Review – Corporate Strategy

Corporate Strategy: Tools for Analysis and Decision-Making

by Phanish Puranam, Bart Vanneste, published 2016

What is corporate strategy and how is it any different from business strategy? That was actually a distinction I hadn’t made in my own mind when I picked this title up. I was generally interested in exploring “strategy” in an economic or business competition sense and this book was one of many I selected for further research. It was a happy accident then to realize there is a difference and this book is all about explaining what it is and why it’s different.

Business strategy aims at creating competitive advantage in a firm-against-firm struggle within a given industry. It flows outward from customer behavior through organizational structure and management practice to policies and processes surrounding marketing, sales, production, distribution and customer service.

Corporate strategy aims at realizing synergies from the joint ownership of different businesses. Synergies can be realized between businesses competing in the same industry but with common ownership (and perhaps diverse geographic territories), the case of a “corporate HQ” utilizing economies of scale in back-end or administrative functions to lower their cost or raise their quality across the individual customer-facing businesses. Synergies can also be realized between businesses operating in distinct industries but where coordination between actors in these industries allows for new products or services to be bundled, consider a bank and an insurance company owned by one corporate parent which can then offer a full range of financial services to customers.

One interesting takeaway from the book is that all public equity investors who do not have 100% of their investments in a single company (ie, they own a portfolio of stocks) are engaged in corporate strategy. However, as the book advises, passive investors are not able to realize synergies which those in control of these businesses can through exerting influence over their management. So, a passive equity investor could have an insight about the unique value of owning a complimentary basket of businesses representing corporate advantage, but they do not have the means to act upon it unless they are able to successfully agitate for M&A activity or have enough resources to get voting control over the companies in which they can sway management to extract the synergies they’ve spotted.

Another concept that was interesting to me was the irony that by bringing businesses under common ownership, a corporation destroys its own best benchmark for valuation (ie, the individual market prices of each business) and thus it is trapped in a perpetual game of trying to evaluate whether it’s coordination of economic activity within the corporation is synergistic and creating value, or wasteful and destroying it.

Warren Buffett as a conglomerator par excellence is an interesting case because, at least nominally, he does not provide managerial oversight to operations of the businesses he owns and has never claimed he has purchased a business for synergistic reasons for corporate strategy. Rather, he purchases businesses ONLY because he considers them to be available on a bargain basis, that is, he thinks they are available for less than their intrinsic value.

The entire point of corporate strategy, according to the book, is to be able to pay market or “fair” prices for assets and businesses, but still realize a profit from owning them, because of the ability to manage or exploit them differently under a joint ownership structure. So, Buffett is NOT a corporate strategist, although he is a really great investor.

And if you can realize synergies AND buy at bargain prices (AND apply leverage safely…) then you are really cooking with gas!

One of the great ironies of the (public) business world is that many managers (they are hardly ever significant shareholders themselves) think they can spot synergies all over the place, which either they or their investment bankers use to rationalize their acquisition activity. But the data demonstrate that few synergies ever appear to be realized– acquiring companies usually overpay, their stock falls on the announcement of an acquisition and the target company’s stock rises. Further, these acquisitions are often followed years later by goodwill writeoffs or divestitures of the previously acquired business or assets.

On average, a corporate parent that divests a business increases shareholder value.

In fact, one of the strategic suggestions of the authors is the always be on the look out for someone who is a better owner of a business or asset than you (ie, willing to pay you more than it’s worth to you to continue owning it) and selling things seems to be one of the most reliable ways for corporate strategists to create corporate advantage. It’s a pity, then, that most corporate strategists are buyers, not sellers!

If some other corporate parent has even stronger synergies with a business than you do, you should consider divesting.

Divesting when you can, and not when you have to is usually preferable.

Imagine that, starting today, the two businesses would be moved into separate ownership and would be operated completely independently, with no communication or exchange of any kind between the two. How would the value of the businesses be effected?

If one thinks one is smart enough to beat the odds, the authors suggest four places to look for synergies from joint ownership and operations for corporate strategists:

  1. Consolidation, creating value by rationalization across similar resources from similar value chain activities by eliminating redundancies, affects mostly costs and invested capital
  2. Combination, creating value by pooling similar resources from similar value chain activities, such as combining purchasing to obtain volume discounts or acquiring a competitor then raising prices for customers, impacts either costs or revenues
  3. Customization, creating value by co-specializing dissimilar resources in order to create greater joint value, results in improved value in production or consumption and involves modification of resources, the transfer of best practices can create unique value
  4. Connection, generates value by simply pooling the output of dissimilar value chain activities, for example customers may value being able to buy a bundle of different products and services together, the product development of one business is being connected to the distribution channel of another

Here are some other major strategy risks that are common:

One common negative synergy is brand dilution, ie, does the brand apply? Another is complexity. Another is market rivalry, this is a significant concern in the advertising industry, where when two firms who serve rivals merge, the chances of keeping both their clients is low.

Governance costs act as taxes that eat into the potential benefits from synergies when they are attempted to be extracted. [ie, the price you pay to operate an acquired business effectively.]

When an autonomous business becomes a division within another, the incentives of the owner and managers are necessarily diluted.

Synergies likely to generate significant transaction costs are less likely to be successfully realized in arms length relationships between independent firms than under common ownership.

I particularly appreciated the discussion about the corporate advantage that can be achieved through thoughtful design of the organization and its management.

One should be able to read the corporate strategy of a company in its organization chart: what kinds of activities does the top management feel are essential to integrate?

While all organizational structures represent a unique combination, there are three “pure form” ways to structure the corporation and its management structure: by activity, by output, by user/customer.

The authors recommend that corporate strategists “Think about the multi-business corporation as a collection of value chain activities” and look for synergies accordingly. But, being economic entities, there are necessary tradeoffs to beware of with each choice:

Grouping similar activities together emphasizes economies of scale at the expense of economies of scope, whereas grouping different activities together does exactly the opposite.

Every grouping arrangement emphasizes certain interactions but excludes others, which show up as opportunity costs and bottlenecks.

Further, if the innovation literature and hundreds of years of business history haven’t beat it into your head yet, things change. That means that the “right” structure (the synergistic one) is likely to change over time. “No structure is permanent.” Corporate strategists should always be considering the possibility that the ideal economic structure for managing the company has changed in reflection of new competitive dynamics, customer tastes and habits or advancements in technology, culture and society. A good rule of thumb might be that the appropriateness of the corporate structure needs to be reconsidered every time a major acquisition or divestiture occurs.

There were two other nuggets of corporate strategy wisdom that stood out to me. One was that most multi-business firms have capital allocation decision-making on auto-pilot. Either every request gets granted, or every request gets denied, or every business gets to keep whatever it generates. The corporate strategist can grab some low-hanging fruit by being thoughtful about capital allocation decisions within the portfolio and providing a critical voice about whether capital should be redistributed amongst divisions or even outside the company (ie, dividend or acquisition activity).

The other was in the author’s description of the typical M&A process (which includes not just execution of the acquisition transaction but also successful completion of the post-merger integration process). The most overlooked, and final, step in the process is Evaluation, which “refers to a post-transaction review of what went right and wrong” and analyzes the economic impact of the transaction on the entire firm. Were synergies realized? In the amounts predicted? Did costs materialize that were surprising? Did any other kind of disruption or distraction that was not anticipated earlier occur during the course of the merger? From my personal experience, it is difficult for management teams to take the time to look into the rear-view mirror like this, and even harder for them to be honest about what they see!!

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Finding My Buffett

Charlie listened. Eventually he asked, “Do you think that I could do something like that out in California?” Warren paused for a moment and looked at him. This was an unconventional question coming from a successful Los Angeles lawyer. “Yeah,” he said, “I’m quite sure you could do it.”

[…]

“Why are you paying so much attention to him?” Nancy asked her husband.

“You don’t understand,” said Charlie. “That is no ordinary human being.”

~The Snowball

Who wouldn’t want Warren Buffett as a friend? Who wouldn’t want to be the ultimate coattail rider as the Charlie Munger of the Berkshire Hathaway-type life story?

While it’s never been clear to me what value Charlie Munger brought to the duo aside from his acerbic wit and getting-high-on-my-own-supply love for See’s Peanut Brittle which undoubtedly boosted sales, it’s fairly obvious what Munger got out of Buffett– encouragement.

And that seems to be all Munger needed to find greatness in himself.

It is actually amazing that this bond was formed and that Buffett was not only willing to share with Munger his secrets but pushed him to try it himself. Why did he do this then? The truth is, it doesn’t matter. The only thing that matters, for Munger anyway, is that Buffett did this.

When I look back at my own history, particularly with regards to my interest in investing, I don’t see any encouraging moments like this. Perhaps I have simply forgotten them, or perhaps they did not occur. I think I had ample opportunity to be encouraged by others and yet I don’t have any recollection of it. As I am currently seeking after my passion in life and searching for what my own greatness might be about, I seem to remember at one time it might have had something to do with being a great investor. Along the way I lost sight of that vision, became discouraged, dejected and doubtful.

This might seem like a good opportunity to blame the various people in my life who might have encouraged me to keep going but did not. That isn’t my point and it isn’t what I believe or am focused on right now. Instead, I notice one more thing about the time that Charlie met Warren. That thing is this:

Charlie asked for what he wanted.

Review – The Snowball (#investing, #books, #business, #review)

[amazon text=The Snowball: Warren Buffett and the Business of Life&asin=0553384619]

by Alice Schroeder, published 2008, 2009 (condensed and updated)

This is my second reading of The Snowball. I enjoyed it almost as much as the first, five years ago, and definitely took away different things from this reading than I did last time. At that time, I was just finishing my “personal MBA”  deep-dive into value investing and was interested in Schroeder’s Buffett bio mainly for the information and insight it would yield into Buffett’s approach and track record as an investor. I was surprised to come away from that reading realizing that the book was a moral parable in the form of a man’s life (an incredibly successful, well-known and near-worshipped man) and my second journey through the book was more focused on the question “How should I think about living my life?” than the question “How should I think about investing?”

I found the book most exciting to read and most interesting personally in the exploration of Buffett’s origins and the detailed narrative about the first twenty years of the partnerships that proceeded his investment in Berkshire Hathaway. As the story wore on and it became more about managing what he had and dealing with the consequences of choices wrought long ago, I found myself losing interest, particularly as the Salomon and Long-Term Capital Management sagas carried on for a mind-numbing fifty-plus pages in total.

Buffett’s childhood was far more unusual than I cared to notice in my first reading. He was obsessed with business, investing and the impact of statistics in life not just from a young age, but in ways that were extraordinary even for someone to be described as “doing X from a young age” would imply by itself. Obsessed is not a word I use lightly here. The young Buffett was probably an odd creature to be around, even for people who loved him or found him interesting or were of unusual talent and ability themselves. This seems confirmed in later years when so many people familiar with him describe feeling exhausted after spending just a few hours with him. It helped me to realize how unfair and pointless trying to compare yourself to a person like Buffett is.

When asked by Bill Gates, Sr., at a dinner what single word they’d use to describe the outcome of their life and their success, Buffett said, “Focus.” As Schroeder describes in many places in the book, and especially at length in the final chapter, “focus” means something completely different when Buffett says it versus anyone of lesser ability and different personality. When Buffett says “focus” he means “to the exclusion of all else, with relentless, all-consuming energy, without tiring or being distracted.” There is no balance working behind the scenes. He gave up a lot of “normal” things most other people would insist on or desire in distinction to that which they were focused on, not as a sacrifice but as an inevitability of his personality.

The most obvious and tragic is his relationship with his family and his relationship with himself. Most other people who are driven towards success in their field and the monetary rewards that typically come with it offer up the excuse of their family as their motivation, honestly or not. This wasn’t the case for Buffett, and achieving supremacy in his profession and in his personal net worth really didn’t do anything to enhance his relationship with his family or the way he cared for them. It is indicated on numerous occasions what kind of tradeoff he would’ve had to make to be more involved with his family, and he never did it. It’s an excellent reminder for someone who sees themselves as driven to achieve that these tradeoffs are real and accepting a “lower rate of return” in one’s efforts is a necessary (and happy?) price to pay to maintain a relationship with one’s family, which itself is valuable.

Buffett’s relationship with himself is also instructive in this regard. Many people wonder how money can’t solve most problems, and why people who are super wealthy continue to eat poorly, exercise infrequently and maintain the same limited psychological state and insecurities they possessed before they achieved glory. The answer again is simple– in the drive toward massive wealth, things get set aside and often it is the improvement of the self as a holistic unit that is set aside first in order to claim excess in one aspect.

Of course, we can’t expect Buffett to be perfect. Nobody is, and the point of mentioning this isn’t to point out the man’s flaws, but to explain them. You can’t have Buffett and have these issues resolved to everyone’s satisfaction. They come with the territory. If you want to be “focused” like Buffett, plan on neglecting your family and yourself, quite a bit. That’s only a judgment if you think those things are objectively more important than wealth or self-actualization in the area of generating wealth. That’s not really a judgment I want to make here and I think it misses the point.

Yet, Buffett’s flaws make for a fascinating lesson in a different way. Though Buffett was unusual, and exceptional, and completely driven toward a single-minded purpose from a young age, the path was far from certain that he would need to tread to get to wherever it was that he would end up going. It’s easy to sit here today reading a book published almost ten years ago, recounting events that unfolded over the past eighty, and see what was inevitable as inevitable. But Buffett made mistakes. Many of them, along the way. That’s what’s truly remarkable, that he made mistakes and still arrived where he did. It’s a good salve for a person carrying around the perfectionist fallacy. Give it a rest and get going, you can make some mistakes and still end up alright if Buffett is any example.

I love reading stories like this, stories of flawed people of unusual ability who managed to achieve something heroic even if their life wasn’t truly ideal. I love knowing it can be done. I love knowing what the pitfalls and the tradeoffs are, so I can be mindful of them myself. I love the way I can give myself permission to not achieve what they achieved (in kind or in magnitude) having the benefit of hindsight to see what it truly took that I can’t give, or won’t.

But most of all, I just love watching someone create something from nothing. That creative energy is uniquely human and what I admire most about our species and this little project called “civilization” that we’re all tinkering away on. The Snowball is not as great an investment manual as I originally thought it was (for that, I’d recommend Buffett’s BRK shareholder letters, along with or after reading Graham’s Security Analysis and The Intelligent Investor), but it is an epic moral profile and a captivating read overall because of it.

4/5

[amazon asin=0553384619&template=iframe image2]

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Review – Common Stocks And Uncommon Profits (#investing, #stocks, #growth, #business)

[amazon text=Common Stocks and Uncommon Profits: And other writings by Philip A. Fisher&asin=0471445509] (buy on Amazon.com)

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.

4/5

[amazon asin=0471445509&template=iframe image2]

Notes – The Snowball, By Alice Schroeder: Part V, Chap. 43-52 (#investing, #books, #Buffettology)

The following are reading notes for [amazon text=The Snowball: Warren Buffett and the Business of Life&asin=0553384619], by Alice Schroeder (buy on Amazon.com). This post covers Part V: The King of Wall Street, Chap. 43-52

The modern Buffett

In Part V of the Snowball, we see Buffett’s transformation from the early, cigar butt-picking, Grahamian value-minded Buffett, through the filter of his Fisherite partner, Charlie Munger, into the mega cap conglomerator and franchise-buyer Buffett who is popularly known to investors and the public the world round.

It is in this part that we also see Buffett make one of his biggest missteps, a stumble which almost turns into a fall and which either way appears to shock and humble the maturing Buffett. It is in this era of his investing life that we see Buffett make some of his biggest rationalizations, become entangled in numerous scandals he never would’ve tolerated in his past and dive ever deeper into the world of “elephant bumping” and gross philanthropy, partly under the tutelage of his new best friend and Microsoft-founder, Bill Gates.

The lesson

Buffett made a series of poor investments but ultimately survived them all because of MoS. There will be challenges, struggles, and stress. But after the storm, comes the calm.

The keys to the fortress

From the late seventies until the late nineties, despite numerous economic and financial cycles Buffett’s fortune grew relentlessly under a seemingly unstoppable torrent of new capital:

Much of the money used for Buffett’s late seventies spending spree came from a bonanza of float from insurance and trading stamps

This “float” (negative working capital which was paid to Buffett’s companies in advance of services rendered, which he was able to invest at a profit in the meantime) was market agnostic, meaning that its volume was not much affected by the financial market booming or crashing. For example, if you owe premiums on your homeowner’s insurance, you don’t get to suspend payment on your coverage just because the Dow Jones has sold off or the economy is officially in a recession.

The growth in Buffett’s fortune, the wilting of his family

Between 1978 and the end of 1983, the Buffetts’ net worth had increased by a stunning amount, from $89 million to $680 million

Meanwhile Buffett proves he’s ever the worthless parent:

he handed the kids their Berkshire stock without stressing how important it might be to them someday, explaining compounding, or mentioning that they could borrow against the stock without selling it

Buffett had once written to a friend when his children were toddlers that he wanted to see “what the tree has produced” before deciding what to do about giving them money

(he didn’t actively parent though)

Buffett’s private equity shop

Another tool in Buffett’s investment arsenal was to purchase small private companies with dominant franchises and little need for capital reinvestment whose excess earnings could be siphoned off and used to make other investments in the public financial markets.

Continuing on with his success in acquiring the See’s Candy company, Buffett’s next private equity-style buyout involved the Nebraska Furniture Mart, run by a devoted Russian immigrant named Rose Blumkin and her family. And, much like the department store chain he once bought for a song from an emotionally-motivated seller, Buffett beat out a German group offering Rose Blumkin over $90M for her company, instead settling with Buffett on $55M for 90% of the company, quite a discount for a “fair valuation” of practically an entire business in the private market, especially considering the competing bid.

An audit of the company after purchase showed that the store was worth $85M. According to Rose Blumkin, the store earned $15M a year, meaning Buffett got it for 4x earnings. But Rose had buyers remorse and she eventually opened up a competing shop across the street from the one she had sold, waging war on the NFM until Buffett offered to buy her out for $5M, including the use of her name and her lease.

One secret to Buffett’s success in the private equity field? Personality:

“She really liked and trusted me. She would make up her mind about people and that was that.”

Buffett’s special priveleges

On hiding Rose Blumkin’s financial privacy: Buffet had no worries about getting a waiver from the SEC

Buffett got special dispensation from the SEC to not disclose his trades until the end of the year “to avoid moving markets”

The gorilla escapes its cage

Another theme of Buffett’s investing in the late 1980s and 1990s was his continual role as a “gorilla” investor who could protect potential LBO-targets from hostile takeover bids. The first of these was his $517M investment for 15% of Tom Murphy-controlled Cap Cities/ABC, a media conglomerate. Buffett left the board of the Washington Post to join the board of his latest investment.

Another white knight scenario involved Buffett’s investment in Ohio conglomerate Scott Fetzer, which Berkshire purchased for $410M.

Then Buffett got into Salomon Brothers, a Wall Street arbitrage shop that was being hunted by private equity boss Ron Perelman. Buffett bought $700M of preferred stock w/ a 9% coupon that was convertible into common stock at $38/share, for a total return potential of about 15%. It even came with a put option to return it to Salomon and get his money back.

But Buffett had stepped outside of his circle of competence:

He seemed to understand little of the details of how the business was run, and adjusting to a business that wasn’t literally made of bricks-and-mortar or run like an assembly line was not easy for him… he had made the investment in Salomon purely because of Gutfreund

Buffett’s disgusting ignorance and hypocrisy

Buffett:

I would force you to give back a huge chunk to society, so that hospitals get built and kids get educated too

Buffett decides to sell the assets of Berkshire’s textile mills– on the books for $50M, he gets $163,122 at the auction. He refused to face his workers and then had the gall to say

“The market isn’t perfect. You can’t rely on the market to give every single person a decent living.”

Buffett on John Gutfreund:

an outstanding, honorable man of integrity

Assorted quotes

Peter Kiewit, a wealthy businessman from Omaha, on reputation:

A reputation is like fine china: expensive to acquire, and easily broken… If you’re not sure if something is right or wrong, consider whether you’d want it reported in the morning paper

Buffett on Wall St:

Wall Street is the only place people ride to in a Rolls-Royce to get advice from people who take the subway

[amazon asin=0553384619&template=iframe image2]

Review – Quantitative Value (#valueinvesting, #quant, @greenbackd, @turnkeyanalyst)

[amazon text=Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors + website&asin=1118328078]

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 [amazon text=a book that explained his Magic Formula&asin=0470624159] 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, [amazon text=The Intelligent Investor&asin=0060555661], 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 [amazon text=the 80/20 principle&asin=0385491743]), 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 [amazon text=a funny experiment conducted by Paul Watzlawick&asin=0394722566] 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 [amazon text=Security Analysis&asin=0070140650] or [amazon text=The Intelligent Investor&asin=0060555661], for example.

4/5

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Review – Losing My Virginity (@richardbranson, #entrepreneurship, #books, #review)

[amazon text=Losing My Virginity: How I Survived, Had Fun and Made a Fortune Doing Business My Way&asin=0307720748]

by Richard Branson, published 2011

 

Spoiler alert– this book is choppy and inconsistent in the pacing and entertainment factor of its narrative. You really need to read between the lines a bit to get the most value out of it. That being said, it’s surprisingly literary for a dyslexic former publisher of a student magazine and I found Branson’s repeated reference to his high-altitude balloon voyage trials to be an outstanding metaphor for his life as a businessman and entrepreneur.

You see, in Branson’s ballon journeys, the key factors of any consistency were that: a.) Branson was knowingly and openly taking what he perceived to be a potentially life-threatening risk b.) Branson was almost always underprepared for it, or decided to go ahead with his attempt despite early warnings that something was amiss and c.) nonetheless, he somehow managed to survive one disaster after another, only to try something bigger and bolder the next time around.

And this is quite similar to the way he comported himself as an entrepreneur on so many occasions. Again and again, he’d make a daring foray into a business, market or industry he didn’t quite understand, the company would stumble after an early success leaving them all on the brink of failure and yet, each time they’d double down and somehow win.

In that sense, Branson is a perfect example of survivorship bias. On the other hand, having so many narrow misses that turn into massive accelerators of a person’s fortune start to make you wonder if isn’t mostly luck but rather mostly skill.

As an entrepreneurial profile, “Losing My Viriginity” is full of all kinds of great successes and astounding failures. With regards to the failures, something I found of particular interest was the fact that Branson’s company were victims of some of the most common pitfalls of other businesses throughout its early history: taken for a ride by indomitable Japanese owners/partnerships in the 80s, repeated victim of the LBO-boom and the private/public buyout-cycle in the 80s and 90s. When you read these stories in the financial press it always seems to happen to the rubes of the business world, but Branson’s foibles help one to realize even rather sophisticated types can get taken in now and then.

The volatility in Branson’s fortunes do leave one with a major question though, namely, why did Branson’s company ultimately survive?

This isn’t a Harvard Business School case study so I don’t mean to pass this off as a qualified, intelligent answer to that question, but I will attempt a few observations and, in typical HBS fashion, some or all of them may be contradictory of one another and none will be provided with the precise proportional contribution they made to the end result:

  • the group had a cultural commitment to change and dynamism; they were not so much their businesses, but a culture and group of people who did business a particular way, a true brand-over-merchandise, which allowed them to reinvent themselves numerous times
  • the group strategically focused on being the low-cost provider in their industry, usually while simultaneously attempting to pursue the seemingly mutually exclusive goal as being seen as the highest quality offering as well
  • the group focused on serving customers but equally saw treating its employees with concern as an important value
  • the group consciously created a brand that could be applied to diverse businesses (see point #1)
  • the group pursued businesses that seemed “interesting” or sensually appealing to it, which ensured that everyone involved was motivated to do well because they liked the work they had chosen

Another thing I noticed about Branson and the development of his company was the attention he paid to the composition of management and owners and his dedication to weeding out those who were not good fits in a charitable way. Channeling the “best owner” principle, Branson made a conscious effort to buy out early partners whose vision and tastes did not match the current or future vision of the group. In this way, the company maintained top-level focus and concentration on a shared strategic vision at all times, sparing itself the expense and distraction of infighting and wrangling over where to go next and why.

Another aspect of the company’s resilience had to do with its operational structure. Branson built a decentralized company whose debts and obligations were kept separate. In an environment where new ventures were constantly subject to total failure, this arrangement ensured that no one business failure would bring the entire group down.

The final lessons of the Branson bio were most instructive and had to do with the nature and value of forecasting.

The first lesson in forecasting has to do with the forecasts others make of us, or the world around us. For example, Richard Branson had no formal business training, he grew up with learning disabilities (dyslexia) and he was told very early on in his life by teachers and other adult and authority figures in his life that he’d amount to nothing and his juvenile delinquency would land him in prison. Somehow this worthless person contributed a great deal to society, through business and charity, and by most reasonable measures could be considered a success, making this forecast a failure. If one had taken a snapshot of the great Warren Buffett at a particular time in his adolescence, when the young boy was known to often take a “five-finger discount” from local department stores, it might have been easy to come up with a similar forecast about him.

I’m not sure how to succinctly sum up the concept there other than to say, “Things change.” Most forecasts that involve extrapolating the current trend unendingly out into the future will probably fail for this reason.

The second lesson in forecasting has to do with how we might attempt to forecast and plan our own lives. When we have 50, 60, 70 or more years of a person’s life to reflect on, it is easy to employ the hindsight bias and see how all the facts of a person’s life were connected and led them inexorably to the success (or infamy) they ultimately achieved. And certainly there are some people, again using Buffett as an example, who from an early age were driven to become a certain something or someone and so their ability to “predict their future selves” seemed quite strong.

But the reality is that for the great many of us, the well-known and the common alike, we really don’t have much of a clue of who we are and what we’ll ultimately become. The future is uncertain and, after all, that’s the great puzzle of life that we all spend our lives trying to unravel. Richard Branson was no different. He was not born a billionaire, in a financial, intellectual, personal or other sense. He had to learn how to be a businessman and how to create a billion dollar organization from scratch. Most of the time, he didn’t even know he was doing it. In other words, HE DID NOT KNOW AHEAD OF TIME that he would become fabulously wealthy, and while he was hard-working and driven, it doesn’t even appear he purposefully intended to become so.

Maybe we should all take a page from Branson’s book and spend less time trying to figure out what’s going to happen and more time just… happening. We could sit around all day trying to figure life out, or we could follow the Branson philosophy where he says, “As for me, I just pick up the phone and get on with it.”

3/5

[amazon asin=0307720748&template=iframe image2]