Wednesday, January 22, 2014

Boyles Asset Management - Q4 2013 Letter Excerpt

Below are a couple of sections (slightly edited for public viewing) from a letter just sent to the investors of the fund I help manage.
Disclosure: I am a portfolio manager at Boyles Asset Management, LLC ("Boyles") and the fund managed by Boyles may in the future buy or sell shares of the stocks mentioned below and we are under no obligation to update our activities. This is for information purposes only and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.


Reasonable Imagination

“I am enough of the artist to draw freely upon my imagination.  Imagination is more important than knowledge.  Knowledge is limited.  Imagination encircles the world.”
– Albert Einstein, The Saturday Evening Post Interview (October 26, 1929)

There is no doubt that an appropriate temperament, a strong analytical mind, robust research process and experience are key determinants of investment success, but it is imagination that doesn’t seem to get much attention.  It is likely that the word imagination is more often associated with artists than investors, but we’ve come to appreciate the role a “reasonable imagination” plays in the investment process.  Perhaps even Mr. Buffett alludes to this in his work, often comparing his effort over the years at Berkshire Hathaway to painting his masterpiece.  It certainly took his imagination to build an investment group not seen before and, more importantly, it took an imagination to conceptualize, in potential investments, the opportunities beyond mere numbers on paper.

Defined by Merriam-Webster as, “the act or power of forming a mental image of something not present to the senses or never before wholly perceived in reality,” the noun begins to take the shape of a concept important to the investment process.  As we know, investing is about laying out cash today for something to be received in the future and so an investor had better be able to visualize as well as articulate what he or she expects to receive.  That takes more than just examining what is before one’s eyes—it takes imagination. 

A properly calibrated imagination plays a role in such things as:

§  conceiving of potential risks not immediately evident
§  hypothesizing about management and board of directors’ motivations
§  appreciating that earnings or cash flow might be markedly different in more or less optimum conditions
§  picturing competitive dynamics and responses over time
§  appreciating competitive strengths of businesses
§  seeing a future for a business that is different from general consensus
§  thinking about future regulatory issues
§  identifying potential catalysts for an investment
§  conceiving of potential future capital investment opportunities (how long is the runway)
§  identifying investment opportunities in a competitive market
§  improving the investment process
§  developing mental models

As can be inferred from the list above, we must be careful to regulate our imaginations, lest we forget that it is a “reasonable imagination,” rather than an “unreasonable imagination,” that counts.  And it certainly is not only about imagining what might be on the upside.  Equally important is an imagination about what might lurk on the downside.  In addition, it is vital to have a reasonable imagination when panic starts to impact markets or individual stocks.  Often it is investors’ imagination that gets the better of them in these situations.

Investors aren’t able to look up the answers or easily crunch some numbers to address these parts of the investment process.  They are not “present to the senses.”  For our part, we’ll continue to work on our investment imagination.

Side-Note 1

Just before we “went to press” with the letter, one of your managers happened to be reading 100 to 1 In the Stock Market, by Thomas Phelps (incidentally, we recommend the book).  Two-thirds of the way through, he came across the passage below that debunks the idea that we are the only ones thinking about the importance of a “reasonable imagination”:

To make a sensible choice we investors must make or accept some assumptions about the future…To make intelligent assumptions about the future we must try to perceive the tendency of events… It all boils down to practical imagination – the ability to see what is not there but will be soon enough to matter to you.

Side-Note 2

If you happen to know a modern art collector willing to pay top dollar for a Miller or Koster, please let us know.

Inefficient Markets

“Two markets are inefficient: very small ones (which are not much use to Berkshire, with its $120 billion), and ones where crazy people are doing crazy things, especially if they’re selling.  From time to time, the big markets have some crazily mispriced securities in them.  But there’s no question that in small markets there’s a lot of opportunity to find mispricings.”
–Charlie Munger (2007 Wesco Financial Annual Meeting)

The above quote from Charlie Munger is about the best summary we’ve seen to explain what we do, and how we believe we can generate good returns over time.  Our main focus has been on trying to find small, underfollowed, and mispriced companies.  We’re willing to look all over the world and have a particular focus on countries that speak and report in English so that we can perform the necessary due diligence we believe needs to be done when managing a concentrated portfolio.  And while our focus has been on smaller companies in the past and remains so today, we have the flexibility to venture into larger companies when opportunities present themselves, which they occasionally will just as they have before, as was evidenced during the depths of the financial crisis about five years ago.

In 2008, during the week that spanned from November 13th to November 20th, Class A shares of Berkshire Hathaway dropped from $103,600 to $74,100, a decline of almost 30% from the high to the low, on rumors that it was having troubles with some of the derivatives contracts it had written on four stock indices.  Those contracts still had between 10 and 20 years before Berkshire would be required to pay out a penny, though there was some worry that mark-to-market losses could force Berkshire to be at risk of falling short of the capital it is required to hold as part of its insurance business.  The rumors turned out to be false, and Berkshire’s stock recovered the full amount of the initial drop one week later, and continued its march upward over the next few years to close 2013 at $177,900 per share.

Berkshire is but one example of what can occasionally happen with the shares of larger companies when fear takes hold and you get to a point where “crazy people are doing crazy things.”  Of the roughly 400 companies with market capitalizations north of $5 billion at the start of 2007, about 15% of them had stock returns greater than 300% for the 5 years to the end of 2013.  Some well-known companies such as Whole Foods, Starbucks, and American Express are all up over 8 times where they traded during the crisis lows.  While we did not participate in the rise of those stocks, our hindsight points out one of the more difficult effects one’s psyche must face in investing: regret.

When looking back, you always find things you wish you had done (or not done), and it is important not to let the feeling that comes with knowing the past affect the way you invest in the present.  When crises strike and Mr. Market panics, the competitive advantages one can have over other market participants are largely psychological. One must be greedy when others are fearful and be willing to look stupid (since no alarm bell rings at the bottom) and look beyond short-term troubles, which can be quite real, in order to focus on long-term values.

While the above examples may be extreme and those values unlikely to repeat themselves anytime soon, history will rhyme eventually, and the opportunity to invest in “wide-moat” businesses at great prices that can compound for years will come again.  We eagerly await the day, though we have no idea when it may come, so we focus our time on what we believe is our best opportunity set at hand.  To quote Thomas Carlyle, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.”  Our time today is largely spent trying to uncover a few gems among the smaller companies while continuing to learn things that we hope will lead to insights and investments in companies of any size.