the article “The Stock I Like Best” on GEICO attracted the attention of a later financial backer, Bill Rosenwald, son of Julius Rosenwald and longtime chairman of Sears, Roebuck & Co.

Notes – A Compilation Of Ideas On Investing

How to Screen for Hidden Champions

• If I could recommend only one book for value investors to read it would be Hidden Champions of the Twenty-First Century
• Reading about Exxon Mobil (XOM) and Apple (AAPL) and Starbucks (SBUX) and thinking you are becoming a business expert is like reading about blue whales and elephants and thinking you are becoming an animal expert. Tiny insects are a lot more common than giant mammals
• Screening for Hidden Champions:
  • 10 years consistent >= 15% op margin and market cap < $1B
  • 10 years consistent >= 15% ROE and market cap < $1B
  • 10 years consistent >= 8% ROA and market cap <$1B
  • 10 years consistent EPS increase and market cap < $1B
• If an ultra-conservatively managed family company earns 10% on equity it would probably earn closer to 20% on equity if it was sold to a professionally managed multinational
• Some companies have negative equity, to correct for this, screen for >= 8% ROA regardless of ROE
• The best place to screen for hidden champions in the UK is SharelockHolmes

Backtesting Net-Nets: Does It Matter?

• Net-nets are a symptom of the overall stock market’s health
• You should ignore a net-net for two years after you buy it, at minimum
• The key to a successful NCAV portfolio is to not sell your winners too fast
• If a stock has low institutional ownership, low short interest, no analyst coverage, and a small number of shares outstanding – nobody is looking at the company; buy net-nets where institutions own the fewest shares
• Inactivity is necessary to really judge your net-net selection skills
• If you are just taking a profit (or loss) in a net-net within 1 to 2 years of buying it – I think you’ve basically just traded a stock on a different basis than you analyzed it
• A good net-net is really just a decent business. Why would insiders still control 10% to 50% of a company that has been public for 10 to 30 years?
• Try to buy the “best” net-net available each month with an emphasis on “safe” rather than “cheap”
• Attractive net-net criteria:
  • Long history of consistent profitability
  • Long tenured CEO
  • High insider ownership
  • Low leverage
  • High cash relative to share price
  • Good capital allocation decisions
  • Simple business
  • Good business
  • Lasting business
• Ideally, you don’t want to pay more than the company’s own cash for the stock
• High insider ownership in a newly public company doesn’t have the same meaning as it does at an old company
• Dividends are nice, not because they’re important but because of what dividends are a symptom of
• Retailers are tough net-nets; a retailer that loses some of its competitiveness is a retailer that could be out of business in a matter of years
• How to sabotage a NCAV portfolio: sell too soon; if you sell your winners when they go up, you destroy the performance of a net-net; the big winners are needed to outweigh the big losers and the mediocre performers
• The holding of net-nets is critical
• Slowly assemble a net-net portfolio over a period of a couple years, and don’t sell anything for those first two years

Should You Wait for a Crash – Or Buy Today’s Best Bargain?

• To get consistently good investment results, follow one of two programs:
  • Buy companies that are clearly selling for less than their conservatively calculated value to a private owner
  • Buy companies that will earn high returns on capital while growing quickly for many, many, many years to come
• During periods of panic, look for obvious mispricings; for example, high quality companies trading at less than 10x FCF; 10x free cash flow is less than stocks are generally worth
• To fill a portfolio in the midst of a market crash, have a shopping list of companies you like but are overpriced ahead of time
• You are very unlikely to cause any sort of catastrophic problem for yourself just by overpaying for the right kind of company. Buying the wrong company is your biggest risk
• Just wait for an obviously wonderful business selling for the kind of price a normal stock sells for in normal times

Warren Buffett Checklist to Invest in a Great Business: KO

• Buffett had 9 criteria he examined when determining whether he was investing in a great business:
  • Does the business have an identifiable consumer monopoly?
  • Are the earnings of the company strong and showing an upward trend?
  • Is the company conservatively financed?
  • Does the business consistently earn a high rate of return on shareholders’ equity?
  • Does the business get to retain its earnings?
  • How much does the business have to spend on maintaining current operations?
  • Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
  • Is the company free to adjust prices to inflation?
  • Will the value added by retained earnings increase the market value of the company?

Free Cash Flow: Adjusting for Acquisitions, Capital Allocation and Corporate Character

• Make your Ben Graham investments on an EV/EBIT basis
• Make your Warren Buffett investments on a price-to-free-cash-flow (P/FCF or P/OE) basis

How to Read a 10-K: What is the Most Important Part?

• The only 10-K I read from cover to cover is the most recent 10-K
• Print out and mark up a hard copy of the latest 10-K, 10-Q, and 14A
• Check all of the 8-Ks and 13Gs from the last year or so
• If there was a scandal, a proxy battle, legal case, unconsummated merger, etc. – read the 8-Ks and other documents surrounding that time period even if it was many years ago
• Read the oldest 10-K as well as the newest
• Read any shareholder letters ever written that are still available
• Enter Balance Sheet, Cash Flow and Income Statement data into an Excel spreadsheet for every year the company reported to EDGAR
• Always have at least 10 years of data
• Look at the notes to the financial statements most critically
• Ask yourself the following questions:
  • What is customer behavior in the industry?
  • Why do customers choose what they choose?
  • What does management really think? What are they really like?
• Gannon prefers investing in companies where he understands customer behavior the best

How Long Should You Hold a Net-Net?

• All we need to do is make sure that the stocks we buy are clearly worth more than we pay for them
• Forget about trading a net-net a full year after buying it and instead focus on the two things that matter most:
  • Picking the right stock (company)
  • Holding that stock regardless of what the market does
• Never sell a net-net in less than one year unless:
  • You made a mistake
  • You need to buy something else (that’s better)
• A one to five year holding period is the right length for net-nets
• Never sell a net-net just because it reached NCAV; NCAV is still really, really cheap

How to Get a Job in Value Investing

• Look for someone trying to build a research team from scratch
• The best combination is often when the position is brand new and the right person was impressed ahead of time
• Do lots of research for free and then let it get into the hands of someone who can hire an analyst
• Talk to everybody whose work you respect by sending them an email; share your best ideas with them
• Set aside time to writing and reading about value investing every single day
• Don’t send your casual thoughts to those you’re trying to impress; you want them to think of you as a thorough, insightful researcher

What is the Buffett/Munger Bargains Newsletter?

• Investing in net-nets is the best way for a dedicated, “do-it-yourself” individual investor to beat the market
• The newsletter’s strategy is to find companies with the following attributes:
  • Simple business
  • Favorable long-term prospects
  • Able and honest management
  • Consistent earnings
  • Good ROE
  • Little debt
  • Very attractive price
• It is modeled on the Buffett/Munger of the 1970s
• “Really good businesses usually don’t need to borrow… they make the most of an already strong business franchise or concentrate on a single winning business theme” -Buffett
• Use the higher of today’s interest rates and long-term average interest rates when considering valuations

How I Pick Stocks for the Ben Graham Net-Net Newsletter

• Traditionally, big net-nets have been poor performers
• The ratio of insider ownership to institutional ownership is actually one of the best predictors of the future stock market performance of a net-net
• What makes for a good net-net?
  • High insider ownership / Low institutional ownership
  • High F-Score
  • Consistent earnings
  • Simple business
  • Decent ROE
  • Decent long-term prospects
• The idea is to get the best business for the lowest price

How Should You Divide Your Research Time?

• I put my energy towards whatever is most clearly undervalued
• I keep cash close to 0% when I have good ideas
• The important thing is picking the exact right company and then picking the approximately right price
• I spent probably half a year thinking about buying DWA before I put in my buy order
• A typical net-net for me is a 10% position held for just over a year
• I spend almost half my time looking at net-nets and almost half my time looking at high quality companies
• I look longer at each high quality company I research

What Would Value Investing 101 Look Like?

• Required reading:
  • Warren Buffett’s Letter to Shareholders (1977-Present)
  • Warren Buffett’s Letter to Partners (1959-1969)
  • The Snowball: Warren Buffett and the Business of Life
  • Buffett: The Making of An American Capitalist
  • Poor Charlie’s Almanack
  • Common Stocks and Uncommon Profits (by Phil Fisher)
  • The Interpretation of Financial Statements (by Ben Graham)
  • The Intelligent Investor (1949 Edition)
  • Security Analysis (1940 Edition)
  • Benjamin Graham on Investing
  • Benjamin Graham: The Memoirs of the Dean of Wall Street
  • One Up on Wall Street (by Peter Lynch)
  • Beating the Street (by Peter Lynch)
  • You Can Be a Stock Market Genius (by Joel Greenblatt)
  • The Little Book That Beats the Market (by Joel Greenblatt)
  • There’s Always Something to Do (about Peter Cundill)
  • The Money Masters
  • Money Masters of Our Time
  • Hidden Champions of the Twenty-First Century
  • Jim Collins Books: Built to Last, Good to Great, How the Mighty Fall, and Great by Choice
  • Distant Force (about Henry Singleton)
  • Kuhn’s The Structure of Scientific Revolutions and The Essential Tension
• Specific reading on extreme market conditions:
  • The Big Short
  • Too Big to Fail
  • This Time is Different
  • When Genius Failed
  • The Panic of 1907
• Knowing about historical episodes is understanding what the paper looked like every morning to folks who were as blind to the future as you are now
• Case studies of investments made by investors whose books, letters, etc., the student has read
• Side-by-side comparisons of stocks with the names of the companies omitted, for example:
  • Buffett’s investment in GEICO, Wells Fargo, Coca-Cola, Gilette, etc.
  • Graham’s investment in Northern Pipeline, DuPont/GM (long/short), etc.
  • Phil Fisher’s examples in his book
  • Joel Greenblatt’s examples from his books
  • Peter Cundill’s investments in his biography
  • Peter Lynch’s investments in his books
  • MSFT at different points in its history, WMT versus Costco, present day modern US railroads, present day comparison of high-quality large versus high-quality small company, comparison of present-day hated companies and historical Warren Buffett equivalent
• Value investing is mostly about doing original research alone
• New value investors love reading books on theory and technique; they spend too lite time studying specific stocks

Professor Geoff’s How to #1: How to Analyze a Foreign Stock

1. Open Google Translate
2. Find the stock on its home stock exchange
3. Read the company’s annual reports
4. Study comparable companies in your home country
5. Enter the stock’s past financials in a Microsoft Excel spreadsheet
6. Use the past financials and comparison companies to appraise the stock’s value to a private buyer
7. Compare the stock’s appraised value to its market price
8. If the market price is more than 75% of the appraised value, forget about the stock
9. If the market price is less than 50% of the appraised value, focus on the stock
10. Otherwise: use your best judgment

Review – Deep Value Investing

Deep Value Investing: Finding bargain shares with big potential

by Jeroen Bos, published 2013

Benjamin Graham’s Principles Applied

Although it provides a summary introduction to the theory of Benjamin Graham’s classic deep value (net-net and discount-to-book value) strategy, Bos’s “Deep Value Investing” is decidedly a practitioner’s guide, not a philosophical work. More accurately, it’s a collection of case studies for observation and analysis– what did and didn’t work in various key examples from Bos’s own investment portfolio.

This is the book’s strength, and weakness. It is a strength because any opportunity to peer into the portfolio of a working money manager and see not only what he’s done, but why he has done it, is often worth the price of admission. Bos gets hands on with the reader and provides the relevant information in each case study, including the start and end date and price of each trade, the relevant balance sheet information and per share calculations and a helpful chart of price movements over time to put it in perspective.

Most importantly, though, Bos provides a lot of qualitative detail that helps to flesh out the simple quantitative analysis. Many curious students of value investing will be happy to see Bos not only explains what piqued his initial interest in each security, but that he also talks about how long and why he waited to get involved in each opportunity and how he interpreted business developments in each case (positive and negative) along the way. He also provides an explanation as to why and how he exited each investment, whether it was a winner or a loser.

This is something that’s missing in most investment case study discussions and it’s a real value add with this book. Another value add is the online support materials for the book, including a record of all relevant publicly available information for each investment that Bos used in his analysis (so you can follow along and see if you can see what he saw), as well as a free eBook version of the title accessible with a special link.

As mentioned, the weakness of the book lies in the fact that it’s mostly a collection of case studies with little else to structure it. In that sense, while the material is approachable and certainly not technical or difficult by any means to comprehend, this is not a “beginner’s book” but better for a reader who has already read a more philosophical work such as Graham’s “The Intelligent Investor” or “Security Analysis”. After reading those, revisiting Bos’s “Deep Value Investing” should yield many profitable insights and appreciation for what he has managed to accomplish.

Additionally, a bit of information that is normally found in these “how I do what I do” guides, that being whether or not the author supports diversification or concentration of portfolio positions and how he sizes his positions and manages his portfolio as a whole in general, are noticeably absent. The mere addition of this insightful information might have pushed this book into the “4-star” range in terms of usefulness and candor. As it is, it’s a “3-star”, though a strong 3-star candidate. A good read, but not essential in any library and by no means a classic like “Security Analysis”, though of course it has no pretensions of being so.

If you’re “deep” into deep value strategies, or want to watch over the shoulder of a talented operator, Jeroen Bos’s “Deep Value Investing” is well worth picking up! Even veteran value guys have something to learn from Bos’s “qualitative-quantitative” combined approach and especially his criteria for exiting a successful investment as it “transforms” over time from a balance sheet to earnings play.

Other Notes

Some of my other favorite observations worth noting:

1.) Liquid assets are what we’re really interested in, for the strongest margin of safety

2.) Share prices tend to be volatile, but book values tend to be stable over time

3.) Service companies tend to offer good value opportunities because they’re light on fixed assets and heavy on current assets; they also have flexible business models that can quickly scale up or down depending on business conditions

4.) Cyclical stocks always look cheapest on an earnings basis at the top of their cycle and most expensive at the bottom of their cycle (which is ironically when they’e a best buy)

5.) To better understanding accounting statement terms, compare treatment of confusing items across different companies in the same industry

6.) When evaluating trade receivables, it’s important to understand who the company’s clients are

7.) Check lists of new 52-week lows for good value investment candidates

How Did I Come Up With My 16 JNets?

A couple days ago someone who follows my Twitter feed asked me what criteria I had used to pick the 16 JNets I talked about in a recent post. He referenced that there were “300+” Japanese companies trading below their net current asset value. A recent post by Nate Tobik over at Oddball Stocks suggests that there are presently 448 such firms, definitely within the boundaries of the “300+” comment.

To be honest, I have no idea how many there are currently, nor when I made my investments. The reason is that I am not a professional investor with access to institution-grade screening tools like Bloomberg or CapitalIQ. Because of this, my investment process in general, but specifically with regards to foreign equities like JNets, relies especially on two principles:

• Making do with “making do”; doing the best I can with the limited resources I have within the confines of the time and personal expertise I have available
• “Cheap enough”; making a commitment to buy something when it is deemed to be cheap enough to be worthy of consideration, not holding out until I’ve examined every potential opportunity in the entire universe or local miniverse of investing

That’s kind of the 32,000-ft view of how I arrived at my 16 JNets. But it’s a good question and it deserves a specific answer, as well, for the questioner’s sake and for my own sake in keeping myself honest, come what may. So, here’s a little bit more about how I made the decision to add these 16 companies to my portfolio.

The first pass

The 16 companies I invested in came from a spreadsheet of 49 companies I gathered data on. Those 49 companies came from two places.

The first place, representing a majority of the companies that ultimately made it to my spreadsheet of 49, was a list of 100 JNets that came from a Bloomberg screen that someone else shared with Nate Tobik. To this list Nate added five columns, to which each company was assigned a “1” for yes or a “0” for no, with category headings covering whether the company showed a net profit in each of the last ten years, whether the company showed positive EBIT in each of the last ten years, whether the company had debt, whether the company paid a dividend and whether the company had bought back shares over the last ten years. Those columns were summed and anything which received a “4” or “5” cumulative score made it onto my master spreadsheet for further investigation.

The second place I gathered ideas from were the blogs of other value investors such as Geoff Gannon and Gurpreet Narang (Neat Value). I just grabbed everything I found and threw it on my list. I figured, if it was good enough for these investors it was worth closer examination for me, too.

The second pass

Once I had my companies, I started building my spreadsheet. First, I listed each company along with its stock symbol in Japan (where securities are quoted by 4-digit numerical codes). Then, I added basic data about the shares, such as shares outstanding, share price, average volume (important for position-sizing later on), market capitalization, current dividend yield.

After this, I listed important balance sheet data: cash (calculated as cash + ST investments), receivables  inventory, other current assets, total current assets, LT debt and total liabilities and then the NCAV and net cash position for each company. Following this were three balance sheet price ratios, Market Cap/NCAV, Market Cap/Net Cash and Market Cap/Cash… the lower the ratio, the better. While Market Cap/Net Cash is a more conservative valuation than Market Cap/NCAV, Market Cap/Cash is less conservative but was useful for evaluating companies which were debt free and had profitable operations– some companies with uneven operating outlooks are best valued on a liquidation basis (NCAV, Net Cash) but a company that represents an average operating performance is more properly considered cheap against a metric like the percent of the market cap composing it’s balance sheet cash, assuming it is debt free.

I also constructed some income metric columns, but before I could do this, I created two new tabs, “Net Inc” and “EBIT”, and copied the symbols and names from the previous tab over and then recorded the annual net income and EBIT for each company for the previous ten years. This data all came from MSN Money, like the rest of the data I had collected up to that point.

Then I carried this info back to my original “Summary” tab via formulas to calculate the columns for 10yr average annual EBIT, previous year EBIT, Enterprise Value (EV), EV/EBIT (10yr annual average) and EV/EBIT (previous year), as well as the earnings yield (10yr annual average net income divided by market cap) and the previous 5 years annual average as well to try to capture whether the business had dramatically changed since the global recession.

The final step was to go through my list thusly assembled and color code each company according to the legend of green for a cash bargain, blue for a net cash bargain and orange for an NCAV bargain (strictly defined as a company trading for 66% of NCAV or less; anything 67% or higher would not get color-coded).

I was trying to create a quick, visually obvious pattern for recognizing the cheapest of the cheap, understanding that my time is valuable and I could always go dig into each non-color coded name individually looking for other bargains as necessary.

The result, and psychological bias rears it’s ugly head

Looking over my spreadsheet, about 2/3rds of the list were color-coded in this way with the remaining third left white. The white entries are not necessarily not cheap or not companies trading below their NCAV– they were just not the cheapest of the cheap according to three strict criteria I used.

After reviewing the results, my desire was to purchase all of the net cash stocks (there were only a handful), all of the NCAVs and then as many of the cash bargains as possible. You see, this was where one of the first hurdles came in– how much of my portfolio I wanted to devote to this strategy of buying JNets. I ultimately settled upon 20-25% of my portfolio, however, that wasn’t the end of it.

Currently, I have accounts at several brokerages but I use Fidelity for a majority of my trading. Fidelity has good access to Japanese equity markets and will even let you trade electronically. For electronic trades, the commission is Y3,000, whereas a broker-assisted trade is Y8,000. I wanted to try to control the size of my trading costs relative to my positions by placing a strict limit of no more than 2% of the total position value as the ceiling for commissions. Ideally, I wanted to pay closer to 1%, if possible. The other consideration was lot-sizes. The Japanese equity markets have different rules than the US in terms of lot-sizes– at each price range category there is a minimum lot size and these lots are usually in increments of 100, 1000, etc.

After doing the math I decided I’d want to have 15-20 different positions in my portfolio. Ideally, I would’ve liked to own a lot more, maybe even all of them similar to the thinking behind Nate Tobik’s recent post on Japanese equities over at Oddball Stocks. But I didn’t have the capital for that so I had to come up with some criteria, once I had decided on position-sizing and total number of positions, for choosing the lucky few.

This is where my own psychological bias started playing a role. You see, I wanted to just “buy cheap”– get all the net cash bargains, then all the NCAVs, then some of the cash bargains. But I let my earnings yield numbers (calculated for the benefit of making decisions about some of the cash bargain stocks) influence my thinking on the net cash and NCAV stocks. And then I peeked at the EBIT and net income tables and got frightened by the fact that some of these companies had a loss year or two, or had declining earnings pictures.

I started second-guessing some of the choices of the color-coded bargain system. I began doing a mish-mash of seeking “cheap” plus “perceived quality.” In other words, I may have made a mistake by letting heuristics get in the way of passion-less rules. According to some research spelled out in an outstanding whitepaper by Toby Carlisle, the author of Greenbackd.com, trying to “second guess the model” like this could be a mistake.

Cheap enough?

Ultimately, this “Jekyll and Hyde” selection process led to my current portfolio of 16 JNets. Earlier in this post I suggested that one of my principles for inclusion was that the thing be “cheap enough”. Whether I strictly followed the output of my bargain model, or tried to eyeball quality for any individual pick, every one of these companies I think meets the general test of “cheap enough” to buy for a diversified basket of similar-class companies because all are trading at substantial discounts to their “fair” value or value to a private buyer of the entire company. What’s more, while some of these companies may be facing declining earnings prospects, at least as of right now every one of these companies are currently profitable on an operational and net basis, and almost all are debt free (with the few that have debt finding themselves in a position where the debt is a de minimis value and/or covered by cash on the balance sheet). I believe that significantly limits my risk of suffering a catastrophic loss in any one of these names, but especially in the portfolio as a whole, at least on a Yen-denominated basis.

Of course, my currency risk remains and currently I have not landed on a strategy for hedging it in a cost-effective and easy-to-use way.

I suppose the only concern I have at this point is whether my portfolio is “cheap enough” to earn me outsized returns over time. I wonder about my queasiness when looking at the uneven or declining earnings prospects of some of these companies and the way I let it influence my decision-making process and second-guess what should otherwise be a reliable model for picking a basket of companies that are likely to produce above-average returns over time. I question whether I might have eliminated one useful advantage (buying stuff that is just out and out cheap) by trying to add personal genius to it in thinking I could take in the “whole picture” better than my simple screen and thereby come up with an improved handicapping for some of my companies.

Considering that I don’t know Japanese and don’t know much about these companies outside of the statistical data I collected and an inquiry into the industry they operate in (which may be somewhat meaningless anyway in the mega-conglomerated, mega-diversified world of the Japanese corporate economy), it required great hubris, at a minimum, to think I even had cognizance of a “whole picture” on which to base an attempt at informed judgment.

But then, that’s the art of the leap of faith!

16 Japanese Net-Nets I Put In My Portfolio

Listed below are the 16 Japanese companies that currently compose my “basket” (portfolio-within-the-portfolio) of Japanese net-nets, which I refer to as “JNets”. While most of my picks were classic Benjamin Graham-style companies trading for 2/3rds or less of their Net Current Asset Value (current assets minus total liabilities), some were selected on the basis of being a Net Cash Bargain (trading below the value of the company’s cash minus total liabilities) or as a Cash Bargain (profitable company with no debt trading for less than the cash on the balance sheet).

Strictly speaking, a Net Cash Bargain is a more conservative valuation than a Net Current Asset Value Bargain as there are more assets in front of the liabilities, while a Cash Bargain is a less conservative valuation (it may or may not be an NCAV Bargain) but typically you are getting a higher quality company with stronger earnings power as a result. As Graham noted, equities can be analyzed much like bonds and the true safety of a bond comes from the underlying company’s earnings power, not necessarily the asset values which are a worst-case fall back measure to protect against loss.

The figures in the list below are all in Yen, typically in millions of Yen besides the per share price. At the time of purchase, the approximate exchange value of the dollar against the Yen was 1 USD = 78 JPY. All figures and prices are the most recent available at time of purchase.

For comparative purposes, I summarize at the end of the list the metrics for the entire basket (as if it was a conglomeration of 100% of the equity of all companies included) as well as on an average basis as a representative for an individual company within the basket.

Links in the name of each company take you to their website, if available. Links in the symbol of each company take you to their Bloomberg business bio page, if available.

16 Japanese Bargain Shares (Net-Nets, Net Cash and Cash Value)

Name: Sakai Trading

Symbol: 9967

Industry/product: imports, exports, and wholesales chemical products, synthetic resins, and electronic materials

Market Cap (Ym): 2,210

Share price (Y): 235

Debt (Ym): 0

Cash (Ym): 2,851

EV/EBIT (10yr avg): 12.3x

NCAV (Ym): 4,973

 

Name: Shinko Shoji Co. Ltd

Symbol: 8141

Industry/product: sells electronic parts and equipment such as integrated circuits (IC) and semiconductor devices, liquid crystal (LC) display modules, condensers, ferrite cores, coils, power supplies, thin film transistor (TFT) thermal printers, head magnets, transformers, motors, sensors, and connectors

Market Cap (Ym): 16,905

Share price (Y): 625

Debt (Ym): 3,000

Cash (Ym): 10,610

EV/EBIT (10yr avg): 12x

NCAV (Ym): 41,899

 

Name: KSK Co Ltd

Symbol: 9687

Industry/product: develops computer software for various systems related to telecommunication and LSI (Large Scale Integration), provides data processing services for government and insurance group, sells OA (Office Automation) equipment and computer peripheral

Market Cap (Ym): 3,300

Share price (Y): 450

Debt (Ym): 0

Cash (Ym): 4,461

EV/EBIT (10yr avg): 1.6x

NCAV (Ym): 4,926

 

Name: Daichii Kensetsu

Symbol: 1799

Industry/product: constructs railways mainly for East Japan Railway, constructs infrastructure such as sewage facilities, tunnels, and waterways, builds commercial, institutional, and residential buildings

Market Cap (Ym): 15,124

Share price (Y): 685

Debt (Ym): 151

Cash (Ym): 17,230

EV/EBIT (10yr avg): 2.3x

NCAV (Ym): 19,099

 

Name: Choukeizai Sha

Symbol: 9476

Industry/product: publishes economics, finance, law, accounting, and tax related books and periodical magazines and business related books, operates a planning center which handles advertising on publishes, provides design & production services for sales promotion pamphlets

Market Cap (Ym): 1,434

Share price (Y): 326

Debt (Ym): 0

Cash (Ym): 2,501

EV/EBIT (10yr avg): -0.1x

NCAV (Ym): 2,933

 

Name: CLIP Corp

Symbol: 4705

Industry/product: operates a network of cram schools in Nagoya, operates soccer school and lunch box delivery services

Market Cap (Ym): 4,022

Share price (Y): 886

Debt (Ym): 0

Cash (Ym): 5,029

EV/EBIT (10yr avg): 0.1x

NCAV (Ym): 4,196

 

Name: Noda Screen

Symbol: 6790

Industry/product: processes electrical components such as plastic package substrates and printed circuits boards (PCBs), through a subsidiary, manufactures and sells screen stencils and fluoride chemical products

Market Cap (Ym): 2,849

Share price (Y): 27,000

Debt (Ym): 0

Cash (Ym): 3,641

EV/EBIT (10yr avg): -0.2x

NCAV (Ym): 4,146

 

Name: Kitakei Co Ltd

Symbol: 9872

Industry/product: wholesales housing materials and home furnishings based in the Kansai area, sells housing facility products such as bathroom units, wooden building materials, special wooden products, housing equipment, veneer boards, chemical products, and housing preservative agents

Market Cap (Ym): 2,963

Share price (Y): 296

Debt (Ym): 0

Cash (Ym): 5,045

EV/EBIT (10yr avg): 16.8x

NCAV (Ym): 5,133

 

Name: Ryosan Co Ltd

Symbol: 8140

Industry/product: distributes electronic components, such as integrated circuits (ICs), electronic tubes, semiconductor elements, and personal computers, manufactures heat sinks

Market Cap (Ym): 47,582

Share price (Y): 1,387

Debt (Ym): 172

Cash (Ym): 36,452

EV/EBIT (10yr avg): 7x

NCAV (Ym): 92,515

 

Name: Daiken Co

Symbol: 5900

Industry/product: manufactures and sells metal and other material parts for building construction and exterior products including curtain rails, exterior panels, garages, and bicycle parking units, provides installation of these products and real estate leasing service

Market Cap (Ym): 2,245

Share price (Y): 376

Debt (Ym): 0

Cash (Ym): 1,753

EV/EBIT (10yr avg): 5.4x

NCAV (Ym): 4,375

 

Name: Ryoyo Electro Corporation

Symbol: 8068

Industry/product: wholesales electronic components including semiconductors, sells workstations, personal computers, and printers, operates offices in Singapore and Hong Kong, trades semiconductors from Mitsubishi Electric

Market Cap (Ym): 22,205

Share price (Y): 771

Debt (Ym): 0

Cash (Ym): 28,443

EV/EBIT (10yr avg): 1.6x

NCAV (Ym): 54,847

 

Name: Nihon Dengi

Symbol: 1723

Industry/product: designs, constructs, and maintains integrated building management systems for air-conditioning, security, and electrical facilities, develops integrated production systems for industrial factories

Market Cap (Ym): 4,805

Share price (Y): 586

Debt (Ym): 0

Cash (Ym): 6,313

EV/EBIT (10yr avg): 4.3x

NCAV (Ym): 8,613

 

Name: Odawara Engineering

Symbol: 6149

Industry/product: manufactures automatic coil winding machines including micro motor, coreless motor, universal motor, and stepping motor type, provides reconstruction, repair, and parts replacement services for its winding machines

Market Cap (Ym): 4,154

Share price (Y): 650

Debt (Ym): 0

Cash (Ym): 5,411

EV/EBIT (10yr avg): 2x

NCAV (Ym): 6,423

 

Name: Natoco Co Ltd

Symbol: 4627

Industry/product: manufactures and sells various types of paints including paints for metals, building materials, and auto repair, manufactures high polymer compounds which are used as material for liquid crystal displays

Market Cap (Ym): 4,414

Share price (Y): 603

Debt (Ym): 0

Cash (Ym): 5,403

EV/EBIT (10yr avg): 5x

NCAV (Ym): 6,967

 

Name: Fuji Oozx

Symbol: 7299

Industry/product: manufactures automobile engine parts such as valves, valve adjusters and rotators, has subsidiaries in Korea, Taiwan, and the United States

Market Cap (Ym): 6,189

Share price (Y): 301

Debt (Ym): 0

Cash (Ym): 6,884

EV/EBIT (10yr avg): 1.6x

NCAV (Ym): 11,623

 

Name: Excel Co Ltd

Symbol: 7591

Industry/product: sells electronic products, such as liquid crystal devices (LCD), semiconductors, and integrated circuits (IC), including thin film transistor (TFT) modules, TFT-LCDs, cellular phones, car navigation systems

Market Cap (Ym): 6,208

Share price (Y): 683

Debt (Ym): 0

Cash (Ym): 6,679

EV/EBIT (10yr avg): 4.7x

NCAV (Ym): 18,574

 

Total Basket

Market Cap (Ym): 129,974

EV (Ym): -15,499

10yr avg EBIT (Ym): 27,046

Debt (Ym): 3,323

Cash (Ym): 148,796

NCAV (Ym): 291,244

EV/EBIT (10yr avg): -0.57x

P/NCAV: 0.45x

P/Net cash: 0.89x

P/Cash: 0.87x

EBIT yield (EBIT/Mkt Cap): 21%

 

Representative Company (Avg)

Market Cap (Ym): 8,123

EV (Ym): -969

10yr avg EBIT (Ym): 1,690

Debt (Ym): 208

Cash (Ym): 9,300

NCAV (Ym): 18,203

Notes – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

• Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
• For a quick comparison, look at:
  • Net income
  • FCF
  • Buybacks + dividends
• Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
• Then, sum all dividends and buybacks over the period, and all net income over the period
• Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
• Then, compare this to net income to see the ratio of earnings paid out to shareholders
• You can compare the growth in net income to retained earnings to get your average return on retained earnings
• Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
• You’re looking for the central tendency of return on retained earnings, whether it is approx:
  • 5%, bad business
  • 15%, good business
  • 30%, great business
• Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

• EV/EBITDA is the best ratio for understanding a business versus a corporate structure
• Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
• General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
• Low P/E and low P/B can be misleading as it often results in companies with high leverage
• P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
• The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
• Control buyers read notes; why use screens that force you to ignore them?
• FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
• EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
• No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
• Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
• “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
• Empirical evidence on ratios:
  • Which Price Ratio Outperforms the Enterprise Multiple? @ GreenBackd.com
  • Which Price Ratio Best Identifies Value Stocks? @ GreenBackd.com

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

• There is something wrong with believing a stock is never worth more than 15 times earnings
• “Growth is best viewed as a qualitative rather than a quantitative factor.”
• Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
• Buffett looks for:
  • Repeatable formula for success
  • Focus
  • Buybacks
• “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
• Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
• Recognizing the value of changes after they happen is important, not predicting them ahead of time
• You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
• Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

• The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
• Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
• Focusing too much on time could be a problem in net-net investing
• Two pieces of advice for net-net investing:
  • Put 100% of focus on buying and 0% on selling
  • Put 100% of focus on downside and 0% on upside
• Money is made in net-nets not by the valuing but by the buying and holding
• “You want to be there for the buyout.”
• The hardest part of net-net investing: waiting
• Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
• Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

• Shareholder composition can help explain why a stock is cheap
• A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
• Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
• Some companies go public as a PR ploy, so investors may be sleepy and inactive
• Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
• Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
• An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

• Info about Geoff Gannon
  • high school dropout
  • bought first stock at 14
  • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
  • over time, became more Buffett and less Graham
  • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
• I like a reliable business with almost no history of losses and a market leading position in its niche
• Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
  • You Can Be a Stock Market Genius (by Joel Greenblatt)
  • The Intelligent Investor (1949 Edition)
  • Hidden Champions of the Twenty-First Century
• Everything you need to know to make money snowball in the stock market:
  • The Berkshire/Teledyne stories
  • Ben Graham’s Mr. Market metaphor
  • Ben Graham’s margin of safety principle
  • “Hidden Champions of the 21st Century”
• Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
• Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
• There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
• One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
• Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
• Extreme concentration works, you can make a lot of money:
  • waiting for the buyout
  • having more than 25% of your portfolio in a stock when the buyout comes
• I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
• “There is a higher extinction rate in public companies than we are willing to admit.”
• Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes

Notes – A Compilation Of Ideas On Investing

Is Negative Book Value Bad?

• Negative equity itself is meaningless (could be good or bad)
• Compare net financial obligations to EBITDA
• Think of borrowed money as the price of time; ask yourself if you’d rather they borrow money or spend time
• Stocks in Geoff’s portfolio tend to:
  • have positive FCF
  • have unusually high ratios of FCF to reported earnings
  • buy back shares
  • pay dividends
  • have excess cash after the above
• “I have found I do not make good decisions when I have to juggle 10 or more opportunities in my head at once”
• “I don’t believe in taking a risk where I think if everything goes perfectly the upside is still going to be in the single digits”
• How much debt is too much debt is a separate issue from whether the debt is being used productively
• When soaring over the market trying to find bargains, these are useful as screening tools:
  • tangible book value
  • EV/EBITDA
• If an entire country’s market has a low P/TBV or EV/EBITDA, this is important to know; you can buy indexes on this info alone
• However, ultimately the following matter more:
  • liquidation value
  • market value
  • replacement value
  • Owner Earnings
• Move beyond being a record keeper — an accountant — and become an appraiser
• The assets that matter most on the balance sheet:
  • cash
  • investments
  • land
  • intellectual property
  • tax savings
  • legal claims
• Cash flow protection is much better than asset protection
• Businesses with special assets that are not separable from the operating business are most likely to not be reflected on the balance sheet and present hidden value
• Being in a strong, safe liquidating position does not necessarily mean you are in a strong, safe operating position
• Working capital needs and capital spending needs are part of the DNA of a business; “you can’t turn a railroad into an ad agency”
• Negative equity itself is not a risk; poor interest coverage is
• Non-aggressive long-run return assumptions:
  • stocks – 8%
  • bonds – 4%
• When looking at companies with negative equity and stock buybacks, ask yourself the following:
  • Earnings yield of stock buybacks > interest rate on borrowed money?
  • Need to adjust financial obligations (such as unfunded pension liability) to determine true extent of liabilities?
  • Are net financial obligations (debt and pensions minus cash) a low enough multiple of their EBITDA?
  • How many years of FCF would it take to pay off all financial liabilities?
  • Is the price of the entire company in terms of EV/EBITDA low enough to justify investment?
  • How reliable is EBITDA, FCF, etc?
• Common concerns in these situations:
  • Moat not wide enough
  • High risk of technological obsolescence
  • No pricing power/cost cutting potential to support margins
• The right company can have negative equity and be investable if it is a wide moat business with almost no need for tangible investment:
  • Negative working capital
  • Minimal PP&E
  • A wide moat

Is It Ever Okay For A Company To Have No Free Cash Flow?

• Four cash flow measures:
  • Owner’s Earnings (most important)
  • EBITDA
  • CFO
  • FCF
• You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:
  • EBITDA is positive
  • CFO is positive
  • Net income is positive
• EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes
• Look for companies that are growing quickly in an industry that is not
• Avoid companies that are fast growing in a fast growing industry; it will face more competition every year
• To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:
  • Will they be competitive?
  • Will competitors over expand?
  • Do they have a moat?
• When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future
• “There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”
• Don’t short a great brand; if you want to short something, short a company:
  • with a product with inherently poor economics
  • a bad balance sheet
  • with deteriorating competitiveness
  • preferably in an industry with a high morality rate
• When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out

Value Investor Improvement Tip #1: Settle For Cheap Enough

• A lot of people look for:
  • lowest P/Es
  • lowest P/Bs
  • highest div yields
  • new lows
• This creates lists of companies that are quantitative outliers, instead of companies you know something about
• You should feel comfortable throwing out 7/10 names found on a screen
• Better to cast a wider net and then focus on companies you can learn a lot about by reading 10-Ks
• Try a screen that combines (Ben Graham-style):
  • above average div yield
  • below average P/E
  • below average P/B
  • fewest unprofitable years in their past
• Start with the company that sounds simplest, then move out slowly and carefully to those you understand less well; stop when you find something cheap that you know you can hold as long as it takes
• Another screen:
  • EV/EBITDA < 8
  • ROI > 10%
  • 10 straight years of operating profits
• You need a good reason for picking stocks that don’t meet this criteria
• It’s hard to figure out companies with a lot of losses in their past; so don’t try
• Familiarize yourself with a few stocks; what insiders have is familiarity
• You want to find companies where you can think more like an insider
• For long-term investing health, it’s better to find a slightly less cheap — but still cheap enough — stock you can get familiar with than a super cheap one that is a mystery
• Anything less than NCAV is cheap enough
• “Some of value investing is in the buying; most of value investing is in the holding; almost none of value investing is in the selling”

Notes – Sanborn Maps, Dempster Mills, Nintendo’s Rise

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

• Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
• Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
• By 1959, represented 35% of partnership assets
• Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
• Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
• Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
• In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
• Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
• The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
• Additionally, Buffett took a control position which gave him an added margin of safety
• Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

• In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
• Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
• Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
• Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
• Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
• Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
• Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
• Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
• Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
• Harry Bottle’s effect:
  • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
  • Correspondingly freed up capital for investments in marketable securities
  • Cut SG&A by 50%
  • Cut factory overhead expenses by 25%
  • Closed 5 unprofitable branches leaving the company with 3 profitable branches
  • Eliminated production lines tying up capital but producing no profits
  • Adjusted prices of repair parts to yield additional annual profits
• Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
• Other notes:
  • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
  • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
  • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

• Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
• The cost of video game consoles has been falling in real terms since the 1980s:
  • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
  • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
  • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
• Home video game systems were a growing market:
  • 1982, 17% of US households had a video game system
  • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
• Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
• Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
• Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
• Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metroid (1987), the first two of which were developed by hit designer Shigeru Miyamoto
• Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
  • Namco
  • Hudson (later acquired by Nintendo and brought in-house)
  • Taito
  • Konami
  • Capcom
  • Bandai
• By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
• Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
• On average, Japanese consumers bought 12 games for every Famicom system purchased
• Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
• NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
• By 1991, 100 licensees with only 10% of software development in-house at Nintendo
• Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
• NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
• WMT did not stock competing video game systems
• In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
• 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
• By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
• In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business

Notes – A Compilation Of Ideas On Investing

Why I’d Never Pay More Than Book Value For Nokia

• You hate to see a group of the top five companies of an industry where they entered the industry at different times; this implies companies are coming and going as they please
• You want the company you’re looking at to have a relatively high market share, ie, the company’s market share divided by the next closest competitor is high (1.5+)
• The first line of defense in competitive environments is having the most customers relative to the alternatives; being the preferred product
• As long as you believe a company’s competitive positions are lasting, you can buy the stock on a P/E basis

Ben Graham Net-Nets That Don’t File With The SEC

• The simplest way to separate safe net-nets from unsafe net-nets is the number of consecutive years of profits
• Profitable net-nets seem to be especially common candidates for abandoning the responsibilities of a public company without actually getting taken private
• If you can’t trust the controlling family, you can’t trust the auditors

Free Cash Flow Isn’t Everything

• Buffett-style approximation of unleveraged return on tangible equity: EBIT/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
• This represents the net investment; in the example of WMT, it represents their ability to finance $50B in productive assets at 0% interest
• Reinvestment in businesses with sustainable double-digit ROIs is superior to receiving dividends (thanks to higher FCF)
• It is harder to find companies who can earn high returns on unlevered equity and increase the size of that tangible equity over time than it is to find companies who can earn high returns on unleveraged tangible equity
• For looking at return on invested tangible assets: EBITDA/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
  • then, go back 15-20 years and find range, median, etc.
  • examine how much tends to be converted to net income or FCF to get an idea of profitability
• FCF != Owner’s Earnings; only counting the cash available after a company grows will result in you passing up many good, growing businesses simply because they’re growing
• If a company is earning good returns on their investments, it’s okay for them to not produce a lot of FCF
• Businesses you’re investing in for profitable future growth should be 150% of the growth you think you could provide with another use of the money; the 50% represents margin of safety in your future compounding
• Over time, more reliable returns compound better than less reliable returns
• The most reliable ROIs tend to be in businesses built around a habit
• Habits are the first line of defense in a business
• The best business defenses involve:
  • defending specific customers
  • defending specific locations
  • defending specific times
• Buffett’s favorites are business which:
  • have pricing power
  • have the lowest costs (can operate profitably at margins competitors can not)
• Your return in a good business, held forever, depends on:
  • Growth; what quantity of earnings are you purchasing today?
  • ROI; how much room is there for reinvesting those earnings in the future?
  • Earnings yield; what will you earn on those reinvested earnings?

Earnings Yield or Free Cash Flow Yield: Which Should You Use?

• Look to the story of Hetty Green; don’t put more into an asset unless the return you can get from that addition is better than what you could get elsewhere
• A company that grows value doesn’t have to pay anything out; with real Owner’s Earnings, no FCF is necessary
• FCF is useful for determining how much money is available for:
  • Dividends
  • Stock buybacks
  • Debt repayment
  • Acquisitions
• In this case, use FCF/Market Cap to determine your “equity coupon”
• Owner’s Earnings is useful for determining: How much bigger will my snowball get this year?
• OE are just as valuable as FCF if and only if the future return on retained earnings is comparable to the average of the past; the wider the moat, the more reliable the historical average is
• If you think you can earn 10% in your brokerage account:
  • a company earning 12% unlevered returns on tangible net assets is probably a wash and it’d be better if they gave them to you
  • but a company earning 20% is a different beast altogether– you’re probably better off letting them compound your money for you
• If you know ROI will stay above what you could achieve yourself, use a P/E type measure (or EV/EBIT or EV/EBITDA, depending on accounting) to price the stock, don’t use FCF
• Valuing businesses by ROI:
  • By earnings; reliably above average returns on investment
  • By FCF; consistent companies with a mixed or impossible to evaluate ROI situation
  • By tangible book; inconsistent companies with an unreliable or poor ROI situation
• Stated another way:
  • Good, reliable companies are snowballs; worth what it can grow as it travels downhill; dynamic
  • Mixed, reliable companies are waterfalls; worth the rate of its flow; constant
  • Unreliable, bad companies are rocks; worth its weight; static
• Remember– assets produce earnings; earnings become assets; the process repeats
• Ask yourself:
  • What is the sustainable rate of cash removable from the business?
  • What is the value added or subtracted from the business by the resource use decisions of management?
• Assume that retained earnings at subpar businesses to be worth less than their stated amount; similarly, retained earnings at above average businesses are worth every penny
• With great businesses with favorable long-term prospects, treat earnings as FCF; it’s fine to use the earnings yield
• Never make the mistake of thinking depreciation is a provision for the future; it’s a spreading out of the past
• At bad businesses, cash is worth much more than inventory, receivables, property, etc.; in these cases, don’t use earnings yield, use FCF yield and asset value

How To Analyze Net-Nets Undergoing Change

• As part of a group, you can easily invest in businesses undergoing change
• “Managers rarely rush to evacuate excess capital from a sinking ship. Usually, they’re still there trying to save the wreck.”
• It’s generally better to invest in a corporation undergoing change than a business undergoing change
• With changing customer habits, it can be nearly impossible to predict future earnings
• I require at least ten years of history before investing in a company for any reason other than its cash; prefer 15-20 years of history whenever possible
• Overcapitalized companies undergoing change are good stocks to follow
• Worldwide, there are fewer investors looking at Swedish stocks than US stocks; that’s an advantage if you’re looking at Swedish stocks, so use it

What Broker To Use When Buying International Stocks (Gannon On Investing)

• Geoff uses a full service broker, but recommends Interactive Brokers or Noble Trading for most others looking to buy foreign stocks
• If going with a full service shop:
  • personally know a broker ahead of time
  • give him your account with a clear understanding of what it is you want to do; try to negotiate a flat, guaranteed commission structure so you know how much it’ll cost you and he knows you’re worth the trouble
  • a good rule of thumb is 1% per roundtrip trade; it’d be greedy for the broker to ask for more than 2%
• If a broker promised me it could buy any stock anywhere in the world for 2% of my assets per year, I’d take that deal
• I look at my cost in a stock on an after-commission basis
• “My broker won’t let me buy that stock” is never a valid excuse; if the broker won’t buy the stock, get a new broker
• “Ben Graham said investing is most intelligent when it’s most businesslike. Business often means work”
• Never let anything get in the way of buying the best bargains, especially not your broker

How To Find Cheap Foreign Stocks

• Online research process for finding foreign stocks:
  • Screen for stocks in specific countries using the FT Screener
  • Check the business description, EV/EBITDA, etc., at Bloomberg
  • Look at the 10-year financial history at MSN Money
  • Go to the company’s website and read their annual reports
• Bloomberg has the best worldwide coverage of stocks in their database
• A good screen to start with at FT.com is a single digit P/E screen– just scoop up the simplest, most obvious bargains
• Many European companies that aren’t too tiny trade in Germany
• Use Google Translate if you’re having language issues
• Beware of accounting differences:
  • US uses GAAP; insists on historical cost and does not permit revaluation of non-financial assets; in general, old US companies with lots of land and inventory (using LIFO) are more likely to contain “hidden assets”
  • RoW uses IFRS; PPE and investment property less likely to be carried on balance sheet at extremely low stated value; different way of valuing biological assets; never uses LIFO accounting for inventory; less likely to mask an asset’s liquidation value than GAAP
• Good screen in the US due to GAAP accounting for depreciation: (Accumulated Depreciation /Tangible Book Value) * (Tangible Book Value/Market Cap) > 1; shows you the cheapest stocks relative to what a competitor would pay to own their assets; produces a real Ben Graham-type list
  • should also add: Tangible Book Value > Total Liabilities
  • and: Net Income > 0
• Due to accounting differences, if you’re new to international investing, focus on earnings bargains, not asset bargains
  • It’s okay to buy companies that are cheap P/B if they have 10 yrs of consistent earnings
  • Otherwise, stick to low P/10yr avg earnings
• Low EV/EBITDA is good to use around the world as it erases some differences in accounting
• Good UK-specific screener– SharelockHolmes

How To Find Foreign Stocks: 13 Promising Companies From The U.K. (Gannon On Investing)

• I went to the London Stock Exchange website; then I browsed stocks alphabetically
• I was looking for potentially promising companies, regardless of price
• In other countries, I start by looking for good businesses I can understand; the bar is higher overseas
• Use the following process for finding promising companies:
  • At the LSE website:
    • clicked “fundamentals” tab
    • scrolled down to ROIC
    • looked for positive number in the double-digits
    • 20%+ ROIC over the last few years
  • Look the company up in Bloomberg
    • If you can’t understand the business description, throw it out
    • If it sounds like it has the potential to earn very high returns on capital, proceed
  • Looked up the annual report’s cash flow statement
    • CFO > CAPEX in each of the last several years
    • ie, should be generating FCF
  • For all the companies that qualify, download the past annual reports into a folder on desktop
  • Start reading annual reports from oldest to most recent
  • Then, appraise the value of the company, ideally without looking at the price first
    • 10x normal EBIT
    • 15x normal FCF
    • if the company is trading at least 25% below the value you appraised it at and you love the business, consider buying
• Searching alphabetically is an old school, Buffett way of stock research
• “Having to form your own opinions from scratch does wonders for investment analysis”; searching from scratch puts you in the best mindset to value a stock objectively
• Three dependable ways to turn up great stock ideas:
  • Go through a list from A to Z
  • Read value investing blogs
  • Direct, personal experience with the company
• Good UK value investing blogs:
  • Interactive Investor
  • 10 Value 10
  • UK Value Investor’s Diary
  • The Sunny Day Investor
• “My best investments come from stocks I study and pass on due to price, only to buy the same stock some 4 or 5 years later when it has its Salad Oil Scandal moment”

5 Japanese Net-Nets: And How To Analyze Them

• Net-net investing worked in actual practice in the 1930s and 1940s in the US; Japan is similar, but worse
• Price and value determine your returns based on four factors:
  • Earnings yield (price)
  • ROI (profitability)
  • Sales growth (growth)
  • Dividend yield (dividends)
• The lower the yield on the stock, the higher its earnings yield, growth and ROI need to be to justify investment
• Japan is experiencing deflation of -0.7% while the US is experiencing inflation of 2.9% so you need to add 3.6% to all Japanese yields to get the equivalent in real terms in the US
• A company’s real dividend yield is effectively a reduction in your hurdle rate
• Japan is a low/no growth economy, so it makes sense to pay out earnings as dividends or retain them as cash rather than tie them up in low-return, long-term investments such as PPE
• The margin of safety in Japanese net-nets is that the dividend yield is a payback unrelated to ROI
• With Japanese net-nets, you exchange low growth and low ROI for high dividend yields, deflation (rising cash value) and excess cash
• Japanese net-nets offer P/E around 10, dividend yield around 3% and net cash close to market cap, meaning you get three bets:
  • the value of the stock’s future retained earnings stream
  • the value of the stock’s future dividend stream
  • the value of the stock’s future cash pile deployment
• The biggest threat to Japanese net-nets is a decline in the value of the  yen; this is the best reason for passing on net-nets in Japan
• “If half my money is in dollars and half is in something else and all 100% of my portfolio is in some of the cheapest stuff on earth– my results will be fine… over time”
• The US in the 1930s is the best illustration of what net-net investing in Japan is like
• “I prefer a lot of uncertain opportunities to make money over time to one seemingly certain exit strategy”
• The quality of net-nets in the US is not as good as in Japan; most US net-nets are extremely unsafe; this is a consequence of a few good years in the stock market