Tuesday, August 26, 2008

Investing in Sustainably Advantaged Businesses - TWST Interview with Larry Coats of Oak Value

We define good businesses as those that we believe have the ability to produce predictable and growing excess cash. The predictability component is defined to a large extent by the company’s positioning relative to customers, suppliers, competitors and substitute products.

If you envision perhaps a diagram where you have a company in the middle and you have those forces — customers, suppliers, competitors and substitute products around it — you would recognize the notion that Buffett talks about in terms of a “moat and castle.” Our use of this framework is really founded somewhat in the teachings not only of Buffett and the “moat-and-castle” concept, but also Michael Porter who is a professor at Harvard and certainly a good strategic thinker. Porter also uses this competitive framework. I asked Mr. Buffett once if this competitive framework that Porter uses is essentially the same thing as his concept of “moat and castle,” and his response to me was, “Well, Porter writes books about it and I make billions, but they’re really the same concepts.”

As we look at good businesses, that’s what we’re asking. Do these businesses have sustainable advantages from an economic and a competitive standpoint so they have the ability to generate above average returns and then can they give us the predictability that we need as we look out into the future. When we get down to the valuation phase, we believe that the value of a business is defined by its future cash flows. We have to value companies looking forward as opposed to looking backwards, if you will. Good management we view as being shareholder-oriented, having demonstrated the ability to run the business and very importantly, having demonstrated the ability to reinvest the excess cash flows that the good business generates into higher-returning investments. If you can’t do that, obviously you need to return that capital to the shareholders.

Then the final piece from a philosophical standpoint is the valuation — good businesses with good management at attractive prices. We view the valuation piece in the framework of a discounted cash flow model using a five-year period and an 8% discount rate, and we’re attempting to buy businesses that we believe are trading at roughly $0.65 to $0.70 on the dollar.
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The Stock Screen

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Screening criteria is posted HERE.
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Tuesday, August 19, 2008

Confessions of a risk manager

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In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
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Related Books:
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Why Technology Hasn't Saved Us From Inflation (but still can)

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Related - The Long Tail: Book and Audio Book
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Friday, August 15, 2008

Known and unknown unknowns

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Related previous post (with book recommendations at end):
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Bruce Berkowitz Stays In The Sunshine

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Tuesday, August 12, 2008

Jean-Marie Eveillard - Value Investor Insight - May 30, 2008

JME: For the past 30 years we’ve sort of floated in style between Ben Graham and Warren Buffett. Graham’s approach is static, quantitative and focused on the balance sheet. There’s no attempt to look into the future and judge the more qualitative aspects of the business. He’d love the Japanese net-nets today, for example.

Buffett’s major idea was to also look more qualitatively for those few businesses with apparently sustainable competitive advantages, where the odds were fairly high that the business would be as successful ten years from now as it is today. In those situations, one makes money not so much from the elimination of the discount to intrinsic value, but more from the growth in that intrinsic value.

When I started out in 1979, both in the U.S. and Europe, there were many Ben Graham-type stocks to uncover after the dismal stock performance of the 1970s. As we grew and markets changed, we’ve moved more to the Buffett approach, but not without trepidation. If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous. With the Graham approach, the very large discount to static value minimizes that risk. Overall, I’d like to believe we’ve learned well from both Graham and Buffett and that we own securities that would attract each of them.

Most of the time the short-term outlook stinks for the companies we end up buying, for company-specific or cyclical reasons. The best opportunities tend to be when the company now facing a lousy short-term outlook was not long before considered a darling of growth investors, and when the problems are now perceived to be more permanent. If you think those problems aren’t really permanent, you can make very attractive investments if you turn out to be right.
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Value Investor Insight
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Thursday, August 7, 2008

Oaktree - Howard Marks: Letter to Clients

Of the two things I think are most wrong about American business, the worst is short-termism. (The other is the ability of executives to thrive while their companies do poorly.) Companies are rewarded for short-term success and penalized for short-term failure, whereas few people ask about the long term. The only thing that matters is “What have you done for me lately?” A lot of this emanates from stockholders.

In a memo several years ago, I listed a few phrases that have sunk into obscurity over the course of my career. They included “fiduciary duty,” “preservation of capital” and “dividend yield.” Another is “long-term investor.”

Most investment managers are measured against a benchmark every quarter and expected to add value. Some clients have their fingers on the trigger, ready to axe a manager who underperforms for a year or two. For this reason, managers sit with their own fingers on the trigger, ready to dump a stock or bond whose short-term performance lags. And company CEOs whose securities are laggards are likewise on the hot-seat, with boards that rarely support executives who disappoint Wall Street.

Too many people think of the long run as nothing but a series of short runs. The way to have the best five-year investment record, they think, is by sequentially assembling the twenty portfolios that will produce the best performance in each of the next twenty quarters. No one wants to invest in a company that may lag until long-term investments pay off down the road. They’ll just sell its stock today, assuming they’ll be able to buy it back later.

Understanding this, companies face great pressure to emphasize short-term results. What might they do in response?

• Maximize revenues (perhaps by stuffing pipelines and offering discounts that accelerate future sales into the present).
• Minimize expenses in slow-to-bloom areas like research and development.
• Borrow to buy back stock, because debt capital is cheap and equity is expensive (despite the fact that equity provides safety and leverage amplifies risk).

Do you want your companies doing these things? Probably not. But do the collective external pressures force companies in these directions? Absolutely. The things that maximize profits in the short run often serve to decrease profits and increase risk in the long run, but they can be mandatory these days.
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GMO - Jeremy Grantham: Q2 Letter

In the meantime, we are living increasingly beyond our means, and Mr. Market is about to help us reconsider our behavior. This century will likely see the end of the Industrial Revolution and the age of “limitless resources.” Higher prices and (hopefully) voluntary improved behavior will together usher in the post-Industrial Revolution phase of limited resources and frugality. We will all modify our behavior and probably quite fast. We will all re-adopt Yankee virtues (or Yorkshire virtues, I might add) of “waste not, want not,” and get accustomed to using our brains instead of our hydrocarbon brawn.

The prices of commodities are likely to crack short term (see first section of this letter), but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced. Using marginal cost as a substitute was ignorant and conducive to wasteful consumption of scarce energy resources. It also enabled us to put our collective head in the sand and ignore the growing need for an enlightened long-term energy and climate policy.

Relatively quickly, in 100 years or so, we will run out of oil, underground water, and most non-fully-renewable resources. At current rates, we will do it very, very fast. A major complication now, though, is that we have been brainwashed by repetition to reject this whole idea as irretrievably pessimistic and defeatist, and just well ...thoroughly un-American.

One of the most unfortunate features of our sustained ability to overcome presumed limitations by applying technology is in the dangerous overconfidence it has given us, particularly in our casual and profligate use of resources. Starting now, higher prices will steadily overcome our optimistic assumptions and change our wasteful behavior. We must remember that, after all, in the wolf story, the wolf finally comes.
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