Review – Common Stocks And Uncommon Profits

Common Stocks and Uncommon Profits: And other writings by Philip A. Fisher

by Philip A. Fisher, published 1996, 2003

Stock market investors who have studied Warren Buffett in detail know that he has cited two “philosophers” of investment theory more than anyone else in being influential in the formation of his own investment approach: Benjamin Graham and Phil Fisher. Graham represents the cautious, conservative, balance sheet-driven Buffett, while Fisher represents the future-oriented, growth-focused, income statement-driven Buffett. If you ask Buffett, while Graham got him started and taught him key lessons in risk management (Margin of Safety and the Mr. Market metaphor), Fisher was the thinker who proved to have the biggest impact in both time and total dollars accumulated. Buffett today, whether by choice or by default due to his massive scale, is primarily a Phil Fisher-style investor.

And yet, in my own investment study and practice, I have dwelled deeply on Graham and did little if anything with Fisher. I tried to read Fisher’s book years ago when I was first starting out and threw my hands up in disgust. It seemed too qualitative, too abstract and frankly for a person of my disposition, too hopeful about the future and the endless parade of growth we’ve witnessed in the markets for several decades since the early 1980s. Surely there would be a time where the Fisher folks would hang their heads in shame and the Grahamites would rise again in the fires of oblivion! After all, “Many shall be restored that are now fallen and many shall fall that are now in honor.”

As my professional career wore on, however, I found there was less and less I could do with Graham and more and more of what Fisher had said that made sense. And if you’re in business, you can’t help but be growth oriented– buying cheap balance sheets isn’t really the way the world works for the private investor. So, I decided it was time to take another look at Fisher’s book and see what I could derive from it as an “older and wiser” fellow. What follows is a review of Part I of the book; I plan to read and review Part II, which is a collection of essays entitled “The Conservative Investor Sleeps Well At Night”, separately.

Keep Your Eye On The Future

One thing I noticed right away is the consistent theme of future-orientation throughout Fisher’s book. Whereas balance sheets and the Graham approach look at what has happened and what is, Fisher is always emphasizing a technique that involves conceptualizing the state of the future. For example, in the Preface he states that one of the most significant influences on his own investment results and those of other successful investors he was aware of was,

the need for patience if big profits are to be made from investment.

“Patience” is a reference to time preference, and time preference implies an ability to envision future states and how they differ from the present and therein see the arbitrage available between the two states. The other key he mentions is being a contrarian in the market place, which sounds a lot to me like the lesson of Mr. Market.

Fisher also says that market timing is not a necessary ingredient for long-term investment success,

These opportunities did not require purchasing on a particular day at the bottom of a great panic. The shares of these companies were available year after year at prices that were to make this kind of profit possible.

While he cites the structural inflationary dynamic of the modern US economy and seems to suggest the federal government’s commitment to responding to business cycle depressions with fiscal stimulus puts some kind of ultimate floor under US public company earnings (unlike in Ben Graham’s time where large companies actually faced the threat of extinction if they were caught overextended in the wrong part of the cycle, Fisher suggests the federal government stands ready to create conditions through which they can extend their debt liabilities and soldier on), he says that the name of the game over the long-term is to find companies with remarkable upside potential which are, regardless of size, managed by a determined group of people who have a unique ability to envision this potential and create and execute a plan for realizing it. In other words, the problem of investing is recognizing strong, determined management teams for what they are, that is, choosing superior business organizations in industries with long runways.

Getting the Goods: The Scuttlebutt Approach

People who know about Fisher typically identify him with the “scuttlebutt approach”. Fisher says scuttlebutt can be generated from:

  • competitors
  • vendors
  • customers
  • research scientists in universities, governments and competitive companies
  • trade association executives
  • former employees (with caveats)

Before one can do the scuttlebutt, however, one has to know where to look. Fisher says that “doing these things [scuttlebutt] takes a great deal of time, as well as skill and alertness […] I strongly doubt that [some easy, quick way] exists.” So, you don’t want to waste your time by going to all the trouble for the wrong idea. He says that 4/5 of his best ideas and 5/6 of the total gains generated over time that he could identify originated as ideas he gleaned from other talented investors first, which he subsequently investigated himself and found they fit the bill. Now, this is not the same thing as saying 4/5 ideas he got from others were worth investing in– the proportion of “good” ideas of the “total” he heard about is probably quite low, but the point again is not quantitative, but qualitative. He’s talking about where to fish for ideas, not how successful this source was.

When I thought about this section, I realized the modern day equivalent was investment bloggers. There are many out there, and while some are utter shit (why does this guy keep kidding himself?) some are quite amazing as thinkers, business analysts and generators of potential ideas. I have too many personal examples of my own here to make mention of them all. But I really liked this idea, cultivating a list of outstanding investment bloggers and using that as your primary jumping off point for finding great companies. The only problem for me in this regard is most of my blogroll are “value guys” that are digging in the trash bins (as my old boss sarcastically put it), whereas to find a Fisher-style company I would need to find a different kind of blogger interested in different kind of companies. But that’s a great to-do item for me to work on in this regard and should prove to be highly educational to boot!

So, assuming you’ve got a top notch idea, what’s next? Fisher is pretty clear here: do not conduct an exhaustive study of the company in question just yet. (In other words, don’t do this just yet, though I loved SoH’s follow-up where he explained what kind of things would get him to do that.) What he does do is worth quoting at length:

glance over the balance sheet to determine the general nature of the capitalization and financial position […] I will read with care those parts covering breakdown of total sales by product lines, competition, degree of officer or other major ownership of common stock […] all earning statement figures throwing light on depreciation, profit margins, extent of research activity, and abnormal or non-recurring costs in prior years’ operations

Then, if you like what you see, conduct your scuttlebutt, because,

only by having what “scuttlebutt” can give you before you approach management, can you know what you should attempt to learn when you visit a company […] never visit the management of a company [you are] considering for investment until [you have] first gathered together at least 50 per cent of all knowledge [you] would need to make the investment

This is the part that really gives a lot of investors pause about Phil Fisher’s approach, including me. Can you really do scuttlebutt, as he envisions it, in the modern era? Can the average investor get the ear of management? Does any of this stuff still apply?

First, some skepticism. Buffett’s biographer Alice Schroeder has said in interviews that much of what made Buffett successful early on in his career is now illegal and would amount to insider trading. The famous conversation with the GEICO chief is one of many that come to mind. This was classic scuttlebutt, and it worked amazingly well for Buffett. And even if it wasn’t illegal, most individual investors are so insignificant to a company’s capital base that they can’t expect nor will they ever receive the ear of management (unless they specialize in microcap companies, but even then management may be disinterested in them, even with significant stakes in their company!) And, assuming they DO somehow get management’s ear, they aren’t liable to learn much of value or interest specifically because most managements today are not only intellectually and politically sophisticated, but legally sophisticated and they are well aware that if they say anything more general than “We feel positive about our company” they’re liable to exposure under Reg FD. This seems like a dead end.

But let me try to tease the idea out a little more optimistically. Managements do provide guidance and color commentary on quarterly earnings calls, and if you are already dealing with a trustworthy, capable management (according to the 15 points outlined below), then there is opportunity to read between the lines here, even while acknowledging that there are many other people doing the same with this info. And people who do get managements’ ear are professional analysts employed by major banks. Again, lots of people read these reports, but there is some info here and it adds color and sometimes offers some “between the lines” information some might miss. And while the information you can get from any one company may be limited, by performing this analysis on several related companies you might be able to fill in some gaps here and there to the point that you can get a pretty fair picture of how the target company stacks up in various ways.

I hesitate a little, but I think the approach can be simulated to a fair degree even today. It’s still hard work. It can’t be done completely, or perhaps as Fisher imagined it. But I think it can be done. And it still comes down to the fact that, even with all this info that is out there, few will actually get this up close and personal with it. So, call it an elbow-grease edge.

After all,

Is it either logical or reasonable that anyone could do this with an effort no harder than reading a few simply worded brokers’ free circulars in the comfort of an armchair one evening a week? […] great effort combined with ability and enriched by both judgment and vision [are the keys to unlocking these great investing opportunities] they cannot be found without hard work and they cannot be found every day.

The Fisher 15

Fisher also is known for his famous 15 item investment checklist, a checklist which at heart searches for the competitive advantage of the business in question as rooted in the capability of its management team to recognize markets, develop products and plans for exploiting them, execute a sales assault and finally keep everything bundled together along the way while being honest business partners to the minority investors in the company. Here was Fisher’s 15 point checklist for identifying companies that were highly likely to experience massive growth over decades:

  1. Does the company have sufficient market scale to grow sales for years?
  2. Is management determined to expand the market by developing new products and services to continue increasing sales?
  3. How effective is the firm’s R&D spending relative to its size?
  4. Is the sales organization above-average?
  5. Does the company have a strong profit margin?
  6. What is being done to maintain or improve margins? (special emphasis on probable future margins)
  7. What is the company’s relationship with employees?
  8. What is the company’s relationship with its executives?
  9. Is the management team experienced and talented?
  10. How strong is the company’s cost and accounting controls? (assume they’re okay unless you find evidence they are not)
  11. Are there industry specific indications that point to a competitive advantage?
  12. Is the company focused on short or long-term profits?
  13. Can the company grow with its own capital or will it have to continually increase leverage or dilute shareholders to do it?
  14. Does the management share info even when business is going poorly?
  15. Is the integrity of the management beyond reproach? (never seriously consider an investment where this is in question)

What I found interesting about these questions is they’re not just good as an investment checklist, but as an operational checklist for a corporate manager. If you can run down this list and find things to work on, you probably have defined your best business opportunities right there.

In the chapter “What to Buy: Applying This to Your Own Needs”, Fisher attempts to philosophically explore the value of the growth company approach. First, he tries to dispel the myth that this approach is only going to serve

an introverted, bookish individual with an accounting-type mind. This scholastic-like investment expert would sit all day in undisturbed isolation poring over vast quantities of balance sheets, corporate earning statements and trade statistics.

Now, this is ironic because this is actually exactly how Buffett is described, and describes himself. But Fisher insists it is not true because the person who is good at spotting growth stocks is not quantitatively-minded but qualitatively-minded; the quantitative person often walks into value traps which look good statistically but have a glaring flaw in the model, whereas it is the qualitative person who has enough creative thinking power to see the brilliant future for the company in question that will exist but does not quite yet, a future which they are able to see by assembling the known qualitative facts into a decisive narrative of unimpeded growth.

Once a person can spot growth opportunities, they quantitatively have to believe in the strategy because

the reason why growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

And indeed, it is. While great growth stocks might be a rarer find, they return a lot more and over a longer period of time. To show equivalent returns, one would have to turnover many multiples of incredibly cheap bargain stocks. So this is the philosophical dilemma– fewer quality companies, fewer decisions, and less room for error in your decisions with greater return potential over time, or many bargains, many decisions, many opportunities to make mistakes but also less chance that any one is critical, with the concomitant result that your upside is limited so you must keep churning your portfolio to generate great long-term results.

Rather than being bookish and mathematically inclined (today we have spreadsheets for that stuff anyway), Fisher says that

the successful investor is usually an individual who is inherently interested in business problems. This results in his discussing such matters in a way that will arouse the interest of those from whom he is seeking data.

And this still jives with Buffett– it’s hard to imagine him boring his conversation partner.

Timing Is Everything?

So you’ve got a scoop on a hot stock, you run it through your checklist and you conduct thorough scuttlebutt-driven due diligence on it. When do you buy it, and why?

to produce close to the maximum profit […] some consideration must be given to timing

Oh no! “Timing”. So Fisher turns out to be a macro-driven market timer then, huh? “Blood in the streets”-panic kind of thing, right?

Wrong.

the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages.

So what kind of timing are we talking about then? To Fisher, the kind of timing that counts is individualistic, idiosyncratic and tied to what is being qualitatively derived from one’s scuttlebutt. Timing one’s purchases is not about market crashes in general, but in corporate missteps in particular. Fisher says:

the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.

He continues,

[the common denominator in several outstanding purchasing opportunities was that ] a worthwhile improvement in earnings is coming in the right sort of company, but that this particular increase in earnings has not yet produced an upward move in the price of that company’s shares

I think this example with Bank of America (which I could never replicate because I can’t see myself buying black boxes like this financial monstrosity) at Base Hit Investing is a really good practical example of the kind of individual company pessimism Phil Fisher would say you should try to bank on. (Duh duh chhhhh.)

He talks about macro-driven risk and says it should largely be ignored, with the caveat of the investor already having a substantial part of his total investment invested in years prior to some kind of obvious mania. He emphasizes,

He is making his bet upon something which he knows to be the case [a coming increase in earnings power for a specific company] rather than upon something about which he is largely guessing [the trend of the general economy]

and adds that if he makes a bad bet in terms of macro-dynamics, if he is right about the earnings picture it should give support to the stock price even in that environment.

He concludes,

the business cycle is but one of at least five powerful forces [along with] the trend of interest rates, the over-all government attitude toward investment and private enterprise [quoting this in January, 2017, one must wonder about the impact of Trump in terms of domestic regulation and taxation, and external trade affairs], the long-range trend to more and more inflation and — possibly most powerful of all — new inventions and techniques as they affect old industries.

Set all the crystal ball stuff aside– take meaningful action when you have meaningful information about specific companies.

Managing Risk

Fisher also gives some ideas about how to structure a portfolio of growth stocks to permit adequate diversification in light of the risk of making a mistake in one’s choices (“making at least an occasional investment mistake is inevitable even for the most skilled investor”). His example recommendation is:

  • 5 A-type, established, large, conservative growth companies (20% each) -or-
  • 10 B-type, medium, younger and more aggressive growth companies (10% each) -or-
  • 20 C-type, small, young and extremely aggressive/unproven growth companies (5% each)

But it is not enough to simply have a certain number of different kinds of stocks, which would be a purely quantitative approach along the lines of Ben Graham’s famous dictums about diversification. Instead, Fisher’s approach is again highly qualitative, that is, context dependent– choices you make about balancing your portfolio with one type of stock require complimentary additions of other kinds of stocks that he deems to offset the inherent risks of each. We can see how Buffett was inspired in the construction of his early Buffett Partnership portfolio weightings here.

For example, he suggests that one A-type at 20% might be balanced off with 2 B-type at 10% each, or 6 C-type at 5% each balanced off against 1 A-type and 1 B-type. He extends the qualitative diversification to industry types and product line overlaps– you haven’t achieved diversification with 5 A-types that are all in the chemical industry, nor would you achieve diversification by having some A, B and C-types who happen to have competing product lines in some market or industry. For the purposes of constructing a portfolio, part of your exposure should be considered unitary in that regard. Other important factors include things like the breadth and depth of a company’s management, exposure to cyclical industries, etc. One might also find that one significant A-type holding has such broadly diversified product lines on its own that it represents substantially greater diversification than the 20% portfolio weighting it might represent on paper. (With regards to indexation as a strategy, this is why many critics say buying the S&P 500 is enough without buying “international stock indexes” as well, because a large portion of S&P 500 earnings is derived from international operations.)

While he promotes a modicum of diversification, “concentration” is clearly the watchword Fisher leans toward:

the disadvantage of having eggs in so many baskets [is] that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them […] own not the most, but the best […] a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Tortured egg basket metaphors aside (why on earth do people care what their egg baskets look like?!), Fisher is saying that the first mistake one can make is to spread your bets so thin that they don’t matter and you can’t efficiently manage them even if they did.

Aside from portfolio construction, another source of risk is the commission of errors of judgment.

when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed

one should sell their holdings, lick their wounds and move on. This needs to be done as soon as the error is recognized, no matter what the price may be:

More money has probably been lost by investors holding a stock they really did not want until they could “at least come out even” than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.

Further,

Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to the fifteen points… to about the same degree it qualified at the time of purchase […] keep at all times in close contact with the affairs of companies whose shares are held.

One vogue amongst certain investors is to be continually churning the portfolio from old positions to the latest and greatest idea, with the assumption being that time has largely run its course on the earlier idea and the upside-basis of the new idea is so much larger that liquidity should be generated to get into the new one. Fisher advises only using new capital to pursue new ideas rather than giving in to this vanity because,

once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all

The concept of “investment” implies committing one’s resources for long periods of time. You can’t emulate this kind of trading activity in the private market, which is a very strong indication that you should try to avoid this behavior in public markets. A particularly costly form of this error is introducing macro-market timing into one’s portfolio management, ie, this stock has had a big run up along with the rest of the market, things are getting heady, I will sell and get back in at a lower cost. I’ve done this myself, most recently with Nintendo ($NTDOY) and even earlier with Dreamworks ($DWA). Fisher says it’s a mistake:

postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly […] if the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 per cent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later.

It plays to a logical fallacy that a company that has run up has “expended” its price momentum, while a company that has not had a run-up has something “due” to it. On the contrary, Fisher points out that many times the material facts about a company’s future earnings prospects change significantly over time from the original purchase, often to the good, such that even with a big run-up, even more is in the offing because the future is even brighter than before– remember, always keep an eye on the future, not the present or the past!

And similarly, if one has an extremely cheap cost basis in a company, one has an enormous margin of safety that should give further heed to trying to jump in and out of the stock when it is deemed to be overvalued.

He adds that, like wines, well-selected portfolio holdings get better with age because,

an alert investor who has held a good stock for some time usually gets to know its less desirable as well as more desirable characteristics

and through this process comes to develop even more confidence in his holdings.

If you’ve read some of my thinking about the philosophy of building multi-generational wealth through a family business, you’ll see once again the direct parallel to private market investing in Fisher’s conclusion:

If the job has been correctly done when a common stock is purchased, the time to sell it is– almost never.

Conclusion

Distilling Part I down to its essence, I concluded that the most important skill for generating long-term gains from one’s investing is still about having a disciplined and consistent investment program followed without interruption and in the face of constantly nagging self-doubt (“In the stock market a good nervous system is even more important than a good head.”) The particular program that Fisher recommends be followed is to:

  1. Create a network of intelligent investors (bloggers) from which to source ideas
  2. Develop a strong scuttlebutt skill/network to develop superior investment background
  3. Check with management to confirm remaining questions generated from the 15 step list
  4. With the conviction to buy, persevere in holding over a long period of time

If you can’t do this, you probably shouldn’t bother with the Fisher approach. Whether it can be done at all is an entirely separate matter.

Another Story About The ER

The following is an email sent by a friend who reads the blog in response to the recent posts about my visit to the ER. It is about an experience he had with his infant daughter and I got his permission to share it as it is illustrative of many of the principles touched upon in my earlier posts:

When [my baby] was 9 days old she presented with what appeared to be an infection in her right eye (eye lid swelling, puss coming out the side, dark skin around the eye [picture attachment omitted]).

I think we waited overnight (details are a little fuzzy now that it’s been over 2 years) before doing anything because we were hoping it would resolve itself without having to go to a doctor, who might urge us to go to the ER, which we wanted to avoid if at all possible.

The next day it didn’t look better so we took her to the pediatrician, who was particularly concerned and brought another doctor into the room to examine her, we expressed our concern that we really didn’t want to go to the ER if at all possible, both doctors said we should go. They were concerned “because she’s so young” and “because the infection is so close to the brain.”

We got to the ER and it took for fucking ever to even get a room, of course you’re shoved into a massive environment of sick people dying to infect you with god knows what disease they have from living a terrible unhealthy life. It was literally like 6 hours before we finally got a room. At this point it was late at night and I kept thinking, “man, her eye looks better, if it looked like this 6 hours ago I don’t think we would’ve been sent to the ER.”

But the doctors kept saying shit like, “yeah we’ve seen things look better but actually be getting worse.”

The doctors wanted to do a blood test to see what the infection was and start her immediately on IV antibiotics. Additionally, they wanted to do a spinal tap (some advanced way of determining what the infection might be). I wanted to push the IV antibiotics back until we knew what the infection might be (as the results of a blood test might indicate), but they kept pushing and saying, “these things can move fast, we really think you should get IV antibiotics ASAP.”

Eventually we caved and agreed to the IV antibiotics (which was an awful experience in their own right because [my baby] was so small, and her veins were difficult to find, took literally 4 practitioners before they could finally access her vein — [my baby] was screaming like crazy and we were saying, “can’t you find someone else to do it?” And the girl said, “don’t feel bad, she won’t remember it.” Who says that?!) As a side note, god forbid you have to go through something like this, but if you do immediately ask for a practitioner from the neonatal intensive care unit (NICU) to insert any IV into your child, they can find a needle in a haystack.

At this point they were still pushing for a spinal tap and I said, “If the blood results come back negative, is there ANY reason to do a spinal tap?” The doctor said typically no. I said, “Well let’s see what the blood results say then.” The results came back negative, so I said I’m not doing the spinal tap. The doctor kept saying, “well, sometimes things can slip by the blood tests.” But I refused. I left to go home and get changes of clothes for me and [my wife] since we didn’t realize we’d be at the hospital for 2 days, and while I was gone [my wife] said that they sent in some other doctor (female this time) to pull at her emotions to try and get her to agree to a spinal tap, but she refused, we didn’t do it — the infection just looked so much better already (even before the god damned antibiotics).

We stayed with [my baby] in the hospital like 36 hours, during that time we were regaled with fantastical tales of babies contracting Hep B and why we should really give her the Hep B vaccine. I kept asking the doctor to give me a realistic example of how [my baby] would contract Hep B at this age. His examples were literally so absurd they’re not even worth typing them, one involved a syringe with Hep B on it being mistakenly inserted into [my baby] by someone in the hospital, it was so ridiculous I could barely listen to it. We didn’t get her a Hep B vaccine, and still haven’t, and she’s miraculously Hep B free! I also mentioned to the doctor, “even if we agreed that [my baby] should get a Hep B vaccine soon, wouldn’t this be a BAD time to give it to her given that she’s obviously fighting off some infection?” The doctor wasn’t fazed by this logic, they’re total vaccine zealots, they’d vaccinate a cadaver given the opportunity.

In any case, in thinking back on the whole situation and what I would do differently, I think I would just wait an extra few hours before going to see the doctor, and when it looked better pre-IV antibiotics, I would’ve said, “let’s wait another few hours and see how she’s doing.” I just don’t buy their insane logic that something is visibly getting better but somehow actually getting worse. I’m sure there’s some textbook case of this happening to 1 in 1,000,000 babies, but doesn’t seem worth the known risks of IV antibiotics at such a young age.

It’s so sad and frustrating that you can’t simply take a doctor’s advice and trust that he’s already thoroughly immersed himself in the risks and benefits of the trade-offs between treatment / non-treatment. All they know is how to limit their own legal liability.

Hopefully you can avoid such a mess from happening to you!

He adds in an addendum:

Since doctors in large hospitals work in shifts, you naturally see the same doctor for awhile, and then see a new doctor for awhile. When it was time for [my baby] to be released, we were given an older doctor (maybe late 50s, early 60s). Not only was he WAY more respectful than pretty much every previous doctor we had, but he literally said something to the effect of, “if you’d gotten an older doctor, you may never have been admitted to the hospital, probably would’ve suggested you wait and see how the infection progressed.”

It seems that the doctors being minted today are inculcated with one-off horror stories starting on day 1 of their education.

Sorry, The Economy Is Officially Closed

One way to describe what I do for a living is “capital allocation.” Really, I am like an internal strategic consultant to a family business (a family of which I am a part) so there is more to it than that, but thinking about where to put our capital is one of the primary functions I serve.

One interesting problem to have when one owns things of value is receiving bids on those things from people interested in buying them when you’re not sure you want to sell. The further above your own estimate of “fair value” their bid goes, the stronger the temptation to take advantage and sell your asset. It seems like a pretty straight forward problem to solve.

The only problem is the market context of the potential sale. Generally, if you’re in a position to get more than fair value for what you’re selling, you’re going to have a hard time finding another asset to buy where the seller isn’t facing the same dynamic. In other words, you can potentially sell one asset at an inflated price and buy another at an inflated price– you’re probably better off just holding on to what you have because there’s no arbitrage in that and it could very well cost you money in terms of frictional costs like brokerage commissions and taxes on imaginary capital gains.

One thing you could do is sell your asset at an inflated value and sit and wait in cash for a better buying opportunity. The problem with that is that cash is, currently, a seemingly barren asset. If you stuff your haul into T-Bills, you’re lucky to earn a few basis points every 90 days– it might as well be zero, and when you factor in the effect of inflation and those damned capital gains taxes once again, it probably is. You could go further out on the yield curve and buy some 10YR Treasury notes, but then you’re exposing yourself to substantial interest rate risk with yields flirting with historic lows.

Meanwhile, most asset owners are earning strong internal returns on their invested capital right now. Say you’re earning 20% a year on your investments, why would you sell them to collect 1.5% over the next 10 years while taking enormous interest rate risk? Or to collect zero for some unknown amount of time sitting in T-bills or cash in a savings account? Every year you stay invested, you get ahead by almost 20% more. Could the value of your investment really drop by that much?

The business cycle is an inevitable fact of owning and operating a business in a modern economy. The question is not could it, but when will it drop by that much, or more? For many business owners and investors, the waiting is the hardest part. Giving up 20% a year for some period of time and avoiding the risk of a 50-60% or greater decline in asset values just isn’t attractive. It isn’t even attractive when thinking about the fact that buying back those same assets at half price could potentially double your return on invested capital during the next boom, an interesting strategy for shortening the compounding time necessary to achieve legendary riches.

For many, this inevitable decline in asset prices is inconceivable. It’s embedded deeply in the fear of selling and going to cash. The implication of this premise is that the economy is officially closed to additional investment. Those who invested earlier in the cycle can stay inside and watch a magnificent show as they earn outstanding returns on their capital while the boom goes on. But for everyone who sold too early, or never bought in, they have to wait outside, indefinitely, and wonder what it’s like– the cost of admission is just too high.

What makes this a stable equilibrium? By what logic has a competitive market economy become permanently closed to new investment, or a change in asset values, or a change in ownership of assets? Under what set of premises could this condition last for a meaningful amount of time and leave people who sell now out in the cold, starving and bitter for returns on capital, forever, or for so long that they would be losing in real terms over time in making such a decision?

To me, this “new normal” is absurd. It is juvenile to believe that the economy is closed and no one else is getting in. It’s silly to think that the people willing to pay those astronomical prices for admission are making a good decision, that they’re going to have a comfy seat and years of entertainment, rather than paying more than full price for a show that’s about to come to an abrupt end. It’s a topsy-turvy world in which the reckless and courageous high-bidders are the ones who get rich. If paying too much for things was the path to riches, we’d all be there by now. I think when everyone’s perception of reality and value skews toward a logical extreme like this, we’re closer to the show being over than the show must go on.

In the meantime, sorry, the economy is officially closed.

Quotes – The Connection Between Time And Value

Nothing important comes into being overnight; even grapes and figs need time to ripen. If you say that you want a fig now, I will tell you to be patient. First, you must allow the tree to flower, then put forth fruit; then you have to wait until the fruit is ripe. So if the fruit of a fig tree is not brought to maturity instantly or in an hour, how do you expect the human mind to come to fruition, so quickly and easily?

~Epictetus

Review – Liberty Defined

Liberty Defined: 50 Essential Issues That Affect Our Freedom

by Ron Paul, published 2012

I have severely underestimated Ron Paul. When I was first learning about the philosophy of freedom over a decade ago, I jumped right into the enormous tomes on economic theory and moral philosophy and skipped the “practical politician” phase. It was only after I had immersed myself deeply in the theory that I became aware of Ron Paul and at that point I was such a purist intellectually that I felt affronted by a guy trying to get his hands dirty in politics. What was the point?

As I came to learn, the point, at least with Ron Paul, is simply to educate and better market liberty via a public platform. And while Ron Paul isn’t intellectually perfect, he’s pretty close. He writes readable and well-argued books on popular economic and political issues (I’ve read End the Fed and recommend it, I have not read The Revolution: A Manifesto) and since leaving public office he has started a Monday through Friday YouTube show, the Ron Paul Liberty Report, where he really pulls no punches in analyzing headline news issues and is even willing to delve into “conspiracy theories” and point out the activity of the Deep State. I’ve learned a lot in keeping up with the show not only in terms of what’s going on and how different events are connected but in how to better form arguments about the principles involved. My esteem for the man has risen, greatly.

I read Liberty Defined with interest. I have been working on my own “elevator pitch” delivery for basic economic and political ideas I consider important and I am always looking for resources which might provide examples of how to convey complex ideas in simple forms. I think this is where Liberty defined excels. The book is 328 pages long, with 50 topics covered, that is an average of 6.5 pages per topic in 12 point font in a medium sized paperback– these are not treatises, they’re more like brief essays. The topics are organized alphabetically and range from Abortion, Assassination and Austrian Economics, through Lobbying, Marriage and Medical Care and end with Trade Policies, Unionism and Zionism. It’s a mix of stuff Americans are always fighting about that they shouldn’t be (Abortion, Marriage), stuff Americans have been fighting about since the founding (Lobbying, Trade Policies), stuff Americans are super confused about (Medical Care, Unionism), stuff Ron Paul thinks its important people understand better (Austrian Economics) and stuff that people think it’s impolite to discuss (Zionism).

While I found many of Ron Paul’s views “predictable” simply because I am well-versed in them, I find his argumentation and simple explanations were always new and surprising to me and his ability to draw metaphors and analogies is outstanding (I particularly liked his discussion of medical insurance and car insurance and what we could expect to happen to car insurance if it was regulated the same way medical insurance is regulated). At the root of his approach is a desire to unmask political cliches — for example, insurance is no longer insurance when you force the providers to cover higher risk individuals at the same rate that they cover low risk individuals, which transforms it into a welfare policy that redistributes wealth — and then follow the inevitable logic and consequence of these policies laid bare. Through this method there turn out to be no real surprises in the economic and political arena, the problems we face are the end result of following flawed premises blindly. A unifying theme that runs through out is that the will to exercise power has historically been combined with the need to confuse and delude the powerless about how and why that power is being exercised because there is no logically defensible argument for exercising the power in the first place– all power concentrated in the hands of political representatives is power taken from the hands of individual people. The meta struggle of history in society is the attempt by individuals to resist the tyranny of political structures. This is the prism through which Ron Paul analyzes all of these issues.

By his definition,

Liberty means to exercise human rights in any manner a person chooses so long as it does not interfere with the exercise of the rights of others.

And so, “only liberty can ward off tyranny, the great and eternal foe of mankind.”

This is a hopeful book, also. While Ron Paul is forceful in his views and is not afraid to call a spade a spade, this is not a polemical work seeking to cast blame and aspersions at political enemies. Instead, Ron Paul says

I do hope that I can inspire serious, fundamental and independent-minded thinking and debate

To me, this is key and what is so lacking from political discourse in this country presently. The way things are, the spending, the wars, the massive social programs, are taken as given. There is no fundamental consideration of these issues, no attempt to forge a new society despite clearly being at a political dead-end. And not only are people not thinking creatively, they aren’t discussing it peaceably. Political discourse is about questioning motives and demagoguing the issues. Creating an environment of open discussion and debate would be a humongous step for social progress even if it leads to no immediate political change. This is a long-term project,

To love liberty requires an act of the intellect… Our job in this generation is to prepare the way.

We may not and likely will not see meaningful political reforms in our own lifetimes, but we could lay the seeds that will germinate in our children’s lifetimes by trying to change the context of the discourse today. That’s a goal worth fighting for in my mind.

I ended up highlighting many ideas and short passages throughout this book. I had hoped to capture a few here but I realize I will just be re-typing too much of the book. This work is not a classic, but it is worth reading, for the liberty-minded and the unfamiliar (or even skeptical!) alike, if only to further the discourse. I think this book will be one I’ll recommend to people asking for a place to start in understanding our topsy-turvy political environment and I plan to keep my copy in my library for future reference. Ron Paul has created a “popular”, everyman’s version of Murray Rothbard’s outstanding For A New Liberty. (I’m also now very excited to move Paul’s The School Revolution higher up on my reading list.)

Review – There’s Always Something To Do

There’s Always Something to Do: The Peter Cundill Investment Approach

by Christopher Risso-Gill, published 2011

A short read, There’s Always Something to Do was nonetheless an entertaining and informative one. Peter Cundill’s life serves as an example of what a value investor can be and should be– consistent, disciplined, well-traveled, philosophical and patient. One of Cundill’s comments in a journal entry stood out from the rest, and not just because it was over-emphatically written in all caps:

THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE AND MORE PATIENCE. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS ATTRIBUTE.

As an investor, you always have to ask yourself what your edge is in any particular situation. For a value investor who tries to “buy dollars for 40 cents” (the slogan of the Cundill Value Fund) and who insists on a margin of safety, often that edge is patience. Buying at a steep discount to perceived value with no concern for relative and contemporary outperformance of arbitrary benchmarks means the patient value investor is often in a position to be paid to wait. This puts him ahead of the game because, as Peter Cundill observes, most investors can’t or aren’t this patient.

The other prime lesson to be learned from Peter Cundill’s life is that value investing is hard work. As the title of the book, an Irving Kahn quote, implies,

There’s always something to do. You just need to look harder, be creative and a little flexible.

Cundill traveled thousands of miles every year, establishing networks of trusted value investors and other local eyes-and-ears he could get ideas from and visiting the world’s stock exchanges in search of the ones with the worst performance record over the previous 11 months. “Given the dearth of bargains today, it pays to search for them everywhere,” Cundill said.

Unending effort and determination came with the territory. Cundill reveled in the difficult, a complicated or hard to decipher balance sheet, particularly one belonging to a foreign company, was not a reason to get upset about the hardships of the business but was rather an opportunity in disguise because such a balance sheet represented a “barrier to entry” for other investors. Cundill’s creativity often led him to look for a “colony of success”, believing that if he found one amazing business story in a particular industry or country that was otherwise depressed, there might be others nearby. In time, Peter came to surround himself with people who believed that “having a hangover was a waste of a day.” Time spent nursing oneself of the effects of the night before was time one couldn’t spend pursuing investment excellence.

Cundill embraced the constant struggle, philosophically choosing to focus on enjoying the journey rather than focusing on the destination. In a piece of personal poetry Cundill observed “no fortunes are made in prosperity, ours is a marathon without end: enjoy the passing moments.”

Cundill was not just a great investor but a great thinker. He spent a lot of time in moments of reflection, contemplating the perfection of his process in various aspects of his investing career and personal life. Below I have captured and organized a few of my favorites to come back to for inspiration in the future.

The Investment Process and Understanding Business

  • I think that intelligent forecasting should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls and so assist management to tailor events and to bend them in the desired direction.
  • In a macro sense it may be more useful to spend time analysing industries instead of national or international economies.
  • It must be essential to develop and specify a precise investment policy that investors can understand and rely on the portfolio manger to implement.
  • In the end, it is always the economic facts and the values which are the determining factors.
  • It is also dangerous to rely on a single strategy in a doctrinaire fashion. Strategies and disciplines ought always to be tempered by intelligence and intuition.
  • The boards of charitable foundations are convenient meeting places for influential people. Their ostensible purpose is intimately bound up with the social and commercial ones.
  • I will never use inside information or seek it out. “All you get from inside information is a whiff of bad breath.”
  • If there’s no natural skeptic on an investment maybe it would be wise to appoint one of the team to play Devil’s Advocate anyway.
On Value Investing
  • Being out on a limb, alone and appearing to be wrong is just part of the territory of value investment.
  • Very few people really do their homework properly, so now I always check for myself.
  • The great records are the product of individuals, perhaps working together, but always within a clearly defined framework. In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.
  • Accounting is a bear market phenomenon. (on people overlooking accounting oversights in bull markets)
  • Every company ought to have an escape valve: inventory that can readily be reduced, a vision that can be sold, a marketable investment portfolio, an ability to shed staff quickly.
  • We always look for the margin of safety in the balance sheet and then worry about the business.
  • We go short on markets, not individual securities.
  • When there aren’t a lot of net-net situations around I get worried about the market and start to sell into cash.
  • When things get so bad that you’re really scared, that’s the time to buy.
  • You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.
  • The problem with big businesses that have moats around them is they tend to over-expand.
  • Search out the new lows.
  • IPOs for the most part are dreams engineered by the hope that pro forma estimates will be met. We deal to a certain degree with the nightmares that everyone knows about.
  • I am a bear market buyer; I like to sell into strength.
  • When a stock doubles, sell half — then what you have is a free position.
  • I pay much more attention to the balance sheet than the profit and loss statement and am always looking for hidden assets on the books.
The Philosophy of Life
  • Good poets borrow and great poets steal.
  • Retirement is a death warrant.
  • An ability to see the funny side of oneself  as it is seen by others is a strong antidote to hubris.
  • Routines and discipline go hand in hand. They are the road map that guides the pursuit of excellence for its own sake.
  • Patience, patience and more patience.
  • Curiosity is the engine of civilization.

Other Notes

  • Peter got together conferences of people with different perspectives and interests and invited guest speakers who were experts on things other than investing to broaden everyone’s mind through inter-disciplinary thinking
  • Peter moved his fund’s operations to London when it was the finance capital of the world; where is today’s London?
  • Peter would automatically sell investments as they got far beyond their intrinsic value (as measured by P/B), thereby creating a “safety valve” that caused him to go to cash heading into bubbles/crashes
  • In emerging markets, Peter looked for an asset-based margin of safety through large fixed assets, which were a lot more difficult to steal or carry off than a pile of cash.
  • Peter sometimes used the “Magic 6s”– stocks trading for 60% of book value, a 6x P/E multiple and a 6% dividend yield.

Video – Michael Mauboussian On Forbes

Intelligent Investing with Steve Forbes presents Michael Mauboussin, chief investment strategist, Legg Mason Capital Management, author of Think Twice

Major take-aways from the interview:

  • 9%, 7.5% and 5.5-6%; the rates of return, respectively, for the S&P500, mutual funds and mutual fund investors, on average– why the discrepancy?
  • Mutual funds underperform the S&P500 on a total return basis due to fees; mutual fund investors underperform the funds mostly due to timing– most individuals buy when funds have done well, sell when they’ve done poorly, exposing themselves to underperformance and missing out on subsequent over-performance
  • Curiously, institutional investors underperform as well; the culprit is overactivity– people believe “if you work hard, you’ll be rewarded”, so institutional investors try to “earn” their returns by moving money around constantly
  • Increasingly, investment returns have to do with luck and not skill; all activities in life fall along a continuum between pure skill and no luck (running competition) to pure luck and no skill (the lottery); the “Paradox of Skill” states that the more skillful competitors are, the more uniform their results become and the more important luck is to explaining differences in results
  • How to accurately judge a manager’s returns? Sample size is important: the more decisions the manager has to make over time, the shorter time horizon can be used to judge them; the fewer decisions they make over time, the longer the time horizon used to judge them
  • Focus on process, not outcome; in investing– analytical process of ideas, behavioral/psychological process, and organizational process (constraints w/in the organization that impede performance)
  • Investing boils down to two activities: handicapping (looking at market assumptions via price and then backing into the scenario that would have to occur for that price to be reasonable, and judging the probability of it occurring) and bet-sizing (waiting until you have a strong advantage and then betting big)
  • Expectations-based investing process: back into the cash flow assumptions that justify current market price; financial/strategic analysis of the company and its industry to see if the company is likely to do better or worse than the market implies; then decide to buy, sell or do nothing– what’s built in? what’s likely to happen? then “over-under” rather than “I know precisely what those cash flows will be”
  • Systems that are entirely skill-based don’t revert to the mean at all; aside from fatigue, running a race 5x will result in the same, highly-skilled winner each time
  • The extent to which a system is not all-skill is the extent to which it can mean-revert, but the question is, what mean? A highly skilled person might come down off a peak but they will not revert to the mean of more normally skilled individuals, for instance (tall parents tend to have tall children, but they might not be as tall as the parents — mean reversion — but you also don’t expect them to go down to the height of the average population)
  • Investing is not all-luck, but it is luck-leaning on the continuum; the best way to judge managers is by process, not performance
  • “Buy cheap and hold”: consider the story of Bob Kirby and the “Coffee Can Approach” [PDF]
  • What can older investors do in today’s interest rate environment? Follow Jim Grant’s advice, “Roll back the calendar 30 years”, ie, nothing, they’re screwed
  • “Patience is the key” to great investment returns