Simplicity Still Pays - WCAM

The complexity of CDOs probably made them seem more attractive to many, but breaking the concept down to its simplest expression could have helped a lot of people see the danger sooner. Subprime mortgages and the instruments built on them only work in economies and financial markets that only go up, continuously and forever.We do not know of any markets that only go up, so we think these instruments look more like a Ponzi scheme than a rational investment. For some reason, people fall for this over and over and over again.

-
SIMPLICITY FOR THE LONG TERM

-

We don't fear complexity, but we prefer simplicity in our investments. Over time, the stock market rewards simplicity.

-

When we call Wal-Mart,Whole Foods, Hershey or Wrigley simple businesses, we do not mean to trivialize the competitive challenges these companies face everyday.We consider them simple because it is immediately clear how they make money, and how they make money for investors.Wal-Mart sells everyday goods at low prices, Whole Foods sells healthy foods, Hershey makes chocolate, and Wrigley makes chewing gum. That part is simple, but each company worked hard to achieve competitive advantage that allows it to execute its simple business in very profitable ways.

-

Even a company doing complicated things can qualify as a simple company. Noven Pharmaceuticals creates and markets superior drug delivery methods, such as patches for treatment of ADHD and estrogen therapy for menopause. The advantages of Noven patches are easy to see: they are much smaller than competing patches, stick better with less skin irritation, and investors get some additional margin of safety through long patents.Drug companies partner with Noven because the patches extend and differentiate proven drug compounds with low development costs and short regulatory approval time frames.

-

A “simple” company easily passes the elevator test favored by venture capitalists when hearing a proposal: if you can explain the business in the time it takes to get from the lobby to the office, it may have merit. To meet this test, a collateralized debt obligation based on credit default swap derivatives would require a very tall building indeed.