The Trouble With Indexing, A Reader Comments

Reader CP had this succinct analysis of the trouble with indexing as an investment strategy:

I think that, in practice, index investing means:
“Treat cash like it’s toxic and buy a little bit of everything at the asking price.”

It’s an idea which has happened to enter a positive feedback loop and thereby generated attractive retrospective returns since 2009. (Although the price appreciation of the S&P since 2007 has only been about 4% a year not counting dividends!)

Buying everything at the asking price would not work or be considered a valid strategy in any type of wholly owned and operated business. Imagine if you just bought every [retail operation] at the asking price.

Actually, people do this from time to time, it’s called a roll up and the stock price chart looks like the market chart now – a parabola followed by a huge crash. Dendreon’s problem was that they levered up and bought every pharma company they could for asking price.

So I don’t see why or how buying pieces of businesses at asking price will do anything except transfer value to the sellers, i.e. result in losses, which will be crystallized someday, for the buyers.

Review – Quantitative Value

Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors + website

by Wesley R. Gray and Tobias E. Carlisle, published 2012

The root of all investors’ problems

In 2005, renowned value investing guru Joel Greenblatt published a book that explained his Magic Formula stock investing program– rank the universe of stocks by price and quality, then buy a basket of companies that performed best according to the equally-weighted measures. The Magic Formula promised big profits with minimal effort and even less brain damage.

But few individual investors were able to replicate Greenblatt’s success when applying the formula themselves. Why?

By now it’s an old story to anyone in the value community, but the lesson learned is that the formula provided a ceiling to potential performance and attempts by individual investors to improve upon the model’s picks actually ended up detracting from that performance, not adding to it. There was nothing wrong with the model, but there was a lot wrong with the people using it because they were humans prone to behavioral errors caused by their individual psychological profiles.

Or so Greenblatt said.

Building from a strong foundation, but writing another chapter

On its face, “Quantitative Value” by Gray and Carlisle is simply building off the work of Greenblatt. But Greenblatt was building off of Buffett, and Buffett and Greenblatt were building off of Graham. Along with integral concepts like margin of safety, intrinsic value and the Mr. Market-metaphor, the reigning thesis of Graham’s classic handbook, The Intelligent Investor, was that at the end of the day, every investor is their own worst enemy and it is only by focusing on our habit to err on a psychological level that we have any hope of beating the market (and not losing our capital along the way), for the market is nothing more than the aggregate total of all psychological failings of the public.

It is in this sense that the authors describe their use of “quantitative” as,

the antidote to behavioral error

That is, rather than being a term that symbolizes mathematical discipline and technical rigor and computer circuits churning through financial probabilities,

It’s active value investing performed systematically.

The reason the authors are beholden to a quantitative, model-based approach is because they see it as a reliable way to overcome the foibles of individual psychology and fully capture the value premium available in the market. Success in value investing is process-driven, so the two necessary components of a successful investment program based on value investing principles are 1) choosing a sound process for identifying investment opportunities and 2) consistently investing in those opportunities when they present themselves. Investors cost themselves precious basis points every year when they systematically avoid profitable opportunities due to behavioral errors.

But the authors are being modest because that’s only 50% of the story. The other half of the story is their search for a rigorous, empirically back-tested improvement to the Greenblattian Magic Formula approach. The book shines in a lot of ways but this search for the Holy Grail of Value particularly stands out, not just because they seem to have found it, but because all of the things they (and the reader) learn along the way are so damn interesting.

A sampling of biases

Leaning heavily on the research of Kahneman and Tversky, Quantitative Value offers a smorgasbord of delectable cognitive biases to choose from:

• overconfidence, placing more trust in our judgment than is due given the facts
• self-attribution bias, tendency to credit success to skill, and failure to luck
• hindsight bias, belief in ability to predict an event that has already occurred (leads to assumption that if we accurately predicted the past, we can accurately predict the future)
• neglect of the base case and the representativeness heuristic, ignoring the dependent probability of an event by focusing on the extent to which one possible event represents another
• availability bias, heavier weighting on information that is easier to recall
• anchoring and adjustment biases, relying too heavily on one piece of information against all others; allowing the starting point to strongly influence a decision at the expense of information gained later on

The authors stress, with numerous examples, the idea that value investors suffer from these biases much like anyone else. Following a quantitative value model is akin to playing a game like poker systematically and probabilistically,

The power of quantitative investing is in its relentless exploitation of edges

Good poker players make their money by refusing to make expensive mistakes by playing pots where the odds are against them, and shoving their chips in gleefully when they have the best of it. QV offers the same opportunity to value investors, a way to resist the temptation to make costly mistakes and ensure your chips are in the pot when you have winning percentages on your side.

A model development

Gray and Carlisle declare that Greenblatt’s Magic Formula was a starting point for their journey to find the best quantitative value approach. However,

Even with a great deal of data torture, we have not been able to replicate Greenblatt’s extraordinary results

Given the thoroughness of their data collection and back-testing elaborated upon in future chapters, this finding is surprising and perhaps distressing for advocates of the MF approach. Nonetheless, the authors don’t let that frustrate them too much and push on ahead to find a superior alternative.

They begin their search with an “academic” approach to quantitative value, “Quality and Price”, defined as:

Quality, Gross Profitability to Total Assets = (Revenue – Cost of Goods Sold) / Total Assets

Price, Book Value-to-Market Capitalization = Book Value / Market Price

The reasons for choosing GPA as a quality measure are:

• gross profit measures economic profitability independently of direct management decisions
• gross profit is capital structure neutral
• total assets are capital structure neutral (consistent w/ the numerator)
• gross profit better predicts future stock returns and long-run growth in earnings and FCF

Book value-to-market is chosen because:

• it more closely resembles the MF convention of EBIT/TEV
• book value is more stable over time than earnings or cash flow

The results of the backtested horserace between the Magic Formula and the academic Quality and Price from 1964 to 2011 was that Quality and Price beat the Magic Formula with CAGR of 15.31% versus 12.79%, respectively.

But Quality and Price is crude. Could there be a better way, still?

Marginal improvements: avoiding permanent loss of capital

To construct a reliable quantitative model, one of the first steps is “cleaning” the data of the universe being examined by removing companies which pose a significant risk of permanent loss of capital because of signs of financial statement manipulation, fraud or a high probability of financial distress or bankruptcy.

The authors suggest that one tool for signaling earnings manipulation is scaled total accruals (STA):

STA = (Net Income – Cash Flow from Operations) / Total Assets

Another measure the authors recommend using is scaled net operating assets (SNOA):

SNOA = (Operating Assets – Operating Liabilities) / Total Assets

Where,

OA = total assets – cash and equivalents

OL = total assets – ST debt – LT debt – minority interest – preferred stock – book common equity

They stress,

STA and SNOA are not measures of quality… [they] act as gatekeepers. They keep us from investing in stocks that appear to be high quality

They also delve into a number of other metrics for measuring or anticipating risk of financial distress or bankruptcy, including a metric called “PROBMs” and the Altman Z-Score, which the authors have modified to create an improved version of in their minds.

Quest for quality

With the risk of permanent loss of capital due to business failure or fraud out of the way, the next step in the Quantitative Value model is finding ways to measure business quality.

The authors spend a good amount of time exploring various measures of business quality, including Warren Buffett’s favorites, Greenblatt’s favorites and those used in the Magic Formula and a number of other alternatives including proprietary measurements such as the FS_SCORE. But I won’t bother going on about that because buried within this section is a caveat that foreshadows a startling conclusion to be reached later on in the book:

Any sample of high-return stocks will contain a few stocks with genuine franchises but consist mostly of stocks at the peak of their business cycle… mean reversion is faster when it is further from its mean

More on that in a moment, but first, every value investor’s favorite subject– low, low prices!

Multiple bargains

Gray and Carlisle pit several popular price measurements against each other and then run backtests to determine the winner:

• Earnings Yield = Earnings / Market Cap
• Enterprise Yield(1) = EBITDA / TEV
• Enterprise Yield(2) = EBIT / TEV
• Free Cash Flow Yield = FCF / TEV
• Gross Profits Yield = GP / TEV
• Book-to-Market = Common + Preferred BV / Market Cap
• Forward Earnings Estimate = FE / Market Cap

The result:

the simplest form of the enterprise multiple (the EBIT variation) is superior to alternative price ratios

with a CAGR of 14.55%/yr from 1964-2011, with the Forward Earnings Estimate performing worst at an 8.63%/yr CAGR.

Significant additional backtesting and measurement using Sharpe and Sortino ratios lead to another conclusion, that being,

the enterprise multiple (EBIT variation) metric offers the best risk/reward ratio

It also captures the largest value premium spread between glamour and value stocks. And even in a series of tests using normalized earnings figures and composite ratios,

we found the EBIT enterprise multiple comes out on top, particularly after we adjust for complexity and implementation difficulties… a better compound annual growth rate, higher risk-adjusted values for Sharpe and Sortino, and the lowest drawdown of all measures analyzed

meaning that a simple enterprise multiple based on nothing more than the last twelve months of data shines compared to numerous and complex price multiple alternatives.

But wait, there’s more!

The QV authors also test insider and short seller signals and find that,

trading on opportunistic insider buys and sells generates around 8 percent market-beating return per year. Trading on routine insider buys and sells generates no additional return

and,

short money is smart money… short sellers are able to identify overvalued stocks to sell and also seem adept at avoiding undervalued stocks, which is useful information for the investor seeking to take a long position… value investors will find it worthwhile to examine short interest when analyzing potential long investments

This book is filled with interesting micro-study nuggets like this. This is just one of many I chose to mention because I found it particularly relevant and interesting to me. More await for the patient reader of the whole book.

Big and simple

In the spirit of Pareto’s principle (or the 80/20 principle), the author’s of QV exhort their readers to avoid the temptation to collect excess information when focusing on only the most important data can capture a substantial part of the total available return:

Collecting more and more information about a stock will not improve the accuracy of our decision to buy or not as much as it will increase our confidence about the decision… keep the strategy austere

In illustrating their point, they recount a funny experiment conducted by Paul Watzlawick in which two subjects oblivious of one another are asked to make rules for distinguishing between certain conditions of an object under study. What the participants don’t realize is that one individual (A) is given accurate feedback on the accuracy of his rule-making while the other (B) is fed feedback based on the decisions of the hidden other, invariably leading to confusion and distress. B comes up with a complex, twisted rationalization for his  decision-making rules (which are highly inaccurate) whereas A, who was in touch with reality, provides a simple, concrete explanation of his process. However, it is A who is ultimately impressed and influenced by the apparent sophistication of B’s thought process and he ultimately adopts it only to see his own accuracy plummet.

The lesson is that we do better with simple rules which are better suited to navigating reality, but we prefer complexity. As an advocate of Austrian economics (author Carlisle is also a fan), I saw it as a wink and a nod toward why it is that Keynesianism has come to dominate the intellectual climate of the academic and political worlds despite it’s poor predictive ability and ferociously arbitrary complexity compared to the “simplistic” Austrian alternative theory.

But I digress.

Focusing on the simple and most effective rules is not just a big idea, it’s a big bombshell. The reason this is so is because the author’s found that,

the Magic Formula underperformed its price metric, the EBIT enterprise multiple… ROC actually detracts from the Magic Formula’s performance [emphasis added]

Have I got your attention now?

The trouble is that the Magic Formula equally weights price and quality, when the reality is that a simple price metric like buying at high enterprise value yields (that is, at low enterprise value multiples) is much more responsible for subsequent outperformance than the quality of the enterprise being purchased. Or, as the authors put it,

the quality measures don’t warrant as much weight as the price ratio because they are ephemeral. Why pay up for something that’s just about to evaporate back to the mean? […] the Magic Formula systematically overpays for high-quality firms… an EBIT/TEV yield of 10 percent or lower [is considered to be the event horizon for “glamour”]… glamour inexorably leads to poor performance

All else being equal, quality is a desirable thing to have… but not at the expense of a low price.

The Joe the Plumbers of the value world

The Quantitative Value strategy is impressive. According to the authors, it is good for between 6-8% a year in alpha, or market outperformance, over a long period of time. Unfortunately, it is also, despite the emphasis on simplistic models versus unwarranted complexity, a highly technical approach which is best suited for the big guys in fancy suits with pricey data sources as far as wholesale implementation is concerned.

So yes, they’ve built a better mousetrap (compared to the Magic Formula, at least), but what are the masses of more modest mice to do?

I think a cheap, simplified Everyday Quantitative Value approach process might look something like this:

1. Screen for ease of liquidity (say, $1B market cap minimum)
2. Rank the universe of stocks by price according to the powerful EBIT/TEV yield (could screen for a minimum hurdle rate, 15%+)
3. Run quantitative measurements and qualitative evaluations on the resulting list to root out obvious signals to protect against risk of permanent loss by eliminating earnings manipulators, fraud and financial distress
4. Buy a basket of the top 25-30 results for diversification purposes
5. Sell and reload annually

I wouldn’t even bother trying to qualitatively assess the results of such a model because I think that runs the immediate and dangerous risk which the authors strongly warn against of our propensity to systematically detract from the performance ceiling of the model by injecting our own bias and behavioral errors into the decision-making process.

Other notes and unanswered questions

“Quantitative Value” is filled with shocking stuff. In clarifying that the performance of their backtests is dependent upon particular market conditions and political history unique to the United States from 1964-2011, the authors make reference to

how lucky the amazing performance of the U.S. equity markets has truly been… the performance of the U.S. stock market has been the exception, not the rule

They attach a chart which shows the U.S. equity markets leading a cohort of long-lived, high-return equity markets including Sweden, Switzerland, Canada, Norway and Chile. Japan, a long-lived equity market in its own right, has offered a negative annual return over its lifetime. And the PIIGS and BRICs are consistent as a group in being some of the shortest-lifespan, lowest-performing (many net negative real returns since inception) equity markets measured in the study. It’s also fascinating to see that the US, Canada, the UK, Germany, the Netherlands, France, Belgium, Japan and Spain all had exchanges established approximately at the same time– how and why did this uniform development occur in these particular countries?

Another fascinating item was Table 12.6, displaying “Selected Quantitative Value Portfolio Holdings” of the top 5 ranked QV holdings for each year from 1974 through 2011. The trend in EBIT/TEV yields over time was noticeably downward, market capitalization rates trended upward and numerous names were also Warren Buffett/Berkshire Hathaway picks or were connected to other well-known value investors of the era.

The authors themselves emphasized that,

the strategy favors large, well-known stocks primed for market-beating performance… [including] well-known, household names, selected at bargain basement prices

Additionally, in a comparison dated 1991-2011, the QV strategy compared favorably in a number of important metrics and was superior in terms of CAGR with vaunted value funds such as Sequoia, Legg Mason and Third Avenue.

After finishing the book, I also had a number of questions that I didn’t see addressed specifically in the text, but which hopefully the authors will elaborate upon on their blogs or in future editions, such as:

1. Are there any reasons why QV would not work in other countries besides the US?
2. What could make QV stop working in the US?
3. How would QV be impacted if using lower market cap/TEV hurdles?
4. Is there a market cap/TEV “sweet spot” for the QV strategy according to backtests? (the authors probably avoided addressing this because they emphasize their desire to not massage the data or engage in selection bias, but it’s still an interesting question for me)
5. What is the maximum AUM you could put into this strategy?
6. Would more/less rebalancing hurt/improve the model’s results?
7. What is the minimum diversification (number of portfolio positions) needed to implement QV effectively?
8. Is QV “businesslike” in the Benjamin Graham-sense?
9. How is margin of safety defined and calculated according to the QV approach?
10. What is the best way for an individual retail investor to approximate the QV strategy?

There’s also a companion website for the book available at: www.wiley.com/go/quantvalue

Conclusion

I like this book. A lot. As a “value guy”, you always like being able to put something like this down and make a witty quip about how it qualifies as a value investment, or it’s intrinsic value is being significantly discounted by the market, or what have you. I’ve only scratched the surface here in my review, there’s a ton to chew on for anyone who delves in and I didn’t bother covering the numerous charts, tables, graphs, etc., strewn throughout the book which serve to illustrate various concepts and claims explored.

I do think this is heady reading for a value neophyte. And I am not sure, as a small individual investor, how suitable all of the information, suggestions and processes contained herein are for putting into practice for myself. Part of that is because it’s obvious that to really do the QV strategy “right”, you need a powerful and pricey datamine and probably a few codemonkeys and PhDs to help you go through it efficiently. The other part of it is because it’s clear that the authors were really aiming this book at academic and professional/institutional audiences (people managing fairly sizable portfolios).

As much as I like it, though, I don’t think I can give it a perfect score. It’s not that it needs to be perfect, or that I found something wrong with it. I just reserve that kind of score for those once-in-a-lifetime classics that come along, that are infinitely deep and give you something new each time you re-read them and which you want to re-read, over and over again.

Quantitative Value is good, it’s worth reading, and I may even pick it up, dust it off and page through it now and then for reference. But I don’t think it has the same replay value as Security Analysis or The Intelligent Investor, for example.

Video – Rahul Saraogi On Value Investing In India

The Manual of Ideas presents Rahul Saraogi, managing director of Atyant Capital Advisors

Major take-aways from the interview:

• Referring to Klarman, finding ideas and doing the analysis is a small part of investing; the two most critical factors to succes in any investment as a minority shareholder are corporate governance and capital allocation
• Good corporate governance means a dominant shareholder who treats minority shareholders like an equal business partner: even aside from egregious fraud and legal violations, you can face situations where dominant shareholders use the company like a piggy bank or to promote personal agendas
• Once you’ve cleared the corporate governance hurdle you must consider capital allocation: many times companies follow the same strategy that got them from 0 to a few hundred million in market cap, which will not work to get them to the next level; often by this time the dominant shareholder is sufficiently wealthy and loses interest in capital allocation to the detriment of minority shareholders
• India’s investment universe:
  • Indian GDP close to $2T
  • Indian market cap $1.5-2T
  • 80-85% of India’s market cap is represented by the top 150 firms: mega-cap banks, steel producers, etc., that trade on ADRs and everyone knows of outside of India
  • Thousands of listed companies below this with market caps ranging from $2-3B to a couple million dollars
  • Rahul finds the next 1200-1300 companies below the top 150, with market caps ranging from $50M-$2B, to be the most interesting opportunity
• Corporate governance is binary: either a company gets it, or it doesn’t
• Case study: 1998, invested in a sugar manufacturer trading for $20M generating $20M in annual earnings with a 14% tax free dividend yield, virtually debt free, strong moats, dominant player in its field, grew from $20M to $900M market cap, the owners were very focused on growing capital, no grandiose desire to build empires, not trying to grow the top line at all costs or gain rankings, just allocating capital wisely
• Every investor is looking for shortcuts and binary decisions, ie, “Should I invest in India or not invest in India?”; the reality is it’s a lot of work, it’s about turning over as many stones as you can– what Buffett has done well is finding people who can compound capital and then staying with them through market cycles
• You can do what Buffett did in any market but you must dive into it, get your hands dirty, do the work it takes and then maintain the discipline to stick with what you’ve found
• Home-market bias: most people are going to allocate most of their capital in their home-market, because by definition anything that is not familiar or proximate is considered risky; consequentially, “locals” will disproportionately benefit from economic and financial gains in their local markets
• India can not and likely will not become a dominant allocation in a foreign investors portfolio; without devoting 100% of your time and energy to understanding that market, or having someone invest on your behalf who does, you will likely not understand the culture, motivation and habits of the people in that market
• “It is imperative that in any market you go with people who understand it and are focused on it full time because investing is ultimately bottom-up”
• Accounting, financial reporting and investor relations practices are modeled off the US and UK so they’re similar; however, many businesses are run by one or two entrepreneurs and they’re often too busy to be available to speak with outside investors, but persistence pays off when they realize you’re interested in learning about their business
• Access to capital in Indian markets has improved, meaning it has become easier for Indian companies to scale
• Why does India have high rates of capital compounding? India is a 5,000 year old civilization and has had borrowing, lending and private markets for capital that entire time meaning people are aware of capital compounding; that being said, India has companies and management that understand ROC, those that don’t, and those that are essentially professional Ponzi-schemes, issuing capital at every market peak and then trading for less than the issued capital at the trough because they’re constantly destroying wealth
• Rahul sees the government as incapable of providing the public infrastructure needed by the growing economy; he sees the economy turning toward a “private-public partnership” model that is more private than public– enlightened fascism?
• As companies rushed into this private-public space, a lot of conglomeration and corporate mission-creep occurred, resulting in systemically low ROC for companies in the infrastructure space as most as poorly run; failure of top-down investing thesis
• “I’m looking for confirmation in facts, not in other investors’ opinions”
• I can comment on whether valuations for individual companies make sense, but I can’t make a judgment on the value of a broad market index, I just don’t think that number means anything
• Risk management: develop assumptions about the company’s business and then periodically analyze what the company is doing relative to original investment hypothesis; if your assumptions prove to be wrong or something changes drastically with the company, that is when you hit a “fundamental stop-loss” and corrective action needs to be taken immediately, even if the stock has done well and the price has risen

Notes – Walter Schloss 1989 Interview With OID

A couple weeks ago I found the 1989 Outstanding Investor’s Digest interview with Walter and Edwin Schloss on Scribd and took a few notes as I read, which I reproduce below for later reference:

• In The Merchant Bankers, the story is told of the Warburg family giving up their fortune to flee Nazi Germany, providing two lessons: be contrarian; and a family should lose its wealth every 3rd generation to ensure descendants don’t become lazy and entitled
• When father and son can get along in a business venture, they can benefit from “compound interest” of accumulated knowledge and technique within the family
• During the “first ten years you get acquainted with what you’re doing” so don’t expect to smash it out of the park the moment you set out in a new concentration
• Companies will avoid LBO takeovers by levering up and acquiring other businesses (such as competitors) themselves
• “Lot’s of times when you buy a cheap stock for one reason, that reason doesn’t pan out, but another one does because it’s a cheap stock.”
• “Sometimes you have to sue just to keep your self-respect.”
• “It’s easier to know when something’s cheap than when it’s overvalued.”
• “Concentrate on what you know and forget about everything else.”
• According to Buffett, “If you’re not disciplined in the little things, you can’t be disciplined in the big things.”
• “Partners, it seems to me, should have somewhat the same point of view” Schloss says about the value of corporate culture
• Focus on working capital stocks, then 50% of BV stocks, then 66% of BV stocks and then 1x BV stocks w/ franchises or special situations
• Look out for managers in it for themselves, even when the stock is cheap

Notes – Distilled BuffettFAQ.com Investment Wisdom Of Warren Buffett

All quotes were originally collected and compiled at the outstanding BuffettFAQ.com

On Learning Businesses

Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Everytime I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, “If you could only buy stock in one coal company that was not your own, which one would it be and why? You piece those things together, you learn about the business after awhile.

Funny, you get very similar answers as long as you ask about competitors. If you had a silver bullet and you could put it through the head of one competitor, which competitor and why? You will find who the best guy is in the industry.

On The Research Process

It’s important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis.

Pick out five to ten companies in which you understand their products, get annual reports, get every news piece on it. Ask what do I not know that I need to know. Talk to competitors and employees. Essentially be a reporter, ask questions like: If you had a silver bullet and could put it into a competitor who would it be and why. In the end you want to write the story, XYZ is worth this much because…

Narrowing the Investment Universe

They ought to think about what he or she understands. Let’s just say they were going to put their whole family’s net worth in a single business. Would that be a business they would consider? Or would they say, “Gee, I don’t know enough about that business to go into it?” If so, they should go on to something else. It’s buying a piece of a business. If they were going to buy into a local service station or convenience store, what would they think about? They would think about the competition, the competitive position both of the industry and the specific location, the person they have running it and all that. There are all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do.

Q: So if they’re walking through the mall and they see a store they like, or if they happen to like Nike shoes for example, these would be great places to start? Instead of doing a computer screen and narrowing it down?

A computer screen doesn’t tell you anything. It might tell you about P/Es or something like that, but in the end you have to understand the business. If there are certain businesses in that mall they think they understand and they’re public companies, and they can learn more and more about them…. We used to talk to competitors. To understand Coca-Cola, I have to understand Pepsi, RC, Dr. Pepper.

The place to look when you’re young is the inefficient markets.

Investment Process

• Read lots of K’s and Q’s – there are no good substitutes for these – Read every page
• Ask business managers the following question: “If you could buy the stock of one of your competitors, which one would you buy? If you could short, which one would you short?”
• Always read source (primary) data rather than secondary data
• If you are interested in one company, get reports for competitors. “You must act like you are actually going into that business, and if you were, you’d want to know what your competitors were doing.”

Four Investment Filters

Filter #1 – Can we understand the business? What will it look like in 10-20 years? Take Intel vs. chewing gum or toilet paper. We invest within our circle of competence. Jacob’s Pharmacy created Coke in 1886. Coke has increased per capita consumption every year it has been in existence. It’s because there is no taste memory with soda. You don’t get sick of it. It’s just as good the 5th time of the day as it was the 1st time of the day.

Filter #2 – Does the business have a durable competitive advantage? This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.

Filter #3 – Does it have management I can trust?

Filter #4 – Does the price make sense?

Finding Bargains

The world isn’t going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time. The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Most of you don’t look like you are overburdened with cash anyway. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.

Don’t pass up something that’s attractive today because you think you will find something way more attractive tomorrow.

Defining Risk

We think first in terms of business risk. The key to Graham’s approach to investing is not thinking of stocks as stocks or part of the stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they’re going to do all right as long as long as they don’t pay way too much to join in to that business. So we’re thinking about business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there’s a hiccup in the business, then the lenders foreclose. It can come about by their nature–there are just certain businesses that are very risky. Back when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial  airplane as a sort of bet-your-company risk because you would shell out hundreds and hundreds of millions of dollars before you really had customers, and then if you had a problem with the plane, the company could go. There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk. Commodity businesses have a lot of risk unless you’re a low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren’t the low-cost producers so it was a risky business. The guy who could sell it cheaper than we could made it risky for us. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself–whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you and not to instruct you. That’s a key to owning a good business and getting rid of the risk that would otherwise exist in the market.

Valuation Metrics

The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it’s not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business’s economic characteristics.

[Highly qualitative, descriptive and verbal, has little to do with the numbers in justifying an investment]

The Ideal Business

WB: The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn’t earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can’t generate high returns on incremental capital — for example, See’s and Buffalo News. We look for them [areas to wisely reinvest capital], but they don’t exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It’s an enormous advantage.

See’s has produced $1 billion pre-tax for us over time. If we’d deployed that in the candy business, the returns would have been terrible, but instead we took the money out of the business and redeployed it elsewhere. Look at the results!

CM: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.

Making Mistakes In Investments

We bought it because it was an attractive security. But it was not in an attractive industry. I did the same thing in Salomon. I bought an attractive security in a business I wouldn’t have bought the equity in. So you could say that is one form of mistake. Buying something because you like the terms, but you don’t like the business that well.

The Market and Its Price

The NYSE is one big supermarket of companies. And you are going to be buying stocks, what you want to have happen? You want to have those stocks go down, way down; you will make better buys then. Later on twenty or thirty years from now when you are in a period when you are dis-saving, or when your heirs dis-save for you, then you may care about higher prices. There is Chapter 8 in Graham’s Intelligent Investor about the attitude toward stock market fluctuations, that and Chapter 20 on the Margin of Safety are the two most important essays ever written on investing as far as I am concerned. Because when I read Chapter 8 when I was 19, I figured out what I just said but it is obvious, but I didn’t figure it out myself. It was explained to me. I probably would have gone another 100 years and still thought it was good when my stocks were going up. We want things to go down, but I have no idea what the stock market is going to do. I never do and I never will. It is not something I think about at all.

Forecasting

People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts. It happens over and over and over.

What’s going to happen tomorrow, huh? Let me give you an illustration. I bought my first stock in 1942. I was 11. I had been dillydallying up until then. I got serious. What do you think the best year for the market has been since 1942? Best calendar year from 1942 to the present time. Well, there’s no reason for you to know the answer. The answer is 1954. In 1954, the Dow … dividends was up 50%. Now if you look at 1954, we were in a recession a good bit of that time. The recession started in July of ’53. Unemployment peaked in September of ’54. So until November of ’54 you hadn’t seen an uptick in the employment figure. And the unemployment figure more than doubled during that period. It was the best year there was for the market. So it’s a terrible mistake to look at what’s going on in the economy today and then decide whether to buy or sell stocks based on it. You should decide whether to buy or sell stocks based on how much you’re getting for your money, long-term value you’re getting for your money at any given time. And next week doesn’t make any difference because next week, next week is going to be a week further away. And the important thing is to have the right long-term outlook, evaluate the businesses you are buying. And then a terrible market or a terrible economy is your friend. I don’t care, in making a purchase of the Burlington Northern, I don’t care whether next week, or next month or even next year there is a big revival in car loadings or any of that sort of thing. A period like this gives me a chance to do things. It’s silly to wait. I wrote an article. If you wait until you see the robin, spring will be over.

Managers Should Be Investors

Charlie makes a good point. Managers should learn about investing. I have friends who are CEOs and they outsource their investing to a financial advisor because they don’t feel comfortable analyzing Coke and Gillette and picking one stock vs. the other. Yet when an investment banker shows up with fancy slides and a slick presentation, an hour later the CEO is willing to do a $3 billion acquisition. It’s extraordinary the willingness of corporate CEOs to make decisions about buying companies for billions of dollars when they aren’t willing to make an investment for $10,000 in their personal account. It’s basically the same thing.

The Value of Accounting

I had a great experience at Nebraska. Probably the best teacher I had was Ray Dein in accounting. I think everybody in business school should really know accounting; it is the language of business. If you are not comfortable with the lan- guage, you can’ t be comfortable in the country. You just have to get it into your spinal cord. It is so valuable in business.

Staying Rational

One thing that could help would be to write down the reason you are buying a stock before your purchase. Write down “I am buying Microsoft @ $300B because…” Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational.

Review – Value Investing: From Graham To Buffett And Beyond

Value Investing: From Graham to Buffett and Beyond

by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biena, published 2001

Three valuation approaches

In the world of value investing, there are three essential ways to value a business: studying the balance sheet (asset values), studying the income statement (earnings power) or studying the value of growth.

Greenwald and company recommend using each approach contingent upon the type of company being analyzed.

The asset value (balance sheet) approach

The virtue of balance sheet analysis is that it requires little extrapolation and anticipation of future values as the balance sheet ostensibly represents values which exist today. (Note: technically, for balance sheet values to be accurate they must have a meaningful connection to future cash flows and earnings which can be generated from them, but that is beside the present point.) Additionally, the balance sheet is arranged in such a way that the items at the top are items whose present value as stated on the balance sheet is more certain because they are closer to being converted into cash (or requiring immediate cash payment), whereas those toward the bottom are less certain. The implication here is that companies trading closer to the value of net assets nearer to the top of the balance sheet are more likely undervalued than those trading closer to the value of net assets nearer to the bottom of the balance sheet.

Putting these principles into practice, when using the balance sheet method, companies which are not economically viable or are experiencing terminal decline should be valued on a liquidation basis, looking at net current asset values and severely discounting long-term fixed assets (and perhaps completely writing off the accounting value of goodwill and certain intangible items). On the other hand, companies whose viability as going concerns is fairly certain should be valued on a reproduction cost basis when using the balance sheet method, meaning calculating a value for replacing the present assets using current technology and efficiencies.

In an industry with free-entry, a company trading for substantially more than $1 per $1 of asset reproduction costs will invite competition until the market value of that company falls. Similarly, a company trading for substantially less than $1 per $1 of asset reproduction costs will find competitors exiting the industry until the market value of the company rises back to the reproduction cost of the assets. Without barriers to entry which protect the profitability of these assets, the assets are essentially worth reproduction cost as they deserve no earnings power premium.

For these firms, the intrinsic value is the asset value.

The earnings power (income statement) approach

Whereas the asset value approach relies more strongly on present market values, the earnings power valuation approach begins to introduce more estimation of the relationship between present and future earnings, as well as the cost of capital. These are decidedly less certain valuations than the asset value method as they rest on more assumption of future phenomena.

The primary assumptions are that,

1. current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow, and,
2. that this earnings level will remain approximately constant into the indefinite future.

Based upon those assumptions, the general equation for calculating earnings power value (EPV) is:

EPV = Adjusted Earnings x 1/R

Where “R” is the current cost of capital.

Earnings adjustments, where necessary, should be made on the following basis:

1. rectifying accounting misrepresentations; the ratio of average recurring “one-time charges” to unadjusted reported earnings should be used to make a proportional adjustment to current earnings
2. depreciation and amortization adjustments; reported earnings need to be adjusted by the difference between stated D&A charges and what the firm actually requires to restore its assets at the end of the year to the same level they were at at the beginning of the year
3. business cycle adjustments; companies in the trough of their business cycle should have an addition to earnings in the amount of the difference between present earnings and average earnings, while companies at the peak of their cycle should have earnings adjusted by the difference between average earnings and present earnings (a negative number)

There is a connection between the EPV of a firm and its competitive position. In consideration of economically viable industries:

1. EPV < asset reproduction cost; management is not fully utilizing the economic potential of its assets and the solution is for management to change what it’s doing, or for management to be replaced if it refuses to do so or proves incapable of doing so
2. EPV = asset reproduction cost; this is the norm for firms in industries with no competitive advantage, and the proximity of these two values to one another reinforces our confidence that they have been properly calculated
3. EPV > asset reproduction cost; this is a sign of an industry with high barriers to entry, with firms inside the barriers earning more on their assets than firms outside of them. For EPV to hold up, the barriers to entry must be sustainable into the indefinite future

The difference between the EPV and the asset value of the firm in question in the third scenario is the value of the franchise of the firm with barriers to entry. In other words, the firm’s intrinsic value should equal the value of its assets plus the value of its franchise.

Similarly, in the second scenario, no premium is granted for the value of growth because with no competitive advantages, growth has no value (the cost of growth will inevitably fully consume all additional earnings power created by growth in an industry characterized by free-entry competition).

The value of growth

The value of growth is the hardest to estimate because it relies the most on assumptions and projections about the future, which is highly uncertain.

Additionally, growth has little value outside the context of competitive advantage. Growing sales typically need to be supported by growing assets: more receivables, more inventory, more plant and equipment. Those assets not offset by greater spontaneous liabilities (accounts payable, etc.) must be funded somehow, through retained earnings, larger borrowings or the sale of additional shares, reducing the amount of distributable cash and therefore lowering the value of the firm.

For firms operating at a competitive disadvantage, growth actually destroys value. Otherwise, growth only creates value within the confines of a competitive advantage. This uncertainty of growth and the competitive context of it leads the value investor to be least willing to pay for it in consideration of the other potential sources of value (assets and EPV).

What’s The Yield On Saudi Prince Alwaleed’s “Strategic” Twitter Investment?

Saudi Prince Alwaleed bin Talal has made a $300M “strategic” investment in Twitter, according to Bloomberg.com:

Alwaleed, who leads the 2011 Arab Rich List, and his investment company agreed to buy a “strategic stake” in Twitter, Kingdom Holding said today. A strategic holding means more than 3 percent, Ahmed Halawani, a Kingdom Holding director, said in an interview. That would give the San Francisco-based company a valuation exceeding $10 billion.

Alwaleed is described by Bloomberg as a businessman and an investor. But Alwaleed is a politician, not a businessman– he is a member of the Saudi royal family, and his capital and wealth are continually generated by the Saudi royal family’s political control over Saudi oil fields. Similarly, Alwaleed is an “investor” in businesses like Citi and Twitter in the same sense that the CIA “invested” in Google and Facebook– for information and for control, not for economic or financial profit.

If this is a challenging view to accept, let’s consider just this recent purchase of his Twitter stake from insiders. According to the article, an industry research group recently cut their forecast for Twitter’s 2011 ad revenue from $150M to $139.5M. What kind of value multiplier did Alwaleed “invest” in if he paid $300M for more than 3% of the company which is now valued at over $10B?

Let’s give Alwaleed the benefit of the doubt and say that Twitter’s 2011 ad revenue comes in at $150M. Let’s further assume that Twitter is a highly profitable company and 30% of their revenues drop down to the bottom line and become net profit. That’s $45M of net profit in 2011.

At a $10B market cap, Alwaleed’s investment was made at 66.6x Price-to-Revenues and 222.2x Price-to-Earnings. I should hope I don’t need to do the math for you to show what kind of growth expectations you have to factor into those ratios for them to make sense.

Now, ask yourself, have you ever heard of the “Best Investor In the Universe”, Warren Buffett, investing in companies at these kinds of multiples? Ask yourself, what kind of margin of safety does Alwaleed have here when paying so much for so little. Ask yourself, is it a credible idea that Alwaleed is truly a successful businessman and investor who has managed to grow his personal fortune to $19.6B (according to Wikipedia) since 1979 by investing at such high multiples?

Alwaleed “is a savvy investor and the hot thing in the IT world is social networking,” said Nabil Farhat, a partner at Abu Dhabi-based Al Fajer Securities.

Historically, how do even “savvy investors” fare investing in the latest “hot thing”?

As hinted at earlier, there is a more reasonable explanation for why Alwaleed invested in Twitter, why he has invested in Citi and News Corp., and why he invests in almost anything– Alwaleed is part of a political front and he makes investments as part of a political agenda. Politics is not an economically efficient system, it cares not for scarcity and cost in the economic sense of productive effort and opportunity cost. Political systems get their revenues from coercion, and they use economic resources as but another means to their arbitrary political ends.

Why did Alwaleed invest in Twitter? Because Twitter played an embarrassing role in the recent “Arab Spring” of revolutionary fervor across the Middle East this year and Alwaleed and his sponsors want to be in a position which allows them the knowledge and influence of the insider, of control. This is what is meant by the savvy Mr. Alwaleed’s “strategic” investment in a not-so-profitable social media favorite.

Why did Alwaleed invest in Citi? Because Citi is a centerpiece to the financial chicanery involving the global drug trade controlled by the CIA, the power-politics of world political intrigue and espionage and the dangerous, corrupt game of arms dealing and the financing of imperial military adventurism.

Why did Alwaleed invest in News Corp.? To control the news!

Let us not confuse legitimate businessmen and investors with political operatives and speculators any longer!

Great Expectations For Investing

I enjoyed the following two commentaries from value investor blogs I follow.

First, from Rohit Chauhan’s “Intelligent investing”, an absurdist scene in near-future India:

If the market and a lot of investors are correct, I can visualize a scene where I will be sitting in my house without power, gas and connecting roads but with the best plasma TV and all kinds of soaps, detergents and packaged goods.

Rohit comments on the fact that infrastructure companies in India are trading cheaply as if their regulatory burdens will not be removed and not allow them to grow, while consumer goods companies are trading at high valuations as if they are about to strongly grow their sales and expand their margins. But for the latter to happen, the former must be resolved.

Conclusion?

Company specific growth depends on a lot of factors beyond the basic macro opportunity and it is rarely a simple, linear process. If you make simplistic assumptions and pay top valuations for it, then the experience can be bad if those expectations do not materialize.

Speaking of expectations, here is one from the “Margin of Safety” blog, written by an anonymous PM managing a private investment partnership, on the differing assumptions between the “I Know” and the “I Don’t Know” schools of forecasting:

In pointing out our inability to see the future in my letter, my intent was to calm potential investors’ nerves. Many saw markets plummeting and they were converting everything to cash just at the moment when the best investment opportunities were arising. I had hoped that I could get them to stop listening to the many pundits in the media who pretended that they knew the future and who all repeated the mantra that we were doomed. I wanted them to focus on what was knowable like the Net Nets that existed at the time. We went “all in” in March 2009, two days before the market bottomed out, not because we could predict the future better than everyone else, but precisely because we tried not to predict it and instead focused on what was knowable.

There has been a seeming race amongst self-declared value investors over the past couple of weeks of ongoing bloodletting in the financial markets to make a contrarian “buy the panic dip” call. It’s like the moment the S&P 500 went 3% into the negative, everyone ran to their dressers and pulled out that dusty old copy of Warren Buffett’s “Be greedy when others are fearful” and began running around town, trumpeting it out to anyone who would take the time to listen.

In their haste to do so, many seemingly ignored whether things were already cheap, or merely getting cheaper. More importantly, few had any specific suggestions as to which companies were now cheap. Instead, these people seemed in a panic of their own to be the first one to declare that everything was now on sale.

But sometimes garbage is garbage and just because it has sold off a little doesn’t mean it didn’t deserve to, or that it won’t ultimately sell off some more. What kind of macro thesis is betrayed by such urgent calls to get one’s money in while the getting is still good any day there happens to be a broad market selloff?

The anonymous PM’s conclusion:

The pendulum reached its apex and has made a significant move back to the other side. Soon it will again be time to buy all of the babies that will get thrown out with the bath water. Are you prepared to pick off bargains, or are you one of the people in the “I know” school who was fully invested on July 7 and selling indiscriminately today? Can you trust your contrarian instincts when those instincts are supported by hard, knowable data, or will you follow the herd and the prognosticators? Which way you answer often accounts for the difference between investment success and failure.

Better yet, I want to know who was fully invested August 5th, prematurely assuming we’d seen the worst of it and so busy making assumptions they didn’t have time to go out and “know” some true discounts firsthand.