Links

For those that are going to the Fairfax Financial Annual Meeting in April and are looking to attend other events around the meeting, discount rates for the YYX Toronto Value Symposium are available. 

***

What “Bullet-Proof Investing” Means to Me? - by Sanjay Bakshi (LINK)

Crisis Investing: How to Maximize Returns During Market Panics (LINK)

Winter 2020 issue of Graham & Doddsville (LINK)

The Flaws of "Subscription Fatigue", "SVOD Fatigue", and the "Streaming Wars" - by Matthew Ball (LINK)

Writing in a Business Context - by Jerry Neumann (LINK)

Some great notes from the book Capital Account: A Fund Manager Reports on a Turbulent Decade, 1993-2002 (LINK)

Related previous posts: 1) THE TENETS OF CAPITAL CYCLE ANALYSIS; 2) Ed Chancellor on the capital cycle...; 3) More from Ed Chancellor on focusing on industry supply...

Can We Have Prosperity Without Growth? (LINK)

Chemical Toxicity and the Baby Bust: Unexpected threats to human fertility and, hence, chemical companies - by Jeremy Grantham (LINK)

Naked Mole Rats Seem More Alien Than Mammal. What Explains Their Weirdness? (LINK)

The Seven Deadly Sins of Banking

From Capital Returns (the excerpt below was from a Marathon letter written in November 2009):

One large European financial institution, however, which didn’t blow up during the Global Financial Crisis is Svenska Handelsbanken, Sweden’s largest bank and a long-term Marathon holding. Over the years we have gotten to know the bank quite well. Our meetings with management have often provided timely insights into the folly of their European banking competitors. A recently published book about the bank, entitled A Blueprint for Better Banking, by Niels Kroner, describes the history and culture of the bank and, as the title suggests, argues that many of the recent problems of the financial system could have been avoided if other banks were run in the “Handelsbanken way.” 

Handelsbanken is a very conservatively run, branch-based retail bank which was the only major Swedish bank not to break in the Nordic banking crisis of the early 1990s. This time around, Handelsbanken has pulled through yet again, avoiding the need to raise fresh capital or receive government support. That puts it on a short list of only three major European banks. Handelsbanken’s decentralised business model encourages branch managers to make loans based on local, face-to-face knowledge of customers rather than relying on centralised credit scoring techniques, as their competitors do. The bank consistently has the best customer service ratings in the industry and the lowest costs (as demonstrated by a low cost to income ratio compared with other banks). A few years ago, we asked management why (as we had been told) there were holes in the carpets at many of its branches. “Carpets don’t make money,” was the reply. 

Having avoided the disasters of its peers, since the beginning of 2007 Handelsbanken shares have outperformed those of all other major European banks. According to Niels Kroner, Handelsbanken has succeeded by not committing what he calls the Seven Deadly Sins of Banking. These are as follows: 

First deadly sin: Imprudent asset-liability mismatches on the balance sheet 

Obviously there are many cases around the world of how borrowing short and lending long can go wrong for banks. Recent examples in Europe include Northern Rock in the UK and the Irish banks. During the boom years, the Irish banks financed household mortgages that had a contractual maturity of two decades or more, with commercial paper of less than one year’s duration. Handelsbanken is acutely conscious of the risks posed by asset-liability mismatches. The bank uses a central treasury function to match and price deposits and loans according to their respective maturities. In this way, branches cannot report a profit by simply engaging in maturity transformation. 

Second deadly sin: Supporting asset-liability mismatches by clients 

The classic example here is foreign currency lending to households in Central European countries. Not long ago, European banks were providing low interest euro and Swiss franc mortgages to Hungarian and Latvian consumers. It was unlikely these customers understood the foreign exchange risk they were running. Handelsbanken does not engage in such lending, mainly because the primary incentive of the branch managers is to eliminate default risk. The worst thing a branch manager can do is to run up bad loans. Internally, branches are ranked on this measure to shame the underperformers. 

Third deadly sin: Lending to “Can’t Pay, Won’t Pay” types 

Here one immediately thinks of banks lending to subprime borrowers and private equity firms. Handelsbanken’s approach is rather to “lend to people with money.” Theirs is a niche lending approach rather than a mass market one. In company research meetings over the years, Handelsbanken told us that the banking industry had become obsessed with earning a few extra basis points of spread each quarter, while losing sight of credit risk, namely the chance that borrowers might never be in a position to repay the principal. 

Fourth deadly sin: Reaching for growth in unfamiliar areas 

A number of European banks have lost billions investing in US subprime CDOs (UBS has blown some $40bn in this manner), having foolishly relied on “experts” who told them that these were riskless AAA rated credits, i.e., they outsourced the underwriting decision. In Scandinavia, many banks pursued growth in the Baltic states and have suffered as GDP in the region has contracted by 15–20 per cent this year (house prices in Latvia are now down 70 per cent from the peak). Handelsbanken’s approach to foreign expansion, by contrast, has always been one of cautious “organic incrementalism,” as they describe it. The bank largely eschewed the Baltic states as too risky. Instead, Handelsbanken expanded its branch network in a number of mature Western European markets – including UK, Germany, and Norway – where it has been easy to recruit good branch managers among those who have grown disillusioned with the centralising tendencies at their old banks. In the UK, Handelsbanken hired local branch managers who brought with them their best clients and most highly regarded colleagues. 

Fifth deadly sin: Engaging in off-balance sheet lending 

Recent examples of the cardinal banking sin of off-balance sheet lending include the use of conduits and SIVs by European banks. By contrast, Handelsbanken’s approach is to accept only risks which it is prepared to hold on its balance sheet until maturity and not to lend money to those that are in the business of lending money themselves. Incidentally this principle also restrained the bank from engaging in pass-the-parcel securitization schemes which have had such a damaging effect on underwriting standards across the European banking system. 

Sixth deadly sin: Getting sucked into virtuous/vicious cycle dynamics 

The sixth deadly sin is to be seduced by what might be termed Ponzi economics. Lending by Scandinavian banks in the Baltic states seemed like a good idea for a long time partly because GDP was growing rapidly. The strong economic growth, however, was a function of rapidly growing credit supplied by the banks themselves. The fact that every bank was lending in the same market made it feel safe, and for a while the virtuous cycle continued. Real estate markets around the world were similarly characterised by the notion that asset quality was independent of credit conditions. Handelsbanken prides itself on its contrarian streak. It is less prone to high level “strategic” moves (which normally entail engaging in happy groupthink) because of its reliance on the branch network. The branches have a fairly consistent risk appetite through the cycle and so tend to lose market share in frothy times (e.g., during the 2006–08 period) and gain share when others are unwilling or unable to lend. 

Seventh deadly sin: Relying on the rearview mirror 

A recent expression of this common financial vice includes the widespread use of value-at-risk models. Such models tend to be based on a limited amount of historic data, which in the years before the crisis were relatively benign. True risk was understated. In its 2007 annual report, Merrill Lynch reported a total risk exposure – based on “a 95 per cent confidence interval and a one day holding period” – of $157m. A year later, the Thundering Herd stumbled into a $30bn loss! After house prices have risen by 85 per cent in ten years, as they had in the United States, was it realistic to expect a maximum decline of 13.4 per cent (Freddie Mac’s worst case scenario)? Handelsbanken determined its capital requirements based on more pessimistic crisis scenarios, such as a repeat of the Swedish banking crisis. 

There are many other ways in which Handelsbanken is different from its peers. In its dialogue with investors, bank representatives refuse to engage in the game of trying to estimate this year’s profit number. They have no other choice, since divisional budgets were abolished in 1972. If managers have budget targets, so the thinking goes, it becomes more difficult to stay out of the market when pricing is unfavourable. 

Management incentives are also unusual. The bank funds an employee profit-sharing scheme called the Oktogonen Foundation, which receives allocations when the group’s return on equity exceeds the weighted average of a group of other Nordic and British banks. If this criterion is satisfied, and it usually is, except at the peak of the cycle, one-third of the extra profits can be allocated to Oktogonen subject to a limit of 15 per cent of the dividend to shareholders. If the Handelsbanken lowers the dividend paid out to its shareholders, no allocation is made to the profit-sharing foundation. 

The foundation channels a large part of its resources into Handelsbanken stock and currently holds 11 per cent of the bank’s equity. All employees receive an equal part of the allocated amount (without the traditional skew towards the upper echelons), and the scheme includes all staff in the Nordic countries and, since 2004, in Great Britain. Disbursements are only made once a member of staff has reached the age of 60. Employees who have been working for Handelsbanken since 1973 have around $600,000 – which turns out to be roughly half the value of a Nobel prize – due to them at retirement, regardless of whether they have worked as the CEO or as a security guard. The system undoubtedly contributes to the bank’s tribal culture and aligns employee interests with shareholders.

Management incentives and insider ownership...

From Capital Returns (the excerpt below was from a Marathon letter in February 2012):

While the increasing influence of the proxy advisory services is welcome, the prescriptive, rule-based approach of these organizations does not suit every case, particularly when it comes to executive remuneration. What is the optimal incentive scheme, then? The answer is it depends on the circumstances. Remuneration structures based on earnings per share (EPS) growth and total shareholder return (TSR) performance measures are increasingly commonplace. Yet they suffer from the problem identified long ago by the management guru, Peter Drucker, who observed that the search for the right performance measure is “not only likely to be as unproductive as the quest for the philosopher’s stone; it is certain to do harm and to misdirect.” This is particularly the case when pay is linked to EPS – a particular bête noire for Marathon over many years. 

The earnings per share measure is prone to manipulation by unscrupulous executives; it takes no account of risk and encourages value destroying acquisitions and buybacks, especially when interest rates are low. It also encourages the quarterly EPS guessing game beloved by the sell-side. At times, it seems that meeting the EPS target has become the main strategic purpose of the company. This is regrettable. Corporate strategy should be about how best to allocate resources. If a turnaround requires a three-year investment phase, management may not pursue the optimal business plan if their compensation is linked to interim EPS results. While these inter-temporal issues can be partly resolved by phasing in performance rewards over a period of years, investor myopia and management’s own interest tend to lead to an exclusive focus on the calendar year EPS, which bears no relation to long-term value creation. 

Linking compensation to total shareholder return (TSR), the most common share price-based measure, is better than EPS, as it forces management to think about what drives shares prices over the medium term. Such schemes suffer from point-to-point measurement, which can be distorted if the stock price at either the start or end date is inflated by takeover speculation or by general overvaluation in the stock market. Then, there are questions over what time frame to measure the returns; also, whether the benchmark should be absolute or relative – both have their merits, neither is perfect. In the case of relative schemes, should the benchmark be provided by a peer group or by the broader market index? Sir Martin Sorrell, the head of advertising giant WPP, has become a very wealthy man thanks to his ability to outperform a small group of marketing service companies. Unfortunately, this wealth creation has not been shared with the company’s owners due to the under-performance of this sector over many years. 

For this reason, we normally prefer corporate incentives schemes to be benchmarked against the stock market index, in line with our own performance fees. Company managers might feel aggrieved that they have no control on performance relative to a broad index, which may be driven by moves in some heavily-weighted sector, such as mining or pharmaceuticals in the FTSE 100. Some companies have come to us seeking to switch from a relative TSR scheme to an absolute one – often after a period of relative outperformance which presumably management believes will end imminently. 

As regards the time frame over which performance should be measured, here one runs into the problem of investor myopia. Since the average holding period for European shares is down to 12 months (see Chart 3.2), the “average” investor has little interest in the performance of a company over a five-year period. We prefer longer measurement periods, with multiyear phasing in of benefits to encourage long-range strategic thinking. The views of high frequency traders and investors obsessed with quarterly EPS should be given a very low weight by management. Time frames may also need to vary by sector. In the capital goods and extractive industries, project terms may be well in excess of five years (for aero engines, product life cycles can be decades). 

Given that each measure has pros and cons, it is not surprising that remuneration consultants seek a compromise, bundling together a mixture of measures in the incentive scheme. But so-called “balanced” approaches, such as those which mix an EPS target with a return on capital overlay and a TSR override, are likely to confuse both management and investors and, even worse, can encourage sophisticated gaming strategies. 

Insider ownership has always seemed to us as the most direct way to deal with the principal-agent problem, which arises with the separation of corporate management from ownership. Our portfolios have tended to be skewed towards companies where successful entrepreneurs run their companies and retain sizeable shareholdings. Pleasingly, a number of companies have followed the example set by Reckitt Benckiser, where executives are required to build up significant shareholdings. Along similar lines, HSBC has recently revamped its incentives so that generous deferred share awards, which vest after five years, have to be held until retirement. Long-term share ownership is probably the best way of concentrating the minds of management on the true drivers of value. The manager’s instinct for wealth protection should guard against excessive risk-taking, the unfortunate counterexample of Lehman’s Dick Fuld notwithstanding.

Assessing management...

From Capital Returns (the excerpt below was from a Marathon letter in June 2014, and provides some good pointers to help in assessing management teams):

Over the last two years, Marathon has engaged in nearly two thousand meetings with company management. This activity, along with preparation and the writing of notes, consumes most of the investment team’s working hours. Yet many commentators view such meetings as a waste of time. One can see their point. Managers are now so well prepared by PR advisers that meetings can seem like a promotional exercise. Investors still turn up. But for many of them, we suspect, their purpose is to gain an informational advantage about the short-term outlook for the business – in our view, a fruitless endeavour. Given the long-term nature of our investment approach, capital allocation is of paramount importance. The prime purpose of our company meetings is to assess the skill of managers at investing money on behalf of their shareholders. 

Meeting management is not a scientific process. Rather, it involves making judgements about individuals, an activity which is prone to error (witness the rate of divorce). We go into meetings looking for answers to questions such as: does the CEO think in a long-term strategic way about the business? Understand how the capital cycle operates in their industry? Seem intelligent, energetic and passionate about the business? And interact with colleagues and others in an encouraging way? Appear trustworthy and honest? Act in a shareholder-friendly way even down to the smallest detail? 

To assess such questions, the format of the meeting is important. In general, the smaller the number of people in attendance the better. Having fewer attendees on both sides of the table – large meetings often include company managers, investor relations personnel, financial PR types, stock brokers, and other hangers-on – encourages a more open and friendly dialogue. It also reduces the risk of attendants showing off, which can result in the conversation becoming hopelessly bogged down in detail. A new and dreadful manifestation of the quest for redundant detail is the “fireside-chat” format used at many sell-side conferences, which typically involves a CEO being quizzed by the specialist analyst. The conversation generally turns into a “deep dive” into factors impacting short-term earnings, which can be of no interest to long-term investors. Questions of this sort can be ludicrous. At a recent conference we attended, the boss of a major industrial firm was asked whether we could expect that same pattern of seasonality as the year before. 

Large delegations from a company can be a sign that the CEO lacks confidence, resorting to a safety-in-numbers approach. This is often the case when dealing with companies in difficulty, as well as with many Japanese, Spanish and Italian firms. Contrast this with Geberit, the highly successful Swiss plumbing equipment company, whose CEO tends to arrive alone at our offices, having seemingly made his own travel arrangements, fitting us in between meetings with plumbers, architects and other customers. 

When it comes to discussing a company’s strategy, it is alarming how frequently one finds managers confused on the topic. Too often, the CEO mistakes a short-term target – say an earnings per share target or a return on capital threshold – with a strategy. “Our strategy is to deliver a 15 per cent return on capital,” they say. Real strategy, whether military or commercial, involves an assessment of the position one finds oneself in, the threats one faces, how one plans to overcome them, and how opponents might in turn respond. During his tenure at General Electric, Jack Welch required managers of GE’s divisions to prepare a few simple slides describing their operating environment in terms of: what does your global competitive environment look like? In the last three years, what have your competitors done to alter the competitive landscape? In the same period, what have you done to them? How might they attack you in the future? What are your plans to leapfrog them? 

Getting CEOs to open up about their competitors can be difficult. They fear that too much openness may lead to a breach of confidentiality (professional investors are a thoroughly untrustworthy bunch) or that revelations about the firm’s true market dominance might raise anti-trust issues. Besides, many managers are so fixated on growth, they fail to anticipate the likely competitor response (another example of the “insider view”). Still, on occasions something useful slips out. When a management team compliments a competitor, this can be like gold dust to investors. Learning that DMGT, the UK media company, found it hard to compete with Rightmove, the property listings website, contributed to our decision to invest in the company. 

Discussing how a firm uses investment bankers and how it makes acquisitions (e.g., whether it prefers friendly negotiated deals to contested auctions) can be revealing. Unexpected diversifications into an unrelated area may suggest that something is not right in the core business. Views on share buybacks can also be highly informative. Very few CEOs see this as a legitimate investment on a par with capital expenditure or M&A decisions, presumably due to an aversion to shrinking any aspect of the company. Many fear that buybacks are an admission that the company has run out of investment ideas. On this subject, we like to hear managers justify buybacks based on an internal valuation model, as this can then lead to an interesting discussion about valuation of their business. 

Forming impressions of the CEO’s character, intelligence, energy and trustworthiness can be gleaned using a variety of questioning techniques. Intellectual honesty can be tested by asking the CEO to pick out what he or she thinks is important. To unsettle the more promotional CEOs, we like to ask what is not working and wait to see whether they have given the matter much thought. Sometimes the boss will seek to evade responsibility by asking a colleague to talk about a problematic area of the business. The CEO in denial often blames problems on a divisional boss and follows up by saying that management has now been changed. How the chief executive interacts with colleagues, such as the CFO or investor relations personnel, often reveals their leadership qualities. We like to see signs of individual curiosity at meetings – revealed, for instance, by their taking an interest in our own business. Signs of humility – say a recognition of past mistakes – give us some confidence that the chief executive has a grip on reality. 

Appearances can also be revealing. A CEO of an industrial company who wears expensive shoes, or a snappy suit, is more likely to enjoy the expensive company of investment bankers than spend his time visiting factories and customers. Signs of vanity are generally off-putting. One CEO was spotted before a meeting carefully adjusting his elaborate bouffant hair style in our washroom. Several months later, he launched a large and foolhardy acquisition. 

Meetings can also provide insights into a management’s approach to costs. This frequently comes out in discussions about compensation. Learning about something as mundane as corporate travel policy can also tell us a lot. After Brazil’s AmBev took over the Belgian-based Interbrew, its managers told us about a new edict limiting business-class flights to those lasting six hours or more. This insight into corporate frugality was a pointer to the same management’s ability to cut costs at Anheuser-Busch – which prior to the merger sported a fleet of eight Falcon executive jets – and increase the US beer company’s operating margins by a massive ten percentage points (between 2005 and 2011). We were equally impressed to learn that senior executives at another company preferred the underground to chauffeured limousine when travelling around London. The number of IR representatives in attendance is a good indicator as to how carefully a company counts its pennies. Of course, we have made mistakes when assessing management teams. But, in our view, trying to spot a great manager remains a game very much worth playing.

Companies which provide indispensable services to their customers...

From Capital Returns (the excerpt below was from a Marathon letter in February 2015):

Companies which provide indispensable services to their customers often prove to be excellent investments 

The typical growth stock starts out with high returns, rising turnover, and glorious prospects, only to stumble in later years. The trouble is that profitable and growing businesses tend to attract lots of competition, especially when they operate in exciting areas, such as technology. Investors who buy growth at high starting valuations generally end up disappointed. There is, however, a certain class of company which we have found is well worth paying a premium for. Our preferred growth stocks undertake apparently unglamorous activities that are essential to their customers – so essential, in fact, that customers pay little attention to what they’re being charged. 

When Marathon encounters such companies, the common refrain of managers is that their products (or services) constitute only a small part of the customers’ total cost and yet are of vital importance to them. It may be that a particular component is “mission critical” for an industrial process or a company’s workflow. For instance, customers may face a very high cost if they have to shut down a production line when a crucial component fails. Hence, reliability weighs more highly than price. The product may also be essential by virtue of its quality, safety or performance attributes. 

Having a high perceived value for customers often combines with some other advantages, which limits competition, ensuring high and sustained returns. These may be economies of scale in manufacturing and distribution, regulatory barriers and high switching costs. Companies talk about “value based,” or “technical” selling, which often involves having highly qualified sales staff “embedded” in the R&D departments of their customers. Sometimes this means that the component is mandated for use over the lifecycle of a product, as is commonplace in the automotive and aerospace industries. 

...While the high profitability of the companies under discussion may be below the radar of their customers, it has not escaped the attention of investors. In the past, when we encountered such wonderful businesses we were prone to assume that high valuations meant they were fairly priced, or even overpriced, in the stock market. A few years later, however, when we reengage with the same firms, we often find that their share prices have shot up. When we first met with Spirax-Sarco in 2005, for instance, it was valued at 17.5 times earnings and the shares were trading around £8. We demurred. Five years later, at our next meeting, the stock was trading above £18. Again, we concluded that it was fully valued. Since then, the share price has almost doubled again. The lesson seems to be that a full price is often justified for high quality, “under-the-radar” businesses.

Five Good Questions for Edward Chancellor about the book "Capital Returns"

Link to video

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Related book: Capital Returns

Related previous posts:

Investors should be thinking 90% about supply...

More from Ed Chancellor on focusing on industry supply...

THE TENETS OF CAPITAL CYCLE ANALYSIS

Investing in a high-quality business...

From Capital Returns:

Investing in a high-quality company can seem dull and unrewarding in the near-term. The lower risk which comes from investing in quality companies is only properly observed over the long-term. The fact that investors are often focused more on the short-term is partly a function of psychology – the human brain is simply not attuned to multiyear planning, being far better at responding to short-term threats and stimuli. This is seen in several behavioural heuristics – notably hyperbolic discounting and recency bias. Short-termism can be intensified in an institutional setting. Performance-related pay for money managers at most investment firms is weighted to annual performance, which discourages long-term thinking. 

Finally, there is another more technical reason why the virtues of a high return business are not always fully appreciated by investors. This is the tendency of investors to focus on the income statement. This fosters a fixation on price-earnings (P/E) valuation metrics and not price to free cash flow (P/FCF). Thus, all earnings growth is seen as equal, even though it is materially more value creative when return on capital and cash flow generation is higher. Faced with a choice between investing in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.

Price and value...

From Capital Returns:

It should never be forgotten that, in its most basic form, investing is always and everywhere about price and value. Price is what you pay, says the Sage of Omaha, and value is what you get. By this definition, every serious investor must be a value investor. This is not to say that investors should restrict themselves to buying companies with low valuation multiples. The business of investment is ultimately about buying stocks at a discount to intrinsic value. 

So how do you calculate value? Well, in theory the value received is derived from future cash flows discounted back to today at the appropriate discount rate. The trouble is that we are rather poor at making predictions, especially about the future. But that doesn’t put us off. We suffer from what Nassim Taleb calls the “epistemic arrogance” – in plain English, we think we are better at making predictions than we really are. The result is that we have a misplaced sense of confidence in our forecasts. Investors like modelling because it appears scientific (the more spreadsheet tabs, the greater the effect). 

Investment models, however, encourage anchoring. Most models are calibrated to produce a current value for a company within a reasonable range of the current price. Another wrinkle is the discount rates. If you don’t accept that historical volatility (beta) is a good measure of risk (which we do not), then it’s not clear how to calculate the appropriate discount rate. At Marathon, we believe that detailed forecasting adds little value. 

One common response to the difficulty of forecasting is to turn to simple value proxies, such as the price-to-book ratio, price-to-earnings (PE) ratio, and free cash flow yield. Many “value” investors advocate buying a basket of stocks which are cheap by these measures. There’s nothing inherently dumb about this approach. Each of the measures is a very useful indicator of potential value, but there’s a danger of oversimplification. Traditional valuation measures say nothing about the specific context of an investment – for instance, a company’s business model, its industry structure, and management’s ability to allocate capital – which determines future cash flows. 

Quantitative valuation measures also tend to encourage a narrow categorization of investment styles. Take for example the S&P US Style Indices. Value stocks are defined by their ratios of price-to-book, price-to-earnings, and price-to-sales. The growth index, on the other hand, is defined by the three-year change in earnings per share, three-year sales per share growth rate, and 12-month price momentum. While some of these factors are powerful, they are too crude to be the sole framework for assessing value.

Links

TED Talk - Allan Adams: What the discovery of gravitational waves means (LINK)

Latticework of Mental Models: Switching Costs (LINK)

Marathon Asset Management – Culture Vulture (LINK)

Why stream Berkshire meeting online? To reach 'key financial centers around the world,' Buffett says [H/T Linc] (LINK)

This indie retailer is thriving thanks to Warren Buffett [H/T Linc] (LINK)

And as for Amazon.com, the scourge of smaller retailers everywhere? "People don't buy paint online," Greenberg said. "Paint spills. The freight (cost) is outrageous. Technology hasn't impacted our business in the same way it has many others."

Howard Marks' video segments from Bloomberg today (LINK)

‘Helicopter money’ on the horizon, says Ray Dalio (LINK)

Apple Versus the FBI, Understanding iPhone Encryption, The Risks for Apple and Encryption - by Ben Thompson (LINK)

Adam Grant continues to make the media rounds, this time talking to James Altucher about his book Originals: How Non-Conformists Move the World (LINK)

Asking more valuable questions...

From Capital Returns (the excerpt below was from a Marathon letter in March 2003):

While the case for long-term investment has tended to centre around simple mathematical advantages such as reduced (frictional) costs and fewer decisions leading (hopefully) to fewer mistakes, the real advantage to this approach, in our opinion, comes from asking more valuable questions. 

The short-term investor asks questions in the hope of gleaning clues to near-term outcomes: relating typically to operating margins, earnings per share and revenue trends over the next quarter, for example. Such information is relevant for the briefest period and only has value if it is correct, incremental, and overwhelms other pieces of information. Even when accurate, the value of the information is likely to be modest, say, a few percentage points in performance. In order to build a viable, economically important track record, the short-term investor may need to perform this trick many thousands of times in a career and/or employ large amounts of financial leverage to exploit marginal opportunities. 

And let’s face it, the competition for such investment snippets is ferocious. This competition is fed by the investment banks. Wall Street relies heavily on promoting client myopia to earn its crust. Why else would Salomon Smith Barney produce a research report which begins “We are focusing on the three month sales momentum model this month”; or Deutsche Bank publish a “Weekly Autos” review? Can there really be much of value to say about industry developments over such limited time frames? Of course not. Even so, we would hate to discourage such research as, from time to time, what the short-term guys are selling can turn out to be wonderful long-term investments. 

The operative word here is “quick.” The longer one owns the shares, however, the more important the firm’s underlying economics will be to performance results. Long-term investors therefore seek answers with shelf life. What is relevant today may need to be relevant in ten years’ time if the investor is to continue owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period. These principally relate to capital allocation, which can be gleaned from examining the company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions and so forth. 

Take marketing, for instance, which can be vital to long-term value creation, yet is often ignored. An understanding of the economics of line extensions and an advertising strategy would have proved useful to investors in consumer products companies. Colgate Palmolive introduced its first line extension – a blue minty gel – in the early 1980s, and supported this new product with a hefty advertising spend. This was Colgate’s first new toothpaste in a generation, and line extensions, which had been used successfully in other household goods, were novel to the toothpaste market. By advertising heavily, the firm hoped to change the buying habits of a generation of shoppers who would subconsciously think of Colgate as they approached the toothpaste section of a supermarket, and when they got there, would find a product which was new, superior and, because of advertising spend, trusted. 

We did not attend any Colgate meetings in the early 1980s, but if they were anything like their equivalents today the questions might have been along the lines of: what does the rise in advertising spend mean for margins next quarter (an almost worthless piece of information)? Or, how will the increase in depreciation from the new product line for minty gel affect earnings (yawn)? Brokerage reports following the meeting may have been like one which crossed our desks this morning, entitled “Thinking Outside the Box, but near term outlook remains dreary,” recommendation: under-perform. Few investors would have understood, and even fewer would have cared, about the transformation that was taking place. 

Even today, Colgate presentations do not mention the company’s advertising spend, which remains in excess of market share in all countries except Mexico, where market share is around 90 per cent. And this is despite 20 years of the firm demonstrating that line extensions and advertising support are powerful competitive weapons. “Most people don’t think it is important,” confessed the firm’s investor relations spokeswoman. Even though we don’t own the shares, Marathon is the only fund manager to have sought and gained a meeting with Colgate’s director of advertising and marketing. 

In the two decades since its first line extension, Colgate’s share price has risen 25 fold, handsomely beating the market. This shows how important it is for long-term investors to understand a firm’s marketing strategy. Yet, given the annual 100 per cent turnover in Colgate shares, very few of the firm’s shareholders have benefited fully from its success. And since Colgate’s investment returns didn’t outperform the S&P 500 in any meaningful way for a full ten years after the introduction of its first line extension, investors with short time horizons wouldn’t have cared about such matters. 

Why did so few Colgate investors stay the course? There are a range of psychological forces stacked up against the long-term investor. In particular, there is strong social pressure from peers, colleagues and clients to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by. J.K. Galbraith observed that: “nothing is so admirable in politics as a short-term memory.” Why should politics have a monopoly on sloppy thinking? Which makes us think that long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information.

Fade rates and the capital cycle...

From Capital Returns (the excerpt below was from a Marathon letter in March 2014):

Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one. From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons. 

Chart 1.7 illustrates the “fade rate” of corporate returns, an idea developed by Holt Value Associates (now part of Credit Suisse). Holt’s concept of the stock market-implied fade rate chimed well with our focus on competitive conditions within industries and the flow of capital into (and out of) high (and low) return industries. Using this framework, two purchase candidates are identifiable. Purchase Candidate A is a company capable of sustaining high returns beyond the market’s expectation (the upper dotted line) – that is, the company remains above average for longer than average. Candidate B is a company which can improve faster than the market generally expects (the lower dotted line). 

Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. For Purchase Candidate A, mispricing stems from a number of sources. One is the underestimation of the durability of barriers to entry. Another is the underappreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked. A recent meeting with the CEO of Bunzl, the leading specialist business-to-business distributor, was instructive in this regard. While sell-side analysts covering the stock have made reasonably accurate forecasts of returns from the core business, they have consistently failed to give management credit for adding value via bolt-on acquisitions, despite 20 years or so of supporting evidence. Investors also appear to be biased against “boring” high return companies, such as Bunzl, which do not offer the prospect of immediate high share price appreciation. 

Chart 1.7 The fade rate  

Source: Marathon, Credit Suisse HOLT. 

The conditions leading to Purchase Candidate B often stem from the market misjudging the beneficial effects of reduced competition as weaker firms disappear, either through consolidation or bankruptcy. Alternately, an unruly oligopoly may tire of excess competition and enjoy an outbreak of peaceful coexistence. The turn in the capital cycle often occurs during periods of maximum pessimism, as the weakest competitor throws in the towel at a point of extreme stress. When the pain of losses coincides with a depressed share price, investors can find wonderful opportunities, particularly if they are willing to take a multiyear view and put up with short-term volatility. 

Management skill at dealing with problems may also be overlooked. This is especially true when a new leader is recruited externally, maximizing the possibility of change. The turnaround achieved at Fiat by Sergio Marchionne in recent years is one outstanding example. Highly competent managers are often attracted by the challenge of turning around a troubled company, not least because of the financial rewards.

THE TENETS OF CAPITAL CYCLE ANALYSIS

From Ed Chancellor in his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15:

The essence of capital cycle analysis can thus be reduced to the following key tenets:

• Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply. 
• Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side. 
• The value/growth dichotomy is false. Companies in industries with a supportive supply side can justify high valuations. 
• Management’s capital allocation skills are paramount, and meetings with management often provide valuable insights. 
• Investment bankers drive the capital cycle, largely to the detriment of investors. 
• When policymakers interfere with the capital cycle, the market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle. 
• Generalists are better able to adopt the “outside view” necessary for capital cycle analysis. 
• Long-term investors are better suited to applying the capital cycle approach.

More from Ed Chancellor on focusing on industry supply...

From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15:

FOCUS ON SUPPLY RATHER THAN DEMAND 

Given that the future is uncertain, why should Marathon’s approach fare any better? The answer is that most investors spend the bulk of their time trying to forecast future demand for the companies they follow. The aviation analyst will try to answer the question: How many long-haul flights will be taken globally in 2020? A global autos strategist will attempt to forecast China’s demand for passenger cars 15 years hence. No one knows the answers to these questions. Long-range demand projections are likely to result in large forecasting errors. 

Capital cycle analysis, however, focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast. In fact, increases in an industry’s aggregate supply are often well flagged and come with varying lags – depending on the industry in question – after changes in the industry’s aggregate capital spending. In certain industries, such as aircraft manufacturing and shipbuilding, the supply pipelines are well-known. Because most investors (and corporate managers) spend more of their time thinking about demand conditions in an industry than changing supply, stock prices often fail to anticipate negative supply shocks [33]. 

ANALYZE COMPETITIVE CONDITIONS WITHIN AN INDUSTRY 

From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm’s profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt. Conversely, a focus on competitive conditions should alert investors to opportunities where supply conditions are benign and companies are able to maintain profitability for longer than the market expects. An understanding of competitive conditions and supply side dynamics also helps investors avoid value traps (such as US housing stocks in 2005–06). 

[33] Several accounting based measures provide insights into the capital cycle. As observed above, stocks with the fastest asset growth tend to underperform. When a company’s capital expenditure relative to depreciation rises above its average level it may be a sign that the capital cycle is deteriorating (see 1.4 “Supercycle woes” and Chapter 1, “A capital cycle revolution”). A rising gap between reported earnings and free cash flow is another warning sign (see 1.7 “Major concerns”). The Herfindahl Index provides a statistical measure of industry concentration which may reveal changes in competitive conditions. Anecdotal signs prove just as useful in gauging the capital cycle. It’s generally a bad sign when a company starts building a grandiose new head office (see 4.9 “On the rocks”)

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Related previous post: Investors should be thinking 90% about supply...

Investors should be thinking 90% about supply...

In one of the interviews Edward Chancellor gave recently, he made the comment below, which I think was probably the most practical investing lesson that can be used going forward:

Ed: And this interesting point is that people, I don’t quite know why, but they love to think about and project demand into the future. They love it, I suppose, because… well, they like projecting demand because demand is unknowable. And because it’s unknowable, then you can have any fantasy you want about it at all, optimistic or pessimistic. 

But given the nature of mankind, those would tend to be optimistic. So a huge amount of work goes into forecasting demand. As our mutual friend Russell Napier says, analysts spend 90% of their time thinking about and forecasting demand, and 10% of their time thinking about supply. 

Now, the interesting thing about supply is that supply actually can be forecasted because in most industries, it takes quite a while for the supply to come on stream. You can see how much assets have grown inside an industry, or inside any particular business. You can see it through any number of measures. 

Through IPO issues, through secondary share issues, through companies taking on more debt, through companies going through a boom, such as the mining companies or the US homebuilders, who have had a surge in profitability, and have reinvested those profits. 

You can measure it technically through looking at things, like current capital spending to depreciation ratios. Or you can look at it, for instance, the rate of reported profitability of a company to its cash flow, the so called cash conversion rate. And if a company is generating large profits, but not generating any cash flow, it’s probably in a negative phase of the capital cycle. 

So the point, to go back to what you were saying, is that investors, if they knew the right way to approach, would be thinking 90% about supply, and then fantasising 10% about the completely, or not quite completely, but more or less completely unknowable demand side.

In his introduction to the book Capital Returns he gives several recent examples where a focus on supply instead of rosy demand projections would have allowed one to better grasp the risk one was taking investing in particular stages of those industry cycles, including the telecoms in the late 1990s, shipping in the 2001-2007 period, and the homebuilding industry that peaked in 2006. The below excerpt on the homebuilding boom is a good example showing the capital cycle and the importance of focusing on industry supply:

Rising house prices after 2002 prompted another capital cycle in the US homebuilding industry. By the time the US housing bubble peaked in 2006, the excess stock of new homes was roughly equal to five times the annual production required to satisfy demand from new household formation. Spain and Ireland, whose real estate markets had even more pronounced upswings, ended up with excess housing stocks equivalent to roughly 15 times the average annual supply of the pre-boom period. Whilst under way, housing booms are invariably justified by references to rosy demographic projections. In the case of Spain, it turned out that recent immigration had largely been a function of the property boom. After the bubble burst and the Spanish economy entered a depression, foreigners left the country by the hundreds of thousands. 

Several well-known “value” investors who ignored capital cycle dynamics were blindsided by the housing bust. In the years before US home prices peaked in 2006, homebuilders had grown their assets rapidly. After the bubble burst, these assets were written down. As a result, investors who bought US homebuilders’ stocks towards the end of the building boom when they were trading around book value – towards their historical lows – ended up with very heavy losses [5]. From a capital cycle perspective, it’s interesting to note that although UK and Australia experienced similar house price “bubbles,” strict building regulations prevented a supply response. Largely as a consequence, both the British and Australian real estate markets recovered rapidly after the financial crisis [6]. 

[5] For instance, the large US homebuilder KB Home experienced a 28 per cent compound annual growth in assets between 2001 and 2006. By summer of 2006, its shares were trading at 1.2 times book. From that point, KB’s book value declined by 85 per cent, and its shares, already well below their peak, fell a further 75 per cent 

[6] The fact that UK housing supply didn’t respond to the British housing bubble is reflected in the superior performance of UK homebuilding stocks relative to their US counterparts over the last decade

Ed Chancellor on the capital cycle...

From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15, which was released in hardcover today:

Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter’s process of “creative destruction” – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing. 

The key to the “capital cycle” approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side. In his book, Competitive Advantage, Professor Michael Porter of the Harvard Business School writes that the “essence of formulating competitive strategy is relating a company to its environment.” Porter famously described the “five forces” which impact on a firm’s competitive advantage: the bargaining power of suppliers and of buyers, the threat of substitution, the degree of rivalry among existing firms and the threat of new entrants. Capital cycle analysis is really about how competitive advantage changes over time, viewed from an investor’s perspective.

Avoiding promotional management...

From Capital Account (and written by Marathon in December 2002):

We suspect that business leaders who are busy promoting themselves or their stock are not properly focused on running their companies. We go out of our way to look for management that cares about shareholder value but doesn't hype its stock. In this respect we admire Johann Rupert, the CEO of Richemont, the luxury products group, who advises against the corporate hard sell on the grounds that 'if you talk up the stock, when the price comes down, the folks come looking for you!' All too often, however, denial and a desire to 'spin' the most optimistic message gets the better of truth in meetings with shareholders. Bad news is rarely telegraphed in advance. One learns to apply a filter to all promotional noises and avoid those companies whose executives seem most talented in the art of spin.

……………….

And in case anyone has missed it, the more recent set of Marathon letters is available in the book Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15.

Keys to successful investing...

From Marathon Asset Management's Neil Ostrer in an interview with Vanguard last year, and probably worth taping on a wall next to your desk:

There are three keys to successful investing. First, being a contrarian with a long-term perspective is very important. Second is the ability to be open to new ideas combined with a skeptical approach to those people incentivized to sell these new ideas. Third, having the ability to focus on what matters, while ignoring what doesn't, is important. 

Adding more information to an investment thesis may improve confidence in a decision but not necessarily accuracy. Dr. Herbert Simon, 1978 Nobel Prize winner, is quoted as saying, "A wealth of information creates a poverty of attention." 

That idea is particularly important to bear in mind in a time when information, data, and models are becoming more complex and readily available, yet the percentage of active managers with a track record of outperformance relative to the market hasn't increased.

[H/T Corner of Berkshire & Fairfax]

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Related books:

Capital Account: A Fund Manager Reports on a Turbulent Decade, 1993-2002

Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15

The Characteristics of Easy and Difficult Turnarounds

In his 1979 letter to shareholders, Warren Buffett wrote:

Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.

In 1990, he also wrote:

Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: “When the phone don’t ring, you’ll know it’s me.” 

And while they seldom turn, and it may in general be best to avoid them, there are certain characteristics that may make the likelihood of success increase should you find yourself looking at or involved in a turnaround. I think the excerpt below, from the book Capital Account, captures those characteristics about as well as anything, and it makes a great addition to any kind of turnaround checklist:

Evaluating the likely success of a corporate turnaround is a notoriously difficult activity for investors. They need to distinguish between easy and difficult turnarounds. In almost every case, however, they must start by understanding how the firm got into trouble in the first place. Most troubled companies can only hope to recover once management open-mindedly appraises the situation -- when there is a mood of denial, turnarounds are unlikely. This explains why successful new starts are so often associated with fresh management, usually from outside the industry.  

 

In Table 5 we rank the factors to be considered when evaluating corporate turnarounds by importance. After the honesty with which management addresses the problem, we consider the second most important issue is the level of investment. A successful turnaround should not need large levels of new investment. After all, why risk throwing good money after bad? 

… There is no shortage of poorly performing companies that appear cheap on paper. But it’s how management allocates capital that determines the success or failure of any turnaround.  

… Firms with short product lives, such as speciality retailers and technology firms, face an uphill battle. Miss a fashion trend or a technology leap and it is very difficult to catch up.  

… To sum up, the three most favourable characteristics for identifying the probability of success in a corporate turnaround are: intellectually honest management, good capital allocation (preferably declining levels of investment) and a robust core business. 

……………….

And in case anyone has missed it, the more recent set of Marathon letters is available in the book Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15.

The balance between an openness to new ideas and a healthy skepticism...

This is from the book Capital Account and was written in 2001 during the tech bust, but it is probably timely for many technology companies today as well:

The challenge for investors is to distinguish the genuine innovations which create sustainable competitive advantage for companies and value for shareholders from the MacGuffins of this world. This requires a balance between an openness to new ideas and a healthy scepticism. In the last few years, we have seen many new investment concepts turn out to be nothing more than flagrant promotions. Even in the more questioning times that lie ahead, an aptitude for spotting absurdities in the stock market -- the financial equivalent of devices for trapping lions in Scotland -- remains an invaluable component in the fund manager's tool-kit.

Links

Warren Buffett: The Oracle of Nebraska Shares His Wit and Wisdom With Business Students [H/T Linc] (LINK)

Vegas Casinos Can Fire Buffett's Utility -- for $127 Million [H/T Linc] (LINK)

An excerpt from Michael Lewitt's The Credit Strategist (via John Mauldin), "Be Careful Out There" (LINK)

Commodity prices are plunging, the dollar is powering higher, the yield curve is flattening, ObamaCare is collapsing, global trade is plummeting and terrorism is spreading across the globe. The high yield credit markets are sending distress signals and 10-year swap spreads are negative. Energy companies are going out of business faster than you can say “frack” and trillions of dollars of European bonds are again trading at negative interest rates. The world is drowning in more than $200 trillion of debt that can never be repaid while European and Japanese central bankers promise to print more money and the Federal Reserve is being dragged kicking-and-screaming into raising interest rates by a paltry 25 basis points. Accurate pricing signals in the markets are distorted by overregulation, monetary policy overreach and group think. Hedge funds are hemorrhaging and investors, desperate to generate any kind of nominal return on their capital, continue to ignor e the concept of risk-adjusted returns. Some market strategists believe this is a positive environment for risk assets; I am not among them. 

... 

Companies in the United States have taken advantage of low interest rates to issue record levels of debt over the past few years to fund buybacks and M&A. This has driven the total amount of debt on balance sheets to more than double pre-crisis levels. However, cash flows have not kept pace, resulting in leverage metrics that are the highest in 10 years.

I missed these earlier, but Jake Taylor's latest Five Good questions interviews were with Dorie Clark about her book Stand Out, and with Wesley Gray about his book The DIY Financial Advisor. And then released today was his interview with Kabir Sehgal about his book Coined.

For print books at Amazon, you can use the coupon code 'HOLIDAY30' to get an extra 30% of that print book (up to $10 value) if you order over weekend. So while it wouldn't ship until next month, it looks like it'll save you $10 on a more expensive book like Capital Returns. I used my code on a cheaper option from Vaclav Smil: Prime Movers of Globalization: The History and Impact of Diesel Engines and Gas Turbines.

And for the next few days, Audible is having a sale with 300+ books priced at $4.95. After going through the list, here are some that I've either listened to and liked or that look interesting:

Misbehaving: The Making of Behavioral Economics

Bird by Bird: Some Instructions on Writing and Life

Why Zebras Don't Get Ulcers: The Acclaimed Guide to Stress, Stress-Related Diseases, and Coping

Meditations (only $2.99)

Do More Faster: TechStars Lessons to Accelerate Your Startup

Lawrence in Arabia: War, Deceit, Imperial Folly, and the Making of the Modern Middle East

The Fellowship of the Ring: Book One in The Lord of the Rings Trilogy [A classic work of fiction with a highly-rated narration.]

What It Is Like to Go to War

Means of Ascent: The Years of Lyndon Johnson

The Curious Incident of the Dog in the Night-Time

Medical School for Everyone: Grand Rounds Cases